AN APPROACH TO THE DEMOCATIZATION OF VENTURE CAPITAL INVESTING
Hawaii Beverage Guide/ Your Dapper Consulting’s team of Crystal Arnold-Nakano and Brent Nakano have developed the following methodical approach to democratize venture capital for both consumers and businesses; un-like a theoretical approach, the investment strategy was used in the Your Dapper Consulting’s acquisition of Hawaii Beverage Guide where just the intellectual property (IP) assets obtained.
The two sides of the coin to investment are the company accruing investors and the company seeking to invest. Your Dapper Consulting, having worked on both sides, found the core questions in any investment scenario to include the following:
For the company seeking investment:
How do we gain the necessary capital (human and otherwise) to help us grow?
Is the company scalable enough to have investors see a significant return?
For the investor:
How do we maximize our Return on Investment (ROI)?
Do we have sufficient capital to make the investment worthwhile?
The Current Models
What is Invested: Cash
Company Involvement: Little to none
Failure results in: Loss of capital and a learning experience in investment selection
Currently cash is provided to the start-up companies to expand operations in exchange for equity. Investments made in this space can be highly lucrative as seen in firms like Sequoia Capital, Kleiner Perkins, and Andreesen Horowitz. However, in order to make the model profitable, venture capital (VC) investment is limited to only companies (e.g. tech companies) with an extremely high growth potential. And because start-ups fail more often than they succeed, they require a boom-bust/feast-famine business model. This means that even if a company can be potentially profitable and benefit their community, it may not be scalable enough to make VC investment worthwhile for investors.
The above scenario occurs because the VC investing model is a derivative of the passive investing approach taken in traditional private equity investing with a risk model quantitatively adjusted for failure. This is problematic because it allows issues to arise that were solvable under a more active management approach. For example:
Start-ups with great longevity and impact potential are assessed mainly on the team’s ability to deliver a quality product versus their administrative acumen, like tax mitigation strategies or Human Resource practices.
Poor business practices, such as failing to pay taxes in a timely manner, can create unnecessary debt challenges that prohibit future investment or impact growth. As the adage goes: “the devil is in the details.”
If the investment fails, the founders and contractors are able to take the operational knowledge and apply it to the next venture and the investor gains a better understanding of the industry they are investing in. However, given the resource and opportunity cost, is it worth it?
What is invested: Founder education in the form of “seminars”/ “founder training” or essentially express business classes for non-business people and “mentorship” and some cash.
Company Involvement: Mentorship/ Some involvement
Failure results in: Minimal loss of time and cash invested
Venture Accelerator “classes” essentially condense an entire semester's worth of traditional academic work into a few hours, it provides founders that lack experience in the topic some idea of what’s going on, however:
It would be more efficient for a founder to be product focused if comparative advantage is taken into account and then have a consultant take care of the task and potentially have a co-founder assist part-time until a full-time person can be hired for the position.
If a particular founder shows great acumen for the task even though they have little experience and may work on full-time on that that task in the future, the founder can then learn along the way as they work side-by-side with The Consultant in the same way that a Junior accountant would learn from a Senior Partner. This approach is also more helpful than mentorship as it often lacks the day-to-day insight that a daily operational role is able to provide.
Venture accelerators do not provide early problem detection and founders who can be too busy or too experienced to identify or solve problems that can compound to the extent that they become insurmountable to overcome.
Currently, management consultants provide guidance on projects based upon research via Power Points and spreadsheets. These services are typically performed in exchange for cash compensation. However:
Assistance with solution implementation is not always provided and as implementation can be difficult and may go uncompleted, the consultant may be rehired to “solve” the same problem.
The general cash compensation for quality consulting services is cost prohibitive to many emerging companies as they require high level expertise, squeezing out every last dollar of investment. This insight, if provided to a growing company, could have significant cash resources in the future from which The Consultant to benefit from. In the current cash only compensation model, this results in long term money and opportunities being left on the table by many management consulting firms.
