Chapter 7

FOUNDATIONS OF NEW VENTURE FINANCE

OVERVIEW

This chapter reviews some of the basic concepts and terminology used for financing new firms. The
steps in the cash flow cycle are detailed, and the means by which this cycle is managed are discussed.
The advantages and disadvantages of the different sources of equity and debt financing are elaborated.
Finally, the various methods of new venture valuations are given.

LECTURE OUTLINE

Financing new ventures involves not only determining capital needs for start-up, but also creating and
allocating value among investors and founders. Financing is one of the major hurdles that entrepreneurs
must overcome, as nearly half of all ventures fail because of poor financial management.
Though financial resources are viewed as key to getting into business, they are seldom a source of
sustainable competitive advantage. This can be better understood by utilizing the resource-based
framework and examining the value, imitability, rarity, and substitutability of the resource.

A. Four Attributes of SCA Applied. For a resource to be a source of sustainable competitive advantage,
it must be valuable, rare, imperfectly imitable, and nonsubstitutable.

1. Value—Financial resources are unquestionably valuable. Without financial resources, a new

enterprise could not become a viable firm.

2. Rarity—The rarity of financial resources may vary depending upon the economic climate. However,
overall financial resources are not considered rare.

3. Imitability—Finance is a homogeneous resource and, thus, not imperfectly imitable.

4. Substitutability—Substitutes for financial resources exist in the form of frugality, efficient

operations, and reinvestment. Furthermore, alliances can be formed as a replacement for financial
resources.

Though financial resources are not considered a source of SCA because they are not rare, imperfectly
imitable, nor nonsubstitutable, the management of financial resources can be a source of SCA. The
ability to manage finances involves a high level of complexity and a human element consistent with the
four characteristics.

I. Determining Financial Needs

Both undercapitalization and overcapitalization can be problematic for a new venture. If the firm raises
too little money, the firm will be undercapitalized and may run out of cash. An overcapitalized firm has
raised too much money and has excessive cash. Overcapitalization may send the wrong signals to
stakeholders and lead to inefficiency and a lack of frugality.

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A. Working Capital and Cash Flow Management. Permanent working capital is the amount of capital
required to produce goods and services at the lowest point of demand. Temporary working capital is
the amount needed to meet seasonal or cyclical demand. Too little permanent working capital may
cause stockouts of inventory or an overly restrictive accounts receivable policy. This can lead to a loss of
sales or damaged reputation. Too much working capital is inefficient and may lead to excessive
inventories, cash levels, and accounts receivable.
The cash flow cycle includes five phases and corresponds to the natural production cycle from
material receipt to finished-goods inventory. The first segment is the accounts payable phase for raw
materials and can be viewed as a source of cash. The remaining phases depict uses of cash and include
raw materials inventory, work-in-process inventory, finished goods inventory, and accounts receivable.
A firm attempting to manage its cash flow cycle will try to maximize the first time phase and limit the
remaining four phases. The sum of the final four phases minus the first phase represents the time in
which the firm must finance every dollar of sales.
The process of managing and controlling the cycle includes five dimensions:

1. Accounts payable—The longer the average accounts payable, the shorter the cash cycle. Strong
relationships with vendors enable AP to be extended.

2. Raw-materials inventory—JIT, information systems, and accurate sales forecasting will assist in
minimizing this inventory.

3. Work-in-progress inventory—Efficient operations, worker training, and capital investment allow

WIP to be minimized.

4. Finished-goods inventory—Accurate sales forecasts, information systems, and strong buyer

relationships allow the firm to deliver goods as soon as they are made.

5. Accounts receivable—Early payment incentives assist in keeping AR to a minimum.

B. Across the Venture’s Life Cycle. Financing needs change over the course of the venture’s life cycle.
Two key phases of financing include early-stage financing and expansion or development financing.
Early-stage financing includes both seed and start-up capital. Seed capital is the amount of money
required to prove that the concept is viable and to finance feasibility studies. Start-up capital, also
known as first-stage financing, is the funding necessary to get the company organized and operational
leading to the first commercial sale.
There are three distinct stages of financing during expansion and development: Second-stage
financing is the initial working capital that supports the first commercial sales. Third-stage financing is
used to increase product or service volumes to the break-even point. Fourth-stage financing leads the
firm from being privately owned to being publicly owned. Few ventures are able to progress to the
fourth stage.

