Making startup finance more efficient #3 - separate owners from managers
Not all startups are hard to value and sell. Take a startup 7-11 or Subway, for example. In fact, there are entrepreneurs that start new franchises of that sort and sell immediately upon opening, having done a lot of the hard work of establishing the business and making a profit in the sale.
The difference between a startup technology company and a startup 7-11 is that almost anyone can operate a 7-11. As most VCs can attest, it is not that easy to replace the management team at a young technology company.
One interesting trend in finance has been the rise of Whole Business Securitization. Securitization refers to the practice of a company selling an asset to a 3rd party (usually a shell LLC created specifically for this purpose) which then borrows from a bank based on the value of the asset in order to get the cash to pay the original company (originator) for the asset. This bit of financial engineering works because the bank is attracted to the asset unencumbered by the decisions and liabilities of the company and provides debt financing at a very low rate.
In a whole business securitization, the originator sells the majority of their assets to the 3rd party LLC. In reality, the majority of “whole business” securitizations have been done on restaurant franchise companies, including Domino’s Pizza and Dunkin Donuts. The banks find lending against the security of the franchise agreements and brand quite appealing, especially when they are legally removed from the encumberances of the original company through the magic of securitization. Here, as in the case of the 7-11, significant value is unlocked by separating the owner from manager of the asset. The original company (like Domino’s) is paid by the special-purpose company that holds the assets according to a contract called the servicing agreement. If something went wrong with the original company (like bankruptcy or incompetence), the banks that lent capital to the special purpose company could appoint a new servicer.
Maybe there are assets within an internet startup that could be monetized by somebody outside the context of that startup. The two that come most readily to mind are domain names and traffic. Say there is a hot new site that has achieved some initial success (say 1M visitors / month). What is the revenue potential? Say a modest assumption of $5 / cpm, 10 views / visitor / month, that is $720K / revenue / year assuming very poor and generic monetization (viagra and dating site ads).
Assuming the above scenario if I were a lender I would be willing to lend $1M to the company through the following scenario. The company would sell the website to a special purpose entity for $1M. I would lend the SPE $1m which it would then use to pay the company. The SPE would sign a servicing agreement with the company that pays the company all revenues over a certain amount (maybe $200K - this is the principal payment) beginning in a certain year (say year 3) and over $0K (company gets everything) from years 0-2. In exchange for the revenues the company would maintain and grow the website. I would charge the SPE interest, in the first several years the interest could be added to the principal so that the company wouldn’t be drained of cash. My investment would be very safe because if something went terribly wrong I could put the loans to the SPE into default and appoint another servicer to maintain and update the site.
This isn’t a lot of money, but I built a pretty significant margin of error into the calculation and digital companies need less and less money.
I’m not sure that it would work exactly like this, but its an idea, and it has worked in other industries.
