In a previous post, we looked at financing risk in terms of the “big picture.” The take-home message was the importance of aligning the business and financial models, so as to find the optimal balance between maximizing the business opportunity while also achieving the optimal risk/reward return on capital investment. The exercise should be performed on a recurring basis as the facts on the business and financial grounds change over time.

Read our previous post in full: Managing Financing Risk: The Big Picture.

Today, we’ll look at some of the significant touchpoints for thinking about and managing financing risk.

Opportunity Scale

Most startups are conceived around business opportunities that could encompass a wide range of scale. As it turns out, the foundational issue in coordinating the business and financial models is scale. Finding the right balance of business model scale and financial model scale involves various team, market, technology and financial variables.

Consider for example SCIPco, a startup with valuable IP in the semiconductor space. A foundational business model question for SCIPco is whether to build its own fabrication facility or pursue the “Fabless” model. All sorts of team, technology and market factors impact that question. The critical financial model consideration is, of course, whether SCIPco has access, and if so on what terms, to the much larger capital resources needed to finance the fab-enabled business model.

A less obvious but very real scale variable is location. All other things equal, a startup based in Silicon Valley will have access to more and larger sources and chunks of capital than a startup located in, say, Green Bay, Wisconsin. (A reality often factors in decisions on where a startup locates itself.)

Scale questions implicate the exit strategy as well. Exit timing – in terms of business maturity as well as time itself – has big implications for financial modeling. Creating early, less-aggressive exit opportunities generally means smaller risk capital investment – to maintain a competitive ROI – which in turn implies more conservative growth planning.

Thus, the first business/financial model touchpoint: matching business model aggression with financial model constraints. Just as entrepreneurs are wise to think about their business model in terms of the addressable markets rather than the total market, so they should develop their financial model in terms of accessible capital rather than the total capital market.

Make or Buy Decisions

Even within a given decision on the broader scaling question, startups ought to think about make or buy questions for various business functions. Most startups have an understandable bias in favor of insourcing mission critical functions. So, for example, SCIPco’s IP portfolio will almost certainly be anchored in inhouse people and technical resources. On the other hand, SCIPco’s need for sophisticated CFO services in the early stages will be real, but probably not sufficient to warrant a full-time CFO.

In pretty much every make or buy decision, the mostly clear advantages of making (controlling your own destiny; QA/QC advantages) must be balanced against the cash burn implications of insourcing vs. outsourcing. And not just in terms of total cost, but as or more important in terms of flexibility – the ability to reduce cash burn aggressively if/when the need arises. So, for example, at launch SCIPco probably does not need an experienced “exit ready” CFO on a full-time basis. On the other hand, with a $50 million growth financing round in the works, with plans to go from that to an exit opportunity, the calculus often flips the other way.

Risk Reduction vs. Dilution Management

If you are thinking about raising venture capital, part of your thinking is (well, it should be) that the current round will be the most expensive capital you will ever raise. (If it wasn’t – if you thought some future round would be even more expensive – why would anyone invest in the current round?) That means that it will be the most dilutive capital you plan on raising, in terms of selling off ownership pieces at the lowest price. Which, finally, means that you have a strong incentive to make the current round smaller rather than larger.

On the other hand, if the current round isn’t enough to get you to the milestones needed to justify a higher price at the next round, chances are that the next round (assuming you can close it) will be flat or even down from the current round price. (And, again, if anyone thinking about investing in the current round expects that outcome, why would they consider investing in the current round at all?)

And thus, every capital raise calls for balancing concerns about immediate dilution against establishing a path forward that includes appropriate valuation step-ups. In more prosaic terms, figuring out how much you think it will take to accomplish your round milestones, in capital/time terms, against how much it might actually take.

My own approach to this question is rooted in something VC pioneer Gene Kleiner once told me: “The time to eat the appetizers is when they are being passed around.” For me, that translates to assuming that if your best guess is that it will take $X and time Y to nail your milestones, figure, for financing purposes, that it will take $1.5X and time 1.5Y to actually get them done. If people want to throw more cash at you than that you should re-thinking your business/financial model fundamentals.

Beware the Pier Financing

For a lot of entrepreneurs, the stress of financial management leads to an understandable but unfortunate obsession with cash burn and, more particularly, how that balances against cash reserves and ultimately hitting the proverbial cash wall. That can lead to thinking about capital primarily in terms of how long it will last, and a concomitant tendency to approach new financing rounds in terms of extending the proverbial cash runway. If you find yourself thinking that way, take a deep breath and start re-thinking the business and financial models from the ground up.

Financing risk, like team, market, and technology risk, can take down a startup even if it’s done a great job of planning for it. There is no way to eliminate it, and at some point, the costs of reducing it exceed the benefits. One thing, though, is for sure: ignore it at your own peril.