BOOTSTRAP FINANCING

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Bootstrap is a situation in which an entrepreneur starts a company with little
capital. An individual is said to be bootstrapping when he or she attempts to
found and build a company from personal finances or from the operating
revenues of the new company.
ownership in the business, but remember to pay back, as nothing
causes more tension in a family than money matters.
Advantages
i.
ii.
iii.
Bootstrap financing means using your own money or resources to
incorporate a venture. It reduces the dependence on investors and banks.
While the financial risk is ubiquitous for the founder, it also gives him
absolute freedom and control over the management of the company. It's
usually meant for small business ventures and is considered as an
inexpensive option. The key to succeeding with this type of funding is to
ensure optimal management of business finances and maintain adequate
cash flow. Let's look at the common sources of such funding.
iv.
Disadvantages
i.
ii.
iii.
Sources:
1)
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BOOTSTRAP
FINANCING
Since you borrow less, your equity will be secured.
You won't be losing money in the form of high interest rates.
Lesser debt means better market position for dealing with lenders and
investors.
Complete control of your company will allow you to be free and creative in
your dealings.
iv.
Customers
The most important aspect of any business, the customer, can be
a source of capital too. You can obtain a letter of credit from them
to purchase goods. Since your company's goodwill and ethics
play an important role in this, it's important not to default. For
example, if you are in a venture for producing industrial bags, you
can obtain a letter of credit from your customer, to source the
material from a supplier. In this way, you don't have to block your
limited capital and still can generate cash flow.
The complete financial risk lies with the entrepreneur.
Raising finance can be time-consuming, which can impact business
operations.
In the long term, this can be an expensive commitment between you and
your supplier.
These methods encourage entrepreneurs to utilize personal resources,
and have shown some outstanding results among small setups, that have
grown into large companies such as Roadway Express, Black and Decker,
Coca Cola, Dell, Eastman Kodak, UPS, Hewlett-Packard, and many more.
1)

Corporate angels
These private investors use their severance or early-retirement
pay from former senior management positions at large
corporations to make entrepreneurial investments. Typically, they
seek a new senior management job in the investment, want to be
involved in one investment at a time, have about $1 million in
cash, and make investments in the $200,000 range.
2)

Joint Utilization
This is a method where you can save the cost of running the
business by sharing the facility, supplies, equipment, and even
employees with another startup. It's also a great way to build your
network.
2)
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3)
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Angel Investors
Angel investors are affluent individuals, often retired business
owners and executives, who provide capital for small business
startups, usually in exchange for ownership equity. They are an
excellent source of early stage financing as they are willing to take
risks, that banks and venture capitalists wouldn't take.
Entrepreneurial angels
The most active of the angel investors, they invest the largest
amounts, generally $200,000 - $500,000. They tend to have
been successful entrepreneurs themselves, now looking for
ways to diversify their portfolio or expand their current business,
rather than looking for a new job.
3)
Credit Cards
Credit card limits can also be used as a source of finance. The
card offers the ability to make purchases or obtain cash advances
and pay them later, the only disadvantage being that it is
expensive in the long term.
Enthusiast angels
Less professional than their entrepreneurial counterparts, these
angels invest in firms more as a hobby now that they are in their
later years. They tend to invest smaller amounts (from $10,000 to
a few hundred thousand dollars) across a number of companies,
but they do not actively participate in their investments.
4)
Micromanagement angels
Peer-to-Peer Lending
This is a method where borrowers and lenders conduct business
without the traditional intermediaries such as banks. It can also
be known as social lending and depends on your social
acceptability. Peer-to-peer lending can also be conducted using
the Internet.
5)
4)
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5)
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Money Pooling
Small sums of money can be borrowed from several family
members, friends, or colleagues. They will have no legal
BUSINESS
ANGELS
These angels prefer great control over their investments, often
micromanaging them from a seat on the company board rather
than through active participation. They may invest in as many as
four companies at a time, adding value as well as money to each.
Professional angels
As investors from backgrounds in professional careers (doctors,
lawyers, accountants), these angels prefer to invest in firms that
offer a product or service with which they have experience,
frequently offering their sector expertise to the investee firm,
although they're usually not too actively involved. Generally
investing in a number of firms simultaneously, they tend to invest
from $25,000 to $200,000 each and prefer to co-invest with their
peers.
What is Barriers to Entry
Barriers to entry are the obstacles or hindrances that make it difficult to enter
a given market. These may include technology challenges, government
regulation and patents, start-up costs, or education and licensing
requirements.
A primary barrier to entry is the cost that constitutes an economic barrier to
entry on its own. An ancillary barrier to entry refers to the cost that does not
include a barrier to entry by itself but reinforces other barriers to entry if they
are present.
An antitrust barrier to entry is the cost that delays entry and thereby reduces
social welfare relative to immediate but equally costly entry. All barriers to
entry are antitrust barriers to entry, but the converse is not true.
1)
BARRIERS TO
ENTRY
2)
Natural (Structural) Barriers to Entry

