Chapter 3
The harsh realities of funding and finance
Exasperation and despair
On Thursday 15th February 2001, a London based organisation, NETPROZ (formed for the purpose of bringing e-business entrepreneurs together with funding organisations) held a special event. The event, called the Equity Food Chain, was part of a unique collaboration between six business networks based in London: NETPROZ, The National Business Angel Network, Netimperative, HRNet, Simplesite and Wave2. The idea was that members of these various communities could come along to the event to ask a panel questions relating to the funding of e-business startups.
It was a particularly apt time to hold this event because in the wake of the many recent dotcom failures, enthusiasm for investment in e-business ventures had fallen off dramatically. It wasn't hard to see why. Only the day before this meeting, an article had appeared in the London Evening Standard, by the city editor, Anthony Hilton, highlighting the problem.
The Nasdaq index of hi-tech stocks had fallen to half of the value it had reached at its peak in March 2,000. At the time of this market high, the average price to earnings ratio of the top 100 stocks had stood at an incredible 165. With stock prices falling to half their former values, it would have been expected that the price earnings ratio would have followed suit and fallen to around 82. Instead, the price to earnings ratio had risen to an unprecedented 811– due to the low earnings and the losses reported by these top 100 companies during the year. It was these kind of figures that were dampening the enthusiasm of even the most optimistic of investors, so, the-business startups looking for funding had every right to feel concerned
As one of the panel, I was sent a list of the questions that had been sent in for the panel to answer. These included the following:
Question 1
What is the best way to secure seed capital to develop a concept for a technology startup?
Question 2
We are a start up company developing a product that could revolutionise the way data is handled over multiple platforms. We have interest and a great deal of help and support from a major technology company. We are still looking for funding. When we first started approaching VCs we thought that our offering would be received with delight as it has the potential for fantastic growth and enormous financial return. We were hugely disappointed however to be frequently told, "Oh well, it hasn't been done before, we prefer tried and tested products".
They all seem so afraid of looking at something new, preferring either something conventional, a mild revolution by somebody who has already tried once and failed, or something being developed by a tribe of Microsoft employees! Even the angel investors we have spoken to say that they are only interested in investing in serial entrepreneurs. Bearing in mind we have secured technological (and later marketing) support from one of the biggest companies in the business, where can we find an investor who is prepared to put the venture back into capital or at least give us a proper look?
Question 3
We are Entrepreneurs currently at funding stage and looking at Business Angel/ VC opportunities. Taking into account the recent reduction in value of Tec stocks, what factors need to be addressed/ altered (if any) when preparing a business plan for potential investors to review?
Question 4
The investor market seems so scared of investing in Start Up technology companies and are demanding a level of development often impossible for companies looking for their first round of funding. With fewer start ups finding funding and fewer companies reaching maturity as a result, surely the pool of companies requiring funding for second round plus (which VCS seem to be looking for) will eventually dry up. Is it any wonder when investors show such lack of faith in the industry that stock market values fall and the general public lose faith in what should be an industry of tremendous growth. What can be done to break this cycle?
Question 5
We all welcome a return to sensible valuations and the application of "normal" commercial logic, but let's not forget that venture capital is still about risk taking. That requires vision and leadership, as well as analysis and clever financial engineering. Does the panel agree that these qualities are now in short supply among the investor community and that the winners will be those with the guts to lead deals rather than follow "safe bets"?
Question 6
We have huge confidence in our business proposition, and very ambitious about its world wide relevance. But we're humble enough to recognise that the world around us will change, and things just won't turn out the way the business plan says they will. How much thinking about this do your investors expect to see in a business plan?" What do the panel think are the critical success factors for funding bids going forward particularly in emerging areas such as content for mobile devices?
Question 7
Are investors, on the whole, more risk averse today? Are there differences between the UK and US?
Question 8
I am particularly interested in Corporate Venturing, and would like the panel to comment on their thoughts on whether there is evidence that Corporate Investors are increasingly willing to seed early stage businesses. As a follow-up I'd be interested to know if the panel agrees with me that the efficiency of this process can be greatly increased if Corporates work in parallel with VCS (Its our view that more Corporate money will free up if larger organisations can be reassured that there are good processes in place for deal evaluation, deal structuring, and ongoing support once the businesses have been funded.)
