Scaling a venture and ensuring its sustainability requires strategic thinking, financial planning, and collaboration. In this discussion, you wil

Financing the entrepreneurial venture

OBJECTIVES

After studying this primer you will be able to:

• Recognize the ‘how, what and when’ of financing an entrepreneurial business: e.g., how to

raise capital, what the funding sources are, when it is most suitable to use each of the

financial sources, how to maximize value in a growing venture, how to forecast financial

performance and cash flow.

• Identify the various financial resources available for entrepreneurial activities and evaluate

their relevance to the business by recognizing their pros and cons for the different stages

of the business.

• Understand the flow in entrepreneurial businesses: i.e., assembling resources, combining

them to build a resource platform that will yield distinctive capabilities, assessing their

longterm and sustainable availability to the business.

• List the business’s needs for the purpose of choosing the best-suited financial resources,

and distinguish between needs for initial financing and venture growth capital.

• Recognize the role of networking for the most valuable financial information and for

locating the relevant, available financial resources.

• Recognize the major processes in managing the business’s financial operations.

• Understand the role of factoring for immediate cash funding while experiencing long

billing cycles that put a strain on cash flow, and understand the actions of factoring.

• Distinguish the key competitive issues facing the entrepreneurial business while buying

and selling a business, including research, due diligence and pricing.

Financing Primer

FINANCING THE ENTREPRENEURIAL VENTURE

THE HOW, WHAT AND WHEN OF FINANCING THE VENTURE

Financing is an important input for every business, especially in its first stages: it enables smooth running of the daily and long-term operations, as well as asset acquisitions, expert recruitment, and the development of marketing and distribution channels. In the early stages, businesses are typically constrained in terms of liquidity, and most entrepreneurs are continually concerned about their finances, as their businesses are typically not yet profitable. Entrepreneurs in the first stages of these emerging ventures cover their fear of the demanding capital-raising marathon by presenting often exciting but sometimes unrealistic business plans to potential investors. Entrepreneurs therefore need to develop skills that are relevant to financing their ventures.

Some of the initial and basic questions faced by entrepreneurs include: how to raise capital for the new venture; what the pros and cons are of each of the sources of capital, as well as their availability and reliability; how to maximize the value in a growing venture in terms of valuation, structuring investments in the entrepreneurial setting, investment staging; how to forecast financial performance and cash flow. Entrepreneurs should be well acquainted with the art of negotiation, and need well-established knowledge on using and managing financial modeling, working capital, fixed versus variable costs, and cash flow versus accounting, among other things. Most entrepreneurs, however, are either not experienced or lack the relevant knowledge to manage their financial or potential financial sources, and they may end up choosing unsuitable sources of financing, managing incongruous negotiation processes with investors and banks, or disregarding some critical techniques and tools that may assist them in raising money for their ventures.

Capital is an umbrella term for the critical and valuable assets for the business such as human, social and financial capital. Financial capital is defined as an economic asset consisting of personal and general funds. Personal funds include an entrepreneur’s personal savings, financial assistance from family and friends, or bank loans based on personal guarantees, whereas general funds consist of seed funding from a developmental agency, government loans and grants, or funds from business angels or venture capital firms. Existing research shows that entrepreneurs tend to rely on personal sources of finance both at the startup stage and as the principal source of initial capital in the following stages of the business (Sullivan 1991; Kelly and Hay 1996; Mason and Harrison 1997; Gompers and Lerner 2001;Wang and Sim 2001;Hindle and Lee 2002;Wright,Pruthi and Lockett 2005; De Clercq et al. 2006;Villalonga and Amit 2006; Mason 2009).

One major problem with choosing unsuitable financial sources has to do with risk: entrepreneurs must understand that any decision they consider has an inherent level of associated risk. Some of the risks that they face are not unique to entrepreneurial markets but others may be, particularly those concerning issues such as penetration costs of products and potential returns, potential buyers, promotional programs, billing, pricing, IT systems, and so on. Avoiding or mitigating exposure to risks is impossible; however, they may be offset by acknowledging diverse financing strategies. Moreover, entrepreneurs’ inexperience sometimes causes them to overemphasize short-term expenses or immediate costs: for example, entrepreneurs that are renting or buying a plant for their business may take into account only the rental costs and ignore additional, indirect or attached costs (local and municipal taxes and other

FINANCING THE ENTREPRENEURIAL VENTURE

expenses). In such a case, the financial analysis will be lacking and consequently, their choice of types of financial sources may be unrealistic (Bruno and Tyebjee 1985; Schwienbacher 2007).

