Category Archives: Business Financing

Reality Check on Crowdfunding

I’m seeing more and more marketing showing up about so-called crowd funding these days. Sorry, but no. Not yet. Reports of crowdfunding in the U.S. are, as of today, just wishful thinking.

That is, to be sure, unless you play with definitions. For example, if you call KickStarter crowdfunding, then yes, Kickstarter is a great source of prepaid sales and donations, great to validate sales, and it’s healthy and growing. And Kiva too, is an excellent source of small loans for startups. However, much as I like both, neither of those is crowdfunding. Crowdfunding is supposed to mean lots of people each buying small shares of a startup or small business to fund it. Crowdfunding is about equity. People who contribute their money in crowdfunding get ownership in the business. Wikipedia Crowdfunding

And that, sadly, is not happening in the U.S. today. Yes, as the Wikipedia definition here suggests, the JOBS act of 2012 was supposed to open the door to crowdfunding; but it didn’t. What was supposed to happen was the Securities and Exchange Commission (SEC) was supposed to publish regulations to open up startup investing to more people investing smaller amounts without as many restrictions as before. And it didn’t.

The angel investment group I’m a member of, the Willamette Angel Conference in Eugene and Corvallis, OR, just finished its 2014 investment in a startup. Despite the promise of the 2012 law and the celebrations that followed, angel investing is now regulated and restricted even tighter than it was before. Our group joined six other angel investment groups in our state to figure out how to implement the regulations published last year. And the result: tighter controls, not looser.

Since our group started in 2009, we were always limited to was the SEC calls accredited investors. We always had to be careful not to advertise our meetings or recruit members openly, meaning that we could only recruit specific people who we had good reason to believe met the SEC qualifications.

Specifically, how is it tighter? This year, despite the myth of crowdfunding, we had to be much more careful than before. Our investment is coordinated with a local event to highlight the availability of angel investment in our region. In all past years, we had five finalist startups presenting their pitch to an audience of 200 or so local people interested in startups. The audience included the 35 or so member angel investors, of course. This year, however, we couldn’t have our finalist startups share their full pitch with the audience because the vague SEC regulations led some attorneys to worry that we’d be hurting the startups by making them guilty of a general solicitation.

To be honest, I’m not that anxious to see real crowdfunding happening. I’m not at all sure it will be the boon to startups we all think. Given that spammers are still making money by promising to enlarge body parts, people are still making some dumb choices on how they spend their money over the web. All we need is a well-publicized fraud to lead public opinion on crowdfunding, and step by step things will get worse, not better. Or so I fear.

But for now, at least: No, there is no crowdfunding going on in the U.S. Angel investment is still restricted to accredited investors only.

 

What’s the Difference Between Angel Investor and VC?

I see this confusion a lot: People use the terms “venture capital,” “venture capitalist,” and “VC” to apply to any outsider investing in a startup. However, it’s really useful to draw some distinctions in this area, between three important classifications: venture capital, angel investors, and anybody else. 

angel investment VC

Venture capital means big-money investment managed by professional investors spending other people’s money. The money comes from extremely wealthy people, insurance companies, university endowments, big corporations, etc. Think of Kleinert Perkins et al., First Round, Softbank, Oak, etc. Venture capital usually comes in millions of dollars. 

Angel investment is people who are accredited investors as defined by the U.S. Securities and Exchange Commision (SEC), which sets wealth criteria:

they must have a net worth of at least one million US dollars, not including the value of their primary residence or have income at least $200,000 each year for the last two years (or $300,000 together with their spouse if married) and have the expectation to make the same amount this year.

Those rules were going to relax with the Jobs Act of 2012, which people would open the gate to crowdfunding, but hasn’t yet.

The most important distinctions between angels and VCS are: 

  1. Angels invest their own money; VCs invest other people’s money. 
  2. Angel investment is much more likely to be in hundreds of thousands than in millions of dollars. 