Your Dapper Consulting’s Hybrid Venture Capital and Consulting Model
Through investing in and operating three start-ups, and analysis of the mechanisms of VC investing, Your Dapper Consulting has developed an investment contracting methodology. It maximizes value for both the firm that is being invested in and the investor by merging and modifying VC and management consulting models. Ultimately, this will democratize both VC investing to those who can invest skill (instead of cash) into a company, and to the companies that are able to receive VC investment, including those in underserved communities.
Model Summary: What is Invested: Consulting services (labor and expertise) and cash (if needed) Consulting services include taking care of tasks that would typically be hired out to a specialized firm (PR, bookkeeping, graphics design etc) and a founder can potentially assist part-time until a full-time person can be hired for the position. Then, if a particular founder shows great acumen for the task (despite having little experience) and can commit to working full-time on that task, the founder can gain invaluable experience through working side-by-side with the consultant in the same way that a junior accountant would learn from a senior partner. This approach is also more helpful than a mentorship which often lacks the day-to-day insight that a daily operational role is able to provide.
Compensation: Cash + Secured (collateralized) debt / alternative compensation with a convertible [debt turned into equity] option.
Cash + Debt = Fair Market Value
Cash is only what can be afforded by the investee.
Debt may be converted into equity under agreed upon parameters.
Collateralization or alternative compensation may be in the form of real property (physical items) or intellectual property.
Learn more in the "Details" segment of this article.
Company Involvement: Part of daily or at least weekly operations
Failure Results in: Acquiring the key assets of the company that was invested in and acquiring more insight into running the company thereby maximizing the assets obtained. However, the assets are only as valuable as the consultant deems them to be useful and is capable of implementing them into another project. Company Involvement: Part of daily or at least weekly operations
Hedging Strategies Your Dapper Consulting’s model also uses hedging strategies to maximize the investment (should the client fail) by:
Protecting against potential fiscal or legal issues through the use of an alternative compensation model, keeping corporate entities separate while allowing for ownership of the assets that define the company.
Enhancing the investor’s learning experience by giving them a role in operations. As we know, information and education are valuable. Many of the best lessons are learned through immersive experiences as patterns that appear while doing the work may not otherwise be absorbed through pure observation.
Amendments to the compensation model are made easier and more precise by using the contract's pre-existing framework.
For Profit Company
Non-Profit Investment Entities
For a Profit Generating Company The for-profit investment space can benefit those not currently involved in venture investing. Example scenarios include:
Consultants who can take on the low-cash scenario and who are interested in the learning opportunity. (e.g. younger consultants can perform these “investment tasks” after their day job.) Cash compensation is ideally the minimum of what it takes to “live” off of, or can be used to supplement the income from the consulting company.
An established consulting firm that has the ability to leverage its current income to hire consultants for a project in an attempt to diversify its revenue stream. This function parallels Google’s former "20% time" rule for working on personal projects.
A hui (group) of professional firms or individuals that can create an investment firm which can provide the necessary resources for a start-up. (e.g. a collaboration between an accounting firm, a graphics design firm, and a PR firm.)
This strategy can create major social changes through the development of a non-profit entity that invests into places considered “prohibitive” due to a high likelihood of failure. An example firm set-up and approach could look like the following: The Investment Approach The Investment:
Consulting services are provided and can be coupled with a venture accelerator-type program and any necessary cash.
The consulting services rendered to the non-profit entity would be recorded to internalize the service. This includes volunteer hours provided.
Cash compensation should be similar to hiring a full time employee at a pay rate normal to the community (possibly minimum wage.) Once funds are available to fulfill specialized roles the consultant may be replaced.
If equity conversion occurs, a payout in profits to the consultant would only occur if a certain threshold is met. A buy-out clause may also be useful. Any profits gained by the equity position are then reinvested into similar companies and used to cover operating expenses.
