Capital comes in many forms. Generally, it can take the form of debt (personal and bank loans, credit card debt) or equity (common stock, preferred stock, etc.). Debt is based on an obligation to repay; equity is a piece of the action.

In addition, capital can be short term (e.g., cash-flow assistance to accelerate cash from receivables) or long term (debt with a life tied to a capital asset, like equipment or real estate). There are also hybrid forms of debt and equity—e.g., convertible debt that can be turned into equity—or preferred stocks that track the value of certain distinct classes of assets on the balance sheet.

The next question is, who provides the capital? Friends and family, banks (which are loaning out depositors’ money, not making investments in equity), venture capital and private equity are well-known choices. But venture capital and private equity are fundamentally different and driven by different investment criteria. For these reasons, their view of the value of a company can be dramatically different.

Venture capital focuses generally on companies that are either pre-revenue (a company pursuing an idea, concept, product, service, etc., but not yet generating any significant revenue), or not generating enough cash flow to pay most, if not all, expenses.

The value a venture capital firm ascribes to a company is based on an assessment of its competitive advantage, including any intellectual property that creates a competitive barrier. A VC will evaluate a company based on its likely value at the time of sale (“exit”), generally five to seven years after investment. If a company has a great idea (e.g., Google) and it is hard for companies to compete with it (e.g., software that is secret or patented), the lack of cash flow will not deter a VC. And from a company perspective, it might actually be advantageous to NOT have cash flow, in order to avoid a private-equity valuation methodology.

Private equity invests in companies that are cash-flow-positive, i.e. generating enough cash from revenue to pay expenses, and have excess cash. PE firms evaluate cash flow and judge the ability to increase cash flow post-investment, by making additional capital investments and operational improvements and by making additional acquisitions to increase the company’s size and efficiency. These acquisitions are generally referred to as “bolt-ons.”

As companies grow to a certain size, there is an increase in the multiple that a buyer is generally willing to pay—so called “multiple expansion.” So a PE investor has an incentive to cause portfolio companies to grow, not only to improve economies of scale, but also to expand the multiple they are paid at exit.

PE values its investments based on cash-flow multiples and growth projections. Generally, valuation is a function of multiples of EBITDA—earnings before interest, taxes, depreciation and amortization. So if you are running a startup that is pre-revenue and certainly pre-cash-flow-positive, you actually are better off with the VC valuation approach. This is why people who raise VC capital generally think it is better to have no revenue (but lots of people begging to get your product).

If you are looking for a PE investor, however, your choices are more along the lines of sell out now, or stay invested in the company alongside the PE firm, betting that the firm will get the company to higher performance levels, through operations improvements and bolt-on acquisitions.

Most PE firms have no interest in companies with less than $5 million of EBITDA; they just don’t move the needle on fund returns, given the size of the fund, and generally require more time and effort to get to scale. A few PE firms, however, do invest in companies below $5 million.•

This article was provided by Matt Neff, a senior advisor to Citadel Earth, and was previously published with the Indianapolis Business Journal.

“The Academy” is a shorthand reference to the faculty members in a college or university. This group ranges from tenured professors (with job security) through associate and assistant professors, all the way down to adjunct professors.

Professors who are on a “tenure track,” i.e. those seeking to climb the ladder to that job-protected status of tenure, are judged over a long time on a number of criteria, including teaching skill and publication of original works. For example, the provost of Indiana University cites “teaching, research and creative activities, and service.”

A recent study cross-referenced the number of publications by academics to those that are cumulative (building on existing knowledge and thought patterns), and those that are novel. Innovative means advancing a new theory or paradigm, or disrupting an established way of viewing something. As one might expect, more than half the publications analyzed (60 percent) were cumulative.

Innovation requires changing a paradigm, which means someone’s existing paradigm will be affected; this is the “disruption” entrepreneurs (and venture capitalists) are constantly seeking. It is creative destruction and involves “moving someone’s cheese.”

Lots of businesses depend on the extension of an existing paradigm (A+B); by adding C, we get something kind of new, and perhaps better. But to create market-changing innovation that disrupts existing models, you have to break something. We no longer rely on A+B+C; now we create X+Y+Z and, we hope, get a dramatically improved outcome, lower cost, etc.

