Investing in Technology Startups

Tough times make it hard for Vancouver technology startups still burning through cash.

How does this sound? I want to start a business. It will not make a dollar of revenue for 24 months. It won’t be profitable for four years, at least. It has no assets whatsoever. In fact, the only asset it will have four years from now is a highly subjective thing called intellectual property. Here’s the good news: once I am up and running and my innovative product has caught on in the market, other larger competitors will buy me out with a stupidly huge valuation. Oh, one more thing. We will definitely need to raise more money after your money runs out.

Are you in?

If investing in a technology startup sounds risky enough in the best of times, imagine how scary it was in the 1970s. Software, biotech and semiconductor companies were being formed that confounded traditional investors. Banks couldn’t get a grip on ­companies without assets and would not lend to them. Traditional equity investors made bets on larger companies that could be leveraged with debt. Once a few successes occurred (Microsoft Corp., Compaq, Apple Inc.), an industry to fund these technology companies emerged. Individual angels invested very early, and the venture capital funds (a more risky form of equity investor) came in after them. The boom and bust of the technology cycles made barons and paupers of these investors.

After the crash of 1987, a similar period to the one we are in now, technology companies faced dire prospects of getting funded. What if MacDonald, Dettwiler and Associates Ltd., Crystal Services (later Crystal Decisions), Distinctive Software (now Electronic Arts Inc.) and many others had not survived? We would not have as vibrant a technology sector.

Currently, things are the worst they have been for technology companies trying to raise early-stage capital, far worse than the late 1980s or the “tech wreck” of 2002-03. If we want a vibrant technology sector in the years to come, how will the struggling young companies find cash and survive? The angel investors are very quiet, and the venture capital funds are struggling because they don’t see any clear “exits” (they make their money when technology companies are bought or go public).

How did the survivors of the previous economic downturns make it through tough times? Some turned to the cheapest and best source of capital: a customer. Having them pay ahead of delivering the product or service is a tremendous way to fund operations. It is common practice today in the software sector to be paid months before actual delivery of the product. Simply sell your software as a service on yearly contracts.

Video game companies have thrived by asking for an advance against royalties in the development of their multimillion-dollar projects. This means getting paid against a future cash stream, and it obviously involves a discount.

As Bob Park, CEO of FinancialCAD Corp. tells it, most early-stage technology companies are afraid to ask their first few customers for money prior to delivery, thinking that customers will see it as a sign of weakness and walk away. He says that in FinCAD’s early struggles back in the ’90s, customer financing was always on the table. Other local success stories involve some early creativity with their customers. Fincentric Corp., sold to Open Solutions Inc. in 2007, had to go to its first customer, Richmond Savings, in 1991 and ask it to pay Fincentric’s payroll during a ­crucial cash crunch early in the company’s development. Just imagine how tough a conversation that would be.

Tough economic times are making it very hard for the technology company that’s still burning cash. Reducing that burn will help find money, but the best shot at surviving this meltdown is to get very creative. The future of our industry depends on it.