Customers as Financiers
Posted by Dr. Earl R. Smith II in Venture Capital, tags: adviser, advisor, advisory board, board of directors, CEO, chairman, coaching, consulting, director, Leadership, leadership assessment, leadership development, leadership styles, Life Coaching, management assessment, Personal Growth, spiritualityDr. Earl R. Smith II
DrSmith@Dr-Smith.com
www.Dr-Smith.com
The last column, Financial Strategies – Some Basic Rules, triggered a particularly heavy flow of responses … most of them describing strategies, some of which had worked and some of which had not, that had been deployed in attempts to arrange the necessary financial resources for an emerging company. Thanks to all of you who took the time to send me your ‘war stories’. I plan to weave the best of them into a future column.
One of my suggested rules, ‘If your product or service is as good as you think it is, and they want it badly enough, they will pay for developing it’ … that your customers could supply the financing for your company’s launch and early growth, drew a number of requests for a practical example. I’m going to devote this column to responding to those requests by describing the evolution of one of my own companies.
This one started, much like the others, because I had identified a major set of problems that a significant group of potential customers had. You will notice that I did not use the term ‘market’ … I have believed from the beginning that amateurs have ‘markets’ and pros have ‘customers’. I began with potential customers and a series of face-to-face contacts with senior executives at those companies. I talked with them extensively, developed a solution to a set of challenges that they knew they had, presented that solution for review and then launched a company based on an agreed upon model.
In this case, the group of potential customers was the major US movie studios. Their challenge was the confluence of the rise of the independent film producers and the financial limits on their ability to produce and distribute films. The studios need to make and distribute as many films as possible in order to spread the risk. They do this to assure a higher probability that enough of them will be winners to pay for the ‘dogs’, the studio’s overhead and generate a nice profit. The independent producers constituted an additional source of film projects. That was the good news. But there was an Ethiopian in the fuel supply.
In the late seventies the movie business was truly bicoastal. Production was centered on the west coast and mostly at the studio lots. Financing was provided by the money center banks, principally those in New York City … where I was living at the time. The banks’ position was that the credit lines of the studios were pretty much tapped out. Even though they recognized that producing and distributing more films would increase the chances of studio profits, they were uncomfortable significantly expanding the lines.
I had a number of friends in the ‘business’ who made me aware of the restrictions on the studios. I suppose, given my reputation for not being able to put down a complex problem until I’d come up with a viable solution, they conspired to prod me into going to work. Well, their strategy succeeded.
The problem was interesting, indeed challenging, as it involved two major industries with radically different cultures and perspectives on the world. The money center banks, although they had been providing financing to the film industry for decades, were mostly ‘belts-and-suspenders’ types who kept a very close eye on risk. The film industry was populated by significantly more entrepreneurial types who were willing to roll the dice ten times in order to win big two or three times. The two different cultures had been locked in a mutually beneficial relationship which was increasingly being stressed.
My first step was to get a thorough understanding of the problem and the dynamics of both perspectives. I talked to a wide range of bankers familiar with the industry and with senior executives in the film business. The principal result was that I now could see the world through the eyes of both the bankers and the studios … I could begin to craft a solution. A collateral result of this process was a partnership with a man who, at the time of our meeting, was CFO of Columbia Pictures.
My second step (and only after determining that there was a market for the solution we might develop) was to build a team of subject matter experts to take advantage of the knowledge I had gathered … and to mount an assault on the challenge. We met over a period of several months and the group was expanded to include other skill sets. Each time we encountered a new area that needed to be covered I went on a search for the best in the field.
Finally we hit on a solution which would allow off balance sheet financing of the top twenty five percent of the risk column of each film project. Although the solution was complex, the underlying enabling conditions were quite simple. In those days the top marginal tax rate in New York City was somewhere around one hundred and three percent … in other words, above a certain level of income, and if you lived in NYC, the combined governments would actually take more than you earned. But more broadly, the combined top marginal federal and state rates approached eighty to ninety percent.
So I involved some of the top tax lawyers in the City and we focused on refining the model. Working with the tax code made all the challenges more difficult as it involved not only tax lawyers but the Internal Revenue Service … without their blessing the approach to the innovative financing would bear an unacceptable risk.
Well, to jump ahead a bit, we came up with a solution that passed muster and presented it to both the studios and the banks. The banks loved it because they would now be able to spread their risk over a larger number of projects and be protected by taking the lower seventy five percent of the risk column. The studios were equally attracted to the idea because they could now finance and distribute a third more films. All that was needed at that point was a source of funds that would take the top twenty five percent of the risk in each project.
I had left Wall Street some two years earlier but had maintained a wide range of connections through the other businesses that I had started. One of my services was providing and vetting investment opportunities for the major clients of the front line street houses and what was then known as the ‘big eight’ … my how things have changed. Once the studios, the bank’s and the IRS had signed off, I approached my clients. I presented my proposition. Because of a combination of tax and economic benefits, they and their major clients found the structure very appealing. The model was now complete.
So, after six months or so of hard and very detailed R&D, we were ready to launch the business. We had organized a source of product, a customer base and a source of financing. Beyond that our customer base had financed the R&D process … in other words, they were so interested in the development of a solution to their problem, and so attracted to the possibilities of our solution, that they provided the financing for the development process. The street houses, banks, studios and accounting firms all supported the R&D process because we were making sure that they all won big as a result. Rather than ‘we-centric’, we were ‘you-centric’. We launched with several hundred thousand dollars worth of no-cost R&D that was funded by the clients … and we launched debt free into immediate profitability.
Fast forward to the late 90s. I had returned from doing my PhD work in Scotland. My wife and I decided to settle in the DC area. Here I could pursue my three principal interests … business, politics and fishing. Imagine my surprise as I began to make contact with the ‘bubble businesses’. Here was an entire industry based on the assumption that their clients were idiots who just didn’t get the latest thing that these people were selling. I sat in on presentations where CEOs of equity funded science projects would rant about how stupid their clients were and how much easier life would be if they just left it all in the hands of ‘Bleeding Edge, Inc.’ The image of these pretentious people who never made a bottom line, talking openly derisively about people who regularly did, etched itself into my mind … and, of course, into the minds of their never-to-be ‘customers’.
Mercifully many of these people are now more appropriately placed as service providers in the fast food industry. The newer generation, along with the survivors of the bad old days, have a significantly different vision of the customer. Now the customer is most likely to be seen as the group of sharp people with a real business and real needs that, if effectively and creatively solved, could support an emerging business. Every now and then an entrepreneurial team will also discover potential customers as a source of R&D support and start-up funding. I highly recommend that experience. It sure beats throwing cold water on the fire that is supposed to warm your house.
© Dr. Earl R. Smith II
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- Presenting to Early Stage Venture Capitalists: A Few Things to Remember
- Gap Analysis
- Venture Capital – The First Meeting
- Red-Teaming: Improve Your Chances of Getting Funded
- Angel’s Sins
- Angel Investing – Governance
Dr. Smith is a proven senior executive, successful entrepreneur, published author and public speaker. He serves on boards of directors and advisory boards or as a strategic adviser to CEOs. Dr. Smith specializes in turnaround management, strategic planning, leadership development and executive coaching. He also works as an executive and/or life coach in the areas of personal growth and spirituality. He is the author of Amazing Pace: Turbo-charged Business Development – a book that shows how Advisory Boards can dramatically increase revenue. Dr. Smith is also the author of Dream Walk: Parables for the Living – a book of Raven Tales and exploration.
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