Raising Capital in 2010

or

Beg, Borrow and Steal 403@ the School of Hard Knocks

also called

Why I hate the word “funding”

Getting the Terminology Right

• “Funding” is what research a project consumes– It is a matter of academic curiosity

• “Capital” is what entrepreneurs need and create– It is a matter of business and wealth creation

• “Cash” is what keeps the enterprise alive– It is a matter of life and death

Getting the Thinking Right

• “Debt” is not the same as “Equity”

• “Expenses” are not the same as “Cash Flow”

• A key programming language: “Accounting”

What’s up with Venture Capital?

The V in VC = Vanishing

Getting To Angels

• It’s about “Math” not “Prayers”

• The technical term is “Win-some, Lose some”

• “Rule of 2-6-2”: Out of every 10 investments– 2 die completely– 6 are the undead... Zombies... Cash never exits– 2 generate all of our returns

• Every entrepreneur thinks they are in the right 2

Angels: Time Value of Money

Investors have CHOICES about where to put their money

Assuming average Time to Exit of 5 years, what are our alternatives?

Portfolio Multiple Equivalent Investment Strategy 1x = (1+0%)5 Hoard Cash 1.5x =(1+8%) 5 Secured Debt2.0x =(1+15%)5 Unsecured Debt3.0x =(1+25%)5 Pay day loans4.5x =(1+35%) 5 Other Startups Like You

The Basic Math

1.0X Dead

Zombies

Live

35% Per Year Rate of Return

4.5X

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Our Expectations = 4.5X

1X

22.5 X

Your Promise = 22.5 X

Entrepreneur MathAverage angel deal looking at 20 X exit, so...

• IF– I want to keep control of my company (66%)

• THEN – 33% of my company needs to be worth > 20X the investment– So 100% needs to be worth > 60X the investment!!

• 80% of companies bought by Google were purchased for less than 100 M$

Angels will do this math, even if you don’t

Corollary: Why are you better than average?

To Close an Angel• Show that our risk is lower than typical

– Better than 20% chance of being in the right 20%– (we won’t believe you, but you get extra points for trying)– Or at least demonstrate that you are keenly aware of risks

• Explain how their exit will be much sooner– Shrink that exponential function, exponentially

• Prove that you understand basic business– Demonstrate a focus on making money for them– Demonstrate knowledge that business is about choices– Connect the dots from cool technology to wealth creation

A good business opportunity will attract investors

Friends and Family Aren’t Like That• They want you to succeed more than they

want to make money

• Or maybe they just aren’t any good at math

Really, they are buying into YOU...

Corollary: If they won’t, who will?

YOU: the most important investor

• “Skin in the Game”... yours first– If you don’t believe, then I won’t either

• “Appetite for Risk”... if you don’t have the stomach, don’t sit at the table

• “Risk” and “Reward” enjoy a Karmic balance

Banks• Banks only provide you cash for the capital you

already have

• They convert “Assets” to “Cash Flow” and vice versa• They don’t share your passion or care about your

ideals

• Banks *ONLY* care about the math

Banks are NOT sources of capital

Financing• Easiest: Product with Gross Margin of 80%

– Customer pays 20% in advance– This is the basis for “just pay S&H” (includes product cost)

• Purchase Order Financing, or “factoring” in lingua banka– Unconditional Purchase order is financeable on *THEIR* credit rating– Conditional purchase order is financeable on YOUR ability to convince

your investors you can meet the conditions

• Services business can be SRED financed– Especially if US sourced revenue

EDC: Export Development Canada

• “Export Express Credit”– $50,000 unsecured loan, repayable over 2 years

• “Export Guarantee”– Provide guarantees to your bank (so your bank will give

you more credit)

• “Supplier Financing” – Purchase your foreign receivables

Government

• It takes work... But in most cases you don’t have to pay it back

• SR&ED Tax Credits• IRAP• OCE• Regional Development Incentives

SR&ED & OITC

• Know this program inside and out

• Simplistic: ~ 40% of 160% of eligible expenditures– There are lots of rules, but they are clear and easy to follow

• You need to actually make the expenditures – You must maintain appropriate records, evidence– Expect to be audited – better safe than sorry

• Note: expenditures and cash flow are not the same thing

IRAP• Most useful program is “Contribution” agreement

– IRAP pays for R&D Salaries (about 60% of project)– Company pays for overheads (about 40%)

• You pay your costs, IRAP reimburses a portion, about 60 days AFTER you spend it and send in proof

• BUT, it can be difficult for many entrepreneurs– It is a finite resource, heavily over-subscribed– Requires a disciplined business management approach– Need to learn how to speak IRAP

• Great program, Fantastic people, Really trying to help– But they are over-worked

• Also provide other useful programs– Market research, mentorship, academic-industrial partnering...

