Sources of Finance for New Ventures Madhura Kodithuwakku Department of Management and Entrepreneurship Learning objectives • To explain the why most new ventures need financing or funding • To discuss alternatives for raising money for a new venture • To discuss matching a new venture’s characteristics with the appropriate form of financing or funding The successful venture life cycle • The venture life cycle begins in the development stage, has various growth stages, and “ends” in a maturity stage. The five life cycle stages are: The successful venture life cycle • The venture life cycle begins in the development stage, has various growth stages, and “ends” in a maturity stage. The five life cycle stages are: – – – – – Development stage Start-up stage Survival stage Rapid-growth stage Early-maturity stage • For the typical venture, operating losses usually occur during the startup and survival stages, with profits beginning and growing during the rapid-growth stage. • Free cash flows generally lag operating profits because of the heavy investment in assets usually required during the first part of the rapidgrowth stage. Development Stage • During the development stage, the venture progresses from an idea to a promising business opportunity. • Most new ventures begin with an idea for a potential product, service, or process. The feasibility of an idea is first put on trial during the development stage. • Ventures determine core strengths and capabilities. The purpose of this stage is to lay the foundation to the business. Startup Stage • The second stage of a successful venture’s life cycle is the start-up stage, when the venture is organized, developed, and an initial revenue model is put in place. • In some instances, the process of acquiring necessary resources can take less than one year. For example, a business venture requiring little physical and intellectual capital and having simple production and delivery processes might progress from the initial idea to actual start-up in one year or less. Survival Stage • During the survival stage, revenues start to grow and help pay some, but typically not all, of the expenses. • The gap is covered by borrowing or by allowing others to own a part of the venture. • However, lenders and investors will provide financing only if they expect the venture’s cash flows from operations to be large enough to repay their investments and provide for additional returns. • Formal financial statements and planning begin to have useful external purposes. • Formalization happens.. Rapid-Growth Stage • The fourth stage of a successful venture’s life cycle is the rapid-growth stage, when revenues and cash inflows grow very rapidly. Cash flows from operations grow much more quickly than do cash outflows, resulting in a large appreciation in the venture’s value. • The successful venture reaps the benefits of economies of scale in production and distribution. • At this stage ventures attempt to make partnerships. Early-Maturity Stage • The fifth stage in a successful venture’s life cycle is the early-maturity stage, when the growth of revenue and cash flow continues, but at much slower rates than in the rapid growth stage. Well managed firms acquire small firms. • The early-maturity stage often happens with decisions by the entrepreneur and other investors to exit the venture through a sale or merger. Why Most New Ventures Need Financing or Funding? Why Most New Ventures Need Financing or Funding? 1. Cash Flow Challenges Inventory must be purchased, employees must be trained and paid and advertising must be paid before cash is generated from sales. 2. Capital Investments The cost of buying real estate, building facilities and purchasing equipment typically exceeds a firm’s ability to provide funds for these needs on its own. 3. Lengthy Product Development Cycles Some Products are under development for years before they generate earnings. The up-front costs often exceeds a firm’s ability to fund these activities on its own. Alternatives for Raising Money for a New Venture Sources Personal Financing Debt Financing Equity Financing Creative Sources Sources of Raising Funds for a New Venture Personal Financing 1. Personal Funding The vast majority of founders contribute personal funds, along with sweat equity, to their ventures. (Sweat equity represents the value of the time and effort that a founder puts into a new venture.) 2. Friends and Family 3. Bootstrapping Friends and family are the second source of funds for many new ventures . Bootstrapping is finding ways to avoid the need for external financing or funding through creativity, ingenuity, thriftiness, cost cutting, or any means necessary. 