Question 9
Given the change in the VC role for funding seed/ startups. What will fill this gap; if anything at all?
Question 10
"The question I have and the problem we face is to recover our business (both on and off line) after funding 'fell through' at the last minute through no fault of our own. The business is still viable and potentially very profitable and dominant however we have a short term funding crisis to deal with and the prospect of starting the funding search again." Where are the investors who can look at a business opportunity as a 'real business' rather than talk in acronyms and look for the latest technology?'
Question 11
Were all the VC's who appeared in the last couple of years really professionals or were they merely gamblers?
Question 12
What are the 3 key elements investors look for in a business plan? In what ways have investors changed their approach to finding suitable startups over the last 6 months? Given that VCS are less likely to invest in unproven start ups, what is the best way to find appropriate angel investors? How critical to investors is having key staff in place, despite the problems in recruiting people to theoretical jobs?
Question 13
With reference to the provinces and funding, business angel networks tend to be a waste of time. Members are old fuddy duddies, who like the prestige of attending meetings but with no intention of funding. What can be done to support entrepreneurs in the provinces?
Question 14
I believe that current tech stock pessimism is the filpside to misplaced tech stock optimism: IT was set up for a fall, and now it's being dismissed prematurely. My main question for the panel is: 'How can businesses in the IT community convey their value in a realistic and convincing manner, so that investor expectations never have to be frustrated on such a scale again?
These questions reflect the general air of exasperation and despair that afflicted so many of the entrepreneurs who attended that event. They'd gone there with the hope that somebody would be able to tell them how to get the necessary funding to finance their business plans. They didn't get the answers they were looking for.
To most of these hopefuls seeking finance, investment decision making appears as a black art, driven by ignorance, prejudice, bias and lack of vision. Yet, if they applied the fundamental basics of investment calculation, together with a grain of common sense, they might have been able to answer their own questions and have a more realistic approach to their business strategies.
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 caricature's. 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 because they will 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 and buy on the basis that they think a share 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.
Getting financing into perspective
Not counting the speculative investors and the various kinds of capital that might be introduced at the birthing stage of an e-business startup, all other forms of financing need to have some basis in rationality.
This basis must, in some way, be related to the four cornerstone concepts of finance and investment calculation:
1) Discounting through time
2) Turning an income into a capital value
3) Turning a capital amount into an income stream
4) Discounting for risk
It is worth noting that all banking, insurance, pension and investment industries are based solely upon these four important concepts. All financiers, and anyone seeking finance, should fully understand the conceptual mind set they represent.
Discounting through time
Discounting through time is the calculation necessary to be able to turn income into capital and capital into income. It's basic premise is that a sum of money in the future is worth less than that same sum of money in the present.
The best way to imagine this is to think of a visual image. Up close it appears large. As the image moves further and further away it gets smaller and smaller. Substitute money for the image and distance for time and you have a good visualisation as to how the value of a sum of money shrinks the further away it is from the present day.
It may seem impossible that a sum of money can reduce in value as it appears further away in time. After all, if you put ten thousand dollars under the mattress and fetched it out after ten years, it would still be the same ten thousand dollars.
However, the factors influencing present and future values are:
1) Inflation, which can cause the actual value to shrink
2) The risk of some unexpected disaster occurring whereby the money gets lost.
3) The money in the present can be profitably invested so that it will increase in value by a future date due to compound interest.
This can be imagined by thinking of two people, each with ten thousand dollars. One puts it under the bed for ten years, the other invests the money in safe securities that pays an interest of 7.2 % per annum which adds each year to the total amount (compound interest). What happens to the values of their respective savings is detailed in figure 11.1
Figure 3.1
Showing how the value of money changes over ten years according to how it is saved
As can be seen from figure 3.1, money not put to work can decrease in value due to inflation. Money invested can increase in value due to compound interest. With inflation at 3% (affecting both ways of saving) and the investment paying 7.2% per annum interest, after ten years the invested money is worth about double the money put under the mattress.
All financial business decision making is based upon being aware of these differences between a present day value and a future value of money. The concern is not only with how much a sum of money will grow to at some time in the future, but, also how much a future sum is worth in the present. For example, the table in figure 3.1 tells us that a sum of $15,000 dollars in the future is worth $10,000 today because $10,000 will turn into $15,000 over ten years.