Regional Initiatives• OCRI– Strong and active entrepreneurship program– Sponsors Lead To Win– Various events– Referrals to Provincial programs (OCE, MARS...)

• Grass Roots Initiatives– The Ottawa Network, DemoCamp, TeamCamp...

The Good news: Opportunity Cost trending to $0

Employees

• Slavery was outlawed long ago, but...... Sweat Equity is part of the package

• Innovative “on spec” or “rev-share” deals

• Directors, Executives and Officers are Special

• But... Get appropriate legal advice

Suppliers

• Take As Long As Possible to Pay

• They often have more patience than you think– If you succeed, you’ll buy more– It’s in their interest that you survive

• Cash is our most precious resource – Count cash in terms of Door-Open-Days

Customers

• The only source of capital you don’t eventually have to pay back

• Customers are the folks who pay you– Avoid Whiners (won’t pay)– Differentiate from Users (don’t pay)

• If you can’t find at least one Customer willing to put it in writing, you have to wonder if any exist at all

Summary: Sources of Capital

• Venture Capital • Angel Capital• Friends and Family• Banks• Government• Employees• Suppliers• Customers

Financial Engineering

• A few illustrations in the art of the possible– Makes many simplifying assumptions – Get professional advice (legal, accounting)

• Start with the typical Founder Scenario– Work for a year from your kitchen for no salary– 1 year later... What do you have?

A Tale of Two FoundersA: Works for a year “for free”

B: Personally Begs, Borrows or Steals $100,000– Lends it to their company– Company uses this stash of cash to pay B a salary+benefits of $100,000– Company pays source deductions of about $35,000

• (B takes home about $65,000 after tax, which gets returned to whence it came)– Company eventually receives SRED Tax Credit of $43,000

• (company repays B $43,000 of the $100,000 loan principal, which also goes back to whence it came)

• When The Dust Settles, both A and B have 0 net cash, but– Founder B shows a $57,000 loan to the company (skin in the game!!)

• which can be offset against future income, tax free even if the company fails – Founder B has EI, CPP benefits– Founder B isn’t “unemployed” to the rest of the world

Your Mileage May Vary, Some Restrictions Apply

Three Founders, IRAP+SREDC: Approved for $100,000 IRAP program and begs, borrows or steals $100,000

– Lends it to their company (showing IRAP sufficient cash to execute the program)– Company pays salary+benefits of $100,000– Company pays source deductions of about $35,000

• (C takes home about $65,000, which gets returned to whence it came)– Along the way, IRAP pays the company $60,000

• (company repays C $60K of the $100K oan, $35K goes to retire the loan, leaving $25K free cash)– Eventually receive SRED Tax Credit of about $16K (SRED is reduced by contributions etc.)

• (company repays C another $16K of the loan principal, total $41K free cash)

• When The Dust Settles, C has net $41K after-tax cash – (equivalent to 60K/year salary)– Founder C also holds a $24,000 loan to the company which can be offset against future income, tax free

even if the company fails– Founder C has EI, CPP benefits– Founder C is employed at a better rate than flipping burgers

• Again, Your Mileage May Vary, Some Restrictions Apply

Put it All Together with an Angel Investment

IRAP & SRED & Angel & BankD: Approved for $100K IRAP program, $30K Equity from Angel, $70K Personally

Secured Bank Loan– Company starts with 100K in bank– Company pays salary+benefits of $100K – Company pays source deductions of about $35K

• (D takes home about $65,000)– Along the way, IRAP pays the company $60,000

• (company repays bank $60,000 of the $70,000 loan)– Eventually receive SRED Tax Credit of about $16,000 (SRED is reduced by contributions etc.)

• company repays bank remaining $10,000 of the loan principal• company has $6,000 left over, but it will also owe some interest

• When The Dust Settles, D has taken home a good salary, AND– Angel investor gets $100K worth of work done for $30K investment– Company has established a good credit rating

Add revenue, and even a break-even business is profitable