Henry Ford is frequently quoted as saying that, if he’d asked his customers what they wanted, they would have said a faster horse. Steve Jobs was famous for saying Apple customers didn’t know they needed something until he could create it and present it to them, demonstrating the utility and why the customer’s old paradigm no longer made sense. Think of an Apple iPhone vs. the old flip phone. Suddenly, with an iPhone, you could select from thousands of applications to make your phone do lots more than it ever had before. Not only did the iPhone have much more utility, but an entirely new market for applications was created.

Academia, and particularly post-secondary educational institutions (colleges, universities), are familiar breeding grounds for the kind of thought that can innovate, and disrupt existing thinking. But as the study quoted above noted, many academics—for understandable reasons—focus on publishing their work and do that by cumulating existing knowledge, i.e. building on existing paradigms. Working on true innovation, creative/disruptive innovation, can be risky for those who aspire to tenure, because, more often than not, those efforts fail, leaving the faculty member with nothing to show the tenure committee.

Some institutions, however, so value innovation that they give tenure credit for innovative ideas that lead to new business models, even if the models fail. University of California, San Francisco, is an example of a school that encourages faculty to innovate, and disrupt, and even create new business ideas, and offers credit toward tenure for doing so. Its view of scholarship includes development of new methods, tools or system processes.

Most other institutions encourage faculty innovation, but it is only the publication (cumulative or creative) that counts toward tenure consideration. Given that time is a precious commodity, the academy does what advances its march to tenure—publish. But in many respects, publication is the enemy of commercialization. Intellectual property—in the form of patents, copyrights, or trade secrets—is a major value driver for startups. If a novel idea is published, it is in the public domain, and therefore no longer patentable, and certainly not a secret.

The ordering of disclosure of new, innovative ideas is therefore significant. Venture capitalists and other investors want to see patentable information protected first, then it can be disclosed in publication. If the desired method of protection is a trade secret, however, no publication can occur.

As a venture capitalist, I interacted with faculty members from many institutions. One former member of the UCSF faculty observed that, if we really want more innovation in the Midwest, we need more Porsches in faculty parking lots. In other words, faculty members whose innovations have led to successful business creations beget more innovation. The delicate issue to address here is, do current conditions requiring more innovation call for changes to the system of tenure?•

This article was provided by Matt Neff, a senior advisor to Citadel Earth, and was previously published with the Indianapolis Business Journal.

My last article on the blood-testing firm Theranos explored how and why so many people could have been deceived by a business strategy and technology that proved to be entirely dependent on deception. Since that article appeared last spring, the unraveling of Theranos has accelerated, and we can now glean some additional learnings.

In addition to the final collapse of the company Theranos, its founder, Elizabeth Holmes, was fined $500,000 by the Securities and Exchange Commission and barred from serving on public company boards. As if that weren’t bad enough, on the criminal side, she has been charged with mail, securities and wire fraud. She is likely to be able to work on business ideas in the federal penitentiary.

So as the final chapter on Theranos is being written in the criminal courts, what additional lessons can be learned?

First, as one of my former partners used to say, “Time wounds all heels.” You can keep a deception alive for only so long, particularly if two or more people are involved. While everyone wanted Holmes to be the female version of Steve Jobs (and she used her wardrobe to help reinforce that impression), she proved to be without substance. And certainly without integrity.

Second, even reputable people with big names can be deceived. Theranos’ board was a who’s who of well-known politicians, diplomats, generals and investors. They were all duped. In the case of George Shultz, a former secretary of the treasury and secretary of state, he was duped even though his grandson, who worked at Theranos, told him fraud was afoot. The grandson ultimately became a whistle-blower about the improprieties at Theranos. (Think about confronting your former cabinet-level grandfather to tell him he’d been played!)

Third, entrepreneurship ain’t beanbag, as they say. It is really, really hard to start a business from scratch. If you want to disrupt an industry, don’t expect the incumbent players to be cordial and collaborative. You are messing up their lives—moving their cheese, so to speak.

We all love the success stories of great disruption. But for every success, there are probably at least 99 failures. Starting a business in the life sciences is even harder because, generally, people’s lives and health are involved. New products or processes in the life sciences cannot be governed by the maxim, “Ship it and fix it.” It has to be right, or as close as scientifically possible, or people’s lives are damaged.

For this reason, the development cycle of life sciences companies is generally longer, riskier and more capital-intensive. While it takes more capital to survive in the life science startup phase, if you survive it and get to regulatory approval, your competitive advantage skyrockets.

