Overview of Financing a Business Venture
Obtaining funds to establish, operate, and grow a business is an essential component of entrepreneurship. Surveys indicate that one of the greatest hurdles to entrepreneurs undertaking a business venture is the availability of funds. It may surprise you to know that of the 500 fastest growing businesses of 2013, more than half of them started with less than $20,000 capital investment. With that said, from that initial investment, these firms were incredibly successful in securing the additional funds necessary to continue operating and growing the business.
Sources of Funding
Adequate financing is incredibly important to the success of a business startup, regardless of the stage of development. There are several basic ways of getting money for your business:
- Company Revenue
- Personal Funds,
- Personal income (Bootstrapping)
- Personal Savings
- Personal Debt,
- Credit cards
- Secured loans or lines of credit (Home-equity loan)
- Gifts from Others
- Generous family members
- Loans from Friends or Family,
- Interest-bearing or Interest-free promissory notes
- Loans from Financial Institutions,
- Generally personally guaranteed or fully secured by assets
- May be government backed (SBA Loans)
- Selling Equity Ownership
- Partners of business co-owners
- Other Methods
- Cash Flow Financing
- Receivable Financing
Each of the above funding sources are discussed in greater detail in individual lectures.
Choosing a Funding Method
Various forms of a funding is available at each stage of the startup ventures. For example, among founders, over 80% of businesses begin with some form of personal funds of the entrepreneur; while approximately 35% receive funding from co-founders of the business. The important thing to remember is that each business is unique. Focus on the type of money that meets the operational needs and personal preferences of the stakeholders. Ask yourself the following questions.
- How much do you need?
- Banks look at smaller amounts than equity investors.
- Know the investment range for types of investors.
- What will the money be used for?
- Banks like to see money used for hard assets.
- Equity investors are willing to accept alternative uses of cash.
- At what stage in the lifecycle is your business?
- Most banks avoid early stage due to the risk.
- What is your capacity to repay the money?
- Lenders look at cash flow of the business for the ability to pay.
- Equity investors look for a exit event return on investment.
- Other Considerations
- Investors look at the individuals involved in the venture as much as the venture.
- Money doesn’t go to the best idea, but to the business team with a solid idea that has the best opportunity to execute.
Funding a New Venture with Company Revenue
Some startup ventures are fortunate enough to fund various stages of business development and growth with funds generated by the business activity. For example, at the seed stage a services firm may be able to take on client work that provides the revenue necessary to establish the business (i.e., develop the full panoply of operations and services offered) and hire employee service providers. A product business, on the other hand, will generally need some level of infusion of capital to develop and test the product before generating income. As such, revenue funding may not be a viable option unless the product business is combined with a service function.
Lifestyle businesses often attempt to use company revenue to operate the business and achieve any available growth. They may also look to debt arrangements to supply critical funding (such as a rotating line of credit to meet payroll). Lifestyle businesses rarely seek or qualify for equity investment from outside investors. Investors generally for growth potential and orientation that is not present in the lifestyle venture.
Startup Ventures are growth oriented. These companies generally reinvest all profits from revenue back into the business to achieve growth. In many cases, the revenue generated by the business is not sufficient to maximize the business’s growth potential. That is, value is lost by failing to acquire outside funding (debt or equity) sufficient to achieve the firms full growth potential.
Seed funds for a startup business ventures generally come from a combination of personal savings and bootstrapping by the founders. Entrepreneurs will use personal assets and may incur personal debt to fund the early stage venture. Personal guarantees of commercial debt are covered in a separate lecture. Common methods of acquiring funds from personal assets include:
- Cash on hand and Savings Accounts
- Borrowing against retirement Accounts
- Selling of personal assets
- Particularly common to cash in chattel paper or other semi-liquid assets.
- Example: Selling stocks, bonds or whole life insurance policies.
- Home Equity Loans
- This is where you take out a loan against available equity in your home.
- This method generally provides a much lower interest rate than other types of commercial loans.
- The principal payments go back into your home and the interest is tax deductible.
- Personal Credit Cards
- Credit cards are good to cover startup expenses of small businesses.
- Generally, they are more useful to add liquidity (cash is more easily available) in an operating business.
- If you have a credit card, you have a built in line of credit. Although credit cards are one of the most costly ways to finance your company, they are routinely used as a source of funds for start-up businesses.
