Chapter 6 – Financing Entrepreneurship
Money is like gasoline during a road trip. You don’t want to run out of gas on your trip, but you’re not doing a tour of gas stations. – Tim O’Reilly, founder and CEO of O’Reilly Media
Chase the vision, not the money; the money will end up following you. – Tony Hsieh, CEO of Zappos
After completing this chapter you will be able to
- Describe the financing considerations for entrepreneurs
- Describe the advantages and disadvantages of debt financing and of equity financing
- List and describe the forms of financing appropriate for the different phases of business development
Securing needed financing is one of the most important functions related to starting a business. It is important, then, to understand what sources of financing exist at various stages of venture development. It is also important to determine what kinds of financing provide the most value for the entrepreneur and the new venture. Debt and equity financing decisions must be considered in relation to the cost of the financing and the amount of control that the owner is willing to sacrifice to get the needed resources.
Entrepreneurs almost always require starting capital to move their ideas forward to the point where they can start their ventures. Determining the amount of money that is actually needed is tricky because that requirement can change as plans evolve. Other challenges include actually securing the amount desired and getting it when it is needed. If an entrepreneur is unable to secure the required amount or cannot get the funding when needed, they must develop new plans.
Once a venture begins to make cash sales or it starts to receive the money earned through credit sales, it can use those resources to fund some of its activities. Until then, it must get the money it needs through other sources.
Bootstrap financing is when entrepreneurs use their ingenuity to make their existing resources, including money and time, stretch as far as possible—usually out of necessity until they can transform their venture into one that outside investors will find appealing enough to invest in.
Entrepreneurs will almost always have to invest their own personal money into their start-up before others will give them any financial help. Sometimes entrepreneurs form businesses as partnerships or as multi-owner corporations with other individual entrepreneurs who also contribute their own personal funds to the venture.
Love money refers to money provided by friends and family who want to support an entrepreneur, often when they have no other ready source of funding after using as much of their own personal money as possible to support their start-up.
Grants and Start-up Prize Money
In some cases, grants that do not need to be repaid might be provided by government or other agencies to support new venture start-ups. Sometimes entrepreneurs can enter business planning or similar competitions in which they might win money and other benefits, like free office or retail space, or free legal or accounting services for a set period of time.
From an entrepreneur’s perspective, the cost of debt financing is the interest that they pay for the use of the money that they borrow. From an investor’s perspective, their reward, or return on debt financing, is the interest that they gain in addition to the return of the money that they lent to an entrepreneur or other borrower.
To provide some protection for the investor (lender) to enable them to accept an interest rate that is also acceptable for the entrepreneur (borrower), the borrower must often pledge collateral so that if they do not pay back the loan along with interest as arranged, the lender has a way to get all or some of the money they are owed. If a borrower defaults on a loan, the lender can become the owner of the property pledged as collateral. A key objective for an entrepreneur seeking debt financing is to provide sufficient collateral to get the loan, but not pledge so much that they put essential property at risk.
When entrepreneurs borrow money, they must pay it back subject to the terms of the loan. The loan terms include the specific interest rate that will be charged and the time period within which the loan needs to be repaid. Several other terms or features of the loan that can be negotiated between lender and borrowers. One such feature is whether the loan can be converted to equity at a particular point in time and according to certain criteria and subject to specific terms.
Sometimes debt financing can be in the form of trade credit, where a supplier provides product to a business but does not require payment for a specific length of time, or perhaps even until the business has sold the product to a customer. Another form of debt financing is customer advances. This might involve a customer paying in advance for a product or service so that the businesses has those funds available to use to pay its suppliers.
Advantages of Debt Financing
One advantage of debt financing is that the entrepreneur is not sacrificing ownership and some control of their venture when they take out a loan.
Another advantage of debt financing is the certainty of the payments the borrower needs to make during the term of the loan. If the borrower takes out a loan for $20,000 over a five-year term at a fixed interest rate of 6.2% with a monthly payment schedule designed to pay off the entire loan by the end of its five-year term, they know that each month they must pay $389 and that over the five years they will have paid back the entire $20,000 loan amount plus a total of $3,340 in interest. With this certainty, the business can accurately budget its payback amount for this loan over the five years.
