Mastermind (mmind) wrote,

Financing Your Idea

You have a great idea for a new or better product and want to start a company. What do you do next? How much funding will you need? How do you manage the finances once you receive funding? Where do you make cuts when situations beyond your control impact your capital? And the favorite Silicon Valley question - when do you go public? I sat down with brilliant David Eckstein, Senior Finance Director of OpenDNS to talk about the most important topic of finances.

Katya: Silicon Valley seems like a dream. Even the dumbest product idea can get funding; is that true?

David: The short answer is no. A lot of companies will contact me to say: “Hey, can you be an advisor? Can you look at my pitch deck? Can you prepare me to pitch to VCs so that my presentation is persuasive? Am I hitting all the important points?”

But there is a natural filtering process on ideas to understand if they are viable.They’ll test out the product or even the pitch on friends and beta users to see if it sticks, but as you go through those stages, various companies fall off. So when you hear about some of the ideas that are really silly or don’t make sense, those ideas probably get filtered out through the vetting process at various stages.

And then you have your VCs, who are smart about their investments. They probably get contacted by ~20 different companies a day, and their job is to look at those 20 companies and choose maybe 1 to actually meet. By nature of time commitment involved, they’ve developed the ability to pick well, and they wouldn’t stay in business if they picked the wrong companies because they’d get burned more times then they’d actually win. So it creates a survival of the fittest amongst the VCs, and therefore they need to make sure that they’re only funding good companies.

I do think some strange ideas that are a little bit foreign to you or me may receive funding, but there is probably an angle we’re not thinking about. When we read about it in the press, it’s being portrayed in a particular way, but the way that it was communicated to the VC might be very different. They may be talking about a big data play that wasn’t harped on in an interview with TechCrunch, or they may be talking about some partnership that we’re not aware of that’s in the works that creates value for that business. So I don’t think that just any company can get money. I think that occasionally, questionable companies get money, but I happen to believe that the good companies will get funding. And that’s the important thing: as long as the good companies get funding, then it’s creating an economy. It’s creating the next wave of technology.

Katya: And when you say “good company,” what do you mean?

David: The best companies are the ones with real technology. They’re the ones with experts who have industry experience, so they’re not just trying out an idea for the first time. If you or I ever started a toothpaste-making service, we wouldn’t know the first thing about it. But say you’ve worked at Colgate for 10 years. We’d be in a much better position because it’s the industry veterans that can start a company and use their expertise to hop over the first 1 or 2 years of R&D and immediately hit the ground running. They’re able to improve upon things that they noticed were deficiencies while they were working for those companies in the past. So the “good companies” have great industry expertise or hire someone immediately with that industry knowledge to help them.

They have really great insight. They have the technical prowess to build something that’s actually changing. They’re not just putting a different cover on something that already exists, but they’re actually going into the engine and changing something about the engine to make it a better product. That to me is a good company.

Katya: Great. So when it comes to making decisions as a VC or angel investor, what is the ratio between the product and the person who is behind the product? I can imagine that there are situations where the product is so exciting, something like Uber, where you look at it from any angle and say, “This product is amazing; it doesn’t matter who runs the company; it’s going to blow up.” And then there might be situations where the product is exactly the same as something else, but it’s run by someone like Jack Dorsey, and he is just such a bright star, that it has to work.

David: I think it’s a fairly even split between investing in ideas and investing in people. You may have a strong product without a great leader, but you’re not going to have a great company without both.  You need both the product and the person to fuse together to create a great company. It’s essential to always balance those two out because the product doesn’t stay stagnant; it’s always evolving. If you don’t have a good leader around that product, it’s not evolving; it’s not changing with the times. I doubt there’s a single great company that we look at today and say, “That’s an amazing company that started out doing exactly what they’re doing today.” There was definitely an evolution along the way so that they could understand the customer’s needs. That’s where that great person, that great product manager, comes in and reshapes the product to make it even better.

Katya: And let’s say everything is working out and you can get funding. Just because you can, should you?

David: I love that question. To be a bit more specific, let’s say you’re offered twenty million dollars, but you’re only looking to raise ten, should you take the twenty million now?

