Extreme Capital

The creation of this page was inspired by an ExtremeProgramming presentation given by WardCunningham on December 4, 2001 to the IEEE ComputerSociety? in PortlandOregon.

In his presentation, Ward touched on the concept of "BXP", or BusinessExtremeProgramming?, which describes practices for financing an XP driven organization.

[This is a working rough draft. Please feel free to constructively elaborate using RealNamesPlease. ThreadMode is discouraged to reduce the overhead of refactoring, but you may send personal comments to mailto:mike@cubiccompass.com . Thanks! --MichaelLeach ]

"What comes first, the chicken or the egg?" is a common question asked by business owners trying to jump start and fund a software business. Cash from customers can keep the business rolling, but you often need cash to get your first customer.

This paper discusses funding options, the expenses involved with operating an XP driven organization, XP revenue models, tax issues, and the use of XP principles in raising capital. An ExtremeEntrepreneur? will seek to utilize a combination of debt, equity, and other financing options.

The majority of startups utilize 2 major sources of capital; debt and equity. Financing your company with debt usually involves borrowing money from a bank or relatives. Equity financing involves selling a portion of your company for cash up front. Both options carry different levels of risk for security holder and business owner.

An ExtremeEntrepreneur? is trying to maximize their interests on 2 fronts. You want to pay the least to get the most. This is in contrast to a financer or investor who is trying to give the least cash to maximize the greatest returns. Onerous terms that significantly favor either side are the foundation for disaster. A WinWin financing agreement is the foundation for success.

Debt Options: Most large banks have loan officers who review business plans and loan money.

Bank loan officers seek to minimize their risk by holding the title, or deed of trust, to material collateral in case the loan can't be paid back. They're more accustomed to restaurant owners seeking money to buy an industrial freezer, or shipping companies purchasing vehicles. A loan officer can easily look up the book value of an asset to estimate the return in case of default. This is not the case with software.

The ExtremeEntrepreneur? deals with IntellectualProperty as their primary products. Some banks specialize in high tech financing and may use an IP valuation to back your loan, but their risk will likely be offset with higher interest rates and several detailed contractual terms.

It's best not to fight the financial institutions and use the banks for assets they're most comfortable with, such as the acquisition of computers, printers, office furniture, and office supplies.

Credit cards are another debt financing option that the ExtremeEntrepreneur? should consider. When you weigh the interest charges of a 17% card against the price of equity capital, which often seeks > 20% equity with 3-5 times returns, credit cards aren't such a bad idea. The astute entrepreneur will also be familiar with continually rolling the balance of high interest cards to lower interest introductory rate cards.

The disadvantage to credit card financing is that you must pay down minimum balances to protect your credit rating. The advantage being you retain 100% ownership of your company.

The returns for a bank or credit card lender are limited to the terms of the loan and in cases of bankruptcy they are often the first to get paid back. This is why debt securities are considered a lower risk option for lenders.

[TODO: Resource links here]

Equity Options: Those who were actively involved in the DotCom bubble are probably well aware of EquityFinancing?. EquityFinancing? involves selling a portion of a company in exchange for cash or services.

VentureCapital? funds are aggressive growth funds that seek to maximize investors money in hot sectors such as Internet Software, Bio-tech, wireless, and other industries. As an example, a VentureCapital? fund may be interested in purchasing 20% of your startup company for $5 million dollars (the amount of equity and investment vary wildly).

Equity investors are really no different than you. They want to put some money into an idea and make more in return at a later date. Unlike debt financing, these investors don't require you to pay back the money. They instead require a entrepreneur to have an ExitStrategy that defines when an investor will get their money back. Common exit strategies are an IPO, acquisition, or merger with a public company.

The returns for an equity investor are unlimited. If the company goes bankrupt, they may get nothing. But unlike a bank who only receives fixed interest payments, an equity investor may see 5, 10, and rare case 100 x's their investment.

[Describe types/stages of equity financers, Friends and Family, Angel, VC]

[Describe relationship to XP. Shorter product life cycles means better steering and milestone reporting mechanism for investors. Onsite customer means reduced risk of a real customer not wanting the product]

Creative/Alternative Options: RoyaltyFinancing?

XP Revenue Models:

[Differentiate Product Focused vs. Service Focused]

[Revenue models: Service- T&M, variable scope, fixed bid. Product- Royalty, OEM, direct sales]

Once one abandons BigDesignUpFront the conventional wisdom that significant prior funding (debt or equity) is required may go out the window.... If one can get a useful first-cut of a product in to the hands of a paying customer early, development MAY become self funding by its own revenue. Surely this is the extreme approach to capital? The trick (and it is a difficult one, else everyone would be doing it) is to think out some evolutionary path to one's intended product that has paying spin offs along the way. Many recent small start ups have started off by offering web design services, incrementally building a library of 'reusable' components. Such a start up may need minimal seed capital. At some point such a start up may have a choice of productizing their code or continuing to offer a service using their code base as a 'secret weapon'. --JamesCrook

A surprising number of companies start off by packaging and selling tweaks to public domain software, and then incrementally replacing components of their 'toolkit' with their own code. This cuts up-front development costs. A more legitimate routes to reducing up front cost (which have been combined with this approach) is to commercialise university research. --JamesCrook

The Tax Man Cometh

There's an ongoing debate about whether software development is an expense or an asset that should be capitalized. The advantage to treating software as an expense is that you can write off all costs associated with it's development at tax time. The disadvantage being that the asset and owners equity columns of your company balance sheet may resemble something looking more like a goose egg, which in turn makes you less attractive to traditional financers, such as banks.

The vast majority of software companies do not capitalize their development. R&D is an expense. At first glance, it seems rather odd that software companies get to derive most of their revenue from an asset that they don't even have to pay taxes on. What a deal! But the truth is, software development is a very risky business and the government understands this.

As an example, lets say you pay 10 engineers $150,000 each to research and develop some software. Fully capitalized, you could then say that your company assets have increased $1,500,000 dollars. The IRS would be more than happy to agree with you and ask that you kindly pay $600,000 in taxes for your new found assets.

How much certainty is there that this asset can be liquidated for the amount invested? Not much! You don't know whether your new product will fly or flop. Therefore, the IRS has granted a safe harbor to the the software industry in the hope you will continue to take risks. This safe harbor basically states that taxpayers can elect to either deduct or capitalize software R&D.

References: "Software Development Costs-Has the Safe Harbor for Deductions Been Withdrawn?", David Hardesty, December 10, 2000 http://www.ecommercetax.com/doc/121000.htm