Chapter 10 - Getting Financing or Funding

The Importance of Getting Financing or Funding
Operating without investment capital or borrowed money is more difficult than they anticipated.

Why Most New Ventures Need Funding
Cash flow challenges, capital investments, and lengthy product development cycles are three reasons that most entrepreneurial ventures need to raise money during their early life.

A. Cash Flow Challenges
Inventory must be purchased, employees must be trained and paid, and advertising must be paid for before cash is generated from sales.

B. Capital Investments

The cost of buying real estate, building facilities, and purchasing equipment typically exceeds a firm's ability to provide funds for these needs on its own.

C. Lengthy Product Development Cycles
Some products are under development for years before they generate earnings. The up-front costs often exceed a firm's ability to fund these activities on its own.

Sources of Personal Financing
There are three categories of sources of money in this area: personal funds, friends and family, and bootstrapping.

A. Personal Funds

Involves both financial resources and sweat equity. Sweat equity represents the value of the time and effort that a founder puts into a firm.

B. Friends and Family

Often comes in the form of loans or investments, but can also involve outright gifts, foregone or delayed compensation, or reduced or free rent.

C. Bootstrapping

Finding ways to avoid the need for external financing through creativity, ingenuity, thriftiness, cost-cutting, obtaining grants, or any other means.

Preparing to Raise Debt or Equity Financing
A carefully planned approach to raising money increases a firm’s chance of success and can save an entrepreneur considerable time. Here are the steps involved in properly preparing to raise debt or equity financing

• Determine precisely how much money the company needs.
• Determine the most appropriate type of financing or funding.
• Developing a strategy for engaging potential investors or bankers.

Sources of Equity Funding
The primary disadvantage of equity funding is that the firm’s owners relinquish part of their ownership interest and may lose some control. The primary advantage is access to capital.

A. Business Angels
Business angels are individuals who invest their personal capital directly in start-ups.The prototypical business angel, who invests in entrepreneurial start-ups, is about 50 years old, has high income and wealth, is well educated, has succeeded as an entrepreneur, and invests in companies that are in the region where he or she lives.

B. Venture Capital
Venture capital is money that is invested by venture capital firms in start-ups and small businesses with exceptional growth potential. Venture capital firms are limited partnerships of money managers who raise money in “funds” to invest in start-ups and growing firms. The funds, or pools of money, are raised from high-net-worth individuals, pension plans, university endowments, foreign investors, and similar sources.

C. Initial Public Offering
An IPO is the first sale of stock by a firm to the public. Any later public issuance of shares is referred to as a secondary market offering. When a company goes public, its stock is typically traded on one of the major stock exchanges.

Sources of Debt Financing
Debt financing involves getting a loan or selling corporate bonds. Because it is virtually impossible for a new venture to sell corporate bonds, we’ll focus on obtaining loans.

There are two common types of loans. The first is a single-purpose loan, in which a specific amount of money is borrowed that must be repaid in a fixed amount of time with interest. The second is a line of credit, in which a borrowing “cap” is established and borrowers can use the credit at their discretion. Lines of credit require periodic interest payments.

Advantages are:

• None of the ownership of the firm is surrendered
• Interest payments on a loan are tax-deductible

Disadvantages are:

• It must be repaid, which may be difficult in a start-up venture in which the entrepreneur is focused on getting the company off the ground.
• lenders often impose strict conditions on loans and insist on ample collateral to fully protect their investment.

A. Commercial Banks

Commercial banks have been reluctant to loan funds to entrepreneurial ventures, largely because they are risk-averse and because lending to smaller firms is less profitable for them compared to lending to large, established organizations.

B. SBA Guaranteed Loans

The most notable SBA program available to small businesses is the 7(A) Loan Guaranty Program.

7(A) loan guaranty program: The main Small Business Administration (SBA) program available to small businesses operating through private-sector lenders providing loans that are guaranteed by the SBA; loan guarantees reserved for small businesses that are unable to secure financing through normal lending channels.

C. Other Sources of Debt Financing
1. Vendor credit (also known as trade credit)

When a vendor extends credit to a business in order to allow the business to buy its products and/or services upfront but defer payment until later. The practice is especially common in retail, but it can be seen in other businesses as well.

