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The Nature of the Funding and Financing Process

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Few people deal with the process of raising investment capital until they need to raise capital for their own firm. As a result, many entrepreneurs go about the task of raising capital haphazardly because they lack experience in this area.

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There are three reasons most new ventures need to raise money during their early life.

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-Cash flow challenges -capital investments -lengthy product development cycles

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Alternatives for Raising Money

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-personal funds -debt financing -equity capital -other (creative) sources

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Sweat equity represents

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the value of the time and effort that a founder puts into a new venture.

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Friends and family are the second source of funds for many new ventures.

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This type of contribution often comes in the form of loans or investments but can also involve outright gifts, forgone or delayed compensation (for a family member who works for the new firm), or reduced or free rent.

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Bootstrapping

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is finding ways to avoid the need for external financing or funding through creativity, ingenuity, thriftiness, cost-cutting, or any means necessary.

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Examples of Bootstrapping Methods

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-Buying used instead of new equipment -minimizing personal expenses -sharing office space with other businesses

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Preparing to Raise Debt or Equity Financing(1 of 3)

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1. Determine precisely how much is needed, 2. determine the type of funding that is the most appropriate, 3. develop a strategy for engaging potential investors

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Two most common alternatives for raising money

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-equity funding -debt financing

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equity funding

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Means exchanging partial ownership in a firm, usually in the form of stock, for funding. Angel investors, private placement, venture capital, and initial public offerings are the most common sources of equity funding. Equity funding is not a loan—the money that is received is not paid back. Instead, equity investors become partial owners of a firm.

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Debt financing

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Debt financing is getting a loan. The most common sources of debt financing are commercial banks and the Small Business Administration (through its guaranteed loan program).

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Sources of Equity Funding

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Venture capital, business angels, IPOs.

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Business Angels

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Are individuals who invest their personal capital directly in start-ups.

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The prototypical business angel is

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about 50 years old, has high income and wealth, is well educated, has succeeded as an entrepreneur, and is interested in the start-up process. The number of angel investors in the U.S. has increased dramatically over the past decade

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venture capital

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Is money that is invested by venture-capital firms in start-ups and small businesses with exceptional growth potential.

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There are about

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650 venture-capital firms in the U.S. that provide funding to about 3,000 firms per year.

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A typical fund is

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$75 million to $200 million and invests in 20 to 30 companies over a three- to five-year period.

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Venture-capital firms fund very few entrepreneurial firms in comparison to

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business angels.

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Many entrepreneurs get discouraged when

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they are repeatedly rejected for venture capital funding, even though they may have an excellent business plan. Venture capitalists are looking for the "home run" and so reject the majority of the proposals they consider. Still, for the firms that qualify, venture capital is a viable alternative for equity funding.

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An important part of obtaining venture-capital funding is going through the due diligence process:

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Venture capitalists invest money in start-ups in "stages," meaning that not all the money that is invested is disbursed at the same time.

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Some venture capitalists also specialize in certain "stages" of funding. For example,

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some venture capital firms specialize in seed funding while others specialize in first-stage or second-stage funding

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An initial public offering (IPO) is

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a company's first sale of stock to the public. When a company goes public, its stock is traded on one of the major stock exchanges.

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Most entrepreneurial firms that go public trade on the NASDAQ, which is

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weighted heavily toward technology, biotech, and small-company stocks.

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An IPO is an important milestone for a firm. Typically, a firm is not able to go public until

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it has demonstrated that it is viable and has a bright future.

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Four reasons that motivate firms to go public

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1. Is a way to raise equity capital to fund current and future operations. 2. An IPO raises a firm's public profile, making it easier to attract high-quality customers, alliance partners, and employees. 3.An IPO is a liquidity event that provides a means for a company shareholders (including its investors) to cash out their investments 4.By going public, a firm creates another form of currency that can be used to grow the company.

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The first step in initiating a public offering is to hire an investment bank. An investment bank is

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an institution, such as Credit Suisse First Boston, that acts as an advocate and adviser and walks a firm through the process of going public.

