RAISING ENTREPRENEURIAL CAPITAL
Praise for Raising Entrepreneurial Capital ‘‘Experiential in its approach, this book will be a great resource to the potential entrepreneur while also serving as an excellent text in entrepreneurial studies programs and other courses. Covering topics of crucial importance and providing a wealth of details, it also includes a variety of material not commonly found in finance texts.’’ Alva Butcher, Acting Director, School of Business and Leadership, University of Puget Sound ‘‘Need money to launch your venture? You need this book. Raising Entrepreneurial Capital will guide you through the intracacies and alternatives for raising money, growing, and harvesting your business venture. It offers practical guidelines and insightful cases that enhance your probability of success.’’ John B. Elstrott Jr., Clinical Professor of Entrepreneurship, Freeman School of Business, Tulane University ‘‘I have been an entrepreneur, venture investor, or venture capitalist most of my 30year professional business career and have been involved in the startup of over 40 companies, some very successful and some not so successful. After reading Raising Entrepreneurial Capital, my only regret is that I did not have access to this book of business knowledge at the beginning of my career. Most of the lessons I learned on the job (many the hard way) trying to raise money in every way known to man are in this book and I find it amazing how much of it is accurately covered in depth by the authors. It will be a great textbook for teaching entrepreneurial finance. I have never seen a book that covers everything one needs to know in such great depth. This book should be required reading for anyone thinking about starting a new business. It will save a lot of wasted time and heartache for a new entrepreneur.’’ Kent L. Johnson, Chairman and Managing Director, Alexander Hutton Venture Capital, Chairman of the Advisory Board of Seattle University’s Entrepreneurship Center ‘‘John Vinturella takes a fundamentals of finance-type primer to a whole new level. Filled with stats, tables, case studies, models, and pros and cons of various financing options, this comprehensive and practical text is both a refreshing guide and a resource for small business entrepreneurs, students, lenders, and investors alike!’’ Paul I. Karofsky, Executive Director, Northeastern University Center for Family Business ‘‘Raising capital is a dynamic topic that Vinturella and Erickson have dealth with in a real-world up-to-date manner applicable to founders of all types of companies. There are far more capital sources than most entrepreneurs realize and the authors have provided an exhaustive approach that will help direct a capital-raising effort and increase its chances of success.’’ Janis Machala, Managing Partner, Paladin Partners
RAISING ENTREPRENEURIAL CAPITAL
JOHN B. VINTURELLA AND SUZANNE M. ERICKSON
Elsevier Butterworth–Heinemann 200 Wheeler Road, Burlington, MA 01803, USA Linacre House, Jordan Hill, Oxford OX2 8DP, UK Copyright # 2004, Elsevier, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone: (þ44) 1865 843830, fax: (þ44) 1865 853333, e-mail:
[email protected]. You may also complete your request on-line via the Elsevier Science homepage (http://elsevier.com), by selecting ‘‘Customer Support’’ and then ‘‘Obtaining Permissions.’’ Recognizing the importance of preserving what has been written, Elsevier prints its books on acid-free paper whenever possible. Library of Congress Cataloging-in-Publication Data Application submitted British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. ISBN: 0-12-722351-7 For information on all Butterworth–Heinemann publications visit our website at www.bh.com 03 04 05 06 07 08 09 10 9 8 Printed in the United States of America
7 6 5 4
3 2 1
To Susan and Matt JBV To Warren, Shannon, and Ryan SME
Table of Contents
Chapter 1
Introduction—In the Beginning
1
Chapter 2
Alternatives in Venture Financing—Debt Capital
41
Chapter 3
Alternatives in Venture Financing—Early Stage Equity Capital
85
Chapter 4
Determining the Amount Needed—The Business Plan
115
Chapter 5
Valuation—Survey of Methods
153
Chapter 6
Venture Capital
189
Chapter 7
Exit Strategies
229
ix
x
Chapter 8
Executing the Exit Strategy
267
Chapter 9
Franchising
289
Chapter 10
Internal Financial Management
311
Chapter 11
Essentials of Risk Management
331
Chapter 12
Opportunities to Do Business and Raise Capital Globally
349
Detailed Table of Contents
Chapter 1
Introduction—In the Beginning
1
Introduction Understanding the Characteristics of Small Businesses The Home-Based Alternative Assessing the Risks Top Five Service Industries
1 4 6 9 10
Organizational Form Sole Proprietorship General Partnership Limited Partnerships S-Corporation LLC—Limited Liability Companies C-Corporation Ownership Structure and Capitalization
12 13 15 16 16 18 18 19
Creative Sources of Capital Initial Sources of Capital Small Firms Typical Use of Financial Services Bootstrap Strategies
20 23 26 28
Experts Explain How Small Businesses Fail Glocal Advantage Company Perspective U.S. SBA’s Small Business Failures: A Framework for Analysis
29 29 30
xi
xii
Joseph M. Sherlock, Management Consultant Perspective Business Bankruptcy Project
31 33
Organization of the Book
33
Summary
34
Discussion Questions
36
Case 1.1 New Tech (A): Overview The Company Challenge: How to Grow? An Advisor Case Study Questions
37 37 38 38 38
References
38
Bibliography
39
Chapter 2
Alternatives in Venture Financing—Debt Capital
41
Introduction Lending Sources SBA Loans—Profile of a Provider Loan Brokers—Online Screening Form
41 42 44 44
Debt Capital Considerations
46
Approaching Prospective Lenders The Loan Package The Lender’s Perspective
47 47 48
Debt Capital Terms and Options
51
Term of Loan Loans May Be Secured or Unsecured Venture Banking Asset-Based Financing Trade Credit
51 53 55 55 57
Case 1: SPS—Financing Strategy
58
Estimating Financing Requirements
62
xiii
Case 2: MDO Products, Inc.—Start-Up Financing Break-Even Analysis
62 65
Estimating Asset Requirements Current Assets Fixed Assets Other Assets Indirect Increases in Assets Capital Requirements as Percent of Sales
67 67 68 69 69 69
Estimating the Liabilities and Equity Current Liabilities Long-Term Debt Equity
70 70 70 71
Case 3: Cajun Yachts, Inc.—Startup Financing
71
Summary
74
Discussion Questions
75
Case 2.1 New Tech (B): How Much Do They Need? Introduction The Challenge: Determining Needs The Challenge: Financial Projections The Solution: Financial Needs
75 75 76 76 77
Appendix 2.1 New Tech (C): Financial Statements Income Statements Balance Sheets
79 79 80
Appendix 2.2 New Tech (D): Financial Ratios Liquidity Ratios Leverage Ratios Profitability Ratios
81 81 81 82
Appendix 2.3 New Tech (E): Key Assumptions
83
Bibliography
83
Chapter 3
Alternatives in Venture Financing—Early Stage Equity Capital
85
Introduction
85
xiv
Angel Investors Early-Stage Investing In Practice Characteristics
86 87 88 90
Other Sources of Early-Stage Funding The Small Business Administration Differing Perspectives Valuation Issues
91 91 94 95
Stages, Or ‘‘Rounds,’’ of Funding Getting ‘‘Off the Ground’’ Rapid Growth Maturity
97 97 97 98
Summary
100
Discussion Questions
101
Example 3.1 New Tech (F): Where Will the Money Come From? The Challenge: Where Will the Money Come From? The Challenge: Conventional Funding The Challenge: Risk Capital Options The Solution: A Financial Package
102 102 103 104 104
Case 3.2 New Tech (G): Are They Worth an Investor’s Time? The Challenge: Are They Worth an Investor’s Time? The Challenge: How Does New Tech Stack Up? The Solution: Getting Their House in Order
105 105 106 108
Case Study: Ecoturista Executive Summary: As Distributed in the Fall of 1999 The Opportunity The Operational Model
109 109 111 111
Bibliography
114
Chapter 4
Determining the Amount Needed—The Business Plan
115
The Business Plan Introduction
115 115
xv
The Executive Summary Vision Statement/Business Description The Market Analysis Competitive Analysis The Venture Team Sales and Marketing Financial Projections Legal Entanglements Are Risks Properly Assessed? Is the Exit Strategy Feasible?
117 118 118 120 122 123 123 123 124 124
The Investor’s Perspective
125
The Financial Projections Pro Forma Financial Statements Case Study: Amazon.com Analysis
127 127 130 134
Summary
136
Discussion Questions
136
Case 4.1 New Tech (H): Is Management Ready? The Challenge: Is Management Ready? The Challenge: Auditing the Management Team
136 136 137
Case 4.2 Web Wired
140
Web Wired Business Plan Change Execution Assurance for Outsourced Manufacturing
140 140
Executive Summary Company Technology, Products, and Benefits Market, Growth, and Competitive Overview Sales, Marketing, and Revenue Management Financial Projections Investment Needs
140 140 141 141 142 142 143 143
Business Plan Opportunity Marketing Sales
143 143 144 146
xvi
Appendix 4.1 Sample Business Plan Template
151
Bibliography
151
Chapter 5
Valuation—Survey of Methods
153
Introduction: Valuation Methodologies
153
Asset-Based Valuation Liquidation Value Replacement Value Modified Book Value
155 155 156 156
Market Multiples Comparables Valuing Service Businesses Mathematical Relationships Woodridge Corporation Superior Plumbing Supply Appropriateness of Methods Valuation: Example
157 157 158 159 159 160 161 162
Capitalization Rates
163
Excess Earnings Approach Defined Example
164 164 165
Free Cash Flow Valuation Defined Illustrating the Free Cash Flow Model Woodridge Corporation Application Notes Determining the Discount Rate
166 166 167 168 170 172
Summary
174
Discussion Questions
175
Case 5.1 New Tech (I): What is the Company Worth? Valuation—The Company’s Perspective Discounted Cash Flow Methods To Do Valuation—The Investor’s Perspective
176 177 177 178 178
xvii
To Do: Case Study Questions New Tech’s Financial Forecast
178 179
Appendix 5.1 Review of Ratio Analysis Liquidity Ratios Asset Management Debt Ratios Profitability Industry Average Data Summary
180 180 181 182 184 186 187
Bibliography
187
Chapter 6
Venture Capital
189
Introduction
189
The Venture Capital Industry Venture Capital Partnerships Types of Funds Investment Characteristics
190 191 193 194
Credible Financial Proposals Amount and Staging of Investment Financial Projections Investors’ Expectations
196 196 197 197
Approaching Private Investors
198
Presentation Develop the Context for the Meeting Set Objectives Prepare for Success
200 200 200 201
Due Diligence
202
The Venture Capital Process Letter of Intent Valuation Issues Structure and Terms of the Deal
203 203 204 206
The Term Sheet Objective Key Term Sheet Clauses
207 207 209
xviii
Summary
216
Discussion Questions
217
Case 6.1 New Tech (J): Getting Investors’ Attention Key Tasks
217 217
Executive Summary of Investment Proposal (Part 1)
218
Executive Summary of Investment Proposal (Part 2)
220
Executive Summary of Investment Proposal (Part 3) To Do
221 222
Appendix 6.1 Sample Term Sheet Offering Terms Terms of the Preferred Stock Terms of Preferred Stock Purchase Agreement Terms of Investor Rights Agreement Terms of Right of First Refusal and Co-Sale Agreement Other Matters
223 223 223 224 225 226 226
Bibliography
227
Additional Resources
228
Chapter 7
Exit Strategies
229
Components of the Exit Strategy Importance of the Exit Strategy Differing Perspectives Valuation by Revenue Multiples Comparison of Returns by Exit Type
229 229 230 231 232
Likeliest Options for Exit Acquisition Earn-Out Debt-Equity Swap Merger Management Buyout Liquidation
232 233 236 237 237 239 239
Other Potential Buyers
240
xix
Individual Buyers Equity Group Buyers Partners and Employees Family Members
240 240 241 241
Going Public The Lure of Going Public Constraints Candidates for a Public Offering Listing Requirements for National Stock Exchanges Comparing the Exchanges Alternative Forms of Listings
242 242 243 244 246 247 248
Initial Public Offering (IPO) Overview Building the Team The Prospectus Finding Buyers for the Offering
249 249 249 251 252
Open IPOs
254
Alternative Methods of Going Public The ‘‘Reverse Merger’’ Direct Public Offering Considerations Related to Alternative Methods
255 256 257 258
Forms of DPOs Risks Across all Forms SCOR Offerings SB-2 Offerings Regulation A Regulation D—Rule 504
259 259 259 261 261 262
Summary
263
Discussion Questions
264
Bibliography
264
Chapter 8
Executing the Exit Strategy
267
xx
Case 8.1 New Tech (K): Finding Compatible Investors Key Tasks The Challenge: Building a Short List The Challenge: Ranking Possible Investors Evaluation of Investors The Solution: Targeting Preferred Investors Next Steps What New Tech Learned
267 268 268 269 269 274 274 274
Case 8.2 New Tech (L): Getting Ready Key Tasks The Challenge: Dress Rehearsal The Solution: The Meeting and After What New Tech Learned
275 275 275 276 277
Case 8.3 New Tech (M): Choosing an Offer Choosing One Key Tasks The Challenge: Negotiating Terms The Solution: Striking a Deal What New Tech Learned The Solution: Final Term Sheet
278 278 279 279 281 281 281
Case 8.4 New Tech (N): Closing the Deal Key Tasks The Challenge: The Due Diligence Review The Solution: Future Growth What New Tech Learned
285 285 286 287 288
Chapter 9
Franchising
289
Introduction Franchising Basics Types of Franchises The Costs Due Diligence
289 290 291 293 295
A Tale of Two Franchises The McDonald’s Model Great Harvest Bread Company
297 297 299
xxi
Franchising Opportunity
300
Financing the Franchise Franchisers Non-Bank Lenders The SBA
302 303 303 303
Summary
304
Discussion Questions
304
Case Study 9.1: Franchising the Neighborhood Restaurant Introduction Kelly O’Bryan’s Neighborhood Restaurant
305 305 305
Bibliography
308
Additional Resources
309
Chapter 10
Internal Financial Management
311
Introduction
311
The Cash Conversion Cycle
312
The Cost of Trade Credit
315
The Cash Budget Sample Cash Budget
317 317
Sources of Short-Term Financing Lines of Credit Asset-Backed Loans Factoring Customers
321 321 322 323 323
Cash Management Lockboxes Bank Cash Management Services
324 325 326
Summary
326
Discussion Questions
327
Case 10.1 New Tech: Monthly Cash Budget Cash Budget
328 328
xxii
Sensitivity Analysis Bibliography
329 329
Chapter 11
Essentials of Risk Management
331
Introduction
331
Defining Risk and Risk Management
332
Relationship of Risk Management to Financial Management
333
The Risk Management Process Step 1—Determination of Risk Management Objectives Step 2—Identification of Exposures to Loss Step 3—Analysis of Exposures to Loss Step 4—Selection and Implementation of Risk Treatment Methods Step 5—Administration of the Risk Management Program
333 333 334 334
Some Core Risk Management Principles Risk Management Is a Process, Not an Event Exposure Identification Is the Key to Successful Risk Management Loss Control Efforts Will Pay for Themselves Pre-Loss Planning Is the Key to Post-Loss Survival Bearing Some Loss Can Be Rational
335 335
Common Exposures to Loss Direct Property Exposures Consequential Property Exposures Liability Exposures Human Resources Exposures Financial Exposures Operational Exposures Strategic Exposures
338 338 338 339 340 340 341 341
Fundamentals of Risk Control Avoidance Loss Control Non-Insurance Transfer
342 342 342 343
335 335
336 336 337 337
xxiii
Overall Risk Control
343
Fundamentals of Risk Financing Retention Insurance Derivatives
343 343 344 345
Advantages of Outsourcing Risk Management
345
Summary
346
Discussion Questions
347
Bibliography
347
Additional Resources
347
Chapter 12
Opportunities to Do Business and Raise Capital Globally
349
The Global Mindset Basic Considerations A Few Words About Communications
349 350 351
Finding and Working With International Partners Basic Considerations Sources of Information and Assistance Testing the Market Working with Partners
352 352 353 356 357
Raising Equity Capital from International Sources Basic Considerations Angels and Venture Capitalists What Investors Want
360 360 360 363
Due Diligence Screening Valuation and Monitoring Exit Strategies Regional Considerations
364 365 366 367 367
Listing on a Stock Exchange Outside the United States
369
Summary
372
xxiv
Discussion Questions
372
Bibliography
373
Index
375
About the Authors
393
About the Guest Authors
394
Preface
This book is about financing the entrepreneurial venture. Why devote a whole book just to financing? The answer is that financial choices, especially those made early on, can affect future growth opportunities and strategic options. To avoid precluding desirable strategic actions later on, the entrepreneur needs to carefully structure the business from the beginning. Many potential entrepreneurs have great ideas for businesses, but without sound financial roadmaps on which to execute, they will simply remain ideas. In this book we consider financing issues at all stages of the venture’s life, from birth of the company through growth, culminating in exit from or sale of the business. We consider internal financial management and risk management as strategies to garner or conserve resources internally. We look at franchising as an entre´e to entrepreneurship that involves somewhat less risk than the traditional start-up method. This book is intended to be a guide that will increase the odds of success for the potential entrepreneur. To that end, the book is detailed and more experiential than theoretical. It is based on standard financial theory but it also benefits from the experiences of many entrepreneurs and lessons learned the hard way. It is our hope that the book will provide useful, practical advice to any aspiring entrepreneur in the all-important task of funding their new business. It is important at the outset to distinguish between entrepreneurial ventures and other types of small businesses. Broadly speaking, new and/or privately held businesses can be divided into entrepreneurial ventures and ‘‘lifestyle’’ businesses. Entrepreneurial ventures can be defined as new business start-ups with high growth aspirations. Typically, the entrepreneur is passionate about an idea or product, is willing to bear substantial risk to see his or her vision brought to market, and is willing to work incredibly long hours to see the vision realized. Entrepreneurship is often defined as the pursuit of opportunity without regard to currently controlled resources. In other words, the
xxv
xxvi
idea is key and the entrepreneur will figure out a way to bring the idea to fruition. Unlike corporate finance, in which the firm is managed for absentee owners and stockholders, and wealth maximization is the goal, in any privately-held business the goals of the business and the entrepreneur are intertwined. Many successful entrepreneurs insist that they are not motivated by the money, but by the challenge or ‘‘the game.’’ This results in the existence of the subspecies, the ‘‘serial entrepreneur’’. Once the start-up reaches some sort of equilibrium or steady state, the thrill is gone for many entrepreneurs and the next start-up beckons them to a fresh challenge. Contrast this vision with that of the much more prevalent lifestyle business. Lifestyle businesses can vary from hobbies turned into incomeproducing sidelines to the sole proprietorships and family-owned businesses with very different growth aspirations and goals. For these businesses, a ‘‘good living’’ or independence is the goal and driving force behind the business. There is no plan to take the business public or sell it to a larger company. Significantly for the purposes of this book, there is no plan to grow the business faster than the internal resources will allow. If all growth is funded internally, financing the business becomes much simpler, and financial management is the primary strategy for financial success. Financing the lifestyle business would lead to a very short book, and most of the topics would be covered in a standard working capital text. For that reason our focus in this book is the faster-growing entrepreneurial firm. Many of the lessons in the chapters on internal financial management and risk management apply to the lifestyle venture as well. Entrepreneurial ventures are interesting to study not only for their financing challenges, but because they currently provide most of the innovation and job growth in the U.S. economy and many economies around the world. Indeed, a 1998 survey of 500 influential Americans1 led Ernst and Young to declare entrepreneurship as the defining trend of the business world in the 21st century. Jeffry Timmons of Babson College dubs the current generation of entrepreneurs the ‘‘E-Generation’’ and declares that they have ‘‘altered permanently the economic and social structure of this nation and the world . . . It will determine more than any other single impetus how the nation and the world will live, work, learn, and lead in the next century and beyond.’’2 Timmon’s forecast may have been somewhat colored by the dot.com euphoria of the late nineties, but the fact remains that entrepreneurship is a catalyst for growth and economic vitality.
1
See http://www.ey.com/global/vault.nsf/us/Entrepreneurial_Age/$file/entrepreneurialage.pdf Timmons, Jeffry A., New Venture Creation: Entrepreneurship for the 21st Century, ed 5, Irwin-McGraw Hill, 1999, p. 3. 2
xxvii
Encouragement of business start-ups is vital to the health of the economy and to the evolution of technology. Today virtually all new ideas and job growth are emanating from the entrepreneurial sector of the economy. The Global Entrepreneurship Monitor 2002, a report3 on entrepreneurship in thirty-seven countries sponsored by the London Business School and Babson College, estimates that 460 million adults worldwide are engaged in entrepreneurial activity.4 The study found a positive correlation between level of entrepreneurial activity and national growth. The level of entrepreneurial activity was lowest in developed Asian countries (Japan, Hong Kong, Taipei and Singapore), slightly higher in the European Union and Israel, substantially higher in the former British Empire (Australia, Canada, New Zealand, South Africa, and the United States), higher still in Latin America and highest of all in the developing Asian countries (China, Korea, India and Thailand). The correlation between entrepreneurial activity and economic growth was strongest in less-developed countries where entrepreneurship tends to be a necessity rather than an option. In countries without an effective national welfare system, the drive to entrepreneurial activity is often the difference between having food on the table and not.5
ACKNOWLEDGMENTS Many thanks to Kent Johnson of Alexander Hutton Capital and Doug Brown for sharing their wisdom and experience. Thanks to Harriet Stephenson for encouraging me down the entrepreneurial path. Especially thanks to my wonderful family: Warren, Shannon, and Ryan. Suzanne My wife, Susan Howell, improved the product by proofreading and by suggesting more objective and less ‘‘inside the industry’’ views and explanations. Our son, Matthew Oiler, provided computer support. As helpful as this technical assistance was, it was minor compared to Susan and Matt’s continuing encouragement. John
3
See http://www.emkf.org/pdf/GEM2002.pdf The study measures entrepreneurship as the percentage of the labor force in businesses fortytwo months old or less. 5 The astounding growth of microcredit throughout the developing world is probably greatly responsible for the prevalence of entrepreneurs in the least developed countries. Microcredit is the granting of very small loans ($25–50), usually to women, to start and run home-based businesses. These women are usually the main financial providers for their families and take the loans and their businesses very seriously. 4
Chapter 1
Introduction—In the Beginning
CHAPTER GOALS In this chapter you will learn about: . the difference between entrepreneurial ventures and other forms of small business . the connection between entrepreneurship and the health of the economy . characteristics of small businesses . reasons for business failure . the relationship between organizational form and business and financial strategy . the pros and cons of various organizational forms the venture can take . ‘‘bootstrapping,’’ the financing options in the very earliest stages of a company’s life
INTRODUCTION This book is about financing the entrepreneurial venture. Why devote a whole book just to financing? The answer is that financial choices, especially ones made early on, can affect future growth opportunities and strategic options. To avoid precluding desirable strategic actions later on, the entrepreneur needs to carefully structure the business from day one. Many potential entrepreneurs have a great idea for a business, but without a sound financial roadmap to execute an idea, it will remain simply an idea.
1
2
Introduction—In the Beginning
In this book we consider financing issues at all stages of the venture’s life, from birth of the company through growth to exit from or sale of the business. We consider internal financial management and risk management as strategies to garner or conserve resources internally. We look at franchising as an entre´e to entrepreneurship that involves somewhat less risk than the traditional method of start-up. This book is intended to be a guide that will increase the odds of success for the potential entrepreneur. To that end, the book is detailed and more experiential than theoretical. It is based on standard financial theories, but it also benefits from the experiences of many entrepreneurs and from lessons learned the hard way. It is our hope that the book will provide useful, practical advice to any aspiring entrepreneur in the all-important task of funding his or her new business. It is important at the outset to distinguish between entrepreneurial ventures and other types of small business. Broadly speaking, new and/or privately held businesses can be divided into entrepreneurial ventures and ‘‘lifestyle’’ businesses. Entrepreneurial ventures can be defined as new business start-ups with high growth aspirations. Typically, the entrepreneur is passionate about an idea or product, is willing to bear substantial risk to see his or her vision brought to market, and is willing to work incredibly long hours to realize the vision. Entrepreneurship is often defined as the pursuit of opportunity without regard to resources currently controlled. In other words, the idea is key and the entrepreneur will figure out a way to bring the idea to fruition. Unlike corporate finance, in which the firm is managed for absentee owners and the stockholders, and wealth maximization is the goal, in any privately held business the goals of the business and the entrepreneur are intertwined. Many successful entrepreneurs insist that they are not motivated by the money, but by the challenge, or ‘‘the game.’’ This results in the existence of a subspecies called the ‘‘serial entrepreneur.’’ Once the startup reaches some sort of equilibrium or steady state, the thrill is gone for many entrepreneurs and the next start-up beckons them to a fresh challenge. Contrast this vision with that of the much more prevalent lifestyle business. Lifestyle businesses can vary from a hobby turned into an income-producing sideline to the many sole proprietorships and familyowned businesses, all with very different growth aspirations and goals. For these businesses, a ‘‘good living’’ or independence is the goal and driving force behind the business. There is no plan to take the business public or sell it to a larger company. Significantly for the purposes of this book, there is no plan to grow the business faster than the internal resources will allow. If all growth is funded internally, financing the business becomes much simpler, and financial management is the primary strategy for financial
Introduction—In the Beginning
3
success. Financing the lifestyle business would lead to a very short book, and most of the topics would be covered in a standard working capital text. For that reason our focus in this book is on the faster-growing entrepreneurial firm. However, Many of the lessons in the chapters on internal financial management and risk management apply to the lifestyle venture as well. Entrepreneurial ventures are interesting to study not only for their financing challenges, but also because they currently provide most of the innovation and job growth in the U.S. economy and many economies around the world. Indeed, a 1998 survey of 500 influential Americans1 led Ernst and Young to declare entrepreneurship as the defining trend of the business world in the twentyfirst century. Jeffry Timmons of Babson College dubs the current generation of entrepreneurs the ‘‘E-Generation’’ and declares that they have ‘‘altered permanently the economic and social structure of this nation and the world...It will determine more than any other single impetus how the nation and the world will live, work, learn and lead the next century and beyond.’’2 Timmons’s forecast may have been somewhat colored by the dot.com euphoria of the late 1990s, but the fact remains that entrepreneurship is a catalyst for growth and economic vitality. Encouragement of business start-ups is vital to the health of the economy and to the evolution of technology. Today virtually all new ideas and job growth are emanating from the entrepreneurial sector of the economy. The Global Entrepreneurship Monitor 2002, a report3 on entrepreneurship in 37 countries sponsored by the London Business School and Babson College, estimates that 460 million adults worldwide are engaged in entrepreneurial activity.4 The study found a positive correlation between level of entrepreneurial activity and national growth. The level of entrepreneurial activity was lowest in developed Asian countries (Japan, Hong Kong, Taipei, and Singapore), slightly higher in the European Union and Israel, substantially higher in the former British Empire (Australia, Canada, New Zealand, South Africa, and the United States), higher still in Latin America, and highest of all in the developing Asian countries (China, Korea, India, and Thailand). The correlation between entrepreneurial activity and economic growth was strongest in less-developed countries where entrepreneurship tends to be a necessity rather than an option. In countries without an 1
See http://www.ey.com/global/vault.nsf/us/Entrepreneurial_Age/$file/entrepreneurialage. pdf Timmons, Jeffry A., New Venture Creation Entrepreneurship for the 21st Century, 5th edition, Irwin-McGraw Hill, 1999, p. 3. 3 See http://www.emkf.org/pdf/GEM2002.pdf 4 The study measures entrepreneurship as the percentage of the labor force in businesses 42 months old or less. 2
4
Introduction—In the Beginning
effective national welfare system, the drive to entrepreneurial activity often determines whether or not there is food on the table.5 To increase any entrepreneur’s probability of success, it is necessary to understand what actions the entrepreneur can take to increase those odds and what hurdles may prevent a venture from succeeding. In this chapter we will focus on the faster-growth entrepreneurial venture and discuss how the choice of organizational form is related to growth and the firm’s need for capital. We will also discuss bootstrapping, creative sources of funding to get the venture through the early times and beyond. The chapter will close with a look at the rest of the chapters that will follow.
