The less-known entrepreneur

Sigo evaluando planes de negocio…

En esta ocasión quiero hacer algunas recomendaciones sobre “el financiamiento”.

A pesar de que he trabajado mucho con empresarios y emprendedores, todavía me sorprende el grado de desconocimiento que hay en el mercado sobre las fuentes de financiamiento.  En particular dado que no hay una falta de oficiales de crédito en las zonas urbanas (de donde provienen la mayoría de los planes que he evaluado en el transcurso de los años).

El error más común va algo así: “…nuestro plan requiere $X, de los cuales 20% serán aporte de los socios y el saldo crédito bancario…”; mejor aún “…estamos dispuestos a aceptar nuevos socios, pero preferimos un crédito bancario…”.

Creo que, a fondo, existe una pobre concepción del negocio de la banca – que existe para otorgar créditos. En el mejor de los casos, eso es solo la mitad del negocio.

La verdad es que el primer proceso que cuida una institución financiera es la seguridad del capital de sus depositantes – los acuerdos de Basilea II enfatizan aún más el tema, por lo que podemos esperar que los órganos normativos presten aún más atención al tema. Como ahorrista, la única razón por la que yo le confío al banco los estudios de mis hijos, su salud, nuestra estabilidad financiera familiar, etc., es porque sé que hay gente muy atenta a esta confianza. Cada vez que se propone “aflojar” el crédito bancario, se está proponiendo “aflojar” la seguridad de mis depósitos…

Bueno, entonces no nos debería sorprender que los bancos no prestan a empresas recién constituidas, ni a empresas que operan a pérdida o que no tienen claramente definida su fuente de repago de un crédito. Tampoco es extraño que pidan garantías reales, ¿no es cierto? Una visita de 15 minutos a la sucursal más cercana de cualquier institución serviría para confirmar estos hechos y dotar a nuestros planes de negocio un mejor vínculo con la realidad y, por ende, una mayor posibilidad para alcanzar el éxito.

Para dejar algunos temas más claros:

• El banco nunca va a prestar más del 50% de la necesidad financiera (si tan solo por el tema de la cobertura hipotecaria) .
• El banco no presta a empresas recién constituidas. Puede otorgar un préstamo personal si la persona que lo solicita tiene las garantía y fuentes de repago suficientes, mejor si es un “buen” cliente (lleva varios años trabajando con el banco).

Por lo tanto, para ser emprendedor, recomiendo iniciar una relación con el banco lo antes posible y empezar a formular el historial crediticio idóneo, manteniendo una conversación abierta y de largo plazo con el oficial asignado – la comunicación es de doble vía.

Most people, even micro finance experts, consider that the micro finance industry is dedicated to providing financial access to the bottom of the pyramid (BOP) through credit or lending technologies similar to bank loans.

In my mind, nothing could be further from the truth: I consider most of the work done by micro finance institutions to be more related to equity investing than anything else.

This is a topic that could be covered in a series of books based on a lot of real interesting research that hasn’t yet been carried out, but let me try to do it some justice.

Time frame: the GAAP periods in traditional businesses (month, quarter, semester, year) work well because a company’s cash ebbs and flows in tune with these time frames; thus, the calendar (which permeates our lives) is more or less synchronized with our expectations of the business cycle we’re examining. We expect that whatever management does, it’ll take a month or a quarter to show up as net income. It is reasonable for us to wait two or three years to see an investment develop meaningful returns. Banks usually lend in year terms.

This is not the case with BOP entrepreneurs, who can easily have four or five different businesses in a calendar year, some of which will survive from year to year, perhaps due to seasonality, while others will rise and fall as a business opportunity presents itself, is capitalized, and liquidated as a normal course of business, in scant weeks or months!

Repayment: many people who are not familiar with micro finance are surprised to find out that a micro finance portfolio has a natural tendency to perpetually grow, even if its MFI stops acquiring new clients (ceteris paribus). I still can see the face of an investor who exclaimed in surprise after he finally got it: “…but that’s an evergreen scheme!” Yes it is.

This is due to the fact that micro entrepreneurs never pay the principal back; sure, they make periodic payments (some call them capital amortization and interest, I call them dividends) weekly or monthly, but, at the end of each “loan” cycle (as little as weeks and as long as months), most of them are looking to get the principal back and then some.