There is no clear answer because as an entrepreneur, you’re giving up control if you allow investors to invest more. As an easy example: the company is worth, let’s say, a hundred million dollars. You have the ability to take either ten million or twenty million, so you’d be giving away an additional ten percent for taking that money. Here are the things you don’t know: you don’t know what the economy is going to be twelve months or two years from now or whenever you’ll be looking to raise money again. You also don’t know for sure what your growth will be like in the future. Maybe in twelve months from now you’re going to have explosive growth, and then that hundred million valuation that you had originally is more like a billion now. Therefore, if you had taken out a hundred million before it would have been your entire company, but now it’s just ten percent of your company. So valuations change over time, but it can also change in the opposite way.

You could also have a lot of buzz and traction about you today but four months from now, nobody remembers who you are. Think about companies like Secret or Yo. Consequently, you as a CEO or CFO or anyone who is involved in the fundraising process, need to think about and look really deeply at your metrics in order to assess your trajectory. What does it take to get to the next echelon in terms of usability or the number of active daily users or the number of paying customers? You need to figure out if it makes sense to bring that money in now. Will bringing that money in now allow you to unlock new opportunities to the business or new revenue streams because you have the additional money to now fund two go-to-market initiatives instead of one? Because you need to consider a huge list of different things when deciding to bring in additional money, there is no clear answer here.

Katya: So let’s imagine you’ve received the money. Let’s talk a little bit about financial discipline.  Does debt encourage discipline, or is it completely different in the startup world? What’s your next step after you get the money? Let’s say you get ten million dollars. How do you think about it?

David: A person in finance should always exercise financial discipline – putting money to its highest and best use. At all times, you want to have a plan that ensures operational continuity.

I try to avoid running a company on debt proceeds. Debt isn’t free and you have to pay it back. Although it may seem like a large cash inflow at time 0, every period in the future, you are required to pay back a portion of that debt. Although it may not be a significant burden immediately in the future, as your cash flow dwindles multiple years out, a finance person may find themselves with their back against the wall and limited options to refinance.

Katya: For my next question I wanted to talk about speed of development versus finance (but considering what you just said, they should really be connected.) So you figure out what you want to do first, and then you finance appropriately, not the other way around?

David: When you raise money from an investor, you should be presenting them with the 3-year company plan. This should bake in the expected new initiatives. Therefore, having the money simply allows you to execute on the plan that you showed the investor. It would be misleading to show an investor one plan but not actually expect to execute it. When the investors give you money, they are buying into a certain burn rate, product roadmap and speed of development.

Katya: Let’s say you’re in a situation where something outside of your control happens to the funding situation. Where do you cut first? If you as a financier or CFO were to look at all of the things that you were spending money on, how should you act?

David: It’s a very tough decision; it’s never easy to pull back because it has compounding and long-term effects. If you cut back today, it totally shifts the plan three or four years from now because of the compounding nature of salaries, the compounding nature of the R&D, the improvements that can be made, and the additional customers that you may land. It also depends on the business.

So let’s just talk about a SaaS business for a second. SaaS, or Software as a Service, has recurring revenue. As a result, the tendency is to cut back on sales and marketing because you already have that existing user base or customer base paying you on a monthly or annual basis. Therefore, if you cut back and let go of all your sales people you still have revenue coming in. That’s very unlike an Internet or an advertising business because every single sale has to be made in those businesses every time, and nothing is guaranteed one month to the next.

So, yes you may have accounts, but if you’re Twitter, you still have to go out to Samsung and bring in the new contract for them to do a promoted Tweet or Promoted Trend, whereas as with a SaaS business with stickier customers, money is still going to be there the next year. If you’re a SaaS business and Samsung is your customer, they were paying you X in year one, and in year two hopefully they’re paying you slightly more because they have become dependent on your service. It’s a core part of their architecture, their IT, and therefore it’s sticky and recurring.

