Time is Money… and Money is Time

Antique Clock

 

This weekend I broke ground on book #7 in the series, The Next Step: The Realities of Startup Funding.

The key lesson is that for startups, money is time.  Or more specifically, money buys your a faster time to market and a potentially faster path to profits.

This is not how venture capitalists or Angel investors talk about money.  For them, money is fuel.  Which, from their perspective, is true too.  Investors invest in order to turn $1 into $10… as quickly as possible.  The tool they use to make that happen is money.  Their masses of dollars are aimed at entrepreneurs who can most quickly turn investment dollars into revenue, and revenue into exits.

Back at the majority of startups, which never raise money from those “professional” sources, money and time are tradeoffs, however, typically with a big limitation on the quantity of money.  With money, you can hire an employee or contractor to build your product or your website or whatever you need built.  You can purchase a list of sales leads or hire a salesperson to make calls all day to qualify leads.  Or, without money, you can do all of this yourself, which will take more time.

As I work with and teach entrepreneurs, I find very few who understand this tradeoff.

It seems as if all the news coverage of the high-flying, highly-funded startups has taught most entrepreneurs the venture capitalists’ story of money.  Have idea.  Raise money.  Make millions.  That second step, “raise money” is talked about as a given, almost a right of all entrepreneurs.  Meanwhile, the reality is that less than 3% of all startups in the U.S. raise money from Angel investors, and far less than 1% from venture capitalists.

Given those stats, what most entrepreneurs should be thinking about is a different story.  Repeatedly questioning, how can I turn my idea into reality without a minimum of funding.  Self funding to start.  A bit of crowdfunding.  Customer revenues as growth capital.  All with a minimum of trading dollars for time.

Time is money is chapter 1 of the new book.  The remainder will cover bootstrapping, crowdfunding, the business model of investors, and the odd story of how startup valuations come about.

If you are an entrepreneur looking for help with your startup, there are six other book in The Next Step series already published, covering the startup process, financial planning, marketing and sales, pitching, splitting founders equity, and an extension to the Business Model Canvas.  All can be found in paper and Kindle on Amazon.com, or as an online subscription and online class at lunarmobiscuit.com/the-next-step.

Investing Without Zombies

BY MICHAEL “LUNI” LIBES – LUNARMOBISCUIT.COM

The results of an investment (in an early-stage startup) depend not only on the success of that startup, but also on the form of the investment.

A sophisticated investor is going to be nodding right now, thinking about liquidation preferences and other common add-on’s to equity investments. But at the same time, those sophisticated investors likely have a majority of their investments in a state where they are worth somewhere between nothing and a 1x return.  A state often called a “zombie” investment.

The root cause of “living dead” investments is not the high failure rate of startups.  Failure leads to truly dead companies.  These zombies are not only still running, but earning revenues or even profits.

The actual root cause is the traditional structure of equity investments.  Take a step back and look at the assumptions of such deals:

  • Investors buy P% of the startup for $X
  • The entrepreneur uses $X to earn $R
  • If $R is sufficiently large, an acquirer buys the company, returning the investor $10X

This is the basic formula for success as an Angel or venture capitalist.  The problem is that successful investors only see this story play out 1 out of every 10 investments, plus 2 investments with a $5X return, a few more with a $1X return, and 4 or 5 that are total losses.  Unsuccessful investors never see the $10X, and without that, have a loss across their portfolio.

I look at this and wonder why the investment structure is optimized for the least likely case, rather than the most likely case.  Is there not an alternate investment form that boosts the returns of the majority of deals above $1X?

Traditionally, the only other form of investment is debt.  It works for homes, cars, Fortune 500’s and the U.S. Treasury, but traditional debt does not provide enough reward for the risk of early-stage investments.  When debt terms are adjusted for investors, the results are too much risk for entrepreneurs.

Looking around the fringes of the financial world, I found a structure that does work.  Revenue-based financing (a.k.a. Royalty-based financing).  This comes in a variety of forms, but in general it works like this:

  • Investors provide $X
  • Entrepreneurs use $X to earn $R
  • Investors receive Z% of $R, until a total of $2X-$4X is returned

The two main variables here are the percent of revenue (Z%) and multiple of return.  Typically the revenue-share is 3%-9% of “top-line revenues”, a metric that is easy to define and compute.  The multiple is commonly $2X for growth-stage investments, and $3X-$4X for early-stage.

This basic structure provides a few benefits for investors.  First, it provides a built-in “exit”, one that doesn’t wait until the entrepreneur has build up enough value to either attract an acquirer or launch an IPO.  Second, it aligns investor interest and entrepreneurs, earn revenues.  Third, it makes no assumptions about when the revenues will arrive, nor requires negotiation on when to issue dividends.  Fourth, it leaves the company management free to operate in whatever manner they please, e.g. management worries about growth vs. profits.  Fifth, it eliminates “zombies” as either companies are alive and earning revenues, or dead (or soon dead) earning nothing.

In short, it provides a reasonable payment for the use of investor capital, while providing a relatively high IRR (with a big boost of that IRR due to the quicker repayments vs. equity).  Plus this structure boots the odds of at least a $1X return, as the investee begins repayments as soon as revenues are earned.

The drawback?  The upside of the investments are capped.  If the structure asks for $4X, then the maximum return is $4X.  However, there are multiple fixes for this issue: tack on some warrants, or toss in some traditional equity.  Do something that adds back in some of the upside.

I discovered this structure while researching the business model for Fledge.  Fledge, in addition to a business accelerator, is also an investment fund, one that targets “conscious” companies, a market with few exits and few comparables.  Fledge uses RBF for its investments, roughly as described above, and so far after 19 such deals, we think it’s not only the right structure for impact investing, but a potential fix for the broken venture capital market everywhere.