Being aware of the way in which a future value seems to shrink as it is brought back to the present allows an important financial calculation to be made. It allows incomes to be given capitalised values. This is illustrated in figure 3.2, where an income of $100 dollars per annum stretching over the next 100 years can be given a value by adding up all the payments discounted through time back to the present day.
Figure 3.2
The value of an income can be calculated by discounting the value of each payment back to the present day and totalling up these discounted values
From figure 3.2, it can be seen that an income over one hundred years has a finite value because the present day value of future payments gradually reduce to zero. In this example, where the interest is assumed to be 7.2%, it can be seen that the capitalised value of an income of $100 per annum approximates to just under $1,400.
Similarly, an income of $10,000 per annum would be valued at $140,000. An income of $100,000 per annum would be valued at $1.4 million. It is through this kind of calculation that the value of a company's equity shares can be valued. If you can estimate the rate of earnings, you can get an idea of the basic value of its shares and therefore its share price.
Of course it is not quite as simple as this because there is an element of guesswork in assuming the correct percentage to use for the discounting. There is also a guess that has to be made as to what the rate of inflation will be. This allows wide differences in opinion as to the correct value of any particular income: according to what values are assumed for the discount and inflation rates. Figure 3.3 shows how an income of $100 per annum might be valued assuming different discount rates.
Figure 3.3
The value of an income will be valued differently according to what discount rate is used. A discount rate of 5% will value a $100 per annum income at $1,985, but, at a discount rate of 50% the value be only $199.
Discounting for risk
Simply discounting back the value of income payments according to the interest expected from a safe investment does not allow for the element of risk. The discount rate has to be suitably chosen so as to allow for all possible risks in the particular investment under consideration.
Consider the example above, where there are two ways of saving money for ten years: under the mattress or safely invested. For the invested money, the risk will be minimal if the funds are put into safe and secure bonds. For the money put under the mattress there is the risk of theft or burglary. If there is a ten percent chance of the money under the mattress being stolen during the ten years, the effective value will be reduced by ten percent because there is only a ninety percent chance of realising the anticipated future amount at the end of the period.
Note
Any risk of loss can be allowed for in this way, simply by adjusting the future value. The fact that there is a risk of the money being stolen means that any expectation as to its future value cannot be as great as if it were locked up in the vaults of an impregnable bank. This lesser value is calculated by multiplying the future value by the probability that the money will not be stolen. So, if there is a ten percent chance of the money being stolen there is a ninety percent chance that it won't be stolen. The future value is then determined as being only ninety percent of the full value of the money. It is these kinds of calculations that are used to calculate the future values of revenue streams and share price valuations.
Investors always have a standard upon which to base their income valuations. This usually takes the form of a current market valuation placed upon an income which is more or less guaranteed, i. e., long term bonds of a large and stable government. This provides them with the market value of a relatively risk free investment. Knowing the price of a risk free investment, enables them to adjust this price appropriately downwards to discount for any perceived risks in any riskier investments.
Risk can also be allowed for by adjusting the expectations of an income. As capital amounts can be converted into income equivalents, risks can be discounted by increasing the income required to justify a particular amount of investment. In other words, a higher rate of return would be needed to compensate for any added risk. This effectively increases the discount rate needed to be applied to the calculation of future values.
For example, if there were twice the risk, the investor would be discounting any projected income back at twice the rate. This can be seen from figure 3.3. If an income of $100 per annum from a safe bond returning 5% is valued at $1,985, then an investment with a five percent risk would have to be discounted back at 10%. So, the value of a $100 dollar per year of income with 5% risk would be worth only $995: about half as much.
If the risks were judged such that there might be a fifteen percent chance of the projected income not being realised, then the discount rate for the projected income would need to be raised from 5% to 20%, reducing the value of this riskier income to $498. It is by using this kind of calculation that an investor can look at the projected income of a business, assess the risk and so be able to give a valuation to the business.
This has great relevance to an investor's or a business angel's expectations of the returns they were looking for in an e-business venture. For example, the early dotcoms that went on to be listed on the market had a failure rate of 80%. If this risk factor is taken into account it would be madness for the valuation of any new dotcom's projected earnings to be based upon a 5% discount rate. A more sensible view would use a discount rate of between 20% and 50%. This would see an investor valuing a business with projected earnings of one million dollars per annum at only between $5 million and $2 million. That is a P/E ratio (share price/earnings ratio) of between 5 and 2.
