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Understanding Risk-oriented Capital

Enter the ‘Valley of Death’ with Courage and Confidence

So you’ve decided to build a new business tied to a large growth opportunity that you want to exploit. You’ve spent some of your own money and time (sweat equity), you’ve convinced family and friends to support you, and now you’re getting ready to raise money from people who aren’t related to or friends with you.

Presumably you’ve gotten comfortable with the risky, uncertain nature of your new venture. One assumes that the excitement of doing your own thing — coupled with the ever-present awareness that it all rests on you to keep it alive — is something with which you have become comfortable. Now you’re getting ready to get on the train that will lead you to growth and a profitable value realization event (exit) or to something shy of that.

In either case, you’re planning to grow quickly and need to convince others to pry loose some investment capital to support your plans.

Contrary to the intuition that suggests that serving a fast growth market will deliver positive cash flow (from all those sales), the reality is that young businesses — even those with strong early sales — need to invest ahead of revenue, early and often. These businesses use funding to hire staff needed to develop, market, and sell the product at hand.

Capital will also be needed to invest in office space, business services, equipment and — subject to the product being developed — prototypes and manufacturing capacity.

Unfortunately, most banks aren’t all that interested in this stage of your development. So, even with early revenue, you may need to pursue risk-oriented capital to support your capital requirements.

Venture-capital investors are comfortable with this notion of losses, at least for a defined period, meaning one to three years at a company’s startup, generally speaking. Investors recognize that this is the nature of early-stage, fast-growth startups — investing ahead of the sales curve is part of the process. While investors would naturally prefer to fund companies that throw off lots of cash, it’s a rare startup that fits that profile.

In contrast to the risk investor, you might not be quite so comfortable with planned, sustained losses. Likely, your optimism tells you that you’ll be profitable after a single year of revenue, but frankly, it doesn’t happen much — at least not with fast-growth startups. On one hand, it likely feels wrong for you to lose money — burn cash — at all. Most of us were raised to be conservative in that way. On the other hand, you need to invest money to make money.

In presentations we give throughout the New England region, we describe the “valley of death” (see graphic at left), reflecting the cash-negative period that a product-development-oriented company goes through to get to a position of positive cash. The term reflects the statistical reality that many companies never live to see the day that they get to a cash-positive reality — i.e. they ‘die’ — close their doors, sell prematurely, etc. — before they realize that exalted state of self-sufficiency.

Against that rather grave outlook, you could take the position that you’ll only invest as much money as you have available after paying your expenses. This may work in slow-growth markets but is problematic in fast-growth markets. Why? Well, you can bet that if you see a fast-growth market opportunity, others will see it as well. Those others might have more resources than you or may be more comfortable taking outside capital to support that cash burn than you do.

So, while the conservative approach may keep you solvent — for now — wait too long, and you’ll see your market opportunity disappear as others who have a greater appetite for risk, losses, and taking on investment partners more aggressively capture market share at your expense.

So, live bold, be brave, and enter the valley of death (or don’t) with courage and confidence. If you don’t make it out of the valley, you’ll have had an unforgettable experience and will be more experienced — if slightly poorer — for it. If you do make it out, you’ll have done something that will set you apart from couch potatoes and the more conservative among us.v

Michael Gurau is managing general partner with Clear Venture Partners, a Portland, Maine-based venture-capital fund-in-formation; [email protected]

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