In a high-failure situation, the ownership of assets should the client fold, are protected by the secured debt clause (Section 7.3) which, combined with the learning opportunity created by working as a consultant, allow for the concept to be pivoted rather than rebuilt from scratch.
Paid management consultant(s) who lead investment strategy and handle operations like in a traditional management consulting service.
General public volunteers who can assist with the manual labor and repetitive tasks of running a business like basic clerical work.
Founders of prospective companies who want to learn how to build a business via helping someone else run their business
Specialized volunteers or firms who can contribute a specialized skill-set.
Start-up Capital The amount of cash needed can be minimized because:
Senior consultants can be retired volunteers.
Junior consultants can be paid respectably because their cash compensation can be split between two entities. (e.g. A $60,000 salary can be split so that the non-profit investment entity raises $30,000 while the other $30,000 is generated by the 50-80 hour/week worth of services provided in an operational role.)
The following is a section by section discussion, similar to IRS Tax instructions, of the rationale used in the corresponding section of the sample contract. We recommend first reading the below paragraph about Services (Section 2.0) then reading the corresponding Section 2.0 in the Sample Contract featured in this article. It, nor the sample contract, should be used as legal advice. Please seek the assistance of a licensed attorney when implementing any legal contract.
*THIS SAMPLE AGREEMENT IS NOT LEGAL ADVICE **FOR ILLUSTRATION PURPOSES ONLY
Section 1.0 Background: General Summary to contextualizes the agreement
Services (Section 2.0): Investing Labor and Expertise
“The consultant” with a diverse skill set works in a short-term operations capacity as a project manager to fill in gaps in the business, thereby investing time in lieu of cash. This approach to investing is similar to “sweat equity” but with a more sophisticated compensation structure. The following are examples of general services that can be provided in lieu of hiring typical independent contractors:
Fiscal consulting (in lieu of bookkeepers or accountants): Accounting and finance perspective
Brand consulting (in lieu of PR and graphics design firms): Market analysis, visual design, external communications consulting, including PR, social media, website development and copywriting.
From an economic perspective, as cash is essentially an IOU with a specific unit of measure which can be exchanged for other goods and services that are also measured in similar units, this process skips over the cash exchange portion of the transaction. By skipping the cash portion of the investment process, this democratizes investment for those who possess valuable skills, but lack the time to generate a substantial amount of cash to invest upfront.
Hiring a full-time member of the team is difficult because a person with the diverse skill-set required is typically cost prohibitive to a start-up lacking significant financial backing.
Hiring part-time employees with advanced skill-sets on a start-up budget is difficult because such people are often employed full-time as third-party contractors for specialty service firms, like accounting or marketing firms.
Hiring a third-party independent contractor can be a gamble or can take longer and cost more than necessary. For example:
A company hires a graphics designer to design a basic print/social media ad composed of pre-existing brand assets, including the logo and product images. Instead, the consultant can create the ad as it only requires arranging existing assets in Adobe Photoshop or Adobe Illustrator.
A non-retail company that sells products hires a web-designer to build a generic website using pre-existing or stock-photos. Instead, the consultant can help the client design the website in Squarespace or Weebly using a template, create a general color palette and vision board for the website, write any additional copies required to avoid overlap with pre-existing brand materials, and use the budget on a professional photographer to create brand-specific photos in the specific style define.
By working in a daily operations capacity, the consultant can observe project development and can quickly identify and solve problems instead of relying on potentially in-experienced managers of the start-up to identify any of the problems first.
Section 3.0: Specifies the duration of the agreement.
Section 4.0: Specifies what performance means.
Section 5.0: Specifies currency to make sure dollars are paid in United States Dollars and not Canadian Dollars
Compensation (Section 6.0)
Cash Compensation (Section 6.1) Cash compensation, provided only to the extent of what the business can afford, provides multiple benefits including:
Cash compensation makes The Client put “skin in the game” rather than just receiving “free” help.
