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choosing right finance.ppt

  1. Chapter 14 CHOICE OF FINANCING Material from ENTREPRENEURIAL FINANCE: STRATEGY, VALUATION, AND DEAL STRUCTURE, by Janet Kiholm Smith, Richard L. Smith, and Richard T. Bliss, © by Stanford University, all rights reserved. Instructors may make copies of PowerPoint Presentation contained herein for classroom distribution only. Any further reproduction, distribution, or use of this material, in any way or by any means, is strictly prohibited without the prior written permission of the publisher.
  2. Learning Objectives • Understand the factors that influence the financing choice • Explain why immediacy of financial need limits financing alternatives and planning yields more alternatives and less expensive ones • Understand why the financing choice depends on size of need, duration, and incentive effects of different financing structures • Evaluate alternatives in light of the venture’s financial condition, development stage, and capabilities of capital providers 2
  3. Learning Objectives (cont’d.) • Identify advantages and disadvantages of relational financing arrangements such as strategic partnering and franchising • Explain how and why financial distress affects available financing • Understand how collateral, relationships, and reputations affect available financing • Recognize that financing involves negotiation between parties with different incentives to complete a deal quickly or to slow negotiations • Avoid financing missteps in dealing with market downturns 3
  4. 4 Financing Alternatives
  5. Basic Considerations That Affect Financing Choices • If prospective investors agree about the venture’s prospects, external financing is preferred to financing by the entrepreneur • If the entrepreneur and investor have symmetric expectations about future prospects, financing that shifts risk to the investor increases the value of the entrepreneur’s claim 5
  6. Other Considerations That Affect Financing Choices • Value of monitoring and advisory functions • Venture’s taxable status • Costs/benefits of subsidized financing (e.g., SBA loans) • Potential for value creation through staging 6
  7. An Overview of the Financing Decision Process • Four critical questions link financial needs to choice of financing. 1. Is there an immediate (urgent) need for financing? 2. Is the near-term financing need large? 3. Is the near-term financing need permanent? 4. How does the financing need in the near-term relate to the cumulative need for financing? 7
  8. First Step: Assess the Current Stage and Condition of the Venture • The stage of development • Development stage and financing options for high-risk ventures • The value of outside advice • The asset base 8
  9. Seed /Start-up Stage • No revenue and few tangible assets • Dominant form of financing is equity from founder, friends, and family • Bootstrapping is common • High-potential ventures may have access to outside capital 9
  10. Figure 14.2, Panel (a) 10 Panel (a) Yes No Small Large 1. Existing shareholders 2. Friends and family 3. Bootstrapping Seed/Start-up venture (no revenue; few tangible assets) Is the need immediate and urgent? How big is the financing need? Equity 1. Existing shareholders 2. Friends and family Debt 1. Bootstrapping Equity 1. Angel investors 2. Venture capital 3. Strategic partner Debt 1. Loan 2. SBA/government programs The Financing Decision Process
  11. Early-Growth Stage • Low, but rapidly growing revenue • Some tangible assets • No profit or operating cash flow • Growth capital can be debt or equity • Additional funding sources that are tied to their operations 11
  12. Figure 14.2, Panel (b) 12 Panel (b) Yes No Small Large 1. Existing shareholders 2. Friends and family 3. Bootstrapping 4. Stretch payables 5. Accelerate collections 6. Factor A/R 7.Asset-backed loan (NWC, PP&E) How big is the financing need? Early growth stage venture (small but growing revenue; some tangible assets) Is the need immediate and urgent? Equity 1. Existing shareholders 2. Friends and family 3. Angel investors Debt 1. Bootstrapping 2. SBA/government programs Other 1. Stretch payables 2. Accelerate collections 3. Factor A/R Equity 1. Angel investors 2. Equity private placement 3. Venture capital 4. IPO 5. Strategic partner Debt 1. Term/revolving loan 2. Asset-backed loan (NWC, PP&E) 3. Vendor financing 4. Customer financing Other 1. Factor A/R The Financing Decision Process
  13. Late-Stage/Expansion • Revenue growth slows • The firm has significant assets and positive operating cash flow • The need for external financing should be moderating • Smaller amounts of equity may come from VCs or through private placement • Operating cash flows make debt more likely 13
  14. 14 Panel (c) Yes No Small Large Late stage/Expansion (revenue growth slows; significant tangible assets and free cash flow) 1. Stretch payables 2. Accelerate collections 3. Factor A/R 4. Asset-backed loan (NWC, PP&E) 5. Revolving credit line 6. Sale of equipment Is the need immediate and urgent? Equity 1. Venture capital 2. Equity private placement 3. Secondary offering Debt 1. Revolving credit line Other 1. Stretch payables 2. Accelerate collections 3. Factor A/R Equity 1. IPO 2. Strategic partner Debt 1. Term/revolving loan 2. Asset-backed loan (NWC, PP&E) 3. Private debt placement 4. Public debt issue Other 1. Factor A/R How big is the financing need? Figure 14.2, Panel (c) The Financing Decision Process