It is these realistic valuations that would see Venture Capital companies and business angels appearing to be extremely greedy when it appears that they want to see their money returned within only two or three years. The fact is they are not being greedy at all, they are simply discounting appropriately for the risks involved in the investment. After all, if venture capital or angel finance didn't allow for the risks involved they would be far better off investing their money in safe government bonds.
The fallacies of conventional funding requirements
Most of the entrepreneurs who attended the NetPROZ event had gone there with a conventional idea of business startups and the requirements necessary to obtain funding.
The usual starting place for an e-business venture is with an idea. An idea is proposed and, like most ideas in e-business would seem to have great merit with the potential to create much revenue and profit. The idea is fleshed out in outline with sufficient technical detail to provide credibility. A plan of action is described and the anticipated returns summarised.
Backing up this plan would be a list of key personnel who would be responsible for carrying it out. This would include a strong management team who would have a sound previous track record of management, cost control and business organisation.
On the strength of the plan and the pedigree of the key personnel, a sum of money will be allocated. The management team are then left to use this money to bring the project to fruition. This they will do by allocating various sums to the various components of the plan in order to complete the project within the specified time.
It all sounds so reasonable and logical, but, the dotcom boom and bust in the years 2000 and 2001 proved conclusively that good ideas, carefully worked out business plans and strong management in the volatile world of e-business do not produce good results. Although there were several spectacular successes, there were even more spectacular failures.
It wasn't simply that some were doing it right and some were doing it wrong. The problem was that a new and rapidly evolving environment is totally unpredictable. Such dynamic complexity is chaotic and defies all logical attempts to predict or control events. Just like the fashion industry, people follow each other in chasing trends and fashions and when a trend or fashion peters out, it gives rise to a different trend or fashion. Whichever way you look at it, investing in any business venture in the field of e-business can be nothing more than a gamble.
Let's look more pragmatically at the criteria upon which conventional funding is based:
1) Business plans
These cannot be anything other than totally unreliable guides as to the way in which an e-business will progress. There is too much uncertainty involved in the e-business environment, there are too many unknowns and unknowables. Technology is changing at such a fast rate that what seems a sensible plan can be rendered completely useless at any time by a competitor unexpectedly applying some new technology to come up with something cheaper or better.
Isn't it reasonable then, for an astute investor to treat any future plans with extreme caution and heavily discount any projected earnings and profits?
2) Proven strong management
As fully explained in the book "The Ultimate Game of Strategy", conventional managerial methods and techniques are totally inappropriate in a volatile, fast moving environment where the necessity is to take advantage of change, rather than to try to control it. Executives and managers who have established their reputations in the more predictable old world economy are liable to hamper the necessary quick reactions and rapid changes that are needed to compete in a fast changing technological world.
This has been proved time and time again, as can be evidenced by the high proportion of dotcom failures. Despite most of them being funded on the basis of sensible sounding business plans and apparently experienced managers and executives, the failure rate has been unacceptably high.
The fact is that many of the failures resulted from the business plans becoming irrelevant and the managers and executives being put into the position of the blind leading the blind. When things start to go wrong, panic sets in and vast sums of money are thrown to waste in desperate moves to try to regain control of the situation. Typical, was the high expenditures on lavish but totally ineffective Web sites and the vast sums spent on inefficient adverting and marketing campaigns.
As with business plans, wouldn't an investor with the knowledge of the limitations of experienced management teams (to control the unpredictable events that are continuously being thrown up in an e-business environment) heavily discount for the probability of failure?
Two kinds of player
There are two types of gamblers: the naive punters and the professional players. The difference between the two is that the naive punter tries to predict a winner and the professional player knows that prediction is impossible.
The naive punter will sometimes back winners, but, this will invariably be more by luck than judgement although they will be convinced that their astute ability to pick a winner gives them a special edge. Usually, their next plunge sees their vision and insight evaporating due to "unforeseen circumstances".
The professional player knows that it is impossible to pick winners, so, will use a strategy that will allow for failure. Downside risks are limited and risk is spread over a number of options. More importantly, the professional player will allow for unpredictable change. The trick is to be in a position to take advantage of sudden and unpredictable events and not be exposed or vulnerable to them.