Aside from those two distinctions, it is generally true that VCs will be more rigorous in studying (called “due diligence”) the investment before they make it. Both angels and VCs will have similar processes for looking at summaries, then pitches, then business plans. 

Anything else is called “friends and family,” which really means “not VC” and “not angel investment.” The laws on investment allow a few so-called friends and family, but there are limits. The intention of all the regulation in this area is to prevent the kind of stock frauds that were rampant during the great depression. 

Crowdfunding is Being Oversold

I think so-called “crowdfunding” is being oversold. Many people seem to think it’s going to mean a lot new investment money for U.S. startups. I don’t think so. Not yet. Maybe never. 

crowdfunding Google search

Crowdfunding, unfortunately, has become one of those bucket terms, that mean different things to different people. I use the term for ease of restrictions on small business and startup investments so more people can invest smaller amounts. And invest means buy shares of ownership. It’s risk investment. I really like KickStarter and the like, platforms startups can use to get financing help in return for prizes, advance purchases, and donations. But that’s not what I’m writing about here. It’s not risk investment. 

Maybe that’s why there is so much action on the web. Lots of offers. A google search (my illustration here) would indicate crowdfunding is everywhere. Half a million hits. 

The JOBs act of 2012 talked about it. Crowdfunding advocates celebrated., but hasn’t changed much. According to reports in VentureBeat and elsewhere, the most recent SEC ruling has as much bad news as good news for startups and angel investors. And some say the latest regulations make things worse, not better. The best summary I’ve seen of that negative view is Naval Ravikant’s letter to the SEC last month. Naval is the founder of Angellist. I posted my view on that a few weeks ago on Huffington Post, talking about some good news and some bad. And Alan McGlade has a good analysis posted as Crowdfunding will Flourish Regardless of What the SEC Does in Forbes.com yesterday. 

Action point? Conclusion? If you’re one of those people thinking crowdfunding is coming soon, don’t hold your breath. 

Q&A: I Need a Loan to Fill Orders

This is another question I received via the ask-me form on my website:

I have master service agreements with [omitted for confidentiality] in the midwest.  I am also working on an agreement with a company in South America.  I have a great reputation with upper management and they want to use my services.  The only problem I find is carrying payroll until the invoices start coming in, in this case they are net 60.  I literally have facilities telling me here are multimillion dollar contracts, but I cannot afford the payroll.  Any suggestions?

Yes, I do have suggestions. And the problem that solutions depend a lot on who you are, what resources you have, and your past history. Still, here’s my offer of help: 

cash flow working capital Shutterstock pot of gold

  1. What you’re running up against is banking law that prevents banks from taking risks with depositors’ money. Banks can loan money for a business plan or a possibility. 
  2. The SBA (small business administration) can guarantee up to 70% of the risk so banks can loan you that money without violating the law. You need to submit paperwork, a business plan, and an application. More than 1,000 banks work with the SBA, so there is probably one near you. Ask the small business banks in your area. The deal is done by the bank, but guaranteed by the SBA.
  3. What most entrepreneurs do, if they have the resources, and they can deal with the risk, is borrow off of existing assets. For example, my wife and I had a lien on our house for years to support a credit line for Palo Alto Software. We didn’t like it. It was risky. But we did it, and it worked out, because the company survived and grew. But you can lose your house or whatever assets you pledge, so be very careful. Never bet something you can’t afford to lose. And business is betting. It’s not something I haven’t done myself, but it’s not something I recommend comfortably.
  4. Before Palo Alto Software, when I was still doing business plan consulting, I found a local non-bank financial company to loan me against invoices from a major local corporation. They charged high interest but they advanced me 80% of every invoice and they didn’t take the risk because they had a hold on my bank account and if an invoice hadn’t had been paid (that, thank goodness, never happened) they would have subtracted the amount from my bank account. Google credit line on receivables to see what comes up. And the difference between that situation and yours is I was getting advances on invoices for finished work. 
  5. Some people find investors to advance them money for a non-bankable situation in exchange for a high interest rate, a small share of ownership (called an equity kicker), and drastic guarantees that give them your company if you can’t pay the loan. All of the terms are negotiable. Search the web for “angel lending” and see what you come up with. Ask your local small business development center (SBDC), chamber of commerce, or business school if they have any leads. There is no paved road for this kind of transaction, so you have to beat the bushes. This is hard to feet, and a lot will depend on who you are, your resources, your business plan, and your past history. It’s asking people to bet on your future. 

