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Unformatted text preview: CHAPTERTEN Getting Financing or Funding OPENING PROFILE BIZOOKI Raising Money Through a Variety of Sources www.bizooki.com In 2008 Andy Tabar, a student at Belmont University, was tweaking his start-up, Bizooki, a Web-based company that helps businesses become more efficient by utilizing global talent. The idea behind Bizooki is that many businesses need technical projects completed more efficiently, like the preparation of Web sites, interactive CO-ROMs, or marketing research, but don't have in-house expertise. By outsourcing the task to the most efficient global provider, the task can be completed inexpensively and on time. Bizooki acts as a matchmaker-bringing together businesses that need these types of tasks completed with a network of global providers. Although Bizooki didn't take a large sum of money to launch, the way Tabar has funded Bizooki is instructive for aspiring entrepreneurs. Rather than trying to raise money from investors or bankers, he has relied on a combination of bootstrapping, loans from friends and family, and creative sources of financing. Tabar's experience raising and managing money started at an early age. As a high school student, he built Web sites, strictly on a cash basis. He didn't need much money because he was essentially selling his time. When he graduated from high school, he brushed up on his knowledge of how to obtain credit, knowing that at some point he'd need external funding. The first step he took was to obtain an ExxonMobil credit card-not because he needed the credit but to start establishing a credit history. Tabar, who grew up in Ohio, chose Belmont University in Nashville primarily because of its entrepreneurship program. He experimented with a number of business ideas before settling on Bizooki. Along the way, he utilized several techniques to either raise money or gain access to resources in creative ways. One example is that as a freshman, he applied for membership to the university's Practicing Student Entrepreneur Program (also called the "hatchery"). Through the hatchery, Tabar and about 70 of his classmates gained access to desks, computers, phones, fax machines, and copy machines, along with the opportunity to brainstorm business ideas with one another. Another example, which is becoming increasingly popular among student entrepreneurs, is that he entered several business plan competitions. He won Belmont's top award in 2006 and 2008, netting $5,000 in cash both times. He also won $5,000 in the University of Evansville's competition in 2008. The cost savings and money generated by these techniques helped Tabar flesh out his idea for Bizooki and get the company off the ground. He borrowed several small amounts of money from an interesting source: Rather than going through a bank, he registered with Prosper.com, a peer-to-peer lending network. Prosper is an online auction Web site that matches people who want to borrow money with people who are willing to make loans. Tabar obtained several loans of around $5,000 apiece through Prosper, but he used Prosper as a platform to obtain loans primarily from friends and family rather than outsiders. Prosper provides a convenient, formal, and legitimate This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. 315 316 PART 3 • MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM Lea .. ning Objectives After studying this chapter you should be ready to: format for people to loan money to one another, even if they know one another before the loan is made. Although Tabar hasn't tried it yet, he is also considering utilizing Zopa.com, which is a similar online peer-to-peer lend­ ing network. Looking forward, Tabar anticipates needing additional sources of funds as Bizooki grows or to launch additional ventures. He has met a number of Explain why most angel investors, primarily through the entrepreneurship program at Belmont. entrepreneurial ventures But he hasn't taken any of their offers, which he believes will work to his need to raise money during advantage in the long run. He believes that moving cautiously, and only their early life. taking money from an investor when the timing is right to grow the invest­ Identify the three sources continues to build his credit history if bank financing becomes an attractive alternative.1 ment, builds credibility and trust in the investment community. He also of personal financing available to entrepreneurs. Provide examples of how entrepreneurs bootstrap to raise money or cut costs. Identify the three steps involved in properly preparing to raise debt or equity I n general, start-ups often have difficulty raising money because they are unknown and untested. Founders must frequently use their own money, try to secure grants, or go to friends and family for help. This effort is often a grueling endeavor. Many entrepreneurs hear "no" many times before they match up successfully with a banker or investor. In this chapter, we focus on the process of getting financing or funding. We begin by discussing why firms raise capital. We follow financing. this with a description of personal financing and the importance of Discuss the difference between the early life of a firm. We then turn to the different forms of equity, personal funds, capital from friends and family, and bootstrapping in equity funding and debt debt, and creative financing available to entrepreneurial ventures. financing. We also emphasize the importance of preparing to secure these types of financing. Explain the role of an elevator speech in attracting financing for an entrepreneurial venture. Describe the difference between a business angel and a venture capitalist. Explain why an initial public offering (IPO) is an important milestone in an entrepreneurial venture. FINANCING OR FUNDING Few people deal with the process of raising investment capital until they need to raise capital for their own firm. As a result, many entre­ preneurs go about the task of raising capital haphazardly because they lack experience in this area and because they don't know much about their choices. 2 This shortfall may cause a business owner to place too much reliance on some sources of capital and not enough Discuss the SBA Guaranteed Loan Program. on others.3 Entrepreneurs need to have as full an understanding as possible of the alternatives that are available in regard to raising money. And raising money is a balancing act. Although a venture Explain the advantages of leasing for an entrepreneurial venture. THE IMPORTANCE OF GETTING may need to raise money to survive, its founders usually don't want to deal with people who don't understand or care about their long­ term goals. The need to raise money catches some entrepreneurs off-guard in that many of them launch their firms with the intention of funding all their needs internally. Commonly, though, entrepreneurs discover that operating without investment capital or borrowed money is more difficult than they anticipated. Because of this, it is important for entrepreneurs to understand the role of investment capital in the survival and subsequent success of a new firm. This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. CHAPTER 10 • GETTING FINANCING OR FUNDING Learning Why Most New Ventures Need Funding Objective There are three reasons that most entrepreneurial ventures need to raise Explain why most money during their early life: cash flow challenges, capital investments, and lengthy product development cycles. These reasons are laid out in Figure entrepreneurial ventures 10.1. need to raise money Let's look at each reason so we can better understand their importance. Cash Flow Challenges 317 during their early life. As a firm grows, it requires an increasing amount of cash to operate as the foundation for serving its customers. Often, equipment must be purchased and new employees hired and trained before the increased customer base generates additional income. The lag between spending to generate revenue and earning income from the firm's operations creates cash flow challenges, particularly for new, often small, ventures as well as for ventures that are growing rapidly. If a firm operates in the red, its negative real-time cash flow, usually computed monthly, is called its burn rate. A company's burn rate is the rate at which it is spending its capital until it reaches profitability. Although a negative cash flow is sometimes justified early in a firm's life-to build plants and buy equipment, train employees, and establish its brand-it can cause severe com­ plications. A firm usually fails if it burns through all its capital before it becomes profitable. This is why inadequate financial resources is one of the primary reasons new firms fail.4 A firm can simply run out of money even if it has good products and satisfied customers. To prevent their firms from running out of money, most entrepreneurs need investment capital or a line of credit from a bank to cover cash flow short­ falls until their firms can begin making money. It is usually difficult for a new firm to get a line of credit from a bank (for reasons discussed later). So new ventures often look for investment capital, bootstrap their operations, or try to arrange some type of creative financing. Capital Investments Firms often need to raise money early on to fund capi­ tal investments. Although it may be possible for the venture's founders to fund its initial activities, it becomes increasingly difficult for them to do so when it comes to buying property, constructing buildings, purchasing equipment, or investing in other capital projects. Many entrepreneurial ventures are able to delay or avoid these types of expenditures by leasing space or co-opting the resources of alliance partners. However, at some point in its growth cycle, the firm's needs may become specialized enough that it makes sense to purchase capital assets rather than rent or lease them. Lengthy Product Development Cycles I n some industries, firms need to raise money to pay the up-front costs of lengthy product development cycles. For example, it typically takes about two years and at least $4 million to develop an electronic game. 5 In the biotech industry, the path to commercial licensing Lengthy Produd Development Cycles Inventory must be purchased, employees must be trained and paid, and advertising must be paid for before cash is generated from sales. Some products are under development for years before they FIGURE 10.1 Three Reasons StartUps Need Funding generate earnings. The up-front costs often exceed a firm's ability to fund these activities on its own. This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. 