In order to turn risks into opportunities and needs into strengths, entrepreneurs need to be able to estimate the firm’s financial needs. Two main factors are essential to this estimation: (1) the net cost of the investments in the long term and (2) the assets in the short term.

Moreover, entrepreneurs should be able to conduct benchmarking research on the costs and expected expenses, using information from colleagues, suppliers and printed materials. Validating the financial analysis, as well as enriching it by including a variety of different items – even those that might be considered marginal or irrelevant may assist in matching financial sources to the firm’s needs. However, some financial terms need to be understood prior to

searching for financial sources: n Return on investment (ROI). The entrepreneur invests capital in a particular combination of assets, from which the company generates sales. Those sales cover the costs of operation and hopefully, will produce a profit.

The return, i.e., the profit from an investment, is divided by the cost of the investment; the result is dependent upon what is included as returns and costs, and it may vary across entrepreneurial businesses (Lusch, Harvey and Speier 1998). It is expressed in the following versatile and simple ratio:

Internal rate of return (IRR). This measure is commonly referred to in the venture capital industry, and includes a concurrent assessment of actual cash flow (see example in Table 12.1) and the value of unrealized investments held in a fund portfolio. A fund’s IRR is sometimes measured after the fund has finally been wound up and no unrealized investments remain. If the risks are equal, investments with higher IRRs pay better when comparing the net expected returns over the useful life of a project being reviewed by management to the funds spent on that decision (or project) (Cohan and Unger 2006).

Assets. Assets are subdivided into current and long-term assets to reflect the ease of liquidating

each asset. From a finance perspective, these assets are the revenue generators. Current assets. Any assets that can be easily converted into cash within one calendar year (e.g.,

cash money-market accounts, accounts receivable, funds parked in near-term instruments earning interest, funds tied up in inventory and notes receivable that are due within one year’s time).

FINANCING THE ENTREPRENEURIAL VENTURE

Table 12.1 The cash flow statement

Jan. Feb. Mar. Apr. May. Jun. Jul. Aug. Sep. Oct. Nov. Dec.

Source of funds

Beginning cash

Sales/income

Sale of assets

Customer deposits

Loans

Contributed capital

Available cash

Salaries

Other operating expenses

Loan payments

Capital expenditures

Tax payments

Total cash out Net

cash flow

Fixed assets. The long-term base of the business’s operation (e.g., equipment, machinery, vehicles, facilities, IT infrastructure and long-term contracts), all of which the firm has invested in to conduct business (George 2005).

Cost of capital. This is the true cost of securing the funds that the business uses to pay for its asset

base. Ando, Hancock and Sawchuk (1997), for example, used the before-tax rate of return on capital, adjusted for inflation, to estimate the cost of capital; Jog (1997) computed the weighted average costs of debt and equity on an after-tax basis for 714 Canadian firms grouped into twenty-two industrial sectors. This ‘financial cost of capital’ constitutes only part of the ‘user cost of capital’, the latter being a broader and more economically complete concept.

Weighted average (between debt and equity) cost of capital (WACC). The firm’s true annual cost for obtaining and holding on to the combination of debt and equity that pays for the fixed asset base. Risks. Two basic approaches in risk and risk control are accepted in the entrepreneurial realm;

both refer to how the capital market can affect the firm and how the firm can control its potential risks in this context. One is the principal agent approach, referring to the use of comprehensive contracts, and the other, the incomplete contract approach, which deals

FINANCING THE ENTREPRENEURIAL VENTURE

with active involvement in venture management (Hart 1995). Entrepreneurs must always decide whether the risk premium of additional potential return is commensurate with the additional risk costs that come with choosing that investment project (Jensen and Meckling 1976; Bourgeois and Eisenhardt 1998; Harvey and Lusch 1995; St-Pierre and Bahri 2006). Due diligence may help in managing potential risks (see example in Table 12.2).

