1. 13–1 IPFW Business Plan Competition Pre-competition Program Financing and Capital Sourcing Options By Dr. Bill Todorovic Richard T. Doermer School of Business and Management Neff Hall 340L, Tel. (260) 481 6940 E-mail: todorovz@ipfw.edu todorovz@ipfw.edu Web: http://users.ipfw.edu/todorovz Web: http://users.ipfw.edu/todorovz/http://users.ipfw.edu/todorovz /

2. 13–2 The Nature of a Firm and Its Financing Sources Factors That Determine Financing –Firm’s economic potential –Maturity of the company –Nature of its assets –Owners’ preferences for debt or equity

3. 13–3 Sources Of Funds Personal Friends and Family Angels Venture Capitalist Banks Government Customers/Suppliers Start-up Going Concern Beginning of Production ? IPO Amount Company Size

4. 13–4 Sources of Financing 01020304050607080 Personal Savings Family Members Partners Personal Charge Cards Friends Bank Loans Private Investors Mortgaged Property Venture Capital Other Percentage of Entrepreneurs Using Source of Financing Sources of Financing

5. 13–5 Critical Financing Factors Accomplishments and performance to date. Investor’s perceived risk. Industry and technology. Venture upside potential and anticipated exit timing. Venture anticipated growth rate Venture age and stage of development.

6. 13–6 Critical Financing Factors Investor’s required rate of return Amount of capital required and prior valuations of the venture Founders’ goals regarding growth, control, liquidity, and harvesting. Relative bargaining positions. Investor’s required terms and covenants.

7. 13–7 Debt or Equity? Entrepreneurs typically prefer debt –Allows them to appropriate as much as of the benefit as possible + retain sole control –Can default Debt is unattractive to investors in emerging technology –Usually little collateral or predictable cash flow –Information asymmetry is lessened by ownership position – shared ownership gives some control –High interest rate to offset risk will stifle growth or cause default

8. 13–8 Debt or Equity Financing? Potential Profitability Financial Risk Voting / Control

9. 13–9 Fig. 13.1 Equity financing Debt financing HIGH LOW HIGH Equity Financing Debt Financing Potential Profitability Financial Risk/Control Tradeoffs Among Potential Profitability, Financial Risk, and Voting

10. 13–10 $28,000 income on total assets of $200,000 14% return on assets ($28,000÷ $200,000) 14% return on $200,000 ($28,000÷ $200,000) No debt equals $200,000 equity With no debt and all equity: Debt Versus Equity Equity: Owners get to keep all of the profits in return for accepting the risk of lower returns

11. 13–11 $28,000 income on total assets of $200,000 14% return on assets ($28,000÷ $200,000) 18% return on $100,000 ($18,000÷ $100,000) $100,000 debt (10% cost) equals $100,000 equity With $100,000 debt and $100,000 equity: Debt Versus Equity (Cont’d) Debt is Risky: Lenders have first claim on profits and must be paid even if there are no profits.

12. 13–12 Fig. 13.3 Sources of Funds

13. 13–13 The Banker’s Perspective Bankers’ Concerns! The Five C’s of Credit –Character of the borrower –Capacity of the borrower to repay the loan –Capital invested in the venture by the borrower –Conditions of the industry and economy –Collateral available to secure the loan

14. 13–14 Questions Lenders Ask Lender’s Questions –What are the strengths and qualities of the management team? –How has the firm performed financially? –How much money is needed? –What is the venture going to do with the money? –When is the money needed? –When and how will the money be paid back? –Does the borrower have qualified support people, such as a good public accountant and attorney?

15. 13–15 Financial Information Required for a Bank Loan Three years of the firm’s historical statements The firm’s pro forma financial statements Personal financial statements

16. 13–16 Negotiating a Loan Terms of Loans –Interest rate –Loan maturity date –Repayment schedule –Loan covenants

17. 13–17 Getting to know your friendly neighborhood Venture Capitalist…

18. 13–18 The myth… and the reality The myth: VCs support good people and good ideas The reality: VCs invest in industries with double digit growth in the middle of the S-curve –Appropriate management team –Specialty funds (earlier and later stages on the S- curve) –Limits the risk to management risk –Produces attractive exit opportunities

19. 13–19 Present Day Situation Myth: There is less available capital Fact: The industry has plenty of money, but limited appetite for new investment Fact: Investor attitudes toward risk have changed

20. 13–20 The venture capital industry Accounts for about 2/3 of private-sector external equity financing of high tech firms in U.S., but less than 1% of all equity in SMEs VC sensitive to capital gains tax, ability of institutional investors to contribute to high risk funds, and performance of the stock market (especially IPOs) Highly specialized by industry, location and stage

21. 13–21 VC fills a void Gap between innovation and traditional sources of debt Risk inherent in startups typically justify interest rates higher than allowed by law VCs must balance high returns for their investors against sufficient upside potential for entrepreneurs to keep them motivated

22. 13–22 What VCs get out of it 10X return on capital over 5 years VCs management fees and high growth funds Fund structured with limited and general partners and a life of 7-10 years

23. 13–23 What VCs Do?