318 PART 3 • MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM Being an entrepreneur in the biotech industry requires a lot of determination and drive. The path to getting a new drug approved takes 8 t o 14 years. This "tortoise­ like pace" of new product development normally takes a substantial up­ front investment before a payoff is realized. takes 8 to 14 years.6 This tortoise-like pace of product development requires substantial up-front investment before the anticipated payoff is realized. While the biotech industry is an extreme example, lengthy product development cycles are the realities ventures face in many industries. Although most new ventures need funding at some point during their launch or development, it is generally unhealthy for a start-up to have access to too much money too fast. This scenario played out for Webvan, a potentially promising start-up. The speed of its expansion, made possible by an overabun­ dance of start-up funds, turned out to be its undoing, as illustrated in the "What Went Wrong?" feature. Sources of Personal Financing Learning Objective Identify the three sources of personal financing available to entrepreneurs. Typically, the seed money that gets a company off the ground comes from the founders' own pockets. There are three categories of sources of money in this area: personal funds, friends and family, and bootstrapping. These sources are depicted in Figure 10.2 and are explained next. Personal Funds T he vast majority of founders contribute personal funds along with sweat equity to their ventures.7 In fact, in a Kauffman Foundation survey of nearly 5,000 new business owners, just 10 percent used external sources of funds their first year of operation. 8 The numbers change some but FIGURE 10.2 Sources of Personal Financing Bootstrapping Involves both financial resources and sweat equity. Sweat equity represents the value of the time and effort that a founder puts into a firm. Finding ways to avoid the need for external financing through creativity, ingenuity, thriftiness, cost-cutting, obtaining grants, or any other means. This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. CHAPTER 10 • GETIING FINANCING OR FUNDING 319 What Went WRONG? Webvan: How Having Too Much Money Can Be Just as Harmful as Having Too Little There's a saying in investment circles that the worst which is more suburban and most people own cars, it thing you can do to a start-up is give it too much did poorly. The lower than expected demand in many money. Too much money can enable a start-up to locations worked against Webvan's need to capture spend money carelessly, expand too quickly, and large economies of scale and resulted in blatant ineffi­ operate unprofitably for too long. In contrast, if a start­ ciencies. For example, in some locations, Webvan's up is on a tight budget, it has to spend its money drivers would have to drive 30 miles to make a single wisely, learn to be self-reliant, and develop a mind-set delivery. of frugality to survive. The results from these actions are not desirable. Webvan had too much money in spades. The Just two years after it made its first delivery Webvan company, which was launched in the late 1990s, collapsed, with no money and investors who had no delivered grocery store items to customers' homes. appetite to invest additional funds. As a postscript, The basic idea behind Webvan's plan was that the although the online grocery market is still in its company could lower the costs of selling groceries by infancy, it does have successes. An example is storing and sorting groceries in huge warehouses and FreshDirect, an online grocer that delivers to resi­ making home deliveries rather than incurring the costs dences, offices, and commuter rail stops in the New involved with running traditional grocery stores. The York City area. Unlike Webvan, the company's expan­ company reasoned that consumers would flock to its sion has been slow, and since its opening in 2002, it service because it relieved them of the time-intensive has added product lines and widened the area it task of grocery shopping. On the allure of this pitch, covers around New York City rather than opened new Webvan was able to raise more than $1 billion of facilities. The company employs 2,000 people and has venture capital and investor funding in the late 1990s. sales around $200 million. Flush with cash, Webvan plowed full steam ahead. The sensible approach to rolling out its service would have been to build a few facilities and work out all the bugs before going nationwide. Instead, Webvan embarked on a 26-city expansion plan. Because of the speed of the plan, it wasn't able to take the lessons it learned in one location and incorporate them into the next, because the next location was already coming online. For example, Webvan built elaborate on-site butcher operations in every ware­ house, only to later determine it was more efficient to buy prepared meat and have it delivered to the warehouses (making the butcher facilities obsolete). Similarly, the company built separate fresh vegetable and fruit operations in each warehouse, only to later determine it was better to combine them. There's more: The simultaneous rollout of the company's service in multiple locations forced it to adopt a single approach to servicing customers, which ignored local demographic and shopping patterns. As a result, its standard service was more popular in some locations than others. In San Francisco, which is densely populated and has a lot of people who don't own cars, it did well. In Atlanta, Questions for Critical Thinking 1. Why do you think Webvan's investors didn't do a better job of supervising its growth? 2. The "You Be the VC 1 0.2" feature focuses on Crushpad, a company that plans to build urban wineries in cities across the United States. What lessons can Crushpad learn from Webvan's experiences? 3. Spend some time investigating FreshDirect, the New York City online grocer mentioned in the feature. Make a list of the things that you believe FreshDirect is doing to grow in a healthy manner. In what ways could FreshDirect get itself in trouble if it received a large infusion of funds and decided to expand aggressively. 4. Describe what you believe would have been a more reasonable money-raising plan and expansion plan for Webvan. Sources: P. Carroll and C. Mui, Billion-Dollar Lessons (New York: Penguin Group, 2008); Hoover's, "FreshDirect," www.hoovers.com (accessed September 15, 2008). not as much as you might think as firms get older. Results from a number of studies that have examined firms that have been in business for just a few years up to a total of eight years show that close to 50 percent of the firms received no external funding-the money came strictly from the personal funds of the founders and the profits of the firms.9 Sweat equity represents the value of the time and effort that a founder puts into a new venture. Because many This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. 320 PART 3 • MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM founders do not have a substantial amount of cash to put into their ventures, it is often the sweat equity that makes the most difference. Friends and Family Friends and family are the second source of funds for many new ventures. This type of contribution often comes in the form of loans or investments but can also involve outright gifts, foregone or delayed compensation (if a friend or family member works for the new venture), or reduced or free rent. For example, Cisco Systems, the giant producer oflnternet routers and switches, started in the house of one of its cofounder's parents. Similarly, Ted Waitt, the founder of Gateway Computer, got his start with a $10,000 loan from his grandmother. There are three rules of thumb that entrepreneurs should follow when asking friends and family members for money. First, the request should be presented in a businesslike manner, just like one would deal with a banker or investor. The potential of the business along with the risks involved should be carefully and fully described. Second, if the help the entrepreneur receives is in the form of a loan, a promissory note should be prepared, with a repayment schedule, and the note should be signed by both parties. Stipulating the terms of the loan in writing reduces the potential of a misunderstanding and protects both the entrepreneur and the friend or family member providing the funding. Third, financial help should be requested only from those who are in a legiti­ mate position to offer assistance. It's not a good idea to ask certain friends or family members, regardless of how much they may have expressed a willing­ ness to help, for assistance if losing the money would cripple them financially. Entrepreneurs who are unable to repay a loan to a friend or family member risk not only damaging their business relationship with them but their personal relationship as wel1.10 Virgin Money helps structure arrangements between business owners and friends or family members. The company offers two plans. The Handshake Basic, which costs $99, is for loans of less than $10,000. Virgin Money provides the parties involved with the documents needed to execute a loan agreement. A more formal plan, the Business Builder, is for loans between $25,000 and $100,000, and includes more elaborate forms of documentation. The cost is more than $199, depending on the nature of the agreement.11 Accountants, attorneys, and bankers can also help people structure loan agreements.12 Bootstrapping A third source of seed money for a new venture is referred to as bootstrapping. Bootstrapping i s finding ways to avoid the need for external financing or funding through creativity, ingenuity, thriftiness, cost-cutting, or any means necessary.13 (The term comes from the adage "pull yourself up by your bootstraps.") It is the term attached to the general philosophy of minimiz­ ing start-up expenses by