Objective: Explore lender and investor perspectives relative to capital needs for nascent firms and their growth strategies.
Goal: What are the most important precepts and prescriptions for an organization to consider regarding financing a new venture?
- A nascent entrepreneur is defined as a person who is trying to start a new business, who expects to be the owner or part owner of a new firm, or a person who has been active in trying to start the new firm in the past 12 months (1)
- A lender is an individual, a public group, a private group or a financial institution that makes funds available to another with the expectation that the funds will be repaid, in addition to any interest and/or fees, either in increments (as in a monthly mortgage payment) or as a lump sum (2)
- An investor commits time, money or capital to an endeavor (a business, project, real estate, etc.) with the expectation of obtaining an additional income or profit. (3)
Financing is needed to start a business and ramp it up to profitability. There are several sources to consider when looking for start-up financing, debt (lender) and equity (investor) financing being the two major sources (4.)
Debt financing involves borrowing funds from creditors with the stipulation of repaying the borrowed funds plus interest at a specified future time. For the creditors (those lending the funds to the business), the reward for providing the debt financing is the interest on the amount lent to the borrower (4)
Types of Debt Financing to Consider (4):
Friends and Relatives: great financing source, however, these investments should be made with the same formality that would be used with a commercial lender. This includes the amount borrowed, the interest rate, specific repayment terms (based on the projected cash flow of the start-up business), and collateral in case of default.
Bonds: debt instrument issued by the company used to raise financing for a specific activity. Bonds allow the company to specify the interest rate and when the company will pay back the principal, while also allowing non-payment of the principal and interest until the bond’s maturity date. This provides risk for the investor because possibility of bankruptcy or a default is a possibility.
Government Programs: typically, assistance in the form of a government guarantee of the repayment of a loan from a conventional lender.
Banks and Other Commercial Lenders: the most popular source of financing and also the most difficult to attain, most lenders require a solid business plan, positive track record, and plenty of collateral.
Commercial Finance Companies: at a rate higher than other commercial lenders, finance companies can be considered when a business is unable to secure financing from other commercial sources. Rely on ability to repay the loan versus track record and profit projections of the business.
Equity financing exchanges a portion of the ownership of the business for a financial investment in the business. The ownership stake resulting from an equity investment allows the investor to share in the company’s profits (4)
Issues Considered by the Investor (5)
Strength of the business plan
- Does it seem likely to fail?
- Can I make my required rate of return?
- What are Agency issues in working with the entrepreneur (entrepreneur’s behaviors, information asymmetry)?
- Issues around moral hazard and adverse selection
- Possibility of introducing behavioral controls into the relationship (perhaps by direct participation)
- Transaction costs associated with the introduction of controls
Repayment and Exit Issues You Need to Address (6):
- Repayment or Investment Exit Ability What evidence exists to convince me I’m going to get a return? What is your personal financial situation.
- Management What evidence exists that indicates that this person can manage his/her affairs well enough to allow the opportunity for a return? Have you looked at your credit history?
- Personal Investment What evidence exists that this person has enough of a commitment to the business so that I’ll be sure he/she wants to work hard to protect it? (If they protect theirs, they will be protecting mine!) Most lending institutions will require at least 25 percent cash/equity contributed to the total capital cost of the project.
- Security If all else (above) fails, what protection do I have to get my money back? What will it be worth when the business fails?
Venture Capitalist Valuation
Investors often look at values based on how they will achieve their required returns
- If the investor requires an annual return of 30% on each investment, then they will work backwards from the liquidity event.
- Example: if $1 million is invested now, then a VC would multiply this by the required interest rate (ex: 2.2) and the number of years to calculate their exit percentage.
- Assuming the firm was worth $5 million in year 5, an investor would want $2.2/$5 or 40% of the company now
Types of Equity Financing to Consider (4):
Personal Savings: Personal resources can include profit sharing or early retirement funds, real estate equity loans, or cash value insurance policies.
- Life Insurance Policies: A standard feature of many life insurance policies is the owner’s ability to borrow against the cash value of the policy.
- Home Equity Loans: If your home is paid for, it can be used to generate funds from the entire value of your home.
Friends and Relatives: Personal relationships can be great a financing source, however, these investments should be made with the same formality that would be used with outside investors.
Equity Offerings: equity offerings can raise substantial amounts of funds, and occurs when the business sells stock directly to the public
Initial Public Offerings (IPO): used when companies have profitable operations, management stability, and strong demand for their products or services. Companies are typically in business for several years beforehand.
Warrants: used for long term financing, warrants encourage investment by minimizing risks and maximizing potential. A warrant grants the owner of the warrant to buy issuing stock at a pre-determined price at a future date. Warrants can be issued to management in a start up company as part of a reimbursement practice.
Angel Investor: individuals and businesses who aren’t solely economically driven, but are interested in helping small businesses survive and grow. Angel investors typically focus on earlier stage financing and smaller financing amounts
Venture Capital: provide capital to young businesses in exchange for an ownership share of the business. Venture capitalists are more economic driven and prefer to invest in companies that have received significant equity investments from the founders and are already profitable. Often focused on short term gain
Funds for Free from the Federal Government
Government Grants: Federal and state governments often have financial assistance in the form of grants and/or tax credits for start-up or expanding businesses.
