4 Strategic Startup Risk Components For Investors

Investors are looking at these four things (whether they realize it or not).

Most startups fail.plane crash

The latest SBA stats give you 1:3 odds your new company will last 10 years, and 50/50 you’ll even make the first five.

So why does anyone invest into an asset class that is so high risk?

Because if you win, there’s nothing like it. You take home a crap-ton of money and you feel like a genius at the top of the world. But in order for that to happen, you have to swim in the high-risk/high-reward end of the pool.

This article outlines four key components of how investors perceive risk and how entrepreneurs can mitigate those risks and increase their chances of building an investment-worthy company.

This is a resource page for FINAN 6300: Venture Capital: Financing New Ventures at the University of Utah. If you’re taking the class—you’re in the right place! If not, feel free to browse.


Table of Contents

  1. Intro
  2. Product Risk
    1. Market cycles and minimum product development
    2. Do you have something ready to sell?
    3. Different, better, special: differentiated competitive advantage
    4. Can it scale?
    5. The product risk spectrum
  3. Market Risk
    1. Is anybody buying?
    2. Do you understand your CAM
    3. Beyond CAC, scalable unit economics
    4. The market risk spectrum
  4. Team & Execution Risk
    1. Bet on the Jockey
    2. Leadership Brand Commitment & Sacrifice
    3. The founder’s dilemma
    4. How many millions are enough?
    5. Growth attributes
  5. Financial Risk
    1. The Economic Model
    2. The Investment Model
    3. The Founder’s Journey
    4. Valuation Basics
    5. The End From the Beginning
    6. The Capital Stack
    7. The Debt Stack
    8. The Equity Stack
    9. Hybrid Financing


Intro

I like to think of startups as the X-games of business.

If you want to really know a person, do a startup with them—the adrenaline rush, the intensity of emotion, the camaraderie of team wins and losses, and that bleeding edge of what’s new in the world can induce a perpetual flow state; if that’s your thing, then startups might be for you.

Startups = the X-games of business

The downside is equally extreme: financial Armageddon, lawsuits, ruined relationships, tolls on your health and intense psychological and emotional pain. (See The Struggle, Ben Horowitz.)

Ben Horowitz describes the struggle for entrepreneurs

Nobody likes playing house odds. The business of investing in startups actually has low odds of success. So, how do investors tip the scales in their favor?

No two investors I’ve dealt with would describe their approach to a deal in exactly the same way. But overtly or not, they are evaluating these four strategic components of risk. The flip side is that these are also components of strength. In other words, if your company is strong in these areas, investors will perceive that as less risky and more investment-worthy.

Raising money as an entrepreneur isn’t about somehow hoodwinking investors into giving you money. It’s about creating real value in your company, and then being able to communicate it.

An early mentor introduced me to the four components of risk, which are Product, Market, Team & Execution, and Financial risk..


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Product Risk

Market cycles and minimum product development

A product (I use product and service interchangeably here) is a thing that empowers people to do something they couldn’t do without it.

When that thing is important to the customer, its described in terms of need. How you deliver your product and fill that need is how you create customer value, which is the key driver of your business success.

But products don’t just appear out of thin air.

idea

Products start as ideas; what could be more ephemeral? Between that flash of inspiration and a real tangible product—the kind that creates enough value that customers want to pay you for it—is a lot of work.

Over the venture capital industry cycles, sometimes the expectation for how mature a product ought to be for the company to be considered for investment has fluctuated. But through all of the industry ups and downs, the more developed your product the less risky it is.

Companies that raise money while still trying to figure out their product/market fit often become money pits for investors. Sometimes receiving investment too early is detrimental to these companies. Instead of being forced to nail a product the customer wants, the founders are perennially returning to the well with tales of how they are right on the cusp of delivering some Earth-shattering new product, if the investors would just pony up another $10 million.

Additional Resources:
On Product/Market fit for Startups, Marc Andreessen
Answers to Your Tough Questions About Growth, Brian Rothenberg


Even companies that went for years without producing revenue, big names like Facebook, Twitter, Snapchat and Pinterest, won investment by showing that they had a product that people wanted and that was mature and compelling enough to attract high numbers of users.

Do you have something that can be sold?

An early benchmark in reducing Product Risk is the point where the product, or at least an MVP is developed and ready for sale.

Crossing that threshold drops risk for investors by an order of magnitude and entrepreneurs sometimes miss the importance of the customer-ready benchmark. It is pretty straightforward to say that something you can sell is more valuable than blueprints or prototypes, but many companies seek to raise money or make commitments (e.g., pre-orders on Kickstarter) before their product is fully developed. That’s okay, it just means much higher risk.

Show, don’t tell

Nobody wants to buy a car until they take it for a test drive. Nobody wants to buy a racehorse until they see it run.

Nobody wants to buy a car until they take it for a test drive.

Showing your product in action is the best way to communicate its value to investors.

During a Q&A session at the Presentation Summit in 2015, Guy Kawasaki responded to a question about whether he’d seen a great presentation by entrepreneurs overcome company weaknesses when they were seeking investment. Guy said, he’d never seen a presentation itself win him over, but that many pitch weaknesses could be overcome by a great demo.

The demo is where the investor gets a sense of the risk or the potential of a product. After the demo, investors are masters of their own imagination around the product’s potential. They may see opportunity in taking the product in an entirely different direction that the founders have in mind (a recurring theme both in the real world and on Shark Tank).

To win the point that your product risk is low, you need to give investors a test drive.

By the time you’re giving a first demo, you’ve already cleared enough hurdles and generated enough interest that you’re face to face or in a web meeting. Remember when it’s demo time, it needs to be short. There may be a time for a deeper dive, but that first introduction needs to be brief and impactful.

An interminable demo with an inappropriate level of detail will stretch attention spans, cause a loss of retention of the information you have already covered, and leave the investor with a negative emotional sentiment after the meeting.

Oren Klaff in his book, Pitch Anything, makes the compelling point that if it only took 5 minutes for Watson and Crick to present their Nobel Prize-winning idea of DNA’s double-helix, the essence of all life on earth, then you ought to be able to pitch anything in 15-20 minutes. He says any longer than that and your audience is starting to lose information you have already given.

Watson-Crick-DNA-model

Watson & Crick demo the double helix

Different, better, special: differentiated competitive advantage

To get a true sense of the product risk you have, ask yourself a few questions. Every product lives in a competitive space. What risks does the company face from competitors? A product with a great value proposition offers customers something unique when compared against the competition. How do you stack up against others vying for the same customers and taking aim at the same market share?

Are there significant first-mover or exclusive advantages associated with your product over the competition’s? Does the company have sunk infrastructure or development costs that a new entrant would have to shoulder in order to compete? What is the major competitive advantage in terms of the marketing mix (product, place, price, promotion)?

The competitive environment is never static; what are the chances of new entrants? What protection do they have against imitators? Are there patents, copyrights, trademarks or other intellectual property (IP) protections to prevent this? Is the ownership of the copyrights or patents clear and undisputed?

At a minimum, your product must be different, better or special to be compelling. Explosive growth companies also fit into one or more of three types of differentiated competitive advantage. Market disruptors, market shapers, and category killers.

differentiation.001

Market disruptor

Is the product a market disrupter? Will the product be a disruptive force in its industry? Will it create an entirely new category where none existed? Products that actually change consumer behavior (like microwave ovens, TiVo, or YouTube) are stellar examples of products that took an existing idea and created an entirely new category from it—a category where they enjoyed first-mover advantage. Other examples of companies or industries that were able to create this type of advantage are Cirque de Soleil, eBay, JetBlue, or FedEx.

Market shaper

Will it shape an existing market? Will it introduce a solution that can completely dominate an existing market segment or redefine it? This advantage is not about creating something entirely new: it is about recreating something, morphing something that already exists into a new incarnation. A company must ask itself if it can enter the market or reinvent itself with such force that it effectively takes over an existing market? Companies that have done this include Netflix, Starbucks and Harley Davidson.

Category killer

Is it a category killer? Will your solution dramatically improve an existing model, by being cheaper, faster or better? The Home Depot is an example of this. The big box format is far better suited to the needs of modern consumers than the small community hardware store. So while The Home Depot and Lowe’s have grown into giants, the corner stores have had to consolidate under co-op franchises like Ace Hardware and True Value just to survive.

Dell is another example of a category killer. Computers were not new, but IBM’s model of selling strictly through value-added resellers (VARS) was not nimble enough to account for how fast the industry was developing. Dell introduced a direct model that kept obsolete products out of the value chain and flipped the cash cycle upside down (they got paid for custom built computers before they had to pay their suppliers for the parts). Once Dell dominated the industry for business PCs, it relegated Big Blue to mainframes and service contracts. (There is also a lesson here in understanding that distribution channels are easy to set up in the beginning, but very difficult to change downstream.)

The most powerful solutions combine more than one of these. Google, for example, did not create a new category—search engine technology had existed for years—but because of its algorithm and improved technology, it did dominate the segment and improve on an existing model.

Apple’s iPod actually did all three. The iPod revolutionized music and audio entertainment consumption and changed both the way consumers combined their entertainment with their computers, as well as disrupting the entire music industry and creating a market for individual tracks, independent musicians, and digital audio instead of traditional compact discs.

Can it scale?

To generate the returns VCs need, you’ve got to be ready to go big. You can’t do that if your product doesn’t have a big market or if your mechanism for making and delivering the product can’t scale.

In Nail It Then Scale It, Paul Ahlstrom and Nathan Furr encourage entrepreneurs to ask about the severity of the pain your product addresses in the market. Is the pain your product solves mosquito bite-level pain, or shark bite-level pain? One is an annoyance; the other is one that must be avoided at all costs.

Another common view of this is vitamins versus painkillers. No matter how good for the end user, vitamins will never have the urgency of painkillers. Which is why family dentists earn $100 per hour and endodontists (who perform root canals on people in the worst kind of pain) earn $900 per hour or more. If lots of people view your solution as the answer to a problem that causes them serious pain, you’ve got scalable demand.

vitamins

The second half of that question is whether you can meet the demand. How well developed are the external resources that affect the product? Are there economies of scale, or diseconomies of scale that affect the company’s ability to maximize growth?

Are the suppliers stable and reliable? Are your relationships strong with those suppliers or tenuous and risky? What impact would an unexpected price increase somewhere in the value chain have on the company’s ability to produce the product and on profit margins? What if a current supplier was to go out of business? What would it mean if the company negotiated better trade credit terms? Are the key components of the product single- or multiple-sourced?

Can your IT infrastructure scale? Are your processes automated and machine driven, or do they require human interaction? If you had 10x or 100x your current number of customers, what would break?

Is there a rationale for vertical integration, where you are able to take control over another part of the value chain and provide that component for less than you are paying currently? What is the outside production capability of the company or the sourcing company? Does the company’s financing plan support the production and development of the product?