Bootstrapping is term used to refer to situations where the entrepreneur splits her time working a job that finances much of the entrepreneurial venture. That is, the revenue generated from some other sources is allocated to fund the business venture. Bootstrapping is very common in early stages of business ventures. Once the venture achieves growth or traction, the entrepreneur must make the difficult decision of when to devote all of their time and effort to the startup venture.
Friends, Family and Fools
Friends and family members may want to support your business venture by lending or gifting funds to you. In some cases friends or family may want to invest or purchase an ownership interest in the business venture. This is the most basic form of crowdsourcing the business venture. You collect funds from a larger group of people who have a vested interest in your success. Each year between 35-40% of startup ventures receive capital from friends and family.
This group is commonly called “friends, family, and fools.” The reason fools are grouped into this category relates to the risk associated with lending or investing in a seed venture. Generally, these individuals are not sophisticated investors; rather, they invest in a foolish or whimsical manner. As such, it is strongly advisable that any business loan or investment follow all formalities for a typical lender or investment relationship. Loans should be made with a well-drafted promissory note, and equity investment should be pursuant to a negotiated term sheet (with all relevant provisions).
Benefits of Friends and Family Financing
Generally, friends and family financing does not involve the formal review process or due diligence involved in commercial loan or angel investment situations. That is, friend and family are not going to conduct a thorough review of your credit history or require extensive collateral to secure the loan. The friends and family relationship is also generally flexible with regard to repayment options and applicable interest rates.
Process for Approaching Friends and Family for Financing
Obtaining money from friends and family can be a risky proposition for the relationship. Money is a touchy subject. The awkwardness in the relationship is magnified by any uncertainty in the relationship. With that understanding, it is advisable to apply a formal approach when asking or seeking funds from friends and family. The following is a proposed process for seeking funds:
- Have an understanding of what type of deal you seek.
- Note: You need to determine whether you want a debt or equity relationship. What should be the terms of each (company valuation, interest rate, how much are you seeking, etc.). Much of this information will be included in the business plan.
- Hold a formal meeting to pitch (explain) the business.
- Note: Do not try to negotiate this during a single meeting. Give the friend or family member time to think over the situation.
- Provides a professional business plan.
- Note: The business plan should have a detailed SWOT analysis. Further, the investor should provide a detailed explanation of the potential risks associated with the business.
- Provide any product or service information, supporting information, or due diligence relevant to the business.
- Use formal documents to memorialize the relationship
- Note: Use a well-drafted promissory note for a debt arrangement. Use a subscription (purchase) agreement and Buy-Sell Agreement for equity investments.
Loans from Lending Institutions
- Micro-loans – These are small seed capital loans (the average is $13,000) made to qualifying businesses by financial institutions or non-profits. Often these loans will be backed or secured by a particular state or federal governmental program.
- Small Business Loans – The US Government via the Small Business Administration (SBA) offers several small business loan programs. Under any SBA loan program, qualified financial institutions under the Small Business Investment Company (SBIC) program make loans to approved businesses. The SBA secures these loans against default, which provides the security necessary for the business to obtain the loan. The SBA will guarantee a certain percentage of the loan (generally 75% or more) against default. The SBA lender will still require a secondary source of repayment (personal credit, collateral assets, etc.) Most SBA loans range from $25,000 to $1 million.The rate on the SBA loan is the prime rate plus 2.75%. There is a closing fee and SBA guarantee fee, which is 1.6 – 2.6% of the guaranteed loan amount. (These fees can be rolled into the loan.)The lending institution must require that the entrepreneur sign a personal guarantee for the debt as well. The SBA has fairly strict requirements to qualify under each available loan program. SBA Programs include:
- LowDoc Loan Guarantee: Loans up to $150K based primarily on personal credit history.
- 7(a) Program: For amounts up to $750K and covers working capital and refinancing.
- 504 Program: For purchase of hard assets up to $1 Million. This uses financing from a third party bank and a Certified Development Company.
- Non-SBA Loans – Private financial institutions may make any form of loan or extend lines of credit to small businesses. There are rash of startups that focus on lending to startup ventures. Banks often make private loans to businesses, but these loans generally requires proof of income history and extensive equity to secure the loan and/or a personal guarantee from the borrowers. The interest rates on non-SBA loans are generally far higher than SBA backed loans, given the higher degree of risk of such loans.
