Experts discuss an IT consulting company's decision to raise venture capital to be used as working capital and to support an aggressive marketing campaign.
The Money Hunt
Midrealms LLC, in Makati City, Philippines, and Boulder, Colo.; founded in October 1999
Full-scale information-technology consulting for companies with operations in the Philippines; offshore custom-software development for U.S. companies
About $100,000 in revenues in 2000; not yet profitable
The company's initial capitalization was $300,000. Most of it was a gift from the father of one of the three founding partners
To raise $570,000 in venture capital, to be used as working capital for 12 months as well as to support an aggressive marketing campaign to attract customers
CEO Ted Kieffer describes a challenge that all too many fledgling entrepreneurs can relate to. "My problem is this: I'm going to run out of money before the company starts turning a profit," he says.
"It basically comes down to two mistakes," he adds. "I didn't reserve cash for marketing in the United States, and I didn't take into account the considerable delay that takes place between starting a project and being able to invoice clients."
Kieffer had founded Midrealms with two high school buddies who, like him, had been educated in the Philippines and were management-consultant veterans. As a young company Midrealms had a strong business concept but a burn rate that threatened its long-term survival. "We wanted to take advantage of the high-quality, low-cost technically savvy labor market in the Philippines," says Kieffer. "We felt that we had an irresistible competitive edge, since we could offer our services at $30 an hour, compared with the $125 to $150 an hour charged by other consultants." The three partners scaled up quickly, hiring nearly 30 employees and creating a monthly operating budget of $20,000. Unfortunately, they failed to fully appreciate the marketing challenges.
Kieffer's efforts to raise additional outside capital have, so far, been unsuccessful. "My first mistake was going to banks. That was incredibly depressing," he recalls, "because they didn't want to touch a business whose assets were mainly intangibles." He approached a handful of venture capitalists as well, but, as he puts it, "their sense was that we weren't at the right stage or we weren't the right kind of company." By late December he was near to closing an $85,000 home-equity loan, with his father's assistance. "That should buy us a little time, but we've obviously got to work on a longer-term solution," he concludes.
Vice-president of Cap Gemini Ernst & Young and founder and director of its new Center for Enterprise Creation, based in New York City
"I'm confused about this company's business model. Is it a full-scale management-consulting service, or an outsourcing technical provider along the lines of what's already well established in India and Pakistan? If it's mainly the latter, then this business has got a problem, because its $30 hourly rates aren't substantially lower than what's being charged by established, industrial-strength companies in those countries and elsewhere, where there's a lower risk because those companies have been around awhile.
"So if we're looking at a business whose costs really aren't low enough to give it a competitive edge and whose business model isn't significantly differentiated in the market, then it's got to make some changes. In the short run it should significantly reduce its staff and rely on independents and outside contractors, which will cut monthly operating costs and extend its life.
"If the business model changes, then the company doesn't need $570,000 to continue operating. It might just need $57,000. And I'd suggest that the founders try to raise the money for expansion from one of three sources: companies in the same industry that are looking to expand into the Philippine market with little risk; "invest-omers," which is our name for major customers who might benefit from helping this company grow and sharing in its increased value; and users, which really just means generating so much new business that they'll be able to internally finance their own growth."
President of Tunstall Consulting Inc., a Tampa-based financing intermediary
"This company's business model has been proven in other overseas markets. But it doesn't have any significant ability to attract customers, because it's small and really can't warranty anything, since its operations are so new and uncertain. That's a big problem.
"If I were the partners, I'd stop everything else they're trying to do to raise capital and instead go to the companies that are already following this model in India and elsewhere. Say to them, 'We're where you were eight years ago.' Those companies may be grappling with higher labor costs that have resulted from all the demand and competition for the labor pool in India and elsewhere. So this business can say, 'Make a strategic investment in our company, and you can then off-load some of your projects at a low cost to us in the Philippines.' That approach would accomplish a lot. It would bring in projects and help improve the cash-flow situation. It would also help this company achieve credibility, which it doesn't yet have."
Founder and co-CEO of AngelSociety, a New York City-based company that produces a magazine and runs forums and an Internet service for early-stage investors
"It sounds as if they can't get on the radar screen for venture capitalists. So the money with a greater risk profile, which might be available to them, would come from angels. Angels have a preference for investing regionally or locally, which gives them a comfort level, since they can kick the tires and keep an eye on things. I'd say that wealthy members of the Philippine community are the company's likeliest source of capital. The next best bet would be angels located in the Colorado area. To find likely investors, they've got to talk to everyone -- make use of every single personal and business contact they have.
"This company hasn't yet been able to get the confidence of an external investor, and that's going to be a red flag to anyone considering an investment."
"The truth is, this company hasn't yet been able to get the confidence of an external investor, and that's going to be a red flag to anyone considering an investment. Realistically, they should plan on raising their capital in several rounds, rather than all at once. Also, a bridge structure for the first round with a preferred feature that allows the investor to convert into the next round at a discount may be helpful. This might sound like a strategy of death by paper cuts, but what I'd suggest is that they first try to raise $100,000 from the outside, which might be more manageable. And then once they've accomplished that and have achieved some results, they can try again."
Jill Andresky Fraser is Inc. 's finance editor.
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