Thomas Thurston, President and Managing Director of Growth Science International, will be the main speaker at this event. Thurston is an authority on how to predict if a business is likely to survive or fail. Through his research at Intel and later at Harvard, he shares insights on the key ingredients for predicting the future of a business. Join him and a panel to learn how to develop a strategy to position a business to succeed.

When:

Tuesday, September 14, 2010; 6:00pm – 9:00pm

Where:

Sunset Center; 19075 NW Tanasbourne Drive, Suite 150

Hillsboro, OR  97214

Registration Link

Rather than vaulting into financial engineering, Greek equations and Modigliani-Miller debates, consider the following first-hand account:[i]

“I’ve got a problem coming up with the bank.  It goes back to the $7.65 million loan that we took out in August 2007 to purchase a new building for our business.  We managed to avoid foreclosure last year by agreeing to turn the deed over to the bank, which gave us a five-year lease on the property in return.  Our monthly payments (including rent and taxes) would start at about $25,000 for the first year and then rise annually to about $80,000 in the fifth year.  At the time, I was relieved.  I mean, we were eight months behind on our payments, and the bank had personal guarantees from me, my two brothers, my two cousins, my mom, and my uncle.  We could have lost everything.  The problem is, our monthly payment is due to go up to about $62,000 in September, and I don’t know if we can cover it.  Business is better, but not that much better.  Any advice?

‒      Mike Baicher, President, West End Express, Dayton, New Jersey” [ii]

West End Express was a thriving commercial trucking and warehousing company that watched in horror as its sales crashed with the recession.  Before the crash West End put $850,000 down on a new facility, and could handle its $70,000 monthly payment.  After the crash it could barely afford $40,000 per month.  As a result West End lost ownership of its property (kiss that $850,000 down payment good by) and was forced into a new deal that it still could not afford, just to spare its family abrupt destitution.[iii] If conditions do not improve, the family could still lose its business before year-end because it can no more afford the new payment than the last one.

The question is… what was its cost of capital?  Whatever the cost, it certainly isn’t captured by a hollow APR (annual percentage rate) or CAPM (capital asset pricing model).

Cost of capital is a function of risk.  Everyone knows that.  More risk, higher cost; less risk, lower cost.  But what does that really mean?

From an entrepreneur’s perspective, risk is the sum of downside tangible + intangible scenarios at a ratio of approximately 20/80 (20% of the risk is tangible, 80% is intangible).  This is problematic because only “tangible” sums tend to show up in mathematical calculations, leaving the majority of risk assessment obfuscated for unwary entrepreneurs.  There’s no substitute for actually thinking it through.

For example, a 2% APR loan is offensively expensive if borrowers must also amputate their right legs, abandon their first-born children and only wear Spandex (no offense to Spandex-lovers).  Meanwhile a 30 year fixed 1,000% APR loan may come at a bargain if the cash produces guaranteed eternal bliss, world peace and unlimited calorie-free cheese fondue (still looking for that deal… by the way).

It would be absurd to ask a venture capitalist for the “APR” of an equity investment because there simply isn’t one – returns are a function of the venture’s future performance.  APR only comes into play when both the time and magnitude of repayment are predetermined.  Neither is the case in venture capital, thus a VC’s downside risk is near total (the business could go bust), whereas risk to the entrepreneur is limited (no personal liability).  “If you can’t tell me your equivalent ‘APR’ is going to be at least 100% a year” …the VC might reply… “you should get the @#$% out of my office!”

It’s equally absurd to ask an RBF investor for the “APR” of a revenue-based investment because there simply isn’t one – returns are a function of the venture’s future performance.  Neither the time or magnitude of repayment are predetermined in an RBF agreement (only a maximum future potential magnitude is agreed upon), with the RBF investor’s downside risk being near total (the business could go bust), whereas risk to the entrepreneur is limited (no personal liability and variable payments fluctuate to match actual cash flows).  In fact, the actuarial portfolio risk of an RBF investor can exceed that of a VC since RBF investors limit (i.e. ‘cap’) their total potential payback.  By comparison, VCs can enjoy unlimited returns and can hold their equity as long as they want to.  What’s more expensive, a 5% royalty up until a 3X multiple (ex. RBF), or 15% ownership of your company in perpetuity (venture capital)?  Think about it.

In the real world, it’s misleading to ask which offers the best “cost of capital” when the pragmatic question is; “which tradeoffs best match the needs of my business today?”  With that in mind, the following represents key generalized strengths and weaknesses of each capital structure:

If an entrepreneur has a strong stomach for downside risk, small business and mezzanine debt are more attractive options.  In that case, repayment is guaranteed and considerations such as APR and the size of mandatory minimum payments become paramount.

