Mark T. Schenkel, Ph.D. Assistant Professor in Entrepreneurship FINANCING AND SOURCES OF FUNDING FOR NEW VENTURES

What Makes Entrepreneurial Finance “Different” from Traditional Finance... ? Lack of history upon which to assess risk What’s the β? Without it, what should the market risk premium be?... Criteria to identify if “big winner” potential exists (Bhide) Lack of ability to compare against other firms when industry is new Lack of short term profit potential in the immediate future Lack of liquidity... CASH IS KING!!! (e.g., Sahlman)

Implications... Entrepreneurial finance involves useful ways of thinking about cash, risk, and value (Sahlman, 1992)... that is, it Teaches skepticism (there are fewer ‘true’ opportunities from a financial perspective than we often think!) Helps us identify the ‘right’ questions to ask and narrow down the potential options, which in turn enable us to make better decisions  Ex: Is “Fit” an “Opportunity”?  Discovery Driven Planning (Market, Margin, Me)  New Venture Strategy  Ex: If I use X financing now and Y financing later, have I created incentives for all stakeholders to work together?

Implications... Helps us identify the ‘right’ questions to ask and narrow down the potential options, which in turn enable us to make better decisions  Ex: Is “Fit” an “Opportunity”?  Discovery Driven Planning (Market, Margin, Me)  New Venture Strategy  Ex: Explicit and hidden costs of using other people’s money... (Bhide)  Danger of misallocation... Throwing money at symptoms  Diminished flexibility...  “Operational lock”  Credibility issues... “What to you mean, didn’t we get it right the 1 st time?”  If I use X financing now and Y financing later, have I created incentives for all stakeholders to work together?

Key Theme... Horse race between capital, greed and opportunity... (Sahlman) Investing in new ventures is cycle process... involves both positive ebbs and flows People matter... Perceptions, judgments, and actions.

CASH FLOW

Example of Cash Flow Cycle Over the Life Cycle of a Business Profits Cash flow Start-up to Early Stage Growth StageMaturity 0

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

Measuring Cash Flow Cash Flow from Operating Activities Cash Flow from Investing Activities Cash Flow from Financing Activities

Internal (i.e., Bootstrapping) Debt Equity PRIMARY TYPES OF FUNDING (I.E., SOURCES)... ?

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

Why Bootstrap? Often necessary for small businesses to get started (New Ventures are generally “poor fit” for traditional lending models (Bhide, 1992) Preserves the value and wealth of a business Difficulty in raising and using money for growth E.g., danger of misallocation (Bhide, 1992) E.g., diminished flexibility (operational – path dependence effects of missing on 1 st attempt (Dierckx & Cool, 1989); credibility loss with lenders (Bhide, 1992))

Bootstrap Marketing Know your customer Impact of message more important than “volume” Remember your market space or niche and the benefits you bring... spend your marketing dollars carefully Marketing is a process, not an event Examples... ?

Human Resources Bootstrapping Employee “stretching” Independent contractors Employee leasing and temporary employees Student interns Equity compensation Non-monetary benefits Examples... ?

Administrative Overhead Bootstrapping Space Furnishings and office equipment Administrative salaries

Operations & Inventory Bootstrapping Outsourcing Just-in-time inventory techniques Effective cost accounting

DEBT FINANCING

Short-term Debt Financing Expected to be paid within one year Most often used to finance short-term expenditures such as inventory, supplies, payroll, etc. Trade debt Banks Asset-based lenders Factors

Long-term Debt Beyond one year Most often used to fund fixed asset purchases Banks: term loans Leasing companies Real estate lenders

Overlooked Forms of Debt Property leases Long-term employment agreements SBA or other government backed lending programs

6 C’s: Criteria for Lending by Bankers 1. Character of founder and key leaders 2. Capital – equity... “skin in the game” Venture 3. Capacity – cash flow capability to easily make interest and principle payments & awareness 4. Conditions – industry trends, seasonality, operational changes, world events, etc. 5. Collateral – “hard” assets to pledge Banker 6. Common sense – what does your gut tell you?

Downside of Debt Increased risk during economic slowdown Impact on proceeds from business sale Restrictive covenants Personal guarantees

EQUITY FINANCING

Sources of Equity Funding Funding from the entrepreneur Family and friends (and “fools”!) Strategic partners Angel investors Private placement SBICs Venture Capitalists

Potential Downsides of Equity Financing Dilution of ownership The risk of sharks Dynamics of adding on new partners

Working with Equity Investors 1. Business plan 2. Confidentiality agreement 3. Letter of Intent 4. Modifications of shareholder agreements

Creating an Array of Financing Prioritize financing needs based on forecasts Focus financing only on what is critical for operations Create an inventory of all assets and what proportion of each can be financed

Creating an Array of Financing AssetPercentage financed Purchase Orders70% A/R (<60 days)70% Inventory30% Leasehold Improvements 50% Building70% Undeveloped land40% Equipment80%

Creating an Array of Financing Identify best source of financing for each asset Multiple funding sources are likely Remember to bootstrap!

Venture Capital: Stages of High Growth Business Funding 1. Initial stage 2. First round financing 3. Second round financing 4. Late round financing

Initial Stage Funding File for incorporation Write business plan Find office and development space Completion of initial design Hire key development personnel Complete prototype unit Complete prototype testing

First Round Financing Secure key vendors Hire key service or manufacturing personnel Rent or build manufacturing facility Purchase manufacturing equipment Market testing First sales contract Production of first manufactured unit First 100, 1000, units, etc.

Second Round Financing Break-even level of sales Development of next generation of product

Late Round Financing Initial public offering Sale of business