Theranos kept the plates spinning longer than most could have, in the rigorous world of peer-reviewed science, by blending secrecy and the appearance of credibility from the supporters Holmes had enlisted. But in the end, no one could have kept all the plates spinning.

Finally, everyone knows the pressure to perform, whether you work at Starbucks or NASA. For an entrepreneur, however, that pressure is an organization’s life or death. Does this work? Can I get it patented? Can I get U.S. Food and Drug Administration approval?

If Theranos could not deliver a disruptive lab test, why would anyone invest? This is an integrity challenge of the first order, and the reason venture capital investors always say that having the right “jockey” is the cardinal investment criterion. Unfortunately, this jockey is going to the big house. And the investors in Theranos have lost over $1 billion.•

This article was provided by Matt Neff, a senior advisor to Citadel Earth, and was previously published with the Indianapolis Business Journal.

Niall Ferguson’s book “The Ascent of Money” provides a long view of the development of currency, and its role in advancing society and commerce. Cryptocurrencies, like other inhabitants of the internet, have the potential to effect a major disruption in money and its regulation, as well as accelerate the velocity of commerce. But they also have the capacity to deceive and destroy value. The question is, can this trend be safely ignored? The answer is no.

I have a nephew who is a cryptocurrency arbitrageur. He quit his day job and now spends his time trading a mind-boggling number of virtual currencies. He started with Bitcoin, then added Ether, then BAT, then EOS, and the list goes on and on. Unlike fiat currency (created and regulated by governments), there is no hard asset (like gold) or performance metric (like money supply indexes) that can be used to evaluate the amount or value of the currency; it’s more of a social phenomenon.

After talking to my nephew, my wife and I decided to take a flier and bought some bitcoin. Six months later, we had made five times our money. We gave some to our kids, got our investment capital out, and we still have two times our original investment. But since then, the market has dropped significantly. In the words of Johnny Carson, “Timing is everything.”

We all know that banking is a “confidence game.” If you are confident in your money, and in your bank, the vast majority of people will leave the money in their bank. If that confidence is lost, all the depositors want their money back at the same time; there is a “run” on the bank. But the bank has lent out the deposits to borrowers. Its assets are receivables, and it doesn’t hold that much cash. This is how banks fail and is the raison d’être for the Federal Deposit Insurance Corp. The FDIC regulates the creation and supply of money, and ensures depositors that their money is safe, thereby creating confidence and avoiding a run.

If cryptocurrencies become trusted, the business of being the “trusted intermediary,”— i.e. banks, insurance companies, and others—might be diminished, certainly disrupted. Their role of taking money and holding/investing it on your behalf, and transferring as you direct, could be affected if suddenly there are channels of direct transfer that can be trusted. So, for banks, insurance companies and others, cryptocurrencies might not be just a new way to transfer money, but a potential existential threat.

Nevertheless, the financial world is beginning to accommodate this new form of currency. Goldman Sachs has established a trading desk for cryptos. The Chicago Board of Options Exchange trades crypto-related contracts. Mastercard just patented a way to use the blockchain (the software that makes cryptocurrencies possible) and Bitcoin to manage credit card charges. The level of activity in the crypto field, and the consequences of missing out on the trend, have pushed large, established players in finance to begin to explore changing their business models.

One recent setback, however, occurred in the United States. The Securities and Exchange Commission, for the second time, declined to approve an exchange-traded fund—backed by Bitcoin—created by the Winklevoss twins (they were early to the Facebook game).

The dilemma for the SEC now is that, given how the market is starting to accommodate cryptocurrencies, if the agency doesn’t develop a regulatory structure that will work, the action will move offshore, leaving it without influence over how the market operates and the level of disclosure required. But given the widening circle of players who are confident they can buy and sell cryptocurrencies, it appears this is not a trend that can be ignored.•

This article was provided by Matt Neff, a senior advisor to Citadel Earth, and was previously published with the Indianapolis Business Journal.

The vast majority of companies in the United States are small, privately owned, with fewer than 500 employees. Many are family-owned, some are venture-capital-backed, others are supported by private equity.

They might have complicated financial structures or are so simple they are run out of a checking-account register. Their strategy might be international finance, mergers and acquisitions, or selling tires.

But they all have one thing in common: They are better off having a board of directors—and one that includes outside parties.