aggressively pursuing cost-cutting techniques and money-saving tactics. There are many well-known examples of entrepreneurs who bootstrapped to get their companies started. Legend has it that Steve Jobs and partner Steve Wozniak sold a Volkswagen van and a Hewlett-Packard programmable calculator to raise $1,350, which was the initial seed capital for Apple Computer. An illustration of how adept some entrepreneurs are at bootstrapping is provided by Michelle Madhok, the founder of SheFinds, a company that helps busy women (through a twice-weekly e-mail newsletter) keep in touch with fashion trends and find good values on the Internet. In describing how she combined her personal savings with bootstrapping to start her company, Madhok said: I financed SheFinds myself and have spent about $5,000 of my own money to get the business off the ground. The most expensive items were forming the LLC, legal costs and public relations. My [Web] site was built for about $250 b y a guy in the This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. CHAPTER 10 • GETIING FINANCING OR FUNDING Table 10.1 321 EXAMPLES OF BOOTSTRAPPING METHODS • Buy used instead of new equipment • Coordinate purchases with other businesses • Lease equipment instead of buying • Obtain payments in advance from customers • Minimize personal expenses • Avoid unnecessary expenses, such as lavish office space or furniture • Buy items cheaply but prudently through discount outlets or online auctions such as eBay, rather than at full-price stores • Share office space or employees with other businesses • Hire interns Ukraine who I found on craigslist (www.craigslist.org). My photos were done for Learning barter and I got a good deal on the illustrations on my site because the artist had downtime. I work with Objective many independents-my lawyer is an independent, Provide examples of because I don't see the value in paying for a big, fancy firm. And I look for discount how entrepreneurs resources on the Internet-if you search around, you can find companies that will bootstrap to raise make quality color copies for about 20 cents a copy. 14 money or cut costs. There are many ways entrepreneurs bootstrap to raise money or cut costs. Some of the more common examples of bootstrapping are provided in Table 10.1. Preparing to Raise Debt or Equity Financing Once a start-up's financial needs exceed what personal funds, friends and family, and bootstrapping can provide, debt and equity are the two most common sources of funds. The most important thing an entrepreneur must do at this point is determine precisely what the company needs and the most appropriate source to use to obtain those funds. A carefully planned approach to raising money increases a firm's chance of success and can save an entrepreneur consid­ erable time. The steps involved in properly preparing to raise debt or equity financing are shown in Figure 10.3 and are discussed next. Step 1 Determine precisely how much money the company needs Learning Constructing and analyzing documented cash flow statements and Objective projections for needed capital expenditures are actions taken to com­ IdentifY the three steps plete this step. This information should already be in the business involved in properly plan, as described in Chapter 4. preparing to raise debt Knowing exactly how much money to ask for is important for at or equity financing. least two reasons. First, a company doesn't want to get caught short, yet it doesn't want to pay for capital it doesn't need. Second, entre­ preneurs talking to a potential lender or investor make a poor impression when they appear uncertain about the amount of money required to support their venture. Step l Determine precisely how much money is needed FIGURE 10.3 Preparation for Debt or Equity Financing This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. 322 I PART 3 • MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM Learning Step 2 Determine the most appropriate type of financing or funding Equity and debt financing are the two most common alternatives for Objective Discuss the difference between equity funding and debt financing. raising money. Equity financing (or funding) 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 (we discuss all these sources later in the chapter). Equity funding is not a loan­ the money that is received is not paid back. Instead, equity investors become partial owners of the firm. Some equity investors invest "for the long haul" and are content to receive a return on their investment through dividend payments on their stock. More commonly, equity investors have a three- to five-year investment horizon and expect to get their money back, along with a substantial capital gain, through the sale of their stock. The stock is typically sold following a liquidity event, which is an occurrence that converts some or all of a com­ pany's stock into cash. The three most common liquidity events for a new venture are to go public, find a buyer, or merge with another company. Because of the risks involved, equity investors are very demanding and fund only a small percentage of the business plans they consider. 15 An equity investor considers a firm that has a unique business oppor­ tunity, high growth potential, a clearly defined niche market, and proven management to be an ideal candidate. In contrast, businesses that don't fit these criteria have a hard time getting equity funding. Many entrepreneurs are not familiar with the standards that equity investors apply and get discouraged when they are repeatedly turned down by venture capitalists and angel investors. Often, the reason they don't qualify for venture capital or angel investment isn't because their business proposal is poor, but because they don't meet the exacting standards equity investors usually apply.16 Debt financing i s getting a loan. The most common sources of debt financing are commercial banks and Small Business Adminis­ tration (SBA) guaranteed loans. The types of bank loans and SBA guaranteed loans available to entrepreneurs are discussed later in this chapter. In general, banks lend money that must be repaid with interest. Banks are not investors. As a result, bankers are interested in minimizing risk, properly collateralizing loans, and repayment, as opposed to return on investment and capital gains. The ideal candidate for a bank loan is a firm with a strong cash flow, low leverage, audited financial statements, good management, and a healthy balance sheet. A careful review of these criteria demonstrates why it's difficult for start-ups to receive bank loans. Most start-ups are simply too early in their life cycle to have the set of characteristics bankers want. Table 10.2 provides an overview of three common profiles of new ventures and the type of financing or funding that is appropriate for each one. This table illustrates why most start-ups must rely on per­ sonal funds, friends and family, and bootstrapping at the outset and must wait until later to obtain equity or debt financing . Indeed, most Learning Objective Explain the role of an elevator speech in attracting financing for an entrepreneurial venture. new ventures do not have the characteristics required by bankers or investors until they have proven their product or service idea and have achieved a certain measure of success in the marketplace. Step 3 Developing a strategy for engaging potential investors or bankers There are three steps to developing a strategy for engaging potential investors or bankers. First, the lead entrepreneurs in a new venture should prepare an elevator speech (or pitch)-a brief, This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. CHAPTER 10 • GETTING FINANCING OR FUNDING MATCHING AN ENTREPRENEURIAL VENTURE'S CHARACTERISTICS Table 10.2 WITH THE APPROPRIATE FORM OF FINANCING OR FUNDING Appropriate Source of Financing or Funding Characteristics of the Venture The business has high risk with an uncertain Personal funds, friends, family, and other forms return: of bootstrapping Weak cash flow High leverage Low-to-moderate growth Unproven management The business has low risk with a more Debt financing predictable return: Strong cash flow Low leverage Audited financials Good management Healthy balance sheet The business offers a high return: Equity Unique business idea High growth Niche market Proven management c arefully constructed statement that outlines the merits of a business opportunity. W hy is it called an elevator speech? If an entrepreneur stepped into an elevator on the 25th floor of a building and found that by a stroke of luck a potential investor was in the same elevator, the entrepreneur would have the time it takes to get from the 25th floor to the ground floor to try to get the investor interested in the business opportunity. Most elevator speeches are 45 seconds to 2 minutes long. 1 7 There are many occasions when a carefully constructed elevator speech might come in handy. For example, many university-sponsored centers for entrepreneurship hold events that bring investors and entrepreneurs together. Often, these events include social hours and refreshment breaks designed specifically for the purpose of allowing entrepreneurs looking for funding to mingle with potential investors. An outline for a 60-second elevator speech is provided in Table 10.3. The second step in developing a strategy for engaging potential investors or bankers is more deliberate and requires identifying and contacting the best prospects. First, the new venture should carefully assess the type of financing or funding it is likely to qualify for, as depicted in Table 10.2. Then, a list of potential bankers or investors should be compiled. If venture capital funding is felt to be appropriate, for example, a little legwork can go a long way in pinpointing likely investors. A new venture should identify the venture funds that are investing money in the industry in which it intends to compete and target those firms first. To do this, look to the venture capital firms' Web sites. These reveal the industries in which the firms have an interest. Sometimes, these sites also provide a list of the companies the This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. 