This is one of the methods used to ensure that they pay the MFI its cut: they borrow say $50 for 16 weeks, pay it back with the promise that they will be able, if they prove their worthiness, to borrow say $60 immediately after (or the same $50 for longer). More like a new round of financing with a capital gains payout (indulge me).

The only exception to this arises from a liquidity event or a liquidation, both of which happen surprisingly frequently in the BOP.

Guarantees: most MFIs have figured out how to work with “social guarantees”. These aren’t real or tangible assets, or if they are, not very useful in recuperating much of the amount in default, but rather anchors in the entrepreneur’s psyche that formalize his or her commitment to abide by the terms of the disbursement. More of a “my word is my bond” kind of thing – very similar to the “informality” mostly seen in angel investing and definitely far from the boilerplate contracting that is the norm in credit operations.

Concluding, a BOP entrepreneur starts and finishes business opportunities in the matter of months, can cover “debt” service from the turnover of her entire business, and takes micro finance on little more than her word. Thus, MFIs behave more like traditional equity players than like loan givers because they cover the entire lifespan of the enterprise, get paid from real or virtual liquidation of the business, are involved in additional rounds of financing, do not base the bulk of their risk management on legal contracts, but rather on relationship management, and defaults are largely written off (after some due effort building and maintaining default disincentives).

Some corollaries (another post):

• Eradicating informality in the BOP would require extensive rewrites of most codes of commerce and the institutionalization of incredibly agile bureaucracies (an oxymoron?).
• Banks can’t do micro finance.
• Successful BOP entrepreneurs (serial micro entrepreneurs), by the very nature of their success, will have trouble growing beyond the BOP – they’re more like arbitrageurs than business managers.
• “Do you have any financial statements?” is a silly question.

I know many investors in alternative markets who insist on including a put option in their investment agreement. Though I understand the motivation, I always caution the negotiating parties about options because of their unintended consequences.

During the negotiations, the entrepreneur is so caught up in the soon-to-arrive disbursement (another post) that the point-blank question “Do you understand what a put option is?” fails to elicit an honest answer and simply causes the person answering the question to respond in a way the will keep the momentum going towards disbursement.

After the proceeds have been spent in accordance with the investment memorandum and subsequent contracts (sure they have! another post), then controversies arise and the stakeholders begin to examine the legal documents more meticulously. That’s when the real questions about terms begin.

“What’s a put option?” asks the entrepreneur fully 18 months after disbursement – the investment officer usually answers “Remember, we talked about this before we signed; it means that we have the right, but not the obligation, to sell you our shares a this valuation once the option has vested – I explained it several times.” The look of utter astonishment on the face of the entrepreneur as she realizes that she has signed a post-dated check to the tune of several million dollars quickly changes to denial, then anger – acceptance may never come. Trust has been undermined.

Once in a while you’ll find an entrepreneur who understands options. In order to accept the put, she insists on a call option – it’s only fair, if you’re mitigating your exit risk by obligating her to buy your shares in the future at some valuation set now, potentially forcing her to buy shares at a “premium”, she’s going to keep the upside by obligating you to sell your shares at a maximum price set now, potentially at a “discount”. Thus, if the company survives but doesn’t become a star, the investor gets his money back and something for his trouble, potentially at a price-per-share above its market price. On the other hand, if the company does skyrocket, the entrepreneur can buy her company back at a price-per-share that may be lower than fair market value (the investor still makes money, mind you, but not as much as he would have without the call). That’s the way it’s supposed to work, in theory anyway.

The problem with options arises when the investor tries to exercise his right to sell – it has been several years since they negotiated and signed the agreement, and the very fact that the put is being exercised means that the company has not done as well as planned. This usually means that there have been disagreements among the shareholders (on who has made poor management decisions, on why the company has missed its targets – you get the idea), which means that there is some degree of enmity between the writer of the put (the entrepreneur) and its holder (the investor). Furthermore, as the entrepreneur is most likely illiquid (investor normally insist that their portfolio entrepreneurs have some “skin in the game”, which normally means, most of her worldly possessions), the put becomes contentious. At best we face a situation where the entrepreneur wants to buy our shares, but can’t, and at worst we face an entrepreneur that not only can’t, but won’t comply with the option. So how do you enforce a put in this condition?