C. Start-up Financing. In order to determine how much financing is required to start the business, the
entrepreneur must estimate how much is needed for four types of uses. These include fixed assets,
current assets, organizational costs, and cash flow requirements for continuing operations. Appendix
10A provides an example of start-up cost calculations.

II. Sources of Financing

Costs of financing are composed of the return that investors are expecting to be paid in addition to the
transaction costs involved in securing, monitoring, and accounting for the investment. Four factors
determine the sources of financing available to the new venture: (1) the stage of business development,
(2) potential for growth and profitability, (3) type of assets to be financed, and (4) the financial or
economic environment.

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A. Equity-based Financing. Equity finance represents an ownership stake in the new venture. Sources
of equity include both inside equity and outside equity through private investors, venture capital, and
public offerings.
Inside equity represents the equity derived from the founder, top management, and their friends.
Founders typically invest personal equity because it is the easiest money to obtain and shows
commitment to outside investors.
Outside equity comes from investors who have no personal relationship with the venture beyond
their investment and their concern for its profitability and protection. Private investors are wealthy
individuals who are willing to invest personal funds into new ventures, given their high risk/reward
opportunities. The ease in accessibility and positive reputations provided by these investors make such
financing advantageous to entrepreneurs. However, these individuals may lack business expertise and
be overprotective of their investment. This source may also be limited as the average investment of this
type is $50,000. Financing beyond this is often required if the firm is successful.
Venture capital funds are professionally managed pools of money composed of wealthy
individuals’ investments. Venture capitalists tend to specialize in certain industries and often expect
returns in excess of 35 to 50 percent. To achieve such returns, the business must have strong potential
for growth and the venture capitalist must own a substantial portion of the firm. Venture capitalists are
often capable of offering additional financing when necessary and can provide the new venture much
needed advice and industry contacts.
In order to maximize the venture’s profit potential, it is often necessary for the founder to take the
firm public. This type of financing can create wealth as it capitalizes earnings at a multiple. The initial
public offering enables the firm to raise a much larger amount of equity capital than was previously
possible. The entrepreneur must recognize the disadvantages as well as the benefits of going public.
These are summarized in Street Story 7-2.

B. Debt-based Financing. Debt is borrowed capital under terms of scheduled repayment at an agreed-
upon interest rate. The loan is often collateralized and default may lead to the loss of the asset. Though
interest rates on debt are historically less than equity, equity remains attractive to new ventures due to
the limited liability of the new venture to the equity shareholders and the difficulty in securing loans
from lending institutions.
Because of the difficulty small businesses have in procuring debt financing, government-sponsored
microloan programs have been established. These programs allow small businesses to acquire credit
and debt financing that cannot normally be obtained through normal channels. Such programs may be
targeted toward specific entrepreneurs such as minorities or women.
To properly position oneself for a loan, relationships with lending institutions should be established
prior to the need for a loan. The lender will typically need to know what the money will be used for,
how much is needed, when and how the money will be paid back, and when the money is needed. Key
criteria used by lenders to determine the attractiveness of a loan include the following:

• character and reputation of the entrepreneur,

• capacity to repay the loan,
• existence of other sources of capital used by the new venture,
• current industry, firm, and economic conditions, and
• potential collateral supporting the loan.

