How to finance the scale-up of your company
This article has been crossposted with The Harvard Business Review Online.
Tom Szaky knows well the meaning of the saying “Beware your dreams, for they may come true.” With the 2004 Christmas retail season rapidly approaching, he was trying everything he could to scale up TerraCycle, a two year old venture selling liquid worm poop as fertilizer in used PET bottles. So far, he had been successful distributing through lots of smaller retailers, but had encountered a flood of rejections from the big box stores. Undaunted, Szaky finally landed a 15 minute meeting with Walmart Canada’s buyer. Instead of telling Szaky to “drop off the face of the earth” (he had been warned this was likely) Walmart Canada placed a huge order — for every one of its stores. But as he recounts in his engaging book, achieving his dream quickly turned into a nightmare when he was confronted with a stark reality: they had sold to Walmart without having the necessary infrastructure in place to handle the huge volume increase. Fortunately for Szaky, he had already laid the groundwork of financing from suppliers, equity investors and others to allow them to double sales in two months.
Contrary to conventional wisdom, the most dangerous period for entrepreneurs is not when they start up from scratch but when they scale up for growth. When you are a startup, there is relatively little to lose, mistakes are fixable, and a small amount of cash and a cohort of committed colleagues can go a long way. But when you suddenly accelerate and grow, whatever your company’s age, things get really hot really fast, largely because your need for cash explodes overnight. Most entrepreneurial ventures, whether they are startups, spinoffs, or smaller companies which have been around for awhile, haven’t given enough thought or planning to financing for rapid scale-up. Here are some ways to keep the heat of new growth from melting you down.
Use multiple sources of finance. Many entrepreneurs who are propelled into a sudden growth trajectory think mostly about raising risk-sharing equity investment from venture capitals or private “angels.” But when you scale up, it is faster, more feasible and less dilutive to cobble together your financing from a combination of equity investors, banks, public funds, suppliers, credit cards, customers, and even employees who will take stock options in lieu of some cash. One retailer I know discovered that the $100 or so penalty to defer California sales tax by a month was actually a cheap source of financing. It doesn’t make as glamorous a story as “raising $5 million from top-tier Valley VCs,” but this is how growth financing typically works in reality.
Cross-leverage money from one source into cash from others. It may seem counterintuitive, but owing money to banks often makes you more attractive to equity investors, not less. To the risk investors, bank debt means that very conservative and experienced eyes will be watching your performance so that you make every payment on time. The risk-friendly equity investor also sees the debt as a cheap way to leverage their returns. So when you get some equity investment, rather than looking for more of the same, immediately talk to the bankers, the state funding agencies and other more conservative lending institutions. Particularly with investors and lenders whose interest is in securing the viability of your growing enterprise, it’s to your advantage to ask before you secure other sources of financing. This kind of cross-leverage strategy diminishes the inevitable “free rider problem” (i.e., we’d love to see you succeed but we’re happy to cheer you on from the sidelines).
Speak different dialects with different capital providers. When you do cross over to talk to the bankers or other financers, learn how to speak their language. Entrepreneurs often get caught up in the heat of the moment: “My venture is scaling up so fast, what an opportunity!” Banks don’t care about opportunities in the abstract — they care about opportunities that repay their principal plus interest, on time, or else securing the debt with other assets they can seize. Public funders — the various state economic development agencies — don’t care about opportunities in the abstract, either, but about opportunities that create jobs, particularly where unemployment is raging. Research institutes, for example, care about seeing their IP solve important problems so they can get more funding themselves. Philanthropies and advocacy groups with funds to disburse care about progress in their area of focus. You get the point. In dealing with diverse potential funding sources throughout your enterprise’s growth, you always need to keep top-of-mind the question “What’s in it for them?”
Be opportunistic about raising money. Of course, both business school and real life experience teach us that it helps to plan out your moves in advance — and it does. But scaling up rapidly is more like piloting a sailboat in open waters than running a train along fixed tracks: chart your course, but take advantage of the waves, currents and weather, and nimbly avoid storms when they approach. Vaunted valley VC, Eugene Kleiner said it well: “The time to eat the hors d’oeuvres is when they’re being passed round.” Many an entrepreneur has passed on the hors d’oeuvres, only to regret it later. As an investor, I have seen quite a few ventures fail from running out of cash. I have yet to see a venture fail from too much dilution.
Manage accounts receivable like a hawk, but pay on time. In my company (Isenberg) we developed a 90-day rolling prediction of our daily account balances that, over the years, became increasingly precise. This saved us hundreds of thousands of dollars in financing. Managing payables is just the flip side of the receivables coin. Pay on time. I know this sounds counterintuitive. Like most firms, my company weathered numerous market ups and downs. Because we meticulously paid suppliers on time when we were cash-rich, we could go back to them for additional time to pay when times were tight. Supplier financing is a powerful, hidden source of cash that works best when times are bad, and is much harder to secure when times are good.
Cultivate customer financing. The flip side of supplier financing is to ask your customers for financing. This can take different forms, including up-front payments, down payments, or covering some of your development expenses, usually of course for a discount on their purchases from you in the future. To secure financing from customers is not necessarily easy: to get it, you will need to understand deeply what their needs are (present or future) and present a compelling pitch for how you can address those needs better than anyone else. In contrast to supplier financing, customer financing is usually more feasible when times are good and customers have cash on hand. But remember, both customer and supplier financing will require you to be skillful in showing how you compellingly address their unmet needs: for example, suppliers want to have a reliable, long term customer who pays predictably; customers want to have the most advanced technology that will give them a competitive edge.
All successfully growing entrepreneurs keep their eye on cash flow and they do it best by having a broad range of capital sources — and cash substitutes — to draw on. Remember, whether you are a later stage startup or a second generation family venture, a thoughtful and flexible financial plan focused on scale-up will allow you to grow fast, be responsive, and thrive.
Written with Daniel Lawton, CEO of Clarity Health LLC and Chairman of Promentis Pharmaceuticals. They specialize in the development of novel compounds designed to more effectively treat schizophrenia and other debilitating illnesses.