Senior managers of start-ups or young companies ask me a series of questions consistently that I always find challenging: What should be growth or ROI for my company? When should I approach a VC fund?
My first question I address to them, what is the long term strategy for your company – an IPO? Or a long term relationship to be handed down to family? There are a couple of answers that I feel cover all those scenarios – what will be your cost of capital? And can you maintain a positive Economic Value Added during the course of your operations?
What is EVA or Economic Value Added? EVA positive means that your ROI exceeds your cost of capital. That is another way of saying, whatever the demand or cost of your capital source, whether it comes from a bank, Family or friends, Private Equity, or Venture Capital, you must make sure that your growth exceeds that capital cost. This tenet can be turned around and restated that if you are going to seek capital from a VC fund, you must make sure that your business model calculations show a growth pattern over the life of the investment that satisfy the cost of capital demanded by the VC fund. In other words, if a VC seeks an annual return of 30%, you cannot present a business selling umbrellas that only grows incrementally less than 30%, or the business will implode and will be EVA negative.
The implications are enormous when you consider this analysis. A CEO of a California company wanted to get access to VC funds. However, his original business plan only indicated a modest annual growth of only 10% annually. So I commented that the plan as it stood was not feasible. But I also said not to despair. By tweeking the original plan, understanding the competitive landscape, setting in new tactics, we can push the upside potential of the company.
In New York, I worked for a telecom startup whose CEO was a serial entrepreneur. What was interesting was that his enterprises he always participated in were the trends at the time: one company researched the cure for AIDS, another was a local real estate development in Manhattan. Telecommunications was going through a transformation and, lo and behold, he started a telecommunications company. Each business was seeking capital in what was a double digit growth market. And, of course, this meant that investors would be entering the “next best thing.” In other words, the company was tailored to fit that trend.
So, a company with a plan that originally saw smaller growth can be transformed into one that can jump into a marketable profile that would attract the cost of capital required from a VC fund. It does require some research and analysis. Mind you that many major publically traded companies have specific departments that focus on identifying markets that are aligned with the company but also represents substantial growth. During my summer MBA program, I myself became involved in analyzing products, paring the least profitable, and identifying strategic trends for the Board of Directors of the Stamford, publically traded company. A similar analytical process can be applied even to young companies as well.
In fact, that is what I did – I sat down with the CEO, went over the projected financials, looked at tactics that would generate the right growth to attract VC funds. What happened that we redesigned the 5 year strategy into one that would grow sufficiently to attract VC funding. I’ve seen this also in the leveraged buyout world when the buyout company acquires a moribund business like a water hose manufacturer and transforms it to a fast growth fiber optic conduit hoses manufacturer, the second largest in the U.S. Even startups can undergo the same transformation – but it must be guided by the cost of capital, and, hence, the long term growth to maintain positive EVA.