UNDERSTANDING THE CHARACTERISTICS OF SMALL BUSINESSES Each year, with some lag time, we get a good picture of what small business is and where it is headed by following data collected by the Office of Advocacy of the U.S. Small Business Administration (SBA); see http:// www.sba.gov/advo/. The office collects data from various authoritative sources and provides a central point for access to these data on their web site. Its sources include the Census Bureau, the Bureau of Labor Statistics, the Department of Commerce, the International Trade Administration, and various other public reports often funded by the Office of Advocacy. These data represent the most current available on the SBA ADVO web site, as of March 31, 2003. Let us look first at how the SBA defines a small business.
What Is a Small Business? For research purposes, the Office of Advocacy uses the small business definition of fewer than 500 employees and provides information for firms of various sizes. For technical purposes such as government contracting, the definition varies by number of employees and by gross revenues. You can learn more from the SBA’s Office of Size Standards at (202) 205–6618 or visit www.sba.gov/size/.
By This Definition, How Significant are Small Businesses to the U.S. Economy? . Small businesses represent more than 99% of all employers. . Small businesses employ 51% of private-sector workers, 51% of workers on public assistance, and 38% of workers in high-tech jobs. 5
The astounding growth of microcredit throughout the developing world is probably greatly responsible for the prevalence of entrepreneurs in the least developed countries. Microcredit is the granting of very small loans ($25–$50), usually to women, to start and run home-based businesses. These women are usually the main financial providers for their families and take the loans and their businesses very seriously.
Introduction—In the Beginning
5
. Small businesses represent nearly all of the self-employed, which are 7.0% of the work force. . Small businesses provide two thirds to three quarters of the net new jobs. . Small businesses produce 51% of private-sector output. . Small businesses represent 96% of all exporters of goods. . Small businesses obtain 33.3% of federal prime and subcontract dollars. . 53% are home-based and 3% are franchises.
How Many Total Businesses are There? The best estimate is that there were about 22.4 million in 2001. Business tax returns totaled 25.6 million in 2001. This number may overstate the number of businesses, however, because one business may operate more than one taxable entity. . There were 16.15 million small businesses without employees in 1999, the latest data year for Census Bureau non-employer statistics. . The number of sole proprietorships, roughly equivalent to nonemployers, increased by 1.1% in 2000 and 1.6% in 2001 (Internal Revenue Service Statistics of Income). . There were 5.61 million businesses with employees in 1999 (Bureau of the Census, Statistics of U.S. Business).
By applying the sole proprietorship growth rates to the non-employer figures, applying similar growth rates from the Department of Labor to the employer figures, and adding together the resulting numbers for employer and non-employer firms, the Office of Advocacy finds that 22.4 million is a fair approximation of the number of existing businesses.
How Many Small Businesses are There? There are about 22.4 million. Subtracting the 17,000 businesses that are large (with 500 or more employees) from the 22.4 million total (22.4 million minus 0.017 million) still leaves a total of about 22.4 million small businesses.
How Many Businesses Do Women Own? Women are estimated to be full or part owners of 9 million businesses and the primary owners in 5.4 million of these (Bureau of the Census). The number of women-owned businesses increased by 16% over the 1992–1997 period, the most recent period for which comparative data are available.
How Many Businesses Do Minorities Own? In 1997 there were 1.2 million Hispanic-owned firms, 820,000 AfricanAmerican-owned firms, 913,000 Asian- and Pacific-Islander-owned firms, and 197,300 firms owned by American Indians and Alaska Natives (Bureau of the Census). Over the 1992–1997 period, Native American-owned firms
6
Introduction—In the Beginning
increased 84%; Asian-owned, 30%; Hispanic-owned, 30%; and AfricanAmerican-owned, 26%.
What Does the Typical Small Business Look Like? This material originally appeared in Wally Bock’s Briefing Memo Newsletter of April 15, 1998. See http://www.bockinfo.com/docs/db1.htm.
Number
Firms and ownership, 1997 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0
w/Empl
Female
Hispanic
AfrAmer
AsianPacIsl NativeAmer
Figure 1.1 Firms and ownership, 1997 (total number of firms estimated to be 22,400,400).
The 17th Annual Dun & Bradstreet Small Business Survey was released in early 1998. For the first time, Dun & Bradstreet used its survey to create a profile of a typical American small business. According to D&B, here is that profile. . . . . . . .
Three employees Annual revenue—$150,000 to $200,000 Owned by a white male (53.4%) Operates at 1.3 locations The owner works 50.4 hours per week. The business is privately owned (not a franchise). The geographic center of small businesses in the United States is located near Kansas City, in Carroll County, Missouri. D&B says that indicates that small businesses are fairly evenly distributed across the United States.
THE HOME-BASED ALTERNATIVE Sources In a report underwritten by the U.S. SBA and published in its Advocacy newsletter (No. 194, March 2000), Joanne H. Pratt6 describes the characteristics of home-based businesses (HBBs). 6
Small Business Research Summary, Home-Based Business: The Hidden Economy, by Joanne H. Pratt, 1999. 133 pages. Under contract no. SBAHQ-97-M-0862.
Introduction—In the Beginning
7
This report is based upon an analysis of previously unpublished data collected by the Census Bureau that breaks out information for both firms operated from home and firms operated from outside the home. The original data were collected as part of the business census that is conducted every 5 years (for business activity in years ending with a 2 or 7). The data cover business activity during 1992. A sampling of 125,000 businesses from the universe of businesses that filed business tax returns in that year as sole proprietorships, partnerships, or subchapter S-Corporations was used by the Census Bureau to create the Characteristics of Business Owners (CBO) survey. This effort was underwritten in part by the U.S. SBA and the U.S. Department of Commerce’s Minority Business Development Agency. The CBO sample includes the smallest ‘‘active businesses’’ (defined as those with at least $500 in receipts) and both employer and nonemployer firms.
Size and Receipts of HBBs Home-based businesses represent 52% of all firms and provide 10% of the total receipts of the economy, about $314 billion in 1992. The share of receipts accounted for by home-based firms varied greatly by demographic group. For example, it was 26% for all African-American-owned firms, but only 8% for home-based firms owned by Asians. Other findings include: . Over 55,000 HBBs had sales of more than $1 million in 1992. These same firms employed over 3.5 million persons both at home and offsite. . About 19% of home-based firms had employees. This compares with 18% of non-home-based firms. . The average receipts of all home-based firms was in the $40,000 range, with some variance by demographic group. However, beginning at $50,000, an increasingly greater percentage of firms are likely to be non-home-based.
Characteristics of HBBs Increasingly, people use their home to earn a primary income, not only a secondary or supplementary income. This varies by industry, demographic group, and location. Of the three general business uses of the home—for clerical work, for production work, and for telecommuting—the most money by far is made by firms that use the home for clerical work. Firms owned by men were more likely to use the home for clerical tasks; firms owned by women were more likely to use the home to produce goods or services on the premises.
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Introduction—In the Beginning
Other findings include: . Forty to 44% of all HBBs required less than $5,000 for start-up. Another 25% or so needed $5,000 to $25,000. By contrast, a quarter of non-home-based firms needed more than $25,000 to start. . One third of all home-based firms use personal assets to start, and 46% used personal savings. Because home-based firms tend to remain in the home—less than 5% eventually move out of the home—there is some evidence that capital constraints prevent more firms from expanding. . Some industries—such as construction and transportation, communications, and utilities—show about the same profit whether operated in the home or outside of the home. In these cases, the home is generally used for clerical work. . Disabled veterans operate 2% of home-based firms, the same percentage as non-home-based firms. . Owners of HBBs work on average 26 to 35 hours per week in their firms; by contrast, owners of non-HBBs work 35 to 43 hours per week, on average. . Regardless of business location, 60% of very small firms sell primarily to individuals. Roughly 10% of customers are local, state, and federal government agencies. Slightly more African-American-owned firms sell to the government than the other demographic groups surveyed. Firms owned by nonminority males showed the highest business-to-business sales, at 43%. . Among the ethnic and racial groups broken out in the study, AfricanAmericans had the highest proportion of female business owners; relatively few Hispanic women own businesses.
Future Prospects and Activities Over half of all HBBs survive 5 years; firms that close do so primarily from lack of cash or access to a business loan. Between 1992 and 1996, about 85% of firms with paid employees survived, compared with 51% of those who had no paid employees. Laws drafted to restrict commerce in the home are outdated in this electronic era and need updating. In addition, restrictive tax rules that prohibit the deduction of legitimate expenses have a negative impact on home-based activity. Specifically: . The use of technology allows HBBs to work in teams without the need for daily face-to-face interaction. This allows a firm to expand beyond the physical confines of a residence as sales increase. . Home-based firms need help in removing business barriers to grow and succeed. Two areas in which they need assistance to enter the electronic world are:
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Introduction—In the Beginning
. obtaining and paying for the credit card merchant status they need for electronic sales. . helping to develop an Internet strategy. As Internet commerce becomes more sophisticated, HBBs may need capital to develop and maintain profitable web sites.
ASSESSING THE RISKS How Many Businesses Open and Close Each Year? In 2001, of the businesses with employees, about 574,500 (approximately 10%) were new and about 585,800 (approximately 10.2%) closed (Advocacy estimates). Not all business closings are failures: 57.4% of business owners with employees and 38.2% of those without employees reported they were successful at closure. In 2001 the number of bankruptcies totaled 39,719, up from the previous year, but below the levels of the early 1990s.
700,000
10.00%
600,000
0.00%
500,000
−10.00%
400,000
−20.00%
300,000 −30.00%
200,000
−40.00%
100,000
−50.00%
0 New Employer Firms Employer Firm Closures
1991
2001 (est.)
Bankruptcies
% Annual Change
Figure 1.2 From Advocacy estimates; U.S. Census Bureau; U.S. Department of Labor, Employment and Training Administration; Administrative Office of the U.S. Courts.
What is the Survival Rate for New Firms? Two thirds survive at least 2 years. According to an Advocacy study of businesses over the 1989–1992 period, about 66% of businesses with employees remain open at least 2 years after start-up, 49.6% are open at least 4 years, and 39.5% are open after 6 years.
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Introduction—In the Beginning
Survival Rate of Businesses with Employees (%) 70 60 50 40 30 20 10 0 After 2 years
After 4 years
After 6 years
Figure 1.3 Survival rate of businesses with employees, founded in 1989–1992.
Which Industries Do Small Businesses Enter? SBA’s Office of Advocacy tracks small companies by industry, based on data provided by the U.S. Census Bureau, Statistics of U.S. Business. In 1997 the number of businesses by industry and percentage of total businesses with 500 or fewer employees were distributed as follows: Industry
Number of businesses
Percentage of total
Services Retail trade Construction Finance, insurance, and real estate Wholesale trade Manufacturing Transportation, communications, and public utilities Agricultural services Mining
2,215,000 1,094,000 662,000 457,000 410,000 329,000 217,000
40.13% 19.82% 11.99% 8.28% 7.43% 5.96% 3.93%
115,000 20,000
2.08% 0.36%
Totals
5,519,000
100.00%
TOP FIVE SERVICE INDUSTRIES For small companies, the largest single category (at about 40% of all small businesses) is services, which are characterized by few employees and little initial investment. Even with some 2.2 million businesses, however, this category does not include everything we typically think of as the service sector of the economy. Transportation, communication, and public utilities
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Introduction—In the Beginning
Number of Businesses, by Industry SBA's Office of Advocacy, based on data provided by the U.S. Census Bureau, Statistics of U.S. Business.
Retail trade Construction Finance, insurance, and real estate Wholesale trade Manufacturing Transportation, communications, and public utilities Services
Figure 1.4 Number of businesses, by industry. From SBA’s Office of Advocacy, based on data provided by the U.S. Census Bureau, Statistics of U.S. Business.
have their own categories, for instance, as do wholesale trade, retail trade, finance, insurance, and real estate. Here are the top five and remainder (other) from the dozen or so subcategories within services:
Subcategory of services
Number of businesses
Percentage of total
Health services (Doctors’ offices, nursing facilities, etc.)
423,000
19.10%
Business services (Advertising, programming, personnel, etc.)
345,000
15.58%
Engineering, accounting, research, management, and related services
275,000
12.42%
Membership organizations (Associations, unions, etc.)
244,000
11.02%
Personal services (Cleaning establishments, hair salons, etc.) Other services
177,000
7.99%
751,000
33.91%
2,215,000
100.00%
Totals
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Introduction—In the Beginning
Subcategory of Services
Health services (Doctors' offices, nursing facilities, etc.) Business services Engineering, accounting, research, management, and related services Membership organizations (Associations, unions, etc.) Personal services (Cleaning establishments, hair salons, etc.) Other services
Figure 1.5 Subcategories of services.
Each of those subcategories, in turn, includes many subcategories of its own. Here are the five categories with the largest number of small companies in the business services subcategory: Number of businesses
Percentage of total
Building cleaning and maintenance services Computer programming services Computer services (other than programming) Commercial art and graphic design Help-supply services (staffing and personnel) Other business services
54,000 30,000 29,000 15,000 14,000 203,000
15.65% 8.70% 8.41% 4.35% 4.06% 58.84%
Total
345,000
100.00%
Business Services Subcategory
Note that this classification is so diverse that the fifth largest business services subcategory barely exceeds 4% of the total number of businesses in the ‘‘sub-subcategory.’’
ORGANIZATIONAL FORM One of the first decisions an entrepreneur must make is what organizational form the business will take. Before making this decision the entrepreneur needs to look down the road and think about what the need for capital will be and what ultimate outcome the entrepreneur would like for the business. Your choice of an organizational form will affect every
Introduction—In the Beginning
13
aspect of your business, including taxes, access to capital, growth opportunities, legal liability, and transfer of ownership. Is it your goal to stay private? Do you want to control and run your business until you retire? Do you anticipate raising capital externally? What is your strategy for creating value? Is capturing market share crucial to your strategy? All of these questions have implications for the way the business is organized. It pays to organize the business initially in a way that will facilitate your goals later on.
SOLE PROPRIETORSHIP The sole proprietorship is the simplest and least expensive business entity to form. If you have a business and have neglected to deal with the issue of organizational form, your business is organized as a sole proprietorship by default. Sole proprietorships have one owner, and the owner and the business are the same legal and accounting entity. There is no requirement to keep company books, and the profits and losses of the business are taxed at the personal level. While this single taxation is usually cited as a benefit of the proprietor form of organization, it can be a disadvantage at high levels of profit or if most of the earnings are retained in the business. This last fact is significant. Virtually all new businesses with growth aspirations are forced to retain all the money they can in the business to finance growth. The tale of the entrepreneur who operated for 2 years without a salary to get the business going is not at all uncommon. If the business is organized as a sole proprietorship (or partnership), all of the income is taxed at the owner’s personal rate, even if he or she never takes a dime from the business. Talk about the worst of all worlds! Currently (2003), the top personal tax rate for a married couple filing jointly is 38.6% paid on income over $307,050. That same level of income in a corporation would be taxed at a 34% rate. Currently, the top marginal corporate tax rate is 35%. A look at the sample tax tables in Tables 1.1 and 1.2 illustrates that a business does not have to be very large before incorporation may make sense from a tax standpoint alone. The owner of a sole proprietorship has absolute authority and unlimited liability for his or her actions, the actions of employees, and any debt incurred by the company. All of the owner’s personal assets are at risk in the sole proprietorship. They are at risk to satisfy unpaid debts, and they are at risk in the event of a lawsuit against the business. Access to capital is limited by the owner’s ability to self-fund or borrow, thus potentially limiting future growth opportunities. By definition it is not possible to accept external investment and retain the sole proprietorship form of organization. Investment equals ownership, and the proprietorship is restricted to one owner.
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Introduction—In the Beginning
Table 1.1 Federal Tax Schedule: Married Filing Jointly If the amount on Form 1040, line 41 is over $0 12,000 46,700 112,850 171,950 307,050
But not over $12,000 46,700 112,850 171,950 307,050 —
Enter on Form 1040 line 42 10% $1,200.00 þ 15% 6,405.00 þ 27% 24,265.50 þ 35% 41,995.50 þ 35% 89,280.50 þ 38.6%
Of the amount over $0 12,000 46,700 112,850 171,950 307,050
Table 1.2 Corporate Tax Schedule If taxable income is: Over $0 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333
But not over 50,000 75,000 100,000 335,000 10,000,000 15,000,000 18,333,333 —
Tax is: $7,500 þ 13,750 þ 22,250 þ 113,900 þ 3,400,000 þ 5,150,000 þ
Of the amount over 15% 25% 34% 39% 34% 35% 38% 35%
0 $50,000 75,000 100,000 335,000 10,000,000 15,000,000 0
Unlimited liability is perhaps the biggest drawback of the sole proprietorship, but limited life of the business is another disadvantage of this organizational form. Since the business and the owner are one and the same, the business ceases to exist when the owner retires or passes away. The lack of a requirement for separate financial statements in a proprietorship results in maximizing informational asymmetries between the owner and anyone doing business with the firm. There is often a tendency in sole proprietorships to mix business and personal expenses as well as assets (the car, the golf membership). This makes it difficult to assess the true profitability and value of the business, which may limit opportunities, both strategic and financial, for the entrepreneur. The sole proprietorship form of organization is simple and inexpensive to implement. It is sufficient for only the smallest companies, with little risk
Introduction—In the Beginning
15
exposure and relatively slow growth aspirations. For the entrepreneurial ventures that are the subject of this book it should generally be avoided.
GENERAL PARTNERSHIP The general partnership is similar to a sole proprietorship with the obvious exception that it has two or more owners. Like the proprietorship, a general partnership is fairly simple and inexpensive to form. Unlike the proprietorship, the general partnership is a separate legal entity, although not in a tax or liability sense. Partnerships must file informational tax returns with the IRS, but profits or losses flow through to the partners and are taxed at the individual partner level. In any general partnership each of the partners is ‘‘jointly and severably liable’’ for the actions of all the partners. This means that each partner is responsible and liable for every other partner’s actions, including any liabilities they incur, as well as the other partners’ share of company liabilities should those partners be unable to pay. Partnerships can be based on an oral agreement between the partners, but it is a much better idea to draw up a formal partnership agreement specifying the rights and responsibilities of the individuals involved. The partnership agreement should specify who runs the business and what the role of the other partners will be. It is critical that a method for determining the value of partnership shares be specified and included in the agreement. Since partnership shares are not publicly traded, there will be no market to determine their value. It is extremely important to agree upon a formula for establishing that value prior to needing the information. If you wait until a partner is leaving the partnership and wants to sell his or her shares back to the partnership, it is inevitable that the exiting partner will establish a considerably higher value for his or her shares than that established by the remaining partners! The rules for transfer of ownership should be included in the agreement, as should specification of the division of profits and losses, compensation, and distribution of assets in the event of dissolution. Typically, new partners can be admitted to the partnership only after a vote of the existing partners. If the partners cannot agree, the partnership will be disbanded and a new entity will have to be formed. The partnership has most of the same disadvantages as the sole proprietorship and then some. Liability is unlimited and compounded by the fact that each partner is liable for 100% of every liability, not just his or her share of the debts. Personal assets of the partners are at risk just as in a proprietorship. It is often possible in a partnership for one or more partners to block initiatives if their risk propensity is less than that of the other
16
Introduction—In the Beginning
partners. While transfer of shares in a partnership is possible, it is subject to the disagreements over valuation mentioned previously, as well as disagreements over the acceptability of new members. Capital raised is limited to the individual resources and borrowing power of the partners. The personal assets of the partners, at the bank’s request, will usually collateralize any bank loans taken on by the business. Again, each partner’s personal assets are at risk for 100% of the liability, not just that partner’s share. Partnerships are relatively easy to form and are not subject to the same reporting requirements as a corporation, which makes them a less expensive form of organization to run than a corporation. In general, the same advice applies to a partnership as that applied to a sole proprietorship. If the business has minimal risk exposure and no significant need for capital for growth, the partnership form may be all that is needed.
LIMITED PARTNERSHIPS Limited partnerships are used in special cases, primarily as fund-raising vehicles. Most common in real estate investment trusts, limited partnerships are the preferred organizational form of venture capital firms. A limited partnership is characterized by a general partner who provides management and bears full legal liability for the actions of the partnership. Limited partners provide capital, are prohibited from being involved in the day-today business of the firm, and have limited liability exposure. All partners are taxed at the personal level on any income earned, the same as for a general partnership. Limited partnerships must be formally created and licensed under state law. This form is more complicated and costly to form than a general partnership, but the limited partners increase the firm’s access to capital and therefore growth is not limited as it may be in a general partnership. It is common in venture capital to establish a new limited partnership for each round of funding that the firm undertakes.
S-CORPORATION A corporation is a legal entity, separate from its owners. Articles of incorporation must be filed with the state, and rules for record-keeping are established. A corporation is considered a more secure organizational form for prospective lenders and investors since its methods of operation are well defined by the tax code. Incorporation is perceived as limiting the owner’s liability, which it does in the case of lawsuits, but personal
Introduction—In the Beginning
17
guarantees are generally still required whenever financing is sought for a new business. An S-Corporation has the limited liability of the corporate form but is a pass-through entity for tax purposes—profits and losses are taxed at the personal rates of the owners. Due to this ability to pass losses to the owners of the corporation, the S-Corporation is frequently preferable as a start-up form, since the losses expected in the early stages of the business may be applied to the owner’s personal tax return. For many small businesses, the S-Corporation combines the tax advantages of a sole proprietorship or partnership with the limited liability and enduring life of a corporate structure. The S-Corporation is limited in its fund raising ability, however. Strict rules define who may be the shareholders in an S-Corporation. For example, the total number of shareholders in an S-Corporation may not exceed 75; shareholders must be individuals and U.S. citizens. Shares are transferable, without a vote of the other shareholders, but only one class of stock is allowed. These restrictions have profound implications on the firm’s ability to raise money. If you anticipate seeking venture capital at some point, it pays to know that venture capitalists generally buy preferred stock, leaving the owners with the common stock of the company. Since only one class of stock is allowed under the S-Corporation, you will not be able to secure venture capital using the S form. While it is relatively easy to convert an S-Corporation to a C-Corporation, it is one more hassle to overcome when raising capital and should be dealt with prior to attempting to raise capital from other sources than individuals. If the entrepreneur violates any of the restrictions regarding shareholders while raising money, the corporation automatically becomes a C-Corporation. The C-Corporation will be discussed later, but a major difference between the two forms is the treatment of gains and losses. All profits and losses are taxed at the corporate level in a C-Corporation and do not flow through to the investors. One of the authors is familiar with a start-up that organized as an S-Corporation, correctly forecasting a period of losses that would be passed through to the owners’ personal tax returns to offset other income. In the process of raising capital for the new venture, the owners accepted money from professional investors organized as a trust. At tax time they were dismayed to learn that the losses they had correctly forecast were not available to them at the personal level because the corporation had automatically ‘‘flipped’’ to a C-Corporation when they accepted capital from sources not considered individuals! It pays to do your homework and always have competent tax and legal advice.
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Introduction—In the Beginning
LLC—LIMITED LIABILITY COMPANY In response to the limitations on eligible investors in the S-Corporation, the LLC, or Limited Liability Company, is increasingly replacing the S-Corporation as the preferred form for early-stage ventures. The LLC is not a corporation in the strictest sense, but it offers many of the same advantages as the S-Corporation. The major advantage is that LLCs do not have the ownership restrictions of S-Corporations, making them ideal business structures for foreign investors and institutional investors. In an LLC, control does not necessarily equal ownership. Unlike the corporate form where one share equals one vote and someone controlling 51% of the common shares can control the company, the LLC structure is more flexible. Control is not tied to ownership and may be defined however the principals want it to be defined. Special allocations of income or loss that do not correspond to ownership interest can be assigned. Like the corporation, articles of organization must be filed with the state. An LLC is a pass-through entity for tax purposes like an S-Corporation, and it has the limited liability feature of the corporate form. Since the LLC has the positive features of the S-Corporation, without the investor restrictions, it is destined to replace the S-Corporation as the preferred organizational form for early-stage companies. It is relatively easy to convert either an S-Corporation or an LLC to a C-Corporation if changing circumstances make the conversion desirable.
C-CORPORATION The traditional form, and most common corporate structure, is called the C-Corporation. This is a legal entity that is owned by an unlimited number of stockholders who are personally shielded from debts or obligations related to the business. The shareholders elect a Board of Directors to oversee the company, and actual management is delegated to the hired management team. The C-Corporation is the most costly form to create and maintain, but if high growth dictates a need for external capital or high levels of earnings retention, it may be the only appropriate form. Incorporation is governed by state law.7 In the corporate form of organization a Board of Directors must be formed, although in most states that board need only have one member. Minutes must be kept documenting all decisions made by the Board. Articles of Incorporation must be filed with the state and appropriate fees paid. Regular shareholder meetings must be 7
A good beginning point for researching state incorporation rules is the site http://www. incorporatein.com that has links to incorporation information for every state.