When searching for a lender, the entrepreneur should not only meet the above requirements but should
also check the references of the bank and its reputation. A bank’s industry experience as well as its
personal chemistry with the entrepreneur may be important factors in assuring a successful relationship.
There are two basic types of debt financing. Asset-based financing is collateralized and is most
commonly used for trade credit. When a specific asset is identifiable with the borrowing need, asset-
based financing is appropriate. The more tangible and stable resources (real estate, building mortgage,
etc.) have higher debt ceilings. Cash flow financing is any unsecured financing based on the underlying
operations of the business and its ability to generate cash. Covenants are the precautionary measures

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that a bank may take with regard to the loan. They are likely to cover the manner in which the funds are
disbursed and managed and may require minimum balances in certain accounts.
III. New Venture Valuation

When a new business is created by purchasing another business or when entrepreneurs are looking for
equity investors, a valuation of the new venture is required. Such a valuation is often difficult and
uncertain due to the lack of historical data. Three basic approaches to valuation can be used: asset-based
valuations, earnings-based valuations, and the use of discounted cash flow techniques.

A. Asset-based Valuations. The purpose of these evaluations is to determine how much the venture
would be worth if it were sold for its tangible and intangible parts. Four basic types of asset-based
valuations exist.
The book value of an asset is the historical cost of the asset less accumulated depreciation. A fully
depreciated asset will have a book value of zero. The book value may understate the economic value of
the asset and may merely be an artifact of accounting practice.
Because of the discrepancy between economic and book values, adjusted book values are sometimes
calculated. These can be higher or lower depending on the circumstance. Often, land may be more
valuable and old inventory less valuable than the established book value.
The liquidation value is the value of the assets if they had to be sold under pressure. From the
investor’s viewpoint, the difference between the value of the investment and the liquidation value of the
assets represents the maximum risk of exposure for the investment.
Replacement value is the amount it would cost to duplicate the firm’s current physical asset base at
today’s price. This is often used as a point of reference in negotiations between a buyer and seller.

B. Earnings-based Valuations. Two problems are inherent in these techniques. These are uncertainty as
to which measure of earnings should be used and which factor is appropriate for capitalization.
Historical earnings is a measure of past performance. Past performance may be an indication of
future performance. However, it must be recognized that the context under which previous
performance has occurred will be different in the future. Calculations can also be made based on future
earnings and the historical resource base. This assumes that the relationship between the firm’s
capabilities and its environment will remain unchanged. However, it is probable that the resource base
of the firm will be modified under new ownership. Perhaps the most appropriate measure of earnings
involves future earnings based upon both the present and future resource base. Earnings calculations for
new ventures should be based upon earnings before interest and tax because it is an accurate measure of
the earning power of the venture before the effects of finance and tax.
The capitalization factor or price-earnings ratio is the multiple that represents the consensus among
investors concerning the growth and reliability of the firm’s earnings over time. Establishing this figure
is often highly uncertain. There are three points of reference that can be examined. One can look for
similar or comparable firms that have recently been valued and employ that capitalization rate.
Alternatively, one can rely on current stock market levels and use its overall P-E ratio. Finally, the
prospects of the industry can be considered. Adjustments can be made for those under highly
competitive conditions and those that are “sunset” industries.

C. Discounted Cash Flow Models. The application of DCF models to entrepreneurial opportunities is
relatively new and must be applied with some caution. One advantage of using these methods is that
it is based on the cash-generating capacity of the firm and not accounting earnings. Furthermore, it
incorporates cash flows that can be appropriated by the founder and top management team such as
retirement schemes, debt repayments, and salaries. For a closely held firm, these may be quite relevant.
The primary disadvantage of DCF is that there are few alternatives to the new venture and the
benefit of comparison is lost. There is also significant uncertainty regarding the inputs into the DCF
equation, including cash flows, discount rate, and the terminal value of the firm.

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 Investors employ the residual pricing method to determine how much of the firm must be sold to
the investor in order to raise the start-up funds. The investor is normally interested in the after-tax
profits after a certain point in time. Up until this time, cash flows will have been reinvested and paid out
to the entrepreneur. The investor uses a “required rate of return” to see whether the firm will be able to
cover the risk exposure, expenses, and the cost of low-return investments made by the investor. In order
for the entrepreneur to establish how much equity needs to be offered in exchange for the investment,
the following information is needed:
• Investor’s required rate of return
• Amount of the investment
• Number of years the investment is to be held
• After-tax profits for the horizon year
• Expected price-earnings multiple

BOXED FEATURES

Street Stories 7-l: Equity Angels

Women have less access to venture capital than men and this is probably due to some stereotypes about
woman businesses: they are not aggressive or competitive, they are in services and retail, they are not
experienced managers. But new sources of financing for women are becoming available. The story
points to a number of these sources and more women-led venture firms are springing up. As women
gain more access to corporate boardrooms and their incomes rise, there will be more women investors
with the motivation and savvy to do venture financing.