The professional poker player does not expect to win every hand, winning comes about through a statistical result of making the best of winning opportunities and not losing too much with the failures. The professional poker player does not make the best gains through being lucky with the initial cards that are dealt, but, through taking advantage of favourable situations that develop during the course of the game. It is this "professional gambler" mentality that is needed by both e-business investors entrepreneurs.
Unfortunately for entrepreneurs seeking funding, the ability to rapidly change and adapt is not something that can be described in a business plan. It can only be identified after events have taken place. This is perhaps why the person who asked question 2 at the NETPROZ event had noticed that investors prefer to back serial entrepreneurs rather than placing their trust in first timers.
Looking for a sensible way to invest
Let's look for a moment at the more regular world of business funding, to see how investment decisions are made when working in a fairly stable and predictable business environment. In this world, business is about rational decision making; doing the right things. The strategy is concerned mainly with reducing risk and eliminating uncertainty. Monitoring and control are the main methods for keeping a business on track to meet targets and reach designated goals.
In a reasonably predictable environment, it is possible to estimate roughly how long it will take to complete a project and how much it will cost. In this way a funding body can have an idea of how much they will have to invest and what gains are possible. By suitably discounting for time and risk they can make an investment decision to fund or not to fund.
This situation is illustrated in figure 3.4, where funding or investment decisions are founded upon facts and figures based upon previous experience and carefully researched projections. The ability to make reasonably accurate future predictions, means that the risk of failure does not have to be heavily discounted in estimating future profitability.
Figure 3.4
In a reasonably stable environment, the value of the anticipated future value will not have to be too heavily discounted. This lessens the pressure on a business to produce exceptional earnings
In a stable and predictable environment, where future projections can be made with some degree of accuracy, a company does not need to forecast exceptional profits to attract funding. All that matters is that there is enough future profit forecast to cover any possible downside risk. The more predictable the environment, the less are the risks and the less the anticipated future profits need to be to cover those risks.
However, in the volatile and unpredictable environment of e-business, the risks associated with reaching an intended goal are much greater. There are too many unknowns. This means that there has to be a far greater allowance made for the risks and in most cases the discount that have to be applied to estimates of future earnings reduce the estimated future value of a business so much that although on paper the investment would appear to be profitable, the realities of the investment decision process make it an unsound investment. This is illustrated in figure 3.5.
Figure 3.5
The added risks associated with an uncertain and volatile environment can reduce the value of a seemingly promising business venture to a point where it would be considered a loss making investment
Figure 3.5 shows graphically how a business that would appear to offer an investor a chance of a very handsome capital gain would actually be a poor investment choice – once the risks and time to realise the gain are taken into account.
The reason why it should be rated as a poor investment decision is not obvious. So, it's worth pausing a moment here to go though a few pragmatic, investment decision calculations.
Calculating an investment decision
While visiting California in January 2001, I decided to call in on a company that I'd learned had a neat little product that supplied an excellent messaging and bulletin board system. Expecting the company to consist of a handful of dedicated technologists, I was amazed when I walked into sumptuous offices with hordes of employees.
What I'd discovered was one of the fabled dotcoms, a company that had acquired $10 million dollars of venture capital funding within a year of startup. From the original two founding partners, the company had expanded to a staff of around 50 people that now included some very high profile sales and marketing executives together with many illustrious technical experts. The company looked very busy and were justifiably proud of their growing customer base. To all the world it looked like a successful company that seemed likely to be satisfying the requirements of the venture capital company that had organised their funding.
However, if we go back in time to when a decision was made to fund this company, we can go though some of the calculations that might have been made. Firstly, we'd look at what the £10 million dollars might have returned as a less speculative investment. Let's say it could have been invested fairly safely by spreading the capital around many different established companies to provide an average return of 7.2 %. That is $720,000 per annum.
The investors would be looking to significantly better this return to be able to justify the risk in investing in an unproven venture. However, it would be accepted that such profitability would take some time to materialise. Lets say this time would have been estimated to be three years: not an unreasonable projection.
With the investment not expected to reach this level of profitability for three years, the value of the investment at that future time would have to be discounted back to be able to compare it with the present day value of the $10 million. From figure 3.2, we can see that every $100 has its value reduced 81% when discounted back at 7.2% over three years. This would mean that the value of the investment must rise to $3.346 in three years time just to retain its value.