Investors are used to thoroughly vetting product risks. They look to see if there are or will be problems with inventory: Are there potential monetary risks and liabilities associated with the product? Does the company have product liability insurance? Has the product undergone third-party testing? What are the results of the testing? What are the capital expenditures to produce the product and support it?

Are the products or services too diversified or too concentrated from a risk perspective? Is there a technology risk (imitation, obsolescence or failure) to the product?

The Product Risk spectrum

At one end of the spectrum, the riskiest end, you have products that exist only as concepts or designs. At the other, you have a company that not only has a product fully developed and ready for sale, but one that has a roadmap and a product development process in place for delivering subsequent iterations or even wholly new products in order to fuel growth.

Products follow a lifecycle. Thanks to Everett Rogers, we have a similar chart on the diffusion of innovations which is sometimes called the technology adoption cycle, (the root of Geoffrey Moore‘s infamous chasm).

product lifecycle.001

The full term of the lifecycle can be long or short, but sooner or later the product you make today will stop attracting customers. Companies need to know where the next products will come from well in advance of the decline of its current offerings.

Ask yourself, where is my product in the product life cycle (introduction, growth, maturity, decline)? Has it gone through successive iterations? Where ought this product go in the future? Are there synergies that you can exploit in development, experience, brandwidth, supply chain, or otherwise?

Ask yourself objectively about where your company stands in terms of the development of your solution. What products does the company depend on for its business and what could be sacrificed? What is the expected longevity of these core products? What is the best plan for the time when these products decline? Are there additional products currently being developed? How long would it take to develop the next version? What’s the approach to R&D? Are these responsibilities defined and in place? Is the company supporting R&D with the required resources?

The next component of risk to consider, is Market risk.


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Market Risk

They call marketing the dark arts.

Let’s look at demystifying some marketing basics—the core basics that drive your business’s revenue generation and signal risk to investors.

I approach these basics with three questions: Has the company sold anything yet? If so, how well do you understand the process for how customers buy? And, how will that process scale?

Is anybody buying?

Has anyone ever bought your product?

That’s the first milestone.

Maybe the company has working prototypes. Maybe it’s still developing its  Minimum Viable Product (MVP)? Maybe the company is working with some beta customers and giving them an early version of the product for free. Maybe the company is financing its proof of concept.

There are legitimate pre-revenue stages that a company may go through. But the risk drops tremendously with that first sale.

purchase

Even though the first sale doesn’t tell you the potential of the product (i.e., how many sales the solution will eventually generate), it does show that someone somewhere is willing to pay for it. And that’s something.

More than just hitting the benchmark, there is a lot of useful data in the process behind that first sale. The process by which you acquire customers (and thereby revenue) is your Customer Acquisition Model (CAM). Identifying your CAM is understanding the systematic repeatable process by which customers buy from you. It is your key to growing revenue. It’s the lifeblood of your company.

The process by which you acquire customers is your Customer Acquisition Model (CAM)

In my experience, most companies cannot articulate their CAM. That poses a real obstacle to rapid growth.

Do you understand your CAM

Take the process apart and examine it. Understand and measure the who, how, why, where, what and when of a purchase.

Can the company diagram the customer acquisition flow, show that it is a replicable process, and that it knows and can control the levers that drive a customer purchase? Is this model repeatable?

I find it helpful to view the CAM from two perspectives: the company point of view  and the customer point of view.

Company POV

The Company POV is the company-centric model of how customers find you and make purchases. This is typically modeled using a diagram of your sales or marketing funnel. In B2B software sales, it typically looks something like this.

pipeline2

 

The model involves some type of lead generation for a sales team. MQL and SQL are Marketing Qualified Leads and Sales Qualified Leads respectively. Approaches vary, but there will be some measurable distinction to indicate how a prospect moves through stages as he/she is becoming increasingly more likely to buy.

Additional Resources:
Predictable Revenue, Aaron Ross
SiriusDecisions Demand Waterfall
What a Great VP of Sales Actually Does, Jason Lemkin
How to Track Customer Acquisitions, Myk Pono

To understand this model, calculate how many leads enter the top of the funnel. Then calculate the conversion rate at each stage, i.e., divide the number of prospects that make it to MQL by the number that entered the top of the funnel as leads.

Follow this through until you know how many leads it takes to generate each closed sale.

Why is this important? A clear understanding of your CAM allows you to tackle the financial implications and calculate your next critical metric—how much it costs to acquire one new customer. This is your Customer Acquisition Cost (CAC).

Look at how much it cost you to generate the leads for a single sale. That is your CAC. Make sure the cost is fully burdened and broken down with every expense associated with getting one unit of your product into the hands of one customer. The cost of acquiring customers does not just include advertising, but everything involved in getting that customer to make a purchase. That means the cost of the sales force, sales and marketing materials, costs involved in simply competing in the market, and equipment used in the sales process (anything from laptops to trade show booths).

Note: When you are focused on growth, you need to know the difference between sales that represent new customers, and your repeat business. CAC always refers to the cost to acquire a new customer—someone who is making their first purchase.

Cost per Sale (CPS) can be used but you need to specify whether you are looking at your new CPS or renewal/repeat CPS. In many cases they will be different.

Customer Point of View

The Customer POV of your CAM is buyer-centric. This is important because viewing the CAM from the buyer’s perspective can illuminate important steps or interactions you may miss from your naturally subjective point of view.

The current vernacular for this is the Customer Lifecycle or Buyer’s Journey, meaning a map used to capture and model the steps a buyer (or in the aggregate, each Buyer Persona) goes through to buy from you. These are actions the customer takes that indicate their progress toward purchase.

This look at the funnel describes measurable stages of purchase psychology which your prospects move through on their way to becoming customers. There are many versions of the model, but it is common for it to include some variation of the following stages.

funnel

The earliest stage in marketing funnels (and buyer’s journey maps) is almost always awareness (Lavidge & Steiner, 1961). That’s because it’s pretty straightforward logic that your customers cannot choose to buy a product or service that they don’t know about. You’re not yet included in what marketers call the prospect’s consideration set (Shocker, Ben-Akiva, Boccara, Nedungadi, 1991). In other words, for them you do not yet exist.

After awareness, the customer begins making judgments about your product, developing esteem for your brand, and ultimately making a purchase decision. .

Additional Resources:
What is a Buyer Persona?, Adelle Revella—Buyer Persona Institute
4 Ways to Model the Buyer’s Journey, George Stenitzer
How to Build an Experience Map, Niall O’Connor

A true understanding of your CAM requires that you blend outside and inside perspectives. Once you understand your CAM, the next question is whether or not it will scale.

Scaling the CAM

Will your customer base grow?

Some processes scale beautifully, while others break down and don’t scale at all. Barriers to scalability magnify risk.

To convey low-risk, companies must have a feasible way to scale their CAM. After analyzing the CAM ask, are the sales and revenue requirements and projections for scaling 10×, 100× or 1,000× reasonable considering the analysis? You have calculated your CAC. How does that play at scale?

It’s common for entrepreneurs to make errors if they haven’t analyzed their CAM this deeply. For instance, the illustration below explains that if it costs $20 to acquire a new customer and the company has a sales and marketing budget of $50,000 dedicated to acquiring new customers—but projected sales growth that indicates a gain of 1 million customers—expectations and allocations are out of whack. Because we know that $50,000 is only enough budget to generate 2,500 new customers.

marketing math

How does the cost of each customer impact the larger economic picture?

Unit Profitability

There is a lot of variability in business models, distribution channels, and how customer needs are met. In analyzing scalability, I like to start granular with unit economics. What are the economics of selling a single unit of the product? I’m a believer that understanding the micro leads to understanding the macro—so I start small.

Let’s say I’m a textbook publisher. I have one title (we’re just getting started). It sells for $100—I know, textbook prices, amiright? Then it costs $20 to produce one copy of the textbook. That includes all my variable costs like raw materials and binding, royalties to the author, etc. which is called my Cost of Goods Sold (COGS).

Price ($100) – COGS ($20) = $80 of gross margin. Sweet!

Gross margin on a per-unit basis is often called contribution margin because it represents the amount of contribution each sale makes to covering fixed and selling expenses.

Let’s say I have $40 in fixed costs that I need each domestic sale to cover. My fixed costs are things like rent, equipment, payroll, etc.

Note: on an Income Statement, marketing costs are typically rolled into Selling, General & Administrative (SG&A) expenses, but for our purposes we want to look at them separately.

One way to look at this is to say, my current CAC is $20.

Price ($100) – COGS & Fixed ($60) – CAC ($20) = Profit ($20) Yay!

Pricing models built around each sale paying its fair share like this are called full-cost pricing models. But the competitive landscape is fierce and businesses have tried some more creative things.

For instance, I could look at this same model and instead of saying I have $20 in CAC, I may say, I have that plus $20 in profit margin I can use to compete for customers. I can discount my textbook, use more expensive marketing techniques, etc. and as long as I stay below $40 in total CAC, I’m profitable.

Using my textbook company as an example (following real-life textbook companies), I may find that my business in the U.S. is sufficient to cover all my fixed costs. But I know there is demand for textbooks in foreign markets. Since my fixed costs of $40 are covered by domestic sales, I now have an extra $40 to use to compete for foreign customers. Any sales I make will add incrementally to my top line!

I’ll drop my price by $50 and spend $30 (i.e., more than for foreign sales) in CAC. Now the textbook that sells for $100 in the U.S. is priced at $50 in the foreign market. This is called variable-cost pricing, because I only have to cover my variable costs on sales made in the foreign market.

If a customer only ever buys once from you, this is where we stop. I don’t get many students buying the same textbook a second time. So for that example, I’ve got to make the business scale on single purchases.

But what about businesses that generate significant repeat purchases?

New vs. Renewal

Ultimately, you only have three levers to pull to increase sales and revenue:

  • More new customers
  • More transactions per customer (frequency)
  • More money per transaction (average ticket)

So where should companies focus in order to maximize their growth? New customers or existing ones?

Marketing executives are quick to offer statistics about how much more it costs to acquire a new customer than to maintain an existing one (typically the statistic falls between 6 and 10 times). This logic would tend to have you focusing primarily on existing customers.

The statistic that is often overlooked is that efforts to increase the average purchase size (often referred to as share of wallet) are nearly four times better at generating revenue than loyalty or frequency programs.

Costco is great at this. I used to think that these guys were nuts. I buy a 10 gallon bottle of shampoo and I don’t go back for a year. I thought they were losing on frequency. Then someone pointed out to me that Costco doesn’t need me to go back for a year because they just captured 100% of my shampoo purchases for the year in a single transaction!

In B2B SaaS software sales (where I spend a lot of my time) we do something similar. We try to capture buyers for extended periods by selling in annual recurring contracts. The goal is to capture the maximum dollars the customer is planning to spend in the fewest number of transactions.