2. Factoring

A financial transaction whereby a business sells its account receivable to a third party, called a factor, at a discount in exchange for cash.

3. Merchant cash advance

The lender provides a business a lump sum of money in exchange for a share of future sales (typically a set percentage of the business’s daily credit card sales) that covers the payment amount plus fees.

4. Peer-to-peer lending

A financial transaction that occurs directly between individuals or “peers.”

Creative Sources of Financing and Funding

A. Crowdfunding
Crowdfunding is the practice of funding a project or new venture by raising monetary contributions from a large number of people, typically via the Internet.

There are two types of crowdfunding sites: rewards-based crowdfunding and equity-based crowdfunding.

• Rewards-based crowdfunding allows entrepreneurs to raise money in exchange for some type of amenity or reward.
• Equity-based crowdfunding helps businesses raise money by tapping individuals who provide funding in exchange for equity in the business.

B. Leasing
A lease is a written agreement in which the owner of a piece of the property allows an individual or business to use the property for a specified period of time in exchange for payments.

C. SBIR and STTR Grant Programs
The Small Business Innovation Research (SBIR) and the Small Business Technology Transfer (STTR) programs are two important sources of early-stage funding for technology firms.

Small Business Innovation Research (SBIR) competitive grant program that provides over $1 billion per year to small businesses for early-stage and development projects.

The STTR Program is a variation of the SBIR for collaborative research projects that involve small businesses and research organizations, such as universities or federal laboratories.

D. Other Grant Programs
Granting agencies are, by nature, low-key, so they normally need to be sought out. One thing to be careful of is grant-related scams.

E. Strategic Partners
Strategic partners often play a critical role in helping young firms fund their operations and round out their business models.

Chapter 9 - Building a New-Venture Team

Liability of Newness as a Challenge
Liability of newness is a Situation that often causes new firms to falter because the people who start the firms can’t adjust quickly enough to their new roles, and because the firm lacks a “track record” with customers and suppliers. By assembling a talented and experienced new-venture team entrepreneurs can overcome the liability of newness.

Creating a New-Venture Team
The way to impress potential investors, partners, and employees is to put together as strong a team as possible. Investors and others know that experienced personnel and access to good-quality advice contribute greatly to a new venture’s success.

A. The Founder or Founders
Elements of a New-Venture Team are:

• Key employees
• Board of directors
• Other professionals
• Lenders and investors
• Board of advisors
• Management team

1. Size of the Founding Team
Teams bring more talent, resources, ideas, and professional contacts to a new venture than does a sole entrepreneur. The psychological support that co-founders of a business can offer one another can be an important element in a new venture’s success. A founding team larger than four people is typically too large to be practical.

There are three potential pitfalls associated with starting a firm as a team rather than as a sole entrepreneur.

• The team members may not get along.
• If two or more people start a firm as “equals,” conflicts can arise when the firm needs to establish a formal structure and designate one person as the CEO.
• If the founders of a firm have similar areas of expertise, it can be problematic.

2. Qualities of the Founders
The level of a founder’s education is important because it’s believed that entrepreneurial abilities such as search skills, foresight, creativity, and computer skills are enhanced through obtaining a college degree.

Prior entrepreneurial experience, relevant industry experience, and networking are other attributes that strengthen the chances of a founder’s success. Launching a new venture is a complex task, entrepreneurs with prior start-up experience have a distinct advantage.

B. The Management Team and Key Employees
One technique available to entrepreneurs to help prioritize their hiring needs is to maintain a skills profile. A skills profile is a chart that depicts the most important skills that are needed and where skills gaps exist.

Type of Labor for New Ventures

• Full- or part-time employee: Someone who works for a business, at the business’s location, utilizing the business’s tools and equipment and according to the business’s policies and procedures.
• Intern: A person who works for a business as an apprentice or trainee for the purpose of obtaining practical experience.
• Freelancer (or contractor): A person who is in business for themselves, works on their own time with their own tools and equipment, and performs services for a number of different clients.
• Virtual assistant: A freelancer who provides administrative, technical, or creative assistance to clients remotely from a home office.