Introduction—In the Beginning
19
held, and the shareholders must approve all major decisions. Records must be maintained of all shareholder votes. Besides the cost of incorporation and the ongoing costs of reporting requirements, the major disadvantage of the C-Corporation is the double taxation of dividends. Profits and losses are taxed at the corporate level. If distributions are made to shareholders, these distributions are again taxed at the personal level. The major advantages of the C-Corporation are limited liability, ease of ownership transfer (which insures unlimited life of the business), liquidity for investors, and potentially unlimited access to capital. If shares are publicly traded, there is the additional advantage of a market-determined valuation for the business. A variation of the C-Corporation is the closely-held corporation. A closely-held corporation has a small number of shareholders, ranging from 30 to 50, no ready market for the corporation’s stock, and active participation by the majority of shareholders in the management of the corporation. It is common to see new businesses organized as closely-held corporations to gain the advantages of incorporation and to reward founding employees with ownership in the company. Other organizational structures include trusts, which are often formed for a specific time frame or purpose, and combinations of legal entities such as ‘‘Co-Ops’’ and joint ventures. Enlist the legal and tax advice of the professionals as to which form suits your venture best. An important consideration in choosing an organizational form is whether or not you will want to use stock options as compensation. Many start-ups use stock options to motivate employees, to allow them to share in the fruits of their labor, and to conserve scarce cash. For options to be worthwhile, however, the firm will have to establish a market for the stock by making the staff saleable at some point. The use of options as compensation heads you down the road to either a public offering of your stock or to the sale of your company. This is obviously a path the entrepreneur should think long and hard about before embarking down that road.
OWNERSHIP STRUCTURE AND CAPITALIZATION Once the legal structure is decided upon, issues of distribution of ownership and distribution of risks and benefits may be addressed. The primary decision to be made is whether the entrepreneur will finance the venture or whether there is a need for other stakeholders, and whether these stakeholders will be investors, lenders, or some combination thereof.
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Introduction—In the Beginning
The advantage of selling shares of ownership to raise capital is that the investor is sharing the risks of the venture. The investor also shares the rewards, however, and the entrepreneur must be careful not to sell the equity too cheaply. Careful records must be kept of all share sales and allocations. It is not uncommon in the early stage of a company’s life to exchange shares for services such as consulting or accounting. Unfortunately, it is all too common that proper records of these share allocations are not kept. Before a firm can raise formal external capital, a clear and current listing of all shares outstanding (the capitalization table) must be provided. It pays to keep careful track of all share transactions from the moment of incorporation. Table 1.3 provides a summary of the various forms of organizations and their distinguishing characteristics. Table 1.3
Various Forms of Organizations
Tax status
Liability
Access to capital
Separate legal entity
Expensive to form
Sole Proprietorship General Partnership Limited Partnership
Pass through
Unlimited
Limited
No
No
Pass through
Unlimited
Limited
Yes
No
Pass through
Unlimited
Yes
Yes
S Corporation LLC C Corporation
Pass through Pass through Corporate level
General partners— unlimited; Limited partners— limited Limited Limited Limited
Limited Unlimited Unlimited
Yes Yes Yes
No No Yes
CREATIVE SOURCES OF CAPITAL—BOOTSTRAPPING As mentioned previously, one primary inhibitor of business success is a lack of start-up capital. Few people have the financial cushion to give up a job for the uncertain income of a start-up venture. The problem of financing is most pressing for new company start-ups and those firms that are experiencing rapid growth.
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Introduction—In the Beginning
Lack of financing does not necessarily doom a business to failure. Each year Inc. magazine identifies the 500 fastest growing companies in America, the Inc. 500. Growth is calculated as the 5-year average growth in revenues. Table 1.4 shows the breakdown by start-up capital invested for the Inc. 500. For the 2002 sample, firms started with less than $1,000 (yes, there were several) were just as likely to be profitable as firms started with more than $100,000.8 Firms started with more than $100,000 reached higher levels of dollar sales and hired more people, but they were less likely to be profitable than firms started with between $1,000 and $10,000. Table 1.4 Seed Cash Stash Inc 500 CEOs surveyed who launched their company with seed capital (%) 14 27 10 15 12 22
Amount of capital (including personal assets) Less than $1,000 $1,000 to $10,000 $10,001 to $20,000 $20,001 to $50,000 $50,001 to $100,000 More than $100,000
From Inc. Magazine.
The rule of thumb for most start-ups is to have enough cash on hand to get the business through the first 18 to 24 months of its life. We have all seen the restaurant that opened and closed 6 months later—great empirical evidence of insufficient start-up capital. Unless you, the CEO, are well known, with a track record of starting and running successful businesses, no formal sources of capital are likely to invest in you in the early stages of your business. Banks usually require an operating history to reduce their risk, and venture capitalists, with their high market share and growth aspirations, are simply inappropriate for the vast majority of firms. Even after start-up, entrepreneurial ventures are constantly in the market for new capital. Experienced entrepreneurs realize that growth requires capital and that the financing of growth is best done in stages. The best financing choices require that the entrepreneur remain flexible, raise as 8
Source: Greco, Susan, ‘‘A Little Goes a Long Way,’’ Inc. Magazine, October 15, 2002, reprint available at http://www.inc.com/magazine/20021015
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Introduction—In the Beginning
little as possible in each financing, and stay abreast of the latest trends in funding. Adequate capital is needed to start up a business, and to provide cash to cover the costs of doing business. These costs can include equipment, inventory, accounts receivable, and sufficient working capital to allow for operating losses on the way to becoming a profitable enterprise. Sufficient capitalization can also provide for early expansion opportunities and for acquiring cost-saving equipment. Financing comes from two basic sources: debt and ownership equity. Debt is money that is borrowed and that must be repaid on some predetermined schedule, with interest. Normally a lender does not receive any ownership interest in the business. Borrowing money at the very start of a new business will create an additional and regular cash requirement to make the debt payments and may put an unsustainable drain on the company’s cash flow. Common equity represents the exchange of funding for partial ownership of the company. Such funds represent money invested in the firm without any requirement of repayment date or terms. Even though equity capital does not burden a new business with loan repayments and interest charges, it may reduce the venture team’s control and will reduce their share of proceeds from the business. Before seeking external sources of capital from investors or lenders, an operating business should thoroughly explore all reasonable sources for meeting its capital needs internally. For example, a business can generate capital internally by accelerating the collection of receivables, disposing of surplus inventories, increasing the amount of earnings kept in the business, or cutting costs. With a lower cash requirement, the business’s ability to secure external financing will be improved. Furthermore, the ability to generate maximum capital internally and to control operations will enhance the confidence of outside investors and lenders. With more confidence in the business and its management, lenders and investors will be more willing to commit their capital. Successful entrepreneurs become expert at ‘‘bootstrapping,’’ the art of doing more with less. Even if this effort fails to generate all of the needed capital, it can sharply reduce the external financing requirement, resulting in less interest expense, lower repayment obligations, and less sacrifice of control. In hindsight, one of the worst things that happened to many dotcoms during the bubble years of the mid-to-late 1990s was receiving too much money too soon. As counter intuitive as that sounds, too much money does not force fiscal discipline on the firm. Many millions of dollars of venture capital went to finance extravagant office space, high salaries, and
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other perks for budding entrepreneurs. A shortage of capital can be a good thing if it forces the business to be efficient and creative.
INITIAL SOURCES OF CAPITAL You The first person to turn to for capital is yourself. Before approaching others, the entrepreneur should exhaust his or her personal sources of capital. Personal sources include savings, a second mortgage, borrowing against stocks or retirement funds, personal lines of credit, and personal credit cards. If possible, get the second mortgage and the line of credit in place before you leave your full-time job. In interviews with 100 firms listed in the 1989 Inc. 500 list of fastest growing companies, Bhide´ discovered that more than 80% of those interviewed started their companies with personal savings, credit cards, and second mortgages.9 For the 2002 list that number was even higher. Of CEOs surveyed, 87% used personal assets to start their business.10 A large part of bootstrapping an organization is doing more with less. If possible, run the business out of your home initially. Amazon.com, Microsoft, Martha Stewart Enterprises, and Hewlett Packard are just a few success stories that were started out of the entrepreneur’s home. A service business requires very little capital to get started and is therefore preferable to a more capital-intensive business for a cash-strapped entrepreneur. Perhaps you can provide a service to generate cash flow and then expand into product sales or other types of production later on. Successful entrepreneurs wear many hats to conserve capital. In the beginning the entrepreneur is likely to be the chief strategist, chief salesperson, CEO, and maintenance person. The VP of Marketing and the CFO should be hired down the road, not at inception of the business. Whenever possible, outsource work rather than hiring people in-house to do the job. The key is to conserve cash by doing more with less. Remember the key is control of resources, not ownership of resources.
Friends and Family Most entrepreneurs turn to friends and family after exhausting their personal sources of funds. Two words of warning are in order regarding friends and family capital. One, treat it professionally. If you must accept 9 Bhide´, Amar, ‘‘Bootstrap Finance: The Art of Start-Ups,’’ The Harvard Business Review, November-December 1992, p. 110. 10 Mochari, Ilan, ‘‘The Numbers Game,’’ Inc. Magazine, October 15, 2002.
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funds from family and friends, do it on a business basis by putting the agreement in writing. Check with a lawyer if you want a binding, legal agreement. You may also get a sample business loan contract form from a bank or lending institution to use as a basis for a written agreement that both parties find acceptable. Be sure to provide relatives and friends with the hard facts about your business venture, emphasizing the risk involved. Make sure to spell out the terms and conditions of the investment— repayment time frame for a loan or number of shares granted for an equity investment. Two, think worst-case scenario. How would you (or your friends and family) feel if the business failed and their investment was lost? If your friends and family cannot afford to lose their investment, they should probably not be investing in the first place. Likewise, if you do not want to jeopardize a friendship or relationship it may be best to look elsewhere for money. Be sure to check with a lawyer before you accept money from anyone in your new venture. There may be limits as to number and type of investors, which will come back to haunt you in later rounds if you have not paid attention to rules and regulations in the earliest stages of financing. Despite the dangers, family and friends’ money is the most common form of financing for start-ups, after personal resources, and the most accessible for small enterprises. Family and friends’ investments provide more than 10 times the total amount of traditional venture capital monies. This is also the most common financing method for early-stage companies that need to boost performance or enhance balance sheets prior to obtaining more formal secondary money. One possible investment mechanism that offers better-than-usual protection for friends and family is a sale and leaseback arrangement. You sell an asset you own (your building, car, etc.) to the friend and he or she leases it back to you at a mutually beneficial rate. This leaves the friend with the asset as collateral while providing you with the use of the asset and minimal cash outflow.
Customers and Suppliers Look up and down your supply chain for potential investors. If you can convince customers or suppliers that their sales will be increased or their costs decreased by using your product or service, it becomes in their best interest to help you survive. This is especially likely in situations where your customer or supplier is a business that is large relative to yours. Perhaps the partner can make a direct investment or make a loan to cover all or part of
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your cash needs. See Exhibit I for an example of an entrepreneur that used just such a relationship with somewhat mixed results.
Exhibit I BORROWING FROM CUSTOMERS*
When Van Strom, president of American Design & Manufacturing, a $2-million advertising-specialty manufacturer in Seattle, needed to buy a $100,000 embroidery machine, he financed it through an unconventional source: one of his company’s biggest customers. ‘‘We would both benefit,’’ he says. ‘‘Increasing our production capacity would increase our ability to service that company’s needs.’’ The customer advanced $30,000 as a down payment for the new machine, with Strom’s company paying the rest of the cost in monthly installments. American Design then paid off the $30,000 credit, along with the monthly interest charges, by fulfilling production orders for ‘‘free.’’ Strom agreed that if the company ever became unable to fulfill the orders, he would pay the customer with cash instead of credit. ‘‘The deal was so simple, so clean, so fast,’’ Strom says. The one glitch, though, was the drain on cash flow. ‘‘We failed to anticipate how much demand that company would have for our product. Its orders came in so quickly—without cash payments attached, of course—that we had to stretch our other payables to meet payroll,’’ says Strom. If he borrows from a customer again, Strom plans to specify 6 months as a minimum payback period. That will leave his company enough time to take on cashproducing business, too. If direct investment is out of the question, negotiate with your supplier for longer credit terms. Perhaps you can extend the payables period from 30 days or less to 60 or 90 days until your cash flow improves. Suggest paying your supplier’s direct costs in 30 days and their overhead and profit when your sales revenue is realized. * Copyright 2003, Gruner þ Jahr USA Publishing, Boston.
Table 1.5 contains a breakdown of initial and secondary funding sources used by the 2002 Inc. 500.
Leasing The key to success in starting a business is control of assets. It is not necessary for you to own your assets merely to have access to them. Lease everything that you can—office space, equipment, and vehicles. This
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Table 1.5 Inc. 500 Sources of Funds Start-up Sources
%
Personal assets Co founders/partners Family and friends Strategic partners/customers
87 28 19 7
Funding sources after the initial round
%
Banks Venture capitalists/private equity investors Friends and family
62 49 23
From Inc. Magazine Oct. 15, 2002.
conserves scarce capital while giving you all-important access to, and control of, productive capacity.
Barter Many communities have trade exchanges that allow members to trade goods and services among themselves. Typically a firm joins a trade exchange and earns credit by ‘‘selling’’ its product or service to other members of the exchange. Credits are banked and used to purchase goods and services from other member companies. Barter exchanges are great ways to get advertising, accounting, printing, and other services while conserving cash for other uses. Simply typing in ‘‘barter’’ on your Internet search engine will reveal a host of opportunities and organizations involved in this rapidly growing field.
SMALL FIRMS TYPICAL USE OF FINANCIAL SERVICES A Federal Reserve Board survey of small business finances showed that about 82.5% of small firms used some form of credit in 1998 (Table 1.6). Small firms use many different sources of capital, including their own savings, loans from family and friends, and business loans from financial institutions. About 55% used loans from depository institutions, 45% had personal credit cards, and 33% had business credit cards. Access to credit is vital for small business survival. In October of 2002, the Office of Advocacy of the U.S. SBA published Small Business Lending in the United States, 2001 Edition. More recent editions may be found at the Office of Advocacy web site, http://www.sba.gov/advo/stats/lending.
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Table 1.6 Small Firms Using Financial Services, 1998* Owner Ethnicity Credit type Credit lines, loans, capital leases Business credit cards Personal credit cards
Small
Total Women
Asian{
Black
Hispanic
55.1
46.1
46.4
48.2
52.7
33.3 45.1
28.2 46.7
26.9 52.8
28.8 44.1
29.0 41.8
* Percent reporting use of various types of credit. { Includes Pacific Islander. From Federal Reserve Board, National Survey of Small Business Finances, 1998.
Findings include the following: . According to the 1998 Survey of Small Business Finances (SSBF), a key supplier of credit to small firms is the commercial banking system. Some 67% of all small firms that borrowed from traditional sources obtain their money from commercial banks. . Of a total of $609 billion in small business credit outstanding from traditional sources in 1997, commercial banks supplied 64%, compared with 12.3% for finance companies, the next most prominent lender. . The dollar value of small business lending continued to increase in 2001, although more slowly than in the recent past. Small business lending (loans under $1 million) totaled $460 billion in June 2001, an increase of 5.4% over 2000. . The dollar value of loans under $100,000 increased by 4.4%; those of $100,000–$250,000 increased 4.1%; and those between $250,000 and $1 million increased 6.4%. . The number of smaller business loans—those under $100,000— continued to grow at a rapid rate—by 10.1%, compared with increases of 5.9% and 7.0% in larger small business loans. Much of the increase in the number of these ‘‘micro-business loans’’ is thought to be the result of the promotion of business credit cards by major banks and finance companies. . For the first time in years, business lending in smaller loans increased more than lending to large firms. Loans over $1 million increased only 0.9% from 2000 to 2001.
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BOOTSTRAP STRATEGIES Once you have begun your business and accumulated your initial capital, there are strategies that can be implemented to use that capital to its fullest potential.
Generate Sales Quickly By attacking a small market niche with a non-capital-intensive business, the entrepreneur is more likely to become operational quickly. A key for all businesses is flexibility. If it looks like your primary product is going to involve a lengthy sales process, listen closely to your customers and see what it is they would buy sooner. Perhaps they are not eager to buy your revolutionary software and retrain all their employees. Maybe what they need immediately is for you to provide the service your software provides. Be flexible and willing to adapt to opportunities you discover in the marketplace.
Generate Cash Flow Quickly Cash flow is crucial. While this is true for all businesses, it is especially critical for start-ups. Profits do not matter—cash flow does. It is cash that will pay your bills and fund growth, not profits. Choose projects or products that will generate cash quickly and steer away from capital-intensive businesses that gobble up cash.
Sell High-Valued Products and Services As mentioned previously, the entrepreneur is likely to be the chief salesman in the new venture. Since the entrepreneur’s time is extremely valuable, it does not pay to have the entrepreneur peddling low-cost items to multiple customers. Higher-valued products are necessary to cover the cost of the entrepreneur’s time and the personalized selling that is necessary in new ventures.
Create the Best Team You Can Afford In the early stages of a venture’s life the business will be unable to support many highly-compensated people. You do not need a CFO, a VP of Marketing, and a Chief Strategist to launch the business. Look for enthusiastic people who are eager to help you in creating something. Choose people with an entrepreneurial spirit who will add value to the enterprise and add to the management team as the business model is proven and cash becomes available.
Control Your Growth Perhaps the best strategy to conserve cash is to grow more slowly. Rapid growth consumes capital at an alarming rate as inventories and people are put in place to support expansion in advance of sales and collections.
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A strategy of more moderate growth may allow the business to be selffinanced but will certainly result in less need for outside financing.
Manage Your Accounts Receivable If possible, get customers to pay in advance or provide a deposit to improve your cash flow. At a minimum, be diligent about collecting accounts receivable and enforcing your credit terms. The Dell model of cash flow management should be aspired to where appropriate. Dell carries very little inventory of parts used to make its computers. Customers ordering a computer pay in advance for their purchase. Dell buys the parts for the computer on credit and extends their payment period as long as possible. Dell’s customers are in effect financing the business, not just the production of their computer.
EXPERTS EXPLAIN HOW SMALL BUSINESSES FAIL Confucius said it best: ‘‘Study the past if you would divine the future.’’
GLOCAL ADVANTAGE COMPANY PERSPECTIVE11 Glocal Advantage, Inc. consults with businesses, not-for-profits, and municipalities on gathering information, performing insightful analyses, and facilitating interaction to accomplish its clients’ goals and purposes. GVI Co-Founders Donna C. L. Prestwood and Paul A. Schumann Jr. have over 60 years of business and organizational experience and have co-authored Innovate!: Straight Path to Quality, Customer Delight and Competitive Advantage, published by McGraw-Hill in 1994. Following are their remarks: ‘‘Most start-ups suffer from undercapitalization.12 Many experts estimate that it takes two to three times the amount of capital estimated by entrepreneurs to reach profitability. Entrepreneurs, and their financial backers as well, try to run the start-up business on a shoestring. In doing this, they run the risk of running short of cash and then having to raise more capital. Raising capital the second or third time for a company that hasn’t met its projections is more difficult than raising the full amount needed at the beginning, as difficult as that is. Another important cause of business failure is poor management. Entrepreneurs are often specialists in one functional but important aspect of the start-up business. They often lack management, leadership, business, 11
Glocal Vantage, Inc. http://www.glocalvantage.com See http://www.glocalvantage.com/BusinessStartupFailureandSuccess/Failure1.html for the view that companies fail primarily because they run out of money. 12
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financial, marketing, or human resource skills and knowledge. Unfortunately the technical or functional expertise is seldom sufficient to sustain the business. Marketing misjudgments can also be fatal. Many such failures in marketing result from the failure to obtain objective knowledge of the market (customer needs, competitive responses, and technological capability). But objective knowledge of the market is not enough. Many start-ups fail because they do not believe and act on the knowledge they have obtained. It’s hard to believe that the dot-coms of 2000, who spent millions on Super Bowl ads, didn’t have the knowledge of the market that should have prevented them from such a foolish display.’’
U.S. SBA’s SMALL BUSINESS FAILURES: A FRAMEWORK FOR ANALYSIS Middle Tennessee State University’s Troy A. Festervand and Jack E. Forrest prepared a research paper for the SBA offering another view of business failure.13 The authors suggest that ‘‘finance-related issues appear to be the number-one cause of small business failure, with three specific subproblems frequently contributing to small business failure.’’ The authors report that 80% of all new businesses fail due to undercapitalization. The inability to secure adequate long-term financing and the high cost of that financing are both serious problems. Burr and Heckman (1979) add that small firms typically require more frequent refinancing and are more highly leveraged, thus exacerbating the problem. Another cause of failure is that small business firms often have excessive debt. As a result, debt management becomes a time-consuming, expensive, and sometimes fatal task. Cash flow problems are another roadblock to success. Since cash flow represents the lifeblood of the organization, prolonged inadequacy of sufficient cash flow can lower a firm’s performance and/or lead to its demise, according to Henz (1986). The inability to control costs contributes to small business failure. Managers often behave in a fiscally irresponsible manner by not exercising prudent control, or by ignoring fiscal reality. The optimal strategy to follow in this situation may be ‘‘simply to spend smarter.’’ This includes tightening up on routine expenditures and collection procedures while critically examining costs, purchase options, and accounting procedures, according to McLean (1987). 13
See http://www.sbaer.uca.edu/Research/1991/SBIDA/91sbi271.txt
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Managerial problems rank as the second leading cause of small business failure after financial problems. Opening a small business requires the desire to be in business and the possession or ability to possess a certain amount of practical skills. Unfortunately, many new owners seem to discount the value of business knowledge and/or experience. One solution to this problem is for the prospective owner to gain experience by working for someone else in a similar business. This allows the would-be enterpriser to learn about best practices and operations before setting up shop. Other alternatives include low- or no-cost counseling provided by SCORE, ACE, SBDC, SBI, and others; Olson (1985) suggests the development of managerial expertise via self-study or some type of programmed learning. Marketing-related problems also pose a serious threat to the small business. While not as conspicuous as financial problems, failure to address marketing issues will lead to business difficulties or failure. The product line offered should occupy a position of central importance. The failure to cultivate and offer an attractive product line for which there is a perceived need is a prime problem facing the small firm. Another product line difficulty is the failure to review product performance and mix periodically (1981). Failure to consider and/or plan a new firm’s competitive position may also result in major problems. Franklin and Franklin (1982) recommend the periodic conduct of a market analysis. This analysis should supply information pertaining to a firm’s target market that is useful in the evaluation of competition, product line, and customers (1988). In addition to primary research, simply listening to customers and observing marketplace activities may prove to be invaluable sources of information.
JOSEPH M. SHERLOCK, MANAGEMENT CONSULTANT PERSPECTIVE14 Joseph M. Sherlock founded VIP Business Services, Inc. (which includes Sherlock Strategies, a business consulting firm, and 1-2-3-Biz, a publishing firm). He writes the popular newspaper column, Doin’ Business, and has produced three widely-acclaimed books about business. Consultant Sherlock suggests we study the reasons for business failure in order to avoid it (Figure 1.6). He quantifies the occurrence of particular reasons for failure based on many years of following Dun & Bradstreet’s small business survey results, suggesting that a consensus of reasons for failure 14
See http://www.joesherlock.com/
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Introduction—In the Beginning
Reasons for Failure 10%
22%
4% Disaster Fraud
2% 1%
Neglect Experience Imbalance Incompetence
61%
Figure 1.6 Reasons for failure.
has resulted. D&B annually surveys a sample of owners whose companies have ceased operations with losses to creditors, often following assignment or bankruptcy. The reasons chosen and percent of occurrence according to Sherlock are: . Disaster (1%) Fire, flood, or acts of God. Adequate insurance protection can often prevent the resulting loss from being catastrophic. . Fraud (2%) Someone is stealing money from the company, usually a dishonest partner or bookkeeper; delegate, do not ‘‘abdicate.’’ . Neglect (4%) ‘‘I can run this thing from my home computer,’’ often giving the company over to employees who have been given no direction or training. . Lack of Line Experience (10%) An owner with insufficient experience in the particular business. . Unbalanced Experience (22%) For example, businesses owners who know the technical part of the business but little about cost control. . Managerial Incompetence (61%) Management is defined as the skillful use of resources to accomplish a purpose. Most small businesses have very limited resources of all types. It is therefore critical that these limited resources be skillfully used, since there is little room for error.
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Sherlock also addresses an issue that owners of many small businesses cite as a reason for the failure of their business—the effect of bad economic times. This may be more excuse than reason, however, as his statistics show that, even in the worst of times: . Business failures typically average four to five failures per 1,000 businesses in any normal year (~0.5%). . In the recession of 1981 to 1983, the failure rate increased to nine out of 1,000 businesses (0.9%). . During the Great Depression of the early 1930s, the annual failure rate was only 1.25%. This means that 98.75% did not fail on a yearly basis.
BUSINESS BANKRUPTCY PROJECT In 1998, Teresa A. Sullivan, Elizabeth Warren, and Jay Westbrook reported on the ‘‘Financial Difficulties of Small Businesses and the Reasons for Their Failure’’ for the Business Bankruptcy Project at the University of Texas at Austin. A major report of the findings of this project was published in the Summer 1999 edition of the American Bankruptcy Law Journal. The question asked of a sample of business owners (multiple responses cause total over 100%) was: ‘‘Why did you end up in bankruptcy court?’’ Responses were (% of respondents): Outside business conditions (competitors, cost increases, etc.): 39 Financing: 28 Inside business conditions (loss of customers, mismanagement, etc.): 27 Tax problems: 20 Dispute with a particular creditor: 19 Personal reasons (illness, divorce): 17 Calamities (fire, flood): 10 Other: 6
ORGANIZATION OF THE BOOK The rest of the book is laid out logically to follow the financing stages of a firm’s life. Chapter 2 is an in-depth look at debt financing. In addition to traditional bank loans, we will discuss asset-based lending, venture banks, and the Small Business Administration’s role in lending to business start-ups.
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Chapter 3 is an introductory look at sources of equity, with a focus on angel investors and the Small Business Administration. Chapter 4 provides a guide to preparing a business plan. A sample plan is provided in the Appendix, and several issues are discussed to aid the entrepreneur in preparing and writing a successful business plan. Special attention is paid in this chapter to the financial section of the business plan. Chapter 5 discusses various methods used in practice to establish valuations for firms. We demonstrate discounted cash flow methodology but also discuss other more simple methods widely used in practice, such as the market multiple approach to valuation. We discuss issues that arise in buying and selling a business and a method for valuing intellectual property. Chapter 6 discusses venture capital and the venture capital method of valuation. We discuss the structure of the venture capital industry, criteria for firms seeking venture capital, and what VCs are looking for in portfolio companies. Chapter 7 describes various exit strategies that can be used to provide liquidity for equity investors in the business. Chapter 8 extends a case used in earlier chapters through the detailed process of achieving exit goals. Chapter 9 looks at franchising as an entre´e to self-employment. Types of franchises, requirements of the franchise relationship, and methods for financing the initial investment are discussed. Several case studies are included to illustrate the range of franchising arrangements available. Chapter 10 is important for all entrepreneurs, whether or not they seek external capital. We discuss internal financial management, including management of the cash flow cycle and cash budgeting. Chapter 11 discusses risk management for entrepreneurs. Part of prudent financial management, the conservation of capital, is structuring the business so that it is protected from unnecessary risks. This chapter discusses the fundamental risk management strategies the entrepreneur should employ to reduce the probability of adverse financial consequences. Chapter 12 is a look at the global equity market and opportunities for entrepreneurs to raise capital internationally, as well as expand their business internationally.