Keep in mind that most of the “alternative” markets work under civil law, wherein the letter of the law is enforced and contracts are limited to repeating what has been legislated – not at all like what our “northern” brethren experience, common law, where the system supports the stipulations of the contract – read more about legal systems. Imagine, then, what happens to a put option clause when “options” have not been included in the local Code of Commerce. Surely, in the face of this void, the legal system will recognize the spirit and intent of the contract and do the reasonable thing?

I know that in more advanced jurisdictions, jurists undergo many years of academic and practical training, and that public service is a laudable professional pursuit. Unfortunately, that is not always true in markets off the beaten path. Because the public sector normally pays so poorly, those lawyers who can, go into private practice, leaving “the rest” to pursue their careers as judges and prosecutors. For sure, there are some great people in the public sector, but more often than not, their knowledge of the law and jurisprudence is tenuous, the motivation is questionable, and their intellect challenged. A ruling, in many cases, boils down to “arguments” not necessarily related to law…

On the other hand, if the investment goes very well and the entrepreneur exercises her call, it is in the best interest of the investor to comply.

Thus, put options don’t really protect investors from the downside, could limit their upside, may undermine the investor-entrepreneur relationship, and will introduce unwanted legal risk into the investment contract.

Please see the rules.

[13 Nov 2008: I get a lot of traffic to this post on the "do put options work?" search string.  I'm curious: are you getting what you're looking for?  Leave me a comment, maybe I can improve it.]

Traditionally, exits are powered by, in order of descending profitability for the investor, an Initial Public Offering (IPO), takeover (sometimes also know as trade sale or acquisition), and buyout.

The key distinction I make between the takeover and the buyout is “who” buys: in a takeover, the buyer is a third party (company or investor), while in the buyout, the buyers are “insiders” (founders, managers, shareholders).

I make this analytical distinction because both “takeovers” and “buyouts” can be leveraged with other people’s money (OPM), to include investment bankers and VCs, and can include elements of management restructuring or workout and management buy-in; thus traditional terminology surrounding the sale of shares is not helpful for the following discussion.

Once you wander off the beaten path, the possibility of doing an IPO are as close to nil as you’re going to get. This is mainly because most “alternative” stock markets are poorly capitalized and deal mainly in fixed-income instruments. I’m not even going to deal with listing foreign companies in the more dynamic exchanges – the chances of pulling it off successfully are so remote, that it doesn’t bear any more attention.

Buyouts are the least profitable because the founders are virtually broke. That’s because, if they had any money at all, they wouldn’t have sought risk capital in the first place (another post). During the life of the investment, we usually encourage dividend discipline and high plowback ratios, especially if the company has grown along our mythical hockey stick projections. So it’s no surprise that by exit time, the founders are no better off financially speaking than they were at the beginning (though their wellbeing may have increased). Thus, buyouts happen at very low valuations, if only because the “buyers” don’t have any cash to pay what their company is worth. Even the constitutional put option that our “northern” brethren include in their boilerplate investment contracts doesn’t improve our situation (in fact, it could end up adding risk – see Do put options really work?).

The consequence of this is that our “exit risk” is concentrated in a takeover – that a larger company (or “bigger fool” if we’re not careful to do value investing) finds our company interesting. From the investors side, we need to make sure to have an impregnable drag along clause and a powerful social network in which we have built significant levels of social capital. From the company side, we need to have either developed proprietary technology or a sizable client portfolio (or both) to become an attractive acquisition target.

The good news in all this is that we can have both strategic and financial clarity from the beginning:

• Strategy: as investors we need to develop a large social network and our companies need to focus on either new technology or market share (or both). We also need to keep in mind that we’re producing value for our clients or users (day-to-day), but concurrently also building value for our buyer (one-time).
• Finance: valuation moves away from a strictly DCF approach because our buyer will normally value the synergies in the deal a lot more than the future cash flows. This is particularly good because we can avoid the prickly problem of the discount rate (another post).

Of course, the bad news is that our exit risk is so high, that the expected rate of return (our discount rate) is way out of hand – particularly if we haven’t paid attention to the strategic implications outlined previously.

The definition of Type I statistical error from wikipedia:

Type I error, also known as an “error of the first kind”, an α error, or a “false positive”: the error of rejecting a null hypothesis when it is actually true. In other words, this is the error of accepting an alternative hypothesis (the real hypothesis of interest) when the results can be attributed to chance. Plainly speaking, it occurs when we are observing a difference when in truth there is none (or more specifically – no statistically significant difference).

