VENTURE CAPITAL DEBATE NEEDS TO GROW UP

Two recent articles, I’m Glad I Did Not Take VC Funding and Canada’s Tech Start-up Scene Needs ‘Aggressiveness and Boldness’, illustrate how the conversation on how to fund your business has become way too polarized. It’s a dialogue that deserves much greater nuance than a simple and binary, pro and con judgment. The decision to raise outside capital should encompass a multitude of factors including:

  • the founders’ growth aspirations;
  • the company’s funding needs relative to internal funding capacity; and
  • the willingness to give outsiders a voice in the company’s future direction.

In my view, the prominence venture capital commands in this conversation does everyone a disservice. Venture capital is generally attracted to a particular type of company. It seeks a very high return on investment, and is willing to tolerate great risk in pursuit of that aim. Not all companies will fit the bill, which is why institutional venture capital funded companies account for less than 5% of all technology businesses today.

How aggressively you choose to pursue growth is entirely your prerogative. Don’t be goaded by those who claim you are not “aggressive” or “bold” enough. While it’s perfectly okay for a venture capital fund to swing for the fences, the default expectation of failure is unpalatable for most entrepreneurs. In an economy with shrinking corporate employment, entrepreneurship is increasingly becoming an alternative source of livelihood for many. Seeking or obtaining venture capital should not be the default measure of success for all entrepreneurs.

Getting back to the funding debate. Most companies eventually seek outside funding of one type or another to support growth. Venture capital is one source, but there are many other options including friends, family, angels, strategic investors, government assistance, bank debt, venture debt, and in certain circumstances, going public.

All outside investors deserve a duty of care, and some may wish input into the future direction of your business. While having more people at the table increases the potential for dissenting perspectives, I believe the benefits outsiders bring to the table typically outweigh any potential loss of control.

As for venture capital (or other outside investors) being evil, keep in mind that positive outcomes get very little media attention. Just like you don’t see newspapers report on planes that land successfully, you are way more likely to hear about bad experiences than good ones.

SOLVE YOUR #1 PROBLEM AND HIRE RIGHT

Who

To help improve your hiring effectiveness, we’re giving away 200 hardcover copies of the bestselling classic Who: The A Method for Hiring by Geoff Smart and Randy Street.

The authors have advised CEOs and executive teams for over 15 years and the book’s research is based on 1,300 hours of interviews with more than 20 billionaires and 300 CEOs. The book offers simple steps for finding the right talent at the right time for the right job. You’ll learn how to navigate the four areas where hiring failure often occurs:

  • Lack of clarity on the job requirements;
  • Weak flow of suitable candidates;
  • Inability to identify the best candidate from a group of similar looking candidates; and
  • Inability to convince the desired candidate to join your firm.

The authors demonstrate how achieving success with their method depends on breaking bad habits they term “voodoo hiring”, and maintaining a laser focus to find “A” players using the “A Method.” The “A Method” is comprised of:

  • A hiring scorecard that sets out the outcomes and competencies of a job well done;
  • Strategies for sourcing suitable candidates;
  • How to gather the relevant facts needed to make an informed decision in accordance with the hiring scorecard; and
  • Advice on how to persuade suitable candidates to join your team.

The book is well written, and includes many anecdotes of the “A Method” in action. One of my favourites is an excerpt of an interview with a sales executive who was let go by a former employer for what the sales executive initially described as “philosophical disagreement.” By repeatedly asking the question “tell me more,” the interviewer discovers that the candidate was actually fired for insulting the CEO in front of the company’s board of directors. But the story does not end there. The interviewer’s continued probing reveals that upon hearing that he was being fired, the sales executive physically abused the CEO, resulting in termination for cause and the loss of $3 million in options!

At Espresso, we regularly hand out copies of Who to visiting customers and prospects – generally to rave reviews. One recent prospect (now a customer) read it cover to cover over a weekend and immediately ordered copies for her entire staff of 30!

Summer is a great time to sink your teeth into a great book and we stocked up on 200 copies of Who just for the occasion. To receive your complementary copy, please email Andrea Russell at andrea@archive.espressocapital.com with your full name, company name and mailing address. Be warned – she might attempt to extract explicit consent to add you to our electronic communication list (if you haven’t already consented).

Happy future hiring!

Kerri Henneberry is an expert in media finance strategy and partnerships. She works as a consultant for Espresso Capital. 

