Mark T. Schenkel, Ph.D.

Assistant Professor in Entrepreneurship

FINANCING AND SOURCES OF FUNDING FOR NEW

VENTURES

What Makes Entrepreneurial Finance “Different” from Traditional Finance . . . ?

Lack of history upon which to assess risk What’s the β?Without it, what should the market risk

premium be? . . . Criteria to identify if “big winner” potential exists (Bhide)

Lack of ability to compare against other firms when industry is new

Lack of short term profit potential in the immediate future

Lack of liquidity . . . CASH IS KING!!! (e.g., Sahlman)

Implications . . .

Entrepreneurial finance involves useful ways of thinking about cash, risk, and value (Sahlman, 1992) . . . that is, itTeaches skepticism (there are fewer ‘true’

opportunities from a financial perspective than we often think!)

Helps us identify the ‘right’ questions to ask and narrow down the potential options, which in turn enable us to make better decisionsEx: Is “Fit” an “Opportunity”?

Discovery Driven Planning (Market, Margin, Me) New Venture Strategy

Ex: If I use X financing now and Y financing later, have I created incentives for all stakeholders to work together?

Implications . . . Helps us identify the ‘right’ questions to ask

and narrow down the potential options, which in turn enable us to make better decisionsEx: Is “Fit” an “Opportunity”?

Discovery Driven Planning (Market, Margin, Me) New Venture Strategy

Ex: Explicit and hidden costs of using other people’s money . . . (Bhide)Danger of misallocation . . . Throwing money at

symptomsDiminished flexibility . . .

“Operational lock” Credibility issues . . . “What to you mean, didn’t we get it right

the 1st time?” If I use X financing now and Y financing later, have I created

incentives for all stakeholders to work together?

Key Theme . . .

Horse race between capital, greed and opportunity . . . (Sahlman)

Investing in new ventures is cycle process . . . involves both positive ebbs and flows

People matter . . . Perceptions, judgments, and actions.

CASH FLOW

Example of Cash Flow Cycle Over the Life Cycle of a Business

Profits

Cash flow

Start-up to Early Stage Growth Stage Maturity

0

Reasons for Cash Flow Problems

Difficulty in collecting receivables Seasonality of sales Unexpected variation in sales Policies on how payments to suppliers Large expenditures up front for projects Capital projects Ineffective inventory management

Measuring Cash Flow

Cash Flow from Operating Activities

Cash Flow from Investing Activities

Cash Flow from Financing Activities

• Internal (i.e., Bootstrapping)

• Debt

• Equity

PRIMARY TYPES OF FUNDING (I.E., SOURCES) . . . ?

Bootstrapping

Techniques and tools that can help achieve the same outcomes while greatly reducing costs.

Why Bootstrap?Often necessary for small businesses to get

started (New Ventures are generally “poor fit” for traditional lending models (Bhide, 1992)

Preserves the value and wealth of a business

Difficulty in raising and using money for growth

E.g., danger of misallocation (Bhide, 1992)

E.g., diminished flexibility (operational – path dependence effects of missing on 1st attempt (Dierckx & Cool, 1989); credibility loss with lenders (Bhide, 1992))

Bootstrap Marketing

Know your customerImpact of message more important than

“volume”Remember your market space or niche

and the benefits you bring . . . spend your marketing dollars carefully

Marketing is a process, not an event

Examples . . . ?

Human Resources Bootstrapping

Employee “stretching”Independent contractors Employee leasing and temporary

employeesStudent interns Equity compensation Non-monetary benefits

Examples . . . ?

Administrative Overhead Bootstrapping

Space

Furnishings and office equipment

Administrative salaries

Operations & Inventory Bootstrapping

Outsourcing

Just-in-time inventory techniques

Effective cost accounting

DEBT FINANCING

Short-term Debt FinancingExpected to be paid within one year

Most often used to finance short-term expenditures such as inventory, supplies, payroll, etc.Trade debt

Banks

Asset-based lenders

Factors

Long-term Debt

Beyond one year

Most often used to fund fixed asset purchasesBanks: term loansLeasing companiesReal estate lenders

Overlooked Forms of Debt

Property leases

Long-term employment agreements

SBA or other government backed lending programs

6 C’s: Criteria for Lending by Bankers 1. Character of founder and key leaders2. Capital – equity . . . “skin in the game”Venture 3. Capacity – cash flow capability to easily

make interest and principle payments & awareness

4. Conditions – industry trends, seasonality, operational changes, world events, etc.

5. Collateral – “hard” assets to pledgeBanker6. Common sense – what does your gut tell

you?

Downside of Debt

Increased risk during economic slowdown

Impact on proceeds from business sale

Restrictive covenants

Personal guarantees

EQUITY FINANCING

Sources of Equity Funding

Funding from the entrepreneur

Family and friends (and “fools”!)

Strategic partners

Angel investors

Private placement

SBICs

Venture Capitalists

Potential Downsides of Equity Financing

Dilution of ownership

The risk of sharks

Dynamics of adding on new partners

Working with Equity Investors

1. Business plan

2. Confidentiality agreement

3. Letter of Intent

4. Modifications of shareholder agreements

Creating an Array of Financing

Prioritize financing needs based on forecasts

Focus financing only on what is critical for operations

Create an inventory of all assets and what proportion of each can be financed

Creating an Array of Financing

Asset Percentage financed

Purchase Orders 70%

A/R (<60 days) 70%

Inventory 30%

Leasehold Improvements

50%

Building 70%

Undeveloped land 40%

Equipment 80%

Creating an Array of Financing

Identify best source of financing for each asset

Multiple funding sources are likely

Remember to bootstrap!

Venture Capital: Stages of High Growth Business Funding

1. Initial stage

2. First round financing

3. Second round financing

4. Late round financing

Initial Stage Funding

File for incorporationWrite business planFind office and development spaceCompletion of initial designHire key development personnel Complete prototype unitComplete prototype testing

First Round Financing

Secure key vendors Hire key service or manufacturing

personnelRent or build manufacturing facilityPurchase manufacturing equipmentMarket testingFirst sales contractProduction of first manufactured unitFirst 100, 1000, 10000 units, etc.

Second Round Financing

Break-even level of sales

Development of next generation of product

Late Round Financing

Initial public offering

Sale of business