(image: shutter stock photo)

Some Hard Advice on Working for Sweat Equity

I just posted Why Sweat Equity Often Stinks on the gust.com blog for startups and angel investors. It’s quite cynical, I’m afraid, but it also reflects what I’ve seen for years.

istockphoto ball and chain

Sweat equity is a dangerous concept. It’s way too easy to misinterpret and misunderstand. And whether it’s intended to be or not, it’s way too often used as a lure to get people to work for less than they are worth. 

The good side of sweat equity is what startup founders earn by building their business. You create, work, develop, grow … and your business is worth more than it was. And you own the upside. 

The bad side of sweat equity is that it’s so often just thinly-disguised exploitation. 

Here’s my advice: if you’re getting paid less than your fair market value in a startup because you’re working for so-called sweat equity, understand that …

  • unless the equity deal is in writing somewhere, 
  • and defined with real numbers including percent of ownership, shares and total shares outstanding,
  • and real conditions such as vesting, and work expectations, what happens if you want to sell out and quit, what happens if they want to buy you out, and what about termination …

… then it’s probably not worth as much as you think. 

And what makes it worse, quite often, is that the people making the empty promises don’t intend to exploit you. They mean it when they say it, early on. But then the money starts flowing, investors come in, the board changes, and promises can’t be kept. Unforeseen circumstances are very common. So what you get is an apology. 

Some more advice: when I say get it in writing, I don’t mean a formal legal contract; at least, not necessarily. I’m a great believer in simple English signed by both parties, laying out what they think they’ve agreed to. Warning: I’m not an attorney. The attorneys are often valuable for pointing out all the issues to consider. But the big contracts usually end up in mediation anyway. Just make sure you have something written to remind everybody of what was promised. 

(Image: istockphoto.com)

Quiz: Can a Business Fail While Profitable?

I’ve posted here before on the problem of survivor bias and how hard it is to identify causes of business failure. Where do you find the people who failed? Do they tell you the truth? Do they even know. 

bills confusion istockphoto

In Are These Three Critical Threats Weeks Away From Sinking Your Business? on tweakyourbiz.com, post author Janine Gilmour interviewed 300 people about their business failure. That seems like a good start. A good interview might be able to get into real causes. 

The first cause: profits aren’t cash. Janine writes, specifically: 

About 60% of the businesses I reviewed were profitable when they failed, but they were upside down in terms of cash flow. 

Fascinating: “about 60%” of these failed businesses were profitable when they went under. I’d read “more than 40%” in this context sometime in the 1990s. 

Conclusion: watch your cash flow. Those of you with business-to-business sales are particularly vulnerable because businesses normally pay later, not now. Sales in those cases aren’t necessarily money until later, sometimes months later, sometimes never. And those of you who manage products, with inventory, are also particularly vulnerable. You typically spend the money way ahead of making the sale; and sometimes you spend the money without ever making the sale. 

Be careful. Profits aren’t cash. And profitable companies fail for lack of cash. 

(Image: istockphoto.com)

Sticky Questions on Startup Ownership and Buy-Sell

I received this interesting detailed question from the ask me form on my website. I’ve decided to answer it here. I think my answer might be useful for others with similar questions. I’m putting the question in quotes, paragraph by paragraph, and adding my response directly where it comes in the question. 