If an entrepreneur wants to mitigate downside risk (tangible and intangible), RBF and equity become more attractive.  Repayment is not guaranteed, therefore considerations such as APR and minimum payments become moot, shifting the focus to royalty rate, repayment cap, ownership %, pre-money valuation and other control points.

What about Mike Baicher?  What if West End Express had been able to purchase its building using RBF?  While its payment may have been the same during good economic times, those payments would have declined during the recession in proportion to revenue decreases (since RBF payments are based on a % of revenue).  In other words, West End would have made its payments in good times and bad, never going into default, without having to suffer the shakedown of a shotgun refinancing.  Neither Baicher, his two brothers, two cousins, mom, or his uncle would have faced personal liability and the risk of losing everything.  Therefore, Baicher could have remained focused on running and turning around his business during the downturn, rather than being sucked into the negative death-spiral of defaulting on one bad deal, losing his property investment, being forced to take another bad deal, and being put in a position where he’s still highly likely lose everything before the holidays.

The cost of capital should never be taken lightly, nor should it be calculated incompletely.  It is a function of downside risk, both tangible and intangible, with intangible risks often the most heavily weighted in human terms.  After all, most of us would rather go financially broke rather than seeing Mom become homeless.

For savvy entrepreneurs this creates both burden and opportunity.  On the one hand, there is no “one number” that dispassionately allows for apples-to-apples comparison between each available funding mechanism.  On the other hand, the underlying variety of each structure offers a contoured menu for entrepreneurs.  Choices can be made  to best fit the needs of any one business at any given time, with trade-offs along multiple dimensions rather than just one.  This is good news for those prepared to think for themselves, and for entrepreneurs who can appreciate the value of both tangible and intangible risk.  Regrettably these distinctions are not always known, and the full menu of capital choices is not always available.  Just ask Mike Baicher at West End Express.

[ii] Id

[iii] Id

Time: Reception 4:00pm; Forum 5:00pm

Location: Portland State University School of Business, Portland, Oregon (Room TBD)

Predicting if Your Business will Survive or Fail

Date: September 21, 2010

Location: The Griffin House, Hood River, Oregon

Registration: OEN Members and Non-Members Welcome.

The United States has a problem: entrepreneurs and venture capitalists are having trouble getting funded.  Less than 1% of startups attract venture capital in the US.  Making matters worse, the US venture capital industry posted negative 10-year returns as of 2010, with a 31% decline in first quarter dollars raised by VC firms (compared with the first quarter of 2009).  Times are hard.

What about other countries?  Does the US have it better?  Worse?  Whether relevant for innovation, portfolio management or old fashioned schadenfreude, the following compares venture capital in the US, Brazil, Russia, India and China.

1. Entrepreneurial Environment.  US startups bemoan excessive regulation, procedure and bureaucracy that add cost and generally frustrate innovation.  It’s a huge pain.  Yet painful as it may be, others have it worse.  As a rough proxy for national “bureaucratic-ness,” the time and procedure required to set up a foreign-owned business compare as follows:

[i]

At one extreme, it takes more than 15 times longer to set up a foreign-owned business in Brazil (vs US).  Another proxy for government-imposed burden is tax, for which Brazil gets more poor marks with taxes at a whopping 38.8% of GDP.

[ii]

While China, India and Brazil have made varied strides to improve their business climates in recent years, Russia registered an actual decline in the 2009-10 Global Competitiveness Report.  Russia dropped 12 places to 63^rd, largely because of a perceived lack of government efficiency, judicial independence and property rights.[iii]

2. Venture Capital Volatility.  The Great Recession vaporized almost a third of invested VC dollars in the US, with devastating effects for startups and fund managers.  Even today the effects of this funding volatility plague the economy.  However volatility was around three times worse in Russia, and twice as bad in India.

[iv]

Compounding the issue, IPOs from Russian companies dried up in 2008 and 2009 while India’s IPO market crashed around 97% from Rs 922.18 billion to Rs 20.33 billion.

