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) 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) 3) 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) 5) 6) 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. 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. 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. Advertising: It is also a sunken cost. The higher the amount spent by incumbent firms, the greater the deterrent to new entrants. 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. 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: 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. 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. 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 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.