This last couple of weeks I’ve been working on a due diligence team looking at a potential investment. As the only accountant on the team it can get pretty lonely.

In September Noam Scheiber of the New Republic published an interesting article on how due diligence really works for a great many early stage investors.

Noam Scheiber article

According to Mr. Scheiber, Seth Bannon was in his late 20s, had the requisite beard…and raised $3 million for his startup from Y Combinator and a number of angel investors. Somehow – when no-one was looking, he managed to rack up liabilities for $500,000 in unpaid employee source deductions, $100,000 in legal fees and a $90,000 penalty to the IRS.

For the most part my colleagues don’t get the idea of financial due diligence. First, they don’t seem to think there is any point in getting financial statements reviewed by a professional accountant. A good deal of the information investors should be looking at is contained in a properly prepared set of financial statements.

Even if you’re going to end up valuing the IP, and ignoring the operations for the most part, it is comforting to know that someone has done some work to substantiate assets and liabilities – so investors aren’t later ambushed by undisclosed liabilities or option agreements that might put the corporation’s status as a CCPC or an eligible business corporation at risk.

The last 2 companies I’ve looked at have had financial statements prepared by the same firm of public “accountants”. In spite of a fairly complex (for a startup) capital structure, neither company had even prepared notes to the financial statements. As a professional, I typically find as much of interest in the notes as I do in the financials.

In both cases there were operations in 2 or more countries and the accountant was really a bookkeeper with little or no training in accounting. Admittedly he is a university graduate and has a Phd from Cambridge in something or other – if his website can be believed.

My point is, if I am performing due diligence on an early stage company I don’t really have time to perform due diligence on the financial statements as well.

WHAT IT IS

according to Wikipedia:

 

In finance, subordinated debt (also known as subordinated loan, subordinated bond, subordinated debenture or junior debt) is debt which ranks after other debts should a company fall in to liquidation or bankruptcy.

 

Such debt is referred to as ‘subordinate’, because the debt providers (the lenders) have subordinate status in relationship to the normal debt. A typical example for this would be when a promoter of a company invests money in the form of debt rather than in the form of stock. In the case of liquidation (e.g. the company winds up its affairs and dissolves), the promoter would be paid just before stockholders — assuming there are assets to distribute after all other liabilities and debts have been paid.

 

Subordinated debt has a lower priority than other bonds of the issuer in case of liquidation during bankruptcy, and ranks below the liquidator, government tax authorities and senior debt holders in the hierarchy of creditors. Because subordinated debts are repayable after other debts have been paid, they are more risky for the lender of the money. The debts may be secured or unsecured, but have a lower ranking priority than that of any senior debt claim on the same asset.

 

Subordinated loans typically have a lower credit rating, and, therefore, a higher yield than senior debt. While subordinated debt may be issued in a public offering, major shareholders and parent companies are more frequent buyers of subordinated loans.

 

WHERE TO BORROW

Most lenders lend against assets. In other words they register an interest in the borrower’s property as collateral, in case the borrower defaults on the loan. However some commercial lenders – or “quasi-commercial lenders” do issue sub-debt to growing companies that have turned the corner to profitability. For these emerging companies, sub-debt can be an alternative to asset-backed borrowing.

Clearly sub-debt is expensive when compared to more traditional asset-backed loans. However it is much cheaper than equity financing.

Not all lenders offer subordinated debt products. In Canada the Business Development Bank http://www.bdc.ca/EN/solutions/subordinate_financing/Pages/default.aspx is one alternative. For BC-based companies VanCity offers alternatives as well https://www.vancity.com/BusinessBanking/Financing/GrowthCapital/

 

HOW TO USE SUB-DEBT

Here are some typical scenarios:

Management buyouts	Subordinate financing can provide the necessary funds for an existing management team to invest in a company and launch an MBO.
Mergers & Acquisitions	Naturally involve both fixed assets and more difficult-to-finance intangible assets such as “goodwill.” Subordinate financing can help companies purchase the goodwill while preserving their cash flow during a period where some uncertainty may exist.
Working capital for growth	Subordinate financing is often used to finance working capital for growth, which enables companies to increase revenues and profits. Entrepreneurs looking to invest money in market penetration, improve product R&D or finance additional headcount can take advantage of subordinate financing without compromising their regular cash flow used for daily operations.

 

What is Value Anyway? (Why Creating Customer Value is at the Heart of Building a Business)

The following is Part II of a multi-part series on value, segmentation and pricing by guest contributor Steven Forth, Partner at Rocket Builders and eFund Member. Read Part I here.

The founder of modern management, Peter Drucker, famously said that the purpose of a company is to create and keep a customer.

It is about customers. You can only build a real business if you can get customers and then keep them. And you keep them by providing value.

But what is value? It is one of those words that we use all the time to mean many different things. But in business it means

• The value that you provide to a customer
• Relative to an alternative

The money you spent developing your product or how much it costs to deliver your service is not its value. It’s value to the customer and not the cost to you.

But I still haven’t said what I mean by value. So here we go …

Value is an emotional or economic benefit to the customer. In most cases, emotional value is more important in business-to-consumer (B2C) and economic value is more important in business-to-business (B2B) but in both cases there are cross overs.

