19.5: New Venture Financing

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4. How do entrepreneurs finance their new business ideas

Many entrepreneurs don’t start a business because they believe that starting a venture will require substantial sums of funding, and they personally do not possess these reserves. The most common means of starting new ventures is by bootstrapping—that is, attempting to found and build a company from personal finances or from the operating revenues of the new company. This term comes from the expression “pull yourself up by your bootstraps” (the fingerholds on boots). Bootstrapping can complement traditional finance sources, helping entrepreneurs to reduce their reliance on them or eliminate these sources entirely. Table $\PageIndex{1}$ depicts seven bootstrapping strategies.

Bootstrapping Strategies
Strategy	Example
Source: Adapted from Martin Zwilling,“7 Ways to Bootstrap Your Business,” Entrepreneur Magazine, December 25, 2015, https://www.entrepreneur.com/article/254217; https://business.fau.edu/centers/ada...ccess-stories/ ; Lucy England, “The artist who painted Facebook's 1^st office took stock instead of cash — and now he is worth $200 million,” Business Insider, June 9, 2015, https://www.businessinsider.com/graf...million-2015-6; Todd Bishop, “Amazon at 20 years: From garage startup to global technology powerhouse,” GeekWire, July 9, 2014, https://www.geekwire.com/2014/amazon...al-powerhouse/.
Stick to a business domain you know and love.	Two recent Florida Atlantic University alumni transformed their love of surfing and the ocean into 4ocean, which sells bracelets and other products. The sales pay local fishermen to clean up plastic and trash in waterways.
Find team members to work for equity rather than cash.	In 2005, Sean Parker, founding president of Facebook, asked artist David Choe to take stock instead of cash for painting the Facebook office walls. That stock was eventually worth $200 million.
Build a plan around your budget rather than your wishes.	Cam Ross started Celise, a biodegradable goods supplier, in college. Strapped for financing, Cameron planned around his available budget, which depended on current sales and wins in business plan competitions.
Defer your urge to have office space until you have customers.	In July 2014, Amazon founder Jeff Bezos started the company from the garage of a home he rented in Bellevue, Washington.
Ask for advances on royalties and vendor-deferred payments.	In the music industry, many songwriters have sought advances against future royalties from their songs.
Negotiate inventory management with suppliers and distributors.	Pet food delivery start-up Petcircle is one of Australia’s fastest-growing companies. They attribute their early success to bootstrapping via managing supplier terms carefully.
Choose a business model to optimize your revenue flow and timing.	Chicago-based restaurant Alinea creates themes and sells out seats month in advance, allowing them to buy in bulk with cash from customers. As payments are upfront and all sales are final, revenue is fixed prior to delivering the meals. This business model eliminates many of the downsides of traditional restaurants’ business models.

Table $\PageIndex{1}$ (Attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Types of Capital

There are two main types of capital for entrepreneurs. Entrepreneurs can access debt capital, which is borrowed money that must be repaid at some agreed-upon future date (e.g., from banks, credit cards, or finance companies), and equity capital, which is the owner’s investment in the company and does not have a specific date for repayment (e.g., angel investors, venture capital).

Debt financing is available to most entrepreneurs and can involve loans of various lengths. Short-term loans typically require repayment in less than 1 year and are often credit-created or bank loans. Immediate-term loans must be repaid in between 1 and 10 years, usually in periods. They are useful for small and moderate-sized companies. Long-term loans last over 10 years. Businesses must be operating for a long period of time to be approved for these loans to show stability and reliability to repay their debt. Equity capital does not require a business to promise to repay any debt. Equity capital is an investment in the business, frequently from selling common stock.

Sources of Capital

Entrepreneurs can utilize capital from several sources. The most common type of capital is personal savings. By using personal savings, the venture eliminates the expectation of repayment on a loan, and the entrepreneur does not face as much financial backlash when profits do not meet expectations. Friends and relatives can often be a fast way to gain capital. However, financial issues may create tension in these relationships. Angel investors are individual investors or groups of experienced investors who provide venture financing from their own funds. Venture capital is financing obtained from venture capitalists, investment firms that specialize in financing small, high-growth companies and receive an ownership interest and a voice in management in return for their investment. Internal funds are retained earnings within a firm that can be reinvested into the business.

Banks offer many types of loan services, including lines of credit, straight commercial loans, term loans, accounts-receivable loans, warehouse-receipt loans, and collateral loans. A line of credit is an informal agreement between the bank and the borrower (the business). Straight commercial loans are based on the borrower’s financial statements and are typically made for 30–90 days. Term loans mature in 1 to 10 years. Accounts-receivable loans are made against a borrower’s receivables, and once collected, the bank is repaid. Warehouse-receipt loans use inventory as collateral for a loan, and as the inventory is sold, the loan is paid off. Collateral loans use real estate mortgages, life insurance policies, stocks, and bonds as security to ensure loan repayment.

Crowdfunding is the process of raising new venture funds from a large “crowd” audience, typically virtually from the Internet. Crowdfunding is rapidly becoming a popular way to fund new ventures, with over $1.04 billion in 2018 for U.S. businesses alone. Crowdfunding comes in three main forms: (1) reward-based, in which backers receive an early version of the product or another reward, (2) equity, through which individual investors receive a company share, and (3) debt, which allows the backer to earn interest. The world’s largest crowdfunding platform is Kickstarter, which has received over $4 billion in pledges from 15.5 million backers for 25,700 projects. The average crowdfunding campaign raises $818; however, some companies raise millions of dollars. Typically, each crowdfunding project sets a goal for a specific time period, and entrepreneurs publish web pages to depict their product services.

catching the entrepreneural spirit

You need financing for your start-up business. How do you get angels interested in investing in your business venture?

Show them something they understand, ideally a business from an industry they’ve been associated with.
Know your business details: potential investors want to know about annual sales, gross profit, profit margin, and expenses.
Be able to describe your business—what it does and who it sells to—in less than a minute. Limit PowerPoint presentations to 10 slides.
Angels can always leave their money in the bank or invest in another promising ventures, so an investment is often in a sector that interests them. Timing is also important—knowing when to reach out to an angel can make a huge difference.
Present a competent management team with a strong, experienced leader who can explain the business and answer questions from potential investors with specifics, and can quickly earn potential investors’ trust and respect.
Angels prefer something they can bring added value to and may want to be involved with your company—for example, with a seat on your board of directors.
Emphasize the likely exits for investors and know who the competition is, why your solution is better, and how you are going to gain market share with an infusion of cash.

Sources

Guy Kawasaki, “The Art of Raising Angel Capital,” https://guykawasaki.com, accessed February 2, 2018;

Murray Newlands, “How to Raise an Angel Funding Round,” Forbes, https://www.forbes.com, March 16, 2017;

Melinda Emerson, “5 Tips for Attracting Angel Investors,” Small Business Trends, https://smallbiztrends.com, July 26, 2016;

Nicole Fallon, “5 Tips for Attracting Angel Investors,” Business News Daily, https://www.businessnewsdaily.com, January 2, 2014;

Stacy Zhao, “9 Tips for Winning over Angels,” Inc., https://www.inc.com, June 15, 2005;

Rhonda Abrams, “What Does It Take to Impress an Angel Investor?” Inc., https://www.inc.com, March 29, 2001.

concept check

What sources of capital are available to entrepreneurs?
What are the associated risks for various sources of capital?