If share of wallet campaigns typically generate four times the revenue of retention programs, dollars spent purely to acquire new customers generate nearly three times more revenue on average than programs designed to increase the average ticket.

That means you can typically grow sales 11 to 12 times faster by focusing on new customers than you can by simply massaging your existing ones. In terms of priority and cost, your growth depends primarily on acquiring new customers.

New v Ren

Note: In the old days, software was primarily sold on-premises via the installation-and-maintenance model. Customers would make a large up-front purchase to buy software and have it installed on their local servers. This was then followed by an annual maintenance contract, typically 15–20% of the initial purchase price that recurred every year.

The SaaS model simplified this tremendously by making annual (or monthly) renewals the same price as the first year. Renewals effectively only differ because there are no new CACs, which simplifies calculating the LTV (see below).

Although not as expensive as attracting this customer in the first place, I may have some cost to maintain the customer due to my loyalty program or continued advertising.

 

CAC/LTV the “Magic Ratio”

When you look at a customer over their entire relationship with your company—initial purchase and all subsequent repeat purchases—you arrive at the Lifetime Value (LTV) of a customer.

Beyond just the profitability of selling a single unit, now you can see how much the entire relationship is worth. This means you can see not just what you can spend to make one sale, but what you can spend to acquire the customer. Counterintuitively, this means you may lose money on the first, or even some of the subsequent sales, but you will ultimately profit by acquiring the customer. LTV is the present value of all future profits that customer will generate.

Here’s a graph of the relationship between CAC and LTV.

CAC LTV

(A more detailed look at LTV/CAC here.)

AOL Example

Back in the 1990s, Steve Case was CEO and Chairman of a company that understood this—America Online. AOL had their model figured out. It started with a marketing process that involved flooding the world with CD ROMs.

Not every CD would generate a customer. A lot of these CDs went straight into America’s trash cans. Some of them even found their way to more creative ends, like Christmas tree ornaments, or rear-view-mirrors, but AOL knew that a certain percentage of them would find their way into the CD ROM drives on America’s computers. Some people would load the software, use the free trial offered there, and then a certain percentage of those would stay on with AOL as paying customers.

In 1997, AOL was signing up 75,000 new customers per week (at a time when only 11 percent of U.S. households had Internet access).  AOL’s CAC was $93. At an average revenue per customer of $18 per month, they would break even in the sixth month.

The expected customer lifecycle was 42 months. That meant their customers had a LTV of $756.

AOL could compare its cost for each customer with what each customer was worth. By also incorporating their cost of capital, they could determine what they needed to spend on customer acquisition in order to match their marginal revenue to their marginal cost and achieve the most profitable growth.

AOL was taking advantage of the arbitrage between their CAC and LTV by artificially extending the breakeven period to 24 months, so they could cycle more of their revenue into growth.

Additional Resources:
Calculating LTV and CAC for a SaaS startup, by David Skok
The Dangerous Seduction of the Lifetime Value (LTV) Formula, Bill Gurley
In Defense of the Lifetime Value (LTV) Formula, J.J. Colao

You can evaluate how much growth you can fuel with your own profits versus using outside financing. If you need outside financing, you can tell how much you need to scale to a certain point. 

Ask Yourself:

In evaluating Market Risk for a company, ask yourself: What is the mechanism for acquiring the very next customer, and then the next 100 customers? Is it so-called Salesforce math—knowing that each sales rep can produce so much revenue, so scaling is about hiring the right number of salespeople? Is it winning retail shelf space or the competition for package appeal? Is it infomercials and call centers? Is it your digital marketing strategy via organic SEO for your website, or Google AdWords?

For example, what is the pricing structure? Is the pricing in line with the segment of the market that the company is targeting? How does the pricing structure compare with the competition? What are the barriers to entry into the markets? Does the company have a competitive advantage over the competition? If so, what is that advantage?

What is your advertising model and where do you get the most bang for your buck in terms of new customer acquisition? What are the limits of this advertising channel? Can it reach a sufficient number of new customers to meet your growth projections or do you need to budget for trials in additional channels?

The power of a brand, either your own or an associated brand, can have a huge influence as companies pursue their growth. Is there a brand name or names associated with your product or service? Does the company have any third-party endorsements, which allow them to lean on the brand strength of another firm, product or individual?

Can the company describe the distribution channel or channels? Startup companies have the luxury of identifying and choosing the best distribution channels for their needs. Distribution Channels are very difficult and expensive to change once they have been established.

Start by asking if the market is scalable. Have any feasibility studies been performed which provide third-party support for the fundamentals of scalability in the market? The size and growth of the market tells us how many potential customers there are to acquire. Is there enough market out there to support the growth multiples you are after? Does the solution serve a niche market? Is that niche growing or contracting?

Your market analysis should also tell you something about the competitive landscape. If you hope to capture five percent of the market share, you need to know how competitors sell, who you are going to take that market share away from and why customers that comprise that share will switch to you. You cannot operate in a tiny and shrinking market and expect to scale upward.


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Team & Execution Risk


There are many investors that look at the management team as 100% of whether or not they will invest. If an entrepreneur has built a successful business before, that reduces the appearance of risk.

Bet on the Jockey

Before evaluating the higher-level functions of a company’s leadership, it must pass a simple yes or no test: “Can the CEO and the leadership team execute?”

There’s a common saying, Bet on the jockey, not the horse.

jockey

Why prioritize the team over a great product or outstanding market opportunity?

The best product idea and all the customer demand in the world cannot overcome the impact of a terrible CEO. On the other hand, a great CEO can overcome all kinds of flaws in the product, weaknesses in the market, etc.

Can the Leadership Team Execute?


Another way of looking at this is to say, an A execution of a B strategy will win over a B execution of an A strategy.

Leadership Brand: Commitment and Sacrifice

Brand stems from the true values of the company. Company values stem from the core personal values of its leaders. The CEOs role as the evangelist for the company’s compelling vision means that he or she is the personality that must embody the compelling vision of the company. CEOs must be the visionaries, the brand evangelists, the preachers of the company’s story both internally and externally. The tone set by the company’s leadership and its brand are tightly linked.

In 2016, Elizabeth Holmes (Founder and CEO of healthcare unicorn, Theranos) gave the commencement address at Pepperdine University. She spoke about the level of commitment and drive required to build a great company.

In the early days, she said, they had a sign in the lab that read, “Success is not the result of spontaneous combustion. You must set yourself on fire.” That’s the kind of drive and passion companies need.

holmes

A brand is more than just the vogue marketing-speak that wafts through the halls of agencies on Madison Avenue. Your brand is your company’s soul.

If the CEO is not preaching the compelling vision, what are the chances that it will make it to your salespeople, your cashiers, or your customer service team? The brand needs to be at the heart of the company’s entire cultural ecosystem.

Your brand is your company’s soul

Inconsistencies undermine the strength and integrity of your brand. These creep in when the compelling vision is not the cohesive or true focus of the CEO. Everyone watches the leaders for cues to what is important within the organization. The CEOs real brand—the company’s true values—is communicated (intentionally or not) by the principles of commitment and sacrifice.

What do you mean commitment and sacrifice?

Decisions. Choices.

When you make a choice to embrace one opportunity, you are by default not embracing another one. Each decision is both a commitment to your choice, and a sacrifice of other options.

VC firms face this frequently. If they decide to invest in one company, they are often sacrificing their ability to invest in a competitor, even one that hasn’t been created yet. Their commitment to the investment company, brings with it the sacrifice of other, potentially better, investment opportunities later.

The decisions of sacrifice and commitment will eventually show everyone, from employees to customers, what management truly values.

A founder’s brand of leadership often presents itself in his or her management style. Do they exercise a command and control style of leadership? Or does the founder demonstrate his or her commitment to employees with a service-leadership approach, removing impediments and facilitating success from each employee in his or her function? Does the leadership function in an impressive fashion—the Lao Tsu style, requiring little if any micromanagement and built on mutual respect and accomplishment? Are victories celebrated? Do employees feel part of something bigger than themselves?

What is the brand ecosystem stemming from the company’s leadership? Is it flexible and results oriented? Or is it a brand that reflects how the company has stagnated in the methods of its operations, a company that values its traditional activities even after they have become obsolete. Does it value creativity and input from employees?

Or has a dog-eat-dog style yielded a not-invented-here leadership brand?

Finally, the leadership brand should communicate the company’s growth goals and commitment to creating shareholder value. Do the company employees, investors and partners know that the company is driving for growth? Is it clear that growth is a core value of the leadership team and that growth milestones are critical benchmarks within the company? Has the company laid out a strategic growth plan that looks attainable? What are management’s long-term goals?

Additional resources:
New Brand World, Scott Bedbury

The Founder’s Dilemma

In 2008, Noam Wasserman penned the HBR article (which he later turned into a book) entitled The Founder’s Dilemma. It’s a real description of where many founders struggle in their relationship with investors.

For exponential growth, the founder typically has to surrender a large measure of both control and ownership in the company. That can be very difficult.

Senior management and the board of directors are not always on the same page. It’s typical for the first CEO of a growth company to be the founder. He or she is entrenched in the history and roots of the company, but is not always entrenched in the best management practices.

Entrepreneurs are, by nature, control freaks. They have brought the company to its current state by sheer force of will.

Sometimes that same strength of personality that created the company starts holding the company back—oftentimes there comes a point when a company is ready to grow beyond its roots, but the CEO is not.

Sometimes that same strength of personality that created the company starts holding the company back

It’s a tough road.

Additional Resources:
From CEO to Chairman: One Entrepreneurs Decision to Hand Over the Reins, Scott Johnson (previous CEO of Workfront, formerly AtTask)

Entrepreneurs are required to navigate through many transitions. One of these is the transition from owning all the stock at a low value to owning a portion of the company and working to increase value. This can get a little ugly because very few entrepreneurs have all the skills necessary to execute their business ideas completely.

So the simple truth is that a lot of CEOs get fired or otherwise transition out of the CEO job (maybe to take seats on the board or provide a consultative role) shortly after a company raises its first equity financing and hits the throttle on growth.

The result is that the company ends up shopping for a new CEO.

Finding a great CEO is not easy and often companies go through two or three generations of management trying to find the right fit. In the end, it is not uncommon for the board of directors, tired and desperate to get the company on solid footing, to become focused on one side of the business: the earnings and revenue side. They typically end up with management who are operations experts, but who know little or nothing about stock or financing, or the relationships on the investment side of the business.

Research Wasserman cites shows less than 25 percent of entrepreneurs are still CEO by the time their company makes its IPO.

Why do entrepreneurs struggle to transition within the companies they create?

One reason is that It takes a different set of skills to manage a company through its phases of growth than it does to simply get one off the ground.

It is easy and natural for personal issues to get in the way of the success of the business. Entrepreneurs, who are the first CEOs of the company, are often blind to these conflicts because with all their passion, their blood sweat and tears, it is so difficult to be objective.

