I’ve been witnessing a disturbing trend, all in context, over the past 4 months in the consumer capital raise arena. I call it the “steak sauce” round. A stake sauce round occurs when a company tries to raise an interim round between its Series A and Series B. It’s grown up brother is called the “bomber” round, when a company raises an interim round between its Series B and Series C. These are often marketed as A-1 rounds (“steak sauce”) or B-1 rounds (“bombers”). Collectively we refer to them as “tweener rounds”. That said, I have seen more steak sauce offerings than bombers.

So why are we seeing so many interim rounds. Generally speaking, a majority of these offerings come to bare as a result of a company under performing it’s cash flow projections. Often times, in the interest of preserving value for the existing shareholders, a business is marketed under an aggressive set of projections so as to maximize valuation. It’s hard to ask for more money than your projections require, because it essentially invalidates them to a degree. However, projections are often made in a vacuum and fail to take into account the fluctuation’s that invariably occur when you are subject to economic cycles. All consumer businesses will experience some level of performance degradation in a deteriorating consumer environment. Given today’s economic climate it is not surprising that we are seeing so many steak rounds.

The second underlying cause of a steak round is that first time entrepreneurs underestimate the cost associated with market penetration. Invariably, in a start-up capital deployment is not fully efficient. Additionally, many consumer categories are either highly competitive or require work to educate the market on the value proposition. This takes more dollars than anyone ever anticipates.

Steak rounds are no fun for anyone. No surprise there. Existing management has to market the progress of the company in order to recruit more capital and existing investors must show support (hopefully with deep pockets) in order to incent new money to come into the equation if possible. Often times management must put on a brave face in light of performance that has not met. Further, this is a distraction for management at a critical time as tweener rounds can be protracted exercises, and the company is likely operating in challenging environment, hence the need for the additional capital ahead of plan.

So if you are faced with seeking fries for your steak round, how do you come up perfectly cooked (note I did not say well done)? A few ideas:

1) My first suggestion is to take mitigating action well in advance of tacking institutional capital. That is to focus your strategy on either profitability or defined market penetration. It is more marketable to show traction in one market that it is to show limited traction, but a broad distribution foot print. This is counter intuitive to many, but an ounce of prevention is worth a pound of cure. Of course this might not always be a viable strategy.

2) If you take anything away from my blog, ever, it is that you should not re-open your prior round. Not only is this a weak market signal, but it complicates things later down the road. It’s like getting a tattoo when you are 18; there is a high likelihood that you might regret that very demarcation later in life. Instead go for a convert. Convertible debt at a discount to the next rounds valuation offers the best opportunity to bring in new money due to the protections that it provides.

3) Be realistic, your convert should be at a discount to the next round and offer warrant coverage. Go heavy on the warrant coverage as opposed to the discount. Warrants will dilute everyone when exercised, discounts only dilute those who have invested to date when realized. I often hear from people who take my advice on a convert but do not offer a discount. More often than not those people end up less than enthused with the results of their tweener. Discounts of 10% – 33% are appropriate and warrants of 10% – 20% of the investment are within the acceptable parameters.

Of course, the way out of this mess is to be realistic about your capital plan in the first place. Easier said that done. However, the price of imperfection later is much greater than the value created by creating the price of perfection now. I know there I go again, robbing you of value on behalf of investors.

/bryan

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