C. The Roles of the Board of Directors
A board of directors is a panel of individuals who are elected by a corporation’s shareholders to oversee the management of the firm. A board is typically made up of both inside and outside directors. An inside director is a person who is also an officer of the firm. An outside director is someone who is not employed by the firm.

A board of directors has three formal responsibilities:

• Appoint the firm’s officers
• Declare dividends
• Oversee the affairs of the corporation

1. Provide Expert Guidance

Attributes of Effective Boards of Directors

• Strong communication with the CEO
• Customer-focused point of view
• A complementary mix of talents
• Decisiveness
• Mutual respect and regard for each other and the firm’s management team
• Ability and willingness to stand up to the CEO and top managers of the firm
• Strong ethics

Attributes of Strong Board Members

• Strong personal and professional networks
• Respected in their field
• Willingness to make personal introductions on behalf of the firm
• Strong interpersonal communication skills
• Pattern recognition skills
• Investment and/or operating experience
• Ability and willingness to mentor the CEO and the firm’s top managers

2. Lend Legitimacy
Achieving legitimacy through high-quality board members can result in other positive outcomes. Investors like to see new-venture teams, including the board of directors, that have people with enough clout to get their foot in the door with potential suppliers and customers. Board members are also often instrumental in helping young firms arrange financing or funding.

Rounding Out the Team: The Role of Professional Advisers
Founders often rely on professionals with whom they interact for important counsel and advice. In many cases, these professionals become an important part of the new-venture team.

A. Board of Advisors
The main purpose of a board of advisors is to provide guidance and lend legitimacy to a firm. The most important thing that advisory board members can do is make high-level introductions to early customers, suppliers, and business partners.

B. Lenders and Investors
Ways Lenders and Investors Add Value to an Entrepreneurial Venture

• Help identify and recruit key management personnel
• Provide insight into the industry and markets in which the venture intends to participate
• Help the venture fine-tune its business model
• Serve as a sounding board for new ideas
• Provide introductions to additional sources of capital
• Recruit customers
• Help to arrange business partnerships
• Serve on the venture’s board of directors or board of advisors
• Provide a sense of calm in the midst of the emotional roller-coaster ride that many new-venture teams experience

Other Professionals
Attorneys, accountants, and business consultants are often good sources of counsel and advice.

Consultants
A consultant is an individual who gives professional or expert advice. the role of the general business consultant has diminished in importance as businesses seek specialists to obtain advice on complex issues such as patents, tax planning, and security laws.

Consultants fall into two categories: paid consultants and consultants who are made available for free or at a reduced rate through a nonprofit or government agency.

Chapter 8 - Assessing a New Venture’s Financial Strength and Viability

Introduction to Financial Management
The financial management of a firm deals with questions such as the following on an ongoing basis:

• How are we doing? Are we making or losing money?
• How much cash do we have on hand?
• Do we have enough cash to meet our short-term obligations?
• How efficiently are we utilizing our assets?
• How do our growth and net profits compare to those of our industry peers?
• Where will the funds we need for capital improvements come from?
• Are there ways we can partner with other firms to share risk and reduce the amount of cash we need?
• Overall, are we in good shape financially?

Financial Objectives of a Firm

• Profitability is the ability to earn a profit.
• Liquidity is a company’s ability to meet its short-term financial obligations.
• Efficiency is how productively a firm utilizes its assets relative to its revenue and its profits.
• Stability is the strength and vigor of the firm’s overall financial posture.

The Process of Financial Management

1. Preparation of Historic Financial Statements

• Income statement
• Balance sheet
• Statement of cash flows

2. Preparation of Forecasts

• Income
• Expenses
• Capital expenditures

3. Preparation of Pro Forma Financial Statements

• Pro forma income statement
• Pro forma balance sheet
• Pro forma statement of cash flows

4. Ongoing Analysis of Financial Results

• Ratio analysis
• Measuring results versus plans
• Measuring results versus industry norms

Financial Statements
Historical financial statements reflect past performance and are usually prepared on a quarterly and annual basis. Publicly traded firms are required by the Securities and Exchange Commission (SEC) to prepare financial statements and make them available to the public.

