Through the Looking Glass: Two Sides of Start-Up Financing, Part 2

Stephen DeAngelis

January 12, 2011

The first of this two-part series looked at investing in start-up companies through the eyes of an investor. This post looks at the other side of financing — raising capital as an entrepreneur. Any entrepreneur who has had to raise significant amounts of capital knows that it can be challenging and time-consuming. In an article dealing with the challenges of raising capital, Jonathan Moules relates the story of two men, Peter McGeough and Henning von Spreckelsen, who knew they had a good idea for a better milk bottle top and thought they had a solid eight-year business plan [“Find the finance – and hold your nerve,” Financial Times, 31 October 2010]. They were right about the idea, but wrong about the plan. Moules explains:

“In fact, it took them eight years to get someone to buy their idea, and even then revenues were only £168,000 for the year. The plans both for [a] UK factory and target market bit the dust much earlier, after the milk industry pulled its support for [their company’s] product development. When McGeough and his team finally found a market for their product among food producers in North America, the founders had to go back to their eight angel investors for a further £4m of cash to build a factory in the US. ‘It was a big ask,’ McGeough admits. But what he and his team did have was the entrepreneurial survivor’s instinct. ‘I could say it was stubbornness or bloody mindedness,’ McGeough says. ‘We wanted to prove to the dairy industry that they were wrong, but we also believed that we could come up with a solution.'”

In yesterday’s post, Luke Johnson labeled this trait as “obsessiveness” and he recommended that investors look for it in an entrepreneur. Investors like obsessiveness in entrepreneurs because it means that they will likely grind through to success. Moules likes obsessiveness because it differentiates the best entrepreneurs from the also rans. He writes:

“Most … would-be entrepreneurs fall by the wayside, … exhausted by the stream of rejections, or perhaps attracted back to the perceived security of a salaried post. Even a successful technology start-up can expect to be on a diet of baked beans and goodwill for three years, according to Robin Klein, founding partner of seed funding business The Accelerator Group (TAG). Most of the businesses TAG backs do not make any revenue for 12 to 18 months, according to Klein, who has made investments in more than 70 early stage ventures over the years. ‘It is the toughest time for any business,’ he says. The length of time new entrepreneurs have to spend without salary may increase in the coming years, particularly if, as forecast, the recovery of the economy remains sluggish and the banks remain unwilling to lend. The question then becomes how best to survive, what can be cut and where else a business owner can get cash to keep trading. The temptation may be to rush headlong into anything that can generate revenues for the business. McGeough admits that in the lean years he and his co-founders at Bapco [Closures] would do whatever consultancy work they could to keep a roof over their families’ heads.”

There seems to be two schools of thought when it comes to obsessiveness. The school described by Moules could be described as the “stick-to-it” school of thought. The other school of thought could be described as the “know when to change” school of thought. This latter school of thought was discussed in article I referred to yesterday [“The pivotal moment,” The Economist, 2 December 2010]. According to this school of thought, it is essential to “know how to pivot: ie, dump [an] old business model and adopt a new one.” The article continues:

“Fail to twirl and your start-up may become one of the ‘living dead’, warns Eric Ries, a serial entrepreneur and blogger. He writes that pivoting is particularly important if you are what he calls a ‘lean start-up’. Yet you can have too much of a good thing, he cautions. An entrepreneur can overdo it and become a ‘compulsive jumper, never picking a single direction long enough to find out if there’s anything there.”

Not everyone agrees that pivoting is a good idea, even for lean start-ups. According to “stick-to-it” school of thought, “Chasing revenues might not be the best strategy.” Moules continues:

“According to Klein, … some of the most successful start-ups, such as internet telephony provider Skype, were far more focused on getting their product right [than chasing revenue]. ‘Skype had no revenue for years, but the founders and backers were very clear that if they could get millions of users there was a business model lurking in there somewhere,’ Klein says. A much better use of time is to focus on stripping out the costs of the business, according to Stefan Glaenzer, a serial entrepreneur and investor who founded Ricardo.de, Germany’s largest online auction company, before moving to London in 2000 to support other technology start-ups.”

