1. 13–1 Copyright © by South-Western College Publishing. All rights reserved. IPFW Business Plan Competition Pre-competition Program Financing and Capital Sourcing Options By Dr. Bill Todorovic Department of Management and Marketing 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. Debt or Equity Financing? Potential Profitability Financial Risk Voting / Control

9. 13–9 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. $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 Copyright © by South-Western College Publishing. All rights reserved. $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 Copyright © by South-Western College Publishing. All rights reserved. Fig. 13.3 Sources of Funds

13. 13–13 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. Negotiating a Loan Terms of Loans –Interest rate –Loan maturity date –Repayment schedule –Loan covenants

17. 13–17 Copyright © by South-Western College Publishing. All rights reserved. Getting to know your friendly neighborhood Venture Capitalist…

18. 13–18 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. What VCs get out of it 10X return of 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 Copyright © by South-Western College Publishing. All rights reserved. What VCs Do?

24. 13–24 Copyright © by South-Western College Publishing. All rights reserved. When the Market is Down…

25. 13–25 Copyright © by South-Western College Publishing. All rights reserved. The Overhang: Uninvested Capital Complements of Thompson Venture Economics

26. 13–26 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. Other Sources of Financing Community-based financial institutions Large corporations Stock Sales –Private placement –Initial public offering (IPO)

29. 13–29 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. Business Suppliers and Asset-Based Lenders (cont’d) Commercial Banks –Line of credit –Revolving credit agreement

35. 13–35 Copyright © by South-Western College Publishing. All rights reserved. Business Suppliers and Asset-Based Lenders (cont’d) Commercial Banks (cont’d) –Term loans –Chattel mortgage –Real estate mortgage

36. 13–36 Copyright © by South-Western College Publishing. All rights reserved. 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 Copyright © by South-Western College Publishing. All rights reserved. Discussion?Discussion?