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    • 1. <ul><li>Learning objective: </li></ul><ul><li>Types of financing available. </li></ul><ul><li>Commercial bank loans. </li></ul><ul><li>Research and development limited partnerships. </li></ul><ul><li>Private placements. </li></ul>Chapter 11 Sources of Capital
    • 2. Types of financing: <ul><li>Debt financing involves an interest bearing instrument, usually a loan. </li></ul><ul><li>Asset-based: some asset must be used as a collateral. </li></ul><ul><li>Entrepreneur pays back amount borrowed, plus interest. (Amount unrelated to sales or profits of business.) </li></ul><ul><ul><li>Short term money is used for working capital. </li></ul></ul><ul><ul><li>Long term debt (&gt;1year) is used to purchase assets (often with part of asset used a collateral). </li></ul></ul><ul><li>Advantage: Entrepreneur retains ownership position and have greater return on equity. </li></ul><ul><li>Disadvantage: If payments too large, inhibits growth. </li></ul>11-1
    • 3. Types of financing: <ul><li>Equity financing offers the investor some form of ownership. </li></ul><ul><li>The investor shares in the profits of the venture. </li></ul><ul><li>In a market economy, all ventures will have some equity, as all are owned by someone (single or multiple owners). </li></ul><ul><li>Equity funding provides the basis for debt financing. </li></ul><ul><li>Key factors in choice of financing: availability of funds, assets of the venture, prevailing interest rates. </li></ul><ul><li>Usually a combination of debt and equity financing is used. </li></ul>11-1
    • 4. Factors Affecting Type Of Financing <ul><li>Availability of Funds </li></ul><ul><li>Assets of Venture </li></ul><ul><li>Prevailing Interest Rates </li></ul><ul><li>All Financing Requires Some Level of Equity </li></ul>
    • 5. Internal vs. External Funds <ul><li>Internally generated funds come from sources within the company, e.g. profits, sale of assets, reduction in working capital, and accounts receivable. </li></ul><ul><ul><li>Short term internal funds can be obtained through extended payments to suppliers, or collecting accounts receivable more quickly. </li></ul></ul><ul><ul><li>Little used assets can be sold or leased. </li></ul></ul><ul><ul><li>Start-up ventures usually use internal funding source: “plough all profits back into the venture.” </li></ul></ul><ul><ul><li>To minimize financial needs: assets should be on a rental basis whenever possible, not an ownership basis. </li></ul></ul><ul><li>Alternative (external) sources should be evaluated by: </li></ul><ul><ul><li>Length of time funds available </li></ul></ul><ul><ul><li>Costs involved </li></ul></ul><ul><ul><li>Amount of control lost </li></ul></ul>
    • 6. External Funds <ul><li>Self </li></ul><ul><li>Family &amp; Friends </li></ul><ul><li>Suppliers &amp; Trade Credit </li></ul><ul><li>Commercial Banks </li></ul><ul><li>Government Loan Programs </li></ul><ul><li>R &amp; D Limited Partnerships </li></ul><ul><li>Venture Capital </li></ul><ul><li>Private Equity Placements </li></ul><ul><li>Public Equity Offerings </li></ul><ul><li>Other Government Programs </li></ul>
    • 7. Personal Funds <ul><li>Few new venture started without using personal funds of entrepreneur. </li></ul><ul><ul><li>Savings, life insurance, car/home mortgage, etc. </li></ul></ul><ul><li>Least expensive in terms of cost and control. </li></ul><ul><li>Essential in attracting outside funding. </li></ul><ul><li>Put your money where your mouth is! </li></ul><ul><li>Outside investors wants demonstration of financial commitment: </li></ul><ul><ul><li>Wants to see entrepreneur has committed all monies available. (Level of commitment reflected by percentage of available assets rather than absolute amount.) </li></ul></ul>
