ICOs: A promising innovation, but pitfalls abound. Photo courtesy of Christopher Michel.
Partly because of Burkland’s roots in Silicon Valley and partly because we tend to focus on newer, venture-backed companies, many of the questions we’re asked by founders and CEOs have to do with new ways of doing things. Over the past few years, nothing has captured the imagination of the startup business sector quite like bitcoin and blockchain as a whole. Entrepreneurs want to know how they can take advantage of this technology for their companies and their products. As strategic CFOs of these companies, we’re being asked frequently about cryptocurrency in general and initial coin offerings (ICOs) in particular.
Blockchain in two paragraphs
In very simple terms, blockchain originated as a massively distributed online system that validates, clears, settles and records bitcoin transactions. Since inception in 2009, blockchain has evolved to include both private and public systems that can simultaneously secure, chronologically verify, validate and record the movement of any asset from one party to another.
Why the term “blockchain”? Transactions in the system are pooled together into a group, or block, from which alphanumeric information is gathered and combined with data from the immediately preceding group to form a complex and unique math problem. This problem is then presented to the respective blockchain’s distributed network, which uses its collective computer power to find a solution. Once the math is solved, all the transactions in the block are verified, the block in question is “sealed,” data is taken from it to form the basis of the next block, and the process starts over again – thus creating a linked “chain” of blocks.
Blockchain’s role in money
At first, bitcoin and its blockchain were focused on the use of cryptocurrency as a digital medium of exchange and thus the potential to replace or compete alongside traditional currencies and the legacy banking networks that support them. But over the past few years, attention has pivoted to the practical applications of blockchain technology. This is because blockchains can securely and permanently record any transaction without the use of third parties. This disintermediation of middlemen adds up to very low transaction costs when clearing and settling transactions, and the technology underpinning digital ledger technology provides the ability to program “smart” contracts that can programmatically execute without the need for either side to trust the other. At scale, these capabilities are going to be particularly useful in a very wide range of industries – finance, real estate, retailing, banking, insurance, logistics, healthcare, etc.. Indeed, it is very possible that every major corporation in the world will be using this technology (even if their customers don’t know it) in some part of their business within five years.
A common denominator in any blockchain is a token, or coin, that can act as an incentive for the network’s participants to solve for the blocks that keep the whole system humming along. A blockchain’s tokens are the fuel that establishes, verifies and records a chain’s transactions, so no token = no chain. This is where Initial Coin Offerings – ICOs for short – come in.
Blockchain role in raising capital for your startup
Blockchain startups quickly seized that the sale of these tokens – or coins – was a unique way to raise capital. Typically, an ICO involves the online sale of a pre-determined number of tokens for use or utility inside a blockchain ecosystem, usually before it is built. The startup thus raises capital without technically selling equity or incurring debt, and can fund the highly technical work necessary to build, test and deploy their system. These offerings have proven immensely popular, with the post-ICO value of some tokens quickly skyrocketing thousands of percent in secondary trading.
However, there is a catch. ICOs don’t click neatly into legacy securities laws and have blossomed primarily because they have operated outside the bright regulatory lines designed to protect investors, such as registration with the SEC and regulations against general solicitation. ICOs have been pumped mercilessly on social media, and since one can take part in an ICO with the mere swipe of a mobile phone screen, hype has quickly gotten far ahead of substance. Unsurprisingly, regulatory agencies worldwide are now catching up, taking a very close look at whether these tokens are actually securities in the issuing company, and whether their sale to a random unaccredited investor via a social media post is actually an unregistered offering of those securities. For its part, the blockchain community has argued vociferously that most ICOs aren’t equity at all, but just the pre-sale of digital usage rights that can be redeemed later for some level of utility within a blockchain. Both sides have a point.
The incredible appreciation of these tokens in secondary markets on crypto exchanges has heightened the SEC’s interest, as has the colossal amounts of capital being raised via ICO. ICOs have already brought in more than $13 billion YTD across 537 ICOs globally, according to Reuters, nearly double last year’s $7 billion and a far cry from the $1.3 billion in early-stage and seed-round funding from VCs so far this year. As far as capital formation goes, this clearly a whole new ball game.