Obtaining a loan from a lender requires an understanding of what the lender is looking for with regard to the loan. The lender provides debt capital for your business. The lender will make a profit on the loan by charging an interest rate on the debt that reflects the level of perceived risk of default. Often, the risk associated with making a loan to a startup venture is too high to undertake in the absence of some form of security in the form of personal guarantees and collateral.
- Collateral – Collateral for a loan is generally assets of the borrower (personal property, equipment, real estate, securities, receivables, etc.). The lender will take a security interest in the collateral to secure the loan. See our Secured Transactions lecture series to further explore security interests in collateral. Without sufficient collateral, most financial institutions will not make loans to startups, unless the loan qualifies for some sort of backing – such as a small business administration (SBA) backed loan.
- Funds from Owners – In addition to a personal guarantee by the entrepreneur and posting collateral to secure the loan, financial institutions will require that the entrepreneur invest their own funds in the venture. Lenders like to see some sort of financial commitment by the owner. (Generally, 10% to 20% of startup funds financed by the owner).
- Business Plan – The lender will require a detailed business plan to adequately judge the amount of risk in lending to the business venture. The business plan will outline the assets and debts of the business (Balance Sheet), the income history of the business (income statement), and a statement of cash on hand (cash flow statement). These documents will demonstrate the assets available to secure the loan, the profitability of the venture going forward, and the cash available to service the debt payments.
- Credit History – The bank will review the credit history of the business (generally Dunn & Bradstreet) and the credit rating of the owners. This demonstrates the business and owner’s commitment to creditworthiness.
- Personal Guarantee – Lastly, the bank will require each owner to sign a personal guarantee for the business loan. This means that, if the business defaults on the loan, the bank may seek to collect the outstanding loan balance from the owners.
- SBA Backing – Remember, SBA backing provides additional security for qualified loans from approved lenders. Approval of SBA backing often allows a business to obtain a loan that otherwise is too risky for the lender. For example, an absence of any of the above-referenced requirements may make a loan too tenuous without SBA backing.
What is a Promissory Notes
Any commercial loan will require a debt instrument (known as a promissory note) evidencing the debt and outlining the obligations of the borrower to repay the funds. These documents will generally include all relevant terms of the lending relationship, including interest rate and repayment schedule. As previously mentioned, debt relationships between friends and family should also employ a promissory note. This adds formality to the relationship that aids in setting the expectations of all parties. Further, the promissory note is the best way to memorialize the creditor-debtor relationship for tax purposes.
Repayment Schedules of the Promissory Note
Repayment structures on a promissory note may vary considerably. Below are explanations of basic repayment structures used in the promissory note:
- Amortized Payments: Most business loans amortize over the life of the lone. That is, you will make equal payments at set intervals (usually monthly) throughout the life of the loan. Some portion of the loan payment will equal interest and the rest will pay toward principal. Early in the life of the loan, a high percentage of the loan constitutes interest and a small portion is applied to principle. As the principle balance diminishes a greater portion of the loan becomes principle and small portion is attributed to interest.
- Fixed (Single Payment) Repayment Date: Some loans, such a certain types of bridge loans, are structured to be paid off in a single payment. At some specific time as indicated in the note, the borrower is obligated to repay the loan in full. These are normally short-term loans that are repaid by refinancing or consolidating the loan with other outstanding debts. These types of loans are very common in leveraged buy-outs or company acquisitions. Basically, the loan is issued at a given interest rate and pursuant to an origination fee. The origination fee is the primary source of compensation to the lender.
- Note: Sometimes a borrower will simply decide to pay off an existing debt. In some promissory notes, there will be a prepayment penalty if the borrower repays the note prior to its maturity date.
- Scheduled Amortized Payments with a Final Balloon Payment: This repayment structure provides for amortized payments for a specific amount of time. Unlike fully amortized payments, however, the time period does not provide for the full repayment of the loan. As such, at the end of the repayment term, the borrower must make a single payment (balloon payment) paying off the remainder of the debt. While this form of loan provides for reduced recurring payments, the balloon payment can cause serious issues for the business. Often, the balloon payment is paid through refinancing of the debt. This incurs an additional origination fee charged by the refinancing lender.
- Scheduled Interest-only Payments with a Final Balloon Payment: This types of structure requires the borrower to make scheduled payments for a specific period with a single balloon payment repaying the entire debt at some point in the future. The payments made under this structure only constitute interest and no principle. This allow the lender to collect interest on the full amount of the loan throughout the duration of the loan. This form of loan generally has the lowest recurring payment terms, but has a very high balloon payment.
