October 2017

There will be storms ahead. Make sure you learn resiliency from the ones that came beforehand.

Photo courtesy of Christopher Michel.

For millions of people in the U.S. and the Caribbean, the summer of 2017 is synonymous with tremendous suffering and loss, as one of the most active hurricane seasons in history hit their communities. As tactical response to the storms scales down and recovery begins, strategic focus will shift to making critical systems more resilient – such things as the water levies in Houston, and the power grid in Puerto Rico.

Although there is a world of difference between how governments and organizations respond to the challenges of large-scale disasters like storms and how a management team runs a business, I think there are some valuable resiliency lessons that can be drawn for startups.

When I’m not working as a consultant, I serve as a Civil Air Patrol liaison officer to FEMA’s Region II. In this capacity, I’ve worked six major hurricanes in the past several years, including Sandy in 2012 and this year’s Irma & Maria. Aside from master-of-the-obvious missives like “failure to plan is planning to fail,” here’s my top five list of lessons from disaster response every CEO can incorporate into their business strategy.

  1. Resources always govern results. There is never a shortage of demands on an organization’s resources, and the natural tendency is to pay the most attention to the fire burning brightest at the moment. However, an organization’s effectiveness is metered by the resources it can strategically bring to bear, not devote to this or that tactical fix. Avoid the trap of allocating resources (in a company, usually capital or talent) to things that are not bringing your organization closer to your broader goal. Also, avoid the cardinal mistake of not allocating enough resources to do the job at hand properly. Another landmine is the order in which you deploy your resources, which can matter as much as getting them in the first place. To use a FEMA parallel, there’s no use surging hundreds of trucks to help distribute food and water in Puerto Rico unless there are drivers on the ground to operate them. It sounds obvious, but in high-stress environments, it’s the simple and obvious things like this that will make or break the impact of scarce resources.
  2. Know what has to come first. Prioritization and precedence are critical to resource management, so knowing (or carefully planning for) what should receive support first is paramount if you are to avoid going back and doing something over again, or worse, detracting from your ability to deal with more important things down the road. Resources are almost always limited, while demands invariably outstrip supply. Management must prioritize, but it should do so more adroitly than merely forecasting an ROI on capital invested; look at your resources holistically, with your strategic goal in mind, and parse out in which order they should be expended. Bear in mind that it’s not always immediately apparent what should come first, and your decisions regarding prioritization will be based on incomplete information.
  3. Consequence management. This is one of the most common mistakes I see leadership teams make. While they may be very adept at allocating resources and prioritizing, CEOs often fail to extrapolate the broader impacts of their decisions, and how their choices may affect subsequent requirements. The more ambitious the goal and the tighter the timeline, the less likely is that you have really worked through how everything fits together, and how what you decide today may govern what has to be done tomorrow. I recommend mapping out how your decisions will move your startup towards its ultimate goal in order to see where the consequences lie.
  4. Avoid the soda straw. Every executive, commander and leader is at risk of viewing their world through the proverbial soda straw, focusing on the immediate requirements or mission they are tasked with at the moment to the virtual exclusion of everything else. This is a natural tendency: concentrate on the immediate task for survival. However, maintaining situational awareness of the entire enterprise – and its priorities – is key, no matter how exciting or promising a certain project might look today. In the disaster world, this means remembering that almost every decision comes with a long logistical and economic tail that must be managed – for instance, the person who orders thousands of first responders and military personnel to a hurricane zone must also think of the lodging, provisioning, and sanitary requirements they will place on an area that is likely to be already highly deficient in all three.
  5. Rapidly iterate based on new information. Private sector companies typically exist in rapidly-changing environments, and as the old saying goes, no plan ever survived the first hour of combat. Don’t be afraid to abandon prior conceptions about your market or customers in favor of new, real-life information you receive from the field. In this sense, treat your decisions as MVPs (Minimum Viable Products) that are just starting points from which to depart. Real-time adjustments are more valuable than anything you put up on a white board six months ago. And make decisions quickly – one of the few unassailable advantages a startup has over its larger competitors is an inherent ability to move very quickly, so use it often. Case in point: Google’s plan to use high altitude balloons to temporarily take the place of cell towers may restore mobile phone service in Puerto Rico weeks or even months ahead of any other solution available from local telecoms or the government.