Blockchain ICOs: A blessing and a curse
From our perch as on-demand CFOs, ICOs remain problematic because they are still in the regulatory grey zone. Beyond blocking access from US-based IP addresses, ICO issuers typically do little or no AML/KYC vetting, and don’t require anything close to accredited investor attestation. Investors in ICOs, meanwhile, have few rights and are typically not provided any company financial information prior or subsequent to the ICO. To top it off, marketing of ICOs remains wholly unregulated, and although the legal community has rapidly adopted capital structures from the Regulation D and crowdfunding worlds, concerns remain that these offerings will ultimately run afoul of SEC regulations concerning how one attracts investors.
And while more mundane, the accounting of successful ICOs remains murky, since the jury is still out on whether the proceeds from an ICO should be taken onto a company’s financial statements as equity, debt, or even deferred revenue from sale of a product. All have thorny issues; equity is out if the SEC deems the token a security, debt is a reach given the way tokens and blockchains work, and booking ICO proceeds as deferred revenue – potentially the most apt description from an accounting point of view – is problematic because secondary appreciation of the tokens could result a tremendous hit to the balance sheet when the future performance obligation created by the tokens is valued at its cash redemption value.
Hold your horses
We’re excited by the innovation in capital formation that ICOs represent. For the moment, though, they come with major implications for companies (and their management teams) not only tactically, i.e. the SEC might want to talk to you, but also strategically should a future round of financing be complicated by the consequences of using a structure few outside of the crypto world fully understand. Tread carefully and thoughtfully when considering an ICO, and don’t hesitate to contact us at Burkland for an unvarnished analysis of the pros and cons of this type of financing for your startup.
Craft a sticky story of your company’s journey.
Photo courtesy of Christopher Michel.
Last week I had a Monday morning meeting with the founder of a pre-seed, self-funded company. We had been collaborating for almost a year and he told me that they had their first pitch competition in three days. He wanted to do a review of their pitch with me.
After a quick run through his pitch, I gave him my brutally honest take on it: “None of it was usable”
The deck would have been OK for an investor sit down, but it was not appropriate for a three minute pitch in front of an audience where the goal is not to attract investors but rather to win a competition – or at least to peak interest and to be memorable. After all, win or not, you want them talking about you afterwards. A totally different frame of mind is necessary in the prep and the delivery for an event like this. You do not need to be a Ted Talk master, but you do need to tell an authentic story people will remember and connect with.
Unfortunately, they had already submitted the deck and could not make changes. I pondered for a moment. The deck had one good slide so I advised them to just focus on that one slide and ignore the rest. As scary as it sounded, a good story focusing on one good visual was much better than a bad story focused on many bad visuals.
Here’s how we re-worked their pitch.
Make you and your story the focus of your pitch. If your story is powerful when you sit down one-on-one, then it is simply a matter of figuring out how to translate it into one that captivates a large audience. So for my friend (founder), this meant it was time to break him down and build him back up.
We began by asking all sorts of questions….
Now, can you tell all this in no more than three powerful sentences?
Notice that not once did I ask about Sales Growth, Exit Strategy, MRR, LTV or financial models, setting up the story is all about you and your story. If your story is compelling, the details can follow. It doesn’t work the other way around.
Here are my top 9 pitch tips that can help you weave a sticky story that is authentic.
After considering these pitch tips, it was only a matter of weaving the the story in a sequence that made it progress. Here’s the outline we used:
Happy to report that being the amazing entrepreneur he is, he turned this advice into a pitch competition victory three days later.
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 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:
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 😉
A consumer play not yet served by Amazon. Photo courtesy of Christopher Michel.
“Warren Buffet just confirmed the death of retail as we know it,” – that’s the headline of an article published by Business Insider last week. If your startup is in the consumer retail space, you should take notice.
Warren Buffet is usually spot on when it comes to having long-term vision. To illuminate this long-term view and how it applies to the consumer retail outlook, here is an exchange he and Charlie Munger, vice chairman of Berkshire Hathaway, had at their most recent annual meeting earlier this month:
Warren Buffet: “The department store is online now, I have no illusion that 10 years from now will look the same as today, and there will be a few things along the way that surprise us, the world has evolved, and it’s going to keep evolving, but the speed is increasing.”
Charlie Munger: “It would certainly be unpleasant if we were in the department-store business.”
As strategic CFOs for consumer startups, we’ve learned 3 lessons we’d like to share in order to help you position your startup to attract the investment that will bring success in the evolving retail landscape that Mr. Buffett refers to.