Economies of scale: If a market has significant economies of
scale that have already been exploited by the existing firms to a
large extent, new entrants are deterred.
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Network effect: It refers to the effect that multiple users have on
the value of a product or service to other users. If a strong network
already exists, it might limit the chances of new entrants to gain a
sufficient number of users.

High research and development costs: When firms spend huge
amounts on research and development, it is often a signal to the
new entrants that they have large financial reserves. In order to
compete, new entrants would also have to match or exceed this
level of spending.

High set-up costs: Many of these costs are sunk costs that cannot
be recovered when a firm leaves a market such as advertising
and marketing costs and other fixed costs.
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Ownership of key resources or raw material: Having control over
scarce resources, which other firms could have used, creates a
very strong barrier to entry.
Artificial (Strategic) Barriers to Entry

Predatory pricing as well as an acquisition: A firm may
deliberately lower prices to force rivals out of the market. Also,
firms might take over a potential rival by purchasing sufficient
shares to gain a controlling interest.

Limit pricing: When existing firms set a low price and a high output
so that potential entrants cannot make a profit at that price.
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Advertising: It is also a sunken cost. The higher the amount spent
by incumbent firms, the greater the deterrent to new entrants.
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Brand: A strong brand value creates loyalty of customers and
hence, discourages new firms.

Contracts, patents, and licenses: It becomes difficult for new firms
to enter the market when the existing firms own the license or
patent.
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Loyalty schemes: Special schemes and services help oligopolists
retain customer loyalty and discourage new entrants who wish to
gain market share.

Switching costs: These are the costs incurred by a customer
when trying to switch suppliers. It involves the cost of purchasing
or installing new equipment, loss of service during the period of
change, the efforts involved in searching for a new supplier or
learning a new system. These are exploited by suppliers to a large
extent in order to discourage potential entrants.
3)
Government Barriers to Entry

Industries heavily regulated by the government are usually the
most difficult to penetrate; examples include commercial airlines,
defense contractors, and cable companies. The government
creates formidable barriers to entry for varying reasons. In the
case of commercial airlines, not only are regulations stout, but the
government limits new entrants to limit air traffic and simplifying
monitoring. Cable companies are heavily regulated and limited
because their infrastructure requires extensive public land use.