323 324 PART 3 • MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM Table 10.3 GUIDELINES FOR PREPARING AN ELEVATOR SPEECH The elevator speech is a very brief description of your opportunity, product idea, qualifications, and market. Imagine that you step into an elevator in a tall building and a potential investor is already there; you have about 60 seconds to explain your business idea. Step 1 Describe the opportunity or problem that needs to be solved 20 seconds Step 2 Describe how your product or service meets the opportunity or solves the problem 20 seconds Step 3 Describe your qualifications 1 0 seconds Step 4 Describe your market 1 0 seconds Total 6 0 seconds firm has funded. For an example, access Sequoia Capital's Web site (www.sequoiacap.com), a well-known venture capital firm. A cardinal rule for approaching a banker or an investor is to get a personal introduction. Bankers and investors receive many business plans, and most of them end up in what often becomes an unread stack of paper in a corner in their offices. To have your business plan noticed, find someone who knows the banker or the investor and ask for an introduction. This requirement is explained in blunt terms by Randall Stross, the author of eBoys, a book about the venture capital industry. Stross spent two years observing the day-to-day activities at Benchmark Venture Capital, a prominent Silicon Valley venture capital firm. According to Strauss, The business plan that comes in from a complete stranger, either without the blessing of someone the venture capital firm knows well or without pro­ fessional recommendations that render an introduction superfluous, is all but certain not to make the cut. In fact, knowing that this is the case becomes a tacit requirement from the perspective of a venture guy: Anyone whom I don't know who approaches me directly with a business plan shows me they haven't passed Entrepreneurship 101.18 The third step in engaging potential investors or bankers is to be prepared to provide the investor or banker a completed business plan and make a presentation of the plan if requested. We looked at how to present a business plan in Chapter 4. The presentation should be as polished as possible and should demonstrate why the new venture represents an attractive endeavor for the lender or investor. Because the process of raising money is complicated, it is important to obtain as much advice as possible for how to navigate the funding process. One approach is to find a mentor, as illustrated in the "Partnering for Success" feature. SOURCES OF EQUITY FUNDING The primary disadvantage of equity funding is that the firm's owners relinquish part of their ownership interest and may lose some control. The primary advan­ tage is access to capital. In addition, because investors become partial owners of the firms in which they invest, they often try to help those firms by offering their expertise and assistance. Unlike a loan, the money received from an equity investor doesn't have to be paid back. The investor receives a return on the investment through dividend payments and by selling the stock. The three most common forms of equity funding are described next. This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. CHAPTER 10 • GETIING FINANCING OR FUNDING 325 Partnering for SUCCESS Want Help Navigating the Process of Raising Money? Find a Mentor Raising money isn't easy. It is a complex and painstak­ The ideal situation is to find a mentor in your own ing process, where experience helps. This reality puts community so you can meet face-to-face. Still, the first-time entrepreneurs at a disadvantage. While there online options provide business founders a wide are many good books about raising money and SBDC range of mentors to choose from, which may result in and SCORE counselors can be helpful, what many a better match. Online mentoring and counseling rela­ first-time business owners find most helpful is to find a tionships are becoming increasingly common. Nearly mentor to guide them through the process. 40 percent of all the counseling and mentoring done A mentor is someone who is more experienced by SCORE counselors is now done online. than you are and is willing to be your counselor, con­ Similar to any relationship, a business founder fidant, and go-to person for advice. There are two should be careful and only share private information ways to find a mentor. First is to work your network of with a mentor once a trusting relationship has been acquaintances-professors, business owners, accoun­ established. tants, attorneys-to determine if there is someone available that you trust, has experience raising money, and is willing to become your mentor. Many first-time entrepreneurs are surprised by how many people are eager to share their expertise and enter into a mentor­ ing relationship. The second way is to utilize one of the growing number of Web sites that help match business Questions for Critical Thinking 1. I f you were starting a business, would you check out one of the online mentoring sites? Why or why not? 2. To what degree do you believe that having a mentor founders with people who are willing to become men­ can make the difference between an entrepreneur tors. One site is MicroMentor.org, which is a nonprofit succeeding or failing? In what areas of the entrepre­ that matches business founders with mentors. You can neurial process do you think mentors are called go to the site and fill out a profile about yourself and upon the most? your goals, and then search profiles of potential 3. What are some of the traditional, off-line sources of mentors who match your needs. Once a match is mentoring for entrepreneurs? Which of these could made, the mentoring can take place through e-mail, you take advantage of if you decided to launch a instant messaging, Web conferencing, or over the firm? How large a role have these organizations phone. There is a tab on MicroMentor's Web site that played in the growth and success of entrepreneur­ provides access to "success stories" of business founders who have had excellent results using its ship in the United States? 4. Spend some time experimenting with one of the service. A similar service is iMantri-a for-profit organi­ mentoring Web sites mentioned previously. Is the zation where mentors charge for their services. iMantri site easy to navigate? After spending some time makes money by taking a cut of the fees. looking at the site, would you be more likely or less There are also Web sites geared toward helping entrepreneurs raise money with that also pro­ likely to use it if you were in the process of starting a company? vide a mentor-matching service. Examples include GoBigNetwork.com and Jumpstart's ldeaCrossing.org. These sites offer online ads for mentors. Source: Wall Street Journal (Eastern Edition) by K. Sports. Copyright 2008 by Dow Jones & Company, Inc. Business Angels Business angels are individuals who invest their personal capital directly in start-ups. The term angel was first used in connection with finance to describe wealthy New Yorkers who invested in Broadway plays. The prototypical busi­ ness angel, who invests in entrepreneurial start-ups, is about 50 years old, has high income and wealth, is well educated, has succeeded as an entrepreneur, and invests in companies that are in the region where he or she lives. 19 These investors generally invest between $10,000 and $500,000 in a single company 30 to 40 percent and are looking for companies that have the potential to grow per year before they are acquired or go public. 20 Jeffrey Sohl, the director of the University of New Hampshire's Center for Venture Research, estimates that This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. Learning Objective Describe the difference between a business angel and a venture capitalist. 326 PART 3 • MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM only 10 to 15 percent of private companies meet that criterion.21 Many well­ known firms have received their initial funding from one or more business angels. For example, Apple Computer received its initial investment capital from Mike Markkula, who obtained his wealth as an executive with Intel. In 1977, Markkula invested $91,000 in Apple and personally guaranteed another $250,000 in credit lines. When Apple went public in 1980, his stock in the company was worth more than $150 million.22 Similarly, in 1998 Google received its first investment from Sun Microsystems' cofounder Andy Bechtolsheim, who gave Larry Page and Sergey Brin (Google's cofounders) a check for $100,000 after they showed him an early version of Google's search engine.23 Can you image what Bechtolsheim's investment was worth when Google went public in 2005? The number of angel investors in the United States, which is estimated to be around 258,200, has increased dramatically over the past decade.24 The rapid 2007, angels invested $26.0 billion in 57,120 small companies.25 By comparison, during that same period, venture capital funds invested about $29.9 billion in 2,648 deals.26 Software accounted for the largest share of angel investments, with 27 percent of total investment in 2007, followed by health care services/ medical devices and equipment (19 percent), biotech (12 percent), industrial/ energy (8 percent), retail (6 percent), and media (5 percent).27 In exchange for increase is due in part to the high returns that some angels report. In their investment, angels expect a rather hefty annual return-usually in the neighborhood of 35 to 40 percent.28 They also usually fill a seat on the board of directors of the firms in which they invest and provide varying levels of manage­ rial input. Business angels are valuable because of their willingness to make relatively small investments. This gives access to equity funding to a start-up that needs just $50,000 rather than the $1 million minimum investment that most ven­ ture capitalists require. Many angels are also motivated by more than financial returns; they enjoy the process of mentoring a new firm. Oron Strauss is a 1995 Dartmouth College graduate who received angel funding. Recalling an experience with his angel investor, Strauss said, About a year ago, when I was having a particularly bad week, I fired off a long, heartfelt e-mail message to my angel. I explained, in great detail, the difficulties I faced and my thoughts about them. His response was succinct: "All sounds