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b) SWOT analysis
While Porter’s framework focuses on analyzing an industry by understanding its positioning among the different actors it is interacting with, a SWOT analysis will try to emphasize the immediate determinants of the company’s survival, namely its Strengths, Weaknesses, Opportunities and Threats (whence the acronym SWOT). Obviously, both analyzes will return the same information, but analyzed through a different perspective: while the first approach will allow you to grasp the mechanics underlying the interactions, the second will show a clear assessment of your chances to survive within the sector.
i. Strengths
This category regroups, literally, the strengths of your business. They can be:
- operational:
For instance, you can have a technical edge over the competition because your R&D department performs better than average: this will yield a higher productivity because of lower operating costs, or this will allow you to produce better products. Either way, you will be more competitive than your neighbor, which will translate into higher margins.
Another strength might be given by a strong bargaining power relative to your suppliers and due to the large size of your company; if you happen to be a big player in the industry, you can assume that you will be able to secure better prices from your suppliers than your competitors will be able to get.
- financial:
Imagine your company is going through a period of economic crisis. It will then be in a much stronger position when its financial leverage is rather low (i.e. when it has little debt outstanding). The reason for this is that it will still enjoy some financial flexibility and will be able to resort to debt if necessary. Moreover, paying interests on debt can be crippling for the bottom line in a period of crisis, since the turnover of your business is then rather small. More generally, always remember that you should avoid cumulating operational risk with financial risk.
Typically, this is the reason why startups never resort to debt financing: since they are in a period of growth and their revenues are uncertain during the first few years, raising debt would be too risky an option (and probably very costly, because lenders would account for the risk level when determining the cost of debt). Instead, a startup would prefer equity financing, that is to say funds injected by investors who will then own a part of the company in exchange for their investments, i.e. a right to future profits if there are any. However, these investors won’t be guaranteed to recover their initial investment. Why is this solution more interesting for a startup ? Because in case of low net income (or worse, in case of losses), it won’t have to worry about paying back creditors and thus will reduce its chances to go bankrupt.
Now you might think that equity raising is the perfect way. Beware, for there is no heaven in the financial sphere !
Equity financing is indeed freeing you from the need to pay back debt, but if you fail to bring in sufficient returns to the company shareholders (or more generally owners, in the case of a private company), then you will fail to attract other investors in the future, or equivalently your company shares will trade at a very low price and future investors will be able to buy stakes in your business for peanuts (and since you don’t want this to happen, this simply means that you won’t be able to raise fresh equity in the future). What may be even worse, you will have difficulty selling your stakes in the business, since it will then be worth so little.
Equity financing thus also carries a cost in terms of future opportunities. We will come back to this point later when we will introduce the notions of required rate of return and return on equity.
Another danger of equity financing lies within the fact that your company might be undervalued
at the moment you are raising the funds: imagine that you have just developed the new Ebay, with an initial investment of $50K. Unfortunately, you realize that in order to speed up the development of the startup you will need an additional marketing campaign which will cost you $50K. What you will then do is try to find partners, that is to say raise fresh equity, and you will do it while being sure that your company will be worth $1M one year from now. What does this mean ? Well, this means that you just sold half of your company to a partner for $50K, knowing that this partner will have a claim on $500K just one year from now. Was this a good deal ? Of course no, because you created all the value and a purely financial investor was able to step in and take away half of that value for only $50K, with no other form of contribution (no skills, no innovation, etc …). But you needed that money, and apparently this was the only way. This is what private equity firms are doing: buying stakes in promising companies and selling them back with a profit a few years later (however, private equity firms often bring to the table not only funds but also their managerial experience; therefore, we can’t really say that their contribution is purely financial, even though structurally speaking they are just a portfolio of financial investments in different companies).
Those are the reasons why startups often resort to hybrid debt, for instance convertible bonds, in order to finance their first projects. Convertible bonds are debt with an option for the creditor to convert this debt into shares of the company at a later time and at a price which was agreed upon at the moment of the issuance. As a result, creditors will be able to recover their debt if the company is generating just enough cash, but will also have an option to convert that debt into equity if the company’s growth is exceptional (in other words, when buying convertible bonds, creditors share both the downside risk and the upside potential of the startup, which may of course seem more appealing and encourage investments).