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Using loyal customers as a source of funding for product development.

Loyal customers may be a source of funding for product development

Marshall Rafal, founder of OLI Systems Inc., in Florham Park, N.J., wanted to finance a new product. If all goes well, Rafal's exploitation of his company's strong market position into research-and-development capital will spawn a company 20 times as large as OLI. He raised the funds by going to the people who know OLI best and have the most (after OLI) to gain -- his customers.

A consortium of four customers (DuPont, Davy Energy & Environmental, a large chemical company, and a major petroleum company) will supply roughly $500,000 in return for a special deal on the resulting product. The balance -- about a half-million dollars -- will come from a marketing agreement with a large computer company, a venture capitalist, or, if all else fails, Rafal's personal resources.

Not many companies could ask their customers to finance research and development. In fact, in cases in which OLI writes computer software that simulates the behavior of water-based chemistry, customers consider the software top secret. A customer usually wouldn't want OLI's other customers to own, or even know about, its competitive tools.

But his company's new project, says Rafal, precludes the problem of competition. He proposes to develop software to help his customers treat waste from chemical, oil, and other processes. The environmental issue is uniquely unifying. "They're all in this together," says Rafal. "If some little chemical company screws up and there are fatalities, then every chemical company in the world will suffer."

For Rafal, a big benefit of customer financing is that he can tap into customers' expertise. In fact, he's counting on that to both develop his software and test it. "This is a complex program," he explains. "If you sell the first five [software] licenses and those companies become your first test sites, you can run into problems with customer relationships [should something go wrong]."

Rafal didn't intend to rely on customers for capital a couple of years ago, when he first noticed that more of his business was coming from companies with environmental concerns. Sensing an opportunity, Rafal began visiting industrial sites, with a long list of questions to assess manufacturers' interest. After interviewing 18 manufacturers, he knew there was demand for an environmental-simulation program and what some of its features should be. Without any extra funding, OLI began development work on an environmental data bank and a component of the simulator in late 1988.

Eighteen months later, Rafal felt he was on the threshold of an intensive product-development period. Almost on a whim, he decided to make a short presentation on his new venture, the environmental simulation program (ESP), at OLI's annual user-group meeting last October. He was surprised that several clients approached him after the meeting and expressed interest in the product. Rafal quickly decided he should try to channel that enthusiasm into a customer consortium. He followed up with a solicitation letter and business proposal to 18 companies, some of which he had interviewed during his earlier market research.

This is the deal Rafal suggested: in exchange for a commitment to invest $150,000, consortium members would get a perpetual, nonexclusive license for ESP. That meant they could use as many copies of the software in as many places as they wanted. Also, Rafal promised members that they could participate in a steering committee that would guide the development and content of the ESP package. That met OLI's needs, of course, but it also appealed to a company's interest in having its specific pollutant problems addressed by the new software.

Finally, Rafal offered to repay consortium members out of his revenue stream. That made the deal infinitely more attractive than it would have been had the investment been treated as an equity infusion. A loan is simply easier to get a large company to approve than a stock purchase. Rafal protected himself from cash-flow duress by designing an unusual repayment schedule: ESP would put 20% of all licensing revenues, once they began to flow, into a royalty pool. Twice a year the money would be paid out on a pro rata basis to consortium members until they had received 125% of their investment.

The repayment feature creates tax advantages, too. If Rafal had not offered to repay consortium members, the R&D funds would have been treated as license fee income. Naturally, that income would be taxable. Treated as a loan, however, those funds don't appear on the income statement, so OLI doesn't pay taxes on them. When Rafal repays the loan, the interest will be tax deductible. If, for some reason, revenues from ESP never materialize, OLI doesn't have to repay the loan. At that point, the company would have to log the funds as income, but since it will have already incurred expenses in researching and developing the product, that income would likely be entirely sheltered from taxes.

Why would Rafal's customers make a loan even though they might not be paid back? Primarily because if they didn't, the product might not come into existence. Second, the $150,000 investment is far cheaper than paying to use ESP later -- an outsider the size of Du Pont would probably have to pay about $225,000 per year. The involvement in developing the product is an additional selling point. "By participating in the project as a consortium member, Du Pont has direct input and guidance in the technical content," says Noel C. Scrivner, of Du Pont's engineering servicing division.

Raising money this way isn't cheap. For one thing, you're giving up potential revenues from consortium members. Then there's the significant pre-development cost that OLI incurred. ESP has already eaten up about $400,000 in development costs during the past 18 months.

But Rafal figures there's little downside to consortium capital. If ESP doesn't sell, the company won't have to pay back the consortium members. What's more, even as a dud in the marketplace, ESP will be a big help to OLI. Rafal's company will be able to undertake environmental contract work, sell one of the important components of the ESP system, and use ESP to strengthen the market for its existing software. That's a win-win situation.


What's in it for the customer

The strength of Marshall Rafal's proposal lay in a shrewd assessment of his customer's growing need for a special product. Still, Rafel's proposal had to be attractive, too. In return for loans of about $500,000 from consortium members, here's the offer he made:

* No charge. Consortium members may use as many copies of ESP software as they want, forever, at no additional cost.

* S pecial attention. Members get to participate in a steering committee that will guide product development. They can be sure their particular interests will be addressed in the product's final form.

* Money back. If ESP sells, consortium members will get their capital back, plus 25% simple interest.

Last updated: Jul 1, 1990

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