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. Buy items cheaply but prudently via options such as eBay. Share office space or employees with other businesses. Hire interns. Preparing to Raise Debt or Equity Financing Two Most Common Alternatives Equity Funding Debt Financing Means exchanging partial ownership in a firm, usually in the form of stock, for funding. Is getting a loan. Preparing to raise Debt or Equity Financing Determine precisely how much money is needed Determine the type of financing or funding that is the most appropriate Develop a strategy for engaging potential investors or bankers Sources of Equity Funding Venture Capital Business Angels Initial Public Offerings Business Angels • Business Angels – Are individuals who invest their personal capital directly in startups. – The prototypical business angel is about 50 years old, has high income and wealth, is well educated, has succeeded as an entrepreneur, and is interested in the start-up process. – These investors generally invest between $10,000 and $500,000 in a single company. – Are looking for companies that have the potential to grow between 30% to 40% per year. Venture Capital • Venture Capital – Is money that is invested by venture capital firms in start-ups and small businesses with exceptional growth potential. – Venture capital firms are limited partnerships of money managers who raise money in “funds” to invest in start-ups and growing firms – Management Fund – Angel investors tend to invest earlier in the life of a company, whereas venture capitalists come in later. Initial Public Offering • Initial Public Offering – An initial public offering (IPO) is a company’s first sale of stock to the public. When a company goes public, its stock is traded on one of the major stock exchanges. – An IPO is an important milestone for a firm. Typically, a firm is not able to go public until it has demonstrated that it is viable and has a bright future. Sources of Debt Financing • Banks – Historically, commercial banks have not been viewed as a practical source of financing for start-up firms. • Banks are interested in firms that have a strong cash flow, low leverage, audited financials, good management, and a healthy balance sheet. • Government grants for start-ups • Small business loans (private funds) Other Sources of Debt Financing • Vendor Credit – Also known as trade credit, is when a vendor extends credit to a business in order to allow the business to buy its products and/or services up front but defer payment until later. • Factoring – Is a financial transaction whereby a business sells its accounts receivable to a third party, called a factor, at a discount in exchange for cash. Creative Sources of Financing or Funding Crowdfundin g Strategic Partners Leasing Crowdfunding • Crowdfunding (Crowdsourcing) – Crowdfunding is the practice of funding a project or new venture by raising monetary contributions from a large number of people (the “crowd”) typically via the Internet. • Two Types of Crowdfunding Programs – Rewards-based crowdfunding allows entrepreneurs to raise money in exchange for some type of amenity or reward. – Equity-based crowdfunding helps businesses raise money by tapping individuals who provide funding in exchange for equity in the business. • OnMarket Crowd – – https://www.onmarket.com.au/crowdfunding-investment/ https://www.onmarket.com.au/equity-crowdfunding/ Leasing • Leasing – Most leases involve a modest down payment and monthly payments during the duration of the lease. – 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. Strategic Partners • Strategic Partners – Many partnerships are formed to share the costs of product or service development, to gain access to particular resources, or to facilitate speed to market. – Older established firms benefit by partnering with young entrepreneurial firms by gaining access to their creative ideas and entrepreneurial spirit. Strategic Partners • Biotech firms often partner with large drug companies to conduct clinical trials and bring new products to market. • The biotech firms benefit by obtaining funding from their partners, and the partners benefit by having additional products to sell. Matching a New Venture’s Characteristics with the appropriate form of Financing or Funding Sources Personal Financing The Business has high risk with an uncertain return: • Weak cash Flow • High Leverage • Low to Moderate Growth • Unproven management Debt Financing The Business has low risk with a more predictable return: • Strong cash flow • Low leverage • Audited financials • Good Management Equity Financing The business offers a high return: • • • • Unique business idea High Growth Niche Market Proven Management Financing through the venture cycle. Life cycle stage Types of financing Major sources/ players Development stage Seed financing Entrepreneur’s assets, family and friends Startup stage Startup financing Entrepreneur’s assets, family and friends, business angles, venture capitalists Survival stage First-round financing Business operations, venture capitalists, Suppliers and customers, Government assistance programs and commercial banks Rapid-growth stage Second round financing Mezzanine financing Liquidity stage financing Business operations, suppliers and customers, commercial banks and investment banks. Early maturity stage Obtaining bank loans Issuing bonds Issuing stocks Business operations, Commercial banks, Investment banks. Class Activities • Draw a plan for financing your venture – – – – – – How much do you need? (Target) Identify sources of funding Decide on methods to be used to raise the fund How to proceed? What are the key issues and challenges? How to deal with them?