Why? A good board serves multiple valuable functions. If nothing else, regular meetings require company management to articulate where the company is (performance) and where it is going (strategy). Everyone might agree on what the company can and should do, but having a periodic report from management and questions from a board add a discipline that is in itself valuable for management.

Second, a good board has three over-arching responsibilities: Define strategy, select and hold management accountable, and safeguard financial performance. If you strip down all the things a board does, it really boils down to these three critical objectives. Management executes the tactics to accomplish these goals, but having an outside body hold management accountable yields positive results.

Third, a healthy board will ask questions of management, and board members will inject their individual business experiences into the discussion. This is critical, and why having a diverse board is so important. You want a variety of perspectives. Different experiences, disciplines and training add value to board deliberations.

And you want genuine debate and discussion. A board member who does not participate adds no value, other than window dressing. If all board decisions are unanimous, you’ve either found the easy business we all have been searching for (truly a unicorn) or you are not having the vigorous business discussion you should have. After that vigorous debate, everyone should lock arms and walk out of the room as a team, knowing that a full range of views has been considered.

Which leads me to my final point: What is a “good” board? One that includes diversity of perspective and shows a willingness to speak up (and out) and debate, and to contribute to a group chemistry that affirms questioning. In my experience, it’s not the bad judgment about known facts that does the most damage; it’s the thing you never saw coming. The blind spot, the change in the market, the risk incurred that didn’t seem that significant at the time but, when cumulated, turns into a potential disaster.

A good board is always asking, What’s next? What don’t we see? What’s the next threat? How can we improve this? The board can also help management take a longer-term view—look not just at the tactics of performance today, but at the future and how and whom should be identified to create that future.

If you view your board as just a nice ornament, you should expect that output: ornamental. There are some CEOs who simply want mushrooms—watered, fed, kept in the dark. A strong CEO wants a strong board, one that will put leaders through their paces on a regular basis, whose members will ask probing questions and help management avoid the freight train it never saw coming down the track.•

This article was provided by Matt Neff, a senior advisor to Citadel Earth, and was previously published with the Indianapolis Business Journal.

I saw the magician David Copperfield in Las Vegas one time. The headline of the act was that he would make an elephant disappear, right before the audience’s eyes! After lots of buildup, which was actually audience conditioning, the elephant was introduced with a flourish. And then, as David Copperfield worked his magic, it was gone.

As the chief once said in the movie “Little Big Man,” “sometimes the magic works, sometimes it doesn’t.” With the attention-grabbing lab-testing company Theranos, it didn’t. Failure happens a lot in business; things don’t work out with people, markets change, reimbursements are cut, yada yada yada. But Theranos was different, in epic proportion. What made it so unique, and how in the world could so many smart people be completely misled?

Recall that Theranos was founded by a charismatic 19-year-old named Elizabeth Holmes. Holmes had a compelling story: She dropped out of Stanford after her freshman year and used her tuition money to start Theranos. Her stated goal was to end the painful process of drawing blood to run lab tests. What if lab testing could become so automated, so precise, that only 1/1000th of the amount of blood was needed? Think of the impact on the chronically ill who endure routine blood draws, as well as pediatric patients who have much less blood than adults, or the elderly, with brittle veins? This would be rCitadel Earthary, disruptive, and really profitable!

Holmes set about to condition the audience. She adopted Steve Jobs-like attributes, aggressively protecting secret processes, and dressing in exclusively black turtleneck shirts. She became the rage: a wunderkind, visionary, scientific genius, and the founder of a unicorn, a startup valued at $1 billion. At peak, its valuation was $9 billion.

Theranos was masterful at recruiting high-profile individuals to its board of directors and advisory board. These included two former secretaries of defense, two former secretaries of state, notable investors and U.S. generals. The military would obviously be a large market for the Theranos testing equipment, and who wouldn’t have faith in people of this stature?

The company also lined up partners who would begin to roll out the product to consumers. Walgreen’s invested in Theranos and began to offer its test menu at Walgreen’s stores.

Over the course of 14 years, Theranos caused heart palpitations in the world of lab management. If the company had in fact accomplished this automated, small-sample processing, then many labs across the world had just become obsolete. Those laboratorians, and many others, asked to see how Theranos had accomplished this feat. But Theranos jealously guarded its secrets and did not engage in the scientific method of publishing data, inviting the scientific community to scrutinize, challenge, and seek to replicate that data. That method, among other things, seeks to offset what is known as “confirmation bias,” the human tendency to find proof that supports your opinion, or hypothesis, or to, in a sense, see what you had hoped to see.

