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innovation in financing

The Arrogance of Entrepreneurs
By Al Berrios

"Cockamamie!" That's what the bank said... But we'll show 'em.

(Wordcount: 1,413; Pages: 3) “You are wrong!”, rebutted a factor (a firm that lends companies money based on their accounts receivables.)  “[To think that the business seeking money has more leverage than the lender is just arrogant!]”  Little did I know that my statement in defense of entrepreneur rights was to strike such a nerve.  No less than 4 professionals (the factor, a bank officer, a business coach, and a “business development” consultant) teamed up to insist that my statement to the panel was ludicrous beyond belief; questioned what I did for a living, prepared to crush my business expectations had it been anything but management consultant or a name-brand firm; that it was nothing short of questioning the existence of God, where I was a heretic deserving disembowelment.

The event I attended on Thursday, Oct 25, 2007 was hosted by M2 Power’s Ester Horowitz, a respected consultant and instructor to entrepreneurs.  She arranged for a panel to discuss “Raising Capital” by professionals: Business Broker Rand Brenner, bank vice president Sal Costa of Sterling Bank, lawyer Irv Brum of Ruskin Moscou, and Lou Piccolo, a management consultant.  During the panel, at least two dozen ways to raise money were presented. 

At the end, here’s what I said, or a loose paraphrase: “I think it’s worth noting that there is too much emphasis placed on the entrepreneur catering to the funder, when in fact the entrepreneur is the client.  If that’s not enough reason to address the entrepreneur with respect, consider then that they’re also the ones with the business idea.  With so many options to raise money, and so few good ideas (a ratio my research has pegged at roughly 6:1), it’s important to note that the entrepreneur brings as much leverage to the negotiating table as the funder.

“And while on the topic, on what basis does a funder effectively evaluate things like management skill, character, and passion of an entrepreneur and his business idea?  With all due respect to the funding community, whether you or any of your 40,000+ colleagues (1) in the NYC area have actually had any experience starting and managing a business doesn’t actually mean you’ve analyzed every decision you’ve made (within your individual context) to be able to conclude an entrepreneur who does not make those same decisions isn’t worth a risk. 

“Furthermore, based on conversations I’ve had with over 400+ finance professionals and 150+ entrepreneurs last year, that other than recollections of experiences, funding professionals rarely analyze the loans or investments they make, nor track the success of their ‘clients’ scientifically enough to evaluate the next entrepreneur effectively.  Frankly, I don't think enough funders are qualified enough to make any assessment on the likely success of an entrepreneur’s business model and I challenge the community to deny a loan or investment to an entrepreneur on anything other than ‘gut’ instinct.”

I may have gotten off easier had I just insulted mothers.

After tempers cooled (and the factor left), I requested clarification of their views.  The thinking among the funding community appears to be that every Tom, Dick, and Harry has an idea for a business (typically, the same ideas.)  Thus, the primary criteria they utilize on which to lend are things like credit scores and background (not to mention, “skin in the game” or collateral).  Licensing requirements, commissions and quotas, and any number of legal requirements aside, a big reason for this sort of vetting is because the funders themselves aren’t the ones who write the checks. 

Most, in fact, function as a middleman, collecting fees for introducing the real deep pockets – banks – to the entrepreneur.  (Alternatively, they may write the checks, but then repackage as collateralized debt bundles to sell in the open market to very large institutional investors, thereby removing risk from their portfolios).  And their challenge is that since the banks will never meet “their clients”, they’ve got to present standardized information that can quickly and objectively be compared against thousands of loans and investment requests.  (Worth mentioning is that discrimination laws have further forced banks to separate the job of accepting requests and reviewing them, so that there’s no hint of redlining or any other sort of discriminatory practices that bank can be taken to court over.) 

Troubling as it may be for a middleman to think they’ve got all the advantage between them and an entrepreneur, even more troubling is that they seem absolutely oblivious to the disintermediation the internet has done to them.  In other words, completely taking into consideration their perspective that they do more than merely offer commodity products like loans and investment-for-equity, there’s nothing to prevent an entrepreneur from bypassing you altogether by going to deep pockets directly, or government agencies, or non-profits that fund social causes, business partners or vendors, or any number of alternative forms of funding.

But most importantly, what the internet does is reduce the cost of finding a funder willing to negotiate with the entrepreneur on terms the entrepreneur wants.  In other words, up until recently, the #1 and 2 competitive advantages of funders were: the ignorance of entrepreneurs with regards to the variety and creativity of funding a venture; and the subsequent cost of an entrepreneur finding his ideal funders.  These are advantages only because all funders offer the same things at the same costs (more on this in a second).

So, if the cost of educating an entrepreneur and raising capital were reduced, funders would lose their competitive advantages (but not their fee negotiating leverage, since presumably, the ideal match can request what they want since they’re not competing with another ideal match.)

But fees are irrelevant anyway: funders also seem oblivious to the fact that an entrepreneur would gladly pay for creative funding, not the cheapest funding.  (Like a tax lawyer who pays an accountant to do his taxes since he’s looking for advice, not a tax filer.)  Thus, the primary differentiators that allows a funder to charge premium fees for their funding are:

a) creativity in funding a venture (what mix of funding sources and in what amounts, time periods, tax advantages, and costs are the best);

b) the speed with which they can deliver their funding (the faster, the better for an entrepreneur; but thanks to the myth that the funder has the advantage and the time value of money, the longer the funder takes to deliver the funds, the better for that funder, a potential reason why a once-promising idea may fail);

c) the size of the funding the funder is able to deliver, whether surgically small or strategically big.

Ultimately, what I concluded was that funders are foolishly neglecting that their competitors aren’t other factors, bankers, etc, but in fact, all of the sources of funding available to the entrepreneur.  Upon realizing this, one could speculate that the market for their products and services may actually be much bigger than they believe it to be.  It’s this inability to see this larger market for their products and services that also prevents the funding community from re-categorizing the business ideas they review as anything other than “sexy” vs. run-of-the-mill.

More over, if a money center bank can innovate and automate the vetting process so a typical loan officer, business officer, or other investment professional takes less than a minute to ferret out businesses with the most profit potential for the bank with the least possible risk, much of the funding establishment would be put out of business, with their inefficient and obsolete, yet ridiculously expensive and also arrogant, business model.

It’s this lack of innovation in the evaluation process that has up until now made the concept of financial supermarkets unworkable.  Although there’s no difference for a local grocer who gets his funding from the local branch or an investment banker, the difference exists internally because an investment banker supposedly isn’t an investment banker unless he deals with clients who require loans in the hundreds of millions or billions of dollars, never mind that the transaction is virtually the same.  In addition, the tax laws exploitable on any loan to any business work the same regardless of the size of the loan. 

In other words, the lending community’s class-order perception of itself has prevented it from innovating and wrecked it’s own business potential to make more money from essentially the same service: financing business ideas.  And unforgivably, they’ve worked (and continue to work) diligently to maintain entrepreneurs ignorant of their options and their true costs of raising capital. 

Footnotes

(1) Census.gov

Al Berrios is Managing Director of al berrios & co., a strategy innovation consultancy advising organizations on succeeding in a service and information economy. Write or Subscribe to Consumer Strategies Report.