SUMMARY We can be better prepared to succeed in small business by knowing what it is and where it is headed. One of the best sources of this information is the Office of Advocacy of the U.S. Small Business Administration (SBA); see http://www.sba.gov/advo/.
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For research purposes, the Office of Advocacy uses the small business definition of fewer than 500 employees and provides information for firms of various sizes. By their definition, small businesses represent more than 99% of all employers and represent nearly all of the self-employed, which are 7.0% of the work force. There are about 22.4 million total businesses and about 17,000 businesses that have 500 or more employees. The typical small business has three employees and annual revenue of $150,000–$200,000. It operates at 1.3 locations, and its owner works 50.4 hours per week. For small companies, the largest single category (at about 40% of all small businesses) is services, which is characterized by few employees and little initial investment. In 2001, of the businesses with employees, about 10% were new and about 10.2% closed (Advocacy estimates). According to an Advocacy study of businesses over the 1989–1992 period, about 66% of businesses with employees remain open at least 2 years after start-up, 49.6% are open at least 4 years, and 39.5% are open after 6 years. Not all business closings are failures: 57.4% of business owners with employees and 38.2% of those without employees reported they were successful at closure. One of the first decisions an entrepreneur must make is what organizational form the business will take. This decision will impact every aspect of the business, including taxes, access to capital, liability and transfer of ownership. The sole proprietorship form of organization is the simplest and least expensive business entity to form. The general partnership is similar to a sole proprietorship with two or more owners. Limited partnerships have a general partner (or partners) to provide management and bear full legal liability, while limited partners provide capital only. An S-Corporation has the limited liability of the corporate form but is a pass-through entity for tax purposes. The S-Corporation is frequently preferable as a start-up form, since the losses expected in the early stages of the business may be applied to the owner’s personal tax return. The S-Corporation is limited in its fund-raising ability, however. Strict rules define who may be the shareholders in an S-Corporation. In response to the limitations on the S-Corporation, the LLC, or Limited Liability Company, is increasingly replacing the S-Corporation as the preferred form for early-stage ventures. The LLC is not a corporation in the strictest sense, but it does not have the ownership restrictions of S-Corporations, making it an ideal business structure where the venture has foreign and institutional investors. The traditional form, and most common corporate structure, is called the C-Corporation. This is a legal entity that is owned by an unlimited number of
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Introduction—In the Beginning
stockholders who are personally shielded from debts or obligations related to the business. The C-Corporation is the most costly form to create and maintain, but if high growth dictates external capital or high levels of earning retention, it may be the only appropriate form. A variation of the C-Corporation is the Closely Held Corporation, which has a small number of shareholders, ranging from 30 to 50, no ready market for the corporation’s stock, and active participation by the majority of shareholders in the management of the corporation. A primary inhibitor of business success is lack of start-up capital. Financing comes from two basic sources: debt and ownership equity. Debt is money that is borrowed and that must be repaid on some predetermined schedule, with interest; normally a lender does not receive any ownership interest in the business. Borrowing money at the very start of a new business will create an additional and regular cash requirement to make the debt payments. Equity represents the exchange of funding for partial ownership of the company; such funds represent money invested in the firm without any requirement of date or form of repayment. Even though equity capital does not burden a new business with loan repayments and interest charges, it reduces the venture team’s control and their share of proceeds from the business. Most start-ups suffer from undercapitalization. Many experts estimate that it takes two to three times the amount of capital estimated by entrepreneurs to reach profitability. Entrepreneurs, and their financial backers as well, try to run the start-up business on a shoestring. In doing this, they run the risk of running short of cash and then having to raise more capital. Raising capital the second or third time for a company that has not met its projections is more difficult than raising the full amount needed at the beginning, as difficult as that is. Another important cause of business failure is poor management. Entrepreneurs are often specialists in one functional but important aspect of the start-up business. They often lack management, leadership, business, financial, marketing, or human resource skills and knowledge. Unfortunately, the technical or functional expertise is seldom sufficient to sustain the business.
DISCUSSION QUESTIONS 1. How can the organizational form chosen for a business affect strategic options for the company down the road? 2. Think about the differences between an entrepreneur and the founder of a lifestyle business. Are they very different? Where do you see yourself?
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3. Why is a firm started with $10,000 just as likely to be profitable as one started with $100,000? 4. What are the pros and cons of accepting money from other than yourself at start-up? 5. Limiting growth is one way to limit the reliance on external sources of funds. Are there potential costs associated with slow growth? 6. What are the major reasons for small business failure? What can one do to plan around them?
CASE 1.1
NEW TECH (A): OVERVIEW15
A small but successful company considers its future.
THE COMPANY New Tech Distributors Corp. (New Tech) assembles and distributes computer components from their facilities in Burnaby, British Columbia. The company distributes 30% of its products to companies in the United States and the balance across Canada. Stuart Chip, 38, started the company in his basement in 1995. He had just returned to Canada after spending 5 years with Digimoti, a Japanese semiconductor company. Today, New Tech has 20 employees and approximately $3 million in annual sales. New Tech distributes computer components by courier, primarily to the replacement market, including small computer repair shops, as well as larger retail and service organizations. About 70% of its volume is transacted with small businesses, while the balance is with larger ‘‘blue chip’’ companies. About 80% of the company’s products are purchased from thirdparty suppliers and delivered to customers with no value added. The remaining 20% consists of computer power modules, which the company assembles. Stuart currently owns 100% of the company but is considering offering some shares to his management team: Elizabeth Pratt, accountant; John Harley, sales manager; and Kevin Matley, who heads up production. The company has experienced rapid growth, and research indicates that its market continues to expand. Many computers in use now are showing signs of age; repairs are common, and many users want to upgrade their existing computers. Home personal computers represent a growing market, but given New Tech’s relatively small sales volume, the company believes it 15 With permission. From ‘‘Steps to Growth Capital,’’ a web site produced by Industry Canada. Please visit www.growth.ic.gc.ca
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only accounts for 0.5% of the total North American market. Its marketing plan shows the company doubling sales in less than 5 years.
CHALLENGE: HOW TO GROW? Despite Stuart’s initial success, he is concerned that New Tech cannot continue to grow without an injection of additional capital. His bankers have advised him that he will not meet New Tech’s sales objectives without such an infusion. Stuart wants to expand the power module side of the business by introducing a new line of products. At this point, he is considering nonconventional financing. However, he has never done this before. Where does he start? How complicated is the process? How much money does he need?
AN ADVISOR Clearly, Stuart needs some answers. His banker recommends meeting with a financial advisor and gives him three names. Stuart interviews the three candidates and chooses one after checking references, including their past experiences raising financing capital for small businesses in his industry. Stuart chooses Grant Argent, a financial advisor with experience in raising venture capital and knowledge of the computer hardware industry. Stuart wants Grant to help guide New Tech’s effort to secure the investment they need.
CASE STUDY QUESTIONS 1. What organizational form should Stuart form to facilitate the company’s expected growth? Why? 2. What financing options does Stuart realistically have at this time? 3. Which financing option do you recommend he pursue first? 4. What milestones has the company already achieved? 5. What milestones could be linked to future financing?
REFERENCES Bruno, Albert V. and Joel K. Leidecker. ‘‘Causes of New Venture Failure: 1960s vs. 1980s,’’ Horizons, Vol. 31 No. 6, (November-December 1988), pp. 51–56. Burr, Pat L. and Richard Heckman. ‘‘Why So Many Businesses Flop and Some Succeed,’’ Across the Board, (February 1979), pp. 46–48.
Introduction—In the Beginning
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Franklin, William H., Jr. and Stephan C. Franklin, Sr. ‘‘Five Mistakes Often Made by Small Businesses,’’ Journal of Small Business Management, (September 1982), pp. 5–6. Henz, Donald J. ‘‘In Search of Excellence—The Lesson for Small Businesses,’’ SAM Advanced Management Journal, (Summer 1986), pp. 29–35. McLean, Tom. ‘‘Small Companies: Failure and Success,’’ Accountant’s Magazine, Vol. 91, (October 1987), pp. 58–59. Olson, Philip D. ‘‘Entrepreneurship: Process and Abilities,’’ American Journal of Small Business, (Summer 1985), pp. 25–31. Peterson, Robin and David Lill. ‘‘An Examination of Marketing Factors Related to Small Business Success,’’ Journal of Business Management, (October 1981), pp. 64–66.
BIBLIOGRAPHY Banham, Russ, ‘‘Upgrading Cash Flow at Dell,’’ CFO Magazine, December 1, 1997. Bhide´, Amar, ‘‘Bootstrap Finance: The Art of Start-Ups,’’ The Harvard Business Review, November-December 1992, pp. 109–117. CCH Business Owner’s Toolkit, ‘‘Choosing an Organizational Form,’’ See http://www. toolkit.cch.com/text/P12_4100.asp Covin, J. and D. Slevin, ‘‘New Venture Strategic Posture, Structure, and Performance: An Industry Life Cycle Analysis,’’ Journal of Business Venturing, 5, 123–135, 1990. Greco, Susan, ‘‘A Little Goes A Long Way,’’ Inc. Magazine, October 15, 2002. Hofer, C. W. and W. R. Sanberg, ‘‘Improving New Venture Performance: Some Guidelines for Success,’’ American Journal of Small Business, 12, 11–25, 1987. Ibrahim, A. B. and J. R. Goodwin, ‘‘Perceived Causes of Success in Small Business,’’ American Journal of Small Business, 11, 41–50, 1986. Mochari, Ilan, ‘‘The Numbers Game,’’ Inc. Magazine, October 15, 2002. O’Neil, Hugh M. and Jacob, Duker. ‘‘Survival and Failure in Small Business,’’ Journal of Small Business Management, Vol. 21 No. 1, (January 1986), pp. 30–37. Reynolds, Paul D., William D. Bygrave, Erkko Autio, Larry W. Cox, and Michael Hay, Global Entrepreneurship Monitor 2002 Report, Ewing Marion Kauffman Foundation, November 13, 2002. Rock, Andrea. ‘‘The Sweet Taste of Success,’’ Money, Vol. 13 No. 10, (October 1984), pp. 82–90. Smith, Janet Kiholm and Richard L. Smith, Entrepreneurial Finance, ed 1, John Wiley and Sons, New York, 2000. Stevenson, Howard H., A Perspective on Entrepreneurship, Harvard Business School Publishing, Cambridge, Mass., 1983. Timmons, Jeffry A., New Venture Creation Entrepreneurship for the 21st Century, ed 5, IrwinMcGraw Hill, Chicago, 1999.
Chapter 2
Alternatives in Venture Financing—Debt Capital
CHAPTER GOALS In this chapter you will learn about: . several options that are available to the firm as debt financing . the best way to prepare yourself before approaching a lender, in order to increase the probability of securing financing . various terms of repayment that can be attached to loans . methods of estimating the firm’s need for external funds by preparing pro forma income statements and balance sheets
INTRODUCTION There is no one best method of raising capital. Financing methods will vary with changes in the economy, competitive factors, and as a result of legal, legislative, and regulatory actions. Top entrepreneurial companies use various combinations of debt and equity, depending on which is the most advantageous for the particular stage of growth they are financing. Their aim in financing is to create increasingly higher valuations for the firm by minimizing the total cost of raising capital. Bank debt is not a major source of financing in the earliest stages of a startup. The use of bank debt virtually always requires that some equity has come in first. A bank will look at how much equity the entrepreneur has committed to the business as a signal of the entrepreneur’s faith in the business. In addition, banks usually require an operating history, supported by financial
41
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Alternatives in Venture Financing—Debt Capital
statements, of 3 to 5 years to demonstrate the viability of the business. Once an operating history has reduced the risk to the prospective lender, a rough rule of thumb is that a dollar of early-stage equity can support a dollar of debt, if there is some additional collateral to further back the debt. Lenders often feel that a start-up will have difficulty in quickly generating the sales or cash flow necessary to service the debt. Consequently, the lender will want to have his or her debt secured with a tangible asset with a reasonable secondary market value. Even then, the lender’s risk is not completely mitigated since the asset value will normally decrease with time, and there is always the possibility that management may not be up to the company-building challenge at hand. Debt for start-up companies will most likely be short-term debt (one year or less) to be paid back from sales. Short-term debt is traditionally used for working capital needs and small equipment purchases. Long-term borrowing can be used for some working capital needs, but is usually assigned to finance property or equipment that serves as collateral for the debt.
LENDING SOURCES While commercial banks are the most common source of short-term debt, there are several choices for long-term financing. Equipment manufacturers provide financing directly and through leases. Finance companies provide direct loans and factoring of accounts receivable. Vendors often provide financing, both through trade credit and installment sales contracts. The Small Business Administration (SBA) provides loan guarantees that allow commercial banks to lend to customers they would otherwise not lend to. In addition, various state agencies and leasing companies provide long-term financing. Table 2.1 summarizes the most recent research performed by the Federal Reserve Bank on the state of small business financing, particularly credit. Small businesses in the Fed study are defined as having less than 500 employees. As you can see in Table 2.1, financing choices change as the company grows and there are many options open to firms of all sizes. With the exception of personal credit cards and loans from friends and family, the typical company’s use of all types of external credit increases as it grows. When it comes to bank lending, variations in lending criteria between institutions can affect a firm’s ability to raise funds. Some banks specialize in lending to small or new businesses, and some shy away from the practice altogether. A substantial fraction of firms that have had loan applications denied have had the same proposal financed later by another lender. It pays to shop around and be persistent.
Table 2.1 Sources of Credit for Small Business Percentage of each category using selected source Number of Employees
Credit Line
Bank1
Capital Lease
Trade Credit
Loan from Owner
Strategic Partners
Personal Credit Card
Business Credit Card
Friends and Family
0–1 2–4 5–9 10–19 20–49 50–99 100–499
13.42 20.83 34.08 50.59 59.07 62.67 74.81
23.12 37.59 57.65 66.49 76.04 80.97 73.38
3.29 7.42 14.26 23.19 21.71 31.75 27.71
42.69 56.86 71.14 77.90 80.67 80.67 83.37
17.49 26.25 27.47 34.24 33.69 36.02 28.76
4.82 4.12 6.88 10.46 11.82 9.28 12.87
44.91 46.75 44.00 50.38 39.51 30.29 23.00
19.19 28.46 41.93 51.39 55.61 56.52 59.67
3.95 5.90 6.15 8.66 12.93 6.88 4.63
41.10 45.71 47.83 51.84 47.59 41.50 45.37 33.21 24.79 22.39
11.14 20.75 27.11 31.90 43.06 44.04 54.45 62.68 67.66 62.09
5.19 2.92 4.78 7.52 7.32 6.29 8.35 7.41 6.20 4.82
Sales (in thousands) Less than 25 25–49 50–99 100–249 250–499 500–999 1,000–2,499 2,500–4,999 5,000–9,999 >9,999 1
9.11 11.25 15.20 22.48 36.82 41.74 51.48 68.80 75.74 81.36
16.10 26.27 29.47 46.18 50.93 65.58 74.60 83.59 74.69 74.49
2.82 2.36 7.73 11.31 11.29 19.81 17.81 18.60 24.77 23.67
30.34 46.78 54.30 63.01 75.85 77.27 80.15 79.86 72.10 76.58
21.36 17.77 26.19 29.12 30.08 31.86 26.82 25.74 34.98 29.26
43
Bank debt includes mortgages, vehicle loans, and equipment loans.
3.87 3.03 4.84 5.57 4.70 10.56 9.86 8.81 11.17 10.73
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Alternatives in Venture Financing—Debt Capital
SBA LOANS—PROFILE OF A PROVIDER The SBA does not loan money. Rather, it provides loan guarantees for businesses seeking loans from SBA-sanctioned lenders. These guarantees make it feasible for commercial lenders to make loans that they otherwise could not make due to the lack of credit history for a business start-up. An example of an SBA lender is provided by the CIT Group. CIT Group, Inc. (NYSE: CIT)1 is a leading commercial and consumer finance company. Founded in 1908, the company has nearly $50 billion in assets under management. CIT is headquartered in New York City, with locations throughout North America, Europe, Latin and South America, and the Pacific Rim. CIT Small Business Lending Corporation is the nation’s leading provider of SBA loans. It provides financing packages to a wide variety of small businesses, including assisted living facilities, auto lube businesses, chiropractors, construction loans, convenience stores, day care centers, franchises, funeral homes, gas stations, hotels/motels, nursing homes, physicians, restaurants, veterinarians, women-owned businesses, and more. Restrictions on CIT’s services include: . The minimum loan size is $50,000, and the maximum loan size is $5 million. . The start-up must be a franchise. . Applicant should be a U.S. citizen or resident alien. . Working capital is limited to 40% of the loan amount.
CIT’s Website also lists businesses that may not be eligible, or eligible only under specific conditions, for financing through CIT Small Business Lending Corporation. These include pawn shops, trailer parks, campgrounds, transient motels, SBA loan packagers, businesses engaged in gambling activities, membership-based businesses, businesses engaged in agricultural crop or livestock production or processing, Internet service providers, Internet marketing companies or other Internet based businesses, retail/wholesale lumberyards, loans secured by rolling stock (vehicles), used auto retailers, amusement/recreation businesses, and home-based businesses. A look at the type of business that CIT will finance, and those that it will not, gives an indication of the perceived risk of various business start-ups.
LOAN BROKERS—ONLINE SCREENING FORM Loan brokers act as middlemen in assisting businesses to secure debt financing. Loan brokers forward a brief description of a loan application 1
For more information, visit www.cit.com
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to various sources of loan funding. These lenders then compete against each other to try and win the company’s business. An online loan application will look something like this:
Industry:_________________________________________________________ Amount of Financing Requested:
_________________________
Please check one that applies: Startup
Existing Business
Years in Business:__________
Sole Proprietorship
Partnership
Corporation
Purpose of Financing: Equipment Financing
Working Capital
Receivables Financing
Receivables Factoring
Purchase a Business
Commercial Real Estate
Other:_________________________________________________________ Briefly Describe Purpose of Financing: ________________________________________________________ Personal Guarantees available?
_____________
Credit History of Owner?
Excellent
Satisfactory
Poor
Credit History of Business?
Excellent
Satisfactory
Poor
Company’s Gross Revenue:
__________________________________
It is easy to see what lenders consider important from this form. Credit history is certainly always a factor, but so are industry, business stage, and corporate form. The purpose of the loan and willingness of the owner to personally guarantee the loan can also have weight. Interestingly, on this form the company profitability answer was defaulted to ‘‘Yes.’’ We wonder if ‘‘No’’ is even an option. While this impersonal approach to lending may save time at the beginning, in the longer run there is no substitute for having a long-term relationship with a banker that includes periodic face-to-face discussions. A personal
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relationship with a banker increases the odds that the banker will be there for you should you experience unforeseen cash flow needs or other financial difficulties. Your business banker can be a good source of advice and guidance. After all, he or she has probably worked with hundreds of companies and seen most of the pitfalls that can befall a new business. Best of all, a long-term banker knows your and your company’s histories, as well as your sense of responsibility about the debt. He or she can often, factoring in knowledge of your character, overrule the rejection of applications based on mathematically derived ‘‘point systems.’’ Likewise, he or she can inform you of new financial products that might be advantageous to you.
DEBT CAPITAL CONSIDERATIONS Entrepreneurs can occasionally finance start-ups with more debt than equity, but there are distinct disadvantages to this strategy. First, where debt is heavily relied on, lenders will generally provide only what is projected as the minimum amount required. Once in operation, the venture may experience continuing cash flow problems as it grows, and the bank will be unwilling to extend more credit to an already highly leveraged firm. Second, debt results in fixed costs, which exacerbate a company’s cash flow concerns. Paying close attention to strained cash flow requires that management time be diverted from company operations. It also limits the venture’s ability to secure additional financing in the future. On the other hand, there is one big positive to using debt. Debt does not decrease or dilute the entrepreneur’s equity position, which in turn increases the entrepreneur’s return on invested capital. Debt’s fixed and low (relative to equity) cost means that if the business succeeds beyond the entrepreneur’s wildest expectations, the bank’s return is still fixed and the windfall flows through to the founders. However, if credit costs go up, or if sales do not meet projections, debt service cash flows can cause severe constraints for the company. Under these conditions, additional debt will be difficult to obtain, and the venture team may find itself seeking equity funding under very unfavorable conditions. The area of capital structure, how the firm is financed, is an area where best practice differs between corporate finance and entrepreneurial finance. In corporate finance you most likely learned that the firm should strive to minimize the weighted average cost of capital by taking on debt until the point where the increased risk of the debt causes the overall cost of capital to rise. This theory is predicated on the assumption of unlimited access to capital. As long as the firm has access to new equity capital, it can continue
Alternatives in Venture Financing—Debt Capital
47
to borrow until the absolute level of debt causes all investors to raise their required rates of return and thus the firm’s cost of capital. New businesses do not have unlimited access to capital. Until a firm becomes publicly traded capital access will usually be a constraint. The new venture’s equity is typically limited to the personal resources and friends and family financing mentioned in Chapter 1. The primary consideration for the new venture is cash flow, and debt reduces cash flow. The firm must maintain a reserve of borrowing capacity for emergencies and keep debt to a level that does not jeopardize the firm’s existence through unsustainable negative cash flows. The bottom line? An entrepreneurial venture is often forced to use less debt than is theoretically optimal due to cash flow constraints and the inability to secure additional equity.
APPROACHING PROSPECTIVE LENDERS Before putting a loan proposal together, seriously consider how you might respond to the following questions: . . . . . . .
How much money do you need? What will the money be used for? When and how will you repay the loan? How much debt does your current financial worth support? What is the highest amount of debt with which you would be comfortable? How risky is the venture? What collateral can you provide to reduce the risk to the lender?
Your ability to plan for the financial needs of your new venture will play a major role in how much capital you will be able to raise.
THE LOAN PACKAGE A loan package includes a business plan, which includes a market analysis, a projected balance sheet, profit and loss projections, and cash flow projections. Business plans are the topic of Chapter 4, but we must briefly talk about them here as part of the method for determining financial need. The amount of detail and research needed in the financial projections is directly related to the amount of outside capital you hope to secure. In addition, a loan package must include the amount of the loan, how the loan money will be used, when the money will be needed, when the loan will be repaid, the source of repayment funds, and the amount of collateral you
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have to secure the loan. You should also include the amount of equity capital you are personally investing in the business venture. Another part of the loan package should be personal information about you and anyone else involved directly or indirectly in the new business. The personal information included in the loan package should include education, work history, and business experience of everyone involved in the new business. You should also include credit references, personal income tax statements for three years, and updated financial statements. Information about the nature of the loan and personal histories of those involved may be a major factor in getting the loan.
THE LENDER’S PERSPECTIVE How do lenders evaluate your loan package? Essentially lenders look at the 5 C’s of credit to evaluate any loan.2 The 5 C’s are: . Character: What is your reputation within your company, within the industry, and within the community; basically, are you honest and committed to the business? A personal credit history will be used to assess your credit-worthiness and character. . Capacity: What is your ability to repay the loan? Financial ratios are usually calculated to help answer this question, but sales and earnings forecasts will also be used. . Capital: How is the firm capitalized? How much equity is there? How much equity have you personally contributed? . Conditions: How sensitive is your business to changes in the economy? Will you be hard hit by a downturn or is your business recession-proof? . Collateral: What assets do you have, either business or personal, to collateralize the loan?
Anticipate your strong and weak points as they may appear to a potential lender. While you assume that your new business will generate the cash flow to repay the loan, lenders must consider the alternatives. Know the competitive environment well. Know not just your current competitors but any potential entrants to the market as well. ‘‘We have no competition’’ is a red flag to any lender or investor—it likely indicates that either there is no market, or that you have not done your homework.
2
In Great Britain the CAMPARI system is used for the same purpose: Character, Ability, Means, Purpose, Amount, Repayment, and Interest and Insurance.
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Alternatives in Venture Financing—Debt Capital
Do you personally have the capacity to repay the loan? Lenders not only look at the business’s financial projections, but also your ability to repay the loan if the business does not work out as planned. Even if you have chosen a form of organization that includes limited liability, a lender will often demand a personal guarantee if the business is new or appears risky. Do you have outside income (investments, a working spouse)? Would you be able to return to your present job? Do you have other skills that could produce income? Be prepared to provide solid answers to these questions and be able to offer real evidence. Have you personally made a sizable financial commitment to the business? Knowledgeable lenders know from experience that if the venture turns bad it will be easier for you to back out if you do not have your own money at risk. They expect that you have provided as much of the needed capital as you can afford to put at risk. After all, if you have not invested in your business, why should they? What percentage of the needed capital for your new business do you expect to borrow? As guidance to what is normal in your industry you can use industry average debt ratios. Averages for most industries are available from Dun & Bradstreet and RMA. Table 2.2 provides data in RMA Statement Study format to which we will be referring from time to time; we are projecting that these figures are norms for the industry in which our end-of-chapter case study New Tech competes.
Table 2.2 New Tech Industry Group: Common-Size Financial Statements* Assets Cash & Equivalents Trade Receivables – (net) Inventory All Other Current Total Current Fixed assets (net) Intangibles (net) All Other Non-Current Total Non-Current Total Assets
% of total assets 4.9 28.3 31.2 5.6 70.0 23.9 1.7 4.4 30.0 100.0 (continued )
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Alternatives in Venture Financing—Debt Capital
Table 2.2 — cont’d Liabilities
% of total assets
Notes Payable-Short Term Current Maturities – L/T/D Trade Payable Income Taxes Payable All Other Current Total Current Long Term debt Deferred taxes All Other Non-Current Total Non-Current
11.6 2.6 11.8 0.8 13.2 40.0 5.8 0.5 3.3 9.6
Total Liabilities Net Worth
49.6 50.4
Total liabilities & net worth
100.0
Income data Net Sales Profit as % of Sales Operating Expenses Operating Profit All other Expenses (net) Profit Before Taxes
% 100.0 33.3 27.5 5.8 2.7 8.5
New Tech Industry Group: Financial Ratios by Quartile* Ratios/quartile:
1
Current: Current Assets/Current Liabilities 3.4 Quick: (Current Assets-Inventory)/Current Liabilities 1.7 Sales/Receivables 9.2 Cost of Sales/Inventory 7.9 Cost of Sales/ Accounts Payables 20.7 Sales/Working Capital: Sales/(Current Assets-Current Liabilities) 3.3 EBIT/Interest 27.4 Fixed Worth: Fixed Assets/Stockholder’s Equity 0.3 Debt/Worth: Total Debt/Equity 0.3 Profit Before taxes/Stockholders Equity 43.6 Profit Before taxes/Total Assets 24.5 Sales/Net Fixed Assets 12.6 Sales/Total Assets 2.4 *Revenue Group ¼ $0-10 MM Annual
2
3
1.7 0.9 7.6 3.6 13.4 8.3 5.5 0.4 1.2 21.1 13.7 9.0 2.0
1.2 0.5 5.4 2.6 9.5 20.9 0.1 1.1 2.6 7.6 1.7 5.6 1.6
Alternatives in Venture Financing—Debt Capital
51
Recognize that a new business is a much higher risk for a lender than an existing business or a home loan. New small businesses fail at a rapid rate; estimates of failure rates range from 65% to 80% in the first 5 years. It is not likely that the assets of those that fail can be easily turned into cash for repayment of the loan, so expect to borrow somewhat less than the average for your industry. If a lender turns you down, ask him or her for specific reasons. If the reasons cannot be countered with this lender, the insight gained can be used to strengthen the presentation to the next one.