    • 8. Family and Friends <ul><li>Next most common source of capital. </li></ul><ul><li>Relatively easy to obtain, but amount may be small. </li></ul><ul><ul><li>Often more patient regarding repayment. </li></ul></ul><ul><li>If in form of equity funding, family member or friend has an ownership position in the venture. </li></ul><ul><li>If they have direct input into the operations of the venture, may have negative effect on employees and profit. </li></ul><ul><li>To avoid potential future problems: </li></ul><ul><ul><li>Keep business arrangement strictly business. </li></ul></ul><ul><ul><li>Loans should specify interest rate and repayment schedule. </li></ul></ul><ul><ul><li>Should be up-front and put agreement formally in writing. </li></ul></ul><ul><li>Entrepreneur should carefully consider impact of investment on family member or friend before it is accepted. Will lost have severe impact on friends/family? </li></ul>
    • 9. The Role of Commercial Banks: <ul><li>Commercial banks are the most frequently used source of short-term funds. </li></ul><ul><li>Debt financing: requires some asset with value as collateral. </li></ul><ul><ul><li>Collateral can be business assets, personal assets, or assets of a co-signer of the note. </li></ul></ul>11-3
    • 10. Types of bank loans include: <ul><li>Asset-based loans: </li></ul><ul><li>accounts receivable loans </li></ul><ul><li>inventory loans </li></ul><ul><li>equipment loans </li></ul><ul><li>real estate loans </li></ul><ul><li>Cash-flow financing: </li></ul><ul><li>lines of credit </li></ul><ul><li>installment loans </li></ul><ul><li>straight, commercial loans </li></ul><ul><li>long term loans </li></ul><ul><li>character loans </li></ul>11-4
    • 11. Accounts Receivable Loans <ul><li>Good basis, esp. if customer base is creditworthy. </li></ul><ul><li>Bank may finance up to 80% of value of accounts receivable. </li></ul><ul><li>Factoring arrangement: </li></ul><ul><ul><li>The factor (bank) buys the accounts and collects the money. </li></ul></ul><ul><ul><li>If receivables not collected, the factor sustains the loss, not the business. </li></ul></ul><ul><ul><li>More costly than securing a loan against accounts receivable. </li></ul></ul><ul><li>Real Estate Loans </li></ul><ul><li>Easily obtained to finance land, plant or building. </li></ul><ul><li>Usually up to 75% of value. </li></ul>
    • 12. Inventory Loans <ul><li>Good basis if inventory is liquid, i.e. can be sold quickly. </li></ul><ul><li>Finished goods inventory can be financed up to 50% of value. </li></ul><ul><li>Trust receipts: The bank advances a large percentage of the inventory price of goods and is paid on a pro rate basis as inventory is sold. </li></ul><ul><ul><li>Often used to finance floor plans of retailers, e.g. car dealers. </li></ul></ul><ul><li>Equipment Loans </li></ul><ul><li>Used to secure longer term financing, up to 3 to 10 years. </li></ul><ul><li>When new equipment bought, 50% to 80% of value can be financed. </li></ul><ul><li>Sale-leaseback: Entrepreneur “sells” the equipment to a lender and then leases it back for use. </li></ul>
    • 13. Cash Flow Financing (Conventional Bank Loans) <ul><li>Lines of credit </li></ul><ul><ul><li>Most frequently used </li></ul></ul><ul><ul><li>Company pays a “commitment fee” at the beginning and pays interest on outstanding borrowed funds </li></ul></ul><ul><li>Installment loans </li></ul><ul><ul><li>Used to cover working capital needs, usually for 30 to 40 days. </li></ul></ul><ul><ul><li>Easy to get for going venture with track record of sales and profit. </li></ul></ul><ul><li>Straight commercial loans </li></ul><ul><ul><li>Used for seasonal financing; self-liquidating. </li></ul></ul><ul><ul><li>Like installment loans, funds advanced for 30 to 90 days. </li></ul></ul><ul><li>Long term loans </li></ul><ul><ul><li>Usually available to only more mature companies. </li></ul></ul><ul><ul><li>Funds available for up to 10 years, with fixed debt repayment schedule. </li></ul></ul><ul><li>Character loans </li></ul><ul><ul><li>Assets of individual pledged as collateral, or loan co-signed by another person. </li></ul></ul>
