Letter number 84 of October 2014


News : Four mistakes to be avoided at all costs when financing a start-up

It is extremely difficult to create a company out of nothing and to turn it into a successful business.  Alongside the start-ups that are major success stories (Facebook, Virgin Airline, etc.), how many failures?  A massive number. This is the reason why only 29% of companies created in the United States survive 10 years after their inception and 16% in France.

Source: Entrepreneur Weekly, Small Business Development Center, Bradley Univ, University of Tennessee Research, January 2014.

So, even though the financial aspects of setting up a company are not the most important part of the process, it is important not to get it wrong.

One of the features that is characteristic of entrepreneurs is optimism, which is sometimes pushed to the point where they become unconscious of risk. Another is to focus solely on the project to a point that is extreme.  The combination of these two factors often results in the neglect of the financial aspects of the company, and all the more so since finance is rarely the entrepreneur's favourite subject.  Here are four major financial errors that the entrepreneur should avoid when setting up and developing a start-up.

1/ Believing that a single round of financing will be enough. Investors rarely finance a start-up over several years. At the very most, they’ll finance its requirements for 12-18 months, i.e., the time required to complete the next step, such as the development of a prototype for example.  If the entrepreneur completes this step successfully, the shareholders will agree to finance the next step, either alone or with new investors.  If not, it is most likely that they will stop paying out funds there and then.  And the start-up will die a natural death, which is unfortunately what happens most frequently.  Carrying out several rounds of financing is a way for investors to ensure that the entrepreneur is not being stubborn and sticking with a project that has no future. The entrepreneur is not necessarily the loser because if all of the steps are successfully completed, the company will grow with each step and the entrepreneur will benefit in the form of less dilution of his or her stake in the capital. 

This point is all the more important since raising funds generally takes around six months (between the preparation phase, the approach of investors and implementation). During this period, the entrepreneur is highly mobilised (at least one-third of his or her time), and with a fund-raising every 12-18 months, this will rapidly become one of the main tasks of the budding entrepreneur. But it’s a sign that the adventure continues!

2/Believing that it’s possible to finance a start-up using debt. Using debt makes is possible to reduce the share of equity in the financing of the project, and thus to maximise the share of the capital that the entrepreneur will hold. But budding entrepreneurs should not delude themselves. Banks will not finance a company with negative cash flows, which is the common lot of all start-ups, as it has not demonstrated that it is viable and able to pay back its debt using positive cash flows.  At the very most, an entrepreneur needing to finance equipment for which there is a secondary market (vehicles, freezers, etc.) could find solutions such as leasing, where lenders will minimise their risk by retaining ownership of the assets.  But Internet, biotechnology, telecoms, etc. start-ups, since they do not have this type of asset, should finance themselves using equity capital only.  

This is in any case much better for such fledgling companies, since debt goes hand in hand with regular repayments which do not fit at all well with the uncertainty and flexibility needed for the entrepreneurial adventure.  There are very few entrepreneurs that have not had to change economic models in the start-up phase. Being open to change is in fact a sign of intelligence.

3/ Believing that convertible bonds are a magical cure-all.  The major advantage of convertible bonds is that they can (potentially) issue future equity at a premium of 20 to 50% compared with today’s value of this same equity and so reduce by as much, the potential dilution of the entrepreneur’s share.  But what a mistake this is most of the time! The entrepreneur only sees the conversion and forgets that convertible bonds are repaid in cash if the value of the company has not grown sufficiently.  In this case, we have a catastrophic scenario to the power of two.  The company has not stuck to its business plan, which means that free cash flows are much lower than predicted at the time when it has to pay back, in cash, a debt that normally should have been paid back simply by issuing new shares.  This will lead to certain bankruptcy, or at best, emergency refinancing by new investors which will result in the massive dilution of the entrepreneur.  Time to kiss those dreams goodbye, one by one.

The convertible bond is a good product for companies that are at a stage of development that enables them to generate positive free cash flows, and not for start-ups, which are condemned to spending a few years in the torment zone of negative cash flows[1].