DEBT CAPITAL TERMS AND OPTIONS The type of business you are in affects the amount of start-up capital you will need. Service businesses need relatively little; manufacturing businesses need much more. In some cases, the new businesses may only need capital for short periods of time for inventory purchases or salaries. In other cases, facilities and equipment must be bought or leased, inventory purchased, and there must be enough cash left over to run the business until revenue can support the needed cash flow. Knowing the type and amount of capital needed will help you figure out the best source of capital for your new venture. Leasing business equipment is a sound way to reduce capital needs. What is important is control of operating assets, not ownership of the assets. Leasing conserves scarce capital for more productive uses in the business. Everything from office furniture to food processing equipment can be obtained from leasing companies or commercial finance companies. Leasing is generally more expensive than bank financing and is limited to items that have a long serviceable life, widespread use, and are easily repossessed in the event of default. In many cases, you have the option to buy the equipment for an agreed-upon amount at the end of the lease period.
TERM OF LOAN Once all options are investigated, capital needs can be classified as either short- or long-term. Short-term needs are generally those of up to 1 year; long-term needs are those of more than 1 year. Short-term financing is most common for assets that turn over quickly, such as accounts receivable or inventories. Seasonal businesses that must build inventories in anticipation of selling requirements, and that will not collect receivables until after the selling season, often need short-term
52
Alternatives in Venture Financing—Debt Capital
financing for the interim. Contractors with substantial work-in-process inventories often need short-term financing until payment is received. Wholesalers and manufacturers with a major portion of their assets tied up in inventories and/or receivables also require short-term financing in anticipation of payments from customers. Short-term notes can be issued for periods as brief as 10 days to fill an immediate need; commercial banks are the ordinary source of short-term loans for small businesses. Short-term borrowing usually requires repayment within 60 to 90 days. Notes are often renewed, in whole or in part, on the due date provided that the borrower has lived up to the obligation of the original agreement and the business continues to be a favorable lending risk. Long-term financing is borrowing for a period greater than 1 year. This general classification includes ‘‘intermediate debt,’’ which is borrowing for periods of 1 to 10 years. Longer-term borrowing is often associated with the need for fixed assets such as property, plant, and equipment where the assets will be used in the business for several years. Longer-term notes can be issued for periods of several years, and sources are more varied. For example, the venture may finance a major piece of equipment with its vendor, and real estate is usually financed with a mortgage company. Recurring needs, a series of short-term needs, should often be more realistically viewed as a long-term or permanent need for capital. This is because the cash flow requirements are permanent—they do not disappear even at low levels of sales. Long-term funds should therefore be used to cover such short-term financing needs to avoid the crises that could occur if capital were not available to meet a recurring short-term requirement. Credit lines: When a business has established itself as being worthy of short-term credit, and the amount needed fluctuates from time to time, banks will often establish a line of credit (LOC) with the business. The LOC is the maximum amount that the business can borrow at any one time and is essentially a loan on demand. As a result of a cash budget forecast, the entrepreneur can spot fund deficits and surpluses before they happen. An LOC should be large enough to cover the maximum funds shortfall over the next year. The line is repaid out of cash flows as they materialize, and the line is increased as needed up to the preauthorized maximum. The LOC offers the firm maximum flexibility. Funds are not drawn on the LOC unless needed, and thus interest is not incurred unnecessarily. Additionally, repayment is flexible and not required until the firm has sufficient cash flow to repay the LOC. The exact amount borrowed varies according to the needs of the business but cannot exceed the established credit line. Also, the bank will insist that the LOC be paid off at least once a year to ensure that short-term financing is not being used for long-term needs.
Alternatives in Venture Financing—Debt Capital
53
Small business loans: For small businesses, capital borrowed for periods greater than 10 years is usually available only on real estate mortgages. Other long-term borrowing usually falls into the intermediate classification and is available for periods up to 10 years. Such loans are called ‘‘term loans’’ and are generally recorded as long-term Notes Payable on the balance sheet. For term loans, payment of principal and interest is ordinarily scheduled on an annual, semiannual, or monthly basis. Payment schedules: When the terms of a loan are negotiated, a payment schedule is established for both interest obligations and principal repayment. These are usually amortized over the life of the loan, resulting in a constant payment, with the interest portion decreasing and principal portion increasing with each successive payment. Other schedules might use a current interest plus constant amount of principal structure, resulting in a declining payment as the loan progresses, or some long-term schedule that must be renewed annually. A typical amortizing loan is the least flexible for any business. Any flexibility in repayment terms that the entrepreneur can negotiate up front increases the odds of surviving a cash flow crisis should one emerge. Discounted notes: In some cases, particularly in short-term borrowing, the lender may require that the interest on a note be prepaid. The total amount of interest due over the term of the note is then deducted from the principal before the proceeds are issued to the borrower. The note is then referred to as discounted. Discounting has the effect of increasing the cost of the loan to the borrower. Let us say the entrepreneur needs $100,000 to cover working capital needs for the near term. If the loan offered is a 10% discount interest loan, 10% will be deducted from the loan proceeds by the bank up-front. This means that the entrepreneur receives only $90,000 and pays $10,000, 10% of the nominal amount of the loan, resulting in an effective cost on a 1-year loan of $10,000/$90,000 ¼ 11.11%. Alternatively, if the entrepreneur needs the full $100,000, he or she will be forced to borrow more: 100,000/ (1 or .10) ¼ $111,111. Interest will be 10% of the full loan amount, $11,111, on a usable loan proceed of $100,000, again an effective rate of 11.11%.3
LOANS MAY BE SECURED OR UNSECURED Secured debt is a loan for which the borrower pledges certain assets as collateral (security) to protect the lender in case of default on the loan. If the business defaults on the loan through failure to meet interest obligations or principal repayments, the note-holder (lender) assumes ownership of the 3
The amount of the loan is figured as Funds required/(1 discount percentage).
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Alternatives in Venture Financing—Debt Capital
collateral. Such claims on specific assets pledged as collateral take effect before claims of other creditors are addressed. In long-term borrowing, fixed assets such as real estate or equipment are usually pledged as collateral. For short-term borrowing, inventories or accounts receivable are the usual collateral. Obviously collateral reduces risk to the lender, and the interest rate will be lower to reflect the reduced risk. Often, however, the presence of collateral is necessary to reduce the risk enough to induce the lender to make the loan at all. Lenders do not usually advance 100% of the book value of the asset being offered as collateral. For accounts receivable, only current receivables are considered acceptable collateral and only 70% to 80% of the book value of current receivables will typically be loaned. Inventory is less liquid than receivables, and a correspondingly lower percentage is applied to the book value of inventory, typically in the 40% to 60% range. Essentially, the percentage advanced depends on how easily the asset can be converted into cash quickly. Unsecured debt is not secured by specific collateral but rather by the general earning power of the business. If the company defaults on a payment, the unsecured creditor, under normal circumstances, has few options. They can renegotiate the amount due, perhaps by seeking collateral, or they can sometimes force the company to liquidate. In liquidation, the holder of an unsecured note would normally be part of a group that divides the assets left after the secured debt holders have been satisfied. The value of assets available at that point is often zero, or at best a small percentage of what is owed. When accepting an unsecured note, the lender will often place certain restrictions on the business to reduce the probability of default on the loan. A typical restriction might be to prohibit the company from incurring any debt with a prior claim on the assets of the business. For example, a term note agreement might prevent a company from financing its receivables or inventories, since this would result in a prior claim against the assets of the business in liquidation. Obviously, restrictions like this reduce the firm’s future financing options and can prove very costly in the long run. Such restrictions may have no effect on the business’s ability to operate. However, in other cases, such restrictions could be severe. For example, a business may have a chance to sell to a major new customer who insists on extended credit terms. This will require the business to seek additional external financing, which could be secured by the new customer’s accounts receivable. However, the restriction on securing financing with a prior claim on the firm’s assets of the unsecured note could prevent the business from taking advantage of this significant opportunity for sales and profit improvement.
Alternatives in Venture Financing—Debt Capital
55
Personal guarantees are required by many lenders when issuing credit to new corporations. Creditors normally have no claim against the personal assets of the stockholders of a corporation if the business should fail; the liability of a corporation’s shareholders is limited to their investment in the business. In new ventures, however, a personal guarantee by the owner (or owners) can protect the creditors if the business fails and may be necessary to secure a loan. In other words, the limited liability feature of the corporation does not apply to new ventures if a personal guarantee is necessary to secure a loan in the first place. Interest rates at which small businesses borrow are relatively high because of the risks involved. Banks and other commercial lending institutions normally reserve their lowest available interest rate, the so-called prime rate, for those low-risk situations such as short-term loans for major corporations where the chances of default are slim and the costs for collection, credit search, and other administrative tasks are minimal. Because of the higher risks involved in loaning to small businesses, lenders often seek greater collateral while charging higher interest rates to offset their added costs of credit search and loan administration.
VENTURE BANKING A relatively new kind of lending has emerged in conjunction with the rise of venture capital firms that provide equity financing. Some banks, Silicon Valley Bank being the best known, provide loans to high-growth firms that have just received venture capital. Using the equity provided by the venture capitalist as collateral, the bank loans additional capital to increase the total money raised by the entrepreneurial venture. Venture bankers look a lot like venture capitalists in their operations. Silicon Valley Bank, for example, lends only to technology and life science companies. This allows it to develop an expertise in assessing the risk of these early stage ventures. Typically, the bank will earn competitive interest on the loan plus warrants or options for shares as compensation for the risk of lending to early-stage companies.
ASSET-BASED FINANCING Once a company has been in business some time, it may have built up assets that can be used to secure a loan. Also known as asset-backed financing, these loans are specialized and not available to all firms. Assets must fit strict criteria before they become acceptable collateral in the lending process. Inventory financing is most commonly used in automobile, boat, and appliance retailing. As each unit is purchased by the retailer, the
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manufacturer is paid by the lender. The lender is repaid by the retailer when the unit is sold. Interest is determined separately for each unit, based upon the actual amount originally paid by the lender and the period between the time the money is paid and the time the lender is reimbursed by the retailer. For inventory financing to be feasible the assets must be individually identifiable, usually by a serial number, so that an audit can verify the presence of unsold assets at the dealer’s place of business. Accounts receivable financing can take two forms. Pledging, or ‘‘assigning,’’ receivables as collateral for a loan results in the receivables remaining with the business and serving as collateral only. The company is responsible for collecting and maintaining receivables and granting new credit. Another way in which the business may use its accounts receivable is by ‘‘factoring’’ them, or selling them to a third party at a discount based on the ages of amounts owed. This is not a loan; it is essentially liquidation of an asset to produce ready cash. In many industries, factoring is considered a sign of weakness. It is a common business practice without negative implications in others, such as the garment manufacturing industry and personal finance companies. Sometimes when customers must pay invoices directly to a third party, the factor, it creates doubts about the company’s financial stability and, therefore, its ability to deliver.
Assigning Accounts Receivable When receivables are assigned, the amount of the loan varies according to the volume of receivables outstanding and the creditworthiness of the company’s customers. Assigning receivables is especially appropriate for new ventures that sell to large established corporations. In an assignment the determining factor is the creditworthiness of the company’s customers—not the company itself. The ability to use accounts receivable as collateral depends on the nature of the accounts. A business selling at the retail level to numerous individuals will be unlikely to be able to assign its receivables as collateral. A small aircraft parts manufacturer selling to Boeing and Lockheed would have much less trouble. When accounts receivable are assigned, the borrower is still responsible for collection of those accounts. Upon collection of any assigned receivable, the amount received should be applied to the loan. Interest is based on the amount borrowed and the time between receipt of proceeds by the borrower and repayment to the lender.
Factoring Accounts Receivable When accounts receivable are factored, they are sold to a third party, the factor, and the borrower has no responsibility for collection. The borrower
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pays the factor a service charge based upon the amount of each receivable sold. In addition, the borrower pays interest for the period between the sale of the receivable and the date the customer pays the factor. Since the factor is responsible for collection, it will only purchase those receivables for which it has approved credit. Typically, the factor will withhold a reserve, 20% for example, that is not remitted to the entrepreneur until the accounts are collected. Factoring is usually viewed as a financing source of last resort due to the high costs associated with it. It is important to understand, however, that the factor is not only providing financing but is also providing the credit and collection operation for the business. Thus, a company that factors its accounts receivable may be able to cut staffing and save in other areas.
TRADE CREDIT Once the business has gotten started and is purchasing goods and reselling them, some cash flow assistance is often available by using trade credit, credit extended by suppliers in the normal course of business. Careful use of this segment of accounts payable may be thought of as a loan available on a relatively informal basis without the requirements for application, negotiation, auditing, and legal assistance often necessary with other capital sources. Using such credit wisely can often help the new business secure extra capital that it needs, without recourse to lenders or equity investors. This is particularly true whenever the capital need is relatively small or short in duration. When using trade credit, there are certain rules to live by. Take full advantage of available payment terms. If no cash discount is offered and payment is due on the thirtieth day, do not make any payments before the thirtieth day. Free financing is being offered for 30 days, and the entrepreneur should maximize his or her use of free credit. Where a discount is involved, evaluate losing the discount versus the benefit of taking the extra time to pay; paying the discounted amount within payment terms is almost always beneficial. The cost of foregoing the discount can be simply calculated as follows: (1 þ periodic rate)n 1 ¼ effective cost of foregoing the discount discount % ð1 discount %Þ n ¼ number of discounting periods in a year, i.e., 365/(payment date discount date) where periodic rate ¼
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For example, if terms of 2/10 net 30 are offered, the effective cost of foregoing the discount and paying on day 30 is: {1 +r [0.02(10.02)]}18.251¼44.59% a very expensive source of financing!4 The cost of foregoing a discount on trade credit should always be compared to the short-tem lending rate offered at a bank. The bank rate will usually be lower than the rate implicit in foregoing a discount, but sometimes the bank may not be willing to lend and the higher cost of foregoing the discount is the firm’s only option. Whenever possible, the entrepreneur should negotiate extended payment terms with suppliers if cash flow is a problem. For example, ask a supplier to extend the discount period or invoice you for this month’s purchases in the next month’s business. In the previous example, if the supplier would agree to accept the full amount on day 60 rather than day 30, the cost of trade credit would fall to 15.88%. Trade credit must be used judiciously. Its easy availability is particularly welcome in brief periods of limited needs. Used imprudently, however, it can harm relations with key suppliers and jeopardize your ability to locate other competitive suppliers who are willing to extend credit to your business. Customer prepayments. When customers pay for work in installments as the work is completed or pay in advance, they are, in effect, financing the business. For example, a carpenter reduces capital requirements when the customer purchases the building materials for a remodeling project. In addition, it is not uncommon to request a deposit from customers when ordering items, particularly special items.
CASE 1:
SPS—FINANCING STRATEGY
The following case study will be used to illustrate the points made in the chapter so far.
The Opportunity Superior Plumbing Supply, Inc. (SPS), wholly owned by the Beavy family, was a successful wholesaler to the contracting trade when they were offered the opportunity to become a distributor of Behemoth Quality Products. At that time, SPS’s income statement showed annual sales on the order of $3 million, gross margins just over 22%, and net income of around 3%: 4
The number of compounding periods is calculated as 365/(3010) ¼ 18.25.
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Superior Plumbing Supply, Inc. Income statement
2001
Sales Cost of goods sold Gross margin Other income Total income
$3,016,204 2,347,826 22.2% 26,278 $694,656
EXPENSES Payroll Operations Selling Administration Depreciation Total expenses Operating profit/loss Profit as % of sales
252,281 114,098 85,558 116,555 34,988 $603,480 $91,176 3.0%
Notes on the income statement: . Gross margin is the percentage of each sales dollar left after paying the cost of goods sold. . Operating profit/loss is generally termed ‘‘EBITDA,’’ for earnings before income tax, depreciation, and amortization. This is to focus on how the company is performing, without regard to financing costs. . Profit/loss as % of sales, or ‘‘net margin,’’ is the percentage of each sales dollar left after paying for the cost of goods sold and all expenses, including interest.
Expenses are grouped in rather broad categories for simplicity. Acquiring the Behemoth line would be a major step up in prestige, but it carries a number of commitments with significant capital obligations on the part of the distributor. A rough budget indicates that these obligations and cost estimates would include: Build and furnish a showroom, existing space Saleable display fixtures Inventory supporting Behemoth product Conduct a media campaign for a grand opening
$40,000 $20,000 $190,000 $30,000
TOTAL
$280,000
The ability to adapt existing space, and the vendor’s offer to contribute showroom design and display furnishings, would hold down the cost of
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building improvements. Three-fourths of the project cost is in inventory, when saleable display items are considered. Extended payment terms, offered by the vendor, would allow the showroom to open by the time the bills come due. The only expense item is for media, which benefits not just the new product line but general awareness of the business in its target market.
The Financing Decision Negotiations with Behemoth had gone on through the fall of 2001, based on projected 2001 financials. When these were completed in early 2002, the Beavys decided to go ahead with the project. It was important that they move quickly, because showrooms have their heaviest traffic in early spring, as homebuilders are finalizing plans and specifications. Successful launch of the new product would require a nearimmediate start for the 45–60 day construction and preparation period. Inventory could be ordered, and upon its arrival SPS could announce that it has the line and that the showroom will be open soon. All that remains is to consider how SPS might finance this major growth initiative. Equity? Company ownership, to that point, had always been kept entirely within the family. While the Beavys felt that they were already fully invested personally, they were confident that this deal could be done without surrendering equity to an outside investor. Debt? Debt was the method chosen, in particular a credit line with the company’s bank. The bank would approve a line of credit of $280,000; it was the Beavys’ sense that the need at any point would be considerably less than $280,000. With significant assets to collateralize the total amount, they could, if they chose to, convert the line of credit to a term loan at any time. The balance sheet and selected financial ratios prior to the expansion are shown below. Superior Plumbing Supply, Inc. Balance sheet 2001 Assets
Liabilities
Cash Accounts receivable Collection days Inventory Turns Other assets
51,210 320,808 45.7 341,332 6.9 197,615
Accounts payable Other liabilities Total liabilities
321,828 40,449 362,277
Equity
548,688
Total assets
910,965
Total liabilities & equity
910,965
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Notes on the balance sheet: Collection days are calculated as total accounts receivable divided by daily charge sales. This is a measure of effectiveness at collecting on accounts, and the result for SPS approaches the norm for the industry. Charge sales were estimated to be 85% of total sales. Collection days ¼ Accounts receivable/ [(Sales 0.85)/365] Inventory turns are calculated as inventory divided by cost of goods sold per day. SPS turns over its inventory roughly 7 times a year, or inversely, stocks about one seventh of a year’s sales at any given time. Industry norm is 4 to 6 times a year, so SPS is making better use of its assets than most. Inventory turnover ¼ Inventory/(COGS/365)
Banker’s Perspective Ordinarily, before issuing a credit line a lender would require that the Beavys confirm their ability to repay in a cash budget. The cash budget would have to show that the added sales and higher margin of the Behemoth items would build quickly enough that the debt payments, over the term of the loan, would not drain cash reserves. The higher margins on the expansion are due to the fact that Behemoth sales would ‘‘cannibalize’’ some lower margin sales currently being made, but would mostly draw a new, and less price-conscious, clientele.
Discussion Assess the decision to take on the new line from a strategic standpoint. Behemoth has provided SPS with forecasts based on market research and previous product launches that indicate that the new endeavor would be highly profitable for SPS. Should Behemoth’s research that SPS will succeed be enough, or should SPS independently verify? How would they go about doing so? . Weigh other factors that deserve consideration; e.g.: . Personal factors, such as the owner’s retirement horizon and next generation interest in perpetuating the family business . Market factors, such as competitive issues, and opportunities as ‘‘firstmover,’’ leading their competitors into a new market segment. . What is the impact on operating costs of the Behemoth line? . What is the impact on total costs of the interest on the LOC? . If indicators are positive, are there other suitable options to the suggested financing approach? . Under this approach, should they borrow less and ‘‘pay as they go more?’’
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ESTIMATING FINANCING REQUIREMENTS An entrepreneur’s success in raising funds for the business depends on good planning, realistic forecasting, and knowing what sources of capital are available. The total amount of capital needed to start the venture is a product of reasonable sales forecasts and pro forma financial statements. Assuming that the total amount of capital needed exceeds the entrepreneur’s ability to invest (or willingness to risk) generates a more difficult question: How can the entrepreneur convince available financing sources to provide the capital needed? The answer depends on the ability of the business to generate cash flows. Minimizing total capital requirements, shortening time to break even, long-term growth potential, etc., all relate to how quickly and how high a business can grow profits and, more importantly, cash flows; these functions include, of course, holding down costs, growing ‘‘smartly,’’ and seizing opportunities. Forecasting a company’s profits, and for many, determining when it will achieve a break-even point, is a critical component of the financial proposal, an income statement perspective. Equally important is the amount of assets required to create the infrastructure to generate these profits, the corresponding balance sheet perspective. The net increase in profits minus the increase in assets net of any increase in liabilities is the company’s increase or decrease in cash flow. It is imperative to remember that cash flow, not profits, will drive the success of the business. Let us demonstrate these concepts in another case study.
CASE 2:
MDO PRODUCTS, INC.—START-UP FINANCING
MDO is contemplating a new business to make circuit boards for a home automation system. In keeping up with developments in the industry, they have become aware of newly developed equipment that, while expensive to acquire, will permit them to be highly responsive to different design specifications, while doing so more economically than current competitors.
Estimating Sales Pro forma financial statements are driven by the assumptions made regarding future sales. To increase the validity of the sales forecast, MDO must study the market, sales in their product niche, recent rate of growth of these sales over the last few years, as well as the competitive situation and the competitive advantage of their product. Marketing plans must be developed
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that, within available funds, provide the quickest route to becoming a market force. MDO Products’ sales forecasts for the next 3 years are shown in the following table, with projected dollar sales reflecting an average unit sales price of $125. The founders’ personal assets are sufficient that, by their signing personal guarantees, the bank will lend the firm an increasing amount over the next 3 years at 12% interest. The bank would lend $100,000 in the first year, another $50,000 in the second year, and an additional $50,000 in the third year. MDO will be required to pay interest only on what has been borrowed to date.
Year 1 Year 2 Year 3
Projected unit sales
Projected $-sales
Year-end loan balance
12% interest expense
2,000 3,200 4,800
$250,000 $400,000 $600,000
$100,000 $150,000 $200,000
$12,000 $18,000 $24,000
Examining Operating Expenses Operating expenses include such expenses as the cost of acquiring the product or the expenses related to marketing and distributing the product. MDO will want to classify these expenses according to those that do not vary as sales increase or decrease (fixed operating expenses) versus those that change proportionally with sales (variable operating expenses). The fixed production costs for MDO are expected to be $100,000 per year, while the fixed overhead expenses (marketing expenses and administrative expenses) should be about $50,000. Thus, annual operating costs are $150,000 before a single unit is sold. The variable costs of producing the automation circuitry will be around 20% of dollar revenues (sales), and the variable marketing expenses will be approximately 30% of dollar sales. In other words, given an expected $125 sales price, the combined variable costs per unit, for both producing the circuitry and for marketing it, will be $62.50.
Forecasting Profits A company’s profit is a primary source for financing future growth. The more profitable a company, all else being constant, the more funds it will have for growing the firm. Thus, a basic awareness of the factors that drive profits is necessary to make the needed profit projections. Let us return to
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MDO to demonstrate how we would estimate a new venture’s profits in future years. The entire financial forecast hinges on the sales forecast. The variable costs and many of the asset levels are dependent on the level of sales achieved. The sales forecast is thus the most important part of the financial forecast. In forecasting sales it is important to thoroughly understand your market, the competition, and competitors’ responses to your actions. For simplicity in the MDO example here, we do not develop a sales forecast but merely assume a 60% and 50% increase in sales over the 2 years of the forecast. Variable costs increase with sales. Sometimes the relationship is linear and sometimes it is not, for example, where increases in quantity sold lead to lower per unit costs. It is important to understand and model the exact relationship between variable costs and sales in the financial projections to have an accurate forecast of cash flows. Variable production costs add to the cost of goods sold, decreasing gross margin in the income statement. Interest expense: When borrowing money, the borrower agrees to pay a fixed interest rate on the loan principal. For instance, a simple interest loan for $100,000 for a full year at 12% interest, would result in interest expense of $12,000 for the year (12% $100,000). Few loans are simple interest loans, and interest is usually calculated as a percentage of the declining loan balance, which means interest expense will decline over time. Again, for simplicity in the MDO example, we assume a simple interest loan. Taxes: The firm’s taxes are, for the most part, a percentage of taxable income, where the rate increases as the amount of income increases. Assume the income tax rate will be 25%, that is, taxes will be 25% of earnings before tax (taxable income). We may now forecast MDO’s profits: MDO Products, Inc. Projected income statements
Year 1
Year 2
Year 3
Sales Cost of goods sold Fixed costs Variable costs (20% of sales) Total cost of goods sold Gross profits
$250,000
$400,000
$600,000
Line 1
$100,000 50,000 $150,000 $100,000
$100,000 80,000 $180,000 $220,000
$100,000 120,000 $220,000 $380,000
Line Line Line Line
2 3 4 5
OPERATING EXPENSES Fixed expenses Variable expenses (30% of sales) Total operating expenses Operating profits
$50,000 75,000 $125,000 $25,000
$50,000 120,000 $170,000 $50,000
$50,000 180,000 $230,000 $150,000
Line Line Line Line
6 7 8 9
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Interest expense (rate 12%) Earnings before tax Taxes, 0 if neg. earnings, else 25% of earnings before tax
12,000 $37,000 0
18,000 $32,000 8,000
24,000 $126,000 31,500
Line 10 Line 11 Line 12
Net income
$37,000
$24,000
$94,500
Line 13
The following steps were taken to project MDO’s net income for the next 3 years: We first compute the expected cost of goods sold (line 4) and the operating expenses (line 8) for the given level of sales. Subtracting these costs and expenses from the firm’s sales gives us the company’s operating profits, or earnings before interest and taxes (line 9). The final computation involves estimating income taxes, where the taxes are 25% of earnings before tax. However, we have a small complication resulting from the $37,000 loss in year 1. Typically, when a company has a loss from its operations, the tax laws allow us to use the loss against any income in other years. To keep things from becoming too complicated, we shall assume that we simply do not have to pay taxes when we have a loss. The result of all our computations suggests that the firm will lose money in year 1 in the amount of $37,000, followed by positive net income in years 2 and 3 of $24,000 and $94,500, respectively. We have completed our first task, that of projecting the firm’s future profits. Let us now turn to the second issue: determining the firm’s breakeven point, an issue of concern to any investor in our company.