    • 14. Lending decisions are based on the five C’s. Can you name them? <ul><li>Character </li></ul><ul><li>Capacity </li></ul><ul><li>Capital </li></ul><ul><li>Collateral </li></ul><ul><li>Conditions </li></ul>11-5
    • 15. Bank Lending Decisions <ul><li>Banks are very cautious in lending money, esp. to new ventures. </li></ul><ul><li>Decisions made based on quantifiable information and subjective judgment. </li></ul><ul><li>Loan officer does a careful review of the borrower. </li></ul><ul><ul><li>Past financial statements are reviewed (for key profitability and credit ratios, age of accounts receivable and entrepreneur’s capital invested and commitment). </li></ul></ul><ul><ul><li>Future projections on market size, sales and profitability are evaluated to determine ability to repay. Projections realistic? </li></ul></ul><ul><li>Loan application form is a mini business plan. </li></ul><ul><ul><li>Provides information on the credit worthiness of person and ability of venture to repay the loan. </li></ul></ul>
    • 16. Lending Questions <ul><li>Does Entrepreneur Expect To Be Carried By Loan? </li></ul><ul><li>Is Entrepreneur Committed To Spend Effort To Succeed? </li></ul><ul><li>Business Have Unique Advantage? </li></ul><ul><li>Downside Risks? </li></ul><ul><li>Protection Against Disasters? </li></ul>
    • 17. Bank “Shopping” Process <ul><li>Complete Business Plan &amp; Application </li></ul><ul><li>Evaluate Several Alternative Banks </li></ul><ul><ul><li>Should compare track record and lending policies of several banks. </li></ul></ul><ul><li>Select One With Positive Experience in Business Area </li></ul><ul><li>Set Appointment </li></ul><ul><li>Present Case/Plan </li></ul><ul><li>Borrow Maximum Amount Possible </li></ul><ul><ul><li>Provided prevailing interest rates and terms are satisfactory. </li></ul></ul><ul><ul><li>Care should be taken that venture will generate enough cash for interest and principal repayment. </li></ul></ul>
    • 18. Access the SBA online at www.sba.gov. <ul><li>The SBA guarantees that 80% of the loan will be repaid to the bank if the company defaults. </li></ul><ul><li>Micro-loans are made up to $100,000 through the SBA’s “LowDoc Loan Program.” </li></ul>11-6
    • 19. Research and Development Limited Partnerships <ul><li>Useful when developing a new technology involving high risk and significant expense. </li></ul><ul><li>Sponsoring company (general partner) </li></ul><ul><ul><li>Do the research and development leading to a marketable technology on best-effort basis. (success not guaranteed!) </li></ul></ul><ul><li>Limited partners </li></ul><ul><ul><li>Provide funds and assumes limited liability for loss. </li></ul></ul><ul><ul><li>Tax advantages. </li></ul></ul><ul><ul><li>Shares in profit if development succeeds. </li></ul></ul><ul><li>Procedure: </li></ul><ul><ul><li>Funding stage: contract between two parties established. </li></ul></ul><ul><ul><li>Development stage: actual research performed. If successful, </li></ul></ul><ul><ul><li>Exit stage: reap commercial benefits via equity partnerships, royalty partnerships and joint ventures. </li></ul></ul><ul><li>Benefits/Cost: </li></ul><ul><ul><li>Provides funds with minimum equity dilution </li></ul></ul><ul><ul><li>Expensive to establish </li></ul></ul>Shared risk &amp; rewards
    • 20. Private Placements are another source of funds. <ul><li>Private investors may be: </li></ul><ul><ul><li>family </li></ul></ul><ul><ul><li>friends </li></ul></ul><ul><ul><li>wealthy individuals. </li></ul></ul><ul><li>Private investors usually want an equity position in the business. Active or passive? </li></ul><ul><ul><li>“ Regulation D” simplifies private offerings and contains specific operating rules. </li></ul></ul>11-7