Glaenzer prefers cutting costs to raising capital because the latter “will cost you a lot of time – and sometimes time is the most valuable commodity you have.” Moules concludes:

“You can make your own luck, and survive longer by choosing good backers, according to Glaenzer. ‘It all comes down to the selection of the right partners, be it mentors, advisers or seed investors,’ he says. It is helpful if your financial backers have a passion for what you are trying to achieve, Glaenzer notes. ‘If you have someone who is only looking at the return on investment, they might not go the extra mile when you need them,’ he says.”

Because raising money is hard, Robert Dighero, co-founder of White Bear Yard, which provides office space for early stage technology ventures in central London, asserts:

“My first rule of finance for start-ups is to raise money when you can, not when you need to. Start-ups quite rightly worry about dilution, but the consequence of raising more money than you need may be a few per cent extra dilution. The consequence of raising less money than you need is that you go bust. Start-ups always need more money than they think so raise more money than you think you’ll need.” [“Raise more, forget an office and do most of it yourself,” Financial Times, 31 October 2010].

Dighero, however, doesn’t recommend where you should look to raise capital. Moules’ article primarily looked at entrepreneurs who had sought traditional forms of financing through banks or angel investors. A number of entrepreneurs are now looking at new sources of capital. One of those sources is called royalty financing [“An Alternative Financing Option for Start-ups,” by Scott Austin, Wall Street Journal, 2 December 2010]. Austin reports:

“When first-time entrepreneur Philip Vaughn recently began searching for start-up capital, he traveled down two conventional paths. Mr. Vaughn, co-founder of travel-review aggregator Raveable.com in Kirkland, Wash., says he wasn’t interested in forking over a large chunk of equity to venture capitalists or committing to ambitious investment-return expectations. He also considered a loan, but knew that banks had made it onerous for young companies like his to obtain debt financing. ‘We’re in a weird spot’ but we have ‘a decent amount of revenue coming in,’ says Mr. Vaughn who expects Raveable’s sales to grow two to three times annually. So he’s considering an alternative called royalty financing, in which a company pays back a loan using a percentage of revenue. Traditionally found in industries such as mining, film production and drug development, royalty financing is being seen more among technology companies and other early-stage firms with growth potential. In the past year, new firms such as Arctaris Capital Partners LP in Waltham, Mass., Cypress Growth Capital LLC in Dallas, and Revenue Loan LLC in Seattle have sprung up to provide royalty financing.”

Austin points out that each investment firm puts it own spin on financing structures, “but one thing remains constant: The companies receiving the loans agree to pay a percentage of incremental revenue, usually from 2% to 6%, either over a specified time period or until a negotiated multiple of the investment is paid back.” Although this may sound like an attractive path to take when raising capital, Austin warns that “there are caveats.” He explains:

“The cost of capital may be more expensive than bank debt, especially if a company’s revenue rises well above expectations and there is no negotiated ceiling. Also, because these are loans, it’s still possible to default on them. And it can be difficult for a young company to manage its cash flow when some of its revenues are already spoken for.”

Austin reports that to be attractive to lenders, start-up companies must have “a consistent recurring revenue model.” On the upside, “royalty investors say the default provisions of royalty loans are generally less onerous than bank debt, and the payments are variable not fixed, allowing for flexibility if a company loses a major customer or has a down year.” The big deal for most entrepreneurs is that they “give up little or no equity in these royalty scenarios.”

 

A second unconventional way to raise capital is through the internet [“Tapping the Crowd for Funds,” by Emily Maltby, Wall Street Journal, 8 December 2010]. Maltby reports:

“When recent college graduate Bronson Chang wanted to renovate his uncle’s candy shop in Honolulu, he decided to tap his social network for the funds via a ‘crowdfunding’ website, instead of seeking a loan at a bank. Crowdfunding sites—such as ProFounder.com, Peerbackers.com, Kickstarter.com and IndieGoGo.com—allow entrepreneurs to raise money collectively toward a monetary target. Entrepreneurs can create a profile on a crowdfunding site listing their monetary goals, an explanation of how the funds will be used, and an end-date for the campaign. Once the information goes live on the site, investors can pledge money toward the entrepreneur’s goal. These sites typically take a small percentage of the funds that an entrepreneur takes home.”

