SOPHISTICATED FINANCE

Death Spiral Financing

A couple of readers emailed to ask what a "death spiral" was, which was referenced in a recent post on Financing Fees . A death spiral is a financing where massive equity dilution is attached as a condition if a certain event does not take place. For example, you issue convertible bonds which convert into one million shares of common stock, but if the company does not go public by 2009 the conversion ratio changes to 50 million shares. In most death spirals, the existing controlling shareholders lose control if the death spiral triggers.

In my experience two types of investors offer death spiral financings--very large sophisticated investors (like the Walton family) and hedge funds. Sophisticated investors offer death spirals because they see sufficient value to be happy if they end up as the controlling shareholder. Hedge funds use them because they are another alternative to balance risk and return. The bravado and unceasing optimism of entrepreneurs make them very susceptible to death spiral financing offers. They call them death spirals for a reason. They should be the last alternative that one considers and you should be facing imminent liquidation before you accept such a financing.

Random Thoughts

My muse appears to be on vacation this week. Yes--I know this is getting to be a recurring theme, but preparing those SEC documents shuts down the desire to write about anything else. A few quick thoughts follow:

1. Microsoft pulled out of its negotiations with Yahoo because Balmer always had reservations about the deal and used the price difference as the excuse to "gracefully" exit. Nobody walks away from a deal that size over $1-2 per share. No--Steve Ballmer did not call and tell me this, but my explanation is the only logical explanation for the deal collapsing or Microsoft not going hostile. Why did Ballmer start down this road and then change his mind, consider that he and his CFO are a relatively new team that may still be finding their way.  My previous posts on this deal are here and here.
2. Warren Buffet has come out and recommended investment in Europe due to the comparative strength of the Euro versus the US Dollar in the medium term. My thoughts on the subject were here.
3. UBS has reportedly sold a $5 billion portfolio of sub-prime mortgages to a U.S. hedge fund at a discount of only 25 percent. This comparatively minor discount would support claims last week from the Bank of England that banks had over reacted in writing down the value of their sub-prime portfolios.
4. Data has been circulating on the Internet this week that shows the most popular apps on Facebook are for "fun". And all along, I thought Facebook was going to solve world hunger. Everyone building apps for Facebook may want to reconsider their business plans.

Financing Fees

Ask the VC is a blog written by some savvy guys who are all VCs, including Brad Feld from Foundry Group. Today's post deals with a real case where a founder gave up ten percent of his company to get an advisor on board with connections to VCs. I recently saw a case where a founder paid 30 percent for a 90 day bridge loan involving warrants (120% per annum). While obviously both founders were stareing a death spiral in the face, or at least I hope they were, why do so many startup entrepreneurs overpay for capital. There are several reasons:

1. There are a lot of unscrupulous advisors out there who will overcharge; that's why you do background checks and get multiple proposals
2. Entrepreneurs do not consult their advisors and attorneys; mentoring reduces the risk in startups partly because it stops you from doing stupid things and anybody can afford a five minute call to an attorney/accountant/mentor to ask what market fees are
3. Entrepreneurs do not know how to calculate the value of the equity, warrants and options they are giving up; if you do not know how to calculate the value of these instruments you should not be trading them like baseball cards
4. High stress makes for poor decision making; plan ahead

A couple of guidelines to avoid overpaying to raise capital:

1. Loan sharks charge 4-8 percent per month. If the interest rate you are paying approaches these levels (after imputing the cost of any equity you are giving up), then you can be sure you are overpaying
2. The highest fees I have ever seen to successfully raise equity was for a company with eight years of losses. The fees were 10 percent in cash and 10 percent warrant coverage (1 warrant for every 10 shares sold). I would like to point out that these fees were 100 percent contingent on the capital being raised and there was no upfront fee.
3. Upfront fees to raise capital range from 0-$25,000 and the arranger should be putting some real effort into improving the business plan and/or financial model. Fees may vary based on the city where you are located but not by too much. Anybody short of a well known investment bank does not get a six figure upfront fee. (Remember that these fees are for early stage companies and not for a $100 million private equity deal.)

The more you need the capital, the more likely you are to make a mistake. Start the capital raising process early and do not overpay.

A thank you to loyal reader, Kendall, for pointing out the Ask the VC post.

A Collection of Excel Posts

In an effort to make it easier for Google searchers and readers to find the correct post they need on Excel or financial models, I have collected them here.

A reader wrote to say that they had not seen anybody give away for free so much help on Excel. Hopefully my small contribution helps.