BREAK-EVEN ANALYSIS At what sales volume will we insure that there are no operating losses (correspondingly, zero operating profit)? This is called the firm’s break-even point, where sales revenues exactly cover their operating costs and expenses. A significant advantage of some business ideas is that the venture can break even at what seems to be an easily achievable volume. A technique for quantifying that volume, called break-even analysis, examines the interaction among fixed costs, variable costs, prices, and unit volume to determine the combination of elements in which revenues and total costs are equal. Fixed costs are those expenses necessary to keep the business open and are not impacted by sales volume. They will include such things as rent, basic telephone expenses and utilities, wages for core employees, loan or lease payments, and other necessary expenditures. An entrepreneur should also include a living wage for himself/herself as a fixed cost.
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Variable costs include those expenses that change as a result of sales volume. This can be a relatively simple relationship, as in cost of goods sold, where, for example, the variable cost of our average $125 circuit board is $62.50. Variable costs can also be very complex; for example, higher sales in one area of our business may increase long distance charges. Labor costs may be fixed for full-time employees, then, as sales increase, some overtime is incurred until additional personnel can be justified. Generally, a break-even analysis focuses on a relatively narrow range of sales volume in which variable costs are simple to calculate. The variable cost in a coffee shop is simply the cost of goods sold. For a pizza delivery operation, it might be the cost of ingredients and some cost allocated for operation of the delivery vehicle. A general term often used for the difference between selling price and variable cost is ‘‘contribution margin,’’ or the amount that the unit sale contributes to the margin available to pay fixed costs and generate profit. For example, at MDO, we estimated fixed production costs at $100,000 per year and fixed annual overhead expenses at $50,000. In addition, each item that we sell, at an average of $125, introduces a variable cost of $62.50 to produce and market. Contribution margin, i.e., the amount that a unit sale contributes to the margin available to pay fixed costs and generate profit, is then: Contribution margin ¼ Difference between selling price and variable cost ¼ $125 $62.50 ¼ $62.50 At break-even, our sales just cover fixed costs, that is, contribution margin extended over the break-even sales level is equal to fixed costs. Expressed to solve for that sales level: Break-even sales ¼ (Fixed costs)/(Unit contribution margin) ¼ $150,000/$62.50 ¼ 2400 units Sometimes the break-even calculation is not so simple, for example, if the business has a number of products with different variable cost percentages. In this case the break-even dollar level of sales can be calculated as: Break-even dollar sales ¼ Fixed costs/Contribution margin percentage Assume that the average contribution margin for MDO for a variety of products is 50%. The break-even volume of sales would then be: $150,000/0.5 ¼ $300,000 annual sales Break-even analysis can be used in helping the entrepreneur better understand the relationship of the financial factors involved in measuring the feasibility of a proposed venture. From a preliminary analysis of selling
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prices that the market will bear, prevailing costs, and reasonable expectations of sales volumes, the entrepreneur can avoid making serious mistakes and may discover significant opportunities. It is important to recognize that the break-even point is a moving target. As the firm grows, fixed costs will invariably increase, increasing the required break-even level. Each new employee needs a desk, computer, and other fixed costs associated with his or her job. This raises the actual level of fixed costs, which will increase the break-even point. Getting the business past its break-even point is a significant milestone in the development of a venture. If reaching this point took longer than forecast, strains on the amount of working capital remaining may have to be addressed. Even though the days of losing money may be over, the accumulated losses remain from the period before reaching this point.
ESTIMATING ASSET REQUIREMENTS Profits are only part of the financial needs picture. We must also estimate how much it will cost to acquire the assets needed to start the business and to assure a basis for the growth needed to sustain it. A minimum level of inventories is usually required to start the business. From there, inventory increases are generally funded within the normal course of a growing business. Equipment and other assets may be needed to start the business, though acquisitions to address growth can be staged. If the firm is a food store, for example, planning must provide for the store building, cash registers, shopping carts, inventory, office equipment, and other items required in this type of operation. The store building is an item where there are considerable economies to starting with a size that accommodates some projected growth; additional registers, carts, etc., may be added as business increases. A firm’s assets are generally classified into one of three categories: current, fixed, and other assets.
CURRENT ASSETS Current assets comprise the assets that are relatively liquid; that is, within the firm’s operating cycle these assets will be converted into cash. The current asset items mainly include cash, accounts receivable, and inventories. Current assets represent the company’s working capital. Also, the term circulating capital is sometimes applied to these three items, emphasizing the constant cycle from cash to inventory to receivables to cash, and so on. Careful planning is needed to provide adequate current asset capital for the new business.
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Cash. Every firm must have the cash essential for current business operations. Also, a reservoir of cash is needed because of the uneven flow of funds into the business (cash receipts) and out of the business (cash expenditures). The size of this reservoir is determined not only by the volume of sales, but also by the regularity of cash receipts and cash payments. However, since cash is a non-income producing asset, there is a limit as to how much cash we want to keep on hand. Accounts receivable. The firm’s accounts receivable consist of payments due from its customers. If the firm expects to sell on a credit basis—and in many lines of business this is necessary—provision must be made for financing receivables. The firm cannot afford to wait until its customers pay their bills before restocking its shelves. Inventories. Although the relative importance of inventories differs considerably from one type of business to another, they often constitute a major part of current assets. Seasonality of sales and production affects the size of the minimum inventory. Retail stores, for example, may find it desirable to carry a larger-than-normal inventory during the Christmas season. Prepaid expenses. When starting a company, we may need to prepay some of the expenses. For example, insurance premiums may be due before the business actually opens, or utility deposits may be demanded before the electricity at the business can be turned on. For accounting purposes, these expenses are recorded as current assets and then expensed during the year as used. Each of these expenses may be small individually, but together they can be quite substantial.
A Little More on Cash: Liquidity Concerns Liquidity is the ability of a business to meet maturing financial obligations as they come due. A conventional measurement of a company’s liquidity is its current ratio, which merely compares the firm’s current assets (mainly cash, accounts receivable, and inventories), to its current or short-term debt (shortterm liabilities). The current ratio is measured as follows: Current ratio ¼ current assets/current liabilities
FIXED ASSETS Fixed assets are the more permanent-type assets that are intended for use in the business, rather than for sale. Fixed assets needed in a new business might include machinery and equipment, buildings, and land. For example, a delivery truck used by a grocer to deliver merchandise to customers is a fixed asset. In the case of an automobile dealer, however, a delivery truck to be sold in the ordinary course of business would be part of the inventory and thus a current asset.
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The nature and size of the fixed-asset investment are determined by the type of business operation. A modern hair salon, for example, might be equipped for around $80,000, whereas a motel might require 50 or more times that amount. In any given kind of business there is a minimum quantity or assortment of facilities needed for efficient operation. It is this principle, of course, that excludes small business from automobile manufacturing and other types of heavy industry. A firm’s flexibility is inversely related to its investment in fixed assets. Investments in land, buildings, and equipment involve long-term commitments, underscoring the importance of a careful estimation of fixed-asset needs at the business planning stage.
OTHER ASSETS The third category of assets is classified as other assets, and includes such items as intangible assets, often including patents, copyrights, and goodwill. For high-tech start-ups, patents may represent a significant percentage of initial assets. This category can also include organizational costs—costs incurred in organizing and promoting the business. Such start-up costs are shown as ‘‘other assets,’’ and the amount may be converted to expenses over multiple years. Finally, other assets can comprise investments made, but not actually used in operating the business. For instance, the company might acquire long-term investments in stocks or land that is being held for speculative motives.
INDIRECT INCREASES IN ASSETS Some short-term assets increase spontaneously as the firm grows. These sources will increase as a natural consequence of the firm’s sales increasing. For instance, as sales increase, accounts receivable or cash will naturally increase. As sales increase, the firm purchases more inventory and inventory rises, if not linearly at least spontaneously with sales.
CAPITAL REQUIREMENTS AS PERCENT OF SALES Asset needs tend to follow sales increases. Given that we have estimated our future sales with some degree of accuracy, a ratio of assets to sales is often used to estimate asset requirements. We can roughly estimate asset requirements by applying standard industry average percentages to our sales forecast. RMA, Dun & Bradstreet, Inc., banks, trade associations, the Small Business Administration, and other organizations compile industry standard
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norms for numerous types of businesses. If no standard data can be located, then estimating capital requirements inevitably involves common sense and educated guesswork. The key to effectively forecasting asset needs in this way depends on an understanding of the relationship between projected sales and assets. The amount of a firm’s sales is the primary driving force of future asset needs. We need sufficient assets to produce goods in sufficient quantity to meet sales forecasts. This is not an endless ramp but applies within a range of output. A minimum investment in assets to open the business can generally be identified. We must be above some efficient sales volume for these relationships to be valid; below this, outsourcing may become more attractive. Sales forecasts can then be related to additional assets required. Above some sales volume, economies of scale may suggest other approaches. While the asset-to-sales percentage will vary over time, and even among the various firms within an industry, the relationship tends to vary within a relatively narrow range. For example, the asset-to-sales relationship for grocery stores is on average around 20%, compared with about 65% for an oil and gas company. We may also use this method to project the individual asset investments. For instance, we can expect there to be a relationship between the amount of accounts receivable and sales. The Cajun Yachts case discussed later illustrates the use of percentage of sales forecasting, but first we must talk about the right-hand side of the balance sheet.
ESTIMATING THE LIABILITIES AND EQUITY CURRENT LIABILITIES Just as some current assets increase spontaneously with sales, so do some current liabilities. As the company orders more inventory, accounts payable will automatically increase. As sales volume rises, income will also rise, which increases the accrued tax liability. As more labor is employed, wages payable automatically go up. In effect, these spontaneous increases in short-term liabilities provide a spontaneous source of financing for the firm.
LONG-TERM DEBT Spontaneous increases in short-term liabilities can be augmented with increases in longer-term debt. There is a limit as to how much debt a firm can use in financing the business, however. In general, the amount of total debt, both short-term and long-term, is limited by the amount of equity
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invested in the business. If the entrepreneur does not make a conscious decision about the split between debt and equity, the bank will do it for him.
EQUITY The equity ownership of a company comes initially from the owners making an investment in the firm. We think of these funds as external equity; that is, they come from outside the business itself. After the company has begun operations, additional equity may then come either from the owners investing more in the business or from profits, in whole or part, being retained within the company for future growth. The retention of profits within the company for investment purposes is called internal equity or retained earnings. These funds come from reinvesting the company’s profits into the business—money that could have been distributed to the owners, but instead was reinvested for them. For the small firm, internal equity is the primary source of equity. In summary, a firm’s financing requirements, the money needed for operating and growing the company, come from several sources: external financing, either from borrowing money (debt capital) or from the owner’s investment (equity capital); sources of spontaneous financing, such as accounts payable and accruals; and internal financing, which comes from the profits retained within the business, rather than being distributed to the owners.
CASE 3: CAJUN YACHTS, INC.—START-UP FINANCING Helen Bougere is planning to start a new business to produce pirogues and other small fishing boats. After studying similar companies in southwest Louisiana, she believes the business could generate sales of approximately $250,000 in the first year and has significant growth potential in future years. Helen has searched for a manufacturing facility and has found a building suitable for the needs of the business that is currently available at a reduced price, owing to a recent real estate downturn. The building, along with the necessary equipment, will cost about $50,000. Based on her investigation of the opportunity and industry norms, she has made some projections, which follow. The requirements for cash, accounts receivable, and inventories have been estimated as percentages of sales (5%, 10%, and 25%, respectively) according to industry norms. Given anticipated sales of $250,000 and the asset-to-sales relationships, dollar values can be established for these components and total current assets. The fixed asset requirement for Cajun Yachts, Inc. was established by Helen’s purchase of the building and equipment.
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Cajun Yachts, Inc.
Assets Cash Accounts receivable Inventories Total current assets Fixed assets
Percentage of annual sales
Actual, based on $250k sales
5% 10% 25% 40%
$12,500 25,000 62,500 $100,000 50,000
Total assets
Notes
Real estate and machinery (Estimated market price)
$150,000
Thus, we forecast investment in assets at $150,000, some immediately and the rest as the firm continues in its first year of operation. While these amounts are only rough approximations, the estimates should be relatively close if we have identified the asset-to-sales relationships correctly and if sales materialize as expected. Earnings after taxes, with competitive pricing, will be about 12 % of sales; thus $250,000 of sales should result in after-tax profits of $30,000 (12% $250,000). By relying on the relationship between assets and sales, we have provided a way to estimate the firm’s asset requirements. We must now estimate how those asset investments will be financed.
Initial Investment and Spontaneous Financing Helen will invest $40,000 in the venture in return for 20,000 shares of common stock. By year end the firm’s equity should be around $70,000— $40,000 of the original investment in the company, plus $30,000 projected profits after taxes that is to be retained. Cajun Yachts has negotiated with a supplier to extend credit on inventory purchases; as a result, it is expected that accounts payable will average about 8% of sales. Accounts payable: (8% $250,000 sales) ¼ $30,000. Accruals, such as larger amounts in the various accounts awaiting payment, should run approximately 4% of annual sales. Accruals: (4% $250,000 sales) ¼ $10,000.
Bank Financing and Conditions The bank will finance 70% of the building to be used in manufacturing and warehousing the firm’s product ($35,000 of the $50,000 cost) with the building serving as collateral for the loan; the loan will be a 25-year mortgage. The bank has agreed to provide a short-term line of credit of $20,000 to Cajun Yachts. The firm can borrow up to this amount as the need arises,
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using it for buying inventory and extending credit to customers during the active spring and summer months, and paying down during the slack winter months. As conditions for the bank agreeing to loan the money to Cajun Yachts, Inc., the banker would impose two loan restrictions. Failure to comply with either of these terms would result in the bank loans coming due immediately. The firm’s current ratio (current assets/current liabilities) should not fall below 1.75, and no more than 60% of the firm’s financing should come from debt, including both short term and long term; that is, total debt relative to total assets should not be greater than 60%.
Revised Financing Plan Based on the foregoing information, we may now formulate the projected debt and equity section of the balance sheet for Cajun Yachts, Inc., which also reflects the financial requirements for the firm for the first year of business. These are shown in the balance sheet below.
Cajun Yachts, Inc.: Projected Balance Sheet: Year End Current assets Cash Accounts receivable Inventory Prepaid expenses Total current assets
Liabilities $12,500 25,000 62,500 0 $100,000
Fixed assets
$20,000 10,000 15,000 $45,000
Long-term debt
Equipment Buildings Land
50,000 0 0
Total fixed
$50,000
Other assets Investments Patents Total other Total assets
Current debt Accounts payable Accruals Credit line Total current liabilities
Long-term notes Mortgage
0 35,000
Total long-term
$35,000
Total debt
$80,000
Capital 0 0 $0 $150,000
Common stock Retained earnings Total equity Total debt þ equity
$40,000 30,000 $70,000 $150,000
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The amount of the line of credit is a plug figure to make the balance sheet balance. In effect, by balancing the balance sheet we have forecast our line of credit need for the year. Note that if all goes as planned, Cajun Yachts will be able to satisfy the banker’s loan restrictions, both in terms of the current ratio and the debtto-total asset relationship. From the balance sheet, we can compute these ratios as follows: Current ratio ¼ current assets/current liabilities ¼ $100,000 $45,000 ¼ 2.22 Debt ratio ¼ total debt/total assets ¼ $80,000 $150,000 ¼ 53.3% Hence, the current ratio of 2.22 exceeds the minimum requirement of 1.75, and the debt ratio of 53.3% is within the maximum limit of 60%. Both outcomes would more than meet the bank’s requirements.
SUMMARY Adequate capital is needed to start up a business, provide cash to cover costs of doing business, such as equipment, inventory, and accounts receivable, and to allow for operating losses on the way to becoming a profitable enterprise. Expansion opportunities or a chance to purchase cost-saving equipment can also create a need for extra capital. Financing comes from two basic sources: debt and ownership equity. Top entrepreneurial companies use varying combinations of debt and equity. They determine which is the most advantageous for the particular stage of growth they are financing. Customers and suppliers can be sources of financing, as can bootstrapping—doing more with less. As smaller ventures mature, debt financing becomes a viable option. Commercial banks are the most frequent lenders. Key questions to consider before requesting a loan would include: . . . . .
How much money do you need? How much debt does your current financial worth support? Can you borrow it, thereby retaining full ownership of the company? What is the highest amount of debt with which you would be comfortable? How risky is the venture?
Loans can be classified as either short- or long-term. Short-term needs are generally those of up to 1 year; long-term needs are those of more than 1 year. Even within this basic classification, numerous options are available as to payment schedules, provision of collateral, etc.
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To raise capital for your new business, you should be able to first determine how much capital you will realistically need. Others evaluate your proposal based on the ability of the business to generate profits. Minimizing total capital requirements, shortening time to break even, long-term growth potential, etc., all relate to how quickly and how high you can grow profits; these functions include holding down costs, growing ‘‘smartly,’’ and seizing opportunities. Forecasting a company’s profits, and for many, determining when it will achieve a break-even point, is a critical component of the financial proposal, basically an income statement perspective. Equally important is the amount of assets required to create the infrastructure to generate these profits, the corresponding balance sheet perspective.
DISCUSSION QUESTIONS 1. In most cases the firm’s financial needs forecast, as expressed in the pro forma financial statements, depends on the sales forecast. How would you go about forecasting sales for a new venture? What steps can you take to improve the accuracy of your forecast? 2. Banks will typically impose covenants, restrictions on a firm’s behavior, before granting a loan to reduce their risk. What types of covenants might a bank impose? Are there costs to the firm associated with these covenants? 3. What are the pros and cons of financing a start-up with debt? With equity? Does one source of financing seem to dominate the other? 4. Calculate the cost of trade credit with the following terms: 3/10 net 60. Do you think the firm should forego the discount as a source of credit? Why or why not?
CASE 2.1 NEW TECH (B): HOW MUCH DO THEY NEED? INTRODUCTION How much growth capital will New Tech Distributors need to finance its future growth? Stuart Chip, founder and owner of New Tech Distributors Corp., wants to take his company to a higher level. He is very optimistic about New Tech’s expansion program and its capability for producing power modules. He realizes that the key to New Tech’s future growth and success is to produce and sell a new line of highly profitable power modules that can provide New Tech with higher margins and improved financial performance. He feels that the market for power modules is growing rapidly
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and this is the right time to expand. However, Stuart needs growth capital to build new production facilities, market the new line, and fund ongoing operations. See Appendix 2.1 for projected financial statements and other forecasts.
THE CHALLENGE: DETERMINING NEEDS Stuart asks Elizabeth Pratt (New Tech’s in-house accountant) to take the lead in this project. However, because of the importance and complexity of this proposal, he wants Elizabeth to get as much information as possible from the company’s management team to help her in preparing the first draft of the investment proposal. Elizabeth turns to you for assistance in developing the initial forecasts. Elizabeth realizes that potential investors will be asking questions about the assumptions used in producing the financial projections. Investors will also want to explore the assumptions used by management to determine their sales revenue and expenses. She produces a list of key assumptions (see Appendix 2.3).
THE CHALLENGE: FINANCIAL PROJECTIONS Cost of a New Production Facility New Tech will need to build a new production facility to house the new product line. Building a production facility for the new line will cost $1,100,000 in 2001. The company will also need $225,000 in marketing funds to launch the new product line successfully in 2001.
Working Capital Requirements Elizabeth calculates that the 30% increase in sales revenue in 2001 would require additional investments in working capital of $200,000. As the table below shows, the working capital requirements break down this way: $100,000 will be invested in accounts receivable, $75,000 in inventory, and $75,000 in other current assets. This $250,000 will be partly financed by a $50,000 increase in accounts payable, leaving a requirement of $200,000. Accounts receivable Inventory Other current assets Increase in current assets Less: accounts payable Net change in working capital
$100,000 $75,000 $75,000 $250,000 $50,000 $200,000
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Earnings The company paid a dividend of $50,000 in 2000. The amount of dividends going for the future has not been determined at this time, so you will need to make an assumption about dividends going forward.
Break-Even Point Another element of the proposal that Elizabeth feels is important to calculate is New Tech’s break-even point. Before making this calculation, Elizabeth had to discuss with the production manager the level of production required to cover the fixed and variable costs associated with the new line. To calculate the break-even point, she needs information about the expected unit selling price, expected sales volume, and the marketing variable and fixed costs. She also had to go through each item on the income statement and classify all costs under two categories: variable and fixed. After going through this exercise with the management team, she figured out that, in 2001, total variable costs would amount to $1,250,000 and fixed costs, to $2,334,000. She uses the information to determine the amount of revenue that would be required for the company to break even over the forecast period.
THE SOLUTION: FINANCIAL NEEDS How much money does New Tech need to raise? Elizabeth estimates that New Tech will require the following funds to launch the new line immediately: Equipment to produce new line (fixed assets) One-time marketing costs (selling expense) Ongoing operations (working capital) Financial cushion
$1,100,000 $225,000 $200,000 $50,000
Total financial needs
$1,575,000
Your Assignment Using the assumptions given in the case, your task is to forecast the income statements and balance sheets for the next 5 years. Make sure to make the balance sheet balance each year. If assets are less than liabilities and equity, use the Marketable Securities account to hold the extra assets. If assets are greater than liabilities, use the Term Loan as the balancing item. Is $1,575,000 New Tech’s total need for external financing? What is the break-even level of sales in 2001? When do you estimate New Tech will hit break-even? Make sure you list all assumptions that were necessary to develop your forecast.
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Using the results of the ratio analysis (discussed in Appendix 2.2) along with your pro formas and break-even analysis, can New Tech make a strong case for a loan to cover all its financial needs?
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APPENDIX 2.1 NEW TECH (C): FINANCIAL STATEMENTS INCOME STATEMENTS The income statement shows New Tech’s actual performance for 2000. New Tech Distributors Corp. Income Statements ($000)
2000 Actual
Sales revenue Cost of goods sold Purchases Freight Labor Depreciation and amortization Utilities, insurance, etc.
3,000
Total cost of goods sold
1,185
Gross margin
1,815
610 60 380 110 25
Selling expenses Salaries Commissions Travel Advertising Depreciation and amortization Special promotional program
620 60 60 70 30 17
Total selling expenses
857
Administrative expenses Salaries Leasing Depreciation and amortization Research and development
395 50 60 50
Total administrative expenses
555
Total operating costs
1,412
Operating income Interest income Interest charges Income before taxes Income taxes
403 5 95 313 109
Income after taxes
204
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New Tech Distributors Corp. Statements of Retained Earnings ($000)
2000 Actual
Retained earnings (beginning of year) Net earnings for the year Subtotal Dividends
500 204 704 50
Retained earnings (end of year)
654
BALANCE SHEETS The balance sheet shows New Tech’s financial structure at the end of 2000. New Tech Distributors Corp. Balance Sheets ($000) Assets Current assets Cash Marketable securities Prepaid expenses Accounts receivable Inventory Other assets Supplies, etc.
2000 Actual
20 100 60 450 350 70 84
Total current assets
1,134
Capital assets Gross capital assets Accumulated depreciation
1,775 560
Total net capital assets Goodwill Other assets
1,215 45 5
Total assets
2,399
Current liabilities Accounts payable Term loan Working capital loan Accruals Current portion of long-term debt
550 125 50 60 30
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Total current liabilities
815
Total long-term debts
400
Total liabilities
1,215
Owners’ equity Capital shares Retained earnings Total owners’ equity
530 654 1,184
Total liabilities and owners’ equity
2,399
APPENDIX 2.2
NEW TECH (D): FINANCIAL RATIOS
One way to define and measure a company’s performance is with financial ratios. Calculate the following financial ratios for each year in the forecast. Is New Tech’s performance improving or deteriorating? Use the industry averages in Table 2.2, and the starting point in 2000 as your basis for comparison.
LIQUIDITY RATIOS Does the company have sufficient cash and near cash to pay its bills and payroll on time? 2000 Actual Liquidity Ratios Current ratio (times) Quick ratio (times) Sales/accounts receivable COGS/inventory COGS/accounts payable Sales/working capital
1.39 0.96 6.67 3.39 2.15 9.40
LEVERAGE RATIOS What is the proportion of a company’s debt versus equity? These ratios display the methods and sources of financing used in acquiring assets and their impact on the earnings available to shareholders. Is the company accumulating too much debt as it moves forward? Note that we can assess the impact of debt by focusing on the income statement as well as the balance sheet.
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2000 Actual Leverage Ratios Total debt/total assets (percent) Long-term debt/equity (times) EBIT/interest expense
50.65% 1.03 4.24
PROFITABILITY RATIOS Is the business generating a sufficient return on its investments? These ratios show the relationship between profit and revenue generated, resources employed (assets), and shareholders’ equity. Do the company’s profitability ratios look adequate to you? 2000 Actual Profitability Ratios % Gross margin to sales Operating income/sales Profit before taxes/sales Profit before tax/total assets (percent) Profit before tax/equity
60.50 13.43 10.43 13.05 26.44
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APPENDIX 2.3
NEW TECH (E): KEY ASSUMPTIONS
This is a list of the most important quantitative assumptions that New Tech used to develop its financial projections.
New Tech Distributors Corp. Key Assumptions (Base Case) 2000 Actual Sales revenue Annual sales growth Sustainable growth (beyond 2002) General and administrative expenses Research and development expenses Depreciation and amortization Income tax rate Fixed assets addition Interest rates Working capital loan Excess cash and marketable securities Term loan
$3,000,000 15.0% 15.0%
2001 Forecast 30.0%
2002 Forecast 20.5%
$445,000
$490,000
$555,000
$50,000
$100,000
$100,000
$200,000
$325,000
$375,000
35.0% $200,000
35.0% $1,100,000
35.0% $740,000
7.0% 4.0%
7.0% 4.0%
7.0% 4.0%
10.0%
10.0%
10.0%
BIBLIOGRAPHY Banking Liason Group Ltd., ‘‘Bank’s Lending Criteria,’’ http://www.bankexperts.co.uk/campari. htm. Brigham and Daves, Intermediate Financial Management, ed 7, Dryden Press, New York. Inc.com, ‘‘A Hitchhiker’s Guide to Capital Resources,’’ http://www.inc.com/articles/finance/ capital/banking/869.html. Knowledgequest Education Group LLC, ‘‘A Short Primer on Business Financing,’’ http:// www.kqventures.com/bfp/main.html. Minority Business Development Agency, http://www.mbda.gov/. Morebusiness.com, ‘‘Running Your Business: Financing Guide,’’ http://www.morebusiness.com/ running_your_business/financing. Myers, Stewart C., ‘‘The Capital Structure Puzzle,’’ Journal of Finance, 34(3), 575–592, 1984. Timmons, Jeffry A., New Venture Creation Entrepreneurship for the 21st Century, ed 5, IrwinMcGraw-Hill, Chicago, 1999.
