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Technopreneurship Week 13

Identify the types of financing available.


Understand the role of commercial banks in
financing new ventures, the types of loans
available, and bank lending decisions.
Know the basic stages of venture funding.
Be aware of the informal risk-capital market.
Understand the nature of the venture-capital
industry and the venture-capital decision
process.
Explain several valuation approaches of a
company.

One of the most difficult problems in the
new venture creation process is obtaining
financing. For the entrepreneur, available
financing needs to be considered from the
perspective of debt versus equity and using
internal versus external funds.
Two types of financing need to be
considered:
1. Debt financing
2. Equity financing

A financing method involving an interest-
bearing instrument, usually a loan, the
payment of which is only indirectly related
to the sales and profits of the venture.
Typically, debt financing (also called asset-
based financing) requires that some asset
(such as a car, house, plant, machine, or
land) be used as collateral.

Requires the entrepreneur to pay back the
amount of funds borrowed as well as a fee
expressed in terms of the interest rate. There
can also be an additional fee, sometimes
referred to as points, for using or being able
to borrow the money.
If the financing is short term (less than one
year), the money is usually used to provide
working capital to finance inventory, accounts
receivable, or the operation of the business. The
funds are typically repaid from the resulting
sales and profits during the year.
Long-term debt (lasting more than one year) is
frequently used to purchase some asset such as
a piece of machinery, land, or a building, with
part of the value of the asset (usually from 50 to
80 percent of the total value) being used as
collateral for the long-term loan.

Does not require collateral and offers the
investor some form of ownership position in the
venture. The investor shares in the profits of the
venture, as well as any disposition of its assets
on a pro rata basis based on the percentage of
the business owned.
Key factors favoring the use of one type of
financing over another are the availability of
funds, the assets of the venture, and the
prevailing interest rates.
Usually, an entrepreneur meets financial needs
by employing a combination of debt and equity
financing.

Financing is also available from both internal
and external funds. The type of funds most
frequently employed is internally generated
funds.
Internally generated funds can come from
several sources within the company: profits,
sale of assets, reduction in working capital,
extended payment terms, and accounts
receivable.
In every new venture, the start-up years involve
putting all the profits back into the venture; even
outside equity investors do not expect any
payback in these early years.
The other general source of funds is external
to the venture.
Alternative sources of external financing
need to be evaluated on three bases:
1. The length of time the funds are available
2. The costs involved
3. The amount of company control lost.

1. Personal Funds
2. Family and Friends
3. Commercial Banks




Few, if any, new ventures are started without the
personal funds of the entrepreneur. Not only are
these the least expensive funds in terms of cost
and control, but they are absolutely essential
in attracting outside funding, particularly from
banks, private investors, and venture capitalists.
The typical sources of personal funds include
savings, life insurance, or mortgage on a
house or car.
These outside providers of capital feel that the
entrepreneur may not be sufficiently committed
to the venture if he or she does not have
money invested.


After the entrepreneur, family and friends are a
common source of capital for a new venture.
They are most likely to invest due to their
relationship with the entrepreneur. This helps
overcome one portion of uncertainty felt by
impersonal investors knowledge of the
entrepreneur. Family and friends provide a small
amount of equity funding for new ventures,
reflecting in part the small amount of capital
needed for most new ventures.
Commercial banks are by far the source of
short-term funds most frequently used by the
entrepreneur when collateral is available.
The funds provided are in the form of debt
financing and, as such, require some tangible
guaranty or collateral some asset with value.
This collateral can be in the form of business
assets (land, equipment, or the building of the
venture), personal assets (the entrepreneur's
house, car, land, stock, or bonds), or the assets
of the cosigner of the note.

There are several types of bank loans
available. To ensure repayment, these loans
are based on the assets or the cash flow of
the venture. The asset base for loans is
usually:
1. Accounts Receivable
2. Inventory
3. Equipment
4. Real Estate

Accounts receivable provide a good basis for a loan,
especially if the customer base is well known and
creditworthy. For those creditworthy customers, a
bank may finance up to 80 percent of the value of
their accounts receivable.
When customers such as the government are
involved, an entrepreneur can develop a factoring
arrangement whereby the factor (the bank) actually
"buys" the accounts receivable at a value below the
face value of the sale and collects the money directly
from the account. In this case, if any of the receivables
is not collectible, the factor (the bank) sustains the
loss, not the business.
The cost of factoring the accounts receivable is
of course higher than the cost of securing a loan
against the accounts receivable without
factoring being involved, since the bank has
more risk when factoring.
The costs of factoring involve the interest
charge on the amount of money advanced until
the time the accounts receivable are collected,
the commission covering the actual collection,
and protection against possible uncollectible
accounts.

Inventory is another of the firm's assets that is
often a basis for a loan, particularly when the
inventory is liquid and can be easily sold. Usually,
the finished goods inventory can be financed for
up to 50 percent of its value.
Trust receipts are a unique type of inventory loan
used to finance floor plans of retailers, such as
automobile and appliance dealers. In trust
receipts, the bank advances a large percentage
of the invoice price of the goods and is paid on a
pro rata basis as the inventory is sold.


