Show Me The Money:
The Cash-Burn Rate is More Important Than Ever

Is Your Venture Capitalist-Financed Customer Able to Pay for the Credit Sale?
By Cathy Markowitz, Director of Credit Newport Corporation and
Scott Blakeley, Blakeley & Blakeley LLP Fall 01

Venture capitalist (VC) financed businesses, often referred to as dot-coms, have provided new avenues for manufacturers and distribu-tors to bring the product to market and make sales. Identifying the potential transformation in the distri-bution chain to scores of industries, VC's poured $100 billion into startup dot-com companies last year. The hallmark of the VC investment in a dot-com is to invest at the dot-com's startup, perhaps put an additional round or two of financing, and cash out through an IPO or when the dot-com is sold.

VC's never expected profits immediately from their dot-com investments. However, the VC's are restless with the continued downturn with their dot-com investments. Many dot-coms have burned through operating cash reserves, face losses and fierce competition, and tightened investment requirements from venture capital firms, resulting in a failure to pay vendors.

For the vendor selling to the dot-com, the capital structure is not like a "bricks-and-mortar" enterprise that relies on bank financing or internal financing to operate. Banks and asset-based lenders generally do not offer financing to the dot-com because of its limited operating history and lack of tangible assets to secure the financing. However, when a dot-com's funding disappears, the dot-com often desperately searches for a buyer of the business. The insolvent dot-com either shuts its door, finds a buyer or takes cash at any price. Vendors go unpaid. Tired of companies burning through cash, bondholders have recently sued to halt use of cash and liquidate assets to pay creditors.

What Assets?
The value of most dot-coms is intellectual property, such as customer lists, licensed technology and engineering teams. In analyzing whether to sell the dot-com on credit, the credit professional must use different credit criteria. Excess cash burn rate is often the benchmark to determine whether the dot-com has assets available to pay for the credit sale. However, given the shakeout of dot-coms, a credit professional can no longer look to the VC to provide an additional round of financing to pay the vendor. Indeed, VC's view the current dot-com investment market as a "down round". This year VC's are expected to invest half what was invested last year. This means it is harder than ever for dot-coms to obtain additional financing, and perhaps harder to pay the vendor.

With the source of future capital stalled, more dot-coms are running out of cash and faced with either shutting their doors, finding a buyer, or securing cash from a VC at an extraordinary price. What does this mean to the credit professional?

No Assets Available For Vendors With Liquidating Dot-Com

A number of initially well-funded dot-coms have closed their doors, and auditors for several well-known dot-coms have issued warnings that the dot-com's survival is in "substantial doubt." Liquidation is a growth industry for the dot-com, and a dot-com's liquidation yields little for vendors. Indeed, a dot-com's market value bears little in a liquidation. E-Toys had a market value of $10 billion and its tangible assets have yielded cents on the dollar in the Chapter 11 liquidation. Creditors are owed over $285 million. Pets.com had a market value of $300 million. In an out-of-court liquidation, Pets.com assets yielded $6 million. Northpoint Communications had a market value of $5.6 billion, and was sold for $135 million. Webvan is a recent dot-com failure. With over $1 billion invested in venture capital money, Webvan recently filed Chapter 11 to liquidate its assets. Prior to its bankruptcy filing, Rhythms, an Internet provider, was spending $1.9 million a day greater than its revenue.

While a bricks-and-mortar company may have tangible assets that will allow it to reorganize should it run into financial difficulty, dot-coms do not fare well. The dot-com that cannot obtain an additional round of financing simply disappears. While a bricks-and-mortar company may find a buyer for its assets, a dot-com usually does not have such an opportunity. Dot-com assets are liquidated at 30% of invoice in best case.