In many cases, your CFO can help you not only properly define your company’s strategic goals, but also help you execute the day-to-day demands in order to reach them in a focused and efficient manner. Like with disaster response, there is no one thing that makes all the difference, but rather countless small elements that make up the overall effort. To sum up, remember another old saying: Manage the little things right, and the bigger things will take care of themselves.

If you’re in for a long race, venture debt financing could give you the air you need to get to the next peak in better shape. Photo courtesy of Christopher Michel.

Raising venture debt is always an interesting subject for startups. For some CEOs it is completely off their radar, and for others it is a taboo subject. In between these extremes, there’s a growing number of startups using venture debt effectively to buy time for a higher valuation, making it a cheap form (in terms of amount of stock it costs) of financing while the value of your company rises.

I thought we could shed some light into whether venture debt is a good thing for your company by creating a simple model you can use to project its long-term effects on your valuation and on your stock and explore if it makes sense for you. For a sense of the value of this exercise, under a relatively conservative growth scenario, Venture Debt could save the company from having to give away 3% of equity. Before getting into detail about how this model works, it’s worthwhile to spend some time reflecting on a couple of issues you will need to think through before raising money this way: covenants and purpose.

Covenants and Purpose

Many think that some banks and venture debt providers require excessive terms and may tie up the company with covenants that hurt you in the long-run. Our experience with this is that most of the terms and covenants can be negotiated, with the exception of the investor support covenant, which requires the venture investors of your company to agree they will continue to support the company or the covenant is triggered. Even the MAC (Material Adverse Change) covenant, which seems to be the most draconian of all because it gives the venture debt provider the option of not following up on their promise if there is a significant change in the company (based on their definition), can often be negotiated. What you need here is a supportive board that has a venture investor with venture debt experience, working closely with you and your CFO to ensure you get the best deal for the company.

Putting in place venture debt is best done right after a VC raise. You can usually structure it to pull the funds much later – and face only a small portion of the costs before pulling the funds. The goal is to have it available in the future in order to buy time for growth so that the next round comes a bit later, giving you more time to increase the value of your company. This means that  growth should be the purpose for making your case to raise venture debt with your board. Emergency money or, worse, an excuse just to spend more, is what this kind of financing can unfortunately be wrongly associated with. Although if it comes down to using it in the event of an emergency, that can also be a valuable use, but in that case, it’s usually just to give another shot at pivoting and potentially save the company rather than juice value. In any event, raising venture debt with growth in mind, before you need it, will help you get better terms with debt providers and negotiate favorable covenants.

The Model

The basic assumption behind our model is that you’re raising venture debt for the purposes of growing. As such, the spreadsheet helps you look at two scenarios of growing: with and without venture debt. The results, once you input your numbers, are quite simple:

  1. Whether using venture debt made you save equity
  2. Whether using venture debt gave you time to increase the value of your company

If there is a positive number answering these questions, then you should take a closer look at venture debt. We plugged in numbers to show you how it works, feel free to substitute these with yours (red fields are input fields and the two key outcomes are highlighted in yellow).

Click here to access the spreadsheet.

The model begins by assuming a venture raise just happened (Cash at the End of Period 0, $10 million in the example). In the example, you raise $5 million in venture debt, giving away 0.2% of equity (0.1% when you put the facility in place and the other 0.1% when you draw the money), and paying a setup fee of $30,000. Cash burn is the same in both cases ($3 million), except for the venture debt payments. The example assumes a valuation growth of 25% every period (in this case, every 6 months). Note that you pay the bank the initial fee ($30,000 in the example) even though you don’t draw the venture debt of $5 million until you need it in the third semester.

This model is built to show the debt enabling a six-month funding delay in your next round ($20 million in the example) and assumes the same valuation for both scenarios, as it is just comparing financing structures in isolation. The result in the example: you raised money at a valuation of $97.6 million in the last semester rather than raising it at a valuation of $78.1 million six months before. The net value saved was $3 million, leaving you with 3.07% in equity you can keep. Not too bad!

Does venture debt work for you?

If you plug your numbers into our model through this link (red marks indicate input fields), you will see the impact of using debt in addition to equity for some of your financing. The model buys you time, but you need to keep in mind that growth needs to happen.