As a result, in those situations the tendency is usually to cut in sales and marketing, because you don’t need to grow as fast. Therefore, you don’t need additional sales people landing new accounts because you can just rely on your existing sales in order to become profitable or get to a place where you aren’t reliant on outside funds.

Katya: What would you say was the dumbest thing you have seen a company spend money on?

David: I heard rumors of CFOs and financial people putting money into assets that they thought were safe when they were not safe. So without getting into specific companies, there have been situations in which some CFOs may have put money into Bitcoin at the height of the market. That clearly that wasn’t a great investment from where we stand now. You don’t get promoted or a pat on the back for taking the money that’s being pulled in from VCs and putting it into risky assets with the hope of generating a return.

Your job is to put it into the safest, most risk-free asset and generate almost no return. Indeed, the highest and best use of cash should be the company’s activities. The VC made that decision in the past. They said, “I’m going to give you this money,” and they expect you to put it towards growing the business. They don’t expect you to become a financial advisor and start investing that money into various stocks or Bitcoin or different risky assets, because that’s not the business’s intention.

Katya: So let’s say you have the money, you’re spending it well, everything is good. When would you do an IPO?

David: So it’s typically said that a company should look to go public when it’s achieved certain things. All of the internal readiness needs to be there because there are very arduous reporting requirements that must be done so that investors are constantly updated on the health of the business.

First, You need to be ready from a corporate systems and people standpoint. This means that you have to have the reporting mechanisms in place to tell the market the metrics it needs to hear. You also have to have staffed parts of the business appropriately, especially in investor relations team that can perform the IPO. Second, a company in the technology space should look to go public when it hits a certain revenue threshold, which would be determined by the sub-sector and business model of the company. Third, depending on the story you’d want to tell to the market, you should be growing at a certain rate year over year, also dependent on your particular industry and business model.

Becoming a publicly traded company can be a major milestone for a company, but not every company wants to go through with it. Going public means that you are giving up ownership and control of the venture so that investors can own large chunks of the company; but unlike taking venture funding, you can no longer control who those investors are or how long they hold your stock. In addition, it also opens you up to scrutiny in every way. In the initial S-1 filing, you must disclose all of your risk factors, and it becomes an open book on what the company’s health is. You need to be positive that there aren’t any major concerns or issues with your business model or product.

From an investor standpoint, there are certain things one might look for in a company going public. And if they don’t find them, they won’t invest and the IPO will probably go south. For instance, one thing investors always look at is whether one customer makes up more than ten percent of your revenue. So, let’s say you’re dependent on Apple, and they’re the ones who are buying all of your screens. If Apple decides to go to a different distributor, your business is gone. Investors really wouldn’t feel comfortable if one customer makes up a large percentage of your overall sales because of the obvious risk involved. So, there are a bunch of little things that need to be in the right place for investors to buy into it and for you to be ready as a company to go public.

Katya: Do you think for some companies, it’s more of an emotional decision and they go public before they really should?

David: I think that the walk-up to an IPO is a very involved process. You’ll have to get buy-in from your board members and executive team, and you’ll have to hire bankers to actually get the job done. If you’re not in a position to go public, one of these three parties will advise against it. It’s often the case that the bankers are going to stay around the company after the IPO, so I would hope that they are incentivized to provide sound advice in order to create a long-term relationship.

Katya: And one last question. In the next two years, which product do you think is going to blow up that’s in the very early stage now and not yet on the market?

David: One area that’s more of a fascination for me than an area of expertise is the “Do-It-Yourself” home automation. I look at Nest and think, “Nest can be all over the house. There are a lot of different sensors and inputs. There are so many places this company can plug into your home.” You have thermostats and carbon monoxide detectors. Eventually, I imagine they’ll move into home security. You might have vacuum cleaners that are going to have video cameras and sensors on them that will alert you if there are people in the home that shouldn’t be in the home. Or ovens you can start to warm up via phone before you get home. I think the connected home is particularly interesting because there is the potential for a rapid influx of new products and then an eventual consolidation, as Google has sucked up a few of the companies. It’s a very nascent field and I’m excited for a smarter home.
Tags: david eckstein, financing, ipo, money, opendns, risk, vc
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