A false positive normally means that a test claims something to be positive, when that is not the case. For example, a test saying a woman is pregnant when she is actually not pregnant is an example of a false positive.

In risk capital, I like to define Type I errors as those where an investor rejects what would have been a good investment because he can’t tell that it’s different than a bad one. I call it a Type I error because the prevailing mindset in investing is “this is a bad investment”. Thus, a false positive (the conclusion that my hypothesis is right when, in fact, it isn’t) occurs when I discard a plan as bad when it is good.

If you’re an investor and want to argue that the primary hypothesis in your culture is “this is a good investment”, don’t fret, just add another “I” to “Type I” errors when you read this post (and the opposite when you see Type II). That is, this article would be about your firm committing Type II errors…

This is not entirely the investors’ fault, as entrepreneurs contribute to the situation: the great ones sometimes don’t make it clear that they are, in fact, the “next Google”, while the not-so-great ones (another post) do their best to look like the great ones.

But if we set that fact aside for a moment, and concentrate on the investor, why does my great plan to conquer the world receive the tepid “let me think about it” instead of the “here’s $20mm at whatever valuation you like” that it deserves?

If we go back to the original use of the term, in the field of statistics, we’ll find that researchers look to eliminate either Type I or Type II – notice the “either / or” proposition. In applied statistics, we can eliminate Type I errors and allow Type II, or vice versa, but not both. In order to eliminate both, our information system must be at least as complex as the universe it studies and cover all the individuals (become a census) . In the real world, the expense of a census is prohibitive, thus, we need to allow for one or the other kind of errors.

Back to investing.

Because investors have finite resources (mainly time, but also money, arguably) and are looking for capital appreciation and returns, they should have a system that doesn’t allow Type II errors (the false negative or the bad investment that looked good) . The cost of this is the existence of Type I errors (the good investment that looked bad). Right?

Wrong. A search through the literature clearly demonstrates that few (if any) investors approach anywhere near a zero Type II error – failure rates for risk capital are normally greater than 50% (that is, the investors are committing Type II errors more than half the time). In fact, most will freely admit that their game is a numbers one – out of 10 investments, 1 or 2 support the entire portfolio.

So, given that we’re really bad at eliminating the Type II errors from our screening systems, shouldn’t we pay closer attention to eliminating the Type I errors? In other words, given that we invest in failures most of the time, shouldn’t we make sure that the good investments get funded?

I freely recognize the enormous simplifications in my argument. It’s similar to the simplification set forth in most of my classes in mechanics (infinitely rigid, frictionless, flat surface) and economics (ceteris paribus). At the very least, there’s room enough to invite an expert on control theory or process control into the fray.

And it sure would be fun/profitable to be the investor who figures this one out…

So there are less entrepreneurs per capita off the beaten path.

You may have noticed that I’m ignoring the multitudinous crowds of micro entrepreneurs, but you’d be making a mistake. Micro Finance Institutions (collectively know as MFIs in “the literature”) are, in my tiny world, the VCs of this sector – see MFIs are equity investors. Suffice it to say that the big bulge of people involved in less-than-formal economic activity has its own institutional investors who generate some pretty handsome returns. I’m not ignoring them; they are already being serviced (or soon to be serviced) by a financial system that actually works.

Ok, so there are less high growth/exceptional return entrepreneurs per capita off the beaten path.

As we know, angel and VC funding is a numbers game – you know that you’re going to take a huge number of losses, transaction wise (anywhere from 60 to 90% failure rates are normal), but that the financial returns of your relatively few successes more than make up for it.

If the entrepreneurial failure rate is lower, the surviving entrepreneurs are proven, and there are many less entrepreneurs to screen through, shouldn’t investing in “alternative” markets be enormously attractive?

Hmm. If we believe in “perfect information“, then we also have to come to the conclusion that we’ve missed something along the way. Why is “investing” in these alternative markets relegated to development and humanitarian efforts? (Who mainly do more harm in the long term that the accumulated good results they achieve in the short term – another post). With the gargantuan capital overhangs of the world capital markets, one would think that the “alternative market” asset class could have the potential of achieving stability much like the risk capital asset class has (whereby, despite recent poor performance, their funding is still on the rise – links).