Street Story 7-2: Going Public: Pros and Cons

This Street Story provides a list detailing both the advantages and disadvantages of going public. While
the advantages are often well known and include accessing additional cash for expansion, the
disadvantages should not be discounted. By going public, the venture loses its confidentiality and has
increased accountability to the stockholders. The entrepreneur may lose some control of the company
and risks a possible takeover. Emphasis is focused on earnings per share and on managing the stock
price, which may conflict with long-term performance goals that the entrepreneur may maintain. Before
deciding to go public, the entrepreneur needs to consider not only the gains from the additional
financing but also the drawbacks.

Street Stories 7-3: Hard Lessons in Financing

This story gives four important tips to entrepreneurs as they search for financing for their business
ventures. The tips: make projections realistic, don't hassle with an unenthusiastic investor, use contacts
to find financing, and be flexible. Entrepreneurs frequently have a "one way" orientation towards
financing and spend a lot of time and trouble in unrealistic searches with people who do not understand
their businesses.

DISCUSSION QUESTIONS

1. In what ways can financial resources be a source of sustainable advantage? Why are financial
resources not a source of SCA?

The management of financial resources can provide the firm with a sustainable competitive advantage.
The organization, processes, and routines that a firm develops may allow a level of efficiency that sets it
apart from the competition.
However, financial resources alone technically do not provide competitive advantage. Overall,
financial resources are not rare, as it is estimated that $66 billion is available through formal and

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informal sources. Furthermore, financial resources are not imperfectly imitable. Financial capital is a
commodity. Financial resources are also not nonsubstitutable because they are typically required and
little else can replace the input of capital.

2. Why is undercapitalization dangerous for a new venture? How can overcapitalization also pose a
problem?

Both undercapitalization and overcapitalization can be problematic for a new venture. If the firm raises
too little money, the firm will be undercapitalized and may cause the firm to run out of cash, particularly
during periods of growth. Street Story 10-1 provides a good example of the problems caused due to
undercapitalization. An overcapitalized firm has raised too much money and has excessive cash.
Overcapitalization may send the wrong signals to stakeholders and lead to inefficiency and a lack of
frugality.

3. What are the elements of the cash flow cycle?

The cash flow cycle includes five phases and corresponds to the natural production cycle from material
receipt to finished goods inventory. The first segment is the accounts payable phase for raw materials
and can be viewed as a source of cash. The remaining phases depict uses of cash and include raw
materials inventory, work-in-process inventory, finished goods inventory and accounts receivable.

4. How can managing and controlling the cash flow cycle save the entrepreneur money?

A firm attempting to manage its cash flow cycle will try to maximize the first-time phase of accounts
payable and limit the remaining four phases of materials inventory, work-in-process inventory, finished
goods inventory, and accounts receivable. The sum of the final four phases minus the first phase
represents the time in which the firm must finance every dollar of sales.
The process of managing and controlling the cycle includes five dimensions.
A. Accounts payable—The longer the average accounts payable, the shorter the cash cycle. Strong
relationships with vendors enable AP to be extended.
B. Raw materials inventory—JIT, information systems, and accurate sales forecasting will assist in
minimizing this inventory.
C. Work-in-progress inventory—Efficient operations, worker training, and capital investment allow WIP
to be minimized.
D. Finished goods inventory—Accurate sales forecasts, information systems, and strong buyer
relationships allow the firm to deliver goods as soon as they are made.
E. Accounts receivable—Early-payment incentives assist in keeping AR to a minimum.