Yet another advantage of debt financing is that it allows companies to tradeon equity. Trading on equity enhances the rate of return on common shareholders’ equity by using debt to financing asset purchases or to take other measures that are expected to cost less than the earnings generated by the action taken. For example, if a company borrows $20,000 at 6.2% interest and uses that money to purchase a machine it will use to increase its return on equity by 20%, then it is trading on equity. In this case, the company is financially better off than it would have been if it had not taken out the loan. Of course, the inherent risk involved with this strategy is lowered when income streams are relatively stable.
Disadvantages of Debt Financing
A disadvantage of borrowing money is the need to report to those from whom you borrowed the money. This might be particularly true when lenders, often bankers, have interests or incentives—mainly getting their money back plus at all of the interest owed to them during the loan term through regular monthly blended loan payments—that might not fully align with the interests and incentives of the borrower, which might include being able to pay the money back when they are best able to do so without also impacting other parts of their business, like the need to pay their employees or their facility lease payment at the end of a month when an expected customer payment did not arrive as planned.
Another disadvantage of borrowing is that the business’s ownership of the property it pledged as collateral for the loan is placed at risk. For many new ventures, a loan is only possible to acquire if the owner provides their personal guarantee that the money will be paid back as determined in the loan agreement, thus putting personal property at risk.
From an entrepreneur’s perspective, the cost of equity financing is the loss of some control over their venture as they must now share ownership of the business. From an investor’s perspective, their reward in exchange for purchasing an ownership interest in the business is the potential to share in the business’s anticipated future success by possibly receiving dividends (a portion of the profit that is distributed to owners) and by possibly being able to sell their ownership interest to another investor for more than the amount they purchased that ownership interest for originally.
The protection for the investor, who might be a shareholder if the ownership interest is represented in the form of shares in the business, is in the influence they can exert in the company’s decision-making processes. This influence is normally proportionate to their share of the ownership in the overall business. Equity investors normally seek to earn a competitive return on their investment that is in line with the level of risk they assume by investing in the business. The riskier the investment, the higher the return the investor expects.
Stock investors might invest in a public offering where the company’s shares are made available to the public—and by which the company becomes a public company. An initial public offering (IPO) is where a company’s stock (its shares) are sold to institutional investors who then resell them to the public, usually through a securities exchange like the Toronto Stock Exchange (TSX).
When an IPO occurs, a company goes through a legal process to sell shares in its company for the purpose of raising capital. This is called going public. An important part of going public is setting the initial price for the shares being offered for sale (the offering price). The amount that the company will raise is the price they sell the new stock at multiplied by the number of shares they sell less any fees and other expenses incurred to make the sale. If they set the initial selling price of the shares too high, they might not sell all of the shares and the company won’t raise as much capital as anticipated. If they happen to sell all of the overvalued shares, the share price will fall once it begins trading on the exchange. Setting the offering price too high indicates that the company and its agents helping it with its IPO, called underwriters, have valued the company higher than investors in the marketplace value it. If the company sets the offering price too low, it will raise the amount of money planned, but will find out too late that it could have raised much more capital by setting the offering price higher. In this case, the company and its underwriters have undervalued the company and the initial investors will make all of the gains that the company could have when they sell the shares on the exchange almost immediately after they purchased them for more money than they purchased them for.
Stock investors might also invest in a private offering (or private placement) where the shares are sold to a few investors rather than to the general public through an exchange. Institutional private placements involve selling the shares to institutional investors like insurance companies. Private offerings cost less and are subject to less stringent regulation than public offerings, mainly because it is expected that private investors will be more diligent on their own and require less regulatory protection than do public investors.
Venture capital is raised when investors pool their money. The venture capital fund is then used to very carefully invest in existing but usually young companies that are expected to experience high growth. The venture capital company does not expect to invest for long and it expects to generate a large return. For example, it might expect to invest in an opportunity for a period of up to five years and then get out of the investment with five times the money it originally invested. Of course, only some investment opportunities will generate the returns hoped for and others will return far less than expected.