As you might imagine, investors who use crowdfunding sites are unlikely to be wealthy like traditional angel investors. In fact, crowdfunding investors generally don’t even get what traditional investors would consider a return on investment (i.e., “investors often are promised only token compensation such as coupons or free samples”). As a result, entrepreneurs looking for capital from crowdfunding sites are generally looking for $10,000 or less. Maltby reports, however, that this may be changing. She continues:

“Sites like ProFounder are facilitating much larger fund-raising campaigns. ‘We’re at the beginning of a huge crowdfunding movement that will disrupt the traditional channels for funding,’ says Bo Fishback, vice president of entrepreneurship at the Ewing Marion Kauffman Foundation, a research organization in Kansas City, Mo., dedicated to start-ups. He reasons that entrepreneurs prefer the idea of pooling small amounts from ordinary people, rather than ‘trying to say the right things to get a rich guy to cut a check.’ In September, Mr. Chang used ProFounder to create a private fund-raising Web page, showcasing the business plan of Uncle Clay’s House of Pure Aloha LLC. He invited 75 family members, friends and customers to view the plan and asked them to contribute money. Nineteen people invested a total of $54,000 in exchange for a 2% cut of the store’s revenue over four years, starting in late 2011.”

In other words, Chang cut a hybrid deal that used both crowdfunding and royalty funding. Maltby provides a short history lesson in how crowdfunding began:

“The crowdfunding concept started a few years back as a way for photographers, filmmakers, musicians and other artists to cobble funding—usually from their fan base—in order to complete their creative works. Crowdfunding has now extended from the art world to the business world, thanks to the popularity of social-media outlets like Facebook and Twitter. ‘The economy, combined with strengthening social media, allows entrepreneurs to get funding that isn’t available at the banks,’ says Sally Outlaw, co-founder of Peerbackers, which launched in October and caters exclusively to entrepreneurs.”

Maltby reports that a woman named Regan Wann was able to raise more than $4,000 in 45 days through a crowdfunding site that enabled her “to expand her Shelbyville, Ky., tea shop, Through the Looking Glass LLC.” Maltby explains how Ms. Wann did it:

“Ms. Wann touted the initiative to customers, and linked to it on her Facebook page and her blog. A total of 60 customers, family members, friends and strangers contributed. The supporters got a combination of gifts, depending on the amount pledged, including free tea samples and the honor of naming one of the tea rooms. ‘I did not know what the response would be,’ Ms. Wann says. ‘Every day until the day I hit my goal, I worried I wouldn’t make it. The day I achieved my goal, I was so excited.’ Ms. Wann had reason to worry. RocketHub, like many crowdfunding sites, holds the pledges until the goal is met. If the campaign falls short at the end date, all funds are returned. Crowdfunding has other drawbacks. Because it is so new, some people aren’t comfortable with the concept. Indeed, Ms. Wann received an additional $2,000 from supporters who wanted to help—just not through RocketHub. And some customers and fellow business owners were so put off by the initiative that they no longer patronize the store, she says. … There are risks for the financial backers as well. The crowdfunding sites may conduct a preliminary check to ensure the business is legitimate, but cannot be held responsible if it isn’t. The sites usually don’t enforce allocation of the funds or that supporters receive their promised gifts. (In the case of ProFounder, investors receive a term sheet outlining their investment.) Another caveat: success isn’t guaranteed. Roughly 45% of the projects on RocketHub hit their goals, although that rate drops to about 25% for small-business ventures. IndieGoGo releases funds regardless of whether the goal is met, and some 40% of projects receive at least $500, but only about 10% of projects hit their targets.”

It shouldn’t surprise anyone that crowdfunding sites struggle to raise capital. They really aren’t very well known and the ROI offered to investors remains unattractive. If crowdfunding sites were to offer interest rates that beat Wall Street averages, I suspect a lot more money could be attracted. The one thing that isn’t different about these new avenues for raising capital is how difficult it can be. As an entrepreneur, you need to decide what is best for you. There are no perfect solutions.