normal. You're handling it well. Keep up the good work." My first reaction was dis­ appointment over what struck me as a curt response. Then I realized that the angel had given me the best possible response. He understood that what I was going through was normal and that I would make it. 29 Most angels remain fairly anonymous and are matched up with entrepre­ neurs through referrals. To find a business angel investor, an entrepreneur should discretely work a network of acquaintances to see if anyone can make an appropriate introduction. An advantage that college students have in regard to finding business angels is that many angels judge college- or university­ sponsored business plan competitions. The number of organized groups of angels continues to grow. Typically, each group consists of 10 to 150 angel investors in a local area that meet regularly to listen to business plan presen­ tations. While some groups focus on a specific industry, most groups are open to a variety of areas and select those markets with which some of their members have expertise. The Angel Capital Education Foundation provides a list of angel groups in the United States and Canada on its Web site (www.angelcapitaleducation.org). In many areas, local governments and non­ profit organizations are active in trying to bring entrepreneurs and angel investors together. This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. CHAPTER 10 • GETIING FINANCING OR FUNDING 327 It's important to be fully prepared and look sharp before meeting with a business angel. This team of entrepreneurs is taking one last look at its PowerPoint presentation before presenting its business plan to an angel investor. Venture Capital Venture capital is money that is invested by venture capital firms in start-ups and small businesses with exceptional growth potentia1.30 There are about 650 venture capital firms in the United States, which provide funding to about 2,600 firms per year. As mentioned, in 2007, venture capital firms invested $29.9 billion in just over 2,600 companies.31 The peak year for venture capital investing was 2000, when $106.6 billion was invested at the height of the e-commerce craze. A distinct difference between angel investors and venture capital firms is that angels tend to invest earlier in the life of a company, whereas venture capitalists come in later. The majority of venture capital money goes to follow-on funding for businesses originally funded by angel investors, government programs (which are discussed later in the chapter), or by some other means. Venture capital firms are limited partnerships of money managers who raise money in "funds" to invest in start-ups and growing firms. The funds, or pools of money, are raised from wealthy individuals, pension plans, university endowments, foreign investors, and similar sources. A typical fund is $75 million to $200 million and invests in 20 to 30 companies over a three­ to five-year period.32 The venture capitalists who manage the fund receive an annual management fee in addition to 20 to 25 percent of the profits earned by the fund. The percentage of the profits the venture capitalists get is called the carry. So if a venture capital firm raised a $100 million fund and the fund grew to $500 million, a 20 percent carry means that the firm would get, after repaying the original $100 million, 20 percent of the $400 million in profits, or $80 million. The investors in the fund would get the remainder. Venture capitalists shoot for a 30 t o 40 percent or more annual return on their invest­ ment and a total return over the life of the investment of 5 t o 20 times the initial investment.33 Some venture capital "funds" invest in specific areas. For example, in 2008 Kleiner Perkins Caufield & Byers launched a $100 million fund to finance companies building new applications, services, and compo­ nents for Apple Inc.'s iPhone and iPod Touch. The managers of the fund indicated that they planned to make investments ranging from $100,000 of seed capital to $15 million of expansion capital for qualifying companies.34 This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. 328 PART 3 • MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM Because of the venture capital industry's lucrative nature and because in the past venture capitalists have funded high-profile successes such as Google, Cisco Systems, eBay, and Yahoo!, the industry receives a great deal of attention. But actually, venture capitalists fund very few entrepreneurial ventures in comparison to business angels and relative to the number of firms needing funding. Remember, venture capitalists fund about 2,600 companies per year, compared to 57,000 funded by business angels. As mentioned earlier in this chapter, many entrepreneurs become discouraged when 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." This target causes venture capitalists to reject the majority of the proposals they consider. Venture capitalists know that they are making risky investments and that some investments won't pan out. In fact, most venture firms anticipate that about 15 to 25 percent of their investments will be home runs, 25 t o 35 percent will be winners, 25 to 35 percent will break even, and 1 5 to 25 percent will fail.35 The home runs must be sensational to make up for the break-even firms and the failures. Still, for the firms that qualify, venture capital is a viable alternative to equity funding. An advantage to obtaining this funding is that venture capital­ ists are extremely well connected in the business world (by this we mean that they have a large number of useful contacts with customers, suppliers, government representatives, and so forth) and can offer a firm considerable assistance beyond funding. Firms that qualify typically obtain their money in stages that correspond to their own stage of development. Once a venture capitalist makes an investment in a firm, subsequent investments are made in rounds (or stages) and are referred to as follow-on funding. Table 10.4 shows the various stages in the venture capital process, from the seed stage to buyout financing. An important part of obtaining venture capital funding is going through the due diligence process, which refers to the process of investigating the merits of a potential venture and verifying the key claims made in the business plan. Firms that prove to be suitable for venture capital funding should conduct their own due diligence of the venture capitalists with whom they are working to ensure that they are a good fit. An entrepreneur should ask the following Table 10.4 STAGES (OR ROUNDS) OF VENTURE CAPITAL FUNDING Stage or Round Seed funding Purpose of the Funding Investment made very early in a venture's life to fund the development of a prototype and feasibility analysis. Start-up funding Investment made to firms exhibiting few if any commercial sales but in which product development and market research are reasonably complete. Management is in place, and the firm has completed its business model. Funding is needed to start production. First-stage funding Funding that occurs when the firm has started commercial production and sales but requires additional financing to ramp up its production capacity. Second-stage funding Funding that occurs when a firm is successfully selling a product but needs to expand both its production capacity and its markets. Mezzanine financing Investment made in a firm to provide for further expansion or to bridge its financing needs before launching an IPO or before a buyout. Buyout funding Funding provided to help one company acquire another. This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. CHAPTER 10 • GETTING FINANCING OR FUNDING 329 questions and scrutinize the answers to them before accepting funding from a venture capital firm: • D o the venture capitalists have experience in our industry? • D o they take a highly active or passive management role? • Are the personalities on both sides of the table compatible? • Does the firm have deep enough pockets or sufficient contacts within the venture capital industry to provide follow-on rounds of financing? • Is the firm negotiating in good faith in regard to the percentage of our firm they want in exchange for their investment? Along with traditional venture capital, there is also corporate venture capital. This type of capital is similar to traditional venture capital except that the money comes from corporations that invest in start-ups related to their areas of interest. Initial Public Offering Another source of equity funding is to sell stock to the public by staging an initial public offering (IPO). An IPO is the first sale of stock by a firm to the public. Any later public issuance of shares is referred to as a s econdary market offering. W hen a company goes public, its stock is typically traded on one of the major stock exchanges. Most entrepreneurial firms that go public trade on the NASDAQ, which is weighted heavily toward technology, biotech, and small­ company stocks.36 An IPO is an important milestone for a firm.37 Typically, a firm is not able to go public until it has demonstrated that it is viable and has a bright future. Firms decide to go public for several reasons. First, it is a way to raise equity capital to fund current and future operations. Second, an IPO raises a firm's public profile, making it easier to attract high-quality customers, alliance partners, and employees. Third, an IPO is a liquidity event that provides a mechanism for the company's stockholders, including its investors, to cash out their investments. Finally, by going public, a firm creates another form of cur­ rency that can be used to grow the company. It is not uncommon for one firm to buy another company by paying for it with stock rather than with cash. 38 The stock comes from "authorized but not yet issued stock," which in essence means that the firm issues new shares of stock to make the purchase. Although there are many advantages to going public, it is a complicated and expensive process and subjects firms to substantial costs related to SEC reporting requirements. Many of the most costly requirements were initiated by the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act is a federal law that was passed in response to corporate accounting scandals involving prominent corporations, like Enron and WorldCom. This wide-ranging act established a number of new or enhanced reporting standards for public corporations. The first step in initiating a public offering is for a firm to hire an investment bank. An investment bank is an institution that acts as an underwriter or agent for a firm issuing securities.39 The investment bank acts as the firm's advocate and adviser and walks it through the process of going public. The most important issues the firm and its investment bank must agree on are the amount of capital needed by the firm, the type of stock to be issued, the price of the stock when it goes public (e.g., $12 per share), and the cost to the firm to issue the securities. Although not fully known as this book went to press, the effects of the global financial crisis that surfaced in late 2008 on investment banks could be quite substantial. At a minimum, early indications are that the transactions of invest­ ment banks will be more heavily regulated in countries throughout the world. This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. Learning Objective Explain why an initial public offering (I PO) is an important milestone in an entrepreneurial venture. 