The government-run website grants.gov is an excellent place to start. It has all the information you need to understand the process of obtaining funds from the federal government. The huge benefit of Carmike Grande since that you will not be required to repay a grant. This is in contrast to alone you might request from the Small Business Administration. The downside is that obtaining grants is its own Challenge and quite different than writing a business plan. It is likely that you will need input from someone who has expertise in writing Grant applications. The second downside is that being process of obtaining federal funds is not a quick one. If you desire to get your company up and running quickly then this mechanism is not going to fit your needs.
Capital Needs & Growth Strategies (5)
Equity Financing over Enterprise Lifecycle
- Concept Stage
- Family and Friends
- Business Start Up
- Government Programs
- First Stage Expansion
- Some Venture Capital
- Bank Financing
- Second Stage Expansion
- Venture Capitalist
- Third Stage Expansion
Interrogate and Extend Concepts
Goal: Propose and answer clarifying questions about the session. These clarifying questions are intended to consider and challenge the resources, ideas, and concepts.
Q & A #1: What should I pursue absolute control over the company direction or funds?
The reality is that there are several scenarios: You can potentially give up so much equity that you lose interest in your organization and have little incentive to carry on.
Starting a new venture is incredibly time-consuming and stressful. If you give up too much equity to launch your new enterprise you may end up with so little obvious potential return that it’s hard to justify the effort involved. Alternatively, you can be so focused on maintaining control that you miss opportunities to obtain the funds you all actually need to launch the company. An investor is not going to buy into your concept unless they perceive that they will receive a fair return on their investment.
You will need to seek the middle ground where you give up some equity in exchange for sufficient funds to support the vision you have created. One solution which is effective is to ask for funds in stages. That is, only asked for as much money as you need at the exact moment. That process maximizes the value you get for the money since as the company achieves success it will be able to acquire more money at a lower cost per equity given away.
Q & A #2 (DEVIL’S ADVOCATE): Money is money right?
In fact, money comes and multiple forms.
Some investors will be a poor match for your vision and goals. Imagine an investor who only cares about profit in a company where you care about sustainability and treatment of employees. You will end up in endless fights about how to save money.
Or you may choose the investor who can give you more money to launch your company but is swamped with other activities. You may have done better with the investor who less last money but who had the time to help answer your questions and guide you in your new enterprise.
Goal: Supply current, quality web links to supplementary material that support, illustrate, elaborate/expound on, typify, and challenge a concept, piece of content, or idea.
- Why we chose the supplementary material: Financing Your New Venture provides information regarding the financing solutions available, as well as sharing when and how these solutions can be obtained, delivering the content in an accessible PowerPoint format.
- What is important about it: Financing is a key function in any business. Ventures that handle cash flow negatively do not last. Financing Your New Ventures provides steps to valuing your business for venture capitalists, and angel investors, while providing tips to finance your venture the best to your ability with additional resources first.
- What part(s) of the Learning Module it supplements: Financing Your New Venture supports the various forms of financing available, be it debt or equity, while providing tips on how to secure the financing necessary.
- What the key takeaways are: As a new venture you should determine if it is important to raise enough money to cover the total cumulative negative cash flow. Despite what you decide, reducing the amount needed through careful management of expenses and cash flow should be the goal. Personal funding is the most common and least expensive form of financing, but may not reap the cash necessary. Turning to debt financing doesn’t involve reducing control as equity financing does, but each have their pros and cons. If equity financing is determined to be favorable, be aware that if you want an investor, you have to show them a specific exit strategy (sometimes more than one).
- Why we chose the supplementary material: We hear the importance of financing for new ventures, but aren’t given the tools to manage and dictate financing services to work efficiently.
- What is important about it: Discusses and defines asset management and it’s place in debt and equity financing
- What part(s) of the Learning Module it supplements: While the various levels of financing are discussed, Financial Resources for New Ventures shares the importance of managing the financing tool chosen to make it work for the business efficiently.
- What the key takeaways are: Financing means more than merely obtaining money, but is very much a process of managing assets wisely to use capital efficiently.
Planning New Venture – (2008) Planning the New Venture. In: Nurturing Science-based Ventures. Springer, London
- Why we chose the supplementary material: Discusses the importance of a business plan in financing your venture, providing a step by step checklist of what should be in a business plan.
- What is important about it: Provides information on what a business plan is, what should be included in a business plan, along with who will read the business plan.
- What part(s) of the Learning Module it supplements: While Learning Module E discusses investor and lender perspectives regarding financing, Planning the New Venture provides the what and how to achieving this financing, through use of the business plan.
- What the key takeaways are: Lenders and investors want to know that you’ve invested time, money, and effort into the life of the business before they’ll ever consider investing. A business plan shows commitment to the venture, and provides a road map to what you want to achieve, and how you plan to achieve it.
Debt and Equity Financing – Dr. Bill Todorovic Richard T. Doermer School of Business and Management
- Why we chose the supplementary material: This material provides a comparison of debt and equity financing, touching on factors considered in financing along with questions lenders may ask
- What is important about it: Being aware of the questions lenders could ask, and factors taken into consideration for financing, venture will be better prepared and aligned for financing success.
- What part(s) of the Learning Module it supplements: The material supplements the detail of financing available for debt and equity financing
- What the key takeaways are: It’s basically high profitability vs. high financial risk
The Life Cycle of Entrepreneurial Ventures
Types and Sources of Financing for Start-up Businesses