Commercial property prices have struggled in many areas over the last few years, and as a result we've seen a few business plans submitted to us with buying a building to house the company as part of the plan. For newcos seeking investment this is usually a show-stopper with professional investors, and is likely to be challenged on a number of grounds.
- First of all, it changes the need for funding. Say one needs a first round of $1m and then $500k to buy a building. If one doesn't buy the building it materially changes the investment needs.
- Secondly, it changes the cashflow model. Investors may want to drip-feed money based on various objectives. They can't do that with a large capital item like a building. If the company survives its first few years then perhaps making a real estate investment to save money over a decade or so might make sense. But hopefully there will be better opportunities in the business to create value.
- Thirdly, it mixes the activity of the business. Tech startups should be applying capital to being tech startups, not property speculation companies. Typically, investors going into a newco at best 1-in-10 chance of getting a big return on their money, even at series A. It is unlikely to fit the investment committee criteria in a big fund: if the fund's capital is designated for early stage, they would want a $1m investment to go into startups, and not half and half into property. Investments like this are rarely capital efficient. Buying a building isn't going to give a "hockey-curve" return in the way that the rest of the business might. In fact, if the business is growing rapidly there are many circumstances under which one might consider selling any company building and investing the money in growing the business instead, for a better return.
- To this end, buying a building looks like a hedge: that the entrepreneur may be worried it won't work and wants a source of rental income to fall back on if it goes wrong. If it goes wrong, however, things won't work that way with the investors.
- Finally, it's worth considering how this might affect an exit from the business. If one has built up $1m of saleable business value and wants to sell out, that extra $500k which was raised and spent on property will increase the transaction price by 50% and not give any extra upside on disposal. It's just a barrier to the entrepreneur getting paid out.
Ultimately, if one has been offered a sweetheart deal on property, it's worth raising any capital separately and in a different vehicle. Tying it up with a newco deal will make investors nervous that it's some sort of mechanism for extracting the funds straight out of the company they're investing in. This is very much like entrepreneurs paying themselves large salaries -- it's only fine when it's their own money!
We're always happy to share thoughts on this at the usual address.