When venture capitalists say “NO”—creative financing strategies & resources, by Ron Peterson

Neil Houghton suggests that: “Free is usually more expensive. As a result of our goal to deliver eyeglasses in the developing world, we have also received a lot of free help, and I appreciate that we have received it. However, there is often a hidden cost, and a reluctance to get the deal terms out and clear early, since it seems so good. But if the other side isn’t in it for the long haul, or if the effort doesn’t hit to the core of the other organization’s mission, things get difficult or end up being counter-productive. Accountability is difficult. I think this experience can be generalized to other organizations, where something appears free but really ends up being more expensive.” Harvey Mackay’s book Dig Your Well Before You’re Thirsty is a good resource on the topic and the movie Startup.com showed how early services that were rendered free, cost the company dearly later on.

1. Enables the entrepreneur to invest less of his or her own financial capital in the venture and to reduce overall risk by diversifying.

2. Since well diversified outside investors have lower required rates of return than an entrepreneur who has put everything they own into one venture, increasing the amount of outside investment increases the present value of the venture. The entrepreneur can normally capture some of this value gain by retaining a larger ownership interest.

3. An outside investor may contribute advice and information that enhances value, permitting the entrepreneur to share in the gain.

• Banks are not in the risk business and require substantial guarantees for loans. While a few banks are becoming more equity oriented, any loans provided carry the constant need for interest payments and the eventual payment of the entire loan—emerging companies need permanent equity capital that frees them from this overhanging problem.

• Angel investors are difficult to find. The networks that look to place accredited investors with entrepreneurial ventures have rarely born much fruit.

• Small stock sales to the public can be ideal since these equity investors are not as interested in the portion of the company they own as the story of where your company can go. Stock buyers are not all the same, however, and the difference between conventional stock purchasers and these affinity buyers is profound. The former seek a relatively quick capital gain in a liquid market and it is unlikely that your company can provide this—and are you ready for the possible headaches? If you need time to infuse funds and grow to reasonable benchmarks, affinity buyers are your answer since these are the ones who choose to understand your company or your industry and usually provide patient money that will stay for several years—an ideal investor without usual stock problems. Don’t discount affinity stock buyers as customers, either, since the average stockholder in a company is often a loyal buyer, while also providing you an enthusiastic and unpaid sales/referral force. An SEC qualified stock elevates the status of your company and gives you worldwide credibility.

• Opportunities to learn and acquire new technologies.

• Access to complementary technological resources and capabilities that are housed in other firms.

• Developing credentials and access to intellectual property, particularly when alliances involve universities or other research centers.

• Access to new markets.

• Minimizing costs by sharing or other access to resources.

Shell Oil developed a technology for applying genetic engineering modeling to data abstraction, and spun off the technology into a new company as Kalido, Inc., with a $15 million investment. Sam Walton offered his idea for a new discount concept to his employer, JC Penney, was told they weren’t interested, and started Wal-Mart. Marconi offered the chance to develop radio to the Italian Government and was also greeted with no’s, only to find eager backers in Great Britain and the United States. Merrill Lynch set up an internal venture capital fund to help entrepreneurs within the brokerage firm’s ranks. Merrill’s emphasis is understandably upon technologies that will support and extend current financial businesses.

Big companies find that corporate insiders are often not the best people to run a new company since too few executives really fit an entrepreneurial mold. They often want a lifeline back to the company if the arrangement doesn’t work out (failure for them is an option, unlike most entrepreneurs).

Thermo Electron and Safeguard Scientific are both companies that have spun out new firms by the dozens, and exemplify the type of company that develops a technology and wants to rapidly put it to commercial use in a new entity, a form of “skunkworks.” Venture Capital firms are funding these kinds of firms, either immediately or following some added seasoning. Xytrans was spun-off from Lockheed Martin and eventually received $8 million in VC funding from SpaceVest. Lockheed and the U.S. Army had jointly invested $200 million in Xytrans’ technology. Xytrans would also have the support of a $40 million Lockheed lab that came when the parent stayed on as a minority owner. Given the amount of investment that a corporation may have already made in a technology and often well-protected intellectual property, the appeal is strong. This becomes doubly so when the core technology team stays together with the new entity and when a group of customers is involved, providing immediate revenues and occasionally, even profits.

Drug-development firm Kalypsys was spun out of the Genomics Institute of the Novartis Research Foundation, and garnered $43 million of venture capital financing. Barrier Therapeutics is an independent company that was begun in a Johnson & Johnson subsidiary, licensed three dermatological products about to enter Phase III trials, and received a $16 million investment from J. P. Morgan Partners. Corporate partnerships and credentials can make it far easier to attract capital.

Corporate venture capital funds have become major sources of funding for new companies that can relate their business models to the needs of large companies. (See Chapter six for a full description of these sources.)