Chapter 3
Alternatives in Venture Financing—Early Stage Equity Capital
CHAPTER GOALS This chapter will introduce you to: . equity financing alternatives beyond friends and family but before formal venture capital . angel market . various programs offered by the Small Business Administration . issues and perspectives involved in negotiation with an equity investor . the effect of stage of firm development on the valuation of the firm . financing choices at the various stages . an actual business plan used as a request for funding
INTRODUCTION This chapter begins with a broad overview of the equity financing process. We will introduce the alternatives for equity financing available and focus on angel investors. Venture capital, while introduced here, will be developed further in Chapter 6. Public equity sales will be covered in Chapter 7. Equity capital ranges from owner-invested funds at start-up to stock sales on organized stock exchanges. Equity can be divided into private equity and public equity. Public equity involves any sale of stock on a formal stock exchange. In a public sale, investors typically do not know the founder or management team and are purely financial investors. Private equity, on the other hand, is any investment made in exchange for ownership shares in a
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company whose shares are not traded on a stock exchange. Typically, a private equity investor is at least somewhat familiar with the management team and may be actively involved in the company as an advisor, board member, or employee. All equity investors are looking for an appropriate risk-adjusted return on their investment. Given the risk of investing in an early-stage company, those returns can seem high by conventional capital market standards. Since few companies can provide the required rate of return solely through dividend distributions, some sort of ‘‘liquidity event’’ or exit strategy is generally called for to enable early-stage investors to sell their shares and realize a return on their investment. This is an important consideration for any entrepreneur contemplating a private equity offering. To provide the return your investors expect, at some point you will most likely have to sell the company one way or another. Only a very small minority of super-high-growth entrepreneurial ventures will ever make it to the public equity stage, however. While more options are available in private equity, the fact remains that there is a capital gap for firms that wish to raise growth capital but do not have the market share and revenue projections required for a public stock sale. A viable private business with steady growth prospects that needs to raise anywhere from a few thousand dollars to $2 million is susceptible to this capital gap. Without high growth prospects there is little chance of a public stock offering, which reduces the exit opportunities, for a potential investor. Without good exit opportunities, outside investors are reluctant to invest in the first place, which greatly reduces the company’s access to capital. For firms in this situation, slow and steady growth is the preferred operating strategy because it reduces the need for external capital and increases the likelihood that capital needs can be satisfied internally.
ANGEL INVESTORS After family and friends, the next source of equity capital for many entrepreneurs is high-net-worth individual investors, usually called ‘‘angels.’’ It has been estimated that angels invest in 50 times as many deals as venture capitalists, though in smaller amounts. In the United States (US) in 2002, approximately 300,000 angels invested $30 billion. This was down 33% from 2001.1 Both years are probably high by more historical standards. Longer-term estimates indicate that angels invest $10 to $20 billion per year in as many as 30,000 deals.2 Over the past several years, new venture capital investments 1
Friedman, Josh, ‘‘Angels Give Wing to Entrepreneur’s Ideas,’’ Los Angeles Times, February 17, 2003. 2 Sohl, Jeffrey E., The Early-Stage Equity Market in the USA, Venture Capital, Vol. 1 No. 2, 1999.
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have totaled around $12 billion per year. In the United Kingdom (UK), the next most active angel market, angels play a less important role but still provide significant capital to growing businesses. A 2001 Bank of England report cites the most recent estimates of 500 million pounds of angel investment relative to 6.2 billion pounds in venture capital in the UK.
EARLY-STAGE INVESTING Angel investment is impossible to quantify with any precision because no formal angel ‘‘industry’’ exists and solid statistics cannot be captured from this nebulous group. In an attempt to gauge the volume of early-stage investing usually associated with angels, Table 3.1 shows historical investment in seed and early stage firms by professional investors from 1995–2002. When angel investors were involved in a formal round of financing, their investment is included in the totals. The numbers in Table 3.1 include much more than angel investment, and any angel investment not part of a formal round of financing is excluded. The table does, however, illustrate the trend in early-stage financing, which should parallel the volume of angel investment over the last several years. Table 3.1 illustrates the relatively faster growth of early-stage investment relative to start-up investment by professional investors through 2000.3 Table 3.1 Early Stage Investing Activity By Year (Dollars in millions) Year Start-up/seed Number Early stageb Number Year Start-up/seed Number Early stage Number
1995 a
$1,331 443 $1,784 512 1999 $3,331 810 $12,135 1,718
% Change NA NA NA NA % Change
1996 $1,543 512 $2,853 772 2000
þ79% $3,152 þ13% 663 þ122% $26,233 þ67% 2,888
% Change þ16% þ16% þ60% þ51% % Change 5% 18% þ116% þ68%
1997 $1,341 529 $3,520 889 2001 $799 249 $9,267 1,277
% Change 13% þ3% þ23% þ15% % Change 75% 62% 65% þ56%
1998 $1,856 720 $5,474 1,031 2002 $303 148 $4,068 805
% Change þ38% þ36% þ56% þ16% % Change 62% 41% 56% 37%
From Price-Waterhouse-Coopers/Venture Economics/National Venture Capital Association: Money Tree Survey 2003. a Concept or development stage. Company usually less than 18 months old. b Product or service in testing or pilot, may have revenue. Company less than 3 years old. 3
Seed stage is defined as a business with a concept or product under development. Usually the company is less than 18 months old. Early stage companies typically have a product in testing or in a pilot, may have revenue, and are less than 3 years old.
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There is also a trend towards larger deals as the percentage increase in dollars invested outpaced the percentage increase in number of deals. Despite the more rapid run-up in early-stage firms through 2000, start-up firms suffered larger percentage declines when the bubble burst in 2001. Angels provide a bridge between friends and family financing and more formal venture capital. They partially serve the capital gap that is created by venture capital’s migration toward larger and larger deals. While there is no such thing as a ‘‘typical’’ angel, in the US 90% of angel investors are male and many are cashed-out entrepreneurs.4 An angel investor might be a successful entrepreneur, a professional (e.g., doctor or lawyer), or a person with inherited wealth. The Securities and Exchange Commission (SEC) provides a strict definition of who an angel can be financially, however. Angels must be ‘‘accredited investors,’’ which means that they have a net worth of $1 million, individual annual income greater than $200,000, or joint marital income greater than $300,000. The income requirements must have been met in each of the past 2 years and must be expected to continue. The reason for the accredited investor condition is an attempt to deal with the risk of these early-stage ventures. By limiting potential investors to persons of substantial means, the SEC is assuming that the individuals will have sufficient business savvy to evaluate the risks prior to investing.
IN PRACTICE Organizationally, angels can range from individual investors operating alone, investing in one deal a year, to highly structured LLCs that closely resemble venture capital partnerships. Historically it has been difficult for investors to locate angels because no records are kept of who they are, and most angels prefer to operate fairly anonymously. Identifying promising deals has likewise been difficult for investors. To reduce search costs and mitigate the inherent informational deficiencies in this market, angels are increasingly banding together into angel networks. Jeffrey Sohl estimates that in the past 5 years the number of angel networks in the US has grown from 50 to over 170.5 Angel networks typically organize under some form of legal structure, which ranges from loose to well defined, have either full- or part-time professional management, follow a standardized investment process, and have a web site to publicize their existence. Businesses seeking financing can submit a two-page business plan to the network’s web site for consideration. 4 Friedman, Josh, ‘‘Angels Give Wing to Entrepreneur’s Ideas,’’ Los Angeles Times, February 17, 2003. 5 Ibid.
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A team of members will scan the submissions and select the most promising ones for further investigation. Networks normally meet once a month to hear pitches from firms seeking financing. A usual meeting would involve three 30-minute presentations from entrepreneurs, with added time for questions and answers. What happens next depends on the structure of the network. In the informal networks, interested investors approach the entrepreneur and write a check directly to him or her. The network serves simply as a forum to reduce search costs, and any deals are done directly between interested investors and the entrepreneur. More formal networks have investors contribute an amount annually, say $50,000, into a common pool. The pool proceeds are then invested according to a majority vote of the investors. It is not uncommon for an angel to belong to several networks and invest occasionally on his own. Some networks allow investors to come and go freely, others run closed networks, demand dues, and require attendance at meetings. Angels’ relatively high tolerance for risk may stem from a desire to earn a greater return on their investment than more traditional investments can offer, their enjoyment of involvement in a rapid-growth venture, or a desire to offer their expertise to others. Many angel investors are entrepreneurs who want to give back by mentoring a new generation of entrepreneurs. The thrill of growing a company provides part of the reward they demand from investing. Overall, angel investors have a specific niche in the venture funding hierarchy. They generally provide seed or early-stage capital, in amounts ranging from $50,000 to $2 million. This level of financing is typically used to get the firm to the next major milestone, for example, product development or the signing of a major contract. Few angels would invest $2 million on their own in any one company, but by pooling their investment with other angels, they are able to offer larger amounts to early-stage ventures. Individual angel investments range from $10,000 to $500,000, with an average investment of less than $200,000. By investing through a network, larger sums can be aggregated for investment and angels can enjoy the benefits of diversification. Rather than investing $200,000 in a target company, the investor can invest $20,000 in 10 companies and achieve some degree of risk-reducing diversification. Currently the $2 million and under range is a funding range underserved by venture capital (VC) due to the high fixed costs of due diligence and monitoring undertaken by venture capitalists. The amount of time and money invested in checking out the claims in the business plan and monitoring and mentoring management is similar whether the investment is $250,000 or $10,000,000. Consequently, venture capitalists tend towards
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larger, later-stage investments given the fixed costs involved. Additionally, the rise in venture capital activity through the 1990s saw the size of many venture capital funds grow exponentially, while the number of partners in the funds did not keep pace. Consequently, VC funds were forced to migrate towards larger and larger deals due to human capital constraints. The marked decrease in venture capital activity that followed the burst of the dot.com bubble may result in a return to smaller funds doing smaller deals. For small businesses seeking relatively modest equity investments, however, angels can frequently provide all the investment that the business requires. Even angels need exit strategies.
CHARACTERISTICS Angels typically invest in technologies with which they are familiar. For example, an investor who made millions in software is more apt to invest in a technology or software company than a biotech start-up. Angels also tend to invest in businesses near their homes. The radius of interest in investing is usually a 1- to 2-hour drive from the investor’s home. This is to allow the investor to monitor and mentor the entrepreneur. National angel networks have met with limited success and probably can be expected to continue to do so, as effective monitoring requires a physical presence by the investor. Angel investors are usually willing to wait 5 to 7 years for a return on their investment. Most commonly, that return is realized through the sale of the business to another company. The required return is somewhat lower than that required by venture capitalists in early-stage deals. Required rates of return are in the 40% to 50% range, although realized returns tend to be somewhat lower than that. These returns are less than that required by venture capitalists for early-stage investments. While at first this seems counterintuitive, since the earlier-stage investing performed by angels is surely riskier that the later-stage investments made by venture capitalists, most angels invest at least in part for the thrill of being involved in an entrepreneurial venture. They mentor and develop the entrepreneur, which effectively reduces the risk of their investment. In addition, they share the benefits of their own experience and participate in the excitement of launching a new business. It seems for many angels it is not just about the money. The involvement of angels in target companies varies widely. Some angels will invest in only one or very few ventures at the same time, in order to be more directly involved as an advisor. Others use the start-up market as an alternative investment vehicle to the stock market and take a much more hands-off approach. Even for these angels, however, the chance of the ‘‘big hit,’’ the 1000% return on investment, makes the start-up market preferable to the stock market.
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Angels are generally less formal and less public in their approach to investing than venture capitalist. This can sometimes be a problem for the entrepreneur. It is not uncommon for an angel investor to back out of a deal at the last minute. Investors cite changes in their financial condition, lack of time, or ‘‘personal factors’’ as reasons for their change of heart. Angel investing is a much more personal, emotional type of investing than venture capital and can sometimes leave the entrepreneur high and dry at the worst possible time. Most angels are quite entrepreneurial themselves, with a ‘‘been there, done that’’ attitude toward the long hours required. In order to keep their entrepreneurial spirit alive, they choose to invest in promising new ventures rather than the stock market. Their approach is often to act in a mentoring role toward the venture team, while making sure they are nurturing the growth of their investment. Angels can frequently offer direct experience in an industry, broadly based business experience, and useful contacts in the financial and business community. In this part of their role, they can provide a greater sense of focus and direction to the venture team. Angels generally do not list themselves in directories or advertise for clients. Matchmaking services are available on the Internet, where entrepreneurs post business plans and investors scan them for ventures of interest. A simple search on the key words ‘‘angel investors’’ will lead to many of these services. The best way to find angel financing, however, is through networking, often through the entrepreneur’s business colleagues, accountants, and lawyers. Most angels are far too busy to randomly scan web sites for potential deals. In addition, a personal recommendation from a respected colleague serves as an initial screen of the prospective investment. In a market where search costs are high and informational asymmetries large, any action that reduces these costs helps the market to run more efficiently and increases the entrepreneur’s probability of finding funding.
OTHER SOURCES OF EARLY-STAGE FUNDING THE SMALL BUSINESS ADMINISTRATION One good starting point in looking for capital is the U.S. Small Business Administration (SBA). The SBA sponsors an angel network and a number of venture capital funds and manages grants issued by the federal government.
ACE-Net The Angel Capital Electronic Network, or ACE-Net, was initiated by the SBA’s Office of Advocacy in response to a 1995 White House Conference on
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Small Business. The White House conference issued a mandate to make funding more accessible to business start-ups and address the capital gap left by traditional venture capital firms. Today ACE-Net is an independent, notfor-profit network housed at the University of New Hampshire. This Internet-based network serves both small companies looking for investors and investors looking for promising investment opportunities. In the past 4 years ACE-Net has helped 2,500 entrepreneurs secure more than $4 billion in financing. ACE-Net provides networking opportunities to local and regional affiliates operating in 46 states and Puerto Rico. Regional offices are usually affiliated with universities or state entrepreneurial centers. Financings range from $250,000 to $5 million. ACE-Net has an educational and research mission in addition to its financial network. Among the resources provided, entrepreneurs may use short-forms developed by ACENet in collaboration with the SEC to facilitate fund raising in multiple states. In addition, ACE-Net’s attorneys are available to answer questions and provide guidance. ACE-Net succeeds by lowering the transaction costs of investing and servicing the capital gap faced by most start-ups.6
SBIC The SBA’s Small Business Investment Company (SBIC) program allows private investment partnerships (SBICs) to form venture capital funds by leveraging their initial investment capital with debt capital available to entrepreneurs through SBA guarantees. Created by Congress in 1958 to fill the capital gap impeding small business growth, SBICs are licensed and regulated by the SBA but are privately-owned and -managed investment funds. Essentially, an SBIC is a venture capital fund, regulated by the SBA and in return allowed to borrow backed by SBA loan guarantees. An SBIC may be started with a $5 million equity investment. Of the amount invested, 30% must be provided by investors unaffiliated with the manager of the fund. The equity contribution entitles the fund to borrow up to three times the amount of equity contributed, up to a maximum of $108.8 million. Loans to the SBIC are made by commercial banks but are guaranteed by the SBA. SBICs provide start-ups with equity investments, loans, and hybrid investments of debt and equity. From March 31, 1960 through March 31, 2002, SBICs invested $36.55 billion in over 130,000 companies. Slightly less than half of those financings were to firms 2 years old or less. Table 3.2 illustrates the role of SBICs within the venture capital market. SBICs tend to invest in smaller deals and at earlier stages than conventional venture capital firms. As Table 3.2 illustrates, SBICs provide funding to a 6
More information on ACE-Net can be found at their web site: http://www.ace-net.sr.unh.edu
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Table 3.2 SBIC Share Of Venture Capital Market 1997–2002 Number of financings
2002 2001 2000 1999 1998 1997
SBICs
Non SBICs
Total Venture Capital
SBIC % of Total
2,853 3,306 2,946 2,306 1,614 1,334
2,056 3,034 6,101 4,472 2,504 2,191
4,909 6,340 9,047 6,778 4,118 3,525
58 52 33 34 39 38
Dollar financing (in billions) 2002 2001 2000 1999 1998 1997
$2.28 4.02 4.56 4.72 3.01 2.08
$19.43 34.57 93.75 48.96 17.71 13.09
$21.71 38.59 98.31 53.68 20.72 15.17
11 10 5 8 15 14
Average dollar financing (in billions) 2002 2001 2000 1999 1998 1997
$0.80 1.21 1.55 2.05 1.86 1.56
$9.45 11.39 15.37 10.95 7.07 5.97
From SBA.
high percentage of firms seeking venture capital, but the dollar amount invested is a much smaller percentage of total venture capital.7
Grants The Office of Technology of the SBA administers two types of grants for federal agencies. With the intention of fostering innovation and invention, and recognizing that most innovation occurs in the small firm sector, the 7
More information on SBICs, including a list of SBICs, can be found at the SBA’s web site, http://www.sba.gov/INV
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federal government seeks to make funding available to high-tech start-ups for research and development. Each year federal agencies are required to set aside a portion of their annual research and development (R&D) budgets to be granted to small technology firms. Under the Small Business Investment Research (SBIR) program, 10 federal agencies award 2.5% of their annual R&D budgets to small firms. Awards of up to $100,000 are made to firms exploring ideas, so-called Phase I grants. Awards of up to $750,000 are made to firms acting upon the results of their exploration through Phase II grants. In 2001, the latest year for which statistics are available, over $300 million was awarded to firms in the idea exploration stage, and an additional $852 million was awarded to firms in Phase II. The Small Business Technology Transfer Research (STTR) grants target firms doing research for federal labs, universities and public agencies. In 2001 nearly $63 million was awarded through this program.
DIFFERING PERSPECTIVES Entrepreneurs seeking outside equity want to raise as much money as they can while giving up as little ownership as possible. Investors, on the other hand, strive to maximize their return on investment by putting in as little money as possible for the largest share of ownership. The percentage of the company given up in an external financing depends completely on the ‘‘post money’’ valuation of the company. The post money valuation is the value of the company, assuming that the required financing is provided and that the company achieves the forecasts in its business plan. Typically the post money valuation is calculated by taking net operating income at some point in the future, usually in year 3 or 5, and multiplying it by a multiple of earnings appropriate to the firm’s industry. The resulting number is discounted to the present at the investor’s required rate of return to arrive at the post money valuation for the firm. As an example, assume you are negotiating with an angel investor. The angel is willing to invest $250,000 in your company. With that money you both agree that you should be able to achieve net operating income 3 years from now of $300,000. If the multiple (and this is the key number) appropriate for your industry is five times earnings, this gives your business a time three valuation of 5 $300,000 ¼ $1,500,000. Assuming the angel wants a 40% return on his investment, the value today, or the post money valuation, of your business is: $1; 500; 00 ¼ $546; 647 (1 þ 0:40)3
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For a $250,000 investment the angel should receive $250,000/$546,647 ¼ 46% of your company. Few entrepreneurs would jump at the chance to relinquish so much ownership in exchange for so little investment, but what the example illustrates is that the entrepreneur must either generate more income to increase the company value or negotiate for a higher multiple. Both are difficult tasks. In establishing the valuation of the company, entrepreneurs tend to minimize the risk involved in growing the venture into a successful enterprise. Cash flow forecasts tend to be optimistic and the required rate of return relatively low. High cash flows and low discount rates result in high company valuations. Investors, on the other hand, tend to consider the risk more realistically and discount the value proposition accordingly. Thus there is often a wide discrepancy between what the entrepreneur thinks the company is worth and what the outside investor thinks. Entrepreneurs understand that at any valuation, the more funding they ask for, the higher the percentage of the business they will have to give up. Investors realize, however, that the financial agreement must leave company founders with enough ownership to provide incentive to make the business succeed. It is unusual for an outside investor to want more than 40% to 50% of the business. If the investor owns too much of the company, the entrepreneur is essentially working to maximize the investor’s wealth rather than his own, which is not terribly motivating for the entrepreneur! This limit to the ownership percentage places an automatic cap on potential financing. A business with a $5 million post money valuation would be unlikely to raise much more than $2 million from an outside investor. It is critical for an entrepreneur seeking external capital to assess the value of the company from the perspective of the close investor and to appreciate the dynamics of the entrepreneur/investor relationship. This relationship revolves around a tradeoff. Funds for growth are exchanged for a share of ownership. The entrepreneur will be asked to give up a large share of ownership of the company, possibly a majority stake. The outside investor seeks to value the venture to provide a return on investment commensurate with the risk taken.
VALUATION ISSUES The first step in addressing the differing perspectives of the two parties to the negotiation is to agree on a current value of the company. Different methods used to establish that value will be taken up in Chapter 5. In this chapter we will discuss some basic valuation issues. One of the most important factors in determining the value of a venture is the stage of development of the company when a prospective investor considers it.
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Companies typically follow some version of the following stages. . Development/Conception: The business is in the idea stage, has no customers, or is not yet able to provide the product or service being offered. At this stage the owner wears virtually all of the hats, and the owner and the business are indistinguishable. Financing at this stage comes largely from the owner. . Start-up: Facilities, equipment, and employees are acquired to commence production. Start-up costs lead to negative cash flows that are typically covered by the owner, friends, and family. . Early growth: The business has a demonstrated workable business model. Revenues may grow rapidly, but earnings and cash flow are negative. External capital is needed to finance growth. Angel investors may be added to the owner and friends and family at this stage. . Profitability and rapid growth: Retained earnings and debt finance rapid growth. External equity capital may be supplied by angels or venture capital. . Maturity: Cash flow is positive, and market penetration is good. There is no need for external financing. This is the stage at which the company may be sold to allow investors to harvest their investments. For any company at this stage, the challenge is keeping the entrepreneurial spirit alive while enjoying the benefits of positive cash flow and size.
A business with revenue, even if it is operating at a loss, will usually receive a higher valuation than a company with no product revenues, little expense history, and an incomplete management team. This is because the absence of one or more of these elements increases the risk associated with the venture. Each successive stage above commands higher valuations as the business achieves milestones, confirms the ability of the management team, and progresses in reducing fundamental risks. The best way for the venture team to build value in a company, once in operation, is to achieve the goals and milestones designated in the business plan within the projected time frames. As milestones are achieved, risk is reduced and subsequent rounds of financing can usually be raised at more attractive valuations. It will be helpful to understand the accepted ‘‘stages of growth’’ used by financing sources: Financing provided in the seed or concept and start-up stages is generally referred to as early-stage financing. For rapid growth companies, equity financing may then accelerate to first and second ‘‘rounds’’ of funding. Later stages for such companies are often called mezzanine and harvest.
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STAGES, OR ‘‘ROUNDS,’’ OF FUNDING GETTING ‘‘OFF THE GROUND’’ Seed or Concept Seed financing can be used to demonstrate the product or service and to get the venture to a scale where it becomes of interest to outside investors. If the business can achieve some self-sufficiency with this financing, or at least accumulate enough assets to acquire debt financing, equity financing beyond this level may never be required. This stage is characterized by an idea or a concept. The objective at this stage is to assemble some key management, refine the business plan, assess market potential in detail, and structure the company. The stage ends with the completion of a start-up business plan and the formation of the company. To finance seed and concept companies, the entrepreneur almost always starts with personal, relatives,’ and friends’ money and may then proceed to seeking informal investors (that is, angel financing). Traditional venture capital firms have little interest in funding a company at this stage. The risk level is too high, and the time for achieving a payout or harvest is hard to determine.
Start-Up Start-up is often characterized by there being one principal pursuing the project on a full-time basis. Milestones are being established, a management team is being built, market analysis is ongoing, and initial customers are being identified. More formal funding is being considered. The primary objective at this stage is to reach a comfortable and convincing level in achievement of objectives of the plan, formation of the management team, and measuring the market for the product or service. Companies at this stage commonly seek funding from angel investors, early-stage venture capital firms, and, in some cases, grants from foundations and government sources. Traditional venture capital firms may show an interest, assuming that a top-rated management team is assembled, patentability or proprietorship is proven, and rapid growth marketability is demonstrated.
RAPID GROWTH Funding a rapid-growth company generally means going to the venture capital marketplace. A practical minimum investment for venture capital firms, or VCs, is $3 to 5 million because of the considerable amount of due
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diligence required. VCs demand highly-developed business plans with detailed financial projections. VCs are usually more demanding than angels. Their objective is to take a significant amount of venture ownership, keep a close rein on the firm, and achieve returns far larger than typical investment vehicles. Exit strategies are highly dependent on the market for IPOs (initial public offerings), that is, the attitude of public investors toward buying stock in a relatively unproven venture. When the market for IPOs is hot, venture capital flows freely.
First Stage Typically, a company seeking first-stage funding is a going concern, though it may have experienced some setbacks. In the case of a product, operational efficiencies and some competitive advantages may have been demonstrated; for a service, it may have shown some degree of market acceptance. Goals at this stage are to achieve market penetration and initial sales goals, to reach break-even and beyond, increase productivity, reduce unit costs, and build the sales organization and the distribution system. Financing is often needed to improve processes and to support initial marketing efforts. At this stage, companies may have received some prior financing from bank loans and leasing companies. Sales, support, and supply agreements are often entered into at this stage with potential customers, service providers, suppliers, and manufacturers. Traditional VC firms are just beginning to show interest in investment; in fact, if the venture’s requirements exceed their minimum investment criteria, it is often their favorite phase in which to enter.
Second Stage As significant sales develop, so do assets and liabilities, and cash flow management becomes critical. Goals are to obtain consistent profitability, add significant sales, and expand the marketplace from regional to national, possibly evaluating international opportunities. Companies at this stage often receive additional funding from traditional venture capital firms and institutional investors.
MATURITY Mature companies seldom need additional cash. The company showing the potential to be a major success characterizes this stage. The management team is set. Processes are efficient to near optimal in all areas from design and development of second-generation products to marketing and distribution. Goals are to increase market share, look at international opportunities,
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and begin to think of ‘‘harvest’’ opportunities. Cash flow is no longer needed to fund rapid growth and thus becomes available for dividend distributions.
