Financing new ventures chapter 4 – determining the amount of capital

 

Could someone answer several questions of the following? Just please answer what you make sure, don’t need all of them:

Too little, you may miss your milestone and next round will be costly, if available at all

Too much, current round is too costly. Too much dilution and tendency to waste it.

Like Goldilocks, it should be just right.

Market for capital is very cyclical.

Reached $100 billion is 1999, and dropped to $10 billion by 2009, and was not exceeded again until 2018 and 2019. This year? Who knows but it won’t be much.

How to determine needs?

TRADITIONAL – Build a cash flow statement projection. Generally out 4 to 5 years. Always do monthly or at least quarterly. Why?

Seasonality. Can kill companies. Think of a snowboard company that one of my students had. Received lots of money in winter. None in summer. But when did he need to buy materials? Yup, in the summer. Better have saved enough cash or was able to finance it.

Determine your key drivers/assumptions of cash flow growth.

STARTUP – Revenues and expenses highly variable and subjective, especially revenues.  

 

Many factors are binary, as there are many ways to go.   Think of coming to a series of forks in the road.  Rather than a normal distribution like this: (See the picture -1)

It’s either a winner or loser, not much middle ground.

Some do 2 or 3 projections.

– most likely scenario

– worst case scenario

– best case (but why bother with this one?)

Be careful with spreadsheets, they may imply a fake sense of precision. That doesn’t mean don’t do one. Just understand the limitations and assumptions. Be flexible, not rigid. Use high level quick and dirty projections as a gut check.

What absorbs the most capital?

1) Obviously capital assets. Equipment, buildings, vehicles, but also patents. Lease if you can. You can even lease (license) a patent rather than reinvent the wheel. Lease rates may seem high but they’re cheaper than VCs. Also capital assets are less these days.

Use the cloud for computer hardware/software. Generally incurred up front first year, unless deferred thru leasing (preferred).

2) Product development. R&D. Cost of engineers and developers. Less upfront than capex but mostly in early years 1-3.

Least deferrable, must be paid. #1 priority. Without it you have no product.

3) Sales & marketing. Engineers often forget this or don’t think it’s important. “Build the best mousetrap and they will come.” Not!

Often the biggest component of expense. Comes later. Years 2-4. Can be deferred but revenue growth will suffer.

4) Working capital (inventory & receivables). Also often overlooked. Cash versus accrual problem when projecting. Also can be very seasonal. Think farmers, ski resorts, campgrounds, sports. Affects all growing businesses all years.

5) Lastly leadership and admin. Most discretionary as leaders & execs can take equity vs. cash. Often paid out greatest in exit strategy.   

See working capital models on pages 86 & 87 in the book. Ex. 4.2 and 4.3. See how growth sucks up capital.

If you can, develop a business model with positive working capital cash flows:

1) Gift cards

2) Loyalty programs. Points paid up front.

3) Some grocery stores, retailers, Walmart, although generally only if you are big. small guys must pay cash.

4) Insurance companies

5) Amazon (over 100 days!)

How do investors view the 5 spending buckets?

1) Capital assets? Nay. They would rather you lease.

2) R&D. Essential. High returns. These are the creators.

3) Leadership & admin. Leaders yes. Admin no. Outsource your HR, IT, and accounting.

4) Working capital. No. Deadweight. They won’t invest in businesses with negative 180 days working capital.

5) Sales & marketing. Almost as essential as R&D.

Click into this topic to discuss the mini cases in the pictures.(See the picture -2,-3,-4)

For mini case questions: answer 2 or 3 of them?

1. Mini case: Loyalty Scheme

Would this business be attractive to VCs?   Why or why not?   

What’s the biggest component of spending?  

What are the risks here?   How is this company likely to perform in a downturn like today?

2. Mini-case: Software business

Why are software businesses so attractive to venture capitalists?   

Why are they capable of providing very high returns?

But what are the risks of software companies?

3. Mini case: Bicycle components manufacturer

Why is this business ugly to VCs?

Although margins are relatively high (on an accrual basis) why is this not attractive?   (Hint; think of what the margins are on a cash basis.)

What is likely to be they’re biggest cost spend category?   How could they finance this if VCs won’t?

4. Mini case: Wireless broadband rollout

Would VCs be interested in funding this?

What would be a likely exit for investors?   Who would buy a company like this?   And who is likely to be your competitor(s)?

Why is debt a necessary component of the capital mix?   Are margins of this business likely to be high or low?   Why?

What is likely to happen to marginal revenue over time?

5. Cash flow projections – why bother with a best case?

When companies are projecting 2 or 3 scenarios, they need to prepare and position the company for the potential landscape they’ll be competing in over the next 1 to 5 years. While most would be interested in the most likely and the worst scenarios so that they can hedge against risk and forecast actions that would optimize the company’s revenue, the best case scenario is also crucial in order to plan for actions that would be required at that point. If the best case scenario unfolds and the company did not prepare for it, dollars could be wasted due to lack of repositioning in the stronger environment, opportunity costs incurred, and dollars left sitting instead of being put to work. Additionally, if a startup does not consider a best case scenario, they may also miss the opportunity of attracting additional investors and VC. 

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