The Horizon of Financing Alternatives
By Rob Gettinger
Reprinted from Software Business Magazine
Technology entrepreneurs like you are busy building their companies, which leaves little time to fully explore the host of opportunities to finance them. Not much is written about the world of possibilities between ones bank line of credit and an IPO. There may be some fuzzy knowledge of the venture capital process, but there are many more alternatives to explore (and pitfalls to avoid).
Often, the financing alternative chosen is the one most available to you – factoring. The best advice I can give you is… don’t do it. The reason factoring is so available is because it is so profitable for the issuer. You’re better off using your credit card. At least you can pay that off without penalty.
A reliable and often overlooked alternative to factoring is the financing of maintenance revenue. Some of the more tech-savvy banks will loan between 0.5 – 1.2x such revenue at prime plus two or three. As publishers, you already know that maintenance revenue is extremely reliable and profitable. In recent years a number of banks, including First Union and Silicon Valley Bank, have figured that out too.
The next spot on the horizon is subordinated or convertible debt. This is typically only available to companies with cash flow in excess of $500K annually and with a number of consistently profitable quarters (i.e., evidence you can pay the interest), “Sub Debt” is available at prime plus 4-6%, but often requires and equity kicker, where the issuer is granted options at a value generally above the current market value. Thus, you get to build your company with their money, but they participate in the upside after a negotiated value is achieved. Companies that provide this type of financing include TransAmerica, Allied Capital, Finova, and Greyhound Capital.
The next stop on the horizon is traditional venture capital. The VC industry tends to be regional in nature, unless a certain critical mass of revenue or hype is achieved – in which case larger, national firms take interest. A great deal has been written about the VC’s process, so I will not elaborate here except to say that, despite wild valuations on Wall Street for dot.com companies, VCs still invest conservatively in the 1x-3x revenue range.
The next level of capital comes from the large buy-out or re-capitalization firms. They seek companies from $10MM in revenue and $1MM cash flow up to ten times that size. If you qualify, this is a great source of money and strategic help as well. There are many reasons for companies to consider re-capitalizing, such as taking out disaffected shareholders or cashing in some chips for diversity – while maintaining control of the company. These funds tend to be much more patient than VCs. Enterprises in this category include GTCR, Summit Partners, and the Sprout Group. VCs will not stay in a deal that long. Typically, if you are not filing your S1 Registration within 24 months of funding, VCs get worried.
The next rung on the ladder is a strategic partner. Unlike VCs, they have no learning curve and will almost certainly value the business twice as high. Many of my assignments begin as private placements, but end up as strategic transactions because of the validation and quicker response. The concept of strategic partners often scares entrepreneurs, but it shouldn’t. The biggest VC in California is Intel with over 400 minority investments. Now, more than ever, large companies are taking minority positions in smaller ones without control. They want the company to remain independent, because that is where the value is. Intel is only trading at about 3x revenues. There is much more incentive for the strategic partner to leave you on your own.
The absolute best scenario leading to an IPO is to have both a financial partner and a strategic partner on board. The most favored deals on Wall Street have a brand name VC and an operating company listed in the prospectus. Almost all such deals get executed in this market. The bottom line is if an entrepreneur is fortunate enough to receive a term sheet from a reputable VC, re-cap fund, or operating company, they should put infinitely more weight on what they can build with this money (and their portion of it) than initial valuation. This is particularly true for rapidly growing, early stage companies.
Insight From Robert Gettinger D E A LS Reprinted from February 2000 issue of Software Business Magazine © Webcom Communications Corp., 7355 E. Orchard Road, Suite 100, Greenwood Village, CO 80111, U.S.A, Phone 720-528-3770