I have also added some new sites to the custom Google search engine--Sophisticated Finance Excel--which may prove useful to readers.

The Consequences of Technology Adoption

Two Harvard Business School professors, Diego A. Comin and Bart Hobijn, have just published an interesting paper entitled An Exploration of Technology Diffusion. The paper basically looks at the rate at which fifteen technologies have been adopted by 166 countries over the period from 1820 to 2003 and the resultant affect on economic development. The main conclusion of the paper is that the time to adopt a new technology is the leading factor to explain economic development.

Two examples illustrate the point that shortening the period between invention and adoption of a new technology accelerates economic development. The first example cited by the authors is the Meiji Restoration in Japan (circa 1860) where one of the major objectives was to industrialize Japan by using western technology (and thereby shrinking the time frame to adopt new technologies). As a result of these efforts begun in the Meiji restoration per capita income increased 33 percent. The second example is the Four Tigers (Hong Kong, Singapore, Taiwan and Korea) who in the period from 1960 to 1995 each averaged 6 percent annual economic growth. The data shows that it was the speed to adopt new technologies that explains in large part their phenomenal growth. The data also shows that Latin America is comparatively slow to adopt new technologies and consequently has had much slower economic growth than many other regions.

The paper provides the data to draw some other interesting conclusions about globalization, government policy, new business development, and business management.

Globalization The rapid diffusion of technologies in recent years is probably not due to globalization or the Internet revolution. Over the nearly two hundred year period studied, newer technologies are adopted faster than older technologies. As we consider the free trade dialog, rather than focusing on jobs going off shore the better discussion would be about how to encourage U.S. companies to adopt new technologies faster.

Government Policy The shorter the lag in the adoption of a new technology the greater the economic benefit. Government interference in the development and particularly in the time to adopt a new technology has dramatic negative consequences for economic growth. Government policy on stem cell research and global warming, to cite two examples, could severely slow adoption of these technologies in the U.S. and put economic development at a severe disadvantage.

New Business Development When the number of technologies available for a production method are small an increase in production methods, i.e. a new technology, have a very large effect on economic productivity. Given the limited number of communications methods available pre-Internet (Telephone, radio, television, newspapers) it should not be a surprise the profound effect the Internet has had. More importantly, when looking for new business ideas, look at industries or needs where there are a limited number of technologies for production; energy generation comes to mind.

Business Management A widely held view is that one does not invest in new technology when the cost of using people at low salaries is cheaper. This view is particularly prevalent in emerging markets. The key factor to explain the lack of development in emerging markets is their slowness to adopt the new technologies. Invest in new technology, even if you can not afford it.

While much is said about globalization, economic development and third world governments, it all comes down to how fast can you adopt new technologies--assuming that the goal is economic development.

If you are interested in following the thought leaders at Harvard Business School their new work is here.

Target Customer

A short post entitled Build Value in a blog called Peter's Thoughts got me thinking about the all important and often neglected concept of target customer. The key point in Peter's post was that you create value by satisfying the customer need. He goes on to say that management should never define the product features, but instead management should talk to a lot of customers. I agree 100 percent with what he says, but here is the problem. Who is the customer and more precisely who is the target customer. Most business plans, start ups and troubled companies lack an understanding of their target customer, which is usually demonstrated by their inability to fully describe the customer. Let's take an example. Here are five descriptions of a target customer:

1. A woman
2. A woman with children
3. A middle income woman with children
4. A low middle to middle income woman with children
5. A single, low middle to middle income woman with children

Notice how your perception of the woman changed with each additional descriptor. As your perceptions changed so did the probable needs of the woman.

Probably the most important concept in business after cash flow is target customer. Target customer defines the product, targets the selling strategy, refines the pricing and most importantly gives a concrete reality to the customer by defining their needs. Target customer is not a theoretical concept and is defined and refined by reviewing sales data, meeting customers, analyzing product sales trends and talking with the sales force for their feedback. Understanding the target customer, who may be in a state of constant change, such as for a retailer, is a continuing, constant process. Through this constant process of analysis you insure that your definition of the customer's needs is current, that you have not overlooked a key need which may still be unsatisfied and perhaps most importantly you keep management focused on the customer.

In many of the business plans that I see for new social networking sites I see detailed lists of site features but never get an idea of who would use the site. Most social networking sites are now oriented toward a particular vertical market, but this approach actually places a greater importance on understanding the target customer. If ten sites target photographers, the site that wins is the site that better satisfies the needs of photographer. This will probably be the site that has the most profound understanding of their target customer and not necessarily the site with the longest feature set.