Venture capitalists might exert some ownership control by influencing some business decisions in cases where they believe that by doing so they can protect their investment or cause the investment to produce greater returns, but they generally prefer to invest in companies that are going to be well-run and will not require them to be involved in decisions. Venture capitalists might also provide some assistance, such as business advice, to the companies in which they invest.
A venture round refers to a phase of financing that institutional investors like venture capitalists provide to entrepreneurs. The first phase (sometimes following a seed round in which entrepreneurs themselves provide the start-up capital and then an angel round where angel investors invest in the company) is called Series A. Subsequent venture rounds are called Series B, Series C, and so on.
Angel investors are wealthy individuals who on their own, or often along with other angel investors in a network—like the Saskatchewan Capital Network—invest in new ventures in exchange for an ownership interest in the business. Sometimes angels invest in companies in exchange for convertible debt, an investment that starts off as a loan, usually in the form of a bond, that they can exercise an option to convert to an equity interest in the company at a particular point in time for a pre-determined number of shares. Angel investors are generally less restricted in what kinds of investments they will consider as opposed to venture capitalists, who are using other people’s pooled money. Like venture capitalists, however, they normally undertake a rigorous due diligence process to determine whether to invest in the opportunities they are considering.
Equity Crowd Funding
Equity crowd funding is a relatively new way for entrepreneurs to raise capital. It involves using online methods to promote equity interests in ventures to potential investors.
Investors follow due diligence processes to assess the risk and potential return associated with the investments they are considering. As such, entrepreneurs should maintain a due diligence file or binder that they can quickly draw upon when a desirable potential investor expresses an interest in their venture.
A due diligence file or binder will include copies of many of the legal papers and other important documents that a venture has accumulated that tell the story of the enterprise. These documents will include those related to incorporation, securities it has issued or is in the process of issuing, loans, important contracts, intellectual property documents, tax information, financial statements, and other important documentation.
Advantages of Equity Financing
One important benefit to equity financing is that it does not normally require a regular payback from cash flow. Unlike with debt financing, equity investments do not usually give rise to a regular encumbrance that can increase the difficulty a young company might have in meeting its regular monthly expenses.
Second, when a firm uses equity financing, it does not need to pledge collateral, which means that the company’s assets are not placed at risk.
A potential advantage with equity financing is that, depending upon the form of financing and who the investors are, a firm might gain valued advisers. In addition, investors who exercise their ownership rights to have a say in the operations of the company, or who otherwise provide advise and mentorship to entrepreneurs starting ventures, are usually highly motivated to help the company succeed. Investors expect to benefit only when the companies they invest in succeed, meaning that their financing incentives are aligned with those of the entrepreneur and other owners.
Disadvantages of Equity Financing
Equity financing is often more difficult to raise than debt financing. Second, when they share ownership in exchange for investment into their business, entrepreneurs give up a portion of the value that they create. If things do not go as planned, entrepreneurs can lose control of their companies to their investors.
Different financing sources are used at different phases of business development. The appropriate and available financing sources depend upon the risks and opportunities available to both the entrepreneur and to the investors.
- Personal sources (savings and other income)
- Extended personal sources (family, friends, employees, partners)
- Angel investors (possibly)
- also called informal investors
- wealthy individuals interested in investing their own money in early-stage companies as convertible debt holders or equity investors
- convertible debt (convertible bond, convertible note, convertible debenture) allows the bondholder to convert their debt into an equity interest at an agreed-upon price
- can be a win-win arrangement
- If the company is successful, investor has opportunity to participate as equity investor, but if company is only marginally successful, they get their money back with interest.
- If entrepreneurs have difficulty borrowing money, they can add the convertible feature as a sweetener.