Venture capital has always had its challenges in emerging markets, even in the “good times” before the 2007 collapse.  For example, 20 venture capital funds investing in 74 Brazilian firms between 2003 – 2006 posted negative overall returns.[v] While overall US venture capital returns over the past decade have also been negative,[vi] one 2005 study showed that private equity funds across emerging markets (including a mix of venture capital and larger private equity transactions) similarly produced an IRR of negative 0.3% over 5- and 10-year horizons.[vii]

3. Future Outlook.  With thicker bureaucracies, greater volatility and historically challenging environments, one might expect the future of BRIC venture capital to be gloomy – at least gloomier than that of the US.  However, oddly enough, the exact opposite seems true.

In a recent survey of over 500 global venture capitalists, an overwhelming percentage of VCs predicted venture investing growth in Brazil, China and India (Russia was not sampled) over the next five years.  Meanwhile 85% of respondents predicted declines in US venture capital over the same period.

[viii]

This is cruel irony or poetic justice, depending on one’s viewpoint.  The past few years have been tough for everyone, especially BRIC nations.  However going forward, BRIC nations may have a light of hope at the end of their venture capital tunnel.  As for the US, unless significant steps are taken the light at the end of its tunnel may turn out to be an oncoming train.

Authors:

Thomas Thurston, President, Growth Science International, LLC

Bruce Pascoe, Visiting Researcher, Growth Science International, LLC

Mark Streich, Founder, Surxel Venture Advisors

[ii] Organization for Economic Co-Operation and Development, Center for Tax Policy and Administration, Revenue Statistics 1965-2008, 2009 Edition

[iii] World Economic Forum, 2009-10 Global Competitiveness Report, (2010)

[iv] Dow Jones VentureSource

[v] International Journal of Entrepreneurship and Innovation Management 2006 – Vol. 6, No. 4/5 pp. 341-355

[vi] Cambridge Associates and National Venture Capital Association, Venture Capital Industry Saw Short Term Performance Improvements at the End of 2009, (2010)

[vii] Patricof, Apax Partners, Sunderland, Venture Capital For Development, Brooings Blum Roundtable: The Private Sector in the Fight against Global Poverty Session III: Does Size Matter?  SME’s, Microfinance & Large Nationals, http://www.brookings.edu/global/200508blum_patricof.pdf, (2005, Accessed 9/25/09)

[viii] Deloitte & National Venture Capital Association, Results from the 2010 Global Venture Capital Survey, July 13, 2010.

This is not to, in any way, detract from successful investors; the ability to pick winners, wrestle out a deal and drive others towards a central direction can require tremendous talent and skill.  Rather, the point here is merely to pose a question.  Given the dollars at stake and lives in the balance, will venture investing inevitably evolve in a more empirical direction?  Will there be a robot uprising?

Once upon a time marketing and advertising were a matter of visionary intuition and interpersonal sensitivity.  Yet today statisticians are increasingly replacing marketing MBAs, and software developers are taking the place of bygone “Mad Men.”  If you want to know what makes left-handed, Republican, blonde, female smokers buy pink purses in Nebraska, you’re increasingly better off writing a few lines of code rather than hosting a living room focus group.  Downtrodden liberal arts students with a penchant for business are finding fewer and fewer places to hide.

While intuition-based venture investing works for some, most agree that it usually fails.  Investors spend inordinate time screening deals, only to see around 90% fail (on a good day).  Industry-wide VC returns in the US over the past 10 years are now negative.  Not only is VC investing falling short of LP and GP expectations, but it – by necessity – excludes the gross majority of startups as well.  Less than 1% of startups attract VC investment in any given year.  Less than 95% of businesses attract any equity investment at all (either from VCs or angel investors).

A common counter-argument to empiricism is that venture investing is inherently unquantifiable.  Too unpredictable.  Too subtle; so as to be forever exempt from the purview of robots. Yet is venture capital really more multivariate than manufacturing, biology, chemistry or physics? Anyone who has run a semiconductor fab, high-volume manufacturing plant or pharmaceutical lab might disagree. What makes venture investors immune?  Why are they so special?

The field of Psychology is perhaps a worthy analogy.  Equally amorphous and intangible, psychology is divided between clinical methodologies (relying on human judgment and subjective analysis) and mechanical methodologies (relying on statistics, algorithms and other more objective tools).  More than 136 different studies have tested the relative accuracy of both methods going as far back as the early 1900s, almost invariably concluding that mechanical methods are more consistent, accurate and yield higher quality results.[i] Even in Blink[ii], a book often held up in defense of intuition, author Malcolm Gladwell goes to lengths to call out the limitations of intuition, such as inaccuracy, wishful thinking, knowledge inaccessibility and the mind’s ability to play tricks on itself.  Along these lines it was found that even simple checklists, the most basic of objective tools, reduced hospital surgical mortality by around half. Half![iii]

With so many lives and dollars at stake in the realm of venture investing, can empirical methodologies lend more of a hand?  Should we demand more than “gut feel”?  Could society benefit from a little more robot uprising in venture capital today?