They founded the company. In their minds it is often inseparable from their identity. They think that the company (and their place at the helm) reflects their personal merits. They credit their innate judgment for business successes.

The decision to relinquish control, even if the founder remains the CEO, is too often seen as an admission or symptom of failure instead of an acknowledgement of the company’s evolution, growth and success.

As Wasserman stated,

“Most entrepreneurs want to make a lot of money and to run the show. New research shows that it’s tough to do both. If you don’t figure out which matters more to you, you could end up [doing neither].”

When the founder centers his or her identity on a position within the company, the organization is headed for trouble. There are many reasons for this. They may enjoy the power of being in charge, the control over employees, the lifestyle of being the boss, whatever the case may be. The founder needs to know who it is that he or she is serving. If he is serving himself, the company will soon be off course.

Another pitfall is when entrepreneurs become victims of their own goodwill. They may have seemingly altruistic focuses like creating jobs, meeting employee needs, or maintaining relationships (often these entrepreneurs look at their employees like their family, whether it is a “family business” or not).

These outwardly noble aims distract from the company’s goals to create customer value and shareholder value and by so doing they are self-defeating. As the company fails, the founder finds that he or she is unable to sustain these benevolent reasons for running the company, let alone its growth.

A focus on customer value and shareholder value automatically takes care of all other stakeholders; any other focus does not.

This can run counter to the “stakeholder” philosophy and companies that exist for some other purpose. There’s nothing wrong with an altruistic purpose for a company. But once you take investment, your ability to deliver on other goals becomes dependent on your ability to deliver shareholder and customer value.

As with control of the company, entrepreneurs often struggle with the idea of parting with some of their stock. When the company started, the founder owned it all. It might not have been much, but the founder owned all of it.

In order for the business to grow, and for the founder to raise financing, he or she needs to be willing to give up much of that ownership. I often explain this by asking entrepreneurs if they would rather own a slice of watermelon or an entire grape.

In order to magnify the financial capacity of the founder and the fledgling company, something has to be given up. The company typically has few assets, and little capacity to take on and service debt. The only real currency in it is equity.

watermelon-grape
For entrepreneurs, this can be like giving up a child—they have nurtured the company this far with a lot of TLC mixed with personal sacrifice. Having their effort reduced to a dollar amount can be emotionally difficult if they do not have a vision of the financing as a stepping stone to an organization that will outgrow anything the founder could have produced on his or her own.

How Many Millions Are Enough?

Compensation can be a thorny issue for founders, senior management teams and investors.

Even when firms find the right people to form their leadership teams, the right compensation structure is also needed for the overall company to be successful. Likewise, the wrong compensation structure creates a huge risk that you need to be able to recognize before it comes back to bite you.

Executive compensation is a hot and divisive topic.

Shareholder activist groups, like the AFL-CIO, are increasingly organized and able to garner enough votes to force decisions from a board of directors. Often executive pay is the issue that causes them to pick up the torches and pitchforks. Shareholder activism has gained popularity as management compensation at publicly traded companies and the cash balances on corporate balance sheets have risen.

Some of the recent activist investment funds include Icahn Enterprises, Santa Monica Partners Opportunity Fund LP, and Relational Investors, LLC. These funds participate aggressively as shareholders in the companies with which they have invested, and sometimes will target companies, invest in them, and exercise their shareholder rights in order to underscore the issues, like executive compensation, that they think are most important. Where many of the large cap companies may have gone too far with their response to activism, small and micro caps need to be increasingly aware of the issues surrounding this debate.

Corporate Balance of Powers

Senior management is the group responsible for running the company. The board of directors and the shareholders are responsible for managing the senior management. The board of directors has a responsibility to establish a compensation plan for management that ties the self-interest of executives to increasing shareholder value and harnesses their drive in a way that motivates them to achieve that goal.

 

corporate

So what is the right strategy for establishing executive compensation? How do you align management goals with investor goals?

The board needs to establish a compensation committee.5 Compensation committees are often organized with a charter and they develop certain principles as guidelines for their objectives in making recommendations about executive compensation.

The core principle during such recommendations is that bonuses and stock are the two elements over and above a straight salary that tie in to the two sides of the business. This much is pretty straightforward. Bonuses tie to earnings and revenue goals, while ownership of the business through stock or options create an incentive for executives to increase shareholder value because they are numbered among the shareholders.

If Senior Management Compensation Is Wrong

Compensation for the senior management, and particularly for the CEO, that is aligned incorrectly begins to show signs of the mismatch. As the saying goes, the fish starts to stink at the head. CEOs with a bloated or emaciated compensation package start showing symptoms that their compensation is not properly aligned with their performance in the best interest of the company.

The fish starts to stink at the head

Without having a significant ownership stake in the company, they tend to look for other means of compensating themselves besides the rewards tied in to increasing the total value (customer value and shareholder value) of the company. These could be wages, perks, travel, entertainment, cars, side deals, etc. Even if they have high salaries, little or no ownership equates to no incentive to grow the share price.

Companies that are not focused on big time growth may still provide comfortably for a number of founder interests and lifestyle attributes. So-called lifestyle companies are not typically interesting investment targets for venture capitalists. The cash that a lifestyle business throws off isn’t sufficient to generate the returns VCs need to keep investors in their funds happy.

Growth Attributes

The antithesis of the ego-centric leader is one who is confident in his or her ability yet humble. This leader follows his or her own set of core values. He or she is not trying to emulate the dictatorial command and control leadership style that so often forms a façade masking the inadequacies that weaker leaders exhibit.

Great leaders are unselfish and habitually give the credit for positive results to their team or to others within their organization. This type of leader understands that there will always be someone richer, someone smarter, and someone with more of something. The humility of great leaders causes them to recognize their dependence upon those they serve. Every leader should have enough self-doubt to make them teachable. It is a humility that breeds respect which in turn lays the foundation for greatness.

Their own internal drive for results motivates them to build a team that shares these character traits and who are driven to execute.

Great leaders often find that they manage themselves out of a job. In other words, they develop the ability to empower and guide those they manage to the point that the managers themselves appear to have nothing to do. The paradox for many CEOs is that they spend much of their early careers getting ahead by gaining and demonstrating their expertise and then they transition to giving away their knowledge and surrounding themselves with smarter people than themselves.

Once again, investors need to see that a CEO is confident and capable, but also humble. They need to know that the CEO doesn’t need to be stroked all the time, but instead is exhibiting leadership characteristics that are constantly attracting top talent. The combination of adeptly filling the role of CEO and exhibiting the attributes of leadership that are tied to growth is what creates an inflection point.

Ask Yourself:

Evaluate Team and Execution risk by asking yourself: Can they execute the business plan? Do they have the skills to manage a much larger company than they currently do (i.e., the type they are hoping to become) and thrive under the pressure and demands of the growth that will transform the existing company or will a more seasoned team need to be brought in, and if so when?

Often an early test of a CEO’s capabilities is the ability to surround himself or herself with a competent senior management team. The CEO and the senior management team need to be vetted for their future impact on the company’s growth. Does each member of the team know his or her role, and what value they need to provide?

What are the interpersonal skills of the current management team? What kind of experience do they bring to the company? Is their experience relevant to the current enterprise—are they working in the same field as their professional and educational backgrounds? If not, the company could be trying to fit people it has into roles it needs to have filled, whether or not they actually match. Leaders know to look for people to fit the roles they need, not look for roles to fit the people they have.

How relevant and/or diverse are the resumes of the senior management team? In other words, is there a blend of ages among them, showing that they possess a mix of the excitement and energy of youth and the wisdom of experience? What do their work experience, educational backgrounds, and professional achievements look like? Are they diverse enough to indicate that the team has the ability to evaluate many points of view? Do they have the ability to execute in a disciplined fashion, to set budgets, to implement and analyze?

Often these questions will bring to light individuals who are liabilities to growth. They may have landed in positions via nepotism, personal connections or some type of cultural or political pressure. Nevertheless, being blood-related to someone in the senior management team or the board of directors does not preclude someone from being the perfect candidate to take on a management role.

Does the senior management team have the experience and maturity to work and succeed under the tremendous pressure of a hyper-growth company? How equipped is management to deal with the issues facing the company and to utilize the company’s assets to solve its problems? Is the company facing serious financial issues? Do these financial issues stem from the individuals on the senior management team, and can they resolve them? What other immediate threats or weaknesses will pose management issues for the company? Does the senior management team have key relationships that will help the company grow? What evidence is there that demonstrates the priorities and judgment of the management team?

Finally, in evaluating the jockey, does the CEO radiate the compelling vision of the company and inspire confidence? The vision shown by the CEO is what will be consistently reflected by employees to both customers and investors.


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Financial Risk

Growing a company takes money.

Why?

Well, one reason is the Cash Flow Cycle.

Your business typically demands some investment up front to generate growth and returns later. It takes money to produce your product before you can sell it and get paid. It’s a law of the universe; you have to plant before you can harvest.

Every company should understand its cash flow cycle. The cash flow cycle includes four basic elements:

  1. When do I receive raw materials/goods? 
  2. When do I have to pay for them? 
  3. When do I deliver my product or service?
  4. When do I get paid by my customer? Cash Cycle

Note: How you manage the cash cycle can create a competitive advantage. Dell was famous for flipping the cash cycle on its head, to the point that they were being paid for their product before they had to pay suppliers for the components required to build it.

Software companies are particularly fast-growing and have proven resilient in the otherwise lethargic post-Great-Recession-economy because the software business model has no manufacturing as such, no inventory, and no shipping—all of which wring time and expense out of the cash cycle.

Planting and harvesting in financial terms are called investment and return. The size of your harvest tied to a specific investment is measured as return on investment (ROI). When measuring a company’s efficiency in generating returns based on how much capital it has available (the aggregate of its investments) this is called a company’s return on invested capital (ROIC).

If margins determine your profitability on a product level, ROIC determines your earnings on a macroeconomic level. Growth companies understand that they need to see ROIC.

But let’s take a step back. If the goal is returns, you first need capital to invest in the business. So where do you get the money?

You have two options: you can either make the money or raise the money.

You can either make the money or raise the money

These options are broken down in two models: your company’s economic model and its investment model.

Your company’s ability to make money (i.e., produce profit), is its economic model.

Your company’s ability to raise money is its investment model, which includes the company’s appeal to new investors, its valuation, and increases in its stock price once the company is public.

The Economic Model

It’s not uncommon for startup companies to operate pre-revenue and pre-earnings.

If you’re in that situation, most of this section will be only a hopeful future for you. From time to time the venture capital community has tightened or loosened its purse strings when it comes to investing in pre-revenue companies.

Typically appetite for pre-revenue investing is offset by some other metric indicating future potential, like a rapidly growing user base. These days (2016) with the contraction in unicorn valuations and subsequent chill in Series A deals, revenues are back in vogue.

