It pays for an entrepreneur to understand the desired outcomes of prospective investors.  Investors – of all kinds – strive to maximize their risk-adjusted returns.  No revelation there.  The interesting bits are uncovered when we examine how different investors seek to achieve their common goal.  It is their varied strategies for achieving superior risk-adjusted returns that differentiate one type of investor from another.

Expected risk-adjusted return is a relative measure that is the function of expectations regarding negative cash flow, time, risk, and positive cash flow.  Looks simple enough.  Just minimize negative cash flow, shorten the investment horizon, eliminate risk, and maximize positive cash flow.  In a competitive environment.  With imperfect information.  Hmm…maybe not so easy after all.

Let’s cut through this Gordian knot by examining each variable in turn.

As we discussed in the previous issue, there is more than one kind of risk.  Per Bhidé, irreducible uncertainty is immeasurable and unquantifiable risk, which may be contrasted with the precisely quantifiable risk of, for example, a coin toss.  The latter can be identified through informed analysis and “boxed” contractually.  The former must be mitigated by less tangible, but more flexible, means.  Among the risk management tools available to investors are the following:

Staged investment – An early stage investor will typically invest in phases that effectively gives him the right, but not the obligation, to invest in future rounds.  Contrast this with a leveraged buyout, where the entire amount of the financing is committed upfront.

Contractual risk shifting – Lenders use contracts in the form of covenants, representations, and warranties to shift who bears what risk.  Remedies can include the ability to liquidate collateral, accelerate repayment, or charge higher interest rates.

Collateral – Valuable assets and personal guaranties can provide an investor with a second way out of a deal beyond the cash resources of the venture as a going concern.

Portfolio diversification – Smart investors don’t put all their eggs in one basket.  Sophisticated portfolio diversification has, for example, made personal credit card financing more readily available.

Third-party validation – Investors, like the rest of us, look to the (hopefully) informed opinions of insiders for the assessment of management teams, business plans, and prospects.  Ratings agencies and “lead steer” investors make life easier for others who don’t have the knowledge or resources to conduct the requisite due diligence.

Board representation – If the ability of the management team is in question, it often makes sense for an investor to become an extended member of the team.

The obvious way for an investor to limit negative cash flow is to phase or otherwise limit his investment to avoid putting good money after bad.  Repayment acceleration triggers can reduce a lender’s downside once a loan has been made.  Similarly, registration rights can help a stockholder take some money off the table.  Even though they are equity investors, venture capitalists typically invest in convertible preferred shares that give them a preference in liquidation.  Another really important consideration for all investors is how to reduce the cost of investing.  Conducting effective due diligence, authoring contracts, monitoring performance, participating on a board, and securing collateral are expensive undertakings that are subject to economies of scale.  Consequently, investors tend to be specialists.  Bankers rarely make equity investments, and venture capitalists usually don’t make loans.  One ramification of investor specialization is that growing ventures will need access to an array of capital providers over time.  Marginal businesses, on the other hand, will not.

On the flip side, investors must choose a strategy in regard to positive cash flow.  Lenders typically get paid in the form of interest, but that interest can be fixed or floating.  Interest can be set relative to the underlying cost of funds (e.g., the prime rate) and relative to risk (e.g., as measured by a financial ratio such as leverage or cash flow coverage of scheduled debt service).  Limited upside is traded for (hopefully) minimal risk of loss.  Equity investors, on the other hand, typically get paid through the un-capped appreciation of their stock, but face the real risk of a total loss of their investment.  So called “mezzanine” strategies incorporate “kickers” such as detachable warrants, revenue participation rights, and convertible debt.  Furthermore, one shouldn’t ignore how an investor might conceivably be paid in multiple ways.  A strategic investor may be willing to accept a lower risk-adjusted return in exchange for access to a technology that can be applied profitably in the investor’s core business.  The symbiotic relationship between large pharmaceutical companies and small biotechnology firms is rife with this kind of deal.  Less tangibly, a mother might be motivated to invest in her daughter’s venture for reasons other than the prospect for financial gain.  Likewise, a community may invest in a company with the hopes of diversifying its economy and increasing its tax base in addition to receiving a direct financial return.

Lenders manage the timing of their investments (i.e., their investment duration) through amortization schedules and covenants that can trigger acceleration, the liquidation of collateral, and cash flow recapture provisions.  With less direct control over the duration of their investments, equity investors pay particular attention to exit strategies, which come in just three forms: a public offering, the sale of the company, or the refinancing of the business.  A soft IPO market makes it tougher and more expensive for new companies to raise venture capital, because it increases the expected duration of a venture capitalist’s investment, which can more than offset the often-limited utility of put options and registration rights.