People love Amazon. Consumers are used to finding and ordering on their site or app in a painless and quick way. You do not want to be solving a problem they don’t have. You therefore will have a hard time raising money for an online business selling things that can be easily found and bought on Amazon, like regular books, toys, and small electronics. If you focus on these types of commodity items, investors will have a hard time believing you can source your products for less, or get them to the customer faster, or even get people to visit your site in the first place and transact there when they already have Amazon Prime.
Yet, there is hope for your startup. Although it may seem like they already sell everything, Amazon didn’t get to every category at once (for instance, they are just now getting to furniture and groceries). They didn’t do every category well on the first shot either (case in point: fashion). Your opportunity to play alongside this online giant is by focusing on a niche they are presently not choosing to focus on or have historically had execution challenges with because of obstacles related to merchandising, vendor relations, or other factors. A complex selling process also opens up a window of opportunity, for instance, a market where you need to customize the product online (like glasses), or a market where regulatory compliance makes Amazon’s standard checkout process insufficient (think pet RX), or areas where merchandising is key (like designer fashion).
If all it took to imagine the future of retail was visualizing empty malls and a world where every purchase is made on a mobile app, a sharp guy like Buffet would not have said that “there will be a few things along the way that surprise us.” Although news about the death of bricks-and-mortar retail and retailer Chapter 11 notices surrounds us, many local shops are doing quite well. Online brands are building and emerging faster than ever. One of their “secrets” seems to be to open physical retail along the way for brand support, and for retail “showroom-ing”. This term is used when an online brand (like Warby Parker or Bonobos) opens a bricks-and-mortar location that is open to the public in order to let the customer touch and feel the product. This allows the company to get closer to their end customer and acquire feedback that will be essential for future product development. Often these new retail showrooms carry very limited or even no inventory for purchase, and customers need to wait for their purchases to be mailed to them, as if they had purchased online, while they have had the benefit of a physical try on.
The destruction in legacy retail is a naturally occurring forest fire; it is creative-destruction that opens up space, and creates opportunities for new brands in the form of short- and long-term and pop up leases in premium, high street locations and malls. These opportunities would have been unthinkable just a few years ago. If you think bricks-and-mortar are dead, think of millennials; as connected as they are, they also like to stroll their local neighborhood on weekends and find stuff they can buy. Tourists from areas of the country less dense with early adopters, and international arrivals in particular, can also be introduced to new, emerging brands – in fashion, home, electronics, even food & beverage and health & wellness – through strategically placed physical outposts in high traffic locations. Physical space is here to stay for those startups that are creative and use it to augment their digitally-driven business models.
The model invented by Zara and H&M has put many former titans of the mall on the brink of irrelevance – and they did not do it by shifting consumers online. Fast fashion companies like Zara, H&M, and Forever 21 know that consumers are fickle and what is hot now can become old news next month. Their entire model is designed to take new styles from the designer’s desk to the shelf in just a few weeks, without squeezing their suppliers. As a result, their initial buys are shallow and frequent, and stores only carry current stuff that will not need to be heavily discounted because it went out of fashion while sitting in a warehouse waiting to be shipped – which is a huge issue their competitors have.
Having a lite – or even zero inventory – business model reduces the investment in working capital, which in consumer businesses, is often a risky asset. Getting to inventory-lite requires high inventory turns. High inventory turns are made possible by a kick-ass concept-to-shelf design process, aided by superior logistics. Even better than inventory-lite is inventory-zero. Inventory-zero is inherently less risky, requires the least working capital, results in the highest operating margins, and has a tendency to translate into a free cash flow machine. VCs know this. Think eBay, MercadoLibre, Grubhub, and Opentable, who don’t even own anything they sell. They are the toll-takers of the internet, taking a piece of other people’s transactions, but never actually taking the risk of owning anything or the expense of warehousing or shipping anything. These agency businesses are fantastic business models, but they tend to be winner-take-all because of the importance of scale and network effects, so when attempting to build a toll-taker business, be prepared to answer questions about how you will acquire your customers, how much it will cost to do so, and who your competitors are.
Use them to fine-tune your value proposition
These three things to have in mind when formulating the plan for your consumer startup are by no means exhaustive… the comprehensive list of potential ways to maximize the value of your consumer startup would be a very long one. These are however three key things you should keep in mind as you try to define your value proposition for VCs. They are also key items to keep in mind as you prepare your strategic plan and do your long-term modeling to ensure you have an attractive beachfront to compete supported by smarter finance.