Theranos raised $700 million of capital. Holmes was on the cover of major magazines, black turtleneck and all. Labs around the world began to wonder whether their equipment and methods had just been rendered obsolete. Except that none of this was true.

The Food and Drug Administration could not confirm results. Tests that had been done by Theranos could not be validated. Employees of Theranos began to leak information that further undercut the credibility of the claimed results. The Wall Street Journal did a series of relentless exposes, claiming that this was a fraud—and it was.

Today, Theranos is all but out of business. Holmes was fined $500,000, forced to give up control of Theranos, and barred from public company service for 10 years, on the civil side. The criminal side of the legal risks have not yet been revealed.

So what lessons can be learned from this? Well, first, confirmation bias is a dangerous thing. Due diligence cannot be short-circuited by relying on the presence of big-name investors (remember Bernie Madoff?). There is a reason that the scientific method has developed and persisted over hundreds of years. When you desperately want to improve clinical health care, make it more efficient and cost-effective, automating lab work seems like a natural. We live in an era of quantum leaps in technology; why wouldn’t that happen in blood draws?

At the end of the David Copperfield show, a lot of people saw the magician make the elephant disappear, because that’s what they hoped to see. It was a similar story with Theranos. Except in that case, what disappeared was a unicorn; and a lot of money.•

This article was provided by Matt Neff, a senior advisor to Citadel Earth, and was previously published with the Indianapolis Business Journal.

Hospitals are busy places. They are driven by needs that change rapidly and occur at high intensity, in ways that are difficult to anticipate. Just staying ahead of the immediate demands of patients, and their families, is challenge enough.

And yet, in unforeseeable ways, and at unexpected times, doctors, nurses and hospital staff generate ideas that are truly innovative. The idea might be a workaround, a process that can be replicated, a device that gets a time-consuming job done in a better or faster way—the opportunities are unlimited. These opportunities are generated as a byproduct of the day-to-day events that occur in health care settings.

Yet most hospitals never capture the innovation. The innovations are forgotten, diverted, diluted, or in some cases, killed—without ever being evaluated for their medical and business potential.

And the evaluation of business potential requires a different lens, or mind-set, than that typically used in health care. Patient-facing decisions are all about mitigating risk; first, do no harm. Business decisions, on the other hand, are balancing acts of risk and reward. So to create a flow of business opportunities requires creating a different frame of reference, one that is organizationally tolerated or, ideally, encouraged.

Some larger health care organizations have developed mechanisms to capture these innovations, in different frames of reference. Some have formed venture capital firms to seek out new ideas and try to form businesses out of them. Some have developed websites to ease the submission of innovative ideas to those charged with the responsibility of evaluating them for reproducibility, expansion and further refinement/investment.

In the most aggressive organizations, investments are made in staff whose mission it is to “troll” for innovation, looking under the rocks of everyday events for innovative ideas. These organizations don’t leave it to chance that a busy doctor or nurse will identify something as innovative and submit it; they send miners out into the field to pan for gold.

Two examples of innovative ideas that became businesses will illustrate a case of happenstance and an intentional effort to systematize. A nurse noticed that, when he couldn’t find a vein to draw blood from elderly patients, if he heated up a wet towel and placed it on the site, the vein moved closer to the surface and enlarged, making the blood draw much easier. The nurse ultimately formed a company that now offers heated pads to prepare for venous sticks.

In a more intentional example involving systemization, Indiana University Health has long been known as a leader in diabetes management. Its care pathways were well-defined. Innovators at IU Health learned that diabetes incidence was skyrocketing in China, and health care institutions there struggled to manage the problem. IU Health took its medical management processes, partnered with a Chinese hospital, and began managing diabetes patients over the web, via video link. A new diabetes management business was born.

The point is that, left to happenstance, innovation might or might not float to the surface of health care organizations, given all the other pressing needs. Truly innovative organizations will create disciplines, and organizational structures, to ferret out innovation and to support and fertilize those innovations. They will find ways to get comfortable with risk because innovation requires a tolerance for failure. Those organizations will not only become the leaders in their field but will thrive as they reduce cost, increase patient and staff satisfaction, and ultimately engender an innovative culture.•

This article was provided by Matt Neff, a senior advisor to Citadel Earth, and was previously published with the Indianapolis Business Journal.