Sep 242013
 September 24, 2013  Posted by at 9:16 pm  Add comments

I had a discussion with an entrepreneur today that was facing a challenge.  A potential customer was asking for his startup’s financials as part of their due-diligence.  It’s a conversation I’ve had many times with ATDC companies.

Potential customers or distribution partners sometimes ask startups selling mission critical and enterprise applications for their financials.  The fear for early stage startups is their financials will kill the deal – either by exposing a lack of customers (size), or exposing the financial instability of a startup (weak balance sheet and losses).

There are a few ways of dealing with the request.  But before diving into those, one of the keys to success in those early deals is being relatively transparent that you are an early stage company and emphasizing the benefits of being an early customer.  Being upfront about this has worked very well in ATDC’s Industry Connect program where we connect our startups with Fortune 1000 and established companies as early (paying) customers.  Innovative companies realize it is less expensive and easier to be early than to bear direct and indirect costs of catching up with a competitor leveraging that advantage.

The other key is understanding the nature of the request.  The question really comes down to addressing risk and sometimes internal procurement requirements.  In cases of internal procurement requirements it is necessary to have a senior ‘sponsor’ to help overcome the old additive that “you never get fired for hiring IBM”.  Addressing the risk is often more straight-forward, either by picking appropriately scaled initial implementations or by addressing continuity of operations in a worst-case scenario.  In some cases letting the customer know that you are privately held and do not release that information, in conjunction with addressing the risk issue may get you past the request.

When that isn’t enough, here are a few tactics that I’ve seen work:

Establish a source code escrow – Offer to deposit your source code with a third-party.  Escrow providers have a process for releasing the source code to the customer under certain pre-defined events that would limit the customers ability to maintain the applications.  Some escrow providers offer (and customers sometimes require) additional integrity testing and validation services where they validate the source code, perform a ‘build’, and create documentation for a deployment plan.

Dedicated instance - The source code escrow is the most common way of addressing the risk – but as more applications are moving to the cloud and often depend on connectivity to other services or data sources, savvy customers realize having the source code may not be enough.  All of their data may be in your application.  In these cases a ‘dedicated instance’ of the application running in a third-party hosting environment with the customer listed on the contract for access may be the best solution.  This only works for applications that are priced high enough to afford the extra expense.

Investor letters – In one of my companies we had our investor (in this case Total Technology Ventures) provide a letter of financial support that we submitted with our financials.  The letter was non-binding, but expressed their support and plans to continue to fund operations.

‘Affiliate of’ – In another startup we sold to banks and they were legally required to review our financials.  We explained we were a startup but had solid financial backing.  We positioned ourselves as an ‘affiliate of’ our lead investment firm and they accepted the investment firm’s information as a substitute.

Pot sweetener - A tactic I learned working with Bert Ellis and Bill Nussey that we used successfully at iXL was to offer an incentive – either in pricing or in warrants for early ‘big logo’ customers.  This was essentially a more aggressive form of transparency.

These tactics should only be used when the rest of the deal is in place – all the issues have been addressed and they are ready to purchase.  In the end, the best strategy is transparency and getting them to work on your behalf to get through the procurement process.  If you are selling a ‘pain-killer’ and have senior executives involved in the decision process, more often than not you will be able to navigate through the issue by addressing the underlying risk of continuity of operations and picking a suitably scaled initial deployment.

What else?  What has worked for you when you’ve been asked to provide your financials?

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