Equity financing means investing money in a business organization in exchange for an ownership interest in the business. Selling equity to private investors in a business is commonly called a “private placement”. Early equity financing may come from the founder(s), friends, and family. That is, these individuals capitalize the business very early on and receive a share of the ownership. It is not until later in the development of the business ventures that third-party investors would seek to invest money in the business venture in hopes of making a return on that investment.
What is Equity?
Equity is considered any ownership interest in a business. It may include a partnership interest, membership interest in an LLC, or shares of a corporation. It may even include any contractual obligation to shares proceeds of the venture with third parties (“known as an investment contract”). Any of these types of equities are known as “securities”, the sale of which must comply with state and federal law. In any event, equity investment is the sale of securities to third parties as a method of financing the firm’s formation, growth, or operations.
Who are the Equity Investors?
Outside of founders and friends and family, equity investors in startup ventures are generally broken down into four groups.
- Angel Investors – Angel investors are high-net-worth individuals who invest in startup ventures in hopes of earning a profits. Angel investors sometimes join together in small groups to collectively invest in an early-stage ventures. Angel investment runs anywhere from a few thousand dollars to a group investment of $1 million. In any event, these are the earliest third-party, equity investors.
- Venture Capitalists – Venture capitalists are professional funds managed by an individual or small group of investment managers. These individuals assemble funds from third-party investors. They then manage these funds by investing in promising startup ventures. Venture capitalists may invest a few hundred thousand dollars, up to hundreds of millions in a single firm.
- Private Equity Firms – These are large professional funds. They are organized similarly to a venture capital firm, but generally are far bigger. Their primary purpose is to purchase controlling or total interests in companies. They generally make changes to the company (such as operational streamlining, mergers, acquisitions, etc.) and then resell the company either to companies, other private equity firms, or to the public via an Initial Public Officering.
- Going Public– Going public is the process of registering and selling a companies equity own a public market. In some cases the equity is sold on a large public exchange. Anyone can purchase the companies equity at this point without any restriction. At this point, the company no longer belongs solely to a closely-held group; rather, it is owned by the public at large.
How are Equity Investors Compensated?
Early stage investors seek a return on investment via an exit event. That is, they invest money with hopes that the value of the business will rise. At some point in the future the investor will sell her interest in the company for a profit. This is known as an exit event. Common exit events for early investors are the sale of the company equity to other investors or sale to the general public through an initial public offering.
Notably, early investors generally do not seek a dividend from the startup venture. Rather, the company should use any earnings or profits to continue growing the business venture. A startup that turns a profit early in the life of the business is generally not using the money to meet its growth projections. This can be a very bad sign. As such, startups typically survive and grow by burning all available capital to achieve growth. Often the primary form of growth capital is from outside investors.
Given the objectives of the firm, investors understand that investing in an early-stage venture is risky. As such, investors generally want a generous return on their investment at the time of exit. Early stage investors may seek between 10 and 50 times their original investment. This means that investors require a large stage in the company compared to their investment. Entrepreneurs are often hesitant to sell such large stakes early in the life of their business, as this reduces the ownership and potential gains for the entrepreneurs. The entrepreneurs often take very small or no salaries from the business venture as it grows.
Rights of Investors
It is important to remember that equity investors are owners of the business. As such, they have certain rights that inhere to them as owners. Further, the investor may want to exercise additional controls over the business as a method of protecting their investments. Common ownership rights and control measures for an investor are as follows:
- The right to vote to elect a board of directors (or specific members of the board);
- The right to vote on all major business decisions (or specific approval rights for certain decisions);
- The right to be informed about all significant business decisions (this may include significant record review rights);
- The right to exit the company by forcing redemption of their shares by the company;
What Angel and Venture Capital Investors
Angel investors and venture capitalist are equity investors in startup ventures. These individuals (or funds) provide much-needed capital at various stages of the startup’s lifecycle. Angel investors and venture capital funds are discussed in detail in subsequent lectures. Before doing so, however, it is important to understand at what point in the startup venture’s lifecycle equity investors supply much-needed capital to the startup’.
VC funding is generally divided into different stages of the business. These stages of financing are introduced below in order to demonstrate the role of funds provided by angel investors and venture capitalists. The varying stages of funding are dealt with in greater detail in subsequent lectures.
