Category: Startups

Young Entrepreneurs More Likely to Fail

In spite of Silicon Valley’s apparent fixation on youth – see How Tech Investors are Failing on Due Diligence – a recent academic study has shown that older entrepreneurs are less likely to fail.5 Year Survival by Age

The study spanned 5 years and looked at founders in 5 different age groups by decade (20s – 30s – 40s – 50s – 60s).

Given that the study covers 5 years – about half of the people in their 40s would be in their 50s by the time the study ended.

Note that entrepreneurs in their 30s are marginally more likely to exit by way of M&A transaction than their older colleagues.

How Tech Investors are Failing on Due Diligence

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.

Seth Bannon with requisite beard
Seth Bannon with requisite beard

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.

Subordinated Debt (aka “sub-debt” or mezzanine financing)

WHAT IT IS

according to Wikipedia:

 

In finance, subordinated debt (also known as subordinated loansubordinated bondsubordinated 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.

 

Creating Customer Value

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.

Steven ForthThe 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.

Are Tech CEOs too Focused on the Exit?

A 2014 survey by PwC indicates that most Canadian tech CEOs are focused on an early exit by way of acquisition.

MandA Survey

While PwC concludes that more companies should plan to grow their companies, for my part I am pleased to see that CEOs are becoming more realistic. The fact that only 7% believe that an IPO is the most likely exit, demonstrates that CEOs get it. It is a huge culture shift for companies to evolve from an agile private company to a successful public company.

However companies that want to grow their companies can also look at an MBO (“Management Buy Out”) as another viable exit strategy for angel investors – at least in some circumstances. For BC-based companies the BC VCC Program helps reduce the risk for angel investors. Once a company has traction and has turned the corner to profitability, there are many more conventional financing options available. Mezzanine financing can be used by profitable companies to buy out angel investors particularly where a proven management team is behind the deal. The money isn’t cheap – but it is cheaper than equity!

 

READ PwC‘s REPORT BELOW:

The SR&ED Audit – Q&A

WHEN SHOULD CLAIMANTS CREATE TECHNICAL DOCUMENTATION?

(and when should they assemble it?)

CRA2-150x150

Preparing for an “SR&ED” (Scientific Research and Experimental Development) tax audit should really begin well before your company receives notification that your claim is under review. In fact your company should begin assembling supporting documentation at the same time that you decide to perform eligible SR&ED.

As we’ll see later on from the audit letter itself (see Section 3 on page 2 of the letter), there is an expectation that the documentation was developed at the time the work was being performed. It has been our experience that claimants like to assemble that information only after they receive notification of audit. Presumably they do this in the hopes that they won’t be audited. There are 3 serious problems with this approach:

The chances of being subject to an audit have increased significantly in recent years. It is our belief that claims prepared on a contingent (i.e. success-based) basis receive special attention from CRA. Regardless of the engagement terms, the doubling of SR&ED audit staff means that an SR&ED audit is far more likely.

  1. Documentation assembled after the fact may not have existed before the audit letter was issued – and therefore can’t be construed as ‘contemporaneous documentation. If this is apparent to the auditor, the CRA might elect to deny your claim in its entirety for lack of ‘acceptable’ documentation.
  2. The CRA generally provides 30 days of lead time to assemble supporting documentation. However they don’t communicate by email, but by letter or fax. This effectively reduces the available time to respond by a week or so – and as you’ll see, the amount of documentary evidence requested is considerable – particularly if it wasn’t identified before the claim was filed.

 

DO CONTINGENT FEES INCREASE AUDIT RISK?

Commencing in January of 2014, claimants are required to disclose the nature of any billing arrangement with a third party claim preparer. While the CRA denies that this section is used to screen files for audit, the CRA would hardly disclose how they in fact do screen files for audit – since this is really their ‘secret sauce’.

Certainly it is our experience that files prepared on a contingent basis are far more likely to be audited than those done on an hourly basis.

 

 WHAT KIND OF DOCUMENTATION DOES THE CRA EXPECT?

SR&ED CHRONOLOGY:

The CRA expects claimants to develop ‘contemporaneous’ documentation detailing plans to overcome technological uncertainties and achieve the desired advancement.

Note that the suggested format presupposes sophisticated activity-based costing – from small businesses that are often challenged maintaining rudimentary books and records on a timely basis.

MAPPING SR&ED TO PRODUCT DEVELOPMENT – WHAT IS THE CHALLENGE?

The Income Tax Act requires that SR&ED activities be “related to a business of the taxpayer”.

In fact 95% or more of SR&ED claims relate to the experimental development of new and improved products or processes – which clearly relate to a business. However even the most sophisticated claimants have difficulty distinguishing between the new features of the product or process and the technological advancement required to deliver these ‘new features’.

The engineers who develop those new products don’t explicitly hypothesize about how to overcome technological uncertainties. Instead they focus on development plans for the new features or products. Determining what work is eligible usually involves inferring from the development plan, what technological uncertainties existed and what their ‘hypothesis’ was – often many months after the work was done.

All of which makes it difficult for them to provide contemporaneous documentation of their SR&ED activities – since contemporaneous documentation exists for the entire product development process – and not the more narrowly-focused SR&ED activities.