In terms of an earnings target for the company, it would mean that the break even profitability of the company would have to be increased from $720,000 per annum to $890,000 per annum – just to equal the returns from a safe investment.
As the investor would be looking to see a reasonable gain by choosing to invest in risky ventures, it is most likely that the aim would be more like a minimum of $1.2 million per annum earnings – increasing the value of the investment by about a third. However, this extra return would only be an acceptable target if the profitability actually materialised. In reality, the company might fail, so, the risk of the company failing to make this profit has to be taken into consideration.
At the time the $10 million dollars was invested in this dotcom company in California, investors were investing in hundreds of other similarly promising e-business startups – each of whom the investors might have been confident in expecting to succeed in reaching a suitable level of profitability.
As was subsequently revealed, the failure rate of the dotcom startups was of the order of eighty percent. Only one in five was reaching profitability before their capital ran out. If this risk element had been factored in when the decision was made to invest $10 million dollars in this Californian start up, the investors would have been looking to see a profitability of five times that $1.2 million: about $6 million per annum to sensibly justify their investment decision.
To make sense of this $6 million figure, imagine the investors spreading their risk by investing not in a single company but dividing up the $10 million to take shares in many dotcoms. With four out of five dotcoms failing, eight million of the ten million dollars will have been lost, so, the remaining two million of surviving investments would have to earn five times as much to make up for the lost earnings of the losers.
In theory, it may seem possible for a company to earn $6 million per annum in profits. However, the reality is that any business that is making substantial profits will attract competitors. This competition will compete aggressively for clients, not only winning clients over to them but also raising the cost of attracting new clients. This competitive activity effectively puts a cap on the profitability any company can realistically expect to achieve.
It is like any market situation. If a store starts to earn huge profits by selling a particular item, it won't be long before other stores will be selling it. As they compete with each other for customers, the price would be driven down so that the level of profitability gradually gets in line with all other items that are on sale.
After visiting the dotcom startup in California, I used various search engines on the Web to trace the company's activities as it had been reported in various news media. I found a brief history that explained how the core product had grown out of a university bulletin board system that one of the founders had created. Another of the founders was an experienced deal maker, who had wide connections with venture capital companies in the USA.
The company had acquired an impressive list of executives that included: Vice-president of Marketing/Operations Vice President of Engineering Vice President of Sales, Director of Business Development, Director of Product Management, Director of Quality Assurance. The board of Directors included an impressive list of CEO's from the many different companies that had syndicated in the funding. At a guess I'd say this company was running with an overhead of something like $4 million per annum, in which case, they would have to be trying to obtain an income of at least 5$ million a year – which runs out at about four hundred and twenty thousand dollars a month.
When I read through the impressive looking list of executives and directors, the thought that ran through my mind was "too many fingers in the pie". It certainly didn't look like the lean and adaptive kind of organisation that was needed in a rapidly evolving, massively connected information environment. Sure they had a great product, but, it wasn't so great that it couldn't be copied by hundreds of other competent companies that had far less overheads and without the ball and chain of ten million dollars worth of investment that needed servicing.
They may have a great sales team, they may have hundreds of current clients, but, they were highly vulnerable to other companies being able to offer a similar product – at far less cost – to a market that their ten million dollars of funding had created. What hadn't seemed to have been realised was that the Internet isn't like the world of bricks and mortar where a product is established only by a strong sales force. The competition is just one click away and the ease with which the knowledge of less costly solutions can so easily diffuse through the Internet community means that everyone will soon know where that click is.
This is not to predict that the company I visited would fail, but, its not one that I'd be queuing up to invest in.
A more realistic strategy for e-business funding
In light of fundamental investment calculations, it becomes clear that investments in early stage, e-business ventures involve risks that are unlikely to be compensated by even the most optimistic return expectations. Without a bubble situation, where a naive speculator can sell to an even more naive speculator as equity prices increase beyond reason, investment cannot be justified.
This situation calls for a radical rethink about the funding of e-businesses that are in the early stages of development. A way has to be found where the funding body is not exposed to such high risks. Such a way is possible if we start out with the premise that an investor's capital is sacrosanct and must be preserved at all costs.
