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IPFW Business Plan Competition Pre-competition Program

Financing and Capital Sourcing Options
By Dr. Bill Todorovic

Richard T. Doermer School of Business and Management
Neff Hall 340L, Tel. (260) 481 6940 E-mail: todorovz@ipfw.edu Web: http://users.ipfw.edu/todorovz/

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The Nature of a Firm and Its Financing Sources
• Factors That Determine Financing
–Firm’s economic potential –Maturity of the company –Nature of its assets –Owners’ preferences for debt or equity
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Sources Of Funds

Start-up
Personal

Beginning of Production ?

Going Concern Company Size IPO

Friends and Family Angels

Banks Government

Venture Capitalist
Amount

Customers/Suppliers

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Sources of Financing
Sources of Financing
Other Venture Capital Mortgaged Property Private Investors Bank Loans Friends Personal Charge Cards Partners Family Members Personal Savings
0 10 20 30 40 50 60 70 80

Percentage of Entrepreneurs Using Source of Financing
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Critical Financing Factors
•Accomplishments and performance to date.

•Investor’s perceived risk.
•Industry and technology.

•Venture upside potential and anticipated exit timing. •Venture anticipated growth rate
•Venture age and stage of development.
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Debt or Equity?
• Entrepreneurs typically prefer debt
– Allows them to appropriate as much as of the benefit as possible + retain sole control – Can default

• Debt is unattractive to investors in emerging technology
– Usually little collateral or predictable cash flow – Information asymmetry is lessened by ownership position – shared ownership gives some control

– High interest rate to offset risk will stifle growth or cause default

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Tradeoffs Among Potential Profitability, Financial Risk, and Voting

HIGH

Potential Profitability
LOW

Equity Equity financing Financing

Debt Debt Financing financing
LOW HIGH

Financial Risk/Control

Fig. 13.1
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Debt Versus Equity
With no debt and all equity:

No debt $28,000

income on
total assets of $200,000

14% return equals on assets ($28,000 ÷ $200,000) $200,000 equity

14% return on $200,000 ($28,000 ÷ $200,000)

Equity: Owners get to keep all of the profits in return for accepting the risk of lower returns
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Debt Versus Equity (Cont’d)
With $100,000 debt and $100,000 equity:

$100,000 debt (10% cost) $28,000 income on total assets of $200,000 14% return equals on assets ($28,000 ÷ $200,000) $100,000 equity 18% return on $100,000 ($18,000 ÷ $100,000)

Debt is Risky: Lenders have first claim on profits and must be paid even if there are no profits.
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The Banker’s Perspective
• Bankers’ Concerns! • The Five C’s of Credit
–Character of the borrower –Capacity of the borrower to repay the loan –Capital invested in the venture by the borrower –Conditions of the industry and economy –Collateral available to secure the loan

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Financial Information Required for a Bank Loan
• Three years of the firm’s historical statements
• The firm’s pro forma financial statements • Personal financial statements

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Getting to know your friendly neighborhood Venture Capitalist…

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The myth… and the reality
• The myth: VCs support good people and good ideas

• The reality: VCs invest in industries with double digit growth in the middle of the S-curve
– Appropriate management team – Specialty funds (earlier and later stages on the Scurve) – Limits the risk to management risk – Produces attractive exit opportunities

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Present Day Situation
Myth: There is less available capital Fact: The industry has plenty of money, but limited appetite for new investment Fact: Investor attitudes toward risk have changed

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VC fills a void
• Gap between innovation and traditional sources of debt • Risk inherent in startups typically justify interest rates higher than allowed by law

• VCs must balance high returns for their investors against sufficient upside potential for entrepreneurs to keep them motivated

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What VCs get out of it

• 10X return on capital over 5 years • VCs management fees and high growth funds

• Fund structured with limited and general partners and a life of 7-10 years

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What VCs Do?

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Annual Committed Capital ($M)

100

150

200

250

50

0
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94

19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20

Year
95 96 97 98 99 00 01 02

Complements of Thompson Venture Economics
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The Overhang: Uninvested Capital

Angels
• Well to do private individuals
• Geography and industry specific

• Invest lower amount than VC
• Often a good source of industry experience

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Finding Angels
• Private Individuals • Professionals (lawyers, accountants, bankers) • Local small business development centers • Internet associations (e.g., Technology Capital Network at MIT)

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Other Sources of Financing

• Community-based financial institutions
• Large corporations • Stock Sales
–Private placement –Initial public offering (IPO)

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Why Companies Invest?
• Preemption of new rivals • Replace core earnings lost because of an emerging technology • Apply existing competitive advantage in a rapidly growing market • And some degree of autonomy:
– JVs, alliances, flexible internal management structures

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Government-Sponsored Programs and Agencies
• Small Business Administration (SBA) loans
–Guaranty loan –Direct loan

• Small business investment centers (SBICs) • Small Business Innovative Research (SBIR) • State and Local Government Assistance
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Business Suppliers and Asset-Based Lenders
• Trade Credit (Accounts Payable)
Short-duration financing (30 days)

Amount of credit available is dependent on type of firm and supplier’s willingness to extend credit

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Business Suppliers and Asset-Based Lenders (cont’d)
• Equipment Loan and Leases • Leases
Free up cash for other purposes Leaves lines of credit open Provides a hedge against obsolescence

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Business Suppliers and Asset-Based Lenders (cont’d)
• Asset-based Loan
• Factoring
Accounts are sold to factor at a discount to invoice value
Factor can refuse questionable accounts Factor charges fees for servicing accounts and for amount advanced to firm prior to collection

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Formal Vs. Informal Investors
• Funding structure and flexibility • The fit to the mold • Involvement in the business • Rigidity of relationship with the firm

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Discussion?

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Low Level Investment

Complements of: Timmons/Spinelli New Venture Creation, sixth edition

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First Things First
• Burn rate • OOC (out of cash)

• Search out capital markets
• Increase cash flow

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Strategy Refinement
• Market niche • Suppliers and customers • Diversification or specialization • Reduce fixed costs • Plan for contingency

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Management Refinement

• Management skill, experience and know how • Control of Finance • Turnover

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When the market is down

• Increase Your Effectiveness and Efficiency • Be Creative • Pursue different sources of capital

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Building to Grow

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Good Team

Good Decisions Solid Financing Persistence
Reduce Risk

Every business is built on people

Increase Value

Contingency Plan • Best Case Scenario • Worst Case Scenario • Most Likely Scenario

Create Value • Shareholders • Customers • Employees

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Example 1 Sales Growth; ODG
30,000,000 25,000,000 20,000,000 15,000,000 10,000,000 5,000,000 0 1993 Argo Centaur 1995 1997 1999 2001 2003 Other
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Drive Systems/Gears/Couplings

The Sound Advice
• Monitor Cash Flow (especially if growth is high)
–100 fastest growing companies –Entrepreneur of the year award

• Contingency Plan – get the timing right • Emphasize long term growth • Manage your risk factor

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Example 2: Ergo Distributor

• Sales growth 400-500% • Single supplier – No substitutes • Great financial ratios • Cash flow problems • May go bankrupt in couple of years

LESSON: Use your intuition
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Who invests in VC funds?
• Typically pension funds, financial firms, insurance companies, endowments and high net worth individuals • Small percentage of total funds
– Expect returns of 25%-30%

• Most are structured as limited partnerships • Other forms include:
– – – – Corporate VC funds Private funds Publicly listed funds Labour sponsored funds (in Canada)

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