Of course, the title of this post foreshadowed my next move: poor investor.

• Fear and ignorance: “I saw that National Geographic special on the Amazon / I just watched a tear gas confrontation on CNN / The stuff I got from Amnesty Int’l didn’t show any economic activity – there’s no way I’m going there!”. Disseminating images of a normal daily life doesn’t get viewers or charity donors, but it also doesn’t portray the full picture. Just what image of your country would I form if I only saw the poor, the wretched and the confrontational (I always get a kick out of folk who think that the US is one big ghetto – “why would anyone want to live there?”) .

• Abundance: “we’re doing so well here in Boston (feel free to substitute your favorite economic hub), that we don’t have a need to go anywhere else.” Most investors are overwhelmed by mountains of business plans that claim to be the “next Google” that they don’t really need to cast about to build an overflowing deal pipeline – in fact, they normally have to build a series of filters/crutches to help them deal with the proposals and a “this plan is a bad deal until proven otherwise” mentality (this leads to allowing Type I investing errors).

• Specialization: most funds are sector specialists (biotech, internet, etc.). Given that each geography has relatively few entrepreneurs, in order to keep this specialization, these funds would have to span multiple countries (read: extremely high costs, e.g. due diligence).

• Security: “we know the rules here, we’ve identified and isolated the business risks.” Throw in different laws, jurisprudence, financial systems, languages, cultural norms, and social networks, and it becomes a wonder that there are even some brave souls who travel for leisure, much less to invest.

These barriers get encapsulated so well into investor culture, that even new research is pointed at how to justify not going, rather than to really find out if there are any opportunities (very “unappreciative”, in the Appreciative Inquiry sense). And as we know, when we set out to find reasons to do (or not do, in this case) something, we usually find them.

But I’m not saying that investors are wrong (nor do I think that they are entirely right). What we’re seeing is the confluence (or lack thereof) of the entrepreneur, the investor, and the market.

To be continued…

This is the first of several posts on the reasons why the “beaten path” misses so many places and concentrates in the well-known geographical markets:

• Poor entrepreneur
• Poor investor
• Poor market

Being my first post, I think some ground rules (or caveats) are in order:

1. My experience is limited to the American continent. Though I imagine that much of what I have to say may apply to most “southern” markets in Africa and Asia, and, that from time to time I may use data from those markets to make a point and/or imply that what I have to say extends to those markets, my experience is bounded by the New World.

2. Generalizations help analysts reach useful conclusions. Of course there are exceptions to any simplification (it wouldn’t be that if there weren’t). I mean no slight or disrespect, nor undue glorification to anyone. Readers of this blog are adults with intelligence and an ability to take the good and discard the rest.

3. Disclaimer: it wasn’t me, I didn’t mean it, I wasn’t there. If you can prove the contrary, dock my pay. Furthermore, I am not a lawyer and have no legal training – when I write about legal matters, I do so from my limited exposure and my personal experience. If you do something because I told you to and it turns out badly, tough (but if it turns out well, send me my cut).

4. I can change my mind and edit my posts – get your own blog if you don’t like it.

5. Because this is a space where I can vent or procrastinate, I’m leaving a series of “notes to self” on future topics – that way I don’t have to struggle with writer’s block when I have something more important that I should be working on.

6. I’m biligual.  Though most of the time I will write in English, once in a while, especially when I think that non-English readers may benefit from my effort, I will write in Spanish.  This is not to be interpreted as a slight on either language or you.

I’ll add more of those as I come up with them.

Ok, on to what I have to say.

What do we mean when we say “mainstream markets”?

When we talk about the financial food chain (to simplify: angel, VC, PE, banking, stock exchange) , it is a foregone conclusion that the “real” money is in the US (see rule #1 – I know that there are financial centers outside the US in Europe and Asia; so do you), though some can be found around the major economic hubs throughout Latin America, the real deal belongs to “los gringos”. They’re better organized, informed, protected, and, principally, funded. But is that all?

No. They’re also collocated with major user/consumer markets AND major centers of entrepreneurial activity.

Hence the road map – if you’re looking for solid growth and returns, you need great entrepreneurs, fantastic investors, and hungry markets. Take even one of those away and you’ll struggle.

Next up, the Poor entrepreneur…