This would give an entirely different perspective to funding e-business start ups. How though, could an investor's capital be totally preserved when used in a such a high risk situation, where fast evolving technology and predatory competition make life so uncertain and unpredictable.
Let's consider the question of the preservation of the capital first. The only way capital can be preserved is to invest it in safe securities. So, let's start with this idea. Instead of putting a capital sum into an e-business venture, why not invest the money safely and then let the e-business use the returns from the safe investment to fund its cash flow while it is trying to establish profitability.
Let's take an example of an investment company with $100 million to invest and wants to use ten percent of this money to have an interest in e-commerce. We could imagine that all the money is invested safely to provide 7.2% earnings, but, ten percent of those earnings are allocated to financing the cash flow of an e-business startup.
If we take the same figures as the investment in the Californian dotcom described above, the $10 million earmarked to finance the cash flow of an e-business venture would provide $720,000 per annum of cash flow to finance the business. This works out at $60,000 per month as illustrated in figure 3.6.
Figure 3.6
A capital sum of $10 million can be invested safely to preserve the capital and the income generated from the earnings used to fund the cash flow of a start up e-business venture.
This arrangement preserves the capital base and gives control to the investors who can limit their losses at any time by terminating the cash flow injection if the e-business isn't showing signs of meeting expectations.
This dramatically changes the situation, not only for the investment company, but, also for the e-business venture. The e-business may lose the strategic advantage of having a large sum of money to play with, but, it also means that they are no longer accountable for the safety of a large sum of money. This allows for a more efficient management structure that is concerned only with developing a profitable situation – eliminating the need for the kind of costly executives that would be needed purely to safeguard the large capital base. This cash flow funding arrangement is illustrated in figure 3.7
Figure 3.7
Where a company is having its cash flow financed, any revenues generated will reduce the amount of funding needed. All being well, revenues will increase to where the company reaches a stage of overall profitability and acquires a real capital value.
Notice from figure 3.7 that the cash flow input, needed to finance the business, starts to reduce as soon as the business begins to generate its own revenue. When critical mass is reached, where the profitability can cover the outgoings, no further input from the funding company will be needed. Any further profitability will generate an income which will create a capital gain. As soon as the capitalised value of this profit exceeds the cash that has been injected into the company, then the investing company will start to make real gains.
Comparing the two ways of financing a start up
Providing a company with $10 million of capital needs an experienced and professional team to handle the finances. This will greatly increase the overheads without necessarily improving a company's ability to reach profitability. Mistakes can be costly and if the company loses its way, it can easily start wasting large sums of money on inappropriate strategies while it is seeking to recover its position. This was a notable feature of the many failed dotcoms, where huge sums were spent on ineffective advertising and marketing.
With a large capital available, companies are tempted to design grandiose schemes that might be found to be fatally flawed only after most of the capital has been burned up. Again this was a common occurrence among the dotcom casualties.
Working with a limited cash flow, concentrates attention upon inputs and outputs. Any large scale project or extensive advertising and marketing would have to be financed out of earnings. This may seem restrictive, but, with so many unknowns and so much unpredictability in the world of e-business, gambling on outcomes would expose the company to risks that would not be adequately covered by the probability of gains.
If we take the company in California as an example. They have been forced to take on board a large number of chief executives. Their burn rate is so high that they are forced to go for ambitious sales targets. Perhaps it will pay off for them before their cash runs out, but, the statistical odds against their survival are high.
Far better if the team had been kept small, limited to an overhead of $60,000 a month until success brought them profitability and gave them the cash flow to expand through their earned income. Then their target would have been to produce a revenue better than $720,000 per annum rather than the $5 million they were being forced to aim for when I visited the company.
Maybe they could argue that they would have a better chance of achieving a revenue of $5 million a year with a large staff and greater overheads than a more compact organisation could achieve a revenue of $720,000 per annum. This brings us to the question of efficiency. E-business is not only about having great ideas: more importantly, it is about increased efficiency. In other words it is about reducing the cost of getting something done. This must be the overriding consideration at the heart of all e-business strategies.
The speed with which people and businesses can learn about more efficient ways to satisfy needs make it imperative for e-businesses to be able to respond, change and adapt. This can be taken to mean that the e-business will be in a continuous process of dynamic change as cheaper, more efficient ways to achieve goals emerge. This can be done more efficiently with a small group that is not encumbered by a top heavy management structure.