Cash compensation may provide time availability. This can come in the form of a younger consultant who needs minimal cash to survive, but can invest time.
The benefit to the company being invested in is that they don’t have to pay health insurance and other benefits as it would be covered by The Consultant.
Debt Compensation (Section 6.2)
This clause is the key to democratizing VC investing, as no cash is needed yet the value of the service is treated as if it was rendered at market value rather than only being what the client can afford.
Debt compensation is used as an accounting methodology to track fair market value of the services rendered. This allows the consultant to be fairly compensated for their work at market rates.
Debt Payment Options (Section 7.0):
This section uses debt as an accounting methodology to keep track of the time investment; however, as cash and equity are unreliable compensation methodologies for start-ups, the use of secured debt (with the option of equity conversion) allows for compensation regardless of the scenario.
It should be noted that:
If the repayment of debts is completed through the transfer of assets, the value of the real and IP provided to the consultant by the client should be transacted at or above “fair market value” in order to protect against Chapter 11 U.S. Bankruptcy law, which has a one year claw-back. However, fair market value or even overpayment should be a non-issue as the property should be more valuable to the consultant than to a third-party. Also, an alternative means of compensation is highly unlikely, being that the consultant is using theoretical cash. It should be noted that this transaction is a taxable event. The specific taxes paid vary based upon state and county laws. A Certified Public Accountant or another tax professional should be consulted.
A sale and lease back of tangible property can be used as a way to own intellectual property and other key assets, make money from that property, and hedge against bankruptcy without taking on the liability of the company. The terms of a sale and lease-back can be highly variable and should be reviewed with an attorney who can provide recommendation as to how risk can be hedged against bankruptcy in a particular scenario.
The following outlines the approach to covering all compensation scenarios:
Payment by Cash (Section 7.1) Cash payment is always an option. It is fair to the consultant because it shall be paid at fair market rates.
Payment by Equity (Section 7.2): Convertible Debt Equity conversion is an ideal compensation scenario because it allows for all cash to be reinvested back into the business for growth, which will hopefully result in a larger payout for both parties down the road. In the contract, the key elements to Section 7.2 are:
The investment model assigns a cash value of the services rendered by using the typical market rates as an accounting mechanism, and then uses corporate valuation to determine the equity split (Section 7.2.1). This contrasts the “sweat equity” scenario where equity splits are typically assigned in a semi-arbitrary and somewhat emotional manner.
A multiplier on the cash amount owed to calculate equity percentage can help to incentivize this scenario. (Section 7.2.2)
The conditions that trigger the debt conversion to equity or at least make it permissible shall be included in 7.2.3. This section is especially important to protect the consultant from incurring excessive debt or other issues that shall be listed in Section 22.214.171.124.
Payment by Real Property and IntellectualProperty (Sections 7.3): Secured Debt As an equity position for the consultant may be prohibitive due to a potentially dire financial or legal situation by the client, alternative compensation of the real and IP is provided. This creates a partnership/equity-like situation as both parties own the company’s assets while remaining separate entities. This scenario is feasible as a compensation method because the consultant, as an active manager instead of a traditional cash-investor, knows how to use the assets to make money. This is analogous to how a pro F1 driver can make significantly more money off a F1 race car than an average person with an F1 race car.
Additional Consultant Benefits include:
More immediate compensation than the typical secured debt scenario, which typically requires the collapse of the client or other compensation mechanisms to materialize before receiving compensation.
Being able to receive any “profits” to the company, which can be paid as a fee for the usage of the IP or tangible property. (e.g. the consultant can own naming rights and those naming rights can be leased back for a fee as structured in Section 7.7.)
The Client Benefits from
No changes or disruption in business operations or workflow
The continued services of the consultant.
The optional Section 7.7, which provides Joint Usage of Intellectual Property clause, and mutual ownership of crucial IP or property that cannot be replaced.
Sections 8-12 are generic form contracting items that are worded differently from contract to contract but have similar meanings.