Dr. Earl R. Smith II

By Dr. Earl R. Smith II

In this column I would like to discuss ways to meet the financing needs of a growing company. Let’s start from this point: The CEOs principal contribution to the process is to make sure that the correct financing strategies are in place and well focused.

As CEO, you should make sure that the strategies deployed meet, at minimum, five basic criteria. First, are the financings that are being pursued adequate to the needs of the company? Second, are the right financial instruments being used? Third, are the right sources being approached? Fourth, how does each individual financing strategy fit into the overall capital structure of the company? And fifth, can the company afford the financing … is it really a good idea?

There are a wide range of financing options available to a company. My experience is that the range is often much wider than the focus of most management teams. The question turns on knowing how to finance what and when … and with what financial instrument.

It is the CEOs responsibility to review and approve the strategic plans for developing an efficient financial structure. Here are some suggested rules that might help:

Avoid Equity Financing R&D: I start with this one because it is, by far, the most frequently occurring error. As every MBA will tell you, one of the things they are taught early on is that you don’t fund research by selling equity in your company. The whole idea of a venture funded science project is fundamentally irrational and extremely high risk. And a venture capitalist’s willingness to do so doesn’t make it a good idea. There are other, far more efficient, ways to finance product or service development.

Here is the useful rule: Venture financing R&D is much like getting married for the tax exemptions. Both can be made to look good on paper, but the test is living with the decision and that can get to be very painful.

Avoid Financing Errors In Judgment: During the years that led up to the boom/bust, I was always astounded to find companies with no significant run rate, no customers to speak of and few if any products or services which were market ready … but they had a Vice President of Marketing and a rather large budget allocation for marketing.

I am reminded of a story that the great Mississippi comedian, Jerry Clower used to tell about these two good ol’ boys who stopped a train in the middle of nowhere by waving a red lantern through the darkness. When an angry engineer ask why they had stopped his train the reply came: “We were out hunting and just wanted to see if you wanted a possum.” “You idiots … you stopped this train just to ask me if I wanted a possum? Are you out of your minds? But since the train is already stopped, and I like possum, let me see him and how much do you want for him?”

“We haven’t caught one yet”, came the reply. “We just wanted to see if you wanted one.”

Here is a rule: If you are spending money to sell what you ‘hope to have’, your potential customers will generally treat you as a ‘might become’. If part of the pressure on your financial resources is because you are spending unwisely, financing an error in judgment is a very costly undertaking.

Avoid Myopic Financing Strategies: The great Lotfi Zadeh, father of fuzzy logic, was fond of saying that “when all you have is a hammer, everything starts to look like a nail”. I am constantly amazed at the maniacally myopic approaches that some CEOs have adopted towards financing their company’s growth. It is as if they see their company as a nail, and only the hammer of venture capital will do. These accumulators of the ‘thanks, but no thanks’ seem to be dedicated to going over and over to wells that again and again prove dry. It just doesn’t seem to occur to these people that these repetitive responses are an indicator of an unavoidable truth. I am often lead to ask “just what part of ‘no’ don’t you understand?”

But look people, here is the real world. Venture Capitalists are, for the most part, highly professional people who are having to search harder and harder for good investment opportunities. While you are chasing them and getting turned down, they are spending significant portions of their days looking for good investment opportunities. So, as hungry as they are to invest, what should it tell you if three or four of them have turned you down? Just exactly what part of ‘no’ are you having trouble understanding?

Here are a couple of rules: If four or five professional venture capitalists, who are experienced in your industry, have told you ‘no’, the overwhelming probability is that the next thirty five or forty will give you exactly the same response. I’d look for another way. If you’ve tended to bet the farm on one possibility, you need to stop gambling and start thinking. It is always better to think than gamble. Recidivism is no substitute for learning.

Don’t Ignore Options: I have been astounded in conversations with CEOs who seemed totally focused on the question of arranging financial resources but equally as focused on ignoring alternatives to equity financing. The truth is that there are many more ways to skin that cat.

Here is an example of what I mean. One of the services that I routinely render to managers of investment funds is to do a quick and dirty assessment of a company and its management team. Most often I am asked to assess the team, its business plan and to develop an estimate of the team’s ability to implement that plan. On one such journey I found myself sitting in front of a CEO whose company was developing software for the intelligence community. It was clear both that the CEO was completely focused on arranging venture capital funding for the company (to the exclusion of knowing much about the company’s products) and that the company’s products were nowhere near market ready. Early in the interview, I asked how much SBIR funding the company had. “We don’t have any”, came the reply. “We have decided to go directly for venture funding.”

At that point, the interview was over. Based apparently on the perception that ‘real men’ go for venture capital and the alternatives are for ‘sissies’, the CEO was prepared to ignore very efficient sources of potential financial support.

For those of you not familiar with the program, SBIR stands for Small Business Innovative Research and is one of the government’s principal vehicles for stimulating off-balance-sheet R&D. An important aspect of that program is that a company gets to keep almost all the rights to the intellectual property it develops. It is effectively a grant in support of research and development.

Well, to finish that story, the company didn’t get its financing and the CEO became an insider’s joke within the venture capital community.

Here is a very good rule: Make sure that you are turning over every stone in the pasture. Don’t let your ego or limited understanding of the options limit your company. Get in touch with experts in the field and really pick their brains. Make sure that you are looking down every alley and then pick the most efficient of the options.

So What Are Some Of These Options? There are a whole range of financing options that a company can access. A CEO, who is doing his job, will make sure that all of them are being investigated. Here are five to start with:

• Friends, Family and Fools: This is the traditional starting place for most companies. It can be the only source of borrowing (yes, that’s what I said … borrowing) available. But many companies stop going to this well too early in the game and give away equity in exchange for the relatively small investment.
• SBIR, STTR & Other Grants: There are a whole range of government and non-government sources of grant-based funding that a company should be investigating. Many of them are very easy to access. SBIR & STTR solicitations are available through every major federal department.
• Universities and Research Centers are also sources of research support. The University of Maryland Technology Advancement Program (TAP) is a fine example. By locating the company in that business incubator, a CEO will have arranged access to world class R&D support at low costs. This is a form of financing.
• Your Customers: Remember, it is the customer, not the investor, that is the true test of your company’s value proposition. If your product or service is as good as you think it is, and they want it badly enough, they will pay for it … and, many times, they will pay for its development. The willingness of the very companies which should be most interested in your product or service to invest in the development of your company’s intellectual property should be seen as an indicator of how well you have actually understood your space and how well your proposed solution meets strongly felt needs.
• Strategic Partners: Every once in awhile I encounter a startup company that seems absolutely dedicated to reinventing the wheel … or, to put it another way, re-inventing the whole mouse trap rather than just a better spring. If you have part of a solution, it is sometimes a very good idea to add that insight to a broader mix … and that can often lead to a source of financing.

So what’s a CEO to do? The mantra needs to be a through and balanced approach. Initially cast a very wide net and insist that your team investigate all potential sources. Talk to other CEOs, your banker, your insurance agent … anybody and everybody that might have an idea to contribute. And keep asking, probing and pushing … it is a process that should never end.

© Dr. Earl R. Smith II

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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 advisor to CEOs. Dr. Smith specializes in leadership development and advising management on leadership styles which make them more effective leaders. He also works as an executive and/or life coach in the areas of personal growth and spirituality.

This entry was posted on Tuesday, August 12th, 2008 at 11:34 pm and is filed under Venture Capital. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.