330 PART 3 • MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM There are a number of hoops the investment bank must jump through to assure the Securities and Exchange Commission (SEC) that the offer is legiti­ mate. During the time the SEC is investigating the potential offering, the investment bank issues a preliminary prospectus that describes the offering to the general public. The preliminary prospectus is also called the "red herring." After the SEC has approved the offering, the investment bank issues the final prospectus, which sets a date and issuing price for the offering. In addition to getting the offering approved, the investment bank is respon­ sible for drumming up support for the offering. As part of this process, the investment bank typically takes the top management team of the firm wanting to go public on a road show, which is a whirlwind tour that consists of meet­ ings in key cities where the firm presents its business plan to groups of investors.40 Until December 1, 2005, the presentations made during these road shows were seen only by the investors physically present in the various cities; an SEC regulation went into effect at that time requiring that road show pre­ sentations be taped and made available to the public. Road show presentations can now be viewed online at ww.retailroadshow.com. w If enough interest in a potential public offering is created, the offering will take place on the date scheduled in the prospectus. If it isn't, the offering will be delayed or canceled. Timing and luck play a role in whether a public offering is successful. For example, a total of 332 IPOs raised about $50 billion in 1999, the height of the Internet bubble. When the bubble burst in early 2001, the IPO marketplace all but dried up, particularly for technology and telecom stocks. Since then, the market has recovered some, although it is still not robust, and most firms cannot count on an IPO to raise capital or as an exit strategy. There were 205 IPOs in 2005, 230 in 2006, 237 in 2007, and 43 in 2008. The vitality of the IPO market hinges largely on the state of the overall economy and the mood of the investing public, as evidenced by the sharp downturn in numbers in 2008, a bad year for the U.S. economy. Early evidence suggested that 2009's IPO activ­ ity might be less than 2008's. However, even when facing a strong economy and a positive mood toward investing, an entrepreneurial venture should guard itself against becoming caught up in the euphoria and rushing its IPO. A variation of the IPO is a private placement, which is the direct sale of an issue of securities to a large institutional investor. When a private placement is initiated, there is no public offering, and no prospectus is prepared. SOURCES OF DEBT FINANCING Debt financing involves getting a loan or selling corporate bonds. Because it is virtually impossible for a new venture to sell corporate bonds, we'll focus on obtaining loans. There are two common types of loans. The first is a single-purpose loan, in which a specific amount of money is borrowed that must be repaid in a fixed amount of time with interest. The second is a line of credit, in which a borrow­ ing "cap" is established and borrowers can use the credit at their discretion. Lines of credit require periodic interest payments. There are two major advantages to obtaining a loan as opposed to equity funding. The first is that none of the ownership of the firm is surrendered-a major advantage for most entrepreneurs. The second is that interest payments on a loan are tax deductible in contrast to dividend payments made to investors, which aren't. There are two major disadvantages of getting a loan. The first is that it must be repaid, which may be difficult in a start-up venture in which the entrepreneur is focused on getting the company off the ground. Cash is typi­ cally "tight" during a new venture's first few months and sometimes for a year This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. CHAPTER 10 • GETTING FINANCING OR FUNDING o r more. The second is that lenders often impose strict conditions on loans and insist on ample collateral to fully protect their investment. Even if a start­ up is incorporated, a lender may require that an entrepreneur's personal assets be collateralized as a condition of the loan. The three common sources or categories of debt financing available to entrepreneurs are described next. Commercial Banks Historically, commercial banks have not been viewed as practical sources of financing for start-up firms.41 This sentiment is not a knock against banks; it is just that banks are risk averse, and financing start-ups is risky business. Instead of looking for businesses that are "home runs," which is what venture capitalists seek to do, banks look for customers who will reliably repay their loans. As shown in Table 10.2, banks are interested in firms that have a strong cash flow, low leverage, audited financials, good management, and a healthy balance sheet. Although many new ventures have good management, few have the other characteristics, at least initially. But banks are an important source of credit for small businesses later in their life cycles. There are two reasons that banks have historically been reluctant to lend money to start-ups. First, as mentioned previously, banks are risk averse. In addition, banks frequently have internal controls and regulatory restrictions prohibiting them from making high-risk loans. So when an entrepreneur approaches a banker with a request for a $250,000 loan and the only collateral the entrepreneur has to offer is the recognition of a problem that needs to be solved, a plan to solve it, and perhaps some intellectual property, there is usu­ ally no practical way for the bank to help. Banks typically have standards that guide their lending, such as minimum debt-to-equity ratios that work against start-up entrepreneurs. The second reason banks have historically been reluctant to lend money to start-ups is that lending to small firms is not as profitable as lending to large firms, which have historically been the staple clients of commercial banks. If an entrepreneur approaches a banker with a request for a $50,000 loan, it may simply not be worth the banker's time to do the due diligence necessary to determine the entrepreneur's risk profile. Considerable time is required to digest a business plan and investigate the merits of a new firm. Research shows that a firm's size is an important factor in determining its access to debt capital.42 The $50,000 loan may be seen as both high risk and marginally prof­ itable (based on the amount of time it would take to do the due diligence involved), making it doubly uninviting for a commercial bank.43 Despite these historical precedents, some banks are starting to engage start-up entrepreneurs-although the jury is still out regarding how significant these lenders will become. When it comes to start-ups, some banks are rethinking their lending standards and are beginning to focus on cash flow and the strength of the management team rather than on collateral and the strength of the balance sheet. Entrepreneurs should follow developments in this area closely. SBA Guaranteed Loans Approximately 50 percent of the 9,000 banks in the United States participate in the SBA Guaranteed Loan Program. The most notable SBA program available to small businesses is the 7(A) Loan Guaranty Program. This program accounts for 90 percent of the SEA's loan activity. The program operates through private­ I sector lenders who provide loans that are guaranteed by the SBA. The loans are This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. Learning Objective Discuss the SBA Guaranteed Loan Program. 331 332 PART 3 • MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM The SBA Guaranteed Loan program is a viable source of financing for many entrepreneurs. Approxi­ mately 50 percent of the 9,000 banks in the United States participate in the program. for small businesses that are unable to secure financing on reasonable terms through normal lending channels. The SBA does not currently have funding for direct loans, nor does it provide grants or low-interest-rate loans for business start-ups or expansion. Almost all small businesses are eligible to apply for an SBA guaranteed loan. The SBA can guarantee as much as 85 percent (debt to equity) on loans up to $150,000 and 75 percent on loans of over $150,000. In most cases, the maximum guarantee is $1.5 million. A guaranteed loan can be used for work­ ing capital to expand a new business or start a new one. It can also be used for real estate purchases, renovation, construction, or equipment purchases. To obtain an SBA guaranteed loan, an application must meet the requirements of both the SBA and the lender. Individuals must typically pledge all of their assets to secure the loan.4 4 Although SBA guaranteed loans are utilized more heavily by existing small businesses than start-ups, they should not be dismissed as a possible source of funding. Since its inception, the SBA has helped make $280 billion in loans to nearly 1. 