  15. Development Stage and Financing Options for High-Risk Ventures • Comparison of angels and VCs – Average aggregate annual investment is similar ($21.5 vs. $23.4 billion) – Angels fund 14X more deals annually on average – VC deals are much larger on average ($6.9 million vs. $444,000) – Higher proportion of angel deals are seed/start-up investments (47.3% vs. 9.4%) 15
  16. Table 14.1 16 Angel Investors Year Total Investment (billions) Ventures Receiving Funding Average Investment Size Seed and Start-up Number of Active Investors Percent of Opportunitie s Funded 2002 $15.7 36,000 $436,111 47.0% 200,000 7.10% 2003 $18.1 42,000 $430,952 52.0% 220,000 10.30% 2004 $22.5 48,000 $468,750 225,000 18.50% 2005 $23.1 49,500 $466,667 55.0% 227,000 23.00% 2006 $25.6 51,000 $501,961 46.0% 234,000 20.10% 2007 $26.0 57,120 $455,182 39.0% 258,200 14.00% 2008 $19.2 55,480 $346,071 45.0% 260,500 10.00% Average $21.5 48,443 $443,671 47.3% 232,100 14.7% Source: Center for Venture Research, various reports. Venture Capital Funds Year Total Investment (billions) Ventures Receiving Funding Average Investment Size Seed Start-up Investment (millions) Number Seed Startup Average Seed/Startup Investment Seed and Start-up Expansio n Stage 2002 $21.0 3,125 $6,712,640 $324.4 179 $1,812,291 1.5% 56.3% 2003 $19.1 2,967 $6,437,479 $335.1 208 $1,611,058 1.8% 50.1% 2004 $22.0 3,148 $6,978,399 $458.0 221 $2,072,398 2.1% 41.6% 2005 $23.0 3,208 $7,159,289 $912.4 250 $3,649,600 4.0% 37.3% 2006 $26.3 3,746 $7,024,826 $1,233.5 379 $3,254,617 4.7% 43.0% 2007 $30.5 4,027 $7,578,346 $1,429.7 484 $2,953,926 4.7% 37.0% 2008 $28.0 3,985 $7,024,341 $1,623.9 493 $3,293,915 5.8% 37.1% 2009 $17.7 2,795 $6,325,581 $1,650.2 312 $5,289,103 9.3% 31.0% Average $23.4 3,375 $6,905,113 $995.9 316 $2,992,113 4.2% 41.7% Source: National Venture Capital Association, Total US Investments by Year, 2009 Comparison of Angel Investor and Venture Capital/Private Equity Investment Styles
  17. 17
  18. The Value of Outside Advice • Can the venture benefit from the active involvement of an outside investor? • Is the potential benefit worth the cost (usually, additional ownership)? • Monitoring can add value in at least two ways – help overcome investor concern about the entrepreneur trying to take advantage of the financing relationship – enhance flexibility because an active investor can better discern the true reasons for failure 18
  19. The Asset Base • Debt may be a viable choice if assets are available to secure the loan • Secured lending makes adverse selection and moral hazard less likely • A downside is that the secured lender has little interest in the success of the venture • The entrepreneur’s willingness to be bound by loan covenants signals confidence in the venture 19
  20. Second Step: Assess the Nature of the Venture’s Financing Needs • The influence of immediate financing needs • The influence of near-term financing needs • The influence of cumulative financing needs 20
  21. The Influence of Immediate Financing Needs • Immediate financing sources should require little or no negotiation or be preapproved • Most equity funding is precluded (except possibly from existing investors) • For start-up/early-stage ventures, the only choices may be family and friends or the entrepreneur’s personal wealth/credit • Established firms may be able to generate funds quickly from their operations – accelerate or factor receivables – stretch payables – credit line secured by working capital 21
  22. The Influence of Near-Term Financing Needs • Some near-term financing choices may limit flexibility – pledging an asset as collateral precludes selling it – stretching payables may make it harder to later ramp up production • Factors influencing the choice of near-term financing – amount of financing needed – permanency of the financing need – long-term financing usually places more constraints on future decisions • Using short-term financing to fund long-term assets can increase the uncertainty of cash flows 22
  23. 23 • Issuance costs for debt are lower • Debt issue costs are recurring; equity is permanent • Debt limits flexibility more than equity
  24. The Influence of Cumulative Financing Needs • If operating cash flow will soon be sufficient to fund growth, the long-term impact of near-term financing decisions is less important • If cumulative cash needs are expected to be higher than present needs, near-term financing decisions should not impede the ability to raise capital later • If cumulative needs are going to be lower than current needs, financing arrangement should enable repayment without penalty 24
  25. Financing Choices and Organizational Structure • The relationship between financing and strategic partnering • Pros – takes advantage of partner’s resources – shifts risk to the partner – enables entrepreneur to focus on product development • Cons – potential for conflicts of interest – partner may have limited capability to distribute the product 25