Pro forma financial statements are projections for future periods based on forecasts and are typically completed for two to three years in the future. Pro forma financial statements are strictly planning tools and are not required by the SEC.

Historical Financial Statements
Historical financial statements include the income statement, the balance sheet, and the statement of cash flows. The statements are usually prepared in this order because information flows logically from one to the next.

1. Income Statement
The income statement reflects the results of the operations of a firm over a specified period of time. It records all the revenues and expenses for the given period and shows whether the firm is making a profit or is experiencing a loss

2. Balance Sheet
a balance sheet is a snapshot of a company’s assets, liabilities, and owners’ equity at a specific point in time.

The major categories of assets:

• Current assets include cash plus items that are readily convertible to cash, such as accounts receivable, marketable securities, and inventories.
• Fixed assets are assets used over a longer time frame, such as real estate, buildings, equipment, and furniture.
• Other assets are miscellaneous assets, including accumulated goodwill.

The major categories of liabilities listed on a balance sheet are the following:

• Current liabilities include obligations that are payable within a year, including accounts payable, accrued expenses, and the current portion of long-term debt.
• Long-term liabilities include notes or loans that are repayable beyond one year, including liabilities associated with purchasing real estate, buildings, and equipment.
• Owners’ equity is the equity invested in the business by its owners plus the accumulated earnings retained by the business after paying dividends.

3. Statement of Cash Flows
Summarizes the changes in a firm’s cash position for a specified period of time and details of why the change occurred.

The statement of cash flows is divided into three separate activities:

• Operating activities include net income (or loss), depreciation, and changes in current assets and current liabilities other than cash and short-term debt. A firm’s net income, taken from its income statement, is the first line on the corresponding period’s cash flow statement.
• Investing activities include the purchase, sale, or investment in fixed assets, such as real estate, equipment, and buildings.
• Financing activities include cash raised during the period by borrowing money or selling stock and/or cash used during the period by paying dividends, buying back outstanding stock, or buying back outstanding bonds.

4. Ratio Analysis
To interpret or make sense of a firm’s historical financial statements
The ratios are divided into profitability ratios, liquidity ratios, and overall financial stability ratios.

5. Comparing a Firm’s Financial Results to Industry Norms
helps a firm determine how it stacks up against its competitors and if there are any financial “red flags” requiring attention.

Forecasts
Forecasts are predictions of a firm’s future sales, expenses, income, and capital expenditures. A firm’s forecasts provide the basis for its pro forma financial statements. A well-developed set of pro forma financial statements helps a firm create accurate budgets, build financial plans, and manage its finances in a proactive rather than a reactive manner.

A. Sales Forecast
A projection of a firm’s sales for a specified period
A sales forecast for an existing firm is based on (1) its record of past sales, (2) its current production capacity and product demand, and (3) any factor or factors that will affect its future production capacity and product demand.

B. Forecast of Costs of Sales and Other Items
After completing its sales forecast, a firm must forecast its cost of sales (or cost of goods sold) and the other items on its income statement. The most common way to do this is to use the percent-of-sales method, which is a method for expressing each expense item as a percentage of sales.

Pro Forma Financial Statements
A firm’s pro forma financial statements are similar to its historical financial statements except that they look forward rather than track the past.

A. Pro Forma Income Statement
A financial statement that shows the projected flow of cash into and out of a company for a specific period.

B. Pro Forma Balance Sheet
It provides a firm with a sense of how its activities will affect its ability to meet its short-term liabilities and how its finances will evolve over time. It can also quickly show how much of a firm’s money will be tied up in accounts receivable, inventory, and equipment. The pro forma balance sheet is also used to project the overall financial soundness of a company.

C. Pro Forma Statement of Cash Flows
Shows the projected flow of cash into and out of the company during a specified period.
The important function of the pro forma statement of cash flows is to project whether the firm will have sufficient cash to meet its needs.
Pro forma statement of cash flows is broken into three activities: operating activities, investing activities, and financing activities.

D. Ratio Analysis
The same financial ratios used to evaluate a firm’s historical financial statements should be used to evaluate the pro forma financial statements.