CHAPTER 10
Getting Financing or Funding

The Importance of Getting Financing or Funding

The need to raise money surprises a number of entrepreneurs, in that many of them launch their firms with the intention of funding all their needs internally. Commonly, though, entrepreneurs discover that operating without investment capital or borrowed money is more difficult than they anticipated. Because of this, it is important for entrepreneurs to understand the role of investment capital in the survival and subsequent success of a new firm.

Why Most New Ventures Need Funding

There are three reasons that most entrepreneurial ventures need to raise money during their early life: cash flow challenges, capital investments, and lengthy product development cycles.

Sources of Personal Financing

Typically, the seed money that gets a company off the ground comes from the founders’ own pockets. There are three categories of sources of money in this area: personal funds, friends and family, and bootstrapping.

Preparing to Raise Debt or Equity Financing

Once a start-up’s financial needs exceed what personal funds, friends and family, and bootstrapping can provide, debt and equity are the two most common sources of funds. The most important thing an entrepreneur must do at this point is determine precisely what the company needs and the most appropriate source to use to obtain those funds. A carefully planned approach to raising money increases a firm’s chance of success and can save an entrepreneur considerable time.

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. In addition, because investors become partial owners of the firms in which they invest, they often try to help those firms by offering their expertise and assistance. Unlike a loan, the money received from an equity investor doesn’t have to be paid back. The investor receives a return on the investment through dividend payments and by selling the stock.

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.

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.

Initial Public Offering

Another source of equity funding is to sell stock to the public by staging an initial public offering (IPO). 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.

Commercial Banks

Historically, commercial banks have not been viewed as practical sources of financing for start-up firms. This sentiment is not a knock against banks; it is just that banks are risk averse, and financing start-ups is risky business. There are two reasons that banks have historically been reluctant to lend money to start-ups. First, as mentioned previously, banks are risk averse. The second reason banks have historically been reluctant to lend money to start-ups is that lending to small firms is not as profitable as lending to large firms, which have been the staple clients of commercial banks.

SBA Guaranteed Loans

The loans are for small businesses that are unable to secure financing on reasonable terms through normal lending channels. The SBA does not currently have funding for direct loans, other than a program to fund direct loans for businesses in geographic areas that are hit by natural disasters. SBA guaranteed loans are utilized more heavily by existing small businesses than start-ups, they should not be dismissed as a possible source of funding.

Other Sources of Debt Financing

There are a variety of other avenues business owners can pursue to borrow money or obtain cash. Vendor credit (also known as trade credit) is when a vendor extends credit to a business in order to allow the business to buy its products and/or services up front but defer payment until later. Factoring is a financial transaction whereby a business sells its account receivable to a third party, called a factor, at a discount in exchange for cash. A common type of alternative lending is the merchant cash advance. In a merchant cash advance, the lender provides a business a lump sum of money in exchange for a share of future sales that covers the payment amount plus fees.

Creative Sources of Financing and Funding

Because financing and funding are difficult to obtain, particularly for start-ups, entrepreneurs often use creative ways to obtain financial resources. Even for firms that have financing or funding available, it is prudent to search for sources of capital that are less expensive than traditional ones.

Crowdfunding

A popular creative source of funding for new businesses is 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. Reward-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.

Leasing

A lease is a written agreement in which the owner of a piece of property allows an individual or business to use the property for a specified period of time in exchange for payments. The major advantage of leasing is that it enables a company to acquire the use of assets with very little or no down payment. Leases for facilities and leases for equipment are the two most common types of leases that entrepreneurial ventures undertake.

Other Grant Programs

There are a limited number of other grant programs available to entrepreneurs. Obtaining a grant takes a little detective work. Granting agencies are, by nature, low-key, so they normally need to be sought out.

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CHAPTER 9
Building a New-Venture Team

Liability of Newness as a Challenge

As we note throughout this textbook, new ventures have a high propensity to fail. The high failure rate is due in part to what is known as the liability of newness, which refers to the fact that companies often falter because the people who start them aren’t able to adjust quickly enough to their new roles and because the firm lacks a “track record” with outside buyers and suppliers. Assembling a talented and experienced new-venture team is one path firms can take to overcome these limitations. Another way entrepreneurs overcome the liability of newness is by attending entrepreneurship-focused workshops and events.