5. How do the financing needs of the enterprise change over its life cycle?

Financing needs change over the course of the venture’s life cycle. Two key phases of financing include
early-stage financing and expansion or development financing.
Early-stage financing includes both seed and start-up capital. Seed capital is the amount of money
required to prove that the concept is viable and to finance feasibility studies. Start-up capital, also
known as first-stage financing, is the funding necessary to get the company organized and operational,
leading to the first commercial sale.
There are three distinct stages of financing during expansion and development. Second-stage
financing is the initial working capital that supports the first commercial sales and is typically prior to
achieving a positive cash flow. Third-stage financing is used to increase product or service volumes to
the break-even point and positive cash flow levels. Fourth-stage financing leads the firm from being
privately owned to being publicly owned. Few ventures are able to progress to the fourth stage.

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6. What variables affect the choice of financing sources over its life cycle?

Four factors determine the sources of financing available to the new venture: (1) the stage of business
development, (2) potential for growth and profitability, (3) type of assets to be financed, and (4) financial
or economic environment.
The elements of the overall financial environment that should be considered are

• interest rates and their term structure,

• the level and trend in the stock market,
• the health of the various financial institutions,
• the level of confidence in the economy, and
• government monetary and fiscal policy.

7. What are the pros and cons of raising start-up capital from private investors?

Private investors are wealthy individuals who are willing to invest personal funds into new ventures,
given their high risk/reward opportunities. The ease in accessibility and positive reputations provided
by these investors make such financing advantageous to entrepreneurs. However, these individuals may
lack business expertise and be overprotective of their investment. Personal visits by the investors are not
out of the ordinary and may require extra time for the entrepreneur. This source may also be limited, as
the average investment of this type is $50,000. Financing beyond this is often required if the firm is
successful.

8. What are the pros and cons of going public?

A comprehensive list of the pros and cons of going public is provided by Street Story 10-3. The overall
advantage of going public is accessing a level of capital that will allow the company to expand either
internally or through acquisitions and mergers. Furthermore, it will give the firm the ability to access
increasing amounts of long-term debt. It provides the entrepreneur with the equity for executive
incentives and compensation. It may also be a source of personal satisfaction for top management and
mark a “coming of age” for the firm.
However, several disadvantages of going public should be considered. The venture loses its
confidentiality and has increased accountability to the stockholders. There may be demands for
dividends from the shareholders. The entrepreneur may lose some control of the company and risks a
possible takeover. Emphasis is focused on earnings per share and on managing the stock price, which
may conflict with long-term performance goals that the entrepreneur may maintain.

9. What steps should the entrepreneur take to position the new venture for a loan?

To properly position oneself for a loan, relationships with lending institutions should be established
prior to the need for a loan. There should be a meeting with the president of the institution to introduce
yourself and describe the nature of your business. A contact within the loan department should be
established based upon the recommendation of the bank president.
The lender will typically need to know what the money will be used for, how much is needed, when
and how the money will be paid back, and when the money is needed. Key criteria used by lenders to
determine attractiveness of a loan include the following:

• character and reputation of the entrepreneur;

• capacity to repay the loan;
• existence of other sources of capital used by the new venture;
• current industry, firm, and economic conditions; and
• potential collateral supporting the loan.

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 When searching for a lender, the entrepreneur should not only meet the above requirements, but
also check the references of the bank and its reputation. A bank’s industry experience, as well as its
personal chemistry with the entrepreneur, may be important factors in assuring a successful
relationship.