I advise that companies seek revenue and even profit early, and to grow them as soon as possible. That advice is often viewed as less financially sophisticated.

Many founders and investors, especially in the tech sector, have pursued growth over profitability. Investors interested only the biggest windfalls have pushed entrepreneurs this direction as a go-to strategy. Experienced entrepreneurs can walk a line where they carefully and prudently fuel growth at the expense of revenue.

Sometimes this works to create massive value. But sometimes it doesn’t.

When it doesn’t, you suffer the reputational cost of down rounds and layoffs with the accompanying blight on company morale. Worst case, you become a startup statistic as an otherwise great company flames out and dies.

If you pursue a negative revenue strategy without a plan B and don’t hit everything just right, the inevitable market cycles will crush you. Remember, the first rule of finance is NOT, “Growth at all costs.” The first rule of finance is, “Never run out of cash!”

The first rule of finance is, “Never run out of cash!”

Experienced entrepreneurs and investors see profits as an equitable inoculation against downside risks. The best I’ve seen build layers of redundancy, plans B, C, D, etc., which allow the company to survive unexpected fluctuations in the market, which always come.

Startup companies are fragile. Cash flow just makes your company that much less likely to fail. Remember, the cheapest money you can raise is from your customer in the form of profits.

Profits are the cheapest money you can raise.

The first step in understanding your economic model is knowing how much profit you keep from every dollar you bring in. Before you can answer that, you have to have accurate and reliable data on your company’s finances.

You can’t know what to do next, if you don’t know what you are doing now.

As soon as possible, discipline your company to capture data and use proper data hygiene. If you have work to do here, fix your data first, then return and read on.

Additional Resources:
The Customer Funded Business, John Mullins

Viewing profits as investment dollars that can be reinvested into your company’s growth, means you can track ROIC on those reinvested profits. This is growth fuel that comes with no strings attached, without the burden and liability of debt service or the sacrifice and dilution of selling equity—reinvested profits can accelerate the trajectory of the company’s growth and even drive inflection. A dollar of investment from the company’s own profits is often worth many times a dollar gained by equity or debt financing.

Ask yourself:

If the company can make sales, then you need to know whether or not it is profitable on each sale. Is each product marginally profitable? That is, for each unit the company sells, how much does it make in profit? What is the profit margin? Winning companies are profitable early and establish healthy margins. They defend their margins with disciplined operations and negotiations.

What is the breakeven point at which the unit margins cover the fixed costs? What does the margin and breakeven analysis tell the company? Where is the breakeven in dollars and in units?

Is the company profitable at the enterprise level? If not, could it be? Are there areas where they are leaking cash? Does the company have financial abnormalities? In other words are there conditions where financial weaknesses could kill the company?

You may still need external sources of capital to grow, but consider first how to reinvest as much of the company’s own profits as possible. This seems like common sense, but it is too often overlooked.

The Investment Model

The investment model comes second because investors often want to see that you have your economic model down first.

In your pitch materials, you may or may not choose to include financial statements, but rest assured before investors wire funds, they are going to want to see them.

When they do, they will be making a risk assessment.

The investment model builds on the economic model because earnings and profits are risk antidotes, and mitigating risk is one of the most important keys to attracting investors. As the old saying goes, “You get as much money as you want as long as you can prove you don’t need it.”

Your perceived financial risk is lower if

  1. Your financials tell a good story about the company, and
  2. If they don’t look like they are a lie.

Entrepreneurs sometimes start ventures with the idea that strong sales will cover a multitude of accounting sins, especially if the founder is strong in sales. Chalk this up to a host of examples of short-term thinking that will eventually catch up with you. Sales-driven companies don’t always flame-out early, but as they try to scale the turn-and-burn approach, they hit operational and process roadblocks.

Knowing the true financial condition of the company is a prerequisite to evaluating its condition. If the numbers are lost in a shoebox somewhere, investors may not bother to ask if the company is even worth the effort to find out whether or not it is making any money.

The investment model looks at a company’s offering for attracting investment money.

Motives

Entrepreneurs often misunderstand the motives of investors.

Entrepreneurs are in love with their companies. The company is their baby. It represents their genius, their creativity, their copious hours of time, and their many many sacrifices. They have seen their company grow up through all it’s early stages.

They know it like no one else.

They think if they could get their investors to only know it like they do, the investors would fall in love with their company too. They go out to raise money thinking their job is to get a VC to fall in love.

Sometimes it’s the VC’s job to tell you your baby is ugly.

Even if you have a good company, misunderstandings about the motives of investors can kill an otherwise good deal for both sides. Founders mistakenly think that VCs are in the business of owning companies.

That’s how it works, right? The entrepreneur thinks. VCs trade money for equity. If I build a company that is good enough (and just like every mother loves their child, every entrepreneur thinks their company is a beauty queen), then investors will deem it worthy with a crown of valuation. They will ultimately put a price tag on all that blood, sweat, tears and sacrifice.

Actually, investors are NOT in the business of owning companies. They are in the business of generating returns.

Opportunity and a Reason to Believe

A strong investment model reveals the opportunity your company presents to investors.

Instead of seeming like you have your hand out to investors, when you have a great deal you are doing them a favor by allowing them the chance to be involved.

Do you have a clean capital stack that alleviates risk? Does the company have a clean legal structure, or is the organization of the company a risk in itself? Will errors be difficult to correct? Many investors don’t want the hassle of cleaning up your structure.

Potential private and institutional investors are going to want to see a clear path to getting their money back with a return. Does the future of the company create a handsome exit strategy for them? What kind of returns can they expect?

The Founder’s Journey

How is a company’s capital structure formed?

Well, The capital structure evolves over the life of a company as its needs for cash and ability to raise capital change. I use the following example of the evolution of a typical equity stack.

Entrepreneur Model.png.001

This illustration depicts a fictitious startup company—an amalgam of components from many companies who have followed this pattern—and how its capital structure evolves from its founding until its IPO.

The company’s first round is not really a round at all. It’s bootstrapping, which means founder money and founder stock.

An entrepreneur with an idea and a little savings (or capacity on his or her credit card) comes up with the initial $10,000 of capital to start operating this business. This amount of money is so small it is almost imperceptible as a tiny sliver on the valuation side of the chart. At this point, the founder could issue as many shares of stock as he or she wanted—it is still only a slice of that tiny pie of original working capital, every penny of which will be required to grow the company. In this example, the founder issues 2.9 million shares of stock. The reason this number was chosen will become apparent later.

The founder slaves away at this business, desperately trying to create enough value for its customers that it will survive.

Then, at some point, our founder meets an angel.

Angels are investors that are willing to take on a lot of risk. They may never get their money back. That is why they are looked upon as a gift from heaven because no one on earth would take the risks that they do. The essential characteristic of angel investors is that they often believe more in the founder than in the risk that is associated with the deal. There is a growing cohort of professional angel investors and angel investor clubs and groups. There are many times that number of angel investors who probably wouldn’t even describe themselves as angels. These are friends and family, folks who have a little money and dabble in investing.

For this example, we’ll say our founder has a wealthy aunt.

The aunt invests $100,000 in exchange for 100,000 shares of stock. It’s what she can afford and contribute to allow the founder to pursue his or her dream of building a company, contribute to society, and try to get rich.

Notice that although this investment is not a very large amount in terms of dollars needed for the eventual success of the company, it has a significant impact on the value of the founder’s shares. After she invests in the company, the current value of shares sold ($100,000 ÷ 100,000 shares) is $1 per share, which gives the new company a market cap of $3 million (3 million shares × $1).

How much is a company really worth? As the saying goes, “Whatever a buyer is willing to pay.” Because someone has bought stock in this new business, the company has hit its first value changing event. So-called because private companies are more difficult to value than public companies.

Public companies have a more or less continuous valuation by virtue of the market for their stock. Private companies, however, are typically valued at the last round of financing, because that’s the last time someone determined what they were willing to pay. It might have been years since a private company last sold stock, or it may have never sold stock for that matter.

Despite the name, valuations of private companies (which are the essential basis for any equity financing) are really more about recognizing value, than they are about changing value.

In other words, the rich aunt established a value for the company based on what she was willing to pay per share of stock. Her valuation placed the company’s value at $3 million. This seems like the company jumped from being worth $10,000 to $3 million overnight. In fact, that is exactly what it feels like to shareholders because they cannot watch an index to see what their stock is worth—they just know what its last valuation was (which might have been at the time they bought their shares).

However, the founder has been working on the business during the intervening time since the initial $10,000 valuation. The rich aunt’s funding event allowed the value created during that time to be recognized.

Awhile later, the founder raises a Seed round. Seed VCs have multiplied in the past few years. They will bring some institutional sophistication to the company, for instance they may require the founder to set aside stock in an Employee Option Purchase Plan (EOPP) or Employee Stock Purchase Plan (ESOP) because they know options will be needed soon to recruit the senior team. Seed investors still make relatively small investments, but enough to establish a new valuation.

A couple of years later, the founder has taken that seed and angel money and turned it into a business with real potential. The company has fully developed products, a strong model for acquiring customers and is generating revenues. The company is growing and needs additional capital for sales staff, increased production capacity, more inventory, and financing of its accounts receivable. And the founder’s spouse is sick of the business being run out of their basement.

Armed with a product, a plan and a compelling story, the company is able to court a venture capital firm that specializes in their industry group. They close on their third financing round, an A–round of venture financing, and issue enough stock to give the investors 38 percent of the company. The additional 2.5 million shares are sold for $5 million. At $2 per share, the company now has a market capitalization of $13.3 million.

You can start to see a pattern here. With each round, ask yourself, Are they happy now?

Look at each investor in the company and ask if they are happy. The founder has seen his initial investment of $10,000 go to $5.8 million. The rich aunt who put in her $100,000 has doubled her money. It looks like everybody should be pretty happy.

Eventually, the company takes a B–round of funding, financing round four. Again, the company is valued at the time they issue the stock and the value created in the company is recognized. The Series B investor gets 3.5 million shares at $5 apiece, for a total investment of $17.5 million.

At the new valuation, are the current A–round investors happy? Sure! This valuation places their original investment at over double the value it was when they first made it.

When the company registers its IPO, financing round five, and creates a market for its stock, which is available for public investors, it undergoes yet another valuation. Now everybody who took the risk on the company while it was private should be very happy.

Rich Aunt’s $100,000 has turned into a value of $1.3 million. Likewise the venture capital firms have seen their money grow several times larger than their initial investment.

Sometimes people look at this chart and say, “Wait a minute, when the A–round investor bought in, its 1 million shares equated to 38 percent of the company. But, after the B–round closed, that firm only owned 25 percent. How are they going to be happy with that?”

This is a good point. Nobody likes dilution.

But investors generally do not mind the dilution so much if the next round of valuation is accretive.

Accretive (from the Latin root meaning to become larger or to lay down in layers) means that even though the percentage is smaller, the whole is growing larger.

