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© 2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 11

Sources of Capital

Learning objective:

1. Types of financing available.

2. Commercial bank loans.

3. Research and development limited partnerships.

4. Private placements.


Types of financing:• Debt financing involves an interest bearing

instrument, usually a loan.• Asset-based: some asset must be used as a

collateral.• Entrepreneur pays back amount borrowed,

plus interest. (Amount unrelated to sales or profits of business.)– Short term money is used for working capital.– Long term debt (>1year) is used to purchase assets (often

with part of asset used a collateral).

• Advantage: Entrepreneur retains ownership position and have greater return on equity.

• Disadvantage: If payments too large, inhibits growth.

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Types of financing:• Equity financing offers the investor some

form of ownership.• The investor shares in the profits of the

venture.• In a market economy, all ventures will

have some equity, as all are owned by someone (single or multiple owners).

• Equity funding provides the basis for debt financing.• Key factors in choice of financing: availability of

funds, assets of the venture, prevailing interest rates.• Usually a combination of debt and equity financing is

used.

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Factors AffectingFactors AffectingType Of FinancingType Of Financing

1)1) Availability of FundsAvailability of Funds

2)2) Assets of VentureAssets of Venture

3)3) Prevailing Interest Prevailing Interest RatesRates

4)4) All Financing Requires All Financing Requires Some Level of EquitySome Level of Equity

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External FundsExternal Funds

SelfSelfFamily & FriendsFamily & FriendsSuppliers & Suppliers & Trade CreditTrade Credit

Commercial Commercial BanksBanks

Government Government Loan ProgramsLoan Programs

R & D Limited R & D Limited PartnershipsPartnerships

Venture CapitalVenture CapitalPrivate Equity Private Equity

PlacementsPlacementsPublic Equity Public Equity

OfferingsOfferingsOther Government Other Government

ProgramsPrograms


Personal Funds

• Few new venture started without using personal funds of entrepreneur.– Savings, life insurance, car/home mortgage, etc.

• Least expensive in terms of cost and control.• Essential in attracting outside funding. • Put your money where your mouth is!• Outside investors wants demonstration of financial

commitment:– Wants to see entrepreneur has committed all monies

available. (Level of commitment reflected by percentage of available assets rather than absolute amount.)


Family and Friends• Next most common source of capital.• Relatively easy to obtain, but amount may be small.

– Often more patient regarding repayment.

• If in form of equity funding, family member or friend has an ownership position in the venture.

• If they have direct input into the operations of the venture, may have negative effect on employees and profit.

• To avoid potential future problems:– Keep business arrangement strictly business.– Loans should specify interest rate and repayment schedule.– Should be up-front and put agreement formally in writing.

• Entrepreneur should carefully consider impact of investment on family member or friend before it is accepted. Will lost have severe impact on friends/family?


The Role of Commercial Banks:• Commercial banks are the most

frequently used source of short-term funds.

• Debt financing: requires some asset with value as collateral.– Collateral can be

business assets, personal assets, or assets of a co-signer of the note.

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Types of bank loans include:

Asset-based loans:

• accounts receivable loans

• inventory loans

• equipment loans

• real estate loans

Cash-flow financing:

• lines of credit

• installment loans

• straight, commercial loans

• long term loans

• character loans

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Accounts Receivable Loans• Good basis, esp. if customer base is creditworthy.• Bank may finance up to 80% of value of accounts

receivable.• Factoring arrangement:

– The factor (bank) buysbuys the accounts and collects the money.– If receivables not collected, the factor sustains the loss, not the

business.– More costly than securing a loan against accounts receivable.

Real Estate LoansReal Estate Loans• Easily obtained to finance land, plant or building.• Usually up to 75% of value.


Inventory Loans• Good basis if inventory is liquid, i.e. can be sold quickly.• Finished goods inventory can be financed up to 50% of

value.• Trust receipts: The bank advances a large percentage of

the inventory price of goods and is paid on a pro rate basis as inventory is sold.– Often used to finance floor plans of retailers, e.g. car dealers.