EXAMPLE OF AN AUDIT LETTER

Handling BC Provincial Sales Tax in Xero Online Accounting

With the return to the old regime in British Columbia, businesses are now forced to comply with the complexity of 2 separate consumption taxes (i.e. PST and GST). What prompted this discussion were the challenges faced by one of our clients – a software developer – in complying with the new regime.
To begin with small businesses must understand that accounting software isn’t expert software. Too often there is an expectation that commercial accounting software will provide professional expertise and guide inexperienced users into automatically recording transactions – including sales taxes – correctly.
In fact, from a marketing perspective Canadian customers are not a terribly important source of revenue to an international firm like Xero Limited. Xero is more focused on Australia, New Zealand (local markets), the UK, India and the US (large markets). As a result the software provides adequate generic tools to support various tax jurisdictions, but little or no ‘localization’ for secondary markets like Canada.
No matter how well accounting software has been localized to handle the mechanics of sales tax calculations for a particular jurisdiction, it simply isn’t realistic to expect the software to provide any expertise with respect to understanding what transactions are taxable or at what rates taxes need to be calculated. In fact such determinations are difficult for tax professionals, who invariably need a great deal of context before making decisions.

Handling GST in Xero

The Goods and Services Tax in Canada is a ‘value-added’ tax (aka “VAT”). That means businesses only pay tax on the value they add in taking products and services to the ultimate consumer. It is the ultimate consumer – at the end of the process – who pays the full amount of tax on the good. In the simple case of a consumer good – like a pair of shoes. The end user buys the shoes and pays GST on the full cost of the shoes.
The manufacturer buys raw materials and pays tax on the materials. It then ‘adds value’ by putting the raw materials through a manufacturing process and sells the shoes – usually to a retailer. The manufacturer charges GST on the sale price to the retailer. The difference between the GST collected on the sale price and the GST paid on the cost of the raw materials is remitted to the Canada Revenue Agency (the “CRA”).
Similarly the retailer collects GST from the consumer and gets a rebate from the CRA of the GST paid to the manufacturer. In the end, the final consumer pays the full amount of GST.
This type of value-added tax is commonplace in many countries (other than the US). Xero is familiar with handling value-added taxes and does a good job of handling Canada’s GST. All of the GST collected on sales and paid on purchases is collected in the Sales Tax Payable account.

Handling PST in Xero

Companies that charge PST to customers must remit the PST collected to the their provincial tax authority. However they don’t get any credit for PST paid on purchases. Instead PST paid is treated simply as a part of the cost of the good or service that was purchased.
This approach to sales taxes results in business paying tax on certain of their inputs. Typically raw materials and goods for resale are exempted from PST. However companies must still pay PST on overheads like telephone bills, tools and utilities. The PST paid is generally expected to form a part of the cost of any taxable good or service. Instead of being claimed as reduction or offset of PST collected, the PST ends up on the income statement as an expense.
Unfortunately Xero doesn’t handle this very elegantly.
This means that when entering PST on expenses, it should actually be entered as a second expense line (i.e. currently 7% of the taxable purchase) and should be allocated to the same account as the purchased item:

EXAMPLE
Supplies expense $100
Supplies expense …..7
Sales tax payable ……5
…………………………………………Cash $112

So we have 2 supplies expense lines. The first is subject to GST (input tax credits) at the current rate. The 2nd line represents the PST paid on the supply.
In this way the GST reports correctly as an input tax credit. The PST reports as an expense. Unfortunately the balance in the Sales Tax Payable account combines both GST and PST. So PST should NOT be set up as a sales tax.

Ideally there would be 2 separate Sales Tax Payable accounts (i.e. GST and PST), however it can be made to work as shown above. Of course other workarounds are possible – but they are workarounds, and could easily be misunderstood by bookkeeping staff.

TECHNOLOGICAL ELIGIBILITY: THE NEW NORMAL

JENTEL MANUFACTURING CASE RAISES THE BAR

A case decided in May of 2011 has had an enormous impact on the current assessing practice of CRA with respect to determining eligibility of SR&ED projects.

While about 95% of claims involve ‘experimental development’ (“ED”) – as opposed to scientific research (“SR”) – the judgment brings into question whether most ED is even eligible.

According to Justice Steven K. D’Arcy:

“In my view, the work involved the Appellant using existing manufacturing processes and existing materials in an attempt to improve its existing product. This involved routine engineering and standard procedures.”

 

The law reads:

 

“scientific research and experimental development” means systematic investigation or search that is carried out in a field of science or technology by means of experiment or analysis and that is

. . .

(c) experimental development, namely, work undertaken for the purpose of achieving technologicaladvancement for the purpose of creating new, or improving existing, materials, devices, products or processes, including incremental improvements thereto.”

 

ED invariably involves the use of standard engineering procedures. The truth is that no business sets out to achieve ‘technological advancements’. They set out to build or improve products and services. They necessarily must accomplish this by using standard engineering practices and techniques – since they use engineers and not scientists.

 

Unfortunately the judge seems to have imposed a requirement that the technological uncertainty be explicitly isolated at the beginning of a project, along with an hypothesis for resolving the uncertainty. This is not what engineers do – particularly not in a small business setting. For them the hypothesis is implicit in the development plan.

 

Since that decision was reached, the CRA has doubled their audit staff. They are looking for evidence of:

 

  1. The early identification of the technological uncertainty
  2. An understanding of the difference between ‘routine’ and ‘experimental’ development (I.e. evidence that some sort of ‘filtering’ has taken place)
  3. Timesheets in support of SR&ED projects
  4. A systematic approach involving prototypes, trials and tests

 

This is an unrealistic expectation – particularly when it comes to startups and very early stage companies with limited resources. However it has now become the new normal. And companies that wish to benefit from our otherwise generous SR&ED tax incentives, need to begin to implement procedures that readily produce that kind of evidence.