Sometimes the government imposes barriers to entry not by
necessity but because of lobbying pressure from existing firms.
For example, in many states, government licensing is required to
become a florist or an interior decorator. Critics assert that
regulations on such industries are needless, accomplishing
nothing but limiting competition and stifling entrepreneurship.
Barriers to entry generally operate on the principle of asymmetry, where
different firms have different strategies, assets, capabilities, access, etc. If
all firms were symmetrical, then there would be nothing to choose between
and competition would not exist.
8 examples of entry barriers
1- Trademarks consolidated in the market
Entering a market with prestigious and established brands is extremely
difficult to establish. It is this type of challenge that Chinese automobile
brands pass when trying to enter international markets.
2- Patents
A traditional entry barrier is the existence of patents. It is only after the
expiration of this legal protection that other competitors will be able to
manufacture a product or provide that service in much the same way as the
patent holder.
3- Government policies
To open a bank, for example, a number of legal requirements and licenses
must be obtained. These rigid government regulations for some areas are
examples of typical entry barriers.
Unlike opening a restaurant or a network of hotels, some market segments
such as insurance companies and hospitals, in addition to the financial
institutions already mentioned, need better oversight to protect society,
which makes entry into these markets more difficult.
4- Mastering cutting-edge technologies
It’s easier to manufacture lawn mowers than cars, as these are easier to
produce than airplanes.
The mastery of certain technologies can also be a good example of barriers
to entry.
5- Economies of scale
When entering a market, a new entrant will hardly be able to produce the
same quantities as already established competitors. Fixed production costs
can make it very difficult to overcome this initial stage, making the arrival of
new competitors impossible.
Moral hazard became an important factor leading up to (and after) the
financial crisis that began in 2007. There are two ways to think about moral
hazard and loans.
Lenders: Lenders were eager to approve loans before the mortgage crisis.
Some mortgage brokers encouraged “subprime” borrowers to lie on loan
applications, or they altered documents to make it appear as if borrowers
were able to afford loans that they really couldn’t afford. For example,
sometimes inaccurate income numbers were reported, or no documentation
was required to prove claims about a borrower’s ability to repay.
6- Learning curve
Some industries are characterized by complex operations or demand
training’s which aren’t always easy to learn. Luxury restaurants and fashion
labels are a typical example where entry of new competitors often only
happens when a chef or a stylist has already learned enough in the
company where they were and decide to open their own business.
Why would lenders hand out money when they don’t really know if they’ll
get repaid—especially if they have to commit fraud to get the loans
approved? In many cases, the lenders were only originating (or selling) the
loans. After approving and funding loans, lenders would sell the loans to
investors, who eventually lost money. In other words, the lender took little
or no risk. But lenders had an incentive to keep making new loans because
that's how originators get paid.
7- High capital requirements
The energy industry is one of the most obvious examples of this type of
entry barrier. Imagine the amount of capital needed to build a nuclear power
plant or an oil rig!
8- Access to distribution channels
Many suppliers require exclusivity from their distributors or they’re already
satisfied with the profitability that traditional brands offer and prefer not to
take a risk on new entrants.
When things turned sour, lawmakers and the public got scared. They
worried that if major banks collapsed (some of them were loan originators,
while others held risky investments), they would bring down the U.S.
economy—not to mention the global economy. Because these banks were
considered “too big to fail,” the U.S. government helped some of them
weather the economic storm. If those banks suffered significant losses, the
government promised to protect deposits (in some cases through the FDIC).
Of course, taxpayers fund the U.S. government, so the taxpayers were
ultimately bailing out the banks.
Those who want to overcome entry barriers in a new market can design
more efficient and effective processes than established competitors. This
avoids challenges such as economies of scale, for example.
The Concept of Moral Hazard
Moral hazard comes from the insurance industry. Insurance is a way to
transfer risk to somebody else, but insurance works best when moral hazard
is not at work.
In other words, lenders and investment banks took risks that were borne by
taxpayers.
For example, if you damage a rental car (and you have the proper insurance
in place), the insurance company will pay for repairs or a new car. In
exchange for that coverage, you pay a price that seems fair, and everybody
is satisfied.
MORAL
HAZARD
Borrowers: Moral hazard also appeared with borrowers. As millions of
homeowners struggled to pay their mortgages and defaults skyrocketed,
government programs offered relief. People could avoid foreclosure thanks
to money and guarantees from the U.S. government. Some worried that
borrowers would actually have an incentive to walk away from their
mortgages: They were underwater on home loans, and some might be
tempted to get government aid that they didn’t need. In some cases, their
credit might suffer, but in other cases, borrowers would come out
“unscathed” (although struggling borrowers almost certainly experienced
financial hardship and emotional stress).
Information advantage: Insurance works best when neither you nor your
insurance company expects any damage to occur. The insurance company
uses statistics to estimate how likely the vehicle is to suffer damage, and
they price their services accordingly. You pay much less than it costs to
repair a car, and in most cases, the insurance company doesn’t have to pay
for any repairs. But there are times when you might have an unfair
information advantage over your insurance company.
Example: For example, you might plan to drive into the mountains on rough,
narrow roads. So you get the most generous insurance coverage possible,
and you don’t worry about bouncing over rocks or scratching the paint in
thick brush along the side of the road. You might even have a perfectly good
car available at home, but there’s no way you’re going to drive your vehicle
up that road—so you rent a car and buy insurance.
Moral hazard is when you have an incentive to take risks that somebody
else will pay for: You get to do whatever brings you the greatest potential
benefit, and you don’t suffer the consequences. The more insulated you are
from risk, the more temptation you face.
Moral Hazard and Loans
ISSUES IN
DUE DILIGENCE
1. Accounting Standards

During the due diligence process, it often becomes apparent that
the Target has failed to comply with at least some accounting
standards (for various reasons).