It is true that some consumer products are sold primarily on their economic benefits. We often buy at discount stores in order to save money. But let’s face it, we often do this because it makes us feel that we are saving money and not because we are actually adding up all the costs of driving, parking, buying more than we need and those inevitable impulse purchases. Emotions govern consumer purchases.

The best way to understand emotional value in the context of Maslow’s hierarchy of human needs.

Basically, the higher your appeal the higher the price you can realize. Companies that position themselves on self-actualization (Apple comes to mind with its Think Different campaign or locally Lululemon and itsmanifesto) will command higher prices and higher profits. Companies that pitch themself to appeal to more basic needs will find prices pushed down closer to their costs and will have to make this up on volume (think Wal-Mart). The problem with this is that most start-ups and even most Canadian companies will not be the cost leaders, and competing on cost for basic needs is a tough place to be.

Economics governs B2B. If you are developing a B2B product or service ask yourself “How much money does I make for (for, not from) my customer? You can help your customer make money in different ways.

• Revenue
  • Can you help your customer access a new market?
  • Do you help them increase market share in an existing market?
  • Do you help them win bids against a specific competitor?
  • Do you help your customer provide additional value?
• Costs
  • Do you reduce costs, not because you are cheap, but because you simplify some part of their business or make it more effective>
• Operating capital
  • Do you reduce inventory costs?
  • Can you accelerate collections?
  • What impact do you have on your customer’s financing costs?
• Capital investment
  • Do you help defer a major investment by increasing capacity?
  • Do you make the capital asset more effective or less costly?
  • Do you help shift costs onto the balance sheet so they can be amortised? (Public companies tend to like this)

Of course, different customers will get values from you in different ways, and in different amounts. This is why value is such a powerful way to segment a market and target customers (see the previous post on Why target market segments). And ideally you want your price, how much you charge, to track how much value your customer is getting (that will be the subject of the next post).

Not everything translates into economic value of course, but in B2B, when you push a little deeper with your customers, you can be surprised just how much actually ties back to the economics. For example, there is no question that brand strength can influence B2B buying decisions. “Nobody ever got fired for buying IBM.”

Ed Arnold, VP Product at my old company LeveragePoint, has a great post on how to quantity intangibles like brand strength. He once told me about a dialog that went sort of as follows:

• Sales Guy: “People buy us because of our brand.”
• Ed: “OK, what is the most important thing about your brand?”
• Sales Guy: “Reliability. Our stud just doesn’t break.”
• Ed: “Why does that matter?”
• Sales Guy: “Our customers rely on us to keep operating. If our stuff breaks then they go down. It can cost them millions.”
• Ed: “So there is an economic benefit. What does it cost a customer when they go down? And how much do you reduce the risk of that happening?”
• Sales Guy: “Huh, I’m not sure, but I can talk to our customers and find out.”

That’s it. Talk to customers and find out. But you have to know what you are trying to find out and that is how much value you provide compared to the alternatives available.

You have to be careful when you talk about customer value. If you Google the term you will find that most results are about how much value the customer provides to the seller. And there are lots of consultants and some software tools that will help you segment your market by the most profitable (to you) customers. This is a great way to refine an established business, but it is a terrible way to think about start-ups.

As a start-up your first job is to figure out how to create differentiated value for a specific group of customers (aka product/market fit).

And then make sure that your unit economics make sense. (Unit economics is the cost of selling something relative to the net revenue you get from selling it.)

So get out there, and have conversations with your customers or target customers about how you provide value. And what the customer sees as the alternatives.

——

Rocket Builders will be coaching growth companies on how to use segmentation to choose a market entry point in the Rocket Builder’s Go-to-Market Program. This program is designed for early-stage companies that have initial customers and want to accelerate growth and attract investment.

Steven Forth is a Vancouver consultant, investor and serial entrepreneur. He is a partner atRocket Builders where his work is focused on market strategy including market segmentation, pricing and the design of revenue generation systems. He invests througheFund where he occasionally leads due diligence teams. His newest venture isNugg, a VentureLabs start-up building a platform for team building and collaboration.

According to The Next Web the founders of successful startups pay themselves very modest wages.

The data comes from a new tool called COMPASS from the people behind the STARTUP GENOME PROJECT. It can be set up to pull in data automatically from the likes of Google Analytics, Salesforce, Mailchimp, Quickbooks, Mixpanel, PayPal and Stripe, and it also accepts directly input data too. This information is used to generate a dashboard that shows startup CEOs how they’re faring against similar companies with regard to revenue growth, customer growth and customer lifetime value.

For many would-be entrepreneurs, raising money is the ultimate goal. With a $500,000 seed round, some fledgling CEOs expect a 6-figure salary as a kind of payback for success at raising capital. Most investors will see this as a sign of immaturity or as an indicator of someone trying to build a lifestyle business. Either way this will send most investors packing.

With the exception of India, the salary ranges for startup founders around the world are remarkably similar. Low founder pay is a particularly striking factor in Silicon Valley, when you consider the high cost of living in cities like San Francisco.

Does the stage that a startup is at affect its founders’ salaries? Not as much as you might think. Founders tend to keep their salaries below $45,000 per year until they hit a high-growth product phase. Even then, the average salary for a startup with a mature product is $70,109…

Of course founders should be looking at winning big on exit…if they are looking to align their interests with their investors’.