    • 21. Outside Capital <ul><li>Takes time to raise outside capital at a time when company can least afford the time. </li></ul><ul><li>Often decreases a firm’s drive to make money. </li></ul><ul><li>Availability of capital increases the impulse to spend. </li></ul><ul><li>Can decrease the company’s flexibility and hamper the creativity of the entrepreneur. </li></ul><ul><li>May cause more problems and disruption (but equity needed!) </li></ul><ul><li>Outside capital should only be sought after all possible internal sources of funds have been explored. </li></ul><ul><li>Outside sources should be evaluated; must not forget basics of business. </li></ul>
    • 22. <ul><li>Learning objectives: </li></ul><ul><li>Basic stages of venture funding. </li></ul><ul><li>Informal risk-capital market. </li></ul><ul><li>Nature of venture capital decisions and the industry. </li></ul><ul><li>Approaches for valuation of your company. </li></ul>Chapter 12 Informal Risk Capital and Venture Capital
    • 23. Regarding the basic stages of venture funding: <ul><li>Early stage financing is the most difficult and costly to obtain. </li></ul><ul><li>Expansion or development financing is easier to obtain. </li></ul><ul><li>Acquisition or leveraged buyout financing is used for traditional acquisitions, buyouts and going private. </li></ul>12-1
    • 24. Table 12.1 Stages of Funding Early Stage Financing 12-2 Product development and initial marketing, but with no commercial sales yet; funding to actually get company operations started. Start-up Relatively small amounts to prove concepts and finance feasibility studies. Seed Capital
    • 25. Stages of Funding (continued) Expansion or development financing. 12-3 Bridge financing to prepare company for public offering. Fourth Stage Major expansion for company with rapid sales growth, at break-even or positive profit levels but still private company. Third Stage Working capital for initial growth phase, but no clear profitability or cash flow yet. Second Stage
    • 26. Stages of Funding (continued) Acquisitions and Leveraged Buyout Financing. 12-4 Some of the owner/managers of a company buying all the outstanding stock, making the company privately held again. Going Private Management of a company acquiring company control by buying out the present owners. Leveraged Buyouts Assuming ownership and control of another company. Traditional Acquisitions
    • 27. The Risk-Capital Market <ul><li>Conventional small businesses have more difficulty obtaining external equity capital. </li></ul><ul><li>Sources of funds for early stage financing: </li></ul><ul><li>Public equity market: </li></ul><ul><ul><li>Available only for high-potential large-scale ventures. </li></ul></ul><ul><li>Venture capital market: </li></ul><ul><ul><li>Venture capital firms like to invest in high-potential ventures, with equity participation. </li></ul></ul><ul><ul><li>Venture may need the minimum level of US$500K capital. </li></ul></ul><ul><li>Informal risk-capital market: </li></ul><ul><ul><li>Individual Investors. </li></ul></ul><ul><ul><li>May be best source for first-stage financing. </li></ul></ul>Business Angels
    • 28. Informal risk-capital market <ul><li>This market consists of a group of wealthy “ business angels ” who are looking for equity investment opportunities. </li></ul><ul><li>Angels generally prefer manufacturing of both industrial and consumer products. </li></ul><ul><ul><li>Firms receiving investment funds are generally within one day’s travel. </li></ul></ul><ul><li>Angel investors find their deals through referral sources such as business associates, friends, and brokers. </li></ul><ul><li>Opportunities are rejected : </li></ul><ul><ul><ul><ul><ul><li>Inadequate risk/return ratio. </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Inadequate management team. </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Lack of interest or knowledge in business area. </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Cannot agree on price. </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Entrepreneurs not committed to venture. </li></ul></ul></ul></ul></ul>12-5
