December 17, 2018

Understanding Your "Financing Path"

Rick Norland

Rick Norland
Owner/Thorington Corporation

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What is a “Financing Path”?

 

The creation of a financing plan sounds simple enough - figure out when the company will get what money, from whom, and on what terms. The “when” and “how much” questions are already answered by the financial projections. The “from whom” and “on what terms” is more difficult. This step of the process requires at least a rudimentary understanding of the overall capital markets, including the debt to equity spectrum, the various investor types and what their preferences are, and how the “available spectrum[1]” differs by type of company. We believe that a company’s growth potential and stage of maturity determine the types of investors and lenders that will be attracted to it and, as a result of that, its “available spectrum” of the capital markets.

There are three broadly defined growth potential expectations that can be defined as “Financing Paths.” The very largest opportunities (as measured in both percentage returns and in absolute returns) will attract venture capital investors, giving rise to the first Financing Path – the “VC Path.” At the other end of the spectrum are those businesses that will address a local or regional market. Serving a smaller market, companies on the “Regional Growth Path” are likely to have fewer than, say, 50 employees and generate something less than $10 million in annual revenues at maturity. A third path, the “Medium Growth Path,” is between these two.

 

Selecting your “Financing Path” and Maturity Stage

 

Determining which of the three Financing Paths best describes a company’s opportunity is often a “process of elimination.” First, determine whether the company is suitable for the VC Path. If its opportunity is not large enough for the VC Path, next determine whether the Regional Growth Path is too small. By “default” of being neither on the VC Path nor on the Regional Growth Path, the company is likely on the Medium Growth Path. A discussion of each determination follows.

 

The VC Path

 

The VC Path refers to investment opportunities whose growth expectations will attract venture capital investment as the investee matures. Typically, these opportunities require significant amounts of capital to commercialize the company’s product. There is considerable risk associated with providing this early stage capital. To offer the promise of significant rewards commensurate with their risk, these companies are expected to grow significantly – and companies with significant growth expectations usually require VC funding to achieve them. Few other investor types are comfortable with the greater risks.

While the “available spectrum” for this Financing Path includes numerous options, the primary ones in the first few maturity stages are those offered by the venture capital investors. Hence, this Financing Path is named after the most prominent investor type supporting these companies. Accordingly, the criteria for this Financing Path mirrors the investment criteria used by venture capital investors. Without their support, the company is not on the VC Path.

It is well known that venture capitalists invest in only about 2% of the business plans they see each year. So, while the VC Path is attractive to many companies, history indicates that few get onto it, making it critical to understand venture capitalists’ investment criteria.

It is also important to remember that each company is different, and investors’ interest in industries themselves shift every day. While remembering this “constant change,” there are still a few rules of thumb that can guide companies in determining their attractiveness to venture capitalists. This list of criteria represents the key considerations that venture capital investors have in determining whether to invest in a Seed Stage or Series A investment opportunity (the criteria are targeted specifically to early-stage companies). The major topic areas include:

  • Business model understanding;
  • Technology advance;
  • Revenue potential;
  • Financial considerations; and,
  • Founding team.
  •  

Regional Growth Path

 

At the other end of the Financing Path spectrum are companies that are pursuing local or regional markets. The Regional Growth Path refers to those companies that will always be small, even at maturity. They may perhaps grow to 50 employees and $10 million in annual revenue.

Much of the “available spectrum” for Regional Growth Path companies relates to debt alternatives. Most equity investors need to understand that the company will have a “liquidity event” (i.e. divestiture or public offering) in a few years at most. Most small companies can’t offer that kind of expectation. Therefore, “liquidity” to investors/lenders usually is in the form of repayment of principal and/or accrued return.

Venture capitalists and Angel investors generally become interested in the larger Regional Growth Path companies that may actually be “low-end” Medium Growth Path companies. On that assumption, investors may fund expansion to new markets for a more mature company.

 

Medium Growth Path

 

The third type of Financing Path is the “Medium Growth Path.” A company in this category is often most easily defined by what it is not - something other than a VC Path company or a Regional Growth Path company. Despite that simplistic determination, there are really three sub-categories to the Medium Growth Path. The largest sub-category is for those companies that clearly do not fit the VC Path criteria and are too large for the Regional Growth Path. They are clearly “in the middle.” The next sub-category is for those companies that “may be” VC Path companies, those at the “high-end” of the Medium Growth Path. Similarly, there are some companies that “may be” Regional Growth Path companies, those at the “low-end” of the Medium Growth Path.

 
(1)  At the “high-end”
 

There are a number of companies that look like they are on the VC Path but fail to attract VC funding when required. As well, there are Seed Stage companies that are definitely “close” to being on the VC Path, with some uncertainty. To characterize these opportunities differently, venture capitalists typically invest in only 2 of 100 deals they see. Notionally, the “high-end” of the Medium Growth Path refers to numbers “3, 4, and 5” on the list of deals. They are likely still good investments, just not quite good enough to attract venture capital funding. It can also be difficult to tell beforehand which Seed Stage deals are on the VC Path and which are on the “high-end” of the Medium Growth Path.

Where there is uncertainty, investor caution usually forces these companies to the Medium Growth Path until their fundamentals are more proven and they are “reconsidered” for the VC Path. This tendency can be seen in the “available spectrum” wherein venture capital investors are available only to more mature stage companies.

 
(2)  Strong Cash Flow
 

Companies that are clearly on the Medium Growth Path are not expected to achieve the growth expectations that venture capitals seek and, thus, will not be financed by them. For example, they may only reach annual revenues of $30 million. Some of these companies have businesses that will generate significant cash flows, even after tax. Examples include software companies or service companies. For such companies, an investor/lender is more interested in the company’s ability to take on and service debt and/or dividend obligations than its “equity-based liquidity.” These companies may offer compelling fixed income securities to prospective investors, offering annual cash returns and eventual liquidity in the form of principal repayment/redemption. Such securities may include subordinated debentures that may or may not also be convertible into equity. Normally, such securities are attractive only if the underlying company has already established early sales (say, $1 million to $3 million). Thus, as Medium Growth Path companies reach higher maturity stages, additional sources of capital open up to them to fund continued expansion.

 
(3)  At the “low-end”
 

As with the uncertainty among “high-end” companies, investors at the “low-end” tend to err on the side of caution. As a result, “low-end” Medium Growth Path companies are usually forced to the Regional Growth Path until their fundamentals are more proven and they are “reconsidered” for the Medium Growth Path.

Comments? You can contact me directly via my ExecRanks profile.

[1] “Available spectrum” of the capital markets refers to the fact that lenders and investors have well-established selection criteria that they use to consider opportunities. Hence, individual combinations are not “available” to companies that do not meet these selection criteria. Singly, each investor/lender and security combination is highly targeted to only a very small percentage of companies seeking funds.

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