Typical examples include the Target recognizing income on a
cash basis (rather than an accruals basis) or recognizing revenue
incorrectly (this is more likely if the Target has multiple revenue
streams and/or long-term contracts with stage payments
spanning accounting years).

From an M&A perspective, it is very likely that there will be
differences between the accounting standards adopted by the
acquirer and those of the Target (such differences may be more
pronounced if the transaction is cross-border and where there are

two (or more) accounting conventions being considered (for
instance, US versus UK GAAP).
Once the due diligence team has grasped any historical
trends/norms, they should consider the connection between
actual historical results and budget/forecast to gauge the
accuracy and reasonableness of the Target’s budgets/forecasts.

For instance, if the Target has forecast for revenue growth and/or
margin increases, how successful has it been at achieving this
performance in the past?

A review of the constituents of any projected revenue growth
should be carried out to ascertain if growth is dependent on key
customers, as an example.

The acquirer should also analyze gross margins and any
customer loyalty assumptions, in addition to forecasts relating to
operating expenses (such as employee numbers).
What is an Intangible Asset
An intangible asset is an asset that is not physical in nature. Goodwill,
brand recognition and intellectual property, such as patents, trademarks
and copyrights, are all intangible assets. Intangible assets exist in
opposition to tangible assets, which include land, vehicles, equipment
and inventory. Additionally, financial assets such as stocks and bonds,
which derive their value from contractual claims, are considered tangible
assets.
2. Contingent & Unrecorded Liabilities

It is not uncommon for contingent liabilities (a potential liability
that may occur, depending on the outcome of an uncertain future
event) or incorrectly recorded/disclosed liabilities to be found
within a Target.

At the more severe end of the spectrum, examples include
litigation risks relating to the violation of laws and regulations
(either specific to the industry in which the Target operates or on
a national level), non-payment of taxes, warranty claims and
breach of contract(s). Less severe contingent and unrecorded
liabilities, but nonetheless potentially constituting “deal breakers,”
include:
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redundancy payments to be incurred in the future;
deferred tax (crystallizing on sale of an asset which has appreciated
in value);
the incorrect categorization and accounting treatment of operating
and finance leases;
And dilapidation provisions in respect of leased real estate.
3. Related Party Transactions

Problematic related party transactions are often uncovered during
the due diligence process – the crux of the matter here is noncommercial transactions.

The financial statements of the Target should be carefully
examined.

For instance, it should be determined whether the Target makes
sales to other entities within a group.

If intra-group sales are made, are these at higher margins than
usual? Conversely, if intra-group purchases are made, are these
at lower rates (therefore improving margins)? The balance sheet
of the Target may show loans due to/from related parties.

A review of payables and receivables will reveal the parties these
amounts are due to/from and whether the balance sheet is
“inflated” due to related party transactions.
4. Quality of Earnings

An acquirer will typically base their offer for a Target on a multiple
of its Earnings Before Interest, Taxes, Depreciation and
Amortization (EBITDA) or a similar profit metric.

Therefore, as part of the due diligence processes it is imperative
that the “quality” and sustainability of the Target’s earnings is
reviewed.

When considering the Target’s normalized EBITDA or "run rate,"
the acquirer should exclude non-recurring, non-cash items such
as gains or losses from acquisitions, divestitures, discontinued
business operations or fixed asset sales (all of which have a
distortionary affect on earnings).

Other items to consider include any unusual or non-recurring
revenue and expense items. Furthermore, changes in historical
versus potential management remuneration and major customers
being gained or lost should be considered.
5. Historical Results Versus Budget/Forecast
1.
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BREAKING DOWN Intangible Asset
An intangible asset can be classified as either indefinite or
definite. A company's brand name is considered an indefinite
intangible asset because it stays with the company for as long as
it continues operations.
An example of a definite intangible asset would be a legal
agreement to operate under another company's patent, with no
plans of extending the agreement. Therefore, the agreement has
a limited life and is classified as a definite asset.

While intangible assets don't have the obvious physical value of
a factory or equipment, they can prove valuable for a firm and be
critical to its long-term success or failure.