Show Me The Money: Analyzing Cash-Burn Rate

A dot-com usually does not generate profits or have meaningful tangible assets, and traditional credit scoring may not be an accurate measure of risk of non-payment with a credit sale. With a publicly traded dot-com, the stock market may be a method for measuring its financial strength and ability to repay a credit sale. Given the VC's reluctance to provide additional financing to a dot-com, the credit professional must analyze the excess cash burn rate more closely than ever. The cash burn rate is determined by the amount by which a dot-com's expenses exceed its cash flow. Start-up dot-com's usually raise a year's worth of cash to operate at a time. The adage "cash is king" seems especially true for dot-coms, given their lack of alternatives to finance operations. To determine how long cash may last, and the prospects for payment on a credit sale, the credit professional may divide the dot-com's burn rate by the amount of cash it has. If the dot-com is publicly traded, the credit professional may look to the quarterly burn rate. A high burn rate will result in the dot-com unable to finance operations and repay vendors.

How does the credit professional obtain the financial information for a burn-rate analysis?

Cathy Markowitz is the Director of Credit for Newport Corporation, a global supplier of high precision components, instruments, (continued from page 1) (continued on page 10) micropositioning and measurement products and systems to the fiber optic communications, computer periphereals, semiconductor equipment and scientific research markets.

Recently Newport began finding customer startup companies strapped for cash, and forced to wait months for a second round of VC funding. Newport found VC funding dramatically changed in a year. In addition to funding delays, customers are receiving much less VC funding than projected and the funding is being dispersed incrementally based on milestone accomplishments. In response to these factors and to prevent losses, Newport has made modifications to its customer startup VC matrix:

LEVEL 1 (Up to $250,000)

a) Confirmation of VC investment directly with the investor
b) Bank reference where VC funding is maintained

LEVEL 2 (Over $250,000)

a) Same as above
b) Same as above
c) 35 to 50% deposit and a security agreement

Both versions of this matrix were reviewed by sales and finance before implementation to ensure a fit with customers and to minimize risk. Some customers are reluctant to sign a security agreement or perhaps their VC's prefer that they don't, so Newport is creative with its credit options. Newport encourages startups to consider leasing, or letters of credit, if the startup VC matrix does not suit their situation.

With the economic downturn, there is no guarantee that dot-com startups will survive, so Cathy also does a lot of reading and attending seminars and venture capital forums to continually educate herself. This is a growing market segment for Newport, so there is a need to stay informed on credit and collections techniques as they change. Cathy also relies on the credit network developed through years as a credit professional and on her local NACM affiliate, CMA Business Credit Services.

CMA Business Credit Services helped Cathy form an educational group devoted to this new niche market and the result is the creation of the Southern California E-Merging Companies Education Group, which meets quarterly. The group has defined an e-merging company as any business not generating revenue from operations or traditional sources but from venture capital investment or equity funding. The purpose of the group is to share ideas and techniques through speakers and member expertise and ideally develop new models for credit extension to e-merging companies. There is also a Northern California chapter of the E-Merging Companies Education Group.

High Cash Burn Rate and Zone of Insolvency Cause Bondholders to Sue

In the telecommunications industry, cash burn rates are especially critical. Some creditors, especially bondholders, have attempted to restrict telecom companies from using cash out of fear that they will go unpaid.

Creditors, with a close watch on the cash burn rate, are acting collectively earlier out of concern that the telecom may not pay. Bondholders have recently sued to restrict a company's use of cash out of concern the company's cash-burn rate will render it insolvent and unable to pay creditors. Creditors are demanding payment prior to a default as they contend that the company's board of directors owes a fiduciary duty to creditors when the company is insolvent or near insolvent. Creditors are contending that cash-burn rates of many companies are outstripping revenues and such companies should be liquidated to satisfy creditors' claims rather than continue to operate.

Still Opportunity For Sales

With the downturn in the economy and limited VC funding, a dot-com's cash-burn rate is key with any credit analysis. As Newport Corporation shows, a variety of credit options allows a vendor to make the sale and minimize risk in a down round of VC funding.

Cathy Markowitz is the Director of Credit for Newport Corporation, located in Irvine, California. Her e-mail is cmarkowitz@newport.com.

Reprinted by permission from Trade Vendor Quarterly