Early-stage Financing (Seed, Startup, Series A)
Early-stage financing is generally the realm of angel investors. It is rare that an early stage company will be capable of attracting a venture capital fund.
- Seed Financing – Relatively is a small amount of capital provided to an entrepreneur to prove a concept or to qualify for startup capital.
- Startup Financing – Is a moderate level of financing to companies for completing product or service development and initial marketing. These companies are generally in business for less than 1 year, and have not yet sold their product or service commercially.
- First Stage Financing – First-stage financing (commonly called “Series A” financing) allows companies to initiate full-scale manufacturing or servicing. This is the first stage of equity financing where venture capital firms become interested in investing.
Expansion Financing (Series AA, B, C, D, Mezzanine, Bridge Financing)
Expansion Financing is generally the realm of venture capitalists (including large private equity firms). Some angel investor groups may be able to fit into this class for certain startup ventures.
- Second-Stage Financing – Second-stage financing (“Series AA, B, C, or D rounds”) provides orking capital for initial expansion of the company that is providing services, or is producing and shipping product, and has growing accounts receivable and inventories. This is the heart of venture capital investment.
- Mezzanine Financing – Capital for major expansion of a company whose sales volume is increasing and that is breaking even or profitable. These funds are generally provided by large commercial lenders.
- Bridge Financing – Helps IPO driven companies to obtain short-term financing that will be repaid when the IPO occurs. These funds are generally provided by large commercial lenders.
Acquisition/Buyout Financing (Management or Leveraged Buyouts)
- Acquisition Financing – Provides funds to finance an acquisition of all, or a portion, of another company. These funds are generally provided by large private equity firms in combination with debt secured from large financing institutions.
- Leverage Buyout Financing – This is a specific form of acquisition financing. Leveraged buyout financing combines debt from large financial firms, company debt issuances, management contributions, and private equity investments. This generally occurs when an operating management group seeks to acquire a product line or purchase the entire business from the current owners. Such a buyout may occur at any stage of development from either a private or public company. The acquisition may be for the purchase of select assets or stock.
What is an Angel Investors?
Angel investors are high-net-worth individuals who seek to invest personal funds in early or startup-stage companies. Generally, these investments represent a given percentage of the angel investor’s overall personal wealth investment strategy. Startup companies provide a source of high-risk and high-potential-return investments within the Angel’s portfolio. Angels look to invest in startups that provide a high degree of growth potential, proven management, and sufficient information about the company, its management team, and its market to be able to assess a company’s value. Angel investment has never been more popular. Per a recent study, investors funded approximately 700,000 new businesses in 2012.
What Value to Angel Investors Provide?
Early-stage startups generally need funds to grow operations and to created growth through marketing. The revenue produced by the company is not sufficient to cover the cost of achieving the growth targets. As such, the startup that fails to seek outside funding is losing long-term value by failing to grow to the extent of its potential. As previously discussed, lenders are often not willing to lend money to fund marketing and similar growth-related expenses that do not have some form of collateral to secure the debt.
Angel investors provide the much-needed, growth capital. Angel investment deals are generally between $25,000 and $1 million. Higher levels of investment may require angels to group together to meet the funding requirements. Angel pools are discussed below. The angel understands that the invested funds are best used to grow the startup’s revenue. She does not want a routine return of capital from dividends or a profit-share; rather, she is looking to receive a lump-sum return on her investment at a future exit event. Due to the high degree of risk associated with investing in startup ventures, the angel will seek returns of 10x, 20x, or 30x their money in a 3-7 year period. The exit event may be a new round of funding from angels, angel groups, or venture capitalist. In some cases the angel investor will stay invested in the company for many years in hopes of achieving a return from the sale of the startup to a large company, to an investment fund, or through a public offering.
How Involved are Angel Investors in the Startup Venture?
Angel investors often provide far more than capital to the business. Many angels are successful professionals or entrepreneurs. As such, they can provide valuable business experience for guidance in starting, managing, and growing the business. Angel investors vary in the degree to which they are willing or desire to take part in startup operations. Most investors are silent owners who require specific levels of information disclosure by the company management. The investor will act as a director or advisor to the startup so as to take part in major startup decisions. The daily operations are left to the managers (entrepreneurs). In some cases, angels will be highly involved in all decisions (even operational decisions). These are commonly referred to as guardian angels. They take an active role in business management as a manner of protecting their investment.
What are Angel Investor Pools?