FIVE REASONS WHY USING SOURCE DEDUCTIONS TO FINANCE YOUR BUSINESS IS A VERY BAD IDEA

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Legal and ethical breach of trust

Employers are required to withhold deductions from employees’ wages to pay income tax, CPP/QPP and employment insurance premiums. The funds are deemed to be held in trust for Government of Canada. Abusing these funds is both a legal and ethical breach which may raise some eyebrows.  Breach this fundamental obligation, and you might cause your employees, shareholders, lenders and other stakeholders to question your commitment to meet other obligations.

Incur significant penalties and increases risk of a CRA audit

The penalties for late remittance of source deductions are punitive:

  • 3% if the amount is one to three days late;
  • 5% if it is four or five days late;
  • 7% if it is six or seven days late;
  • 10% if it is more than seven days late, or if no amount is remitted; and
  • 20% penalty if it happens more than once in a calendar year.

If your business is chosen for a full or partial audit, then your costs will escalate. Audits will also distract your finance and management team, consuming resources better applied to growing your business.

Finally, CRA will withhold any tax refunds including your SR&ED refunds until the audit is satisfactorily resolved, further crimping your cash flow.

Exposes directors to personal liability

In Canada, directors are personally liable for unpaid source deductions. In addition, an officer or another person who has control over the collection and remittance of source deductions is also personally liable. Not knowing that source deductions were being diverted does not get the directors off the hook because it is their duty to ensure that these deductions are being remitted to CRA on a timely basis. We prefer to invest in companies with bona fide outside directors because we know that no competent director would allow this conduct to manifest itself on their watch. It’s also worth noting the liability is not limited to the amount of the source deductions but also includes interest and penalties.

Reflects poorly on management’s judgement and acumen

Your CRA remittance history is one of the most important inputs in a lending decision. CRA delinquencies reveal a great deal about a company’s people, processes and financial health. Using source deductions as a source of bridge funding calls into question management’s cash forecasting ability. Repeatedly using source deductions as bridge financing is a sure sign that the business is severely undercapitalized.

Could put you out of business

CRA can garnish bank accounts, and can escalate its recourse to freezing or seizing your assets. Since CRA ranks ahead of your lenders and shareholders, a track record of remittance delinquency result in other funders deeming you too risky for continued support.

Conclusion

Avoid exposing your business to the consequences of not remitting source deductions. If you foresee a cash flow problem, it’s much better (and cheaper) to arrange for some type of bridge financing in advance than to use CRA to solve any funding gap.

WHY SAAS COMPANIES MAKE GOOD REVENUE FINANCING CANDIDATES

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At Espresso our goal is to bring venture debt into the venture capital mainstream. One of the ways we do this is by funding companies earlier in their growth cycle than our counterparts, and another is by funding companies that lack institutional venture capital sponsorship. At the earliest stages we provide venture debt in the form of tax credit financing and, as our clients grow, we offer venture debt in the form of revenue financing to qualifying companies.

Our revenue financing is focused principally on SaaS and other sticky, high margin, subscription revenue based companies. The target market and business model figure prominently in our evaluation process, so in the interest of providing practical guidelines, this post will focus on business to business SaaS companies.

Before diving into the details, it is worth noting that usage of venture debt by technology companies is still in its infancy. Not surprisingly, when and how venture debt can be used beneficially is poorly understood. While the very best institutionally sponsored companies regularly leverage equity financing with venture debt, they make up less than 1% of the overall technology ecosystem. For context, it is worth noting that mezzanine financing (the equivalent of venture debt for later stage companies) is a very significant source of overall funding, and costs approximately the same as its venture debt counterpart.

Once a SaaS company has proven predictable and profitable customer acquisition and achieved minimum operational scale, its risk profile should have improved materially, and the business may be able to support venture debt. Notwithstanding the fact that it will likely continue to consume significant cash to fuel revenue growth, the reduced uncertainty in predicting future performance and ability to use a more data-driven and scientific approach to business management means the business is less risky than what its income statement would suggest. Espresso is not alone in viewing SaaS companies as less risky relative to their P&L performance. A recent Andreessen Horowitz blog post, Understanding SaaS: Why the Pundits Have It Wrong, provides detailed justification for lofty SaaS company valuations (which inherently entail lower discount or risk rates).