4/ Believing that optimism knows no bounds. Naïve entrepreneurs may believe that a very, very optimistic business plan will ensure the best future positions, i.e. that they will be able to maximise the issue price of new shares subscribed by investors and thus reduce the dilution that they will have to accept when investors take a stake in their capital.  This is true in the short term, but what a risk in the medium to long term.

Without knowing it, more often than not, the entrepreneur has pulled the pin out of a grenade and sat on it. 

Because the business plan is very, very optimistic, it is going to be very, very difficult to achieve.  If, which is most likely to be the case, the company has fallen behind its business plan, it is going to be particularly difficult to convince investors in the second round of financing to pay a higher price for shares than that paid in the first round.  More likely than not, the issue price will be lower. In this case, the ratchet clause[2] which the first investors were careful enough to include in the shareholders’ agreement will then be triggered. The investors from the first round will have the right to subscribe new shares issued at a symbolic price so that, in the end, their average cost price is the same as that paid by the investors in the second round, which will reduce the value of the share and make it necessary to issue more shares so as to raise the same amount in the second round.  This will lead to substantial dilution for the entrepreneur who may then find that he/she only holds a few percentage points of the company.  The entrepreneur’s credibility will have suffered a blow and investors from previous rounds will not be very inclined to participate in future rounds, making it a lot more complicated to raise money.

Optimism? Yes.  An issue price for investors that is higher than that paid by the entrepreneur? Yes. But beware of going overboard. Ideally, the value of the share should rise with each round of financing in order to keep everyone happy and to avoid the ratchet clause being triggered. This pre-supposes moderation in terms of optimism, a lack of heavy-handedness and a bit of luck!

But aren’t these the very qualities that all entrepreneurs should possess in order for the entrepreneurial adventure to be a success?

[1] For more see chapter 40 of the Vernimmen 2014

[2] For more see chapter 40 of the Vernimmen 2014 or n°73 of The Vernimmen.com  Newsletter September 2013


Statistics : Cash & cash equivalents as a % of total asset

Since the early 2000s, the share of cash and cash equivalents on companies’ balance sheets has continued to grow:

Part of this cash is not the result of a choice but of a constraint and it is not really available: Some funds are blocked in countries that have strict foreign exchange control rules, other funds involve the payment of additional taxes (withholding taxes) before they can be transferred to the parent company, and other funds are serving as deposits, guarantees, advance payments, etc. which in some countries have to be blocked in special accounts.

And even if funds are not blocked, advance payments by customers will be used to make the products or services orders and to pay suppliers. Accordingly, they cannot be used to repay debts, especially in sectors where activity fluctuates, like aeronautics for example.

Alongside these restrictions, conscious choices have to be made:

  • firstly for operational reasons: to cover the cash requirements of the different sites (stores, outlets, etc.) or to cover seasonality in working capital;

  • the liquidity crisis in the Autumn of 2008 showed that cash can disappear as quickly as water in sand. A lot of financial directors who spent sleepless nights worrying about their companies cash shortages, have vowed that this will never happen to them again and have set up precautionary cash reserves. It is also clear that the more difficult it is for a firm to tap the financial markets in normal times, the more it will tend to accumulate cash on its balance sheet;

  • paying back debts early by using surplus cash can trigger the payment of dissuasive penalties and it sometimes happens that a debt contracted in the past at a fixed rate, costs less than what the cash can earn, which will not encourage the financial director to use one to pay off the other;

  • Frésard[1] has shown that companies that keep a lot of cash on the asset side of their balance sheet tend, in the following years, to win market share from their “poorer” competitors;

  • having cash on the balance sheet ensures that the firm will always be in a position to seize investment opportunities which may arise unexpectedly;

  • clients can only but be impressed by large amounts of cash, in particular when they are signing up for a long-term relationship with the company (public works, defence, etc.). This is why Alcatel-Lucent keeps around €6.4bn in cash on its balance sheet representing 29% of its assets, so as to reassure third parties of its liquidity, while its debt is rated non-investment grade ;

  • for companies with a lot of R&D or intangible assets (pharmaceutical, technology), having cash on the balance sheet partly counter-balances the fluctuations in cash flow and reduces the risk of investment for the shareholder;

  • investment does not necessarily follow divestment as quickly as it did at Danone, when the sale of the biscuit activity and the acquisition of a baby food activity were announced within eight days of each other! There is also the example of Solvay, which announced the sale of its pharmaceutical business in September 2009, and it was only in the Summer of 2011 that the funds were reinvested in the acquisition of Rhodia;

  • ▪ without forgetting the old trick of the financial director, who always makes sure that there's a nice fat sum of cash on the balance sheet, just to reassure shareholders when they take a glance at it.

