Over the years we have had an opportunity to examine many small companies - some we have taken on as clients, others we have not, frequently as a result of this due diligence. Either way, we have had a chance to observe a host of companies and are able to draw some conclusions . . . some which may be helpful to you as well.
The biggest surprise is that small (public) companies generally do not fail because they have poor business plans (execution may well be another matter.) If a company had gotten far enough to garner early investor funding, be public, and had a plan that made it more than just an "idea company" then more likely than not it was prospectively a viable going concern.
That greatest football coach Vince Lombardi famously is reported to have said "We never lost a game, we just ran out of time." Lombardi generally knew what he was talking about . . . after all the Super Bowl Trophy is named after him. His sports wisdom stretches rather handily to small company corporate finance.
Capital-raising for development-stage companies is an optimizing equation: Raise too much, a significant portion of the company has been sold too cheaply (dilution). Raise too little and the company will run out of cash before it can really be otherwise tested.
We note that while management may have an excellent game plan it inevitably takes longer to execute than anticipated. Even if the world will beat a path to your door because of your "better mousetrap" it will take some time for the world to learn that you have one (although this can be accelerated if you have a good investor relations/information program). Then, there are all the other time-consuming impediments: corporate bureaucracy (customers’ purchasing agents or whatever), regulatory issues, staffing needs, scaleability issues of your operation, etc. The list can be endless, and certainly contains some unanticipated obstructions. All these real world intrusions may be ultimately surmountable . . . but on their time schedule, not yours.
Inevitably, in their enthusiasm, corporate managers are overly optimistic on quickly hurdling these obstructive issues. Quite simply, they see the beauty of their endeavor (which may be very real, simply not yet appreciated by the rest of the world.) Simultaneously they are very shy about selling equity too cheaply as they "know" it will be much more valuable shortly (We've met few CEOs who thought their share price was going down, or that it was over-valued.) Thus, they frequently do not raise "extra" capital when they can . . . but then when they need to do so the share price is so much lower that essential capital may no longer be obtainable.
Your correspondent attended the BioCEO Investor Conference (biotech industry) and the critical subject of adequate developmental capital . . . "until companies become cash flow positive" was definitely in the air. The session on financing was heavily-subscribed. The tension (desperation?) as to the fate of companies with years and many millions of dollars already invested but with uncertain $ futures was clearly palpable. One panelist noted that aspiring biotech companies each tend to believe they have "The VERY best science!" behind their respective niche endeavors but under-estimate the financial requirements of fruition. With this comment, you could feel the air go out of the room. They each are certain they are on the road to major success . . . until they run into the slog - usually of FDA approvals and it all slows down and costs a ton more of dollars never anticipated . . . . Certainly it takes that enthusiasm to get a company off the ground - in any industry - but the impediments, whatever they are, germain to any particular industry, tend also to be more substantial than anticipated. Here was a room filled with about 200 incredibly bright “C-level” execs all with multiple degrees, many whose name began with “Doctor” and they were largely fearful of their short-sighted capital planning after years of effort.
Smallish - "Microcap" - companies essentially have just one chance for all to fall into place and for them to succeed for another day. Larger - "Smallcap" - likely have reached a sustainability so that a few stumbles can still be overcome. It's all about capital availability - this is the "Oxygen" that let's the embryonic company develop to a self-sustaining stage. In its enthusiasm management's assessment of reality can test objectivity. Thus management needs a sounding board to test clarity. This is where trusted outside counselors earn their keep. The company's investment banker, taking the longer view as to mutual interests, can be particularly helpful. If the company's attorneys or accountants have an understanding of the business issues, they may also be of great assistance here. These individuals may well be part of the board or separate from it. It is important, though, to remember that boards have a political dimension which may preclude full candor so there must be allowance for that possibility. Whatever the source, management needs a good sounding board against which to test its theories and realities as to the execution of its plan.
And, it must move that plan along with a good investor information program to maximize share valuation so that the door to the capital markets is sufficiently open to raise essential funding, make acquisitions and compensate employees. A higher share valuation allows all of these things to be done at lower cost. Thus the business equation for such a program is a very real one. "Is it worth X dollars to enhance market valuation by 10% . . . 20% . . . 30% and simultaneously reduce the cost of capital by the same. This choice is always a difficult one, though, as the precise improvement in share valuation from investor relations expenditures is difficult to evaluate and is competing with other very pressing dollar demands. The longer view, however, is that a small company is competing in the marketplace for investor dollars and at least some other competitors (also worthy, no doubt) are likely not standing still in that competition.
The answer to our title question is that small companies run out of capital - or the ability to raise capital - before they have executed to a self-sustaining level. To paraphrase Lombardi: Management didn't have a losing game plan, but time simply ran out. The moral is that given the risk/reward relationship it is better to raise extra capital when you can, even with some dilution. The alternative can be . . . quite literally . . . capital punishment.
- Robert S. Darbee Rev 1/09
* * *