In summary, a target customer is defined by their needs which provides the concrete information that fleshes out the standard demographic or segment analysis. While a target customer will undoubtedly evolve, particularly in a start up, one is well advised to define a target customer early in the business plan process in order to provide a concrete reality for the market you propose to serve. Otherwise you may end up with a product or feature set that does not match a customer need.

Bank Losses

Research Recap had a short story on the losses of major banks from mortgage securitization. A summary of the losses by bank is shown below. Note that this week's $12 billion loss at Royal Bank of Scotland is omitted.To put these losses of approximately $218 billion in perspective, the losses are comparable to the annual GDP of the Caribbean and Central America combined. Since the mid-1990s I have thought that derivatives would be the force shaping global finance. I never imagined that such a helpful tool could be so abused.

Cost Cutting?-Update

Yesterday's most popular search that brought readers to this blog was "Deutsche Bank Brothels". Google is not yet sophisticated enough to tell me whether searchers were looking for a list of the brothels or just more details on the story.

For those of you who wrote or commented to say that the bank never took you to a brothel I can only say that you should have proposed a bigger loan.

For those of you looking for a new business idea, I think a guide called "Brothels of the Leading International Banks" would be very popular. Of course, you would first need to document whether any other leading international banks allow expense reimbursement for such activities.

For those of you actually interested in cost cutting I apologize, but some stories are just too funny.

If you missed yesterday's breaking news story on Deutsche Bank it is here.

I will return to more serious posting as soon as I get that 10Q done, but until that time I may ....

Cost Cutting?

In this blog I try to deal with finance and related topics in a serious way. However, sometimes we must digress and thereby provide you with real insight into the world of "high" finance. This morning's lead story on NPR (National Public Radio) is just such an opportunity. NPR reported that Deutsche Bank, one of the largest commercial banks, will no longer allow employees to use company credit cards to entertain clients in brothels and strip joints. This drastic measure is reportedly part of a new cost cutting effort at the bank.

There are several important lessons to be learned from this story:

• The ladies who work in the brothels were unwilling to accept sub-prime mortgages in payment or could not agree on the mark to market discount for the mortgages, an ample amount of such securities being available at Deutsche Bank and presumably the reason for the cost cutting
• The brothel owners patronized by Deutsche Bank will be diversifying into new businesses so that the charge slips will not fall into the prohibited category, thereby leading to a boom in new barber shops, restauarants, etc.
• Deutsche Bank will be at a competitive disadvantage to other leading international banks who can still patronize brothels, so now is the time to bring Deutsche Bank your marginal projects in Eastern Europe, South Asia and Central America.

There was no announcement this morning on whether the bank would finance brothels. We hope that the sleuths at NPR do a follow up on this important unanswered question.

Understanding Auditors

Every audited financial statement has an auditor's opinion which includes in the first paragraph the statement "these financial statements are the responsibility of the company's management". Many auditors draw the conclusion from this statement that the client must prepare their own accounting entries in order to preserve the accountant's independence.

Now let's look at the purpose of an audit. An audit serves two purposes:

1. To confirm that the financial statements are prepared in accordance with GAAP (Generally Accepted Accounting Principles)
2. To establish whether there are sufficient financial controls in place to confirm the accuracy of the financial statements.

The paradox arises because if the auditor prepares an accounting entry then they supposedly compromise their ability to determine the integrity of the financial statements. This is hogwash. One of the benefits of a good accounting firm is that they can provide the accounting entries for complex transactions, such as employee stock options or mandatory redeemable stock. When your auditor tells you that you need to prepare the accounting entries and they will review them, what it usually means is that the auditor has exceeded the man hour budget for the audit. Nothing to do really with financial statement integrity.

Why do auditors end up exceeding their man hour budgets. Simply put--the client's accounting is terrible. No financial controls, no reconciliation of key balance sheet accounts, significant transactions not accounted for, etc. I see poor accounting practices all the time with early stage private companies. The reasons companies have so much trouble with accounting are:

1. Owners hire inexpensive bookkeepers and think they have accounting professionals
2. Owners focus on cash flow and tend to ignore accounting
3. Owners do not appreciate the value of an audit and see it only as an expense

If you are having trouble with your auditor, it almost always means you have problems with your accounting, accounting management and most importantly the financial statements. Get some outside help with your accounting and the relationship with your auditor will definitely improve.