As it is unlikely that the world is getting any less volatile than it is today cash on the balance sheet will still be a popular choice for many years to come. However, this should not justify excesses such as keeping large sums on the balance sheet in a permanent way that could be better used in the rest of the economy[2].



[1] For more see n°56 of The Vernimmen.com  Newsletter January 2011

[2] For more see chapter 35 of the Vernimmen 2014

Research : Access to the equity markets: a tool for growth and innovation

With Simon Gueguen – Lecturer-researcher at the University of Paris Dauphine

Over the last 15 years, a lot has been written on the economic effects of financial regulation. A famous article in 1998[1] showed that the degree of investor protection differed enormously across the world, depending on financial legislation.   Subsequent research looked at the economic consequences of this legislation. It appears that the degree of development of financial markets and protection of shareholder rights is a favourable factor for economic growth. The article that we present this month[2] is one of the many articles on this topic. Its specific interest is that it makes a close study of the channel whereby financial regulation impacts on growth: corporate innovation.

The study covers data on 5 361 companies across 32 countries[3] between 1990 and 2007. The general idea is that investments in R&D are not easily financed by debt. Firstly because they are made up of intangible assets which it is difficult to use as collateral in debt agreements and secondly because their earnings profile (high probability of failure but small probability of major success) attracts equity investors more than it does lenders.

Consequently, access to the equity markets and protection of shareholders in a country encourage investments in R&D, and this effect should be especially obvious for companies that are by nature more dependent on external financing (small and young companies). The econometric study shows, for example, that if we measure the difference between:

– the difference between R&D in small companies in a sector that is highly dependent on external financing (industrial instruments) compared with a sector that is not very dependent on external financing (the textile sector) in a country with good access to the equity markets (Netherlands), and,

– this same difference in a country with poor access to the equity markets (South Africa) 

…then the difference between these differences is 2.2%, or around one-third of average R&A spending.  In other words, a regulatory environment that facilitates access to the equity markets for companies, encourages the R&D of companies that most need external financing. The same method yields a lack of effect on investments in fixed assets that can more easily be financed using debt.

Brown et al conclude that it is important for a financial system to facilitate companies’ access to the equity markets and protection of shareholders' rights. This sort of a system encourages innovation on the part of young companies which can bring new products and new technologies to the economy, and finally long-term growth, according to the Schumpeter paradigm.


[1] R. LA PORTA, F. LOPEZ-DE-SILANES, A. SHLEIFER and R. VISHNY (1998), “Law and finance”, Journal of Political Economy, vol. 106, pages 1113 à 1155.

[2] J. R. BROWN, G. MARTINSSON and B.C. PETERSEN (2013), “Law, stock markets, and innovation”, Journal of Finance, vol. 68, n° 4, pages 1517 à 1549.

[3] The largest part of the sample (2 167 companies) is Japanese; The USA is not included in the study.


Q&A : How do we take customer risk into account when choosing an investment?

Generally, annual provisions of x% of sales are made for customers who ultimately do not pay what they owe. In a financial analysis, like in a discounted cash flow, these provisions net of write-backs on provisions that no longer serve a purpose, are deducted from turnover.


In rare cases where a company is considering an investment for which it will only have one customer (energy, mining, PPP, for example), the use of a statistical provision is no longer appropriate, because either the customer will default, or it will pay. An intermediate situation is unlikely.


Accordingly, we think that the required rate of return for this investment project should be adjusted, i.e., its cost of capital, by a risk premium representing, for example, the difference between the cost of debt of this customer and the cost of debt of a company with a normal degree of solvency (rated BBB+). This premium could be reduced if it turns out to be easy to replace a single defaulting customer.