The reasons why a SaaS company should consider using revenue financing include:

  • Lower cost of capital: waiting longer and building greater critical mass will result in a higher valuation or better still, a higher valuation multiple than an equity financing today, and therefore lower net dilution;

  • Quick access to funding: equity financing typically takes six to nine months to close, and regardless of whether a SaaS company opts to embark on an equity fundraising effort now or in the future, venture debt funding, at least from Espresso, can be applied to sales expansion investments, and therefore shareholder value creation, almost immediately;

  • A funding alternative when equity is not available: many very good SaaS companies, for a variety of reasons, do not attract institutional venture capital interest, so venture debt represents an alternative form of sales expansion capital.

The starting point in our evaluation is determining if a given SaaS company has achieved predictable and profitable customer acquisition AND minimum operational scale. While the first two garner lots of press, as a venture debt lender the third criterion is equally important to us, and worth elaborating on. Minimum operational scale in essence is the level of monthly recurring revenue required to operationally break-even before sales expansion investments. This varies greatly amongst SaaS companies, and depends on a variety of factors including gross margin, customer acquisition cost efficiency, customer churn, customer lifetime value, product development intensity and overall operational efficiency. The Andreessen Horowitz post listed above, and an earlier article by David Skok, Saas Metrics 2.0 – A Guide to Measuring and Improving what Matters, are great reference sources on some of the essential metrics used by leading SaaS investors and SaaS companies to measure performance and manage growth investments.

Once a company has achieved operational scale, the pace of value creation accelerates as each net new investment dollar generates more recurring revenue and hence enterprise value (present value of future cash flows) than it did previously. Looked at another way, some of the extra return generated in each period that no longer needs to be applied to cover operational burn can now be used to service debt, and the growth in the stream of future cash flows provides the means with which the debt can be retired in the future, either via amortization of the principal or a balloon payment upon refinancing of the future cash flows (be it via senior bank financing, cheaper venture debt refinancing when the business is larger and even less risky, and/or equity financing).

For Canadian SaaS companies, particularly those that are not quite ready to attract US venture capital, there is an added reason to consider venture debt – scarcity of equity capital. While in recent years the absolute size of the equity venture capital pool in Canada has grown, so has company formation, meaning that Canadian companies remain capital constrained until they are big enough to attract US venture capital. SaaS companies that have reached minimum operational scale should consider Espresso’s revenue financing as part of their growth capital mix.

VIDEO GAME COMPANY GETS A BOOST

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A first person account on how Espresso Capital helped JVL Labs finance a big step forward.

Back in 2006, a classic David and Goliath battle was being fought in U.S. District Court. The case, involving patent infringement in touchscreen amusement games, pitted Markham, Ontario based JVL Labs against U.S. giant Merit Industries.

“It was like swimming in a hostile and foreign ocean that was never-ending,” is how JVL CEO Peter Guterres describes the 2-year legal ordeal that burdened the company with $15 million in legal fees. Ultimately, a jury in Merit’s home state of Pennsylvania hit JVL with a $4.5 million judgment based on what seemed to be an irrelevant method patent.

“Our machines were no longer using the coin recognition method in question but the American justice system can be a surreal place,” says Guterres. The case forced JVL to re-structure their business. A staff of 70 was cut in half. “That was the hardest part,” says Guterres. “Our team members are like family.”

Outside the halls of justice, JVL’s business was undergoing massive change. The iPad would soon be released. Out of home amusement games were losing market share to improving in home alternatives. JVL deftly read the marketplace and transitioned their team to focus on casinos – the one last place on earth where people left their homes to play games.

The new plan required capital. But traditional banks were reluctant to lend to a company that was both wounded from a lengthy patent dispute and about to embark on a new challenge against a different set of giants. They considered the company’s pivot into the casino market in the same way they viewed an unproven startup. Betting on an uncertain future was too risky and JVL’s present state featured slumping revenues and overdue tax claims.

JVL’s next move was to come to us. He knew Espresso Capital funded intangible assets overlooked by traditional lenders. So he shared JVL’s backstory. He told us how Joseph Levitan immigrated to Canada and began his career by fixing Pac-Man and other arcade games, and how he later became a game operator before deciding to create original titles with his son Val.

Thus, JVL was born. The result was a series of popular game titles, followed by successful expansion into the U.S. before the legal battles ensued.