Dilution in number of shares does not necessarily have to mean dilution in terms of EPS or value. The A–round investor does lose 13 percent of his ownership, but his shares are worth twice as much as they were before.

The simple Are they happy now? model provides the guidance upon which all of the strategies for building your capital structure depend.

Additional Resources:
How Funding Works, Splitting the Equity With Investors—Infographic, Anna Vital

Each round should create more value than the last. Accretive rounds of financing allow you to absorb numerical dilution without dilution in value. Previous investors are happy because the value of their investment is growing.

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Valuation Basics

Valuation is a term that gets a lot of play. With good reason.

Despite the fact that valuation for the earliest of startups can be squishy, and even sometimes an afterthought to justify the amount of the investment, it still matters. Ultimately valuation tells you what the company is worth to the current investor. It’s the price of the company’s equity.

Why does that matter?

Investors hate losing money. In fact there is probably nothing tougher for an investor than taking a loss. If investors get a good deal on an investment, that means there’s a little extra arbitrage, a little cushion to reduce the chance of that happening.

A company’s valuation in relation to its fundamental value, in other words the relationship described by price:value (i.e., valuation:the true value of the company) tells you if the company is a good deal for investors. Will they make money? Is the company over-valued? Undervalued? Fair valued?

Multiples

Shorthand valuation is often done using multiples.

This approach is rooted in the market valuation approach, which essentially says that the value of anything is what buyers are willing to pay. (See Income or Asset approaches for alternate methods) To value something, compare what buyers of similar things are paying.

Businesses, have key stats (like revenue or earnings) that are logically tied to business performance.

Either individual comparables or industry averages can be used to determine the market rate for similar companies. Industry averages serve as valuation heuristics. Market valuation is calculated by multiplying the historical (trailing year or month) performance by the multiple.

For instance, if public SaaS companies over the past decade trade on average at 5x revenue, it’s reasonable to value another public SaaS company doing $100 million in revenue at $500 million. In this case, 5 is the multiple, and $100 million is the value of the key stat.

Additional Resources:
What We Know From A Decade of SaaS, Niehenke, A.
Valuation Multiples: A Primer, Suozzo, P., Cooper, S., Sutherland, G., Deng, Z.
7 Ways Customer Success Drives Company Valuation, Murphy, L.


Lacking industry or comparable data, you can still get a rough approximation until you have better data by using heuristics based on a broad cross section of companies and industries. As a rule of thumb, I use: 1 x revenue and 5 x earnings for private companies, 5 x revenue and 20 x earnings for public companies.

These are oversimplifications, but they give you a place to start.

The Valuation Formula

In 2009, this valuation formula was published by William Sahlman in the HBR. I find it an excellent way to rough in valuation parity between investors and entrepreneurs.

This is one way of looking at an investment hurdle rate, or the point at which an investor has equity sufficient to generate the returns they require.

In other words, if I expected a particular return from my investment, the Valuation Formula tells me how much equity in the company I need to acquire for my investment to generate that return. It can also help senior management teams understand what investors are looking for and be more objective about their company valuation.

Valuation Formula

The terms of this formula are:

IRR = The desired internal rate of return
x = The investment horizon, the terminal value period, or the number of years to exit.
Investment = The amount invested.
Multiplier = A factor used to determine company valuation at exit.
Exit Value = the estimated value of a company performance metric (a key stat like revenue or earnings) used with the multiplier to establish valuation at exit.

The numerator of the formula effectively calculates the future value of the investment if it generates the desired IRR.

The denominator is the valuation of the company at a future exit (i.e., the investment horizon).

The valuation formula is not foolproof; it’s designed as a rule of thumb for estimating the value of a company at some point years into the future based on factors we cannot know for certain. As a result, some valuation methods are better indicators than others, depending on where the company is in its growth.

Here’s a quick example. Let’s say we have an investor who wishes to invest $1 million dollars. His required rate of return is 100 percent (he’s a VC who needs to generate 20% return to his fund, and realistically expects 8 out of 10 investments to fail) and he expects to exit at the end of the third year. The company likewise expects at that point to generate revenue of $15 million, and earnings of $3 million.

Since the company is a VC target we will assume it is private and use the private revenue multiple.

(1+1)^3*(1,000,000)/(1)(15,000,000)=0.533

Calculating the formula yields a hurdle rate of 53.3 percent. So to get the desired IRR, the investor would need to get 53.3 percent of the company for its investment of $1,000,000.

In this scenario, that figure could raise control questions since this would be a controlling interest.

The formula is only a rule of thumb. It will often yield a different hurdle rate based on the valuation method used. However, using a rule of thumb we can still get a good idea of how a company really stacks up, despite some variance, by running multiple scenarios and weighting the results.

It might make sense to run the formula for scenarios that included valuations based on earnings, revenues and book value. We could weight these so that the results of earnings bore 60 percent, revenues 20 percent and book value 20 percent of the total. The idea is to use the formula to get as clear a picture as possible.

Warren Buffett has been called the world’s greatest stock market investor and was named the richest man in the world in 2008. What kind of compounded rates of return do you think Buffett has earned? When I pose the question to my graduate students, I get answers all over the board. Some say 1,000 percent, some 500 percent. They think, “He is the best there has ever been, right? The number has to be something spectacular.”

In fact, Warren Buffett has generated a compound rate of return of 22.3 percent over  38 years. In contrast the S&P 500 has generated a 9.8 percent return over the same period. Investors are often familiar with these or similar statistics and consequently use them as a benchmark.

Note: what’s up with 100% IRR? Warren Buffet, the greatest stock market investor of all time only averages 22.3 percent. Why do VCs think they can do better?

Part of it is the risk/return spectrum. VCs play in a riskier asset class, and so face greater chance of loss, but also higher returns. Another part is what Peter Thiel calls the VC power law. In his book Zero to One, Thiel explains that among portfolio companies of an investment fund, one winner will generate returns greater than the rest of the fund.

peterthiel

You may wonder why a VC is not more interested in your solid business generating 12 percent growth year in and year out. The reason is because there is no chance that your company will be the one. VCs have to aim for exponential growth in order for their business model to work. 

Founding partner at Andreessen Horowitz, Marc Andreessen says it this way, “In VC, the difference is between good and great investments, and good is the enemy of great.”

The End from the Beginning

How much growth can you deliver?

In the early days, it’s easy to think that explosive growth will continue forever.

Senior management teams should always try to consider what the company can realistically capture in earnings in the future. The further out, the less realistic these estimates will be. But by starting with the end in mind, they can establish what a reasonable forecast is for the rest of the capital stack and use these expected earnings as a basis for estimating the company’s valuation into the future.

Look at average earnings per share, P/E ratio, revenue multiple, and growth rates across the industry group. Typical P/E ratios vary across industry groups and you will notice that often the P/E ratio and growth rate are closely tied. The closer these metrics are to each other, the closer the stock price is to being fair valued. (The P/E ratio and the growth rate can even be calculated together as the PEG or price/earnings to growth ratio.) The point is that intrinsic value is based on solid fundamentals.

The reason this is true is that there is only so much sustainable growth that a company can produce. Consider the old Indian fable where the creator of the game of chess presents his chessboard to the ruler of his country. Impressed, the ruler asks the inventor to name his price for this engaging pastime.

The sage inventor says that he will accept one grain of wheat, doubled for every square on the chessboard. The ruler scoffs at what appears to be such a low amount, but as he begins to count out the wheat, he soon sees that this is an amount so large he can never pay it.

In fact, it amounts to over 18 quintillion grains of wheat—80 times the amount of wheat you could harvest if you dedicated every arable acre of land on Earth to wheat!

Likewise, companies cannot sustain exponential growth indefinitely. It is impossible to double your sales every year forever. Eventually companies reach a saturation point and collapse upon themselves, settling out at growth typical for their industry group.

I use a P/E ratio of 40 as my general rule of thumb for sustainability. That does not mean that companies cannot legitimately have P/E ratios higher than this, but it’s unlikely that they can sustain them indefinitely.

Companies will eventually trade for close to the average P/E ratio, revenue ratio, and EBITDA for their industry group.

Companies will eventually trade for close to the industry average.

In late 1999, Microsoft was at the peak of its growth. Their stock was trading at just under $60 per share after a split earlier that year and its daily trading volume was 1.26 billion shares for a market cap of nearly $73 billion. They had a growth rate of about 74 percent, their P/E ratio was over 77, and their earnings were at $7.75 billion.

MSFT Charts

Maintaining this rate of growth would have meant that within five years Microsoft would have a market cap of over $1 trillion. To date, over 17 years lager, the highest market cap of all time was Apple at $700 billion. Inflation adjusted, Microsoft’s would be even higher at $900 billion… but still not $1 trillion.

Was this level of growth sustainable or was it time for Microsoft to have a reality check?

The chart shows that, as expected, Microsoft’s growth slowed and their stock price made a correction. Even for a stellar performer like Microsoft, a trillion-dollar market cap was a pretty tall order in 1999.

For public companies to increase their share price, there needs to be a home for every share of stock at the end of every day.

Private startup companies often have volatility in their growth, but they still want to have an eye to the future. The strategy for building the right capital structure should have only straightforward motives behind it. The right approach is for senior management to be disciplined about forecasting earnings and back up from there. The management team does not want to be either too optimistic or too pessimistic. They want to be realistic.

Executives should take steps to adjust the capital structure so that the company is in the best position to be successful at justifying the valuation required at that next valuation event.

For example, maybe the company is looking at an A–round of venture capital. The rationale is that companies want to raise enough capital, but not too much, for what they need to grow. Senior management wants to obtain those funds by issuing the minimum amount of stock necessary for what is required for that period in the company’s growth, but not more, in order to keep dilution under control.

When it comes time to do another round of financing, hopefully the company can do it at a higher valuation, making it more acceptable to its current investors, making the financing an accretive event to your current or future earnings per share.

Back to Table of Contents

The Capital Stack

Having an attractive cap table can give you a leg up.

Understanding your stack helps you speak the language of investors AND each part of the stack gives you tools to make your deal more attractive to investors. (A good lawyer will help you with this, but you should know it yourself.)

When you go out looking to raise capital, you soon find that there are already other companies out there looking for money, in the same places.

A lot of companies.

You’ve got to beat the competition at winning the minds of investors.

It is a battle for survival and every other company that desperately needs capital is already pitching your investors and using every technique, every ounce of creativity that they have in their arsenal to convince investors that the right place for the investor to put their money is with them.

Capital Stack CompleteHaving a solid capital stack can increase your odds. Senior management
teams need to understand capital structure before they end up learning it by experience—when it’s often too late. You cannot fake your way through this aspect of your business.

What is capital structure, or the capital stack? The textbook definition of capital structure is “the types of sources of capital funds invested in the business.” It includes equity, debt and hybrid equity/debt. It’s the sum total of the value of every share of actual stock, potential stock, and the different types of debt and hybrid debt that can exist within the company.