For example, a business such as Coca-Cola wouldn't be nearly
as successful if it not for the money made through brand-name
recognition. Although brand recognition is not a physical asset
that can be seen or touched, it can have a meaningful impact on
generating sales.
2.
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Valuing Intangible Assets
Businesses can create or acquire intangible assets.
For example, a business may create a mailing list of clients or
establish a patent. A business could also choose to acquire
intangibles.
If a business creates an intangible asset, it can write off the
expenses from the process, such as filing the patent application,
hiring a lawyer and other related costs. In addition, all the
expenses along the way of creating the intangible asset are
expensed.
However, intangible assets created by a company do not show
up on the balance sheet and have no recorded book value.
Because of this, when a company is purchased, often the
INTANGIBLE
ASSET

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purchase price is above the book value of assets on the balance
sheet.
The purchasing company records the premium paid as an
intangible asset, goodwill, on its balance sheet.
Intangible assets only show up on the balance sheet if they have
been acquired.
If Company ABC purchases a patent from Company XYZ for an
agreed-upon amount of $1 billion, then Company ABC would
record a transaction for $1 billion in intangible assets that would
show up under long-term assets.
The $1 billion asset would then be written off over a number of
years via amortization.
Indefinite life intangible assets, such as goodwill, are not
amortized. Rather, these assets are assessed each year for
impairment, which is when the carrying value exceeds the asset's
fair value.
When business angels or venture capitalists put money into a business,
there has to be a way they can realize their investments at a future date.
This is called the exit or harvest for the investor. There are three ways to
exit an investment: an initial public offering, an acquisition, and a buyback
of the investor's stock by the company itself. We've mentioned that most
investors prefer an IPO because it produces the highest valuation in most
cases—but not in every case. An acquisition is the second choice. And a
buyback is a distant third because in almost every instance it produces a
mediocre return.
HARVESTING
INVESTMENTS
One of the questions neophyte entrepreneurs seeking external equity
financing most often ask is, "Can I buy back the investors' equity?" The
answer is, "In principle yes, but in practice it is extremely unlikely." Buybacks
are rare because a successful and rapidly growing company needs all the
cash it can get just to keep on its growth trajectory. It has no free cash to
buy out its external investors. A firm doing a buyback is more likely to be
one of the living dead for which an IPO or acquisition is not feasible, but
somehow the company arranges a refinancing in which it buys back the
stock owned by the original investors.
What is a Harvest Strategy
A harvest strategy is a plan in which there is a reduction or a termination of
investments in a product, product line, or line of business, so that the entities
involved can reap the maximum profits. A harvest strategy is typically
employed toward the end of a product's lifecycle when it is determined that
further investment will no longer boost product revenue.
BREAKING DOWN Harvest Strategy
Products have life cycles, and when the item nears the end of its life cycle,
it will usually not benefit from additional investments and marketing efforts.
This product stage is called the cash cow, and it is when the asset is paid
off and requires no further investment. Therefore, employing a harvest
strategy will allow companies to harvest the maximum benefits or profits
before the item reaches its decline stage. Companies often use the
proceeds from the ending item to fund the development and distribution of
new products. Funds may also go towards promoting existing products with
high growth potential.
For example, a soft-drink company may terminate investments in its
established soda product to reallocate funds to its new line of energy drinks.
Companies have several harvest strategy options. Often they will rely on
brand loyalty to drive sales, thereby reducing or eliminating marketing
expenses for new products. During harvest, the company can limit or
eliminate capital expenses (CAPEX), such as the purchase of new
equipment needed to support the ending item. Also, they can restrict
spending on operations.
A harvest strategy may involve the gradual elimination of a product or
product line when technological advances render the product or line
obsolete. For example, companies selling stereo systems gradually
eliminated sales of record turntables in favor of CD players as compact disc
sales soared and record sales declined. Also, when product sales
consistently fall below the target level of sales, companies may gradually
eliminate the product from its portfolio.
Harvest Strategy for Equity Investors
Harvest strategy also refers to a business plan for investors such as venture
capitalists or private equity investors. This method is commonly referred to
as an exit strategy, as investors seek to exit the investment after its success.
Investors will use a harvest strategy to collect the profit from their investment
so that fund can be reinvested into new ventures. Most investors estimate
that it will take between three and five years to recoup their investment. Two
common harvest strategies for equity investors are to sell the company to
another company or to make an initial public offering (IPO) of company
stock.
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