JVL’s story struck a chord, and convinced us that their management could repeat their early success. As for those overdue tax claims the banks didn’t like? Espresso saw valuable unclaimed tax credits, so we quickly structured a $1M credit facility against JVL’s accrued SR&ED and Digital Media tax credits.

“We considered other options like taking on an equity partner,” said Guterres. “But we weren’t ready to pay the steep cost of dilution. Espresso also fully appreciated the urgency involved, so their fast turnaround gave us a chance to leverage our tax credits and quickly move forward.”

The credit facility allowed JVL to hire additional engineers, overhaul their product line and return to conventional lenders. Two years later, JVL has found renewed success with more than 40 new game titles as well as commercial expansion into South America.

At Espresso Capital, we take great pride in knowing that our innovative solutions helped JVL successfully navigate through a critical period in their journey.

HOW US TAX LOOPHOLES ARE IMPACTING FINANCIAL DECISIONS AROUND THE WORLD

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America’s outdated corporate tax code is providing its biggest multinationals a huge incentive to stash their profits offshore. Can Canadian companies benefit?

According to recent Bloomberg figures, U.S. based companies have accumulated $1.95 trillion in offshore cash and short-term investments. 80 of the top 100 publicly traded U.S. companies operate subsidiaries in tax haven jurisdictions.

The offshore stockpile is growing quickly, enjoying an 11.8% bump from last year. Twenty-two corporate giants, including GE, Microsoft, Apple and IBM, account for almost a trillion dollars of the total amount.

Multinationals use a variety of strategies to shift their income to lower tax jurisdictions because the U.S. maintains the highest corporate tax rate (35%) among OECD countries. This money is destined to remain offshore; at least until these companies can figure out how to bring it home without suffering an enormous hit.

The financial impact obviously involves broader notions of competition and public interest. The matter has received widespread attention from state and federal government agencies and recent congressional hearings have specifically targeted a number of tax strategies deployed by Apple and Google. What has yet to be acknowledged, however, is the potential distortion these strategies impose on the overall financial ecosystem itself.

Consider the Microsoft – Nokia deal. Like many U.S. multinationals, Microsoft has aggressively accelerated its offshore holdings, more than doubling its stockpile since 2010. Last year Microsoft disclosed it would owe $24.4 billion if it brought its international profits home. Instead, it decided to do something else with the money: it parted with $7.2 billion to acquire Nokia’s troubled handset business.

Most pundits were quick to criticize Microsoft, describing the move as an expensive and last ditch gamble to catch up with Apple and Google in the smartphone race. However, after you factor in the difference between the 35% U.S. rate and the actual taxes Microsoft paid offshore, the effective price tag for Nokia was $4.9 billion. This consideration didn’t get much attention in the financial media even though the obvious tax benefit is more than large enough to turn a potentially suspect deal into a winner.

I’m seeing similar tax strategies have an impact on Canada’s tech ecosystem. I sit on the Board of Bit Stew Systems, a leading provider of smart grid analytics to the utility industry based in Vancouver. Recently, Bit Stew received a multi-million dollar Series A investment led by Cisco Systems. The money originated from their office in the Netherlands; another case of “trapped” offshore cash finding a home without suffering a 35% haircut.

Cisco CEO John Chambers made headlines last year when he announced that unless the U.S. tax code is revised, he is no longer interested in buying American companies. This is a big deal. Cisco essentially wrote the handbook on strategic M&A growth. The company has $46 billion parked overseas and their CEO is adamant he won’t spend a penny of it in the U.S. I can’t imagine that a networking startup based in Seattle is going to feel good about that.

Make no mistake, Bit Stew makes great products that could potentially become lucrative additions to Cisco’s existing offerings, but the company is also part of an acquisition roadmap, which for the time being no longer includes the U.S.

I asked Jim Temple, Bit Stew’s CFO, who is based in the U.S., about the broader implications.  “The current tax situation may give some Canadian companies a shot in the arm. The big boys are showing you their playbook,” says Temple. “This creates an interesting opportunity for smaller companies that are very savvy and can create something that fills the gap created by trapped U.S. profits. A 35% tax advantage means not every investment needs to be a homerun.”

Temple also told me he was impressed with Canada’s mix of R&D tax credits and local investment incentives. “All these tax advantages help create liquidity events. That, in turn, moves the market forward and accelerates the local infrastructure, allowing Canadian cities to better compete with their U.S. counterparts. One thing I can say for sure is that my colleagues are watching what’s happening up there more than ever.”