Equipment can be used to secure longer-term
financing, usually on a 3-to 10-year basis. Equipment
financing can fall into any of several categories:
financing the purchase of new equipment, financing
used equipment already owned by the company,
sale-leaseback financing, or lease financing. When
new equipment is being purchased or presently
owned equipment is used as collateral, usually 50 to
80 percent of the value of the equipment can be
financed depending on its salability. Given the
entrepreneur's tendency to rent rather than own, sale-
leaseback or lease financing of equipment is widely
used.
In the sale-leaseback arrangement, the
entrepreneur "sells" the equipment to a lender
and then leases it back for the life of the
equipment to ensure its continued use.
In lease financing, the company acquires the
use of the equipment through a small down
payment and a guarantee to make a specified
number of payments over a period of time. The
total amount paid is the selling price plus the
finance charges.

Real estate is also frequently used in asset-
based financing. This mortgage financing is
usually easily obtained to finance a
company's land, plant, or another building,
often up to 75 percent of its value.
The other type of debt financing frequently
provided by commercial banks and other
financial institutions.
These conventional bank loans include lines
of credit, installment loans, straight
commercial loans, long-term loans, and
character loans.
is perhaps the form of cash flow financing
most frequently used by entrepreneurs.
In arranging for a line of credit to be used as
needed, the company pays a "commitment
fee to ensure that the commercial bank will
make the loan when requested and then
pays interest on any outstanding funds
borrowed from the bank.

can also be obtained by a venture with a
track record of sales and profits.
These short-term funds are frequently used
to cover working capital needs for a period of
time, such as when seasonal financing is
needed. These loans are usually for 30 to 40
days.

A hybrid of the installment loan is the straight
commercial loan, by which funds are
advanced to the company for 30 to 90 days.
These self-liquidating loans are frequently
used for seasonal financing and for building
up inventories.
When a longer time period for use of the
money is required, long-term loans are used.
These loans (usually available only to strong,
mature companies) can make funds available
for up to 10 years. The debt incurred is usually
repaid according to a fixed interest and
principal schedule. The principal, however, can
sometimes start being repaid in the second or
third year of the loan, with only interest paid the
first year.

When the business itself does not have the
assets to support a loan, the entrepreneur may
need a character (personal) loan.
These loans frequently must have the assets of
the entrepreneur or other individual pledged as
collateral or the loan cosigned by another
individual.
Assets that are frequently pledged include cars,
homes, land, and securities. In extremely rare
instances, the entrepreneur can obtain money
on an unsecured basis for a short time when a
high credit standing has been established.

One problem for the entrepreneur is
determining how to successfully secure a loan
from the bank.
Banks are generally cautious in lending money,
particularly to new ventures, since they do not
want to incur bad loans.
Regardless of geographic location, commercial
loan decisions are made only after the loan
officer and loan committee do a careful review
of the borrower and the financial track record of
the business. These decisions are based on
both quantifiable information and subjective
judgments.

1. Character
2. Capacity
3. Capital
4. Collateral
5. Conditions

Past financial statements (balance sheets
and income statements) are reviewed in
terms of key profitability and credit ratios,
inventory turnover, aging of accounts
receivable, the entrepreneur's capital
invested, and commitment to the business.
Future projections on market size, sales, and
profitability are also evaluated to determine
the ability to repay the loan.
Several questions are usually raised regarding
this ability.
Does the entrepreneur expect to be carried by
the loan for an extended period of time?
If problems occur, is the entrepreneur
committed enough to spend the effort
necessary to make the business a success?
Does the business have a unique differential
advantage in a growth market?
What are the downside risks?
Is there protection (such as life insurance on key
personnel and insurance on the plant and
equipment) against disasters?

Although the answers to these questions and the
analysis of the company's records allow the loan
officer to assess the quantitative aspects of the loan
decision, the intuitive factors, particularly the first two
Cs character and capacity are also taken into account.
This part of the loan decision the gut feeling is the
most difficult part to assess. The entrepreneur must
present his or her capabilities and the prospects for
the company in a way that elicits a positive response
from the lender.
This intuitive part of the loan decision becomes even
more important when there is little or no track record,
limited experience in financial management, a
nonproprietary product or service (one not protected
by a patent or license), or few assets available.


In evaluating the appropriateness of financing
alternatives, particularly angel vs. venture capital
financing, an entrepreneur must determine the
amount and the timing of the funds required, as well
as the projected company sales and growth.
Conventional small businesses and privately held
middle-market companies tend to have a difficult
time obtaining external equity capital, especially from
the venture-capital industry.
Most venture capitalists like to invest in software,
biotechnology, or high-potential ventures like Fred
Smith's Federal Express.
The three types of funding as the business develops
are indicated in Table 12.1.