[ii] Gladwell, Blink: The Power of Thinking Without Thinking, Little, Brown and Company (2005)

[iii] Haynes, Weiser et al, A Surgical Safety Checklist to Reduce Morbitidy and Mortality in a Global Population, The New England Journal of Medicine, Volume 360:491-499 (January 29, 2009)

History makes a good argument for equity investing.  Venture capital has created more than 12 million jobs and over $2.9 trillion in corporate revenue since 1970 (and that’s just in the US).[1] Although the venture capital industry recently posted negative 10-year returns, $6.36 in corporate revenue was created for every dollar of venture capital invested between 1970 – 2008.[2] Meanwhile the average return for angel investor groups as of 2007 was 2.6 times the invested capital within 3.5 years (approximately a 27% IRR).[3] Not too shabby.

While a great start, exit dependence underpins why only around 1% of US startups attract equity investment in the first place, and that’s within one of the most stable, liquid, best understood securities markets in the world.  Entrepreneurs in most other nations have it far, far worse.

To the extent that economic vitality depends on innovation, innovation depends on equity investment, and equity investment depends on exits… there is a problem.  Exits are scarce.

In the heyday of 1991 – 2000, less than half of VC-funded companies had an exit.[4] Those were the good times.  In 2009 there was approximately 1 exit for every 10 deals funded (10%).[5] In other words, only around 1% of startups attract equity investment, and among them only around 10% equate to actual exits.  One tenth of one percent.

According to the University of New Hampshire’s Center for Venture Research, even those companies that did have IPOs between 2001 and 2007 had to wait an average of 10.9 years (when backed by angel investors) or 14.4 years (when backed by VCs).[6]

That’s a long time for investors to hold their breath, especially since most investments fail to exit at all.  According to the ACA, “the most sophisticated angels make at least 10 investments to make a return on their investment, counting on one or two to provide nearly all of their return.”[7]

Who has the stomach for all that, especially in today’s economy?  Turns out, fewer and fewer investors do.  Overall, angel investments were down 8.3 percent in 2009 from 2008 while angels more often shied away from riskier seed and start-up deals: new first sequence investments were only 47% of angel investments in 2009, a significant decline from the two prior years.[8]

The point is this: equity investing has been a tremendous benefit to society.  No argument there.  However, inherent structural limitations have made it unsuitable for all but approximately one tenth of one percent of startups nationwide.  What about the other 99.9%?  Surely at least some of the 99.9% have potential to make profoundly positive impacts on communities, economies, customers, employees and commercial ecosystems.  Is there a way to invest in them too, without requiring an exit?

This question is not an armchair triviality, it is a global alarm.  Exits rarely happen, making them a thin instrument upon which to hang the future of startup innovation worldwide.  Is there a 12-step program to cure our exit dependence?  Or… is our creativity so stunted – our addiction so complete – that we can’t fathom alternatives?  Are we destined to be exit junkies forever?

Authors:

Thomas Thurston, President, Growth Science International, LLC

Bruce Pascoe, Visiting Researcher, Growth Science International, LLC

[2] Joint study by the National Venture Capital Association and HIS Global Insight, Venture Impact: The Economic Importance of Venture Backed Companies to the U.S. Economy, (2009)

[3] Wiltbank & Boeker, Returns to Angel Investors in Groups, (November, 2007)

[4] http://venturecapital.doodig.com/2010/02/02/venture-capital-and-entrepreneurial-success-the-exit-funnel-and/ (Accessed June 22, 2010])

[5] See National Venture Capital Association & Thomson Reuters, Venture-Backed Exit Activity Shows Improved Signs of Life in Q1 2010; All-time Record for Venture-backed M&A Exits; Nearly All Venture-backed IPOs Trading Above Offer Price, (April 1, 2010); see also PricewaterhouseCoopers/National Venture Capital Association, MoneyTree Report; Total U.S. Investments by Year Q1 1995 – Q4 2009, (January 2010)

[6] UNH Center for Venture Research, Angel Investors, VCs Look At IPOs Differently, (http://www.unh.edu/news/cj_nr/2009/july/lw22cvr.cfm) (Accessed June 21, 2010)