This is often delineated in a Capitalization Table, which shows all the constituents and how they relate to each other.

The capital stack is essentially how you structure the right side of your balance sheet: the equity stack includes the various components that make up shareholder’s equity, while the debt stack is made up of the various liabilities a company can incur in its quest for capital.

Companies start out with a certain amount of founder’s equity and typically raise investor capital by selling shares of stock.

Ask Yourself:

What is your strategy when selling stock? How many shares do you sell and at what price? What is fair? Are you over-valued or under-valued? Once you have collected a base of shareholders, what then?

Do you have any debt? You may want to raise money through debt as opposed to equity in order to not give up any more of your precious stock. It may be the only money you can get.

Hybrids can also create incentives for investors. They can create multiple ways for investors to achieve their minimum desired required rate of return, or can offset risks for investors.

Does the cap table indicate that the company has a viable financial model?

What is this company really worth? What is its fully diluted market cap. In other words, every share of outstanding stock, which includes those that are trading (issued) and those that are restricted (i.e., held by insiders or control persons) or locked up as well as convertibles such as options, warrants and convertible debt. Is the company public or private? What does the market look like (or will look like if the company were to go public) for this company’s shares? What is happening within the company’s industry group in general?

Ideally, I would look for a complete profile of the company’s stock. You should know how many shares are authorized, issued and outstanding, who the shareholders are and how much they paid for their shares, as well as what the current selling price is.

In addition to the shares currently in the market, what shares will be entering the market? What is the additional supply or overhang which could enter the trading market for these new shares?

You need to know if there are any restricted shares. For instance, in an unregistered private placement under the Securities Act of 1933, Regulation D, stock is not immediately tradable, even if there is a private market for it. Shares are generally restricted for a minimum of six months, longer under certain conditions. Or immediately following an IPO, previous shareholders typically have a lock up period (also generally six months, required by the investment bankers who underwrote the IPO and who were responsible for raising the money) before they—insiders (employees, control persons, etc.)—can sell their shares on the open market.

Overhang

Understanding the capital structure requires an understanding of whether or not any of the shares are being kept back, how many shares, who owns them, and when these shares potentially enter the market.

When will the restrictions expire on any of these shares (when will the restrictive legend attached to the share certificates be lifted)? When could these shares have the potential of being sold into the open market?

Are the optionees vested or not? Are the options slated for a cashless exercise (typical for employee-owned stock options, warrants and financings)? Is the company buying up treasury stock? What can be discerned about the future of the company? What shares might enter the public float over the next year, the next five years, or the next ten years?

Creating a good investment model is really about optimizing the capital structure of a company so that the right signals are being sent to investors based on the fundamental intrinsic value of the company. Having an optimal capital structure can have a huge impact on a company’s chances for success in attracting buyers of its stock, raising money with investors, and executing the very fundamentals which ultimately drive the company’s revenues and earnings.

It is about aligning management’s goals with the goals of investors. It is about making it easy for investors to see that your company really could help them make an investment that generates returns far above what is available on the general market.

The Debt Stack

Giving up equity is not the only way to raise money: companies can also incur debt. The decision a company makes to take on debt liability is serious.

Sometimes entrepreneurs are in a hurry to incur debt. Equity investments can tend to be much more patient money.  

What these founders find is that the old saying that money earns hard and spends easy is really true. Companies will find that borrowed money is easier to spend and more difficult to pay back than they thought, and the decision to take on debt needs to be made with great care.

Before taking on additional debt, you should consider how adding debt will affect your EPS. Practically speaking, debt needs to be serviceable by the company. The company needs to have the capacity of making the payments and meeting their obligations under the terms of the debt.

Will the increased interest payments and fees drag your earnings into an unacceptable range and potentially put the company in danger of going out of business if the debt payments cannot be met?

This debt portion of a company’s capital structure includes short term liabilities such as trade credit as well as long-term liabilities like the various forms of loans and notes—secured, unsecured, senior and subordinate debt.

Short-term Liabilities 

Typically, short-term liabilities are any debts that must be repaid within one year.

A common type of short-term liability is trade credit. Trade credit is the short-term credit that is typically offered between companies up and down the value chain.

Anytime a supplier or vendor allows its customers to pay on terms that extend beyond their receipt of goods or services (i.e., other than payment in advance, COD or upon receipt), it has extended credit. The company’s obligation to repay is a debt which appears under accounts payable under liabilities on the balance sheet.

The terms of trade credit can have a big impact on your business. A supplier may offer standard terms to its customer, like 2 percent 10, Net 30. This means that the customer gets a 2 percent discount for paying before the invoice is aged 10 days and the net balance due on the invoice must be paid before the invoice is aged 30 days.

A little analysis will show if it is worth it for the company to pay early for the 2 percent discount.

The terms for this type of debt vary greatly and are commonly points of negotiation as companies establish relationships with their suppliers and customers. Consider what the impact would be on your business if you had 45 days, 60 days or 90 days to pay on your accounts payable?

Consider sales on a product with a 20 percent margin. The receivables are financed at 5 percent per month and terms are net 30 with the customer. By the time this invoice is 90 days past due, there are no profits left in the sale, and the company actually loses money for every day beyond that.

Companies can sometimes secure loans against their accounts receivable or even against purchase orders. These soft assets are factored, meaning that loans against them are typically up to a maximum of some factor of the total asset. For instance, if you have $1 million in receivables, loans against these receivables may only total $750 thousand. Origination fees and interest on these types of loans can put companies in a bind if receivables age too long.

Short-term loans can be like crack cocaine for growing companies. Once senior management teams get these types of loans from banks or private lenders (which are themselves called factors), the temptation to return to the well again and again can be very strong. If companies are not cautious, they can find that fees and interest will rapidly erode their profits.

Long-term Liabilities

Long-term liabilities are usually some type of loan or note.

When a loan is issued, the lender wants to know how it is going to get its money back. One way companies secure their promise to repay a loan is by attaching the loan to an asset. This means the asset is encumbered by the loan and the asset is now collateral which must stand good for the debt if the company defaults.

Like investors, lenders use indicators of the company’s performance to establish its credit worthiness. They may look at the company’s balance sheet, its quick ratio (assets/liabilities), or an acid test (cash and accounts receivable/short term payables).

Growing companies may not have all of the assets or stability required to obtain a loan from a traditional lender. Creditors will often look to the company founders or officers to personally guarantee loans to the company.

I recommend you absolutely avoid personal guarantees on any form of company debt. Avoiding personal guarantees can be tough for young companies and often requires a lot of negotiation with creditors, but it’s absolutely worth the extra effort.

When a lender asks for a personal guarantee it means that they are not looking at the value of the company or the company’s ability to repay. They are skeptical about loaning to the company itself and they want you to bear more of the risk. If you sign a personal guarantee, plan on repaying the loan personally.

Debt can be unsecured. Unsecured debt is any loan that is only backed by the company’s credit and promise to repay. An example might be a company promissory note. A promissory note with nothing attached is typically an individually negotiated deal with investors.

Back to Table of Contents

The Equity Stack 

Here’s where you outline all the forms of equity in your cap stack.

This could include common shares of stock (both founder stock and common stock purchased by investors), preferred shares, hybrids and convertibles that have the right to become shares of stock based on future events.

Preferred Stock

Preferred stock is a separate class of stock from common stock and can be an incredibly powerful tool. Preferred stock can be issued in subsequent rounds with specified preference, preferred A, preferred B, and so on.

When VCs invest, they typically structure their equity as preferred stock, although they frequently do not take advantage of the more creative possibilities with it.

The essential characteristic of preferred stock is that it is a contract between the company and the shareholder.

The essential characteristic of preferred stock is that it is a contract

Preferred shares of stock do not automatically have voting rights and they are, by definition, preferred in the sense that they have a superior position if the company liquidates, sells assets or issues dividends—in those cases, preferred stockholders are paid before common stockholders.

More importantly, preferred stock allows the company to set forth preferences as terms and conditions to the contract. In the capital stack, owners of preferred shares have a preference over common shareholders. Those preferences are typically outlined by their contract in a certificate of designation and like other contracts could potentially include any provision legally negotiated between the parties.

I’ve included some examples of the use of preferred stock to illustrate the power and creativity inherent in the use of preferred stock to build the company’s capital stack. With infinite possibilities out there, this is not intended to be an exhaustive outline, but only a sampling to introduce readers to the power of preferred stock.

The underlying goal of the capital structure is to facilitate senior management’s mandate to increase shareholder value by making the company more attractive to financial investors and buyers of its stock. Senior management teams need to be asking themselves how they can strategically use preferred stock in the capital stack.

Investors typically evaluate potential investment opportunities on their rate of risk and return. Preferred stock allows a company to create an offering that includes elements that should reduce risk and offer additional opportunities for investors to gain a return of their capital and a return on their capital.

A strategy for reducing risk by virtue of another investment is called a hedge.

By taking advantage of the possibilities with preferred stock, companies can create effectual hedges by including terms that create additional methods for investors to get their return.

What are some possible hedges?

  • Preferred stock can function like a simple interest loan.
  • Preferred stock can pay interest on an equity investment.
  • Preferred stock can be redeemable, so when the terms are fulfilled, say principal and interest payments are completed, the stock is redeemed and investor obligations end.
  • Preferred stock can be convertible to common stock. While it is common to convert 1:1, this can be any ratio.
  • If preferred stock is redeemable convertible preferred, then once the company discharges its obligations new common stock is issued and the preferred reverts to treasury stock, just as if the company purchased them back from the market.
  • Preferred shared can have a coupon and pay periodic interest like a bond.3
  • The interest can be tied to a specified IRR, mitigating some of the risks of purchasing only common stock.
  • Preferred shares could include a clawback provision tied to a performance benchmark, allowing investors to get a portion of their investment back or to trigger some compensatory provision if the terms are not met. For instance, preferred shares could allow investors to draw from an escrow or trust account if the company failed to achieve a specified benchmark like growth rate, earnings or IRR.
  • Although preferred stock does not automatically confer voting rights like common stock does, voting rights can be bestowed by virtue of the contract.
  • Because voting rights are outlined in the preferred stock contract, they do not have to be 1:1. A share of preferred stock could potentially have 100 voting rights. (Companies sometimes structure preferred stock in this way as an anti-takeover provision. Preferred shares can be structured in a way that in the event of an attempted takeover, supermajority voting rights fall to the board of directors or the body holding the preferred shares. In fact, charters and organizing articles can contain provisions for issuing preferred stock where the terms can be determined by the board of directors at the time they are issued. Companies like Marriott4 and Kimberly-Clarke are just a couple of examples of companies that have enacted rights plans based in the use of preferred stock for takeover defense.)

Additional Resources:
The Many Flavors of Preferred Stock, Kennon, J.

Liquidation Preferences 

Liquidity rights support an investor’s desire to get their money back, while collateralization creates another method for reducing risk by securing the preferred shares with company assets.