  26. • The relationship between financing and franchising – Franchising is both a means of implementing rapid growth and an organizational form with decentralized decision making – Franchising is advantageous when centralized management cannot serve market demand as effectively as management that is closer to the market 26 Financing Choices and Organizational Structure
  27. How Financial Distress Affects Financing Choices • Why turnaround financing is different • The influence of financial distress costs on choice of financing 27
  28. Why Turnaround Financing Is Different • Financing distressed firms is different from financing high-risk start-ups for two reasons – the entrepreneur has already failed to achieve a level of success consistent with projections – the financial structures of most firms are based on a premise that the venture will be successful • Because of this, raising financing for a turnaround may be more difficult than getting initial funding • Bankruptcy may be needed to make a turnaround feasible 28
  29. The Influence of Financial Distress Costs on Choice of Financing • The degree of financial distress costs depends on the nature of the venture • Costs of financial distress include – resignation of key employees – deterioration of supplier relationships – loss of customers • If the costs of financial distress are high, financing choices should be made to avoid financial distress 29
  30. How Reputations and Relationships Affect Financing Choices • Reputation: an intangible capital asset that can lose value if the entrepreneur takes advantage of a financing source • Investors may believe the entrepreneur’s desire to protect his reputation will preclude opportunism • Most new ventures cannot rely on reputation • In the short run, survival may take precedence over reputation 30
  31. How Reputations and Relationships Affect Financing Choices • Relationships allow the investor to gain private information about the venture and the entrepreneur • Banks are more likely to lend to customers with whom they have prior relationships • Relationships increase the availability of financing, but do not necessarily reduce the cost 31
  32. Avoiding Missteps and Dealing with Market Downturns • The investor’s perspective on timing • Financing after a marketwide downturn in valuations • Going private as a response to declining market valuations 32
  33. The Investor’s Perspective on Timing • In general, both parties have motivation to complete deals quickly • Investor may also have incentives to delay – a standstill agreement precludes the entrepreneur from seeking other funding – waiting may provide the investor with additional information about the venture’s prospects, i.e., a free option • The entrepreneur should understand that financing takes time, but also be alert to opportunism 33
  34. Financing After a Marketwide Downturn in Valuations • Down-round financing can be caused by – failure of the venture to achieve milestones reflected in earlier valuations – a marketwide decline in valuations • Existing deal structure, e.g., antidilution provisions, can impede raising new funding • To limit the problem, keep deal structures in early financing rounds simple – lower valuations – straight equity with sweeteners 34
  35. Going Private as a Response to Declining Market Valuations • It is difficult for public shareholders to negotiate a financial restructuring that might be needed to raise additional funding • Solution may be to repurchase the public equity, i.e., take the company private • Significant private equity activity in recent years, taking public companies private 35
  36. Choice of Financing - Summary • The menu of financing options is long, but in reality, is limited in any specific situation • A number of factors affect the financing choice – the venture’s stage and financial condition – the immediacy, size, and permanence of the need – existing financial arrangements – the anticipated cumulative need for funding • Funding options may be linked to the choice of organizational structure • Reputation and relationships can influence available financing 36

Editor's Notes

  1. Figure 14.1 – Selected Financing Sources for New Ventures
  2. Figure 14.2 – The Financing Decision Process
  3. Figure 14.2 – The Financing Decision Process
  4. Figure 14.2 – The Financing Decision Process
  5. Table 14.1 – Comparison of Angel Investor and Venture Capital/Private Equity Investment Styles
  6. Table 14.1 – Comparison of Angel Investor and Venture Capital/Private Equity Investment Styles
  7. Table 14.2 – Initial Public Offering and Bond Issue Cost by Issue Size The cost of a public offering includes three components: the spread between the offer price and net proceeds to the issuer; issue costs borne directly by the issuing firm; and underpricing. This figure provides estimates of the first two components (excluding underpricing) for different types and sizes of issues. Source: Table 1 in Lee, I., S. Lochhead, J. Ritter, and Q. Zhao, “The Cost of Raising Capital.” Journal of Financial Research 19 (1996): 59–74.