Equipment Loans• Used to secure longer term financing, up to 3 to 10 years.• When new equipment bought, 50% to 80% of value can be

financed.• Sale-leaseback: Entrepreneur “sells” the equipment to a

lender and then leases it back for use.


Cash Flow Financing (Conventional Bank Loans)

• Lines of credit– Most frequently used– Company pays a “commitment fee” at the beginning and pays interest on

outstanding borrowed funds

• Installment loans– Used to cover working capital needs, usually for 30 to 40 days.– Easy to get for going venture with track record of sales and profit.

• Straight commercial loans– Used for seasonal financing; self-liquidating.– Like installment loans, funds advanced for 30 to 90 days.

• Long term loans– Usually available to only more mature companies.– Funds available for up to 10 years, with fixed debt repayment schedule.

• Character loans– Assets of individual pledged as collateral, or loan co-signed by another

person.


Lending decisions are based on the five C’s. Can you name them?

• Character

• Capacity

• Capital

• Collateral

• Conditions

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Bank Lending Decisions

• Banks are very cautious in lending money, esp. to new ventures.

• Decisions made based on quantifiable information and subjective judgment.

• Loan officer does a careful review of the borrower.– Past financial statements are reviewed (for key profitability and credit

ratios, age of accounts receivable and entrepreneur’s capital invested and commitment).

– Future projections on market size, sales and profitability are evaluated to determine ability to repay. Projections realistic?Projections realistic?

• Loan application form is a mini business plan.– Provides information on the credit worthiness of person and ability of

venture to repay the loan.

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Lending QuestionsLending QuestionsDoes Entrepreneur Expect To Be Does Entrepreneur Expect To Be Carried By Loan?Carried By Loan?

Is Entrepreneur Committed To Is Entrepreneur Committed To Spend Effort To Succeed?Spend Effort To Succeed?

Business Have Unique Business Have Unique Advantage?Advantage?

Downside Risks?Downside Risks?Protection Against Disasters?Protection Against Disasters?

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Bank “Shopping” ProcessBank “Shopping” Process

1.1. Complete Business Plan & ApplicationComplete Business Plan & Application2.2. Evaluate Several Alternative BanksEvaluate Several Alternative Banks

Should compare track record and lending policies of several Should compare track record and lending policies of several banks.banks.

3.3. Select One With Positive Experience Select One With Positive Experience in Business Areain Business Area

4.4. Set AppointmentSet Appointment5.5. Present Case/PlanPresent Case/Plan6.6. Borrow Maximum Amount PossibleBorrow Maximum Amount Possible

Provided prevailing interest rates and terms are satisfactory.Provided prevailing interest rates and terms are satisfactory. Care should be taken that venture will generate enough cash Care should be taken that venture will generate enough cash

for interest and principal repayment.for interest and principal repayment.


Access the SBA online at www.sba.gov.

• The SBA guarantees that 80% of the loan will be repaid to the bank if the company defaults.

• Micro-loans are made up to $100,000 through the SBA’s “LowDoc Loan Program.”

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Research and Development Limited PartnershipsUseful when developing a new technology involving high risk and

significant expense.• Sponsoring company (general partner)

– Do the research and development leading to a marketable technology on best-effort basis. (success not guaranteed!)

• Limited partners– Provide funds and assumes limited liability for loss.– Tax advantages.– Shares in profit if development succeeds.

• Procedure:– Funding stage: contract between two parties established.– Development stage: actual research performed. If successful,– Exit stage: reap commercial benefits via equity partnerships, royalty

partnerships and joint ventures.• Benefits/Cost:

– Provides funds with minimum equity dilution– Expensive to establish


Private Placements are another source of funds.

• Private investors may be:– family

– friends

– wealthy individuals.

• Private investors usually want an equity position in the business. Active or passive?– “Regulation D” simplifies private offerings and

contains specific operating rules.

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Outside Capital• Takes time to raise outside capital at a time when company

can least afford the time.

• Often decreases a firm’s drive to make money.

• Availability of capital increases the impulse to spend.

• Can decrease the company’s flexibility and hamper the creativity of the entrepreneur.

• May cause more problems and disruption (but equity needed!)

• Outside capital should only be sought after all possible internal sources of funds have been explored.

