Seed Stage Capital

If you are looking to start a business with more than your own capital and sweat, then you have joined the hunt for seed stage funding. This least risk-aversive form of equity can be found from two sources: (1) the 3 F’s or (2) angels.

The 3 F’s refers to “friends-family-fools.” It is very difficult to convince someone who does not know you that your judgment is sound and your effort to succeed will be unbounded; therefore, friends and family are a typical source for seed stage money. Of course if you do not succeed, be prepared to lose a friend or pay back a family member. “Fools” is meant to add a humorous slant, but this does lead us to our next category… angels.

I am at liberty to describe angels as fools because I am one (and self-deprecation is a cheap laugh). The term “angel investor” is meant to refer to someone with enough disposable income that he/she actively looks for ways to dispose of capital with risky startups, hoping that occasionally one of these investments will produce a home run. Some angels are very experienced business executives, who can bring far more than money to the table. Other angels just have a fat pocketbook. All angels can be difficult to convince and even more challenging to predict their terms. If you don’t know any angels, one shortcut is to look for an angel group in your area (go to www.angelcapitalassociation.org). Not all angel groups are created equal, so you will have to learn more about their process and members to determine whether pitching them is right for you.

“If you would know the value of money, go and try to borrow some”

When Ben Franklin coined this phrase, I do not think he was explicitly talking about the cost of capital; nevertheless, if you have ever raised capital—either equity or debt—then you know that others value their money quite highly.

There are periods of time (e.g., 2006-2007) where lenders have forgotten the value of money. In Franklin’s era most lenders were lending their own money, unlike today’s more complex financial markets where commercial bankers, investment bankers, and hedge fund managers are lending other people’s money. While these professional lenders should still exercise the same degree of caution as if it were their own money, in practice they can be swayed by many counter motivations. Recently, this has led to overleveraging across many asset classes. What started with the mess in sub-prime residential mortgages has now spread across every other form of debt, and we have given this reaction the title of “Credit Crunch.”

While people have debated whether the Credit Crunch is the result of a crisis of confidence amongst lenders or a shrinking of available capital, I say it is neither. The Crunch is simply the hangover we are all experiencing after the raging party where lenders forgot the value of money. Standards have returned, and in some cases the pendulum has swung back too far; however, in all cases this is the result of a collective realization that money is valuable!

Franklin also said “when you run in debt; you give to another power over your liberty.” As a lender myself, you might think it odd that I would continue to quote a man like Franklin, who was so opposed to debt. The fact is that he was right, but he did not paint the whole picture. Leverage can be a very powerful tool to fuel growth and accelerate return on investment. Moreover, debt in all its forms is significantly cheaper than equity, so if you need cash to grow your business, swearing off debt like Franklin is foolish. HOWEVER, there is no free lunch, and a more reasonable cost of capital comes at its own price, which Franklin termed giving power over your liberty to another.

Private equity firms have proven repeatedly that layering debt onto the balance sheet of portfolio companies leads to greater management discipline and focus on the bottom line. At the same time, we have seen many companies implode unnecessarily under the weight of too much debt. So if you are considering debt to fund your business, what can you take away from all this?

Never rely on a lender to tell you how much debt you can effectively service. Whether you are buying a home, levering your company’s balance sheet, or factoring receivables, if you are truly honest with yourself, you know better than any financier how much debt you can handle without threatening your liberty. A year ago you could have easily found a lender to underwrite a bridge loan on a raw land purchase or a cash flow loan at four times EBITDA or an asset-backed loan at 80% LTV. Today, you will be hard-pressed to find a hard money lender for land acquisitions or three times EBITDA for a cash flow loan or an asset based lender who believes a 3rd party valuation report for which you hired and paid the analyst. So where lenders too liberal last year and are they too conservative today? What you need to take away from this is that the answer to that question should be irrelevant to you. You must define how much risk you are willing to take with your liberty, and use this to determine how much debt you will ask to lend.

Too often I hear equity holders ask, “How much do you think you can lend over my bank?” or admit, “I’ll take as much as you are willing to give me.” I sympathize with the desire to take as much money as possible, but the risks of debt scales with the principal you seek. Ultimately, it is in your best interests not to overreach, even when your lender has forgotten the value of money.

Talent as an Asset

If you are looking to start a business, you are probably obsessing about brand name, market strategy, funding options, product/service attributes, etc. You may be thinking about staffing requirements as well, which I would like to obsess about here.

All venture capitalists need to observe three key attributes before diving into more specific due diligence of an opportunity: (1) large market size, (2) compelling and defensible value proposition, and (3) quality management team. In fact, many experienced investors believe that an average idea with a superior team is a better bet than a superior idea with an average team. This may seem counterintuitive, but bear with me as I explain.

Don Valentine, the founder of Sequoia Capital and an original investor in little companies you may have heard of like Apple, Cisco, Electronic Arts, and Oracle, is also famous for many memorable statements he has made over the years. He has said, “The trouble with the first time entrepreneur is that he doesn’t know what he doesn’t know. After a failure he does know what he doesn’t know and can beat the hell out of people who still have to learn.” Of course, many great inventions, works of art, and ideas come from young minds; however, for day-to-day business building, experience counts.

High growth markets also tend to be highly unstable and unpredictable. In other words, today’s superior idea may be arcane tomorrow. Given these rough waters, wouldn’t you rather have an experienced crew on board? An experienced team can make the most of an average idea or even reshape it over time into a home run; however, an inexperienced team more often than not will only succeed despite themselves, or as Don Valentine has also said, “I like opportunities that are addressing markets so big that even the management team can’t get in its way.” Smart guy, huh?