Let’s say an investor bought 50 percent of a company’s common shares plus preferred shares that grant a $3 million liquidity preference. In this scenario, the preferred shares give the investor claim on the first $3 million of proceeds in a liquidity event.

What if the company decides to sell for $5 million? The first $3 million goes to the investor by virtue of the equity preference attached to the preferred stock. Then the remaining $2 million is divided among the owners. Since this investor also purchased 50 percent ownership, $1 million of that also goes to the investor and the remaining $1 million is divvied up between the remaining shareholders.

A variation on this liquidity structure could provide investors with a required IRR. It could attach to net revenues, gross profits, bottom line earnings, etc. and deliver a percentage to the holder of the preferred before other shareholders are paid—a powerful hedge against the risk of simply buying common stock and hoping for dividends or a liquid market with increasing stock prices.

Consider a scenario where preferred shares require 30 percent of gross profits. The company ostensibly raised enough money to warrant this commitment, and the 30 percent paid on the preferred stock is reflected in the balance sheet, but comes out of cash and is not an expense item, therefore it is not listed on the profit and loss (P&L) statement.

The key here is that the company has effectively raised money and taken on a financing obligation without impacting earnings, which means its EPS and P/E ratios remain intact. It is preventing the impact of necessary growth commitments from distorting the view of the company to investors.

By contrast, look at Omniture (Nasdaq: OMTR prior to being acquired in 2009 by Adobe Systems) as an example below.

Omniture

In the two years prior to being purchased by Adobe, this company made four acquisitions: Visual Sciences, Offermatica, Instadia, and Touch Clarity. Reports detail how Omniture used common stock as the major consideration when making these acquisitions. From its high of over $36 at the end of October 2007, Omniture tumbled to $17 before getting pummeled to $7 by the financial crisis in 2008. Omniture struggled in key areas of their second side of the business—the shareholder side, finding it hard to maintain growth, suffering analyst downgrades and posting negative EPS.

In the end, Adobe gave Omnivore a favorable valuation, but one has to wonder (admittedly Monday-morning quarterbacking) if a strategic use of preferred stock might have been a tactic that would have kept them out of the doghouse for poor earnings performance.

Collateral

What about securing the preferred contract terms with company assets? Equity in a company is, by default, attached to the general assets of the company; however, liquidation preferences can assign specific assets to a particular class of stock.

For example, a company could own an office building as one of its assets. Preferred stock could be sold with provisions that secured the stock with a position against the value of the office building. The preferred stock then becomes capable of a Uniform Commercial Code (UCC) filing as a lien against the asset.

This doesn’t come close to describing even the most common hedges, but it does illustrate the principle of how as a founder, you can structure an offering with redundant hedges to increase investor comfort.

Debt vs. Equity 

As a company looks at its options for raising money, preferred stock can offer an attractive blend of some of the advantages of equity financing plus the flexibility of debt financing. If the company were to simply take out a loan, not only would the loan absorb valuable credit and possibly attach to company assets, but it would fall under the liabilities heading on the balance sheet.

The company may not want a strict liability. If instead they issue preferred stock with the right terms designated in their interest, they could keep the obligation under shareholder’s equity. There are many possible reasons they may want to keep their debt-to-equity ratio from tipping too heavily on debt.

Statements by the Financial Accounting Standards Board (FASB) require that preferred stock with certain characteristics of loans be reported as liabilities. There may be situations where this is more desirable. For instance, if you need to raise subsequent money, paying off loans may be an appropriate disposition of those new funds, while paying money directly to previous investors under some other terms may not be.

Never lose sight of the fact that people buy stock because they expect the earnings of the company to increase and thus the price of the stock to go up. Your strategy should be to keep increasing your earnings so there is always additional intrinsic value that has yet to be realized in your share price.

People buy stock because they expect the price of the stock to go up.

Hybrid Financing

Hybrid financing represents elements of both equity and debt. This is often a benefit to investors because they have the ability to reap the benefits of both equity and debt investments.

Unit Offerings

A hybrid strategy is to bundle common stock and preferred stock together in a single unit. By combining the sale, companies can increase their shareholder base in terms of their common stock and create incentives and hedges for investors via the terms of the preferred stock.

Investors who own one of these units may be looking at the deal and saying, “Well, I cannot yet sell my common stock, but I am making my IRR on the preferred—I am happy.” 

Or the reverse: “I am not yet getting paid back on my preferred, but there is a great market for the common, so I can make money there.”

Either way, the investor has some way of getting money out of the deal.

Maybe senior management needs to create an incentive for current shareholders. The company could be going through a reverse split or bridging to a profitable venture that has not yielded anything substantive yet. They can offer preferred stock to common shareholders for some concession that moves the company toward its goals.

Another scenario is that the company is courting investors who are timid about all the benefits of the unit only being realized in the future. They may feel like they are not making anything on their money while it is tied up in the investment.

Well, the preferred stock can be structured so it pays a dividend.

The investor may counter by saying that he feels ill-treated to be paying taxes on dividends when he does not even have his principal back. In this case, the deal could be structured so that the periodic payments are made as principal repayments rather than interest, so the investor does not have the tax liability during the course of the investment until he gets all his principal back.

The terms of the preferred stock are designed to sweeten the deal and reduce the risk for the investor. Although the concept seems simple, this model can be one of the most powerful tools in your arsenal for building the right capital structure.

Let’s say that after careful analysis, you see that you need to issue more shares to get your capital stack in order, but you do not want your stock price to drop due to a shift in supply and demand. What to do?

A unit offering could be the right solution. If the company’s stock is selling for $10 per share, the company could open a unit offering that combines one unit of common and one unit of preferred for $20. The terms of the preferred are written to soften the risk to investors. Maybe they receive a dividend or an interest position in some asset, but the effect is that after fulfilling the obligations of the preferred stock, the company received $20 and the investor received a share of common stock.

Warrants, Options and Lock-up/Leak-out

Part of the responsibility of senior management during the early years after an IPO should be facilitating an orderly entry of shares into the market.

Volatility in the market wreaks havoc on the stock price and makes it more difficult for management to steadily increase the stock price based on solid fundamentals.

In a perfect world, companies would grow their stock price so the price would never drop, but simply alternate between periods of increase in price and shake out periods where investors who were less aligned with the mission of the company would sell off. The whole pattern would appear very regular, predictable and controlled.

In the real world, however, stocks move up and down. So senior management teams need to try to reduce the volatility and keep things orderly in order for their stock to be the most attractive to buyers.

By using the tools available through preferred stock and unit offerings, senior management teams can work to smooth out supply and demand for their stock.

For example, a share of preferred stock could have warrants associated with it, and warrants could even be sold as a component of the unit in a unit offering. A warrant entitles its owner to purchase shares of stock at a fixed price.

For example, an investor purchasing 100 units in a unit offering for $1,000 could receive 100 shares of common stock worth $5 each, 100 shares of preferred stock which pay a 5 percent dividend annually, and 100 warrants to buy additional shares at $5 apiece. Just like preferred stock, warrants do not have to have a one-to-one relationship to the common shares.

You can have multiple warrants, based on every 5 shares, every 50 shares, or based upon other ratios or contractual agreements.

Warrants can be callable.

They can have registration or no registration rights. The warrants can be callable into restricted stock or convertible into some other form of preferred stock or other asset class.

If for instance the company issues the above units and had a call provision on the warrants, they could call the warrants and, in effect, exercise them for the buyer.

When a warrant is exercised it causes a new share of stock to be issued. The danger is that the company calls the warrant and then an additional volume of stock is injected into the market. Has the company accounted for the impact on the stock price due to the forces of supply and demand?

You may be saying, what about options? Options are typically for much shorter term than warrants and are more commonly issued as company incentives to employees. Employee stock options take many forms, but here is a typical scenario. Options to buy stock are offered to employees at a set price per share for a maximum number of shares. It is typical for options to vest over time with employees, say 25 percent per year over four years. Options can often vest immediately if the company goes public or is sold.

Employees are sometimes given the option of a cashless exercise of their options (warrants can likewise have a cashless exercise). This means that the holder of the option or warrant does not actually have to come up with the cash to purchase the options. They just receive the difference in the option price and the current market price in cash. It is typical for this type of exercise to slightly reduce the total number of options.

Preferred stock and unit offerings can also contain provisions for options and warrants.

Warrants and options are critical to understanding the capital structure of a company. Senior management teams need to know when new stock is going to hit the market. If the company is public, they need to be creating demand for new shares in order to keep the price from falling as new shareholders enter the market, and they need to know what is callable, what is vested and what the terms are.

One of the ways senior management can influence how much stock hits the market and when is through Lock-up/Leak-out agreements. I mentioned earlier how shareholders have a typical lock-up period (generally mandated by the investment bankers) of six months after an IPO. A similar restriction can be created by contract as senior management orchestrates the capital stack.

In fact, when using a unit offering that includes common shares is that the tack time, the aging of those shares and the ability to sell them, is ticking away while investors are content getting their coupon rate or their percentage of earnings based on the terms of the preferred stock. This will usually create greater flexibility because if you need those shares in the float, the legal requirements are already met.

The intent is for stock to hit the open market in an orderly fashion, so that volume spikes caused by new stock entering the market are not as likely to cause the price to plummet. The Lock-up/Leak-out terms can be written as part of the terms of the unit offering, and can be tied into the offering memorandum in a direct registration or a private placement memorandum. The terms can state that investors may not sell for a specified period, may restrict an amount per month that may be sold or an amount based on the overall volume in the market.

The goal is not to prevent people from selling—it is to keep foolish investors from dumping their stock and creating a financial disaster for all of the other shareholders in the company. The company’s stock price and the volume of shares traded will affect the team’s ability to finance and grow the company.

It should be emphasized that once a company is public, its ability to raise money and further execute its business plan is a function of the price and volume of the stock. The company’s success is almost completely dependent on keeping the price of the stock intact with healthy or strong trading volumes.

Look ahead. Plan for the future. Relentlessly execute on your plan. Build your capital structure in order to support explosive growth. In order to do that, senior management teams should know who their investors are and how to appeal to them—what risks can be alleviated and how to communicate intrinsic value and sustainable growth based on the company’s underlying fundamentals. They should know how to value the company fairly and be familiar with the methods and terms that their buyers and investors will be evaluating. They also need to be conversant in the techniques and strategies for making changes to the capital structure in order to achieve the company’s goals.

Understanding and anticipating how the capital structure needs to be aligned is one of the essential skills for leaders who want their companies to enjoy maximum growth. When the objectives of the capital structure align with core goals of the business, it increases the likelihood that senior management teams will be successful getting buyers for the company’s stock and attracting investors.


@chadjardine is the Head of Marketing for @goreact, an edtech company that makes game film for not sports. He teaches marketing at Utah Valley University and venture capital @uutah.