[7] Angel Capital Association, The Value Of Angel Investors And Angel Groups, (http://www.angelcapitalassociation.org/data/Documents/Public%20Policy/Federal%20/Value%20of%20Angels%20FAQ%202009R.pdf), (Accessed June 22, 2010)

[8] UNH Center for Venture Research, The Angel Investor Market In 2009:  Holding Steady But Changes In Seed And Startup Investments, (http://wsbe.unh.edu/files/2009_Analysis_Report.pdf) (Accessed June 21, 2010)

Small Capital Needs

Startup funding exists at the smallest levels, either through microfinance (averaging less than $400 per loan), friends, family, small business loans, government assistance or personal wealth.  While an encouraging beginning, none of these capital sources scale well (unless one happens to be already rich or flush with wealthy loved ones).  Loans are particularly burdensome for entrepreneurs, with microfinance being onerous at larger amounts.

Large Capital Needs

The next level of significant startup funding is via equity investment.  Angel investors often provide equity investments for startups needing between $25,000 – $750,000 ($USD), with a 2008 average invested amount of around $275,000 by Angel groups in the US.[i] The next level of funding is through institutional venture capital firms, who average around $5 million per deal.[ii]

While a partial solution, Angel and VC capital has thus far proven unattainable for the gross majority of startups; not because of the amount of funding desired, but because of the astronomic growth and high exit potential needed to attract this funding in the first place.

To attract equity investment, startups must promise at least 11-fold returns over seven years (or 20-50% average annual returns) with dramatic acquisitions or IPOs.  They must be a “home run,” with no points given for a “double or a single.”  A Kaufman study of the Inc 500 fastest growing firms in the US between 1997 – 2007 found that only 16% received institutional venture capital investment[iii].

The Black Hole

This black hole between diametrically small and large opportunities devours the majority of promising startups.  More than 99% of all employer firms in the US are small and startup businesses (employing more than half of all private sector employees), of which more than 50% fail every five years.[iv] It is worth repeating – roughly half of US employer firms fail every 5 years.  In corporate terms, that is enormous turnover with profound consequences for economies, families and reliant business partners of every manner.  Many businesses fail on their own accord, often deservedly so.  However there are profound benefits to be realized from getting the numerous other, sound, high-potential startups the capital that could maximize their impact.

Who will fill the gap?  What proverbial cork will stop up the black hole?  Who will provide those genuinely deserving startups the funding needed to transform markets, economies and lives?  This is not a call for charity or shoddy investments, it is a call for innovation.  The black hole has been called out.  Startups everywhere wait for an answer – for financial innovation – to whisper back from the abyss.

Authors:

Thomas Thurston, President, Growth Science International, LLC,

Mark Streich, Founder, Surxel Venture Advisors

[ii] Chachere, Peterson & Mendell, National Venture Capital Association & PriceWaterhouseCoopers, Venture Capital Investing Has Modest Start in 2010, Amidst Economic and Market Uncertainty, (April 16, 2010)

[iii] “Right-Sizing the U.S. Venture Capital Industry,” Paul Kedrosky, Ewing Marion Kauffman Foundation, June 10, 2009 (http://www.kauffman.org/uploadedFiles/USVentCap061009r1.pdf) (Accessed June 12, 2010)

[iv] U.S. SBA Office of Advocacy FAQ 2009 (www.sba.gov/advo/stats/sbfaq.pdf) (Accessed June 12, 2010)

Bottom line – Total Angel investment was flat between 2006 – 2008, but the average funding round grew by 14%.  Angels began doing fewer, larger deals.

2. Areas of investment: Top areas of Angel investment in 2008 were (1) software, (2) medical devices and equipment, and (3) business products and services.  When asked about future areas of investment in 2009, biotechnology replaced “business products and services” as number (3).  The lowest areas of investment were retail and distribution, semiconductors and financial services.[ii]

Bottom line – Angels groups have been favoring software and medical device/biotech startups.  Some industries have been disproportionally avoided.

3. Angel dollar amounts: The gross majority of Angel group funding rounds in 2007 were for either less than $150,000 (USD), or between $250,000 – $500,000.  Less than 5% of all Angel group investments exceeded $750,000.[iii]

Bottom line – Angel groups disproportionally favor certain deal sizes, with a 2008 average around $275,000.  It is very rare for Angel groups to fund rounds larger than $750K.

[ii] Angel Capital Education Foundation, 2008 ACA Angel Group Confidence Survey, (2008).

[iii] Angel Capital Association, 2009 ACA Angel Group Confidence Survey and 2008 Member Directory, (2009).