Finally, I’ll retell an anecdote of a college roommate of mine. While he was attending Harvard Business School, he explained to me that regardless of subject matter every HBS class is dominated by the case study method. I was attending Wharton at the time, where many subjects were full of case studies, but accounting and finance were more dominated by lectures. My friend was complaining that since many of his classmates were learning accounting for the first time, they were getting very confused by theoretical questions postulated by the professor through the case study method. For example, his professor asked the class “should your employees’ salaries be expensed or capitalized, because aren’t people really an investment in your company?” Of course, this is a ridiculous question on so many levels, particularly when asked of students just trying to learn the language and rules of accounting; however, the philosophical element of this question is important to consider.

Talented people are an asset, and an investment in talented people is often more critical to success than any other investment in your business. Whenever possible, hire people for roles within your company, where you can say, “he/she could do a far better job of this than I could.” And, on the flip side, when you realize that you have made a bad hiring decision, first determine if there might be a better role for this person in your company. If not, get rid of them as quickly as possible. Mediocre performers aren’t just a waste of capital; they tend to frustrate and de-motivate your high performers.

Solar ETF Launched Today!

Trading under the ticker symbol TAN, this Exchange Traded Fund tracks a basket of 25 public companies that are pure plays in solar technology. With oil closing at $113.79 today, it is no wonder that public markets are bullish on the future solar photovoltaics market.

While solar may only represent a small part of the alternative energy mix to reduce our reliance on fossil fuels, this will be fertile ground for all types of entrepreneurs. The true technology innovators are focused on reducing production costs and increasing photovoltaic efficiency, which is mostly about improving scale production and experimenting with nanotech materials to replace expensive silicon. Nevertheless, millions can be made by Main Street entrepreneurs looking to build installation and service companies, particularly in regions like the Southwest and Southeast where the supply of sunlight seems limitless.

The Color of Money

When Paul Newman played "Fast Eddie" in The Hustler 1961 and reprised his role along with Tom Cruise in The Color of Money in 1986, the color reference to U.S. currency notes was the traditional green cloth of a pool table. Today's game is the race to invent and commercialize green technologies, or GreenTech.

Historians may debate the specific catalyst that led to the inflection point in America's mindset towards "going green." I think Al Gore may lay claim that his Oscar-winning film An Inconvenient Truth, brought the collective consciousness of our nation forward on issues of global warming, carbon footprints, and conservation. As he is no longer running for public office, hopefully his Nobel Prize won't be as misrepresented and maligned by politicians and the press as his poorly worded statement in an interview with Wolf Blitzer in 1999 that "during my service in the United States Congress, I took the initiative in creating the Internet." Of course, he never meant to imply that he "invented" the Internet. I'll bet you have never seen reported the statement from Vincent Cerf (who is commonly referred to as the Father of the Internet) that "the Internet would not be where it is in the United States without the strong support given to it and related research areas by the Vice President in his current role and in his earlier role as Senator." But I digress...

GreenTech is now the hottest ticket in VC, as investors quest for the next "killer app" since Al Gore invented the Internet (oops, there I go piling on!) The term GreenTech refers to all innovations in energy and environmental technologies. Although investors can point to very few IPOs or other liquidity events, this space is expected to result in billions of dollars in value creation for new ventures. As with any Gold Rush, there will be snake-oil salesmen and profiteers at work; nevertheless, I believe that fortunes will be made in the process of saving our small planet.

The Hitchhiker's Guide to the Galaxy... or to VCs

If you feel a bit like Arthur Dent in a bathrobe traveling through an unfamiliar and illogical universe in your quest for venture capital, there is now an interesting guide. While far from a perfect resource, TheFunded.com provides a voyeuristic experience into how specific venture capitalists have treated entrepreneurs, both good and bad. Members of TheFunded.com (including your's truly) post details about their experience pitching and working with particular venture firms and individuals. Of course, the quality of individual opinions is a matter of debate (particularly amongst venture capitalists); however, you can learn a lot from reading these postings. It's also a good resource to build a list of potential VC investors that are active in your space. Sadly, I have not found a posting from Deep Thought yet with "The Answer to Life, the Universe, and Everything."

My goal...

Those of us who are crazy enough to start a business know that there is only so much you can learn about entrepreneurship without experiencing the challenges first-hand. Does this mean that you should not prepare yourself to face these challenges? Can you not learn from others' successes and failures? Of course not!

As arguably the greatest American inventor and statesman, Ben Franklin penned many famous sayings, including "an investment in knowledge pays the best interest." This will not be the last time I refer to BF, because as a great entrepreneur in so many fields and professions throughout his lifetime and as possibly the first rags to riches exemplar of the American Dream, his copious writings provide us with a treasure trove of wisdom from a man who was fantastically successful at so many endeavors.

The purpose of my weblog, however, is not to emulate Poor Richard's Almanack. My goal is to provide my perspective on the contemporary challenges of entrepreneurship, which I hope will be of practical use to others. So, if you are:

• wondering whether to pitch your start-up to an angel network;
• curious about opportunities during a housing market correction;
• puzzled by definitions and uses of founders stock, preferred equity, venture debt, mezzanine debt, senior debt, and factoring;
• wondering when to use a PR firm, hire a VP of marketing, use an outsourced call center, start an ESOP, or make a personal guarantee;
  
• looking for insight into trends in Cleantech, Social Networking, and Venture Capital;

then I hope you find reading my weblog a useful investment of your time.