Table 12.2 Due diligence: main topics

Topic Examples

Organization The business’s minute book, including all minutes and resolutions of and good shareholders and directors, executive committees, and other governing groups standing The business’s organizational chart

The business’s list of shareholders and number of shares held by each Financial Audited financial statements for the past three years, together with auditors’ information reports

The most recent unaudited statements, with comparable statements from the prior year Auditors’ letters and replies for the past five years Any projections, capital budgets and strategic plans

Physical A schedule of fixed assets and their locations assets A schedule of sales and purchases of major capital equipment during the last

three years Real estate A schedule of the business’s locations

Copies of all real-estate leases, deeds, mortgages, title policies, surveys, zoning

approvals, variances or use permits

Intellectual A schedule of domestic and foreign patents and patent applications property A schedule of trademarks and trade names

A schedule of copyrights A description of important technical know-how A description of methods used to protect trade secrets and know-how

Employees A list of employees, including positions, current salaries, salaries and bonuses

and employee paid during the past three years, and years of service

benefits Résumés of key employees The business’s personnel handbook and a schedule of all employee benefits, and

holiday, vacation and sick-leave policies

Licenses and Copies of any governmental licenses, permits or consents

permits

Environmental Environmental audits, if any, for each property leased by the business

issues A listing of hazardous substances used in the business’s operations A description of the business’s disposal methods A list of environmental permits and licenses

FINANCING THE ENTREPRENEURIAL VENTURE Taxes Federal, state, local, and foreign income tax returns for the past three years

State sales tax returns for the past three years Any audit and revenue agency reports Any tax-settlement documents for the past three years

Material A schedule of all subsidiary, partnership, or joint-venture relationships and

contracts obligations, with copies of all related agreements All loan agreements, bank financing arrangements, lines of credit, or promissory notes to which the business is a party Any options or stock purchase agreements involving interests in other companies The business’s standard quote, purchase order, invoice and warranty forms

Product or A list of all existing products or services as well as those under development

service lines Copies of all correspondence and reports related to any regulatory approvals of any of the business’s products or services A summary of all complaints or warranty claims A summary of results of all tests, evaluations and other data regarding existing

products or services and those that are under development

Customer A schedule of the business’s twelve largest customers in terms of sales and a

information description of those sales for a period of at least two years Any supply or service agreements A description or copy of the business’s purchasing policies A description or copy of the business’s credit policy

Litigation A schedule of all pending litigations A description of any threatened litigations Copies of insurance policies that may provide coverage for pending or

threatened litigation

Insurance A schedule and copies of the business’s general liability, insurance claims

coverage history, personal and real-estate property, product liability, errors and

omissions, key man, directors and officers, workers’ compensation, and other

insurance

Professionals A schedule of all law firms, accounting firms, consulting firms, and similar

professionals engaged by the business during the past five years

Articles and Copies of all articles and press releases relating to the business within the past

publicity three years

Source: Modified from FindLaw for small businesses, at http://smallbusiness.findlaw.com/business- formscontracts/be3_8_1.html; the Kauffman Foundation, at www.kauffman.org/; AllBusiness, at www.allbusiness.com/business-finance/equity-funding-private-equity-venture/81-1.html.

FINANCING THE ENTREPRENEURIAL VENTURE

Before entering into the financing process, some general key steps need to be taken, as

illustrated in Figure 12.1.

Long-term

• Land and construction, including local improvements

• Equipment and machinery n Working materials

• Transferable material and furniture

• Startup costs (incorporation, judicial costs, marketing research, credits, and

more)Short-term Startup cash and stock

• Preservation of capital and assets

Figure 12.1 General key steps in the financing process

Prospect

When and how much money is needed?

Meeting criteria

Planning the costs properly

Current needs versus interests

Setting realist goals

Financial process

Assessing financing sources

Closure

FINANCING THE ENTREPRENEURIAL VENTURE The prospect addresses questions regarding when and how much money is needed for the firm,

what it will be used for, and how long the entrepreneur thinks the financial assistance will be needed.

Meeting criteria means planning the costs properly: rather than either overestimating or underestimating the financial requirements needed to properly capitalize the business, the preparation of financial projections in the business plan is essential.