Mezzanine, or ‘‘Bridge’’ Stage Mezzanine, or ‘‘bridge,’’ financing is often a debt/equity hybrid used to allow the company to pursue the options in its exit strategy. If the company plans to go public within 6 months to a year, bridge financing will be structured to be repaid from proceeds of a public underwriting. It may also support a transition period to being acquired by one of the current owners or strategic partners, or selling out to another company. This financing can also support some restructuring of ownership distribution where there are early investors who want to reduce or liquidate their positions. Perhaps management has changed, and the stockholdings of the former management, their relatives, and associates are being bought out to consolidate ownership in the new management’s hands.
Harvest Time Investors eagerly await harvest, where an opportunity is provided to convert their stock to cash and claim the return on their investment. Exit strategies are covered in detail in Chapter 7 but are summarized here. Routes to exit financing include: . Initial public offering (IPO), where ownership in the venture is sold to the public through an equity offering on a public stock exchange . Merger/Acquisition (M & A), where the start-up is merged with or sold to another company . Management buyout (MBO), a buyout of external investors by the management team or other insiders. This consolidates ownership in management or other insiders’ hands while providing an exit strategy for investors who helped fund the company’s growth.
The amount of capital needed by various types of new businesses varies considerably. High-technology companies, such as computer manufacturers, designers of semiconductor chips, and gene-splicing companies, often require several million dollars in initial financing. Stephen A. Duzan, president of Immunex Corp. of Seattle, WA, estimates that it takes $60 million to bring a new biotech company from development stages to the market. Most service businesses, on the other hand, require smaller amounts of initial capital. For example, Debora Tsakoumakis started her business, HB Bakery Connection, in Boulder, CO, with $1,000. In her first year of operation, she filled over 350 orders. From that start, she has developed a network of 400 bakeries in almost every state. Whatever the amount needed, a good financial proposal demonstrates to investors that you are a competent manager and that you may have that
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special managerial edge over other small business owners looking for funding. Any proposal for funding must contain the following items: Financial statements—actual performance for the past few years for operating companies, and pro forma projections (balance sheets, income statements, and cash flows) for the next 3 to 5 years, showing the effect anticipated if the project, whether start-up or expansion, receives funding and is undertaken. This should include an analysis of key variables affecting financial performance, showing what could happen if the projected level of revenue is not attained. We will address this in detail in later chapters. Capitalization—a list of shareholders, how much is invested to date, and in what form (equity/debt). Provisions of the investment proposal—state the financial offer precisely. For equity investors, you may offer a certain percentage of the profits or, more likely, a percentage of business ownership.
SUMMARY Equity capital beyond that provided by the entrepreneur and friends and family is needed to advance the company’s growth. The vast majority of firms are not appropriate for VC and must look elsewhere for that equity. Angel investors are one source of equity potentially available to firms with relatively high-growth aspirations. Angel investors are high-net–worth individuals who chose to invest in start-ups rather than or in addition to investing in the stock market. Many angels are cashed-out entrepreneurs who prefer the thrill and potentially high returns of investing in new ventures. These angels offer guidance and experience to the entrepreneur in addition to dollar investments. Angels are a nebulous group who are hard to track, but it is commonly accepted that they provide significantly more total start-up capital than VC investors. Some angels operate independently, and others band into networks of angels, pooling both resources and potential investment opportunities. Some angels spend significant time mentoring entrepreneurs, and others prefer a more hands off approach to investing. The best way to locate angel investors is through networking. Most angels invest locally, in industries with which they are familiar. Lawyers, accountants, and other entrepreneurs are good sources of introduction to angel investors. The SBA is an intermediary source of financing for new ventures. The SBA does not provide any actual funds to entrepreneurs but rather provides
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venues and guarantees that make financing available. Through a variety of loan guarantee programs, the SBA makes possible commercial loans that would not be forthcoming without the guarantees. The SBA sponsors an angel network (Ace-Net) and venture capital funds (SBICs), in addition to being a clearinghouse for various government grants aimed at new ventures. Entrepreneurs seeking external equity are faced with an inherent conflict. Entrepreneurs seek the most investment for the least equity possible, while investors seek the opposite. The share of the company given up depends on the post-money valuation established for the company. Post-money valuations are a function of sales and earning forecasts, growth rates, and the multiple used to translate earnings into a company value. Negotiations should focus on these underlying factors rather than the actual dollar amount of the valuation. Companies tend to progress through fairly predictable stages of growth that should be matched to sources of financing appropriate for each stage. The conception and start-up stages are typically financed by the entrepreneur and friends and family. Growth stages are more likely to be financed by angel investors and venture capitalists. Very rapid growth may be financed with an initial public offering of the company’s stock. Once a company reaches maturity, growth can typically be financed through internal sources. It is important to remember that the issuance of private equity launches the firm down the path toward the eventual sale of the business. For equity shares to have value, there must be a market for them and this can only be achieved through an IPO or sale of the business.
DISCUSSION QUESTIONS 1. List some potential milestones for a technology start-up. 2. Which financing sources would be most appropriate in getting the firm in Question 1 to each milestone? 3. Research some angel networks in your area. Do they have specific investing guidelines? 4. If you are trying to raise $500,000 to get to your next milestone, and you are willing to give up 15% of the equity in your company for that investment, what operating income to you need to achieve by the third year to accomplish this? Make any assumptions necessary to answer the question.
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EXAMPLE 3.1 NEW TECH (F): WHERE WILL THE MONEY COME FROM? The New Tech case introduced in previous chapters will be used here and in the next section to illustrate some financing issues covered in Chapters 2 and 3.
THE CHALLENGE: WHERE WILL THE MONEY COME FROM? How much from: . Cash flow and other internal sources? . The bank? . Risk capital sources?
What They Need to Raise New Tech now has to consider possible sources of financing. Stuart Chip, New Tech’s owner, and Elizabeth Smart, his in-house accountant, have a good handle on how much financing they need—$1,575,000. Equipment to produce new line (fixed assets) One-time marketing costs (selling expense) Ongoing operations (working capital) Financial cushion
$1,100,000 $225,000 $200,000 $50,000
Total financial needs
$1,575,000
They feel they have a strong case to present to investors, with a comprehensive set of financial forecasts and well-documented assumptions.
Where Will the Money Come From? Their challenge is to determine how much of the $1,575,000 will be financed by: . the company’s internal sources (cash flow from operations, supplier credit, etc.) . external conventional financing sources (bank operating line or term debt), and . risk capital or unconventional sources (subordinated debt or equity)
Key Tasks In order to answer these questions, they have got to: . meet with their bank to determine how much funding they may provide
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. examine the company’s own operations for possible internal sources of funding . consult with an investment advisor and legal counsel on unconventional, external funding sources . consider how much they want to fund with debt (borrowing money) and how much with equity (sale of shares)
THE CHALLENGE: CONVENTIONAL FUNDING What conventional external and internal sources of funding can New Tech tap?
The Bank Stuart and Elizabeth meet with New Tech’s banker, Ted Mooney. He clearly states that the expansion program contemplated by New Tech is too risky and that the bank cannot cover the entire financing package. New Tech’s bank will lend only a very small amount to the company on its accounts receivable and inventories. Mooney explains that the bank does not finance high-risk projects. Mooney tells them that the bank will finance only part of the capital assets and working capital accounts, but not the marketing costs and the cushion. The bank would be prepared to provide a loan of $200,000 to finance part of the cost of the production line (i.e., long-term credit). This would be a 5-year term loan, with annual payments bearing an annual 10% interest charge. The bank is also prepared to increase the existing operating line by $25,000. Mooney indicates that the company’s track record has not been proven enough, and he is not convinced of the validity of the information contained in the forecast. Mooney’s main concern is the lack of experience in managing a fast-growth business. He emphasizes that Stuart’s prior experience was managing a division of a larger company.
Internal Sources Elizabeth’s forecasts indicate that $275,000 will be financed by internal sources (this would cover the one-time marketing costs and a financial cushion). Another $200,000 for working capital will be covered by internal cash flow and supplier credit.
Looking Elsewhere Elizabeth’s calculations show that internal sources and the amount the bank is willing to lend will help finance about half of the required funds.
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Total Financing Needs
$1,575,000
Funded by: Internal sources (cash flow and operating line) Bank long-term debt (new loan)
$775,000 $200,000
Subtotal
$975,000
Estimated risk capital financing required
$600,000
THE CHALLENGE: RISK CAPITAL OPTIONS Should New Tech pursue equity or debt financing? Elizabeth is now ready to go over the numbers with Grant Argent, New Tech’s financial advisor, to discuss the pros and cons of un-conventional long-term financing and what capital structure would be most appropriate.
Equity or Debt? Grant suggests two options: equity participation and a subordinated debt investment. He prefers equity, as it is a long-term investment where the company does not have to make interest or principal payments. Grant feels that at this stage of the company’s growth, New Tech should reinvest the maximum earnings back into the business in order to fuel its growth for the next several years. Equity funding will allow the company to reinvest its earnings in this way. Grant explains that although the cost of equity will be on the high side (investors typically seek a return between 25% and 40% per annum), the cost would not have to be paid by the company on an annual basis. The high return expected by the risk capital investor would be earned at exit, through a buyout situation or an IPO. Grant also points out that although subordinated debt may be a cheaper alternative, it would likely be difficult to raise these funds, given the short track record of the company and the perceived volatility of the industry.
THE SOLUTION: A FINANCIAL PACKAGE How will New Tech match their needs with sources of funds? Elizabeth now knows where she is headed. The bank will cover part of the expansion, but most of the investment would come from outside equity. She calls a meeting of the management team and circulates the financial projections in advance, together with a memo on the proposed capital structure and the pros and cons of equity and subordinated debt financing.
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The package features a capital structure with more equity ($600,000) than debt ($200,000) financing for their long-term needs. They are funding their capital needs with internal cash flow and short-term borrowing.
The Package
Total cost
Internal cash flows and operating line of credit
New line Marketing costs Additional working capital Cushion
$1,100,000 225,000 200,000
$300,000 225,000 200,000
50,000
50,000
Subtotal
$1,575,000
$775,000
Cost or investment Required
Debt
Risk capital
$200,000
$ 600,000
$ 200,000 $ 600,000
What New Tech Learned Stuart and Elizabeth now recognize that: . There is a range of funding sources open to growing businesses. . They will have to put together financing from a variety of these sources in order to meet their funding needs. . Long-term risk capital financing alternatives include equity and subordinated debt. They prefer to use equity because it allows them to reinvest earnings into the business. . Long-term conventional financing alternatives they might consider are mortgages, leasing and term loans. They will pursue a long-term loan from their bank. . They will include cash flow, supplier credit and an extension of their bank line of credit as part of their short-term risk capital financing.
CASE 3.2 NEW TECH (G): ARE THEY WORTH AN INVESTOR’S TIME? THE CHALLENGE: ARE THEY WORTH AN INVESTOR’S TIME? Can New Tech make itself attractive to investors? Can it prove that it has: . Growth potential in the marketplace? . Prospects of exceptional return on investment? . A way for investors to get their money out?
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Grant Argent (New Tech’s financial advisor) stresses that the management team must be able to convince investors that New Tech is a fastgrowing business with excellent profit potential. He informs Stuart Chip (New Tech’s president) and Elizabeth Pratt (New Tech’s accountant) that this evidence has to be documented in a convincing manner in an investment proposal. To do this, they must gather critical information that investors will need to examine before making their decision to invest in New Tech. Potential investors, not to mention Stuart and his team, will need reliable information to: . see what the company’s growth opportunities are and how it will exploit them . put a value on the company’s growth opportunity and expected return . determine the risk element and expected return on investment the investors want to earn . arrive at some parameters for the share of equity the company will offer
Elizabeth can do some of the groundwork on her own, but she asks Grant for some help with the technical analyses that will be required.
Key Tasks The New Tech management team will have to take on a variety of tasks: . assess the external environment, including economic and industry-specific trends, and an analysis of their competitors . examine their own procedures and processes, and develop plans to optimize them to achieve the growth targeted . determine what they feel is the value of the company now, at the beginning of the investment period, based on their financial forecasts . decide on how the investor would be able to take his or her money out and calculate a projected value for the end of the investment period . determine what rates of return an investor might expect given their proposal and forecasts
THE CHALLENGE: HOW DOES NEW TECH STACK UP? . Are the market conditions right for New Tech’s growth? . How does New Tech compare to its competitors?
New Tech in Context Elizabeth starts by developing background information on New Tech’s industry and how it is being affected by current economic trends. She tries to answer these questions:
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. Who are New Tech’s competitors? . What are the economic trends in the industry? . What are industry analysts predicting?
Grant has made it clear to Elizabeth that investors will need to be wellinformed about New Tech’s growth potential, the industry, and the markets in which it competes. She also takes to heart his advice that third-party industry information will help enhance the credibility of the investment proposal. She meets with Stuart and John Harley (New Tech’s sales manager) to determine the type of information and the most relevant information that would be required to convince investors that New Tech is involved in a highgrowth industry with extraordinary potential.
Sources and Analysis Elizabeth gathers the information from a number of sources on the Internet, including New Tech’s industry association, Industry Canada’s database (which provides data on a sector-by-sector basis), Statistics Canada, and various business periodical databases. In addition, Elizabeth uses an industry market research report Stuart ordered last year from EconTechData. She also calls a few brokerage houses for reports on the industry. Elizabeth is able to obtain information on industry shipments, the growth rate of the industry, major markets, and key competitors. She quickly realizes that gathering the information is the easy part of the analytical process; sifting through it all and deciding what is pertinent and most relevant to their project is the most difficult.
The Outlook She collects enough information to confirm that: . the market for power modules is growing rapidly . New Tech is pursuing a conservative market share based on a production level of 2,500 power modules per year . industry-wide shipments have increased by 25% over the last 2 years (according to Statistics Canada data)
The Competition Based on the industry information she obtained, Elizabeth indicates she is going to prepare a competitive matrix to compare the attributes of each competitor’s products to those of New Tech. By benchmarking New Tech against its competition, Elizabeth is convinced that she will be able to demonstrate clearly New Tech’s competitive advantage.
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Proving the Potential for Growth The management team meets to discuss the business environment they are operating in and identify their key opportunities and threats. Stuart invites Grant to help bring an objective viewpoint, from someone who knows what investors will ask. Before the meeting, Elizabeth circulates to all members of the management team the information and statistics she feels are pertinent for the discussion. At the meeting they review the information on key industry characteristics, New Tech’s opportunities, and threats within the industry and market environment. Then the team discusses their prospects and next steps. Stuart believes that the competitive analysis and benchmarking, together with the other industry information Elizabeth has compiled, will satisfy the investors about New Tech’s market opportunity and growth potential. Grant agrees. He stresses New Tech’s strong competitive advantage and the reasons why it is unique. He is able to articulate his vision of New Tech’s future and how he feels it can capture a larger share of the market. He feels that the size of New Tech allows the company to compete effectively against larger competitors. The next step is to clarify what New Tech itself will do to capitalize on the market opportunities.
THE SOLUTION: GETTING THEIR HOUSE IN ORDER . What are New Tech’s strengths and weaknesses? . Can they show investors they have what it takes?
Taking a Hard Look at New Tech Itself Stuart realizes that an important step in becoming investor-ready is doing a tough analysis of their internal operations and building a plan that deals with their weaknesses and builds on their strengths. He addresses this analysis and planning session in the next management meeting devoted to their growth plans. Elizabeth mentions at the meeting that she will be able to write the first draft on New Tech’s business environment and market prospects. However, she points out that information about New Tech’s products and product life cycles in each of their respective markets, including pricing strategy, and the company’s operational and management strengths and weaknesses will have to be drafted by different members of the management team. During the meeting, Stuart informs team members that the strategy behind the new product line is to focus on value-added components. The discussion also centers on the following points:
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. market size and the demand for power modules . how the company is going to hire and train new staff for the new product line . the importance of securing the estimated gross margin on the new product line . the strategy for targeting new customers during the first year . management’s strong and weak points in each division (production, marketing, etc.) . plans for preparing for the launch of the new product line
Elizabeth writes down the specific actions the members of the management team believe are required in order to exploit New Tech’s strengths, the specific actions required to minimize the identified threats, and a plan to mitigate identified corporate weaknesses. The next topic on the agenda is the financial valuation of the company. Because of the complexity of the financial data and analyses, Stuart turns over the meeting to Grant, their financial advisor. Ecoturista, LIC. 2 North First Street #308 San Jose´, CA 95113 USA
CASE STUDY: ECOTURISTA EXECUTIVE SUMMARY: AS DISTRIBUTED IN THE FALL OF 1999 Ecoturista, is an e-commerce-based business-to-business (B2B) travel service and total solutions provider for adventure travel and ecotourism in the Americas.
Our Solution and Competitive Advantage . We supply a single-point of contact to our customers and consolidate a highly fragmented supplier market through the utilization of an electronically linked travel network. We will have a considerable first-mover advantage in this area, one that is difficult to replicate.
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. Our unique combination of superior product and quality options in the travel sector’s fastest growing segment, adventure travel; a complete customer relationship management (CRM) and e-commerce system; technology integration; and our product and marketing support provides the travel experiences that consumers demand and the support services our customers need. . Our identified and reliable travel resources throughout the region make us ready to rapidly expand our scaleable and moveable travel network model. Initial deployment in targeted locations will allow us to deliver product to market within 5 months of startup.
Mission To be the premier B2B total solutions provider for adventure travel and ecotourism in the Americas.
The Problem The highly fragmented wholesale travel sector forces online adventure travel hubs to deal with almost as many providers as trips offered. A dedicated linked e-commerce system for adventure travel in Latin America is non-existent. Brick-and-mortar travel agents must adapt to the trends in the travel industry by embracing technology and tailoring their offerings and services to customer demands.
Methods Our service is based on the design and delivery, through an electronicallybased travel network and reservation platform, of: . a distinctive catalogue of unique, exciting, and high-quality travel experiences . in adventure and cultural travel throughout the Americas . with the utmost respect for the ecology and people of our destination areas
Initial customer acquisition and product offering will focus on U.S.-based online retail travel hubs. We will develop a small network of ‘‘brick-and-mortar’’ travel businesses as a test market leading to substantial expansion in that area. Further, we will leverage our market position and offerings in order to form strategic distribution and marketing relationships with Global Distribution Systems (GDS) and travel consortia. Our competitive advantages create exciting options in exit strategies. As the industry continues to consolidate, and we maintain a leadership position, we become an increasingly attractive acquisition target to both
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GDS and to larger retailers, both of which would benefit from our catalogue and network. The Ecoturista value added is our linked ‘‘on-the-ground’’ network of end-destination providers and hub coordinators, connected through our travel network and reservation system. This ensures a quality travel experience from start to finish, a streamlined supply chain, and allows for a process of continual auditing, managing, and upgrading of our catalogue.
THE OPPORTUNITY Online bookings for leisure and unmanaged business travel tripled in the U.S. in 1999, from $2.2 billion in 1998 to $6.5 billion, and is expected to soar to $28 billion in 2005, according to Jupiter Communications. Though online travel bookings continue to gain in market share, the overwhelming number of travelers still use traditional travel agents (97% of all bookings). More than 50% of the traveling adult U.S. population (147 million) has taken an adventure travel trip; these travelers tend to be web savvy and to utilize the Internet for travel options. The principal interest in Latin American travel generally involves nature or cultural-based activities. Leisure travel to these locations is, almost by definition, adventure travel. In Costa Rica, for example, about two thirds of international visitors include a national protected area in their itinerary. Central and South America have been experiencing average annual growth rates in arrivals of over 15% since 1989. The Caribbean, a more established destination, continues to grow at 4% annually and captures 12.5% of all international travelers to the Western Hemisphere. Over half of all international travelers to South America are from Latin America. The Latin American population is one of the youngest and fastest growing in the world. Further, online travel is predicted to be the second leading e-commerce category in the region by 2005 ($1.4 billion of $8.3 billion in total e-commerce—Jupiter Communications).
THE OPERATIONAL MODEL We will design unique adventure travel tours with Latin American destinations and offer them to travel retailers. Initially, our primary channel of distribution will be bulk sales to online retailers through our web site, www.ecoturista.com. In parallel, we will develop an online catalogue for traditional travel agents and other travel service providers with supporting booking, payment, and commission transactions. At this time, no dedicated, technologically linked, travel network and reservation system for adventure travel currently exists in the Latin
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American region. This creates a first-mover opportunity for Ecoturista. We will leverage our use of technology to increase our competitive advantage, operating online and in real-time, wherever possible, rather than in a fax and wait mode as is currently the norm. We will provide technology solutions and marketing support to our customers, in order to assist them in developing their businesses and in marketing our product. These programs will create a viral marketing effect by establishing name recognition and by providing beneficial business development services. This will be a highly defensible position that will allow us to create excellent opportunities for strategic partnerships with complementary travel service providers and organizations. We will create unique incentive programs that are tailored to and reflect both our product and the cultures in which we operate. Our insight into and experience with the adventure travel market, particularly in Latin America, allows us to customize our product and assist our customers in effectively presenting and selling our offerings.
The Management Team Our President, Bryan Dias, is uniquely qualified, with outstanding academic credentials, rich and directly relevant work experiences, and a genuine commitment to the environment. CFO John Vinturella combines a strong academic background with real-world application, having recently sold a business he started and ran for 20 years, and being involved in the start-up and incubation of several others. We have recently joined the Environmental Business Cluster for the incubation process.
Revenue Model Initial revenue will derive primarily from the business-to-business sale of trips and travel options to US-based online travel retailers. For most, listing our offerings is a low-impact, cost-effective decision; it adds to their catalogue with little effort required for implementation. Sales to travel agents will provide a secondary revenue stream early and form a basis for significant penetration of this vast market after a next round of funding. Travel agency network building will generate various fee-based consulting and support services. Eventual expansion into exploding Latin American travel markets will generate considerable revenue and a firstmover situation.
Financial Proposal We are currently seeking $495,000 in private-investor equity-financing; corresponding share of company ownership will depend on degree of investor involvement. The major priorities for the invested funds are:
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. Building a strong network of service providers across initial destinations, verifying the quality of their services and offerings, crafting onsite alliances that enhance the visitor experience, and refining the model for rollout to other destinations. . Implementing an e-commerce-based reservation and product management system, developing our web site and providing selected technology solutions for our vendors and beta customers. . Developing and leveraging our customer network through immediate marketing, sales, and product support campaigns, and identifying and forming strategic and distribution partnerships. . Increasing company valuation by delivering select product to market, demonstrating our ability to cost-effectively integrate technology, and successfully implementing support services.
Projections begin on receiving $495,000 and assume additional investment of $2 million in 6 months. With this plan, note marginal profitability in year 2, cumulative losses recovered in year 3, and successive annual earnings exceeding initial investment, creating attractive exit opportunities.
Pro-Forma ($000) Revenue Profits (EBITDA) Cumulative profit/ (loss) Cumulative investment Cash flow No. trips sold @ $1,600 avg.
Year 1
Year 2
Year 3
Year 4
Year 5
$809,000 ($1,544,550) ($1,544,550)
$7,264,000 ($598,690) ($2,143,240)
$15,600,000 $2,375,237 $231,997
$23,400,000 $7,957,913 $8,189,911
$29,100,000 $10,475,157 $18,665,068
$2,495,000
$2,495,000
$2,495,000
$2,495,000
$2,495,000
$950,450 465
$351,760 4,290
$2,726,997 9,375
$10,684,911 14,063
$21,160,068 17,344
TO DO:
1. Evaluate Ecoturista’s business model. What is the opportunity? What are the potential threats to the business? What are the strengths and weaknesses of the proposal? 2. Is this likely to be a capital-intensive business? 3. Do the company’s growth projections seem realistic? What is Ecoturista’s cost structure likely to look like? Are the company’s costs mainly fixed or variable or balanced between the two? 4. Does their profit margin forecast seem reasonable? 5. Assume a multiple of five times earnings is appropriate in this industry. What is the post-money valuation for Ecoturista? What share of
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the company must they give up for the desired investment? Does the company seem fundable? 6. Are there or could there be milestones associated with the second round of funding? What might such a milestone be?
BIBLIOGRAPHY Bank of England, Financing of Technology Based Small Firms, February 2001. Bhide´, Amar, ‘‘Building the Self-Sustaining Firm,’’ in The Entrepreneurial Venture, Sahlman, W., H. Stevenson, M. Roberts, A. Bhide´, eds., Harvard Business School Press, Cambridge, Mass., 1999. Churchill, Neil, ‘‘The Six Key Phases of Company Growth,’’ in Financial Times Mastering Entrepreneurship, Birley, Sue and Daniel F. Muzyka, eds., Prentice Hall, 2000. Dellenbach, Robert, ‘‘Three Trends in Startup Financing,’’ American Venture, March 4, 2003. Friedman, Josh, ‘‘Angels Give Wings to Entrepreneur’s Ideas,’’ Los Angeles Times, February 17, 2003. Gannon, Michael, ‘‘Financing in Purgatory,’’ Venture Capital Journal, May 1, 1999. Gates, Stephanie, ‘‘Angels are Increasingly Among Us,’’ Red Herring, June 17, 1999. Hudson, Marianne and Susan Preston, ‘‘Business Angel Investing Groups Growing in North America,’’ Ewing Marion Kauffman Foundation Report, October 2002. Smith, Janet Kiholm and Richard L. Smith, Entrepreneurial Finance, ed 1, John Wiley and Sons, New York, 2000. Sohe, Jeffrey E., ‘‘The Early Stage Equity Market in the USA,’’ Venture Capital, Vol. 1 No. 2, 1999. Worrell, David, ‘‘Our Little Angels,’’ Entrepreneur, January 2003.
Chapter 4
Determining the Amount Needed—The Business Plan
CHAPTER GOALS In this chapter you will develop an understanding of how to prepare the financial portion of the business plan. The format of the entire business plan is introduced, but the focus is on the financials. You will learn the principal financial components of a business plan and how to generate them.
THE BUSINESS PLAN INTRODUCTION Every new business, regardless of size or growth aspirations, needs a business plan. The plan should be your roadmap to success and should provide benchmarks for measuring progress toward the plan’s objectives along the way. Even if you are not currently seeking external financing there will be a demand for your business plan by outsiders. Potential management candidates will surely want to read the plan, as will potential business partners. In forming strategic relationships, other companies will use your plan to assess your viability as a partner. If you are seeking outside financing, lenders as well as equity investors will use your plan to help them decide whether or not to finance your company. Advice given to entrepreneurs regarding the business plan can often seem contradictory. On one hand, investors will say a well-thoughtout, clearly articulated business plan is vital to success in raising money. At the same time, it is well known that potential investors often do not read
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beyond the Executive Summary of the plan. So which is it? Is the business plan vital, or is all your hard work likely to be ignored? The volume of ink devoted to business plan preparation would seem to indicate the plan’s importance. Bookstore business sections are full of books on how to prepare a business plan. One