- Strategic partners
- might include potential customers or potential suppliers who want to have access to a business like the one proposed (and therefore might fund part of its development)—i.e. a building owner (supplier) might help a business develop which will be a tenant
- might include complementary businesses who feel helping the new business get started might help their own businesses—i.e. a hotel investing in a spa next door to their facility
- Angel investors
- Strategic partners
- Customers (possibly)
- They might place orders for services or products and pay for them up-front, thereby providing financing for the new business.
- They might want your business to succeed so it can support their business. For example, a general contractor (future customer) might help a new plumber get started if there is now a shortage of plumbers affecting the building industry.
- Venture Capitalists (possibly)
- These organizations acquire pools of money to invest, so they differ from angel investors in that those making the decisions are not investing their own money; this means they usually consider investment options which have shown some success already (which isn’t usually the case in the start-up phase).
- Asset-Based lenders
- lend money secured by the assets of the borrower – i.e. plant and equipment
- sometimes this can be done quite creatively – i.e. secure a loan with assets that will turn into money … like through accounts receivable or inventories, etc.
- Equipment Leasing Companies
- Venture Capitalists (possibly)
- Asset-Based Lenders
- Equipment Leasing Companies
- Small Business Investment Companies
- U.S. term – developed to bridge the gap between when small businesses need money and the time later on when venture capitalists might provide financing to small businesses
- SBICs are privately owned companies in the United States that are licensed by the Small Business Administration (U.S. Government) to supply equity capital, long-term loans, and management assistance to qualifying small businesses
- Canadian equivalent = Community Futures Corporations
- Trade Credit
- The supplier provides product now on terms so the retailer does not need to pay the supplier for perhaps 30 or 60 or 90 days
- The retailer can then sell the product and collecting the money from the customer before the retailer needs to pay supplier for it the product.
- when a business sells its accounts receivable (its invoices) to a third party (called a factor) at a discount in exchange for immediate money
- differs from bank loan in three ways
- The factor is interested in the value of the receivables; a bank is interested in the firm’s creditworthiness.
- Factoring is not a loan; it is the purchase of a financial asset (the receivables).
- A bank loan involves two parties (lender and borrower); factoring involves three (the business, the factor, and those who owe the money).
- Venture Capitalists
- Asset-Based Lenders
- Equipment Leasing Companies
- Small Business Investment Companies
- Trade Credit
- Mezzanine Lenders
- used to fill the financing gap between relatively expensive equity financing and less expensive forms of financing like secured loans
- structured either as an unsecured or subordinated debt instrument or as preferred stock
- represents a claim on assets which is senior only to that of the common shares
- mezzanine debt holders require a higher return than is the case with holders of secured debt (maybe close to 20% or more – because the risk is higher)
- usually issued as private placements (i.e. fewer legal requirements than with public placements)
- can be used by smaller companies
- mezzanine lenders might have right to convert the debt instrument to an equity instrument
- mezzanine lenders work with companies to ensure the high return they require doesn’t cripple the company, so they might take an equity interest or might defer loan payments until the end of loan term or until the company is sold
- Mezzanine Lenders
- Public Debt
- Initial Public Offerings (IPOs)
- issuing common stock or shares to the public
- used by companies seeking capital to expand (or by privately-owned companies wanting to become publicly traded)
- a major challenge is to figure out how to value the shares offered so underwriting firms are often used to help deal with this challenge
- if the price is set too high maybe all the shares will not be sold (and the desired amount of money will not be raised)
- if the price is set too low the company might lose out on money it could have had (if all the shares sold had of been sold at a higher price)
- money from initial sale of shares goes to the company, but after that the shares are traded between shareholders (the company doesn’t get any of this money)
- the money never has to be repaid, but the owners of the shares have a right to any distributed profits (dividends declared) and to residual dissolution proceeds (what is left over after the debt holders and everyone else is paid off if the company assets are sold)
- Acquisition, Leveraged Buy-Outs (LBO), Management Buy-Outs (MBO)
- LBOs are when the controlling interest in the company is purchased using mainly borrowed money (the assets of the company being purchased are often used as the loan collateral).
- MBOs are often a form of LBOs where the purchasers are the current managers of the company.
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