3 million businesses-more money than any other source of financing. 45 Diane Nelson, the woman who built Kazoo & Company into a successful business and is the subject of Case 4.1, got her start through a $500,000 SBA guaranteed loan. John and Caprial Pence, who own several businesses in Portland, Oregon, have relied on the SBA guaranteed loan program twice for funding. The Pences' story, which is related in the "Savvy Entrepreneurial Firm" feature, illustrates the important role that the SBA loan program plays in funding small businesses and entrepreneurs. The Pences' own the types of businesses that typically don't qualify for equity funding. In their case, the SBA program enabled them to build the thriving businesses that they own today. Other Sources of Debt Financing There are a variety of other avenues business owners can pursue to borrow money. Getting loans from friends and family, discussed earlier, is a popular choice. Credit card debt, although easy to obtain, should be used sparingly. One channel for borrowing funds that is getting quite a bit of attention is Prosper.com, the peer-to-peer lending network that Andy Tabar utilized, as described in the opening profile. Prosper is an online auction Web site that This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. CHAPTER 10 • GETIING FINANCING OR FUNDING 333 Savvy Entrepreneurial F I R M John and Caprial Pence: Ho w the SBA Guaranteed Loan Program Helped Two Entrepreneurs Get the Financing They Needed www. capiralandjohnskitchen.com John and Caprial Pence are two of Portland, Oregon's, The future for the Pences and their ventures looks finest cooks and busiest entrepreneurs. The two run a bright. The restaurant initially brought in around $1 ,000 growing number of ventures in the Portland area, all a day, but now brings in $4,000 to $5,000 on an aver­ focused around fine food. A distinctive aspect of their age weekday. The cooking school offers classes and story is the role that the SBA Guaranteed Loan demonstrations nearly every evening, where partici­ Program has played in their success. The Pences have pants pay from $35 to $135 for hands-on classes or to utilized the SBA loan program twice, and it has been view special cooking demonstrations. Just recently, instrumental in helping them build their businesses. the Pences started broadcasting a television show John and Caprial grew up on opposite coasts and from the cooking school, and Caprial celebrated the met at the Culinary Institute of America in Hyde Park, printing of her eighth cookbook. Commenting on their NY, where they were both attending school to become experiences borrowing money to fund their growing chefs. In the mid-1980s, following graduation, they operations, John Pence remarked, "We learned to get moved to Seattle, where they launched their careers. into this business (cooking) at the lowest debt level In 1990, Caprial won the 1990 James Beard Award for and have a cushion of working capital." Best Chef in the Pacific Northwest. At the same time, she was working on her first cookbook, teaching classes, and appearing on local TV. By 1992, the Pences were able to write their own ticket, and they moved to Portland. In Portland, the Pences bought the old West­ moreland Bistro with private financing and renamed it Caprial's Bistro. In 1998, they decided to remodel and expand the Bistro when space became available next door. The Pences considered several options for financing. The most realistic alternative, based on the advice of their banker, was an SBA guaranteed loan. The Pences agreed, and the bank facilitated a $260,000, seven-year SBA guaranteed loan. The loan enabled the couple to expand the seating capacity of their restaurant from 26 to 70. Following the expansion of their restaurant, the Pences decided to diversify and leverage their cooking expertise by opening a cooking school and cookware shop. A second SBA guaranteed loan, for an identical amount as the first one ($260,000), made these objectives a reality. All three locations, the restaurant, the school, and the shop, are located near one another, making it easy for their customers to visit more than one location in a single trip. The addition of Questions for Critical Thinking 1. When the Pences decided to expand and remodel their restaurant in 1998, what sources of funding or financing were realistically available to them? 2. Do some research to find out what it takes to qualify for an SBA guaranteed loan. What criteria do the SBA and the participating lenders typically apply when evaluating candidates for loans? 3. Based on the material provided here, any additional information you can garner from the Pences' Web site, and your general knowledge of entrepreneur­ ship, write a short analysis of why you think the Pences have been successful. 4. Do you think the Pences would be where they are today if they hadn't been made aware of the SBA Guaranteed Loan Program? Do you think most entrepreneurs are aware of the program? Sources: Caprial and John's Kitchen homepage, www. caprialandjohnskitchen.com (accessed December 16, 2008); S. Herochik, "Restaurateurs Fit More on Their Plate with Help the cooking school and the cookware shop has tripled of Loan Program," the Pences' annual revenue. (accessed January 31, 2006). Bizjournals, www.bizjournals.com/sba/1 matches people who want to borrow money with people who are willing to make loans. Most of the loans made via Prosper are fairly small ($25,000) but might be sufficient to meet a new business's needs.46 There are also organiza­ tions that lend money to specific demographic groups. For example, Count Me In, an advocacy group for female business owners, provides loans of $500 to $10,000 to women starting or growing a business.47 Make Mine a Million $Business, which is aligned with Count Me In and American Express, lends up to $50,000 to female-owned start-ups that have been in business for at least two years and have $250,000 or more in annual revenue. This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. 334 PART 3 • MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM Some lenders specialize in microfinance, which are very small loans. For example, ACCION USA gives history. While $500 $500 credit-builder loans to people with no credit might not sound like much, it could be enough to open a home-based business.48 CREATIVE SOURCES OF FINANCING AND FUNDING Because financing and funding are difficult to obtain, particularly for start­ ups, entrepreneurs often use creative ways to obtain financial resources. Even for firms that have financing or funding available, it is prudent to search for sources of capital that are less expensive than traditional ones. The following sections discuss three of the more common creative sources of financing and funding for entrepreneurial firms. Leasing I Learning Objective A lease is 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 Explain the advantages of leasing for an entrep reneurial venture. exchange for payments. The major advantage of leasing is that it enables a company to acquire the use of assets with very little or no down payment. Leases for facilities and leases for equipment are the two most common types of leases that entrepreneurial ventures undertake. 49 F or example, many new businesses lease computers from Dell Inc. or other PC manufacturers. The advantage for the new business is that it can gain access to the computers it needs with very little money invested up-front. There are many different players in the leasing business. Some vendors, such as Dell, lease directly to businesses. As with banks, the vendors look for lease clients with good credit backgrounds and the ability to make the lease payments. There are also venture-leasing firms that act as brokers, bringing the parties involved in a lease together. These firms are acquainted with the producers of specialized equipment and match these producers with new ventures that are in need of the equipment. One of the responsibilities of these firms is conducting due diligence to make sure that the new ventures involved will be able to keep up with their lease payments. Most leases involve a modest down payment and monthly payments during the duration of the lease. At the end of an equipment lease, the new venture typically has the option to stop using the equipment, purchase it at fair market value, or renew the lease. Lease deals that involve a substantial amount of money should be negotiated and entered into with the same amount of scrutiny as when getting financing or funding. Leasing is almost always more expensive than paying cash for an item, so most entrepreneurs think of leasing as an alternative to equity or debt financing. Although the down payment is typically lower, the primary disadvantage is that at the end of the lease, the lessee doesn't own the property or equipment. 50 O f course, this may be an advantage if a company is leasing equipment, such as computers or copy machines that can rather quickly become technologically obsolete. SBIR and STTR Grant Programs The Small Business Innovation Research (SBIR) and the Small Business Technology Transfer (STIR) programs are two important sources of early stage This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. CHAPTER 10 • GETTING FINANCING OR FUNDING f unding for technology firms. These programs provide cash grants 335 to entrepreneurs who are working on projects in specific areas. The main differ­ ence between the SBIR and the STTR programs is that the STTR program requires the participation of researchers working at universities or other research institutions. For the purpose of the program, the term small business is defined as an American-owned for-profit business with fewer than 500 employees. The principle researcher must also be employed by the business. 