While angel investors are high wealth-individuals who invest their own wealth, they often band together in groups to raise the investment capital needed or requested by a startup venture. In these situations, the angels act very similarly to a venture capital fund. The group will form a special purpose entity (generally an LLC) that will hold all of the Angel’s investment funds intended for the startup. This is important if the funding is called down by the startup as needed. Further, the special purpose entity will hold the ownership interest (membership units or shares of stock) in the startup obtained in exchange for the investment. The individual angel investors then hold a percentage ownership interest in the special purpose entity. This arrangement aligns the interests of all investors and allows for coordination of investment efforts (e.g., single negotiation of terms, single set of investment documents, coordinated due diligence, etc.). The angel pool will generally be manager-managed and one of the angel members will serve as manager of the special purpose entity. Similarly to a venture capital fund, this managing angel will often receive a management fee for their efforts.
What are Venture Capitalist and Capital Funds?
Venture capital funds are pools of funding used to purchase equity interests in growth-based, startup ventures. The venture capitalist is the fund manager who raises funds (raises a fund) from investors seeking to allocate a portion of their investment portfolio to investing in higher-risk (and higher potential return) investments. Venture capital funds may vary in size to meet the class of investment desired by the fund investors. Generally, venture capital funds look for investments in excess of $1 million dollars. Even large funds rarely make investments in a single startup in excess of $100 million. The fund has a fixed duration (generally 7-10 years) and will invest in multiple startup ventures throughout that period. The investments are generally staggered with hopes of receiving staggered returns throughout the firm’s lifecycle.
As previously discussed, investors in startup ventures seek a return on investment via some future exit event. Common exit events include, future equity funding rounds, sale to a strategic acquirer, or an initial public offering. The venture capital firm will seek to exit (and reap a profit from) the investment within 3-7 years (during the life of the venture fund). As such, most venture capital fund investments occur within the first 5 years of the firm’s life. In theory, the fund will return profits to investors during the second half of the firm life. Often these investors will re-invest the profits in another venture capital firm that runs collaterally to the present firm. The objective is to always offer an investment option for the fund investors.
Venture Capital Portfolio Companies
The venture capital firm will generally seek to invest in approximately 10 startups in a given fund. History dictates that 6 of the investments will fail to return the fund’s capital. 3 of the startup funds will break even and make a nominal return to the fund. 1 or 2 of the portfolio companies will have a large return that carries the fund to profitability. Generally, a venture capital firm will generate a 25% Internal Rate of Return for its investors. To achieve this return rate, the successful startup must generate between 10x and 50x the initial investment of capital.
How is the Venture Capital Fund Structured
In it’s most basic form, venture capital funds are organized as limited partnerships. For more information on how limited partnerships work, see our business entities lecture series.
The managers of the firm are the general partners in the limited partnership. Generally, the managers form a business entity (generally an LLC). This LLC may acts as the general partner in the the limited partnership.
Investors are the limited partners in the partnership. The investors may be named individually as limited partners, but this is rare. Generally, investors group together to form one or more business entities (generally LLCs). The business entities then invest funds into the limited partnership and act as the limited partners. Because the business entity is always a flow-through tax entity, it allows for proceeds from investment to flow through to the investors without entity-level taxation. Further, these layers of business entity help protect the fund managers and investors from personal liability in the event the venture capital fund becomes subject to lawsuit. Lastly, this structure allows for the efficient allocation of authority and other tax advantages when distributing proceeds.
Compensation with the Venture Capital Fund
Managers of a venture capital fund receive a management fee for investing and managing the funds contributed to the pool. The management fee generally covers all expenses associated with managing the fund and pays the managers a salary. The management fee is generally 2% of the fund value. All investor funds are not held in the fund at once; rather, funds are called down from investors as needed. This reduces the standing management fee that managers collect. Also, the management fee is generally subject to a sunset provision, which terminates management fee payments after a stated number of years.
Managers also receive a percentage of the profits (capital gains) achieved when exiting the startup (i.e., selling the equity interest in the startup). The managers generally receive 20% of the profits achieved. The gross proceeds from sale of the venture are generally distributed as follows:
- Investors receive in full the amount of funds originally invested in the venture capital fund.
- Investors may receive additional funds to match the management fee paid to managers.
- Investors may then receive any preference multiple (1x, 2x, 3x, etc.) of their money invested.
- Note: There may not be a liquidation preference for fund investors.
- Remaining proceeds are split between investors and managers.
