Our approach is simple: Will a deal benefit entrepreneurs, their companies, and ourselves? If so, it’s a win-win.
One thing we have learned over time is that the best commercial relationships are born of an exceptional value proposition — for all parties. Because our relationships with entrepreneurs are so important to us, we take great pains to examine, and develop our own point of view, as to whether or not the solution we are offering is the best possible deal for the entrepreneur and company – from their vantage point. If it is, then we’re confident it will work well enough for us as well. If we are not able to offer exceptional value to an entrepreneur, even it is a good deal on our end, we simply won’t pursue it.
Being able to add exceptional value to an entrepreneur and his or her company is a foundational piece of criteria for us. Here are a few questions we ask ourselves to figure it out:
1. Do we cost less than additional equity?
Take a look at these three numbers:
31.95% 82.06% 109.13%
Let’s say you’re an entrepreneur with a terrific business plan that will require $500,000 to turn it into a successful company -- and that you are able to raise a $500,000 venture capital investment at a $2 million pre-money valuation. Or, said another way, the entrepreneur will have to give up a 20% stake in his or her company in return for the $500,000 investment.
After five years and a lot of hard work, it turns out that your business becomes worth $10 million. Or perhaps $50 million. Maybe even $100 million.
The three numbers above represent the annualized return your investor(s) would realize in each valuation scenario. Said another way, the figures represent the actual financial cost of the equity from the entrepreneur’s point of view. Seems pretty expensive when compared to most interest rates we know doesn’t it? Can you envision paying a 110% interest rate to buy a new flat screen TV?
The point of this exercise, however, is not to suggest that venture capital is absurdly expensive or without value. Rather, our point is simply to remind entrepreneurs that equity is the most expensive form of capital -- bar none.
The financing solutions we offer at Fundamental are far less costly for entrepreneurs than venture capital. This is one of the foundations for how we think about adding exceptional value to entrepreneurs. By asking the simple question, “Is it less expensive for the entrepreneur’s company?”
2. Does the entrepreneur need our capital?
Emerging companies almost always need capital to help them grow. An important question for entrepreneurs is, “What kind?” Entrepreneurs need to take the time to understand how the money they raise will be spent -- the reason being that it informs the fundraising options. Most emerging companies we see need growth capital primarily for one of two things:
● To fund additional operating expenses before profits are sufficient to do so. This generally needs to be funded with additional equity of some form.
● To fund working capital. This should be funded by Fundamental (or someone like us) with a line of credit.
Often, high-growth companies need both types of funding.
The vast majority of B2B companies -- regardless of the sector in which they operate -- need working capital to grow. Indeed, in many cases, the working capital need is the majority (if not the total) of what the company needs. These companies need to raise working capital, and not necessarily venture capital, or additional venture capital, as the case may be.
We know that if a company needs working capital to grow, then it will come down to the difference between us and any competing offers. And since we are a hyper-competitive firm, we know that our terms -- including how much capital we can offer -- will be best, and that we will be offering exceptional value.
3. Is the entrepreneur committed to growth?
When all is said and done, growth is by far the most reliable way to create value in a company. Almost all entrepreneurs claim to understand this mantra, but far fewer have the conviction to act on it. This topic is one of the biggest and most common mistakes we see made by entrepreneurs claiming a desire to grow -- the unwillingness to access the resources necessary to enable growth. This mistake is not typically made by companies in an overt way. It’s not like the entrepreneur stands in front of mirror and says “I want to grow more slowly.” Rather, it is inaction that is the culprit.
A common sequence is waiting to collect cash before taking the next big order, or by neglect, not pursuing that big order with vigor. Sometimes, companies push customers to pay sooner. This is good thing if payment is beyond industry-convention terms. It’s not such a good thing if it signals financial vulnerability to a big customer. Balance is key.
The financial consequence of forgoing growth is often quite large -- and by count of how often we see it, apparently lost on many entrepreneurs.
Consider the following scenario:
20% gross margins, 60-day payment terms (industry convention), 80% working capital advance rate and 1.5% per month cost.
Selling price $100
Less: costs $(80)
Gross profit $20
Less: working capital costs $(3)
Net gross margin $17
Note the following:
● The working capital line will pay for 100% of the costs by advancing 80% of the selling price.
● The working capital costs for two months at 1.5% per month equals 3%.
The result is that the working capital line pays for 100% of the cost -- therefore the company doesn’t have to put up any other funding to make the product (or deliver the service) and still gets to retain 85% of the gross margin (in this scenario, $17 out of $20).
Even if your particular set of facts differs from this example, the point is that there is almost never a scenario where the cost of working capital comes anywhere close to outweighing the profit to be earned on the next sale. If an entrepreneur is committed to growing, then making sure the next sale is fully financed is an important way we are able to add exceptional value to the companies we back.
4. Will the entrepreneur take advantage of financing flexibility?
Although not as common a mistake as unnecessarily hamstringing growth (to say nothing of the strategic consequences of that), another mistake we see too often is paralysis. Sometimes, it’s analysis paralysis. Other times, it’s the inertia of the status quo. And in still other cases, it’s simply the entrepreneur being convinced that there is a better financing alternative just around the corner -- even when all evidence, even over quite long spans of time, is to the contrary.
This is a particularly painful variety of mistake to watch -- because it’s entirely avoidable. What tennis aficionados would call an “unforced error.”
While there certainly are some financing providers that push long-term commitments, onerous minimum usage requirements, and expensive early termination fees, there are plenty that don’t. This flexibility blunts the rationale for inaction entirely. If you can use a working capital line now and move onto the “better” thing whenever it materializes, why not do it? Time is money, as they say.
We feel that the best relationship is one that works well for both at all times. If there comes a time when it works better for one partner over the other, it’s probably best to part ways as friends. Flexibility in financing is important, and when we find an entrepreneur that embraces this optionality, we know that we can add a lot of value to him or her.
In summary, we ask ourselves, “Are we adding a lot of value to entrepreneurs and their companies?” Our approach is really as simple as answering this single question. If the answer is “yes,” then we will be interested and persistent. If “no,” then we’ll likely move on -- for the benefit of ourselves and these entrepreneurs.