Funding New Product Development

Two Approaches to New Product Development Funding 

From a financial angle, there are two often encountered scenarios when funding the greenfield development of a new product:

  1. The founder /VC approach, where the founder serves as the first provider of funding
  2. The “new project within a large  company” approach

In a venture capital context, it is clear that a project is a calculated financial bet by the owners, whether the founders or the VC. An investor (such as the entrepreneur) puts some money into a company. The investor thinks the project will be wildly successful, even though at the moment, the company has no profits, revenue, or possibly even product.

From a pure net present value (NPV) point of view, it looks like the VC in particular has lost a few marbles. They’re handing over a large sum of money to a group of people who might earn an unknown sum of money a few years in the future, at an unknowable discount rate. They might change the world, or be bankrupt within a few months.

As a result, in pro-forma financial forecasts of expected returns, VCs use their estimated discount rate is as a “fudge factor”. This fudge factor gives them an additional margin of safety, if they believe the revenue forecasts are unrealistic. Specifically, if they don’t trust the entrepreneur selling them a part of his company, a new financial investor (VCs) increases the discount rate to reflect the higher level of perceived risk. This approach is, however, a bit heavy-handed. Moreover, it is imprecise, because it doesn’t really reflect risks in the venture. It also allows anyone to “game” a valuation, based on their intuitive gut feel about a company. Despite these issues with NPV in the context of startups, it has traditionally been the most widely used.

Funding a new product within a larger company is also a bet, but with a different source of capital. Let’s say you are such a product owner or sponsor. You have a pool of money, either as part of an annual budget process, or obtained via an external loan.

Your goal is to earn an excess return over the cost of having that capital. Traditionally, the most cutting-edge tool for detailed analysis like this would have been Microsoft Project. Not only do you draw out your Gantt Charts about the various stages of the project, and base your estimates on what you expect will happen, you can even use Project to calculate project level rates of return using NPV, internal rate of return (IRR), and possibly scenario analysis.

Your cost of capital, typically the weighted average cost of capital (WACC) serves as the benchmark for deciding whether to invest in a project. The WACC is a simple accounting concept, where you take the average interest rate paid on all debt, and estimate the expected return on the equity based on observable comparable companies, and take a weighted average.

The WACC is analogous to the “fudge factor” assigned arbitrarily by an external financial investor in the VC case. Both of them serve a few purposes:

  • They are a “hurdle rate” above which the investment needs to perform
  • They summarize the opportunity cost of investing in that particular project/new product, as the investor or company sponsor could be invested in any other product/project/investment
  • They quantify the “cost of time” which everyone faces, when working on the project.

Unlike the fudge factor, a WACC is based on actual funding the company already has. It’s very real, not an estimate. Arguably, the VC “fudge factor” is just an estimate of an actual mature company WACC, particularly since most of the funding will come from equity investors expecting a high return, so the actual WACC in a VC venture is high. WACC is also based on financial characteristics specific to that company, such as creditworthiness, risk profile, etc. Most importantly, both are fed into an NPV model, which subsequently gives you an invest/no invest criterion.

What are the effects of using this denominator in NPV?

Both of these scenarios focus you on one objective: controlling or minimizing your immediate costs (negative cash flows) until your product launches in the (usually distant) future, according to John Judd, a serial CEO and CFO. This helps to offset the venture liabilities to investors and banks. It also causes more problems than it solves.

In most industries, product lifecycles have shortened dramatically. There is much less certainty than there was in the 1960s and 1970s, when NPV-based waterfall project management styles were the norm, and rightly so. Nowadays, your industry can change completely over the space of a few years. Just ask any music industry executive.

Moreover, this pace of change is accelerating still. Moore’s Law dictates that the number of transistors which can fit on chip doubles roughly every 18 months. This doubles the processing speed available. It does not even take into account improvements in the available software, which obviously affects you if you are competing in the software industry.

Make the Most of Now

Instead of controlling costs, it makes much more sense in a volatile environment to focus on revenue, and how quickly you can generate it. This is because the software industry is still rather young. After spending much of his career promoting project metrics within software engineering, Tom Demarco came to a rather odd conclusion about the role of cost control in IT projects. Demarco notes:

To understand control’s real role, you need to distinguish between two drastically different projects. Project A will cost around $1 mln, and earn $1.1 mln. Project B will cost around $1 mln, and earn around $60 mln. What’s immediately apparent is that while control matters a lot on Project A, but almost not at all for Project B. This leads us to the odd conclusion that control matters a lot on relatively useless projects, and much less on useful projects.

Great software projects generate massive payoffs. You are better off looking at how your project will generate incremental revenue, than pinching pennies, because the software industry is still very young.

Projects like Demarco’s Project A are sometimes necessary, particularly when looking within existing companies. They do work- if you are sure the project will be steady enough to generate stable cash flows. In this case, you are taking a “value investing” Warren Buffet approach, where you want to pay as little as possible for a very stable, slowly increasing, stream of cash flows. Buffet supposedly doesn’t even look at companies that don’t have a 10 year track record of stable and increasing cash flows, and where the current price of the business implies a certain “margin of safety” (hint: it’s really cheap).

SOMETIMES this is relevant for new products in software businesses, or mature businesses using a lot of software. Nonetheless, you are making a rather dangerous set of assumptions about your environment, your competition, and typically a product that doesn’t even exist yet, much less have a track record. Often these assumptions go many years into the future.

What works for investing in Coca-Cola or Heinz (both owned by Buffet’s Berkshire Hathaway), may not apply to an IT initiative. If you are so risk averse, that you only look at actual cash flows from the last ten years, you don’t take into account that most of the big players change every 10 years in IT. You also need to have a really clear business rationale for sticking to 10 year old technology, if you compete with other software companies.