24. 13–24 When the Market is Down…

25. 13–25 The Overhang: Uninvested Capital Complements of Thompson Venture Economics

26. 13–26 AngelsAngels Well to do private individuals Geography and industry specific Invest lower amount than VC Often a good source of industry experience

27. 13–27 Finding Angels Private Individuals Professionals (lawyers, accountants, bankers) Local small business development centers Internet associations (e.g., Technology Capital Network at MIT)

28. 13–28 Other Sources of Financing Community-based financial institutions Large corporations Stock Sales –Private placement –Initial public offering (IPO)

29. 13–29 Why Companies Invest? Preemption of new rivals Replace core earnings lost because of an emerging technology Apply existing competitive advantage in a rapidly growing market And some degree of autonomy: –JVs, alliances, flexible internal management structures

30. 13–30 Government-Sponsored Programs and Agencies Small Business Administration (SBA) loans –Guaranty loan –Direct loan Small business investment centers (SBICs) Small Business Innovative Research (SBIR) State and Local Government Assistance

31. 13–31 Business Suppliers and Asset-Based Lenders Trade Credit (Accounts Payable)  Short-duration financing (30 days)  Amount of credit available is dependent on type of firm and supplier’s willingness to extend credit

32. 13–32 Business Suppliers and Asset-Based Lenders (cont’d) Equipment Loan and Leases Leases  Free up cash for other purposes  Leaves lines of credit open  Provides a hedge against obsolescence

33. 13–33 Business Suppliers and Asset-Based Lenders (cont’d) Asset-based Loan Factoring  Accounts are sold to factor at a discount to invoice value  Factor can refuse questionable accounts  Factor charges fees for servicing accounts and for amount advanced to firm prior to collection

34. 13–34 Business Suppliers and Asset-Based Lenders (cont’d) Commercial Banks –Line of credit –Revolving credit agreement

35. 13–35 Business Suppliers and Asset-Based Lenders (cont’d) Commercial Banks (cont’d) –Term loans –Chattel mortgage –Real estate mortgage

36. 13–36 Formal Vs. Informal Investors Funding structure and flexibility The fit to the mold Involvement in the business Rigidity of relationship with the firm

37. 13–37 Discussion?Discussion?

38. 13–38

48. 13–48 The Three Phases of Venture Activity Fund Raising/commitments – VC firms raising capital Investment – VC firms putting capital to work Liquidity – VC firms exiting investments These are inextricably tied; if any suffers, they all do Complements of Thompson Venture Economics

49. 13–49 Other sources of funding Debt and bootstrapping Leasing Angel capital Government grants Corporate VC Early entry into public markets

50. 13–50

51. 13–51 Other Sources of Financing (cont’d) Stock Sales –Private placement  The sale of a firm’s capital stock to selected individuals –Initial public offering (IPO)  The issuance of stock that is to be traded in public financial markets  Places firm under SEC securities regulations

52. 13–52

53. 13–53 Complements of: Timmons/Spinelli New Venture Creation, sixth edition Low Level Investment Lower Long-term Income Potential (Lower Capacity)

54. 13–54 First Things First Burn rate OOC (out of cash) Search out capital markets Increase cash flow

55. 13–55 Strategy Refinement Market niche Suppliers and customers Diversification or specialization Reduce fixed costs Plan for contingency

56. 13–56 Management Refinement Management skill, experience and know how Control of Finance Turnover

57. 13–57 When the market is down Increase Your Effectiveness and Efficiency Be Creative Pursue different sources of capital

58. 13–58 Building to Grow

59. 13–59 Create Value Shareholders Customers Employees Contingency Plan Best Case Scenario Worst Case Scenario Most Likely Scenario Good Team Every business is built onpeople Good DecisionsSolid FinancingPersistence Reduce Risk Increase Value

60. 13–60 Example 1 Sales Growth; ODG

61. 13–61 The Sound Advice Monitor Cash Flow (especially if growth is high) –100 fastest growing companies –Entrepreneur of the year award Contingency Plan – get the timing right Emphasize long term growth Manage your risk factor

62. 13–62 Example 2: Ergo Distributor Sales growth 400-500% Single supplier – No substitutes Great financial ratios Cash flow problems May go bankrupt in couple of years LESSON: Use your intuition

63. 13–63 Who invests in VC funds? Typically pension funds, financial firms, insurance companies, endowments and high net worth individuals Small percentage of total funds –Expect returns of 25%-30% Most are structured as limited partnerships Other forms include: –Corporate VC funds –Private funds –Publicly listed funds –Labour sponsored funds (in Canada)