Venture debt works when it buys you time for a better valuation because things are going well. You pay for this time with debt and not with equity, saving you equity in two ways: initially by raising debt, and then afterwards by using that debt to get to a better valuation. If your growth scenarios come to fruition, venture debt enables you to raise money a bit later than you would, when the value of your company is higher. That is a great deal if you’re good at forecasting. You can also explore the impact of the debt using different growth scenarios, thus further exploring the potential value or the downside. Have fun 😉

Sometimes in finance, long and complex ways actually take you somewhere.

Although the SEC (Securities and Exchange Commission) does not regulate the financial reporting for your privately held company, you will benefit greatly from understanding, and maybe even adopting, their regulations. When serving in a Strategic Finance role, I ensure that the P&L follows this format and then use the historical data, as well as comparable company metrics, to develop company models.

This guidance is actually a very basic concept that defines the formats for financial statements. By adopting this definition for your subscription company, you will present your financials in an easily consumable format. This format also allows for comparable company comparisons that will help you refine your business model, identify KPIs and manage your business performance. Using comparable company comparisons will help you to better forecast your business and add credibility to your forecasts.

Income Statement Format

The regulation calls for what’s known as a “Two-Step” format, in that “subtotals are used to show decision-useful line items such as gross margin and operating income separately from non-operating income and net income or loss,” as stated by CFR Title 17.

Below is the specified two-step format customized for a subscription company. I’ve defined the resulting ten steps as follows:

  1. Net sales and gross revenues. State separately product and service revenue for each business line which accounts for more than 10% of total net revenue.
  2. Costs and expenses applicable to revenues, stated separately according to the net revenue categories. These expenses are known as Cost of Revenue for subscription companies.
  3. Gross Profit and Gross Margin
  4. Operating expense defined as Selling, General and Administrative expenses, or SG&A, and other general expenses relevant to your business, such as R&D or Operations. Subscription companies typically use R&D, Sales & Marketing, and General & Administrative.
  5. Operating Income, which is Gross Profit minus Operating Expense.
  6. Non-operating expenses, such as Interest, Taxes and Depreciation & Amortization (D&A) expense, if relevant.
  7. Net Income, which equals Operating Income less Non-operating expenses. Use if #6 is relevant.
  8. Earnings Before Interest, Taxes, Depreciation & Amortization, or EBITDA.
  9. Change in Working Capital
  10. Free Cash Flow

In my experience, early-stage, venture-backed companies typically have little or no Interest, Taxes and D&A expense. Most have convertible debt, but do not used debt lines. Most are in loss positions, meaning that they do not generate profits. Also, most are capital-light, meaning that they do not buy equipment above the $2,500 amount typically set for capitalizing purchases. Without non-operating expenses, Operating Income will equal EBITDA. In this case, use Operating Income in lieu of EBITDA because the latter implies that ITDA expenses exist. Free Cash Flow is the cash-based profitability of the company and should be added along with a liquidity metric such as bank balance.

The example in the call-out presents a typical format that I use for subscription clients. Please note that all numbers are entirely fictitious and presented solely to illustrate a financial reporting format. Any resemblance to an actual entity’s results would be coincidental. Additionally, these fictitious results do not indicate any view or opinion on the performance implied by this illustration nor do they suggest the size of the business that should adopt the recommendations herein.

Advantages of this Presentation Format

There are three main advantages you will achieve by adopting this format for your subscription company.

First, anyone who worked in finance will be intimately familiar with this format and can quickly grasp the financial performance of your business. You can skip the time needed to explain your custom single-step P&L and move straight into the performance.

Second, this format will allow you to analyze your performance with respect to comparable public companies. The comparison gives insight into key financial metrics such as gross margins and operating expenses, especially when shown as a percentage of revenue. You can back into R&D headcount using salary and overhead assumptions. Using multi-period financials, you can derive estimates of SaaS metrics such as Magic Number, CAC Ratio, and LTV/CAC. This insight will help you refine your business model, identify KPIs and manage your business performance.

Third, your finance team will use comparable company comparisons to better model your business. Actual revenue growth, gross profit and operating expense margins, cash flow and operating metrics combine to set parameters for the forecast. And this gives you credibility in discussing both the short-term and long-term forecast.

Useful and insightful for CEOs

The SEC directives in the case of subscription companies are quite relevant because they are useful and provide CEOs with great insight into the numbers. I’ve seen this approach work well in fundraising and for financial reporting.  Feel free to contact me if you would like to dig deeper on the topic. emersch@burklandassociates.com