Creating a New-Venture Team

Those who launch or found an entrepreneurial venture have an important role to play in shaping the firm’s business model. Stated even more directly, it is widely known that a well-conceived business plan, one that flows from the firm’s previously established business model, cannot get off the ground unless a firm has the leaders and personnel to carry it out.

The Founder or Founders

Founders’ characteristics and their early decisions significantly affect the way an entrepreneurial venture is received and the manner in which the new-venture team takes shape. The size of the founding team and the qualities of the founder or founders are the two most important issues in this matter.

Size of the Founding Team

The first decision that most founders face is whether to start a firm on their own or whether to build an initial founding team. Studies show that 50 to 70 percent of all new firms are started by more than one individual. However, experts disagree about whether new ventures started by a team have an advantage over those started by a sole entrepreneur. Teams bring more talent, resources, ideas, and professional contacts to a new venture than does a sole entrepreneur.

Qualities of the Founders

The second major issue pertaining to the founders of a firm is the qualities they bring to the table. In the previous several chapters, we described the importance investors and others place on the strength of the firm’s founders and initial management team. One reason the founders are so important is that in the early days of a firm, their knowledge, skills, and experiences are the most valuable resource the firm has. Because of this, new firms are judged largely on their “potential” rather than their current assets or current performance. In most cases, this results in people judging the future prospects of a firm by evaluating the strength of its founders and initial management team.

The Management Team and Key Employees

Once the decision to launch a new venture has been made, building a management team and hiring key employees begins. Start-ups vary in terms of how quickly they need to add personnel. In some instances, the founders work alone for a period of time while the business plan is being written and the venture begins taking shape. In other instances, employees are hired immediately.

The Roles of the Board of Directors

If a new venture organizes as a corporation, it is legally required to have a board of directors—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: (1) appoint the firm’s officers (the key managers), (2) declare dividends, and (3) oversee the affairs of the corporation.

Provide Expert Guidance

Although a board of directors has formal governance responsibilities, its most useful role is to provide guidance and support to the firm’s managers. Many CEOs interact with their board members frequently and obtain important input. The key to making this happen is to pick board members with needed skills and useful experiences who are willing to give advice and ask insightful and probing questions.

Lend Legitimacy

Providing legitimacy for the entrepreneurial venture is another important function of a board of directors. Well-known and respected board members bring instant credibility to the firm. 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

Along with the new-venture team members we’ve already identified, 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 and fill what some entrepreneurs call “talent holes.”

Board of Advisors

Some start-up firms are forming advisory boards to provide them direction and advice. An advisory board is a panel of experts who are asked by a firm’s managers to provide counsel and advice on an ongoing basis. Unlike a board of directors, an advisory board possesses no legal responsibility for the firm and gives nonbinding advice.

Lenders and Investors

As emphasized throughout this book, lenders and investors have a vested interest in the companies they finance, often causing these individuals to become very involved in helping the firms they fund. It is rare that a lender or investor will put money into a new venture and then simply step back and wait to see what happens. In fact, the institutional rules governing banks and investment firms typically require that they monitor new ventures fairly closely, at least during the initial years of a loan or an investment.

Other Professionals

At times, other professionals assume important roles in a new venture’s success. 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. New ventures vary in terms of how much they rely on business consultants for direction. In some ways, 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. In other ways, the role of general business consultant is as important as ever; it is the general business consultant who can conduct in-depth analyses on behalf of a firm, such as preparing a feasibility study or an industry analysis.

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CHAPTER 8
Assessing a New Venture’s Financial Strength and Viability

Introduction to Financial Management

An entrepreneur’s ability to pursue an opportunity and turn the opportunity into a viable entrepreneurial firm hinges largely on the availability of money. Regardless of the quality of a product or service, a company can’t be viable in the long run unless it is successful financially. Money either comes from external sources (such as investors or lenders) or is internally generated through earnings. It is important for a firm to have a solid grasp of how it is doing financially. One of the most common mistakes young entrepreneurial firms make is not emphasizing financial management and putting in place appropriate forms of financial controls.

Financial Objectives of a Firm

Most entrepreneurial firms—whether they have been in business for several years or they are start-ups—have four main financial objectives: profitability, liquidity, efficiency, and stability.

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

To assess whether its financial objectives are being met, firms rely heavily on analyses of financial statements, forecasts, and budgets. A financial statement is a written report that quantitatively describes a firm’s financial health. The income statement, the balance sheet, and the statement of cash flows are the financial statements entrepreneurs use most commonly.

