Understanding – and Managing – Financing Risk
When high impact entrepreneurs and their investors talk about risk, the “big three” categories are usually Team, Market and Technology. In taking an idea and turning it into a business/investment opportunity, entrepreneurs spend (or should spend) a lot of energy understanding and managing each of these risk factors. More often than not, the proximate cause of high impact business failure is attributable to one of these risk factors (usually Team risk – but that is another subject).
There is, I think, another big risk that entrepreneurs, even when they understand it, don’t spend enough energy managing Financing Risk. Which is to say the risk that the deal will ultimately fail not because the team botched the execution; or the market opportunity ultimately was not sufficiently compelling; or the technology did not prove out; but rather because, before any of those risks come home to roost, the company runs out of capital. Financing risk is something every high impact startup should understand and proactively manage. It is of particular concern, however, for entrepreneurs outside of the major venture capital centers.
Now, almost every high impact startup that fails runs out of money. That is not what Financing Risk means. Financing Risk comes to roost when lack of cash is the proximate cause of failure: that is when the cash runs out even though the team is performing; the market still attractive; and the technology still on track. It is when cash runs out, then, even though the other risk factors are still in play. (Which is not to say that, if cash was still available, one of those other risks might have subsequently been realized and cratered the deal.)
Now, some would argue that so long as a deal looks good in terms of the “big three” risks, capital will be available: that is, that financing is always available for otherwise good deals. And, if you live in the (mythical) land of perfectly efficient risk capital markets, they would be right. But the market for venture capital is most assuredly not efficient. If it was, venture investors would not, as so many of them do, have rules about not investing in deals more than two hours from their offices. The unfortunate fact is that even in the venture capital centers (even in Silicon Valley) venture capital markets are less than perfectly efficient. And if they are not perfectly efficient in the center of the venture capital world, imagine how inefficient they are in, say, Wisconsin.
On that note, let’s start with the first way to understand financing risk – geography. To the extent that an entrepreneur is located in a venture capital market that is materially smaller than the market in Silicon Valley, the entrepreneur will endure more financing risk than if he was in Silicon Valley. Locating a startup close to fewer, and smaller, venture firms is a significant challenge, a serious financing risk factor, that otherwise comparable startups in the major venture centers don’t have to deal with.
If geography is a Financing Risk factor, how do you manage it? Well, this won’t be popular in my corner of the world (Wisconsin), but the most effective way to manage geography risk is to relocate the startup to a major venture capital center. Controversial as that idea may be outside those centers, it is probably one of those ideas that is as close to a no-brainer as anything is in the high impact startup world. Of course, whatever its attractions in terms of access to venture capital, there are a fair number of folks who just don’t want to live in a place as crowded, expensive, and generally dysfunctional as California these days. Here is hoping you, if you are a Wisconsin entrepreneur, are among those folks.
If you don’t want to relocate your startup to a major venture capital center, there are other things you can do to reduce Financing Risk. Perhaps the most direct is to scale back your capital needs, typically by some combination of scaling back your business/exit objectives and/or slowing down your timeline. Anyone who has spent a lot of time trying to raise venture money deep in flyover country knows two things: (1) it is hard to get (not impossible, but I think the exceptions mostly prove the rule in this case) deep pocketed venture investors on the coasts to give the same priority to deals in flyover country as they do to deals in their backyard; and (2) smaller regional sources of capital are reluctant to invest in deals that are modeled, in terms of capital needs and exit objectives, to go head-to-head with their mega-deal competitors in the venture capital centers. And let’s be fair: If you were a flyover country Venture Capitalist with only say $25 million to invest in startup deals, and you knew how hard it is to get the mega-funds on the coasts to invest in flyover country deals, you too would be reluctant to invest in a startup that anticipated needing tens of millions of dollars of downstream capital to get to the hoped-for blowout exit.
There are some other tools that can help manage geographic financing risk, as well. If you don’t want to move to a major venture center, you might still consider establishing a presence in a major venture center. For example, if your startup is in the online entertainment space and your core competency is in IT, you might want to consider putting your business development pro in Southern California. I am sure you can think of other examples where “co-locating” a high impact business might make sense for managing financing, as well as other risks.
Another category of Financing Risk is timing; that is, the risk that you will need to raise more risk capital at a time when the risk capital market is weak. You might think that managing this risk is beyond the entrepreneur’s control, but in fact it isn’t. At least not entirely. There are at least three good management tools for addressing timing financing risks. First, control the burn rate. Holding other variables constant, in any risk capital market, and particularly in a tight market, it is easier to raise smaller amounts of capital than bigger amounts (at least to a point). The second timing risk management tool is outsourcing as much of the business as practical. It is usually easier (and better for morale) to turn off an outside development contract to ride out a capital dry spell than fire five developers. Finally, perhaps the trickiest way to manage timing Financing Risk is to build in to the business plan the idea of reaching cash flow breakeven performance (on an operating basis) early, without compromising growth objectives.
This last point is tricky for two reasons. First being the concept of breakeven on an operating basis. By that I mean the ability, at any given time, to cut or even eliminate investments in future growth to reduce expenses so that cash from operations can cover the residual expenses. At the same time, this has to be done without materially compromising the longer term growth story, because mega-exits are almost always built around growth stories, not cash flow stories.
Finally, in terms of managing financing risk, I would be remiss if I did not point out that the stronger a deal is on the other major categories of risk, and in particular the stronger the team, the less financing risk there is. At the end of the day, money follows people in the venture capital business, even more than it follows markets and technologies. Show me an entrepreneur who has made some first-tier venture investors a lot of money, and I’ll show you an entrepreneur who could raise big time venture capital from a tent in Sioux City, Iowa.