IPFW Business Plan Competition Pre-competition Program Financing and Capital Sourcing Options By Dr. Bill Todorovic Richard T. Doermer School of Business and Management Neff Hall 340L, Tel. (260) 481 6940 E-mail: [email_address] Web: http://users.ipfw.edu/todorovz /
The Nature of a Firm and Its Financing Sources
Factors That Determine Financing
Firm’s economic potential
Maturity of the company
Nature of its assets
Owners’ preferences for debt or equity
Sources Of Funds Personal Friends and Family Angels Venture Capitalist Banks Government Customers/Suppliers IPO Amount Company Size Start-up Going Concern Beginning of Production ?
Sources of Financing 0 10 20 30 40 50 60 70 80 Personal Savings Family Members Partners Personal Charge Cards Friends Bank Loans Private Investors Mortgaged Property Venture Capital Other Percentage of Entrepreneurs Using Source of Financing Sources of Financing
Critical Financing Factors
Accomplishments and performance to date.
Investor’s perceived risk.
Industry and technology.
Venture upside potential and anticipated exit timing.
Venture anticipated growth rate
Venture age and stage of development.
Critical Financing Factors
Investor’s required rate of return
Amount of capital required and prior valuations of the venture
Founders’ goals regarding growth, control, liquidity, and harvesting.
Relative bargaining positions.
Investor’s required terms and covenants.
Debt or Equity?
Entrepreneurs typically prefer debt
Allows them to appropriate as much as of the benefit as possible + retain sole control
Debt is unattractive to investors in emerging technology
Usually little collateral or predictable cash flow
Information asymmetry is lessened by ownership position – shared ownership gives some control
High interest rate to offset risk will stifle growth or cause default
Debt or Equity Financing?
Voting / Control
Tradeoffs Among Potential Profitability, Financial Risk, and Voting Fig. 13.1 Equity financing Debt financing HIGH LOW LOW HIGH Equity Financing Debt Financing Potential Profitability Financial Risk/Control
Debt Versus Equity With no debt and all equity: Equity: Owners get to keep all of the profits in return for accepting the risk of lower returns $28,000 income on total assets of $200,000 14% return on assets ($28,000 ÷ $200,000) 14% return on $200,000 ($28,000 ÷ $200,000) No debt equals $200,000 equity
Debt Versus Equity (Cont’d) Debt is Risky: Lenders have first claim on profits and must be paid even if there are no profits. $28,000 income on total assets of $200,000 14% return on assets ($28,000 ÷ $200,000) 18% return on $100,000 ($18,000 ÷ $100,000) $100,000 debt (10% cost) equals $100,000 equity With $100,000 debt and $100,000 equity:
Sources of Funds Fig. 13.3 Debt Equity Personal Savings Other Individual Investors Business Suppliers Asset-Based Lenders Commercial Banks Government-Sponsored Programs Community-Based Financial Institutions Large Corporations Venture Capital Firms Sale of Stock Friends and Relatives
The Banker’s Perspective
The Five C’s of Credit
Character of the borrower
Capacity of the borrower to repay the loan
Capital invested in the venture by the borrower
Conditions of the industry and economy
Collateral available to secure the loan
Questions Lenders Ask
What are the strengths and qualities of the management team?
How has the firm performed financially?
How much money is needed?
What is the venture going to do with the money?
When is the money needed?
When and how will the money be paid back?
Does the borrower have qualified support people, such as a good public accountant and attorney?
Financial Information Required for a Bank Loan
Three years of the firm’s historical statements
The firm’s pro forma financial statements
Personal financial statements
Negotiating a Loan
Terms of Loans
Loan maturity date
Getting to know your friendly neighborhood Venture Capitalist…
The myth… and the reality
The myth: VCs support good people and good ideas
The reality: VCs invest in industries with double digit growth in the middle of the S-curve
Appropriate management team
Specialty funds (earlier and later stages on the S-curve)
Limits the risk to management risk
Produces attractive exit opportunities
Present Day Situation
Myth: There is less available capital
Fact: The industry has plenty of money, but limited appetite for new investment
Fact: Investor attitudes toward risk have changed
The venture capital industry
Accounts for about 2/3 of private-sector external equity financing of high tech firms in U.S., but less than 1% of all equity in SMEs
VC sensitive to capital gains tax, ability of institutional investors to contribute to high risk funds, and performance of the stock market (especially IPOs)
Highly specialized by industry, location and stage
VC fills a void
Gap between innovation and traditional sources of debt
Risk inherent in startups typically justify interest rates higher than allowed by law
VCs must balance high returns for their investors against sufficient upside potential for entrepreneurs to keep them motivated
What VCs get out of it
10X return on capital over 5 years
VCs management fees and high growth funds
Fund structured with limited and general partners and a life of 7-10 years
What VCs Do?
When the Market is Down…
The Overhang: Uninvested Capital Complements of Thompson Venture Economics
Well to do private individuals
Geography and industry specific
Invest lower amount than VC
Often a good source of industry experience
Professionals (lawyers, accountants, bankers)
Local small business development centers
Internet associations (e.g., Technology Capital Network at MIT)
Other Sources of Financing
Community-based financial institutions
Initial public offering (IPO)
Why Companies Invest?
Preemption of new rivals
Replace core earnings lost because of an emerging technology
Apply existing competitive advantage in a rapidly growing market