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the investment bank typically takes the firm's top management team wanting to go public on a road show, which is a whirlwind tour that consists of

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meetings in key cities where the firm presents its business plan to groups of investors (in an effort to drum up interest in the IPO).

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Sources of Debt Financing

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Commercial Banks SBA Guaranteed Loans

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Historically, commercial banks have not been viewed as

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practical sources of financing for start-up firms.

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Banks are interested in firms that have

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a strong cash flow, low leverage, audited financials, good management, and a healthy balance sheet.

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The SBA Guaranteed Loan Program

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-Approximately 50% of the 9,000 banks in the U.S. participate in the SBA Guaranteed Loan Program. -The program operates through private-sector lenders who provide loans that are guaranteed by the SBA. -The loans are for small businesses that are not able to obtain credit elsewhere.

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What is the most notable SBA program available to small businesses.

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The 7(A) Loan Guaranty Program

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Size and Types of SBA Loans

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Almost all small businesses are eligible to apply for an SBA guaranteed loan. The SBA can guarantee as much as 85% on loans up to $150,000 and 75% on loans over $150,000. An SBA guaranteed loan can be used for almost any legitimate business purpose. Since its inception, the SBA has helped make $280 billion in loans to nearly 1.3 million businesses.

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Creative Sources of Financing or Funding

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Leasing Strategic Partners Small business innovation research grants Crowdfunding

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A lease is

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a written agreement in which the owner of a piece of property allows an individual or business to use the property for a specified period of time in exchange for payments.

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The major advantage of leasing is

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that it enables a company to acquire the use of assets with very little or no down payment.

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The two most common types of leases that new ventures enter into are

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leases for facilities and leases for equipment.

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For example, many new businesses lease computers from Dell. The advantage for the new business is that

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it can gain access to the computers it needs with very little money invested up front.

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Most leases involve a

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modest down payment and monthly payments during the duration of the lease.

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At the end of an equipment lease, the new venture typically has the option to

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stop using the equipment, purchase it for fair market value, or renew the lease.

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Leasing is almost always more expensive than

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paying cash for an item, so most entrepreneurs think of leasing as an alternative to equity or debt financing.

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The Small Business Innovation Research (SBIR) and the Small Business Technology Transfer (STTR) programs are

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two important sources of early-stage funding for technology firms. These programs provide cash grants to entrepreneurs who are working on projects in specific areas.

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The main difference between the SBIR and the STTR programs is

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that the STTR program requires the participation of researchers working at universities or other research institutions.

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The SBIR Program is a competitive grant program that provides

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over $1 billion per year to small businesses in early-stage and development projects.

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Each year, 10 federal departments and agencies are required by the SBIR to

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reserve a portion of their R funds for awards to small businesses.

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The SBIR is a three phase program, meaning that

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firms that qualify have the potential to receive more than one grant to fund a particular proposal.

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Historically, less than 15% of all phase I proposals are funded. The payoff for successful proposals, however, is high.

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The money is essentially free. It is a grant, meaning that it doesn't have to be paid back and no equity in the firm is at stake. The small business receiving the grant also retains the rights to any intellectual property generated as the result of the grant initiative.

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Small Business Innovation Research (SBIR): Three-Phase Grant Program

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Phase 1: to demonstrate the proposed innovation's technical feasibility (duration: up to 6 months) $75,000-$100,00 Phase 2: available to successful phase 1 companies. The purpose of a phase 2 grant is to develop and test a prototype of the innovation validated in phase 1 (duration: up to 2 years) (funding: $300,000-$750,000) Phase 3: Period in which phase 2 innovations move from the research and development lab to the marketplace (duration: open) (funding: no funding)

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Biotechnology, for example, relies heavily on

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partners for financial support. Biotech firms, which are typically small, often partner with larger drug companies to conduct clinical trials and bring products to market.

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Alliances also help firms

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round out their business models and conserve resources.

MGT 460: Raising Capital – Flashcards

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