Many companies rely on patents and intellectual rights to safeguard them against competition. However, the idea that a company can rely on patents in technology and business procedures is a fool's paradise in a rapidly evolving environment where new technological breakthroughs are occurring all the time. In a provocative article in New Scientist, 20th January 2001, Robert Matthews described the work of John Koza at Stanford University who is using genetic algorithms to not only evolve solutions to difficult design problems but also to evolve better ways to think about solving them.
The principle of using genetic algorithms for design solutions is to break up all previous solutions into components. Then, from the results achieved by these previous solutions, choose the best and combine their various components in different ways. These hybrid solutions are then tested and the components of the best of these are recombined yet again. This process is continuously repeated until a superior product emerges. In numerous instances, in various different companies in various different industries this technique is regularly delivering solutions to problems that are surpassing anything that humans have come up with before.
This is the way biological evolution works, where superior genes of successful organisms are selected for and recombined in different individuals. This has been the driving force behind all industrial and technological progress, as people take the best ideas of what others have done to come up with superior solutions.
This is happening all the time in the environment of e-business where the best of some ideas are combined with the best of others for a business to leap ahead of its competition. The Internet and the Web thus provide a vast environment where genetic algorithms are unconsciously being used by millions of people in their competition with each other to produce superior e-business solutions.
Of particular interest in Robert Matthew's article was his warning to inventors that they will no longer be protected by their patents as genetic algorithm design techniques become more widespread. Normally, a designer will check with patents to make sure any design they come up with does not include features that have been patented by somebody else. For a genetic algorithm this is not a problem because details of patented ideas can be programmed into the selection process so that they are not included in selected solutions which are used to breed new ideas. In other words, genetic algorithms skirt round patented ideas and seek superior solutions that make these patented ideas redundant.
Now it may be stretching the imagination somewhat to imagine contrived genetic algorithms being designed to do this on any large sale just yet, but, if one looks at the millions of people involved in e-business, each looking at each others best ideas and combining them with their own in a multitude of different ways, it becomes obvious that the whole evolution of the Internet environment consists of a vast number of genetic algorithms at work: seeking more and more efficient solutions to problems and by passing any patents that stand in the way.
It is this picture that any person involved in e-business has to have in mind. It is the picture the business angels, venture capitalists and investors have to think about when they think about backing any particular venture based upon what seems like a good idea.
The fact is that e-business is a dynamic environment, where survival and success can only be achieved through being able to continuously change and adapt. For this, ideas are very secondary, what is more important is people: people who are able to use the Internet to make contact with others to share information and knowledge and to collaborate and combine.
So, my advice to anyone wanting to invest in e-business is to look beyond ideas and knowledge and to concentrate upon the super individuals who have developed superior abilities and technique of communication. As is so often true in business: it isn't what you know, but, who you know that counts.
The efficient structuring of an e-business
This insight into the arcane world of investment decision making allows us to approach the creation of an e-business in a more professional manner. It might be of benefit to the reader to read through once more the questions presented to the panel at the NETPROZ event. How would you answer those questions now?
From the point of view of the purpose of this book, these investment considerations tell us that it is no good devising involved and detailed schemes that require massive funding. Even in the unlikely event that it will be granted, the business would be laden down with an inappropriate management structure that will demand excessively high targets and reduce flexibility.
What we need to look for is a way to create a highly flexible system that has minimal overheads. We must seek situations and opportunities that can quickly produce revenue streams. We must construct a business based upon expendable components that can be selected from, mixed and matched in different ways to deal with new emerging opportunities and rapidly changing circumstances.
Above all, we should be looking to create many strategic contacts, who can be brought into play when and where needed.
In my experience, as a life long entrepreneur, the solution to the funding problem is not to look for funding, but, to let the funding look for you. The moment you start showing signs of making a profit, the financiers and investors will appear like magic – out of the woodwork.
### End chapter 3 ###
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Note: This book lead to the creation of the stigmergicsystems.com website
Copyright 2001 - Peter Small
E-mail: peter@petersmall.net
All rights reserved by Pearson Education (Longman, Addison-Wesley,Prentice Hall, Financial Times for FT.COM imprint