Of Cambodian immigrants and doughnuts

The reader will have noted that amortization schedules, covenants, due diligence, and risk-adjusted pricing are predicated upon the usefulness of analysis.  That’s a bit of a problem, because, by definition, promising startups are characterized by irreducible uncertainty.  Analysis just won’t get you from here to there.

So what does one do when risk takes the form of uncertainty, when contracts are (in economists’ jargon) incomplete?  Most bankers these days, as we’ll discuss below, simply punt and focus on lending against collateral having readily ascertainable value.  Is there no other way?  It turns out there is a way to enforce incomplete contracts.  Samuel Bowles and Herbert Gintis call it optimal parochialism, and it relies upon networks of trust.

Per Bowles and Gintis, Cambodian immigrants run more than 80 per cent of the doughnut shops in California.  We suspect that the typical immigrant’s personal guaranty probably won’t mollify a bank.  Likewise, the liquidation value of doughnut inventory is pretty low.  And, where would a Cambodian immigrant gain doughnut shop management experience?  Raising startup capital would seem to be an intractable problem.  Borrowing through informal credit associations of friends, family, and ethnic community members solves it.  The highest bidder gets the loan.  A web of social relationships creates the environment of trust necessary for lenders to make a leap of faith, and the repercussions of defaulting on the trust of an entire community mitigates repayment risk.

Once upon a time, there was an institution known as a community bank.  Bankers knew everybody in town, directly or through trusted third parties.  Then, as now, loans were assessed according to the “five Cs” – character, capacity, collateral, capital, and conditions.  If you had a good reputation in the community, your character could overcome uncertainty about your business and the lack of collateral.  If you defaulted, you stood to lose the trust of the entire community, which provided a strong incentive to make good on your loan.  However, as the banking industry has consolidated in order to take advantage of economies of scale, credit has been product-ized and centralized, diminishing the role of the community banker in the underwriting process.  As one consequence, the benefits of optimal parochialism have been abrogated, and the character loan is an endangered species.  (It would be interesting, though, to compare the decline in character loans with the increase in the availability of credit cards.)

The benefits of parochialism can also be seen in the realm of venture capital, a full third of which is concentrated in Silicon Valley.  Heck, a big chunk of that is deployed out of single office complex at the top of Sand Hill Road in Menlo Park!  In what John Freeman calls an “economy of time,” third party validation and the mutually reinforcing strictures of investment syndicates help manage risk that is largely undefined, unquantified, and uncontractable.  Parochialism can be smart.  (The adventurous might want to check out the work in this field by Toby Stuart.)

Types of capital and principal strategies

In review, all investors seek to maximize risk-adjusted returns, but they do so using different strategies.  Secondly, economies of scale encourage investors to specialize.  Thirdly, different specialist strategies are best adapted to differing investing environments that are defined by a dynamic array of variables including the types of businesses needing funding, the stage of their development, and the existence or absence of networks of trust.  Our next step, then, is to look at the strategies of different sources of investment capital and assess how adapted they are to promising startups and VC-backable ventures on the economic frontier.

It should come as no surprise that 88% of the 2001 Inc. 500 reported they tapped personal assets for startup capital while only 15% had access to bank lines of credit.  Personal assets represent the most flexible, lowest cost capital available.  A close cousin is personal debt capacity, including credit cards, which is largely based upon historical earnings and debt repayment history.  Somewhat ironically, relatively modest personal resources are almost a prerequisite for the founder of a promising startup.  After all, rich people – people who have a lot, earn a lot, and have lots of personal debt capacity – have high opportunity costs.  They don’t often find the modest likely profit of a promising startup very interesting.  Consequently, as a very limited source of capital, personal assets and debt capacity are really only relevant to the earliest stages of a promising startups life: development and startup.

Construed in its narrowest sense, friends and family don’t really offer much relief to the founder of a promising startup.  After all, if our personal resources are constrained, chances are that our immediate circle of friends and family don’t have a lot of cash lying around to invest.  When they do invest, friends and family rely heavily upon personal knowledge and trust of the founder (versus knowledge of the business and its prospects) to mitigate the risk of very incomplete contracts.  Consequently, propinquity (a word that captures the subtle interplay between the affinity and proximity that trust depends upon) is essential for an extended network of friends-of-friends to be much of a source of startup capital.  That’s just plain tough to orchestrate out in the boondocks, where geographic isolation and local social homogeneity conspire to effectively limit our portfolio of personal relationships.  As with personal assets, friends and family money is most appropriate during the development and startup stages.