    • 29. Informal Risk Capital <ul><li>This market is about US$80 billion, provides 15% of funding for small technology firms (vs. 125 to 15% from venture capitalists.) </li></ul><ul><li>87% of investors buying private placements were individuals or personal trusts. </li></ul><ul><li>Estimated 1.3 million U.S. families (~ 2% of population) has over US$1 million net worth. </li></ul><ul><li>“ Angels” tend to be well educated (with post-graduate degrees). </li></ul><ul><li>In New England, “angels” averaged one deal every 2 years, each deal averaged US$50K. </li></ul><ul><li>Many expect to play an active role in ventures financed. </li></ul><ul><li>Angels have longer investment horizons, typically 7 to 10 years (vs. venture capitalists’ 5-year horizon.) </li></ul>
    • 30. Venture Capital <ul><li>Venture capital, broadly defined, is a professionally managed equity pool formed from resources of wealthy limited partners, pension funds, endowments and other institutions, typically managed by a general partner (the venture capital firm). </li></ul><ul><li>Long term investments in creation of early-stage companies, expansions, and leveraged buyouts. </li></ul><ul><li>Venture capitalists take an equity participation, through stocks, warrants, and convertible securities and has active involvement in the companies. </li></ul><ul><li>Private venture capital firms emerged in the 1960s. </li></ul>
    • 31. Table 12.3 Total Venture Dollars Invested (in billions of dollars) 12-7
    • 32. Venture Capital Firms <ul><li>Private Venture Capital- General &amp; Limited Partners </li></ul><ul><li>Small Business Investment Company (SBIC) </li></ul><ul><li>Industry Sponsored: </li></ul><ul><ul><li>Banks/Financial Institutions </li></ul></ul><ul><ul><li>Non-Financial Companies </li></ul></ul><ul><li>State Government Sponsored </li></ul><ul><li>University Sponsored </li></ul>
    • 33. Venture Dollars Invested Per Deal In $ Billions
    • 34. Venture Investments Stage In $ Millions
    • 35. Venture Capital Process <ul><li>Objective is to generate long-term capital appreciation. </li></ul><ul><li>Return criteria and risk: </li></ul><ul><ul><li>There is more risk in financing a business early in development, so more return is expected (50% ROI) than in later-stage development (30%). </li></ul></ul><ul><ul><li>Pressure for safer investments may be at odds with entrepreneur’s objective of survival and growth of business. </li></ul></ul><ul><ul><li>VCs usually do not seek control of a company, but will want at least one seat on the Board of Directors. </li></ul></ul><ul><li>Investment criteria: </li></ul><ul><ul><li>Strong management team with solid experience, commitment, and flexibility. </li></ul></ul><ul><ul><ul><li>Prefer 1 st rate team and 2 nd rate product than vice versa. </li></ul></ul></ul><ul><ul><ul><li>Commitment of management should be reflected in dollars invested and support of family. </li></ul></ul></ul><ul><ul><li>Product/Market opportunity must be unique. </li></ul></ul><ul><ul><li>Significant capital appreciation opportunity (40 - 60% expected return) </li></ul></ul>
    • 36. Stages in the venture capital decision process: <ul><li>Stage one: preliminary screening. </li></ul><ul><ul><li>The business plan is submitted. (Clearly written Executive summary important!) </li></ul></ul><ul><ul><li>Industry investigated, credentials and capabilities checked, fit with long-term goals? </li></ul></ul><ul><li>Stage two: agreement on principal terms. </li></ul><ul><li>Stage three: detailed review and due diligence. </li></ul><ul><ul><li>Takes one to three months. </li></ul></ul><ul><li>Final stage: final approval. </li></ul><ul><ul><li>A comprehensive investment memorandum is prepared. </li></ul></ul><ul><li>Process involves intuition and gut feeling (art) and systematic approach and data gathering (science). </li></ul><ul><li>VC firm must first decide on composition of its portfolio mix. </li></ul>12-8