It starts like this:

A person ‘X’ owns 15% stake in a startup company – not by investing money but purely by virtue of having dedicating hours for building a product for the company. No salary was to be paid as per an initial agreement. The 15% stake was deduced by a simple calculation: (value of company) / (number of hours worked) x (dollars per hour).

Was it clear in the initial agreement that the formula here was to be used in future buy-sell transactions? Was that agreed to by all? 

The question continues: 

The value of company is therefore, sum of [(number of hours worked) x (dollars per hour)] and [hard cash invested by a person ‘Y’, also taking into consideration year-on-year appreciation of this hard cash]. Lets call that VC.

No, it’s not. The value of the company is what somebody pays for it when they buy it. And if nobody is buying it, then the value of the company is an estimated value. There are lots of formulas for estimating it, and estimates will vary widely. I’ve got more on that below, in my specific recommendations. 

However, it could be valued like you propose, for purposes of a buy-back transaction, if there was a buy-sell agreement that set that formula in the beginning. That’s if and only if. Issues like these are the reason experts recommend that partners and cofounders talk about the eventualities and agree, before the business starts, on how they’ll be handled. You have to agree beforehand or you’re stuck with arguing and negotiating the valuation afterwards. And when you try to pull it apart afterwards, without the benefit of an agreed-upono buy-sell formula, then many formulas might apply. 

And here’s the heart of the question: 

The company is not profitable yet. Person ‘X’ decides to give up his 15% stake of the company. My questions:

– How much is ‘X’ entitled to receive as the value for 15% stake? 
– Calculating backward, would X receive as much as [(number of hours worked) x (dollars per hour)]? 
– How does this change if the only buyers of the 15% stake are also two other stake-holders within this company, one of them by virtue of cash invested in the company, and the other by virtue of hours spent working for the company?

Normally, unless otherwise specified, owning 15 percent of a company means you own some shares that amounted to 15 percent of the total shares issued when they were issued. Ownership privileges are defined in company documents. You might have a seat on a board of directors, or not. You might get dividends when that’s relevant. And you’ll be able to sell those shares subject to securities and exchange regulations. 

Just hypothetically, as an example, say you agreed two years ago that you got 15% because you had put $15,000 worth of work on it for free and the founders agreed then that it was worth $100,000. If it’s launched and very successful now, with sales of $1 million annually, then it’s worth something like one or two times revenues, less a discount for debts, less a discount for not being liquid. In that case your 15% is worth something like $100,000. On the other hand, if it launched, has no sales, no profits, and has spent all its money, then your 15% is worth about zero. Companies are almost never worth a formula based on hours worked. 

So unless you have that buy-sell agreement stipulating the formula you’re using, then it doesn’t apply. Here’s what I recommend. 

  1. Agree on an estimated valuation. The formula you’re suggesting seems like it might be one-sided and self-serving. Good luck with it because it’s going to be hard. Expect disagreements. Depending on how much money is at stake and how severe the disagreement, you might need to work with an attorney and a valuation expert you can agree on. Here are some posts on this blog about valuation. This one is particularly relevant: 5 things business owners need to know about valuation. Sales, sales growth, profitability, and scalability and defensibility make it worth more. Debt, and not being liquid shares, low growth, and losses make it worth less. 
  2. Take 15% of that valuation and negotiate with your cofounders based on that value. I hope for your sake and the sake of your cofounders that things are going well for this business and they’re happy to buy you out. If they aren’t, then you’ll have to keep discounting until you get to an amount they’ll pay you. Or just keep your 15% of the shares, stop working for the company, and hope that someday they’ll be worth something. 

The moral of the story: please, the vast majority of business marriages (partnerships, startups with founders, etc.) end in divorce. Do a business pre-nuptial agreement, which is what they call a buy-sell agreement. 

 

 

Greatly appreciate your response and all your help!