- Note: As previously noted, managers generally receive 20% of additional proceeds. This amount may be far higher if the investors first receive a liquidation preference.
A huge benefit to the managers is that the 20% proceeds received are taxed at a carried interest rate (15%), rather than an ordinary income rate.
Debt versus Equity in the Startup Venture
Both debt and equity funding have significant advantages for the startup venture. The primary advantages (and disadvantages) of each and the are discussed below:
- Debt Capital – Liability or obligation owned to another person or institution and legally required to be paid by a specific date.
- Ex. Bank loans, government guaranteed loans, lines of credit, credit cards, mortgages, notes payable, bonds, accounts payable, trade credit, home equity, leasing contracts, etc.
- Advantages of Debt
- Less costly than equity since most interest rates are less than what investors would require as a rate of return.
- With debt, you don’t give any ownership of your business.
- Disadvantages of Debt
- Debt has less flexibility, since you are required to make constant and periodic principal and interest payment similar to a home mortgage.
- In seasonal businesses or a business with a sudden downturn in sales, debt payments can cause a cash crunch.
- Generally, the entrepreneurs must personally guarantee any debt, which subjects their personal assets to potential liability.
- Best Situations for Debt
- When money required will be used for fixed assets
- Lenders look for some kind of capital in order to take a security interest.
- Use debt when your business needs a line of credit – the advantage is that you only pay interest on the amount of money that you’ve drawn down.
- Equity – Money raised from owners of the business through the sale of Common Stock, partnership interests, other ownership based interests.
- Note: The major sources of equity capital are current owners, new partners, private investors, customers, suppliers, angels, investment bankers, venture capitalists.
- More flexibility – No collateral requirements for equity capital and repayment terms and conditions can be tailored to needs of the business.
- Repayment is generally put of until the business exceeds breakeven or reaches a certain level of profitability.
- Note: It is increasingly common to push of repayment until the exit event.
- It is also a good way of raising large amounts of money for the business.
- Equity is very expenses (the rate of return required by the investor)
- It entails ownership in the business.
- Note: Ownership generally entails the ability to give input as to the big picture management of the business. Such as a seat on the formal or advisor board.
- Some investors are more active than others in the business. This can be a blessing or a burden.
- Best Situations for Equity Funding
- Equity is most suited for startups that require large amounts of working capital or involve a new product launch.
- Again, banks are reluctant to lend cash to businesses for working capital – especially when they are in the startup phase.
- They like to finance the assets found at the top of Worksheet 1, b/c they can liquidate these assets in the event of business failure.
- Investors are willing to take on the risk of a startup for the higher reward. They fund high-risk startups, new product launches, new marketing initiatives, and major growth or expansion of a phase of the business.
- Any items found at the bottom of worksheet 1 are better suited for equity type investors, due to the higher risk to the lender.
Debt to Equity Ratio
The debt to equity ratio is simply the amount of money the business owes in debt to the amount of money it has taken in via equity financing. A company must maintain a debt to equity ratio that meets the capital needs of the company while not making the company fiscally vulnerable. An investor will be reluctant to invest in a highly leveraged business (i.e., has lots of debt) because the equity investment is always subordinate in priority of payment to the debt.
On the other hand, a company that is financed largely through equity loses the opportunity to deduct the cost of capital from the revenue. Plainly stated, interest paid to a lender is deductible; dividends or distributions of money paid to equity investors is not deductible. Depending on the amount of debt or equity financing, this can be a significant amount of money for the business.
In any event, closely tracking the debt to equity ratio as an indicator of potential vulnerability or as a comparison to industry expectations is important.
Other Methods of Financing Business Operations
Specific types of business operations may allow for unique ways to finance operations outside of the traditional debt or equity relationships. Several of these approaches are discussed below:
- Contractual Business Sales
- In the event you are purchasing an existing business, rather than starting a new venture, then see if the current owner is willing to sell the business on contract.
- In this scenario the seller of the business finances the purchase. The seller may be more flexible in interest rates and repayment terms than a traditional bank.
- Inventory & Supplies
- Try to establish trade credit for the purchase of inventory.
- You may also try the Sell-before-build model.
- Your customer essentially finances your inventory.
- Exchange goods for goods or services for services with suppliers.
- Also, there are numerous third-party sites that focus on facilitating bartering between individuals and businesses.
- Customer Financing
- Some businesses are able to securing financing from their customers.
- This is particularly true in Business-to-business (B2B) companies.