51 The SBIR Program is a competitive grant program that provides over $1 billion per year to small businesses for early stage and development pro­ jects. Each year, 11 federal departments and agencies are required by the SBIR to reserve a portion of their research and development funds for awards to small businesses. The agencies that participate, along with the types of areas that are funded, are shown in Table 10.5. Guidelines for how to apply for the grants are provided on each agency's Web site, along with a description of the types of projects the agencies are interested in supporting. The SBIR is a three-phase program, meaning that firms that qualify have the potential to receive more than one grant to fund a particular proposal. These three phases, along with the amount of funding available for each phase, are as follows: • Phase I is a six-month feasibility study in which the business must demonstrate the technical feasibility of the proposed innovation. Funding available for Phase I research ranges from $75,000 to $100,000, depending on the agency involved. • Phase II awards are made for up to $750,000 for as long as two years to successful Phase I companies. The purpose of a Phase II grant is to develop and test a prototype of Phase I innovations. The funding that is available for Phase II research ranges from $300,000 to $750,000, depending on the agency involved. Some agencies have fast-track programs where appli­ cants can simultaneously submit Phase I and Phase II applications. • Phase III is the period during which Phase II innovations move from the research and development lab to the marketplace. No SBIR funds are involved. At this point, the business must find private funding or financ­ ing to commercialize the product or service. In some cases, such as with the Department of Defense, the government may be the primary customer for the product. Table 10.5 SMALL BUSINESS INNOVATION RESEARCH: THREE-PHASE PROGRAM Phase Purpose of Phase Phase 1 Funding Available (Varies by Agency) To demonstrate the proposed innovation's Up to 6 Up to $100,000 technical feasibility Phase II Duration months Available to successful Phase I companies. Up to 2 years Up to $750,000 The purpose of a Phase II grant is to develop and test a prototype of the innovation validated in phase 1.* Phase Ill Period in which Phase II innovations move Open No SBIR funding available, however, federal from the research and development lab to agencies may award non-SBIR funded follow-on the marketplace. grants or contracts for products or processes that meet the mission needs of those agencies, or for further R&D. ·some agencies have a fast-track program where applicants can submit Phase I and Phase II applications simultaneously. Government agencies that participate in this program include the following: Department of Agriculture, Department of Commerce, Department of Defense, Department of Education, Department of Energy, Department of Health and Human Services, Department of Homeland Security, Department of Transportation, Environmental Protection Agency, NASA, National Institutes of Health, and National Science Foundation. This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. 336 PART 3 • MOVING FROM AN IDEA TO AN ENTREPRENEURIAL FIRM Historically, less than 15 percent of all Phase I proposals are funded, and about 30 percent of all Phase II proposals are funded. The payoff for successful proposals, however, is high. The money is essentially free. It is a grant, mean­ ing that it doesn't have to be paid back and no equity in the firm is at stake. The recipient of the grant also retains the rights to the intellectual property developed while working with the support provided by the grant. The real payoff is in Phase III if the new venture can commercialize the research results. The STTR Program is a variation of the SBIR for collaborative research projects that involve small businesses and research organizations, such as universities or federal laboratories. More information about the STIR program can be obtained from the SBA. Other Grant Programs There are a limited number of other grant programs available to entrepreneurs. Obtaining a grant takes a little detective work. Granting agencies are by nature low-key, so they normally need to be sought out. A typical scenario of a small business that received a grant is provided by Rozalia Williams, the founder of Hidden Curriculum Education, a for-profit company that offers college life skills courses. To kick-start her business, Williams received a $72,500 grant from Miami-Dade Empowerment Trust, a granting agency in Dade County, Florida. The purpose of the Miami-Dade Empowerment Trust is to encourage the creation of businesses in disadvantaged neighborhoods of Dade County. The key to Williams's success, which is true in most grant-awarding situations, is that her business fit nicely with the mission of the granting organization, and she was willing to take her business into the areas the granting agency was committed to improving. After being awarded the grant and conducting her college prep courses in four Dade County neighborhoods over a three-year period, Williams received an additional $100,000 loan from the Miami-Dade Empowerment Trust to expand her business. There are also private founda­ tions that grant money to both existing and start-up firms. These grants are usually tied to specific objectives or a specific project, such as research and development in a specific area. The federal government has grant programs beyond the SBIR and STIR programs described previously. The full spectrum of grants available is listed at www.grants.gov. State and local governments, private foundations, and philan­ thropic organizations also post grant announcements on their Web sites. Finding a grant that fits your business is the key. This is no small task. It is worth the effort, however, if you can obtain some or all of your start-up costs through a granting agency. One thing to be careful of is grant-related scams. Business owners often receive unsolicited letters or e-mail messages from individuals or organizations that assure them that for a fee they can help the business gain access to hundreds of business-related grants. The reality is that there aren't hundreds of business-related grants that fit any one business. Most of these types of offers are a scam. Strategic Partners Strategic partners are another source of capital for new ventures. 52 Indeed, strategic partners often play a critical role in helping young firms fund their operations and round out their business models. Biotechnology companies, for example, rely heavily on partners for finan­ cial support. Biotech firms, which are typically fairly small, often partner with larger drug companies to conduct clinical trials and bring products to market. This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. · CHAPTER 10 • GETIING FINANCING OR FUNDING Most of these arrangements involve a licensing agreement. A typical agreement works like this: A biotech firm licenses a product that is under development to a pharmaceutical company in exchange for financial support during the devel­ opment of the product and beyond. This type of arrangement gives the biotech firm money to operate while the drug is being developed. The downside to this approach is that the larger firm ultimately markets the drug and retains a large share of the income for itself. Sometimes strategic partnerships take on a different role in helping biotech firms take products to market and allows them to keep a larger share of the income than licensing arrangements permit. Finally, many partnerships are formed to share the costs of product or service development, to gain access to a particular resource, or to facilitate speed to market. 53 In exchange for access to plant and equipment and estab­ lished distribution channels, new ventures bring an entrepreneurial spirit and new ideas to these partnerships. These types of arrangements can help new ventures lessen the need for financing or funding. Chapter Summary 1. For three reasons-cash flow challenges, capital investment needs, and the reality of lengthy product development cycles-most new firms need to raise money at some point during the early part of their life. 2. Personal funds, friends and family, and bootstrapping are the three sources of personal financing available to entrepreneurs. 3. Entrepreneurs are often very creative in finding ways to bootstrap to raise money or cut costs. Examples of bootstrapping include minimizing per­ sonal expenses and putting all profits back into the business, establishing partnerships and sharing expenses with partners, and sharing office space and/ or employees with other businesses. 4. The three steps involved in properly preparing to raise debt or equity financing are as follows: Determine precisely how much money is needed, determine the type of financing or funding that is most appropriate, and develop a strategy for engaging potential investors or bankers. 5. An elevator speech is a brief, carefully constructed statement outlining a business opportunity's merits. 6. Equity funding involves exchanging partial ownership in a firm, which is usually in the form of stock, for funding. Debt financing is getting a loan. 7. Business angels are individuals who invest their personal capital directly in start-up ventures. These investors tend to be high-net-worth individuals who generally invest between $25,000 and $150,000 in a single company. Venture capital is money that is invested by venture capital firms in start­ ups and small businesses with exceptional growth potential. Typically, venture capitalists invest at least $ 1 million in a single company. 8. An initial public offering (IPO) is an important milestone for a firm for four reasons: It is a way to raise equity capital, it raises a firm's public profile, it is a liquidity event, and it creates another form of currency (company stock) that can be used to grow the company. 9. The main SBA program available to small businesses is referred to as the 7(A) Loan Guaranty Program. This program operates through private­ sector lenders providing loans that are guaranteed by the SBA. The loans are for small businesses that are unable to secure financing on reasonable terms through normal lending channels. 10. A lease is 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. The major advantage of leasing is that it enables a company to acquire the use of assets with very little or no down payment. This document is authorized for use by Chetna mehra, from 12/19/2011 to 5/19/2012, in the course: MGMT 472: Entrepreneurship and Small Business - Turner (Spring 2012), University of South Carolina. Any unauthorized use or reproduction of this document is strictly prohibited. 337 ...
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