At the outer reaches of the friends-of-friends network are so-called angels.  They tend to utilize a somewhat more sophisticated investment strategy that includes third-party validation, personal industry and startup experience, staged investments, and rudimentary contracts.  Frequently, an angel will become actively involved in the day-to-day management of the business.  In aggregate, angels are said to account for a significant chunk of startup financings.  However, individual angels are very often super-specialists.  If you don’t know who they know, don’t live where they live, aren’t in the industry they are familiar with, or their advisory capacity is already absorbed by another, you are out of luck.  Angels that seek a more general investment role must incur higher due diligence and portfolio management costs.  As they band together to share this overhead, they start to look less like friends-of-friends and a lot more like venture capitalists.

As we saw above, venture capitalists do rely somewhat on social networks as part of their investment strategy.  They also rely much more heavily upon analysis, legal contracts, and management participation than any of the preceding investor types.  A self-reinforcing cycle is perpetuated by the high cost of the VC model.  High cost argues for larger investments.  Larger investments, in turn, increases total risk and require that the VC invest in deals that are amenable to analysis.  As a consequence, venture capitalists tend to invest at a somewhat later stage when the passage of time has begun to answer questions about market size, technology, management, and the near-term prospects for an exit.  Promising startups in their early stages need not apply.

With the consolidation of the banking industry, local banks have become providers of liquidity rather than risk capital.  Banks lend against personal guarantees, current accounts receivable, and real estate, and they keep the effective duration of their loans short.  Local offices of big, distant banks can’t count on social networks to mitigate their risk.  After all, do the citizens of our hometown, East Podunk, really care about the performance of Wells Fargo’s loan portfolio?  The bad news, of course, is that banks aren’t a good source of startup capital.  Neither are they a particularly good source of capital for growing companies, which need expanding levels of financing – banks without significant local underwriting authority tend to want to see their debt amortize, not increase.  The good news is that banks do a pretty good job of providing liquidity at a low cost.

Asset-based lenders have a somewhat different model.  Like their name suggests, asset-based lenders make advances against tangible assets.  However, they can lend somewhat more aggressively than banks due to intensive collateral monitoring.  Of course, that’s expensive.  So, asset-based lenders typically charge a significantly higher interest rate than banks.  Like banks, asset-based lenders have a tough time with the intangible assets that underpin many growth companies in a knowledge economy.

So – where is the gap?

Given our focus on promising startups and VC-backable startups as well as the array of investor strategies outlined above, where is the capital gap out here on the frontier?  We believe that there are two gaps – or, more accurately, there are two pairs of gaps, each pair comprised of a financial capital gap and a closely related social capital gap.

In our experience, the first financing gap exists on the cusp between startup and early growth for a promising startup.  The social gap is between entrepreneurs and friend-of-friend type investors.  At the early growth stage, financing needs will typically be in the $50,000 to $300,000 range.  That kind of money isn’t often accessible via personal savings, credit cards, and true friends and family networks per the reasons outlined above.  Furthermore, at this stage a promising startup is still characterized by a high degree of irreducible uncertainty, so investment strategies predicated upon analysis, plans, and contracts aren’t a solution.  That leaves investors who can rely on optimal parochialism to mitigate risk.  In the context of the frontier, geographic isolation can makes things a little too parochial, leaving entrepreneurs with personal networks that aren’t diverse enough to reach friends-of-friend type investors.  Early attempts to bridge this gap – online angel networks, for example – have focused on creating networks of information, but have largely failed to cultivate networks of trust.

The second gap exists at the transition between promising startup and VC-backable venture, where irreducible uncertainty has diminished and the prospect for profit and the need for capital have increased.  Even in those rare cases where local venture capital exists, there is often a financing gap.  The gap remains because getting the first round done when you need three to execute your plan can be a Pyrrhic victory.  Put another way, the first round VC must either have (a) deep pockets or (b) good relationships with other VCs to bridge the total financing gap.  The social capital gap here is the lack of networks of trust between and among VCs.

Although both sets of gaps are relevant, the first is the most pressing.  The first set of gaps effects a larger number of companies, and its resolution will determine the importance of the second set of gaps.