10. Discuss the models and methods of new venture valuation. What are the pros and cons of each
method?

Asset-based valuations—The purpose of these evaluations is to determine how much the venture would
be worth if it were sold for its tangible and intangible parts. Four basic types of asset-based valuations
exist.
The book value of an asset is the historical cost of the asset less accumulated depreciation. A fully
depreciated asset will have a book value of zero. The book value may understate the economic value of
the asset and may merely be an artifact of accounting practice.
Because of the discrepancy between economic and book values, adjusted book values are sometimes
calculated. These can be higher or lower depending on the circumstance. Often, land may be more
valuable and old inventory less valuable than the established book value.
The liquidation value is the value of the assets if they had to be sold under pressure. From the
investor’s viewpoint, the difference between the value of the investment and the liquidation value of the
assets represents the maximum risk of exposure for the investment.
Replacement value is the amount it would cost to duplicate the firm’s current physical asset base at
today’s price. This is often used as a point of reference in negotiations between a buyer and seller.
Earnings-based valuations—Two problems are inherent in these techniques. These are uncertainty
as to which measure of earnings should be used and which factor is appropriate for capitalization.
Historical earnings is a measure of past performance. Past performance may be an indication of
future performance. However, it must be recognized that the context under which previous
performance has occurred will be different in the future. Calculations can also be made based on future
earnings and the historical resource base. This assumes that the relationship between the firm’s
capabilities and its environment will remain unchanged. However, it is probable that the resource base
of the firm will be modified under new ownership. Perhaps the most appropriate measure of earnings
involves future earnings based upon both the present and future resource base. Earnings calculations for
new ventures should be based upon earnings before interest and tax because it is an accurate measure of
the earning power of the venture before the effects of finance and tax.
The capitalization factor or price-earnings ratio is the multiple that represents the consensus among
investors concerning the growth and reliability of the firm’s earnings over time. Establishing this figure
is also highly uncertain.
Discounted cash flow models—The application of DCF models to entrepreneurial opportunities is
relatively new and must be applied with some caution. One advantage of using these methods is that
they are based on the cash-generating capacity of the firm and not accounting earnings. Furthermore,
they incorporate cash flows that can be appropriated by the founder and top management team, such as
retirement schemes, debt repayments, and salaries. For a closely held firm, these may be quite relevant.
The primary disadvantage of DCF is that there are few alternatives to the new venture and the
benefit of comparison is lost. There is also significant uncertainty regarding the inputs into the DCF
equation, including cash flows, discount rate, and the terminal value of the firm.

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DISCUSSION CASE

1. As a taxpayer how do you feel about this program? Do you think it is the role of the government
to create jobs?
This is an opinion question and students will be split. My students tend to think the government should
stay out of most economic activity like this, but Indiana is a relatively conservative state. The taxpayer
is being asked to guarantee a loan. If the loan defaults, the taxpayer pays off the debentures. But it is
possible that the taxpayer can recoup much of the guarantee in liquidation or from the overall benefits to
the tax base that the program offers.

2. If you were on the selection committee for NMVC firms, what kind of experience or credentials
would you be looking for on an application?
I want to see an experienced management team with some exposure to the type of low-income
environment they will be operating in. I want to see a business plan that demonstrates that as the
business gets bigger, it will hire more workers and train those workers in transferable business skills.
But I also want realists, not dreamers. People need to be able to make their business case first, and their
economic development case second. It does no one any good to have failures in this program.

3. Do you think a commitment to the "double bottom line" can be profitable? Is creating jobs a goal
that is compatible with entrepreneurship?
Creating jobs can be compatible with entrepreneurship if the jobs are created organically during the
natural growth of the business. If the business is not growing, pressure to add jobs just adds costs and
puts the existing jobs in jeopardy.

4. Do you think this program will be successful over time? Visit the Small Business Administration
website (www.sbaonline.sba.gov) to check the current status of the New Markets Venture Capital
Program.
The SBA website can be searched for NMVC and will reveal a number of updates and links. But as of
now (March, 2002), not much has been happening.

ADDITIONAL TEACHING ACTIVITIES

The end-of-chapter “Exercises” list activities instructors can assign. Here are some additional ideas:

1. Defend your proposed sources of financing to others, keeping in mind the advantages and
disadvantages of each type. Why are your financial sources appropriate?

2. Role play a request for a loan between yourself and a set of bankers as played by others in your
group. Consider the issues of positioning for a loan as presented in the text.

3. Based upon similar firms, stock market potential, and industry potential, establish an appropriate
price-earnings ratio for your new venture.

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