The harsh realities of funding and finance

Looking from the financier's view point

In contemplating a business venture that involves selling a product or service to a client or customer, it is obvious that it is necessary to build the product or service around what the customer or client actually wants. As obvious as this basic tenet is, it is often completely ignored when it comes to seeking funding or finance for a business venture.

Seeking finance is much like selling any product or service, a profitable revenue stream is being offered for sale in return for a capital sum. It makes sense therefore, to see what a financier wants the revenue stream for and to know how it will be valued by the financier.

Note: I'm using the term "financier" here as a general expression to cover all types of funding bodies that an entrepreneurial business, or, a new business project within a large company, might need to provide exploratory or working capital before it is in a position to generate its own funding needs from earned profits.

Startup or business development financing can take several different forms depending upon the stage:

Preliminary stages

The preliminary stages are during the birthing process of a business venture, the time when there are mainly ideas with no clear directions as to how to proceed. Most ventures at this stage are stillborn and proceed no further.

Birthing usually begins with some inkling of a possible business situation that occurs as a result of recognising an opportunity or seeing the possibility of a unique or better solution to a problem or a need. At this stage it will be necessary to do some market research, make a prototype, develop a proof of concept, etc.

This stage will require much time and skilled effort, but, financing can only be provided on the basis of hope and faith. This is often provided by the instigator or instigators themselves, their friends and families, but, more often is directly or indirectly financed by an employer.

Although the stereotyped startup business venture is romantically thought of as beginning in a garage, most startups originate within companies. Even many private business ventures are birthed within a large company, often where a project is cancelled before coming to fruition and the frustrated employees working on the project leave the company to continue working on the project themselves.

Many ventures also start from within companies when employees recognise an opportunity before the management. They might then develop a business venture to the birthing stage while still working for the company; using the company's time and resources in place of seeking finance. Not a particularly honest way to go about starting a business, but, very common in the world of e-business.

Some startups are birthed from the dying embers of a failed company, where there has been a basically sound, core business idea which has not been successfully brought to fruition through poor business strategy, burdensome overheads or cash burn up. After the company goes into liquidation, the core idea might be taken up by the original initiators, or by the employees, who can then make a fresh start without debts or onerous liabilities.

This phoenix like phenomenon is observed in the fashion industry, where sudden changes in trends or fashion can wrong foot a company, causing bankruptcy. Such companies are quick to restart from new beginnings, after their debts have been wiped out through an official liquidation process. This same pattern is starting to emerge with dotcoms.

There are unlimited ways in which the need for capital at the birthing stage can be circumvented, without the principals having to apply for professional financing facilities. This is mostly a necessity because few financiers will even bother to spend time investigating investment opportunities that consist mainly of speculative ideas and broad assumptions.

In general, financiers don't like uncertainty or unknowns. They prefer to have strong justification for any investments, particularly as most funding bodies have to account to others for their decisions. This practically eliminates all sources of professional funding for the birthing stage of a business.

Start up stage

Many small service businesses can be started without the need for finance. They can boot strap themselves up into profitable operation through charging for services rendered. Most expert services and consultancies can start this way, where overheads are minimal and stage payments can alleviate any cash flow problems.

For the more ambitious startups, there will be a need for seed capital to get the business up and running to where it is either self financing or developed sufficiently to attract serious investment capital.

Seed capital can come from two sources: angels or venture capitalists. Although the distinction between these two sources of finance is very blurred, it may be useful for the purpose of this chapter to treat them as being black and white caricatures. The exaggerated difference we'll define as being the difference between gamblers and business packagers.

The angels will have an interest in the success of the business, taking a gamble on their own judgement as to the viability of the proposition and the ability of the initiators to create profits. Most often, angels will not need detailed business plans and cash flow projections. They will be calling upon their own business experience to recognise talented people and potentially viable situations and will usually have some kind of interest or control to ensure that the venture keeps on track towards profitability.

Venture capitalists on the other hand, usually have very little interest in what a company does, how it does it and sometimes are even unconcerned as to whether or not it will eventually become profitable. They are not gamblers, neither do they put up money based upon their own judgement as to whether a business is likely to be successful. They simply look for suitable situations that can be attractively dressed up to sell on to investors.

Note: This rather cynical caricature of a Venture Capital company is not typical of all Venture Capital companies. It is meant to apply only to the situations involving the financing of e-businesses where there is no way in which a Venture Capital company can be in a position to accurately predict the future viability of the business. This would apply to practically all e-businesses because of the chaotic and changeable nature of the world of digital communications. They can only be guessing and the failure rate of venture capital financed dotcoms has proved this point.

In fact, most Venture Capital companies will go to considerable lengths to investigate the prospects of profitability for the companies they finance. They do make judgements on whether or not a business is likely to be successful because failure reflects upon their ability to pick winners, which in turn affects their credibility with investors.

Basically they provide a service for a particular group of investors who are putting up the capital to finance young and promising companies. These investors will be looking for a return on their capital of something like a 25% compound rate of interest – but this profit comes from selling on, not from the profitable returns of the companies they are financing.

A Venture Capital company will not be looking for just any attractive proposition that comes along, they will tend to specialise in particular technological niches where they have contacts, and inside knowledge. They will have a profile as to what to look for in a company, which will limit selection to the areas of business where they have special knowledge. This profile will also include the particular preferences of their own group of investors.

Many start up companies seeking venture capital finance are unaware that different Venture Capital companies have different profiles with which to select companies to finance and will waste much valuable time and effort approaching those who do not cover their particular area of business.

The important point to note is that Venture Capital companies are not looking for long term results. They are creating a vehicle that they can sell on at a profit for themselves and their investors. This they can do even if a company eventually fails.

The uninformed hysteria of the dotcom bubble resulted in hundreds of thousands of investors clamouring for hi-tech shares simply because they were in fashion and the prices were rising. Some Venture Capital companies responded to this need and made enormous profits for their investors by feeding this share buying frenzy. Many of the investors who ended up with those shares when the music stopped weren't so lucky.

Serious business stage

Once a business has passed the startup stage and shows either an actual or reasonably certain expectation of a profitable revenue stream, it can start to look for investment capital. Investors providing investment capital, for a business coming out of a startup stage, might have several motivations that cover a spectrum of different needs

Firstly, there is the long term investor looking for the potential for steady growth or a reliable dividend income. It is unlikely that this kind of investor would be attracted to Internet businesses. They would not have a long track record and the volatility of the e-business environment could see them being overtaken by events, losing their way or meeting superior competition that emerges out of the blue to crush them out of existence.

However, many long term investors assign a small proportion of their portfolios to speculative investments, sometimes to add a little excitement to their investment strategy, sometimes as a way of keeping in touch with new and unfolding events in new and up and coming markets. These funds may be used for investment in hi-tech new issues.

Secondly, there is the type of investor who would be looking for a short term capital gain. These are the investors who are particularly attracted to hi-tech companies. They gamble on a company's trading expectations being fully realised. Effectively, their investment strategies involve discounting the risks less than the more cautious investors.

Thirdly, there will be the speculative investors, who ignore the risks and the fundamentals and act on spurious information or doubtful reasoning. They will buy on the basis they think a share price will rise sufficient to be able to sell again for a quick profit – presumably to an even more optimistic gambler. All booms are led by this kind of investor.