• Outside sources should be evaluated; must not forget basics of business.


Chapter 12

Informal Risk Capital and Venture Capital

Learning objectives:

1. Basic stages of venture funding.

2. Informal risk-capital market.

3. Nature of venture capital decisions and the industry.

4. Approaches for valuation of your company.


Regarding the basic stages of venture funding:

• Early stage financing is the most difficult and costly to obtain.

• Expansion or development financing is easier to obtain.

• Acquisition or leveraged buyout financing is used for traditional acquisitions, buyouts and going private.

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Table 12.1 Stages of Funding

Product development and initial marketing, but with no commercial sales yet; funding to actually get company operations started.

Start-up

Relatively small amounts to prove concepts and finance feasibility studies.

Seed Capital

Early Stage Financing

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Stages of Funding (continued)

Bridge financing to prepare company for public offering.

Fourth Stage

Major expansion for company with rapid sales growth, at break-even or positive profit levels but still private company.

Third Stage

Working capital for initial growth phase, but no clear profitability or cash flow yet.

Second Stage

Expansion or development financing.

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Stages of Funding (continued)

Some of the owner/managers of a company buying all the outstanding stock, making the company privately held again.

Going Private

Management of a company acquiring company control by buying out the present owners.

Leveraged Buyouts

Assuming ownership and control of another company.

Traditional Acquisitions

Acquisitions and Leveraged Buyout Financing.

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The Risk-Capital MarketConventional small businesses have more difficulty obtaining Conventional small businesses have more difficulty obtaining

external equity capital.external equity capital.

Sources of funds for early stage financing:• Public equity market:

– Available only for high-potential large-scale ventures.

• Venture capital market:– Venture capital firms like to invest in high-potential

ventures, with equity participation.– Venture may need the minimum level of US$500K

capital.

• Informal risk-capital market:– Individual Investors. – May be best source for first-stage financing.


Informal risk-capital marketThis market consists of a group of wealthy “business

angels” who are looking for equity investment opportunities.

• Angels generally prefer manufacturing of both industrial and consumer

products. • Firms receiving investment funds are generally within one day’s

travel. • Angel investors find their deals through referral sources such as

business associates, friends, and brokers.

• Opportunities are rejected:1. Inadequate risk/return ratio.2. Inadequate management team.3. Lack of interest or knowledge in business area.4. Cannot agree on price.5. Entrepreneurs not committed to venture.

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Informal Risk Capital• This market is about US$80 billion, provides 15% of

funding for small technology firms (vs. 125 to 15% from venture capitalists.)

• 87% of investors buying private placements were individuals or personal trusts.

• Estimated 1.3 million U.S. families (~ 2% of population) has over US$1 million net worth.

• “Angels” tend to be well educated (with post-graduate degrees).

• In New England, “angels” averaged one deal every 2 years, each deal averaged US$50K.

• Many expect to play an active role in ventures financed.• Angels have longer investment horizons, typically 7 to 10

years (vs. venture capitalists’ 5-year horizon.)


Venture Capital

Venture capital, broadly defined, is a professionally managed equity poolequity pool formed from resources of wealthy limited partners, pension funds, endowments and other institutions, typically managed by a general partner (the venture capital firm).

• Long term investments in creation of early-stage companies, expansions, and leveraged buyouts.

• Venture capitalists take an equity participation, through stocks, warrants, and convertible securities and has active involvement in the companies.

• Private venture capital firms emerged in the 1960s.


Table 12.3 Total Venture Dollars Invested(in billions of dollars)

0

2

4

6

8

10

12

14

16

18

1991 1992 1993 1994 1995 1996 1997 1998

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Venture Capital FirmsVenture Capital Firms

Private Venture Capital- General & Private Venture Capital- General & Limited PartnersLimited Partners

Small Business Investment Company Small Business Investment Company (SBIC)(SBIC)

Industry Sponsored:Industry Sponsored: Banks/Financial InstitutionsBanks/Financial Institutions Non-Financial CompaniesNon-Financial Companies

State Government SponsoredState Government SponsoredUniversity SponsoredUniversity Sponsored

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Venture Dollars Venture Dollars Invested Per DealInvested Per Deal