Current needs versus interests are the realistic goals that should be set; this is the first step in financing

management that entrepreneurs should determine – the scope and size of their business. Rather than simply jumping into the idea of starting a business without understanding what the business really entails, goals need to be set with respect to the financial requirements of multiple issues – i.e., management know-how and technological skills, HR requirements, among others – in the short and long term.

Financial process. Financing a small business is not a lock, stock and barrel proposition. For many entrepreneurs, no single source will finance their entire operation and they need to look at financing as the sum of their business’s parts.The ideal financing source is one that provides the longest payback period, carries the lowest interest rates, requires little or no collateral and demands no personal liability, but such sources are very difficult to find.Thus a financial process is needed that emphasizes assessment of the different sources of financing and their pros and cons.

Closure is the stage at which the sources of financing are chosen.This should be decided upon with full knowledge of what the financing sources entail, what the entrepreneurs’ obligations to and participation in such financing sources and processes are, and how to best manage such sources.

By obtaining detailed information on operations and finances, entrepreneurs may better understand their business’s needs and make them more attractive to investors. The due-diligence checklist (Table 12.2) addresses some major topics that should be assessed and documented.

FINANCIAL SOURCES

Family and friends. At the very early stages of any startup, entrepreneurs tend to raise money from relatives, colleagues and other people they know well.

Banks. The bank loans money based on the business’s ability to pay back: banks are more likely

to finance businesses that have greater value to minimize their risks. From the bank’s point of view, lending to entrepreneurial businesses is a complex and challenging task since entrepreneurs (i.e., the borrowers) have more information about their firms than the banks have, as entrepreneurs usually do not disclose all important information related to their firm’s business transactions. Furthermore, many entrepreneurs lack the skills to prepare financial statements and business plans, and this amplifies the risk of loaning to entrepreneurial businesses. However, when professional management practices are run in

FINANCING THE ENTREPRENEURIAL VENTURE

an entrepreneurial business, the bank will be more willing to loan money to that business (Colombo and Grilli 2007; Beck, Demirgüç-Kunt and Maksimovic 2008; Le and Nguyen 2009).

Grants. Federally funded programs mandate that certain agencies set aside part of their budgets to fund fledgling high-tech companies with interesting inventions they want to commercialize (e.g., Small Business Innovation Research grant (SBIR); government grants for women and minority-owned businesses). Competition for this money is steep, and as such, if such a grant is received, it is helpful in attracting funding from other investors (Holger, Henry and Strobl 2008).

Angels. Angel investors enable the business to acquire venture capital from individual investors

who are looking for companies that exhibit high growth prospects, have a synergy with their own business or compete in an industry in which they have succeeded. Early-stage companies with no revenues or established companies with sales and earnings can use this source, but they must be ready to relinquish some control of their business. Most important, to successfully accommodate angel investors, the entrepreneurs should be ready to provide them with an ‘exit’ through an initial public offering (IPO) or buyout by a larger firm (Steier 2000; Bruton, Chahine and Filatotchev 2009; Wiltbank et al. 2009).

Bootstrapping. Bootstrapping market entry is a viable model involving launching a business on a low budget, including outsourcing the work, renting rather than buying equipment and bartering for services; this is when entrepreneurs have great faith in their idea and they want to give up any equity, or when they have taken on a small amount of seed financing, just enough to get them into the market. The benefits of bootstrapping are in the speed of raising capital and generating revenue, flexibility in ‘taking the time’ to learn the entrepreneurial process and modify the business’s operations accordingly, efficiency and capital preservation, by using money in a more disciplined manner, tracking expenses carefully, and spending only on the most efficient tactics.

Venture capital. This is a type of private equity capital typically provided by professional, outside

investors to new, high-potential-growth companies in the interest of taking the company to an IPO. Venture capitalists pool their money with additional funds from institutional investors (e.g., pension funds, endowments and foundations), and these investors become ‘limited partners’ in the firm’s funds. Typically, venture funds have a life span of approximately ten years: during the first several years, they invest in promising new companies that then become part of the firm’s portfolio; over the course of the fund’s life,these companies are treated for acquisition or to go public at a premium of the total amount invested (‘exit’) (Sahlman 1990; Gompers and Lerner 1999; Jeng and Wells 1998).

