1. Chapter 15 Choice of Financing Copyright¸ 2003 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. Instructors may make copies of the PowerPoint Presentations contained herein for classroom distribution only. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

2. Learning Objectives Factors that influence the choice of financing. Effects of immediacy on the range of alternatives. Effects of size and duration of need on the range of alternatives. Effects of financial condition and stage of development on the range of alternatives. Advantages and disadvantages of relational financing. Why financial distress affects availability of financing. The difference between financial distress and failure. Effects of collateral, reputation, and relationships on availability of financing. How bilateral negotiation affects deal terms and timing. ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 15

3. A Partial List of Financing Sources for New Ventures and Private Business Asset-based Lending Business Angels Capital Leasing (Venture Leasing) Commercial Bank Lending (various forms) Corporate Entrepreneurship Customer Financing Direct Public Offering Economic Development Program Financing Registered Initial Public Offering Research and Development Limited Partnerships Relational Investing or Strategic Partnering Royalty Financing Self (bootstrapping) Small Business Administration Financing ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 15

4. A Partial List of Financing Sources for New Ventures and Private Business Employee-provided Financing Equity Private Placement Export/Import Bank Financing Factoring Franchising Friends and Family Public Debt Issue Small Business Investment Company Financing Term Loan Vendor Financing Venture Capital ©2003, Entrepreneurial Finance, Smith and Kiholm SmithChapter 15

5. Basic Factors Affecting Financing Capital Providers can diversify their risk at lower cost Cost of managing external capital –Expectation of periodic reporting –Negotiation and transaction costs Leverage is good –Well diversified investors do not need to be compensated for bearing non-market risk –Investor benefits by using equity for financing Resource providers benefit from functions that enhance value –Monitoring and advising can destroy value, however Taxes can affect financing choice, depending on organizational form –Debt has different effects than equity –Timing of taxation can be of benefit to parties –If tax benefits cannot be achieved, it affects decision

6. Factors That Affect the Choice of Financing Financial needs of the venture Stage of Development Financial Condition Product-Market Considerations Organizational Considerations Track Record/Reputation/Relationships ©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

7. Steps in Determining Financing Step 1 Assess Needs of venture Step 2 Assess Current Condition of Venture Step 3 Assess Relation Between Financing choices and Organizational Structure

8. Financial Needs of the Venture Immediacy of the need –Based on time required for negotiation Personal relationships help with trust –Immediate  timing constrains choice –Near-term  Milestone based –Cumulative  Connects near-term and ultimate needs Limits –Ability of source to respond –Negotiation time –Regulation –Near term financing is expensive –Prior financing may limit subsequent financing ©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

9. Financial Needs of the Venture Size of the immediate need –Friends, angels, SBA/Development, IPO –One cannot use a source that does not have the capacity Duration of the immediate need –Shouldn’t use short term sources for long-term needs or vice versa –Transactions costs for short-term sources are lower due to less due-diligence –Short-term  debt secured by assets –Sale of assets (AR) or sale and lease-back –Vendor Financing is expensive because payments can be delayed –Long-term financing (except for passive equity) usually comes with more restrictions

10. Financial Needs of the Venture Cumulative need –Early financing should be arranged so as to avoid the effects of covenants or to allow subsequent financing rounds –If long-term needs are expected to be lower, arrange to pay off near term financing without penalty later

11. Current Condition of Venture Stage of Development Value of outside advice to firm Organizational Structure and tax status Track Record Level and Stability of earnings and cash flows Asset base - Collateralization Existing financing

12. Current Condition - Stage of Development Ability to create stable cash flow  Debt Completeness of the management team Ease of communicating the venture’s merit Value of managerial/consulting services Importance of flexibility/adaptability ©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

13. Current Condition - Financial Condition Risk/Return characteristics of the venture Taxable income status Operating cash flow status Time to a liquidity event Transferability of tax benefits to investors Available collateral Cash flow cycle ©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

14. Financing Distressed Firms Financial distress is not the same as need for cash –Distress = disappointing investors –Violation of covenants –Defaulted on repayment obligations –Inability to carry out plans –Missed milestones Distress means not able to meet expectations –Failure undermines credibility and increases cost of capital and increases likelihood of investor failsafe Turning around a distressed firm is more difficult than an initial funding event –One exception is bankruptcy protection

15. Product-market and Organizational Considerations Importance of rapid growth as a part of product- market strategy Nature and importance of relationship with a supplier or distributor Dedication of distributors to the product Cost s and benefits of centralization of control ©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

16. Track Record/ Reputation/relationships Track record of the venture Importance of future financing needs Past failure or financial distress Likely failure in the near future Reputation of the entrepreneur Relationships with financing sources ©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

17. ©2003, Entrepreneurial Finance, Smith and Kiholm Smith Figure 15-2 Chapter 15

18. Figure 15-3 ©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

19. Sources of SBA Funds Direct Loan Program –Special class –Disaster –Economic distress or equality –Prior denials of other loans usually required Loan Guarantee Program –Most common –Loans guaranteed 80 percent Microloan program –35,000 limits –Startup and small business SBIC –Capital of investor supplemented by SBIC