- It may require you undertaking or completing substantial services for the customer before they will undertake the financing (loan or equity investment) for your business.
- If you have existing customers, they may be willing to pay you in advance for your products. This allows you to use their money to purchase products or inventory prior to sale.
- Purchase on credit
- Trade in older equipment
- If the equipment lifespan is short, investigate leasing or financing through the seller.
- Selling or borrowing against your accounts receivable
- Real Estate
- Consider leasing.
- Remember, you still have to come up with 80% to purchase
- Loan term is generally 18-20 years for commercial mortgages.
- Evaluate Leasing Operational Assets
- Leasing companies are a way to finance computers, office equipment, phone systems, vehicles, and other equipment. Leasing can lower your start-up costs because you won’t have a large initial outlay of cash for the equipment.
- Much of the required expenses of startup can be leased.
- This avoids the large, upfront costs and allows for periodic tax-deductible payments.
- Grants for Small Businesses
- A grant is money that doesn’t have to be repaid.
- Usually made available from the government or a not-for-profit agency (IRS Pub 557).
- Usually charitable
- If you are not a not-for-profit organization, then the availability of grants are limited.
- Example: Small Business Innovation Research Program (SBIR)
- When developing technology that may be of interest to the Government.
- Very competitive program that grants money to small business to explore technology and incentivizes the business by allowing commercial profitability.
Using a Business Plan
The business plan describes the current activities, aims and objectives, and how they are going to be achieved over a set period of time. The primary sections of the business plan are:
- Management and Operations
The basic premise is to show:
- Who you are.
- What do you make or what service you provide (what is the value proposition?)
- How you make it.
- How you sell it.
- The value exchanges that take place. (What money goes where.)
Crafting a Business Plan to Obtain a Loan
To craft an effective business plan, you have to focus on the audience. Appealing to a commercial lender is far different from appeal to an equity investor. A lender is going to be concerned with the ability to service loan payments, risk of default, and securing the loan with business collateral (taking a security interest in business assets).
- Break down the loan request into its essential elements
- Show how much is required for inventory, supplies, signage, prepaid expenses, working capital, etc.
- Demonstrate the availability of capital and other security for the loan.
- Cash Flow
- Your financials should demonstrate that you will have enough cash flow to repay the loan amount.
- Amount of Loan
- You will need to lay out in detail the requested loan amount and the use of the capital.
- As previously discussed, lenders prefer for loans to be used to purchase collateral, such as equipment or real estate.
- Think strategically, as some loan amounts are difficult to obtain:
- Because of internal bank structuring, loans in the range of $20-50K are the most difficult to get.
- The consumer division generally services personal credit or consumer loans up to $20K.
- The commercial division is most focused on loans of $100K or more, so you have to work harder to peak their interest in a smaller loan or line of credit.
- Try to break down your debt needs into smaller phases until you can secure the money from personal credit sources.
Equity Investors and the Business Plan
Equity investors come in a number of forms. For purposes of this lecture, let’s look at angel investors and venture capitalists. These investors have similar interests and expectations with regard to the business. See our Business Planning resources for a detailed analysis of what equity investors are looking for in a potential business investment. Below is a brief summary of how to approach a business plan to attract investors.
- Spend extra time on the executive summary.
- Sometimes this is the only thing that gets read by an angel or VC.
- It should contain an explanation of the business, the value proposition, and the opportunity in less than one page.
- The next important section is the management team.
- Experience and well-rounded management can make all the difference when it comes to success of a business.
- This section should be comprehensive, citing the background, education, experience, skill-sets, and responsibilities for every member of the team.
- You may also include information on the outside professional that you will utilize, such as your attorney, accountant, management consultants, etc.
- Don’t forget to provide information on your advisory board or team.
- Next the VC flips to the financials:
- The first thing that should stand out is the potential return on investment.
- This is usually a product of the revenue and potential valuation of the business in 3-5 years.
- A VC will likely be familiar with the industry and have and idea of what a business of this type with a given annual revenue will be worth at some point in the future.
- If there is a potential of high growth and a high return on investment, then the investor may be interested in your business.
- Lastly, the exit strategy.
- You need to explain your intended business exit strategy.
- Remember, the VC seeks to make its money back at some point in the future (3-5 years) when the business is either sold or goes through an IPO.
- The exit strategy may also be a plan for the business to purchase the VCs equity share though retained earnings or a bank loan.