Initial public offering (IPO) and sellout. When private firms move to public ownership, they can either do so through an IPO or a sellout. In an IPO, a private firm generally sells off a portion of its outstanding equity, but the previous owners retain significant ownership and control of the public corporation. IPO investors, on the other hand, take a significant risk when they

FINANCING THE ENTREPRENEURIAL VENTURE invest in a business whose worth has yet to be revealed in the marketplace. Sellout is a transaction in which a public company generally buys all of the outstanding shares of a privately held business. Both sellout and IPO firms benefit from access to public debt and equity markets, from liquidity of ownership for managers and investors, and from the possibility of linking management and employee compensation to traded securities (Deeds, Decarolis and Coombs 1997; Mulherin and Boone 2000; Certo, Daily and Dalton 2001; Brau, Francis and Kohers 2003; Certo 2003; Certo et al. 2003).

Crowdfunding. Crowdfuning is a form of raising money that takes place, usually via the Internet, where people pool their money to support a start-up or other initiative, usually in return for some sort of amenity rather than loan. Can be equity based, and many other alternative variants. Kickstarter is a popular online crowdfunding platform.

OBTAINING VENTURE AND GROWTH CAPITAL

Several sources of funding and financial alternatives are pertinent for entrepreneurs; they vary in their content, suitability and uses, as well as in their supply process. All businesses know that financing is vital to their present and future success; however, some entrepreneurs – inexperienced ones or those lacking knowledge on the benefits and shortcomings of the different options – may obtain less than optimal forms of financing.

FINANCING THE ENTREPRENEURIAL VENTURE

Every venture fund has a net asset value or the value of an investor’s holdings in that fund at

any given time; therefore, evaluating which financial option best suits the business is difficult.

This decision takes considerable investment knowledge and time on the part of the

entrepreneur and on the part of the investors, as each company is given a valuation that is

agreed upon between the venture firms when invested in by the venture fund(s).In subsequent

quarters, the venture investor will usually keep this valuation intact until a material event

occurs to change the value (Fiet 1996; Mullins 2004; Cumming 2005; de Bettignies and

Brander 2007).

Some entrepreneurs may therefore seek to delegate this decision to an investment advisor or so-called ‘gatekeeper’. This advisor will pool the assets of its various clients and join together entrepreneurs and the best options for them with the shorter funding-process cycles. Some websites can facilitate these decisions.1

NETWORKING AND FINANCIAL INFORMATION

The success of a new venture often depends on an entrepreneur’s ability to establish a network for the mobilization of financial resources. One of the most important key benefits of networks for the entrepreneurial process is the access they provide to information and advice, which may lead to better financial resources for the business.

In the uncertain and dynamic environments under which entrepreneurial activity occurs, resource holders, such as potential investors, ‘angels’, etc., are likely to seek information that helps gauge the underlying potential of a venture, while entrepreneurs seek ways to reduce risks associated with their business process by associating with investors. Access through a network to venture capitalists and professional service organizations, for example, is an important means of tapping into key market information and establishing financial ties (Freeman 1999). Moreover, when an entrepreneurial business is recognized and appreciated by more well-regarded individuals and organizations associated with that entrepreneur in the same networks, it will lead this business to effective and subsequently beneficial financial resource exchanges; in support, there is some empirical evidence that high-tech businesses with prominent strategic alliance partners are able to go public faster and at higher market valuation (Stuart, Hoang and Hybels 1999; Calabrese, Baum and Silverman 2000).

Studies in entrepreneurship have also documented that entrepreneurs consistently use networks to get ideas and gather information that will facilitate their search for financial resources, entrepreneurial opportunities, or a niche (Birley 1985;Smeltzer,Van Hook and Hutt 1991;Singh et al. 1999; Hoang and Young 2000), for example, in organizing and managing a supportive angel or informal investor networks.

The reliance on networks is not constrained to the startup stage. Entrepreneurs continue to rely on networks for business information, advice, and problem-solving, with some contacts providing multiple resources (Johannisson et al. 1994); effective networks have also been found to affect both survival and financial performance of entrepreneurial businesses (Gimeno et al. 1997; Bruderl and Preisendorfer 1998; Honig and Davidsson 2000). Trustworthy ties with suppliers, competitors, distributors, customers, or financial organizations can be important as

FINANCING THE ENTREPRENEURIAL VENTURE

conduits of information and know-how and can lead to re

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