Financial Statements

Historical financial statements reflect past performance and are usually prepared on a quarterly and annual basis. Pro forma financial statements are projections for future periods based on forecasts and are typically completed for two to three years in the future.

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.

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. Income statements are typically prepared on a monthly, quarterly, and annual basis. Most income statements are prepared in a multiyear format, making it easy to spot trends.

Balance Sheet

Unlike the income statement, which covers a specified period of time, a balance sheet is a snapshot of a company’s assets, liabilities, and owners’ equity at a specific point in time. The left-hand side of a balance sheet (or the top, depending on how it is displayed) shows a firm’s assets, while the right-hand side (or bottom) shows its liabilities and owners’ equity. The assets are listed in order of their “liquidity,” or the length of time it takes to convert them to cash. The liabilities are listed in the order in which they must be paid. A balance sheet must always “balance,” meaning that a firm’s assets must always equal its liabilities plus owners’ equity.

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

■ Current assets: Current assets include cash plus items that are readily convertible to cash, such as accounts receivable, marketable securities, and inventories.

■ Fixed assets: Fixed assets are assets used over a longer time frame, such as real estate, buildings, equipment, and furniture.

■ Other assets: Other assets are miscellaneous assets, including accumulated goodwill.

Statement of Cash Flows

The statement of cash flows summarizes the changes in a firm’s cash position for a specified period of time and details why the change occurred. The statement of cash flows is similar to a month-end bank statement. It reveals how much cash is on hand at the end of the month as well as how the cash was acquired and spent during the month. The statement of cash flows is divided into three separate activities: operating activities, investing activities, and financing activities. These activities, which are explained in the following list, are the activities from which a firm obtains and uses cash:

■ Operating 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: Investing activities include the purchase, sale, or investment in fixed assets, such as real estate, equipment, and buildings.

■ Financing activities: 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.

Ratio Analysis

The most practical way to interpret or make sense of a firm’s historical financial statements is through ratio analysis. The ratios are divided into profitability ratios, liquidity ratios, and overall financial stability ratios.

Comparing a Firm’s Financial Results to Industry Norms

Comparing its 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. This type of comparison works best for firms that are of similar size, so the results should be interpreted with caution by new firms. Many sources provide industry-related information.

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.

Sales Forecast

A sales forecast is a projection of a firm’s sales for a specified period (such as a year), though most firms forecast their sales for two to five years into the future. It is the first forecast developed and is the basis for most of the other forecasts. 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.

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. For example, in the case of New Venture Fitness Drinks, its cost of sales has averaged 47.5 percent over the past two years. In 2014, its sales were $586,600 and its cost of sales was $268,900. The company’s sales are forecast to be $821,200 in 2015. Therefore, based on the percent-of-sales method, its cost of sales in 2015 will be $390,000, or 47.5 percent of projected sales. The same procedure could be used to forecast the cost of each expense item on the company’s income statement.

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. New ventures typically offer pro forma statements, but well-managed established firms also maintain these statements as part of their routine financial planning process and to help prepare budgets. The preparation of pro forma statements also helps firms rethink their strategies and make adjustments if necessary.

Pro Forma Income Statement

Once a firm forecasts its future income and expenses, the creation of the pro forma income statement is merely a matter of plugging in the numbers. In the pro forma income statement, the constant ratio method of forecasting is used to forecast the cost of sales and general and administrative expenses, meaning that these items are projected to remain at the same percentage of sales in the future as they were in the past.

Pro Forma Balance Sheet

The pro forma balance sheet provides a firm 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.

Pro Forma Statement of Cash Flows

The pro forma statement of cash flows shows the projected flow of cash into and out of the company during a specified period. The most important function of the pro forma statement of cash flows is to project whether the firm will have sufficient cash to meet its needs. As with the historical statement of cash flows, the pro forma statement of cash flows is broken into three activities: operating activities, investing activities, and financing activities. Close attention is typically paid to the section on operating activities because it shows how changes in the company’s accounts receivable, accounts payable, and inventory levels affect the cash that it has available for investing and finance activities. If any of these items increases at a rate that is faster than the company’s annual increase in sales, it typically raises a red flag.

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. This work is completed so the firm can get a sense of how its projected financial performance compares to its past performance and how its projected activities will affect its cash position and its overall financial soundness.

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