3 Incredibly Common Credibility Killers in Business Plan Numbers

Business plans are about business decisions. When I read them — and I read hundreds of them every Spring — I’m looking for the concrete specifics, like dates and deadlines and tasks and milestones, that point towards execution. But part of that is reasonable, credible projections. And I am way too familiar, way more than I’d like to be, with these three very common mistakes. 

Credibility killer #1: unbelievable profits

Face it: startups aren’t normally profitable. Existing businesses, once they’re established, rarely make more than 10 or so percent profits on sales (that’s profits divided by sales). Some of the best businesses make 15 or 20 percent. 

Therefore, when you project 30, 40, 50 or more percent profits on sales, you’ve lost all credibility. That doesn’t make anybody think you’ve actually going to generate that kind of profitability. It does make people think you don’t know the real costs. 

Additional tip: nine times out of 10, you’ve underestimated the marketing costs. 

Credibility killer #2: ignoring sales on credit

Businesses that sell to other businesses don’t normally get paid immediately. They send invoices for products and services. They wait. Weeks or months later, they get paid. Sales accompanied by an invoice like that are called sales on credit. They count as a sale, but instead of adding to cash they add to accounts receivable, and then they get into the bank account later, when the receivables are paid off. 

If you don’t allow for sales on credit in your projections, you kill your credibility. So plan your cash to include the additional working capital it takes to support waiting to get paid.

Credibility killer #3: expenses vs. assets

We all use the word asset to refer to something good to have, like a friend, a second language, and a college degree. More to the point, we often refer to business advantages such as a product design, software code, a prototype, brand awareness and so on as assets. 

In financial terms, however, assets are specific. They are entries in a balance sheet. Assets are equal to capital plus liabilities. Cash, inventory, accounts receivable, equipment, office furniture, vehicles … those are assets. 

The most common problem with this is what happens when you pay salaries or project fees for software or web development. That’s an expense. It reduces your profits and lowers your taxes. So it’s a loss. Way too often people show those expenses as if they were buying an asset. Sorry, we hope that your programming expenses generate something good for your business; but they are expenses, not purchase of assets. 

Oh, and that land and those buildings your business owns? Those are assets, yes, but they should be on your books for what you paid for them, not what you think they’re worth. 

Summary: 

Finance and accounting have this annoying thing about them: things have to mean what the standard principles say they mean. You don’t get to redefine them back into what you think they ought to mean. 

(Image: shutterstock.com)

7 Steps to Practical Business Stories

Remember, stories aren’t just stories. They’re truth and promise and relationships established. They’re vital to business. There’s more truth in stories than in all the statistics ever published. 

Geoffrey James posted How to Tell a Great Story on Inc.com last month, quoting Mike Bosworth of Solution Selling, and Ben Zoldan, one of his top trainers. So this is how to tell a memorable business anecdote:

1. “Decide on the takeaway first.” There’s a business goal. Yes you want to make conversation, but also make a business point. If you’re selling shoes, tell a story about a shoe disaster, or a shoe rescue. 

2. “Pick the ending ahead of time.” Get the ending that supports the takeaway. 

3. “Begin with who, where, when, and a hint of direction.” He adds:

Every great story–and indeed, every great movie, novel, or TV show–starts with a person (who is going to do something), a place (where things are going to happen), a time (so people can relate “then” to “now”), and just a hint of direction, indicating where the anecdote is headed.

4. “Intensify human interest by adding context.” Details, done right, make it a story. Try to put your people there, caring about the people and the situation. 

5. “Describe the goals and the obstacles.” They call that plot. What was the problem, and how was it solved. 

6. “Describe the decision that made achievement possible.” 

It’s important not to confuse the decision (or turning point) with the ending of the story.  The turning point is not “what happened”–it’s the decision that caused what happened to happen.

7. “Provide the ending and highlight the takeaway.” Don’t assume your listener figured it out. Make sure to say it, out loud. Tell everybody what happened and why it’s important. 

Nice post, good recommendations; thanks Geoff, Mike, and Ben.