    • 37. Valuing Your Company <ul><li>Valuation of the company is at the core of determining how much ownership an investor is entitled for funding the venture. </li></ul><ul><li>Factors in valuation </li></ul><ul><li>Nature and history of business. </li></ul><ul><ul><li>Info on company’s strengths, diversity, risks and ability. </li></ul></ul><ul><li>Outlook of the general economy and specific industry. </li></ul><ul><ul><li>Examination of company’s financial data vs. other companies. </li></ul></ul><ul><li>Book value (net value) of company’s assets and overall financial condition. </li></ul><ul><ul><li>Book value is acquisition cost minus liabilities, may not be a good indication of market value. </li></ul></ul><ul><ul><li>Good valuation should value operating and non-operating assets separately. </li></ul></ul><ul><li>Future earnings capacity. (most important!) </li></ul><ul><ul><li>Weighted average of previous years’ earnings; income by product line help judge future profitability. </li></ul></ul><ul><li>Dividend paying capacity. </li></ul><ul><li>Goodwill and other intangibles. </li></ul><ul><li>Previous sale of assets. </li></ul><ul><li>Market price of the stock of similar companies. </li></ul>
    • 38. Valuation approaches include: <ul><li>Assessing comparable, publicly held companies. </li></ul><ul><ul><li>Difficult to find counterparts. </li></ul></ul><ul><li>The present value of future cash flows. </li></ul><ul><ul><li>More accurate than profits. </li></ul></ul><ul><ul><li>Sales and earnings projected, desired rate of return set, less a discount for failure to meet expectations. </li></ul></ul><ul><li>Replacement value (Cost of replacing assets.) . </li></ul><ul><li>Adjusted book value considers acquisition cost minus liabilities. </li></ul><ul><ul><li>Adjusted for depreciation, good for relatively new businesses. </li></ul></ul><ul><li>The earnings approach is most widely used. </li></ul><ul><ul><li>Potential earnings calculated by weighting current earnings, price-earning ratio set based on industry norms. </li></ul></ul><ul><li>Factors approach. </li></ul><ul><ul><li>Value determined by: earnings, dividend-paying capacity and book value. </li></ul></ul><ul><li>Liquidation value (value if everything sold) . </li></ul>12-9
    • 39. Venture Capitalist’s Factors In Pricing A Deal <ul><li>Return </li></ul><ul><li>Amount of Money Now/Later </li></ul><ul><li>Quality of Deal </li></ul><ul><li>Quality of Team </li></ul><ul><li>Amount Entrepreneur is Investing </li></ul><ul><li>Company’s Future Prospects </li></ul><ul><li>Upside Potential </li></ul><ul><li>Downside Risk </li></ul><ul><li>Investment Collateral </li></ul><ul><li>Liquidity </li></ul><ul><li>Exit Strategy </li></ul>
    • 40. Deal Structure <ul><li>The terms and conditions of the transaction between the entrepreneur and the funding source. </li></ul><ul><li>Needs of funding source: </li></ul><ul><ul><li>Rate of return required. </li></ul></ul><ul><ul><li>Acceptable level of risk. </li></ul></ul><ul><ul><li>Timing and form of return. </li></ul></ul><ul><ul><li>Amount of control desired. </li></ul></ul><ul><ul><li>Perception of the risks involved. </li></ul></ul><ul><li>Needs of entrepreneur: </li></ul><ul><ul><li>Degree and mechanism of control. </li></ul></ul><ul><ul><li>Amount of financing needed. </li></ul></ul><ul><ul><li>Goals of the firm. </li></ul></ul><ul><li>Both venture capitalist and entrepreneur should be comfortable with the deal structure to create a good working relationship. </li></ul>

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