0

2

4

6

8

10

12

14

16

18

1994 1995 1996 1997 1998 1999 2000 2001 2002

In $ BillionsIn $ Billions

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Venture Investments StageVenture Investments Stage

0

10000

20000

30000

40000

50000

60000

70000

1994 1995 1996 1997 1998 1999 2000 2001 2002

Startup/Seed Early Stage Expansion Later Stage

In $ MillionsIn $ Millions


Venture Capital Process• Objective is to generate long-term capital appreciation.• Return criteria and risk:

– There is more risk in financing a business early in development, so more return is expected (50% ROI) than in later-stage development (30%).

– Pressure for safer investments may be at odds with entrepreneur’s objective of survival and growth of business.

– VCs usually do not seek control of a company, but will want at least one seat on the Board of Directors.

• Investment criteria:– Strong management team with solid experience, commitment, and

flexibility. • Prefer 1st rate team and 2nd rate product than vice versa.• Commitment of management should be reflected in dollars invested and

support of family.

– Product/Market opportunity must be unique.– Significant capital appreciation opportunity (40 - 60% expected return)


Stages in the venture capital decision process: • Stage one: preliminary screening.

– The business plan is submitted. (Clearly written Executive summary important!)

– Industry investigated, credentials and capabilities checked, fit with long-term goals?

• Stage two: agreement on principal terms.• Stage three: detailed review and due diligence.

– Takes one to three months.

• Final stage: final approval. – A comprehensive investment memorandum is prepared.

Process involves intuition and gut feeling (art) and systematic approach and data gathering (science).

VC firm must first decide on composition of its portfolio mix.

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Valuing Your CompanyValuation of the company is at the core of determining how much ownership an

investor is entitled for funding the venture.Factors in valuation• Nature and history of business.

– Info on company’s strengths, diversity, risks and ability.

• Outlook of the general economy and specific industry.– Examination of company’s financial data vs. other companies.

• Book value (net value) of company’s assets and overall financial condition.– Book value is acquisition cost minus liabilities, may not be a good indication of

market value.– Good valuation should value operating and non-operating assets separately.

• Future earnings capacity. (most important!)– Weighted average of previous years’ earnings; income by product line

help judge future profitability.• Dividend paying capacity.• Goodwill and other intangibles.• Previous sale of assets.• Market price of the stock of similar companies.


Valuation approaches include:• Assessing comparable, publicly held companies.

– Difficult to find counterparts.

• The present value of future cash flows.– More accurate than profits.– Sales and earnings projected, desired rate of return

set, less a discount for failure to meet expectations.

• Replacement value (Cost of replacing assets.).

• Adjusted book value considers acquisition cost minus liabilities.– Adjusted for depreciation, good for relatively new businesses.

• The earnings approach is most widely used.– Potential earnings calculated by weighting current earnings, price-earning ratio

set based on industry norms.

• Factors approach.– Value determined by: earnings, dividend-paying capacity and book value.

• Liquidation value (value if everything sold).

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Venture Capitalist’s Venture Capitalist’s Factors In Pricing A DealFactors In Pricing A Deal

ReturnReturnAmount of Money Amount of Money

Now/LaterNow/LaterQuality of DealQuality of DealQuality of TeamQuality of TeamAmount Amount

Entrepreneur is Entrepreneur is InvestingInvesting

Company’s Future Company’s Future ProspectsProspects

Upside PotentialUpside PotentialDownside RiskDownside RiskInvestment Investment

CollateralCollateralLiquidityLiquidityExit StrategyExit Strategy


Deal Structure• The terms and conditions of the transaction between the

entrepreneur and the funding source.• Needs of funding source:

– Rate of return required.– Acceptable level of risk.– Timing and form of return.– Amount of control desired.– Perception of the risks involved.

• Needs of entrepreneur:– Degree and mechanism of control.– Amount of financing needed.– Goals of the firm.

• Both venture capitalist and entrepreneur should be comfortable with the deal structure to create a good working relationship.

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Economy & Finance

equity financing

commercial bank loans

term financing

debt financing

types of bank loans

assetbased loans

inventory loans good

choice of financing