Thursday, 24 October 2013

Four Principles for SME Financing - Additional Revenue Streams via IP Monetization?

I recently had an interesting discussion with some of my entrepreneur clients about financing. This gave me the thought that I could perhaps try to share some ideas for those engaged in early financing rounds. We were discussing a question that was rather much as follows: 

“How much funding should we seek from investors, considering that we have two alternatives: A and B. If we select A (which is a joint project with our customer), we need significantly less capital than with alternative B, and we might be in a very beneficial situation in the subsequent rounds if we are able to construct workable demonstration facility as a customer project. Alternatively, we can opt for alternative B, immediately going for our own business model where we naturally would need a larger investment. So what’s your view?”

Sound familiar? Let me shed light on some key issues to consider. Of course this is not really a question for a lawyer, but we ended up providing a recommendation that entrepreneurs should keep the funding amounts small in the early rounds when the valuations are lower and then scale up the amounts in the later rounds when it is a lot more clear how money can create value and when the valuations will be higher. These very same words were used by Fred Wilson in an excellent post on valuations vs. ownership in more detailed terms, a VC and principal of Union Square Ventures—really worth checking out.

If you choose option A, as this company did, they might still need some funding for their operations and the following points could help you:

M&A activity in Finland is relatively high and this autumn we seem to have increasing movement among the foreign investors, at least in the form of contacts towards our firm, TRUST. However, valuations have traditionally been lower in Finland, which seems to indicate that companies are sold at the development phase earlier than similar companies in, say, Sweden. To some extent, this is due to the lack of funds, problems with First North and inactive bond markets for SMEs unlike in Norway, for example. Opting for VC too early might mean that investors are not competing against each other as there might just be one VC investor. Naturally, this also influences the deal terms and how much control your are able to maintain after the first rounds. 

Even in option A, you would need funding and some issues to be considered:

First, the terms of payment in cleantech and/or mechanical/process technology deals tend to be more front-loaded nowadays — an issue which would generally make customer deals more tempting (don’t be afraid of using this option and negotiating payment milestones carefully using guarantees to provide safety to the customer). 

Second, Finnish companies should be more active in seeking patent and technology licensing arrangements to finance their operations (your foreign competitors use these tools as well — say if the process can be used for coal in addition to other substances and coal is not within your core business, you might consider licensing the coal application to China for example. Feels like making money for nothing, right?).

Third, consider industrial players as investors either from the customer or supplier side. Business angels have shorter investment cycles and they are unlikely to provide further funding or they do not have ample resources at least. Also you need to take into account that industrial players might have different business interests as they are not necessarily making their profit from the exit within the next 5 years. Also consider, e.g., conversion of your suppliers’ deliveries as contributions-in-kind; less need for funding and smaller “financing cap” between the customer payment and time when you have to pay for your supplier. The optimal solution would be to draft customer and supplier agreements back-to-back so that there would not be any financing cap, but this is not always possible in long-term industrial projects.

So to summarize our thesis, “not too much money too early”, “best to have several investors”, “consider alternative business models to support your business”, “consider alternatives for VC investors”. Hopefully this helps!