1. Early-stage financing is usually the most
difficult and costly to obtain.
Two types of financing are available during
this stage:
a. Seed capital
b. Start-up capital


The most difficult financing to obtain through
outside funds, is usually a relatively small
amount of funds needed to prove concepts and
finance feasibility studies.
Since venture capitalists usually have a
minimum funding level of above $500,000, they
are rarely involved in this type of funding, except
in the case of high-technology ventures of
entrepreneurs who have a successful track
record and need a significant amount of capital.
involved in developing and selling some
initial products to determine if commercial
sales are feasible.
These funds are also difficult to obtain.
Angel investors are active in these two types
of financing.

2. Expansion or development financing is easier to
obtain than early-stage financing.
Venture capitalists play an active role in providing
funds here. As the firm develops in each stage, the
funds for expansion are less costly.
Generally, funds in the second stage are used as
working capital to support initial growth.
In the third stage, the company is at breakeven or a
positive profit level and uses the funds for major
sales expansion.
Funds in the fourth stage are usually used as bridge
financing in the interim period as the company
prepares to go public.

3. Acquisition financing or leveraged
buyout financing is more specific in nature.
It is issued for such activities as traditional
acquisitions, leveraged buyouts
(management buying out the present
owners), and going private (a publicly held
firm buying out existing stockholders,
thereby becoming a private company).

There are three risk-capital markets that can
be involved in financing a firm's growth:
1. The informal risk-capital market
2. The venture-capital market
3. The public-equity market

Although all three risk-capital markets can be a
source of funds for stage-one financing, the
public-equity market is available only for high-
potential ventures, particularly when high
technology is involved.
Recently, some biotechnology companies raised
their first stage financing through the public-
equity market since investors were excited
about the potential prospects and returns in this
high-interest area.
The most misunderstood type of risk capital.
It consists of a virtually invisible group of
wealthy investors, often called business angels,
who are looking for equity-type investment
opportunities in a wide variety of
entrepreneurial ventures.
Typically investing anywhere from $10,000 to
$500,000, these angels provide the funds
needed in all stages of financing, but particularly
in start-up (first-stage) financing.
Venture capital is one of the least
understood areas in entrepreneurship.
Some think that venture capitalists do the
early-stage financing of relatively small,
rapidly growing technology companies.
It is more accurate to view venture capital
broadly as a professionally managed pool of
equity capital.

To be in a position to secure the funds needed, an
entrepreneur must understand the philosophy and
objectives of a venture-capital firm, as well as the
venture-capital process.
The objective of a venture-capital firm is to generate
long-term capital appreciation through debt and
equity investments.
To achieve this objective, the venture capitalist is
willing to make any changes or modifications
necessary in the business investment. Since the
objective of the entrepreneur is the survival of the
business, the objectives of the two are frequently at
odds, particularly when problems occur.

A typical portfolio objective of typical venture-capital
firms in terms of return criteria and risk involved is
shown in Figure 12.4 .
Since there is more risk involved in financing a
business earlier in its development, more return is
expected from early-stage financing (50 percent ROI)
than from acquisitions or leveraged buyouts (30
percent ROI), die late stage in development.
The significant risk involved and the pressure that
venture-capital firms feel from their investors (limited
partners) to make safer investments with higher
rates of return have caused these firms to invest
even greater amounts of their funds in later stages of
financing.
In these late-stage investments, there are
lower risks, faster returns, less managerial
assistance needed, and fewer deals to be
evaluated.
The venture capitalist does not necessarily seek
control of a company, but would rather have the
firm and the entrepreneur at the most risk.
The venture capitalist will want at least one seat
on the board of directors. Once the decision to
invest is made, the venture capitalist will do
anything necessary to support the
management team so that the business and the
investment prosper.
Whereas the venture capitalist expects to
provide guidance as a member of the board
of directors, the management team is
expected to direct and run the daily
operations of the company.
A venture capitalist will support the
management team with investment dollars,
financial skills, planning, and expertise in any
area needed.

Since the venture capitalist provides long-term
investment (typically five years or more), it is
important that there be mutual trust and
understanding between the entrepreneur and
the venture capitalist.
There should be no surprises in the firm's
performance. Both good and bad news should
be shared, with the objective of taking the
necessary action to allow the company to grow
and develop in the long run.
The venture capitalist should be available to
the entrepreneur to discuss problems and
develop strategic plans.

1. The company must have a strong
management team that consists of
individuals with solid experience and
backgrounds, a strong commitment to the
company, capabilities in their specific areas of
expertise, the ability to meet challenges, and
the flexibility to scramble wherever
necessary.

A venture capitalist would rather invest in a
first-rate management team and a second-rate
product than the reverse. The management
team's commitment should be reflected in
dollars invested in the company. Although the
amount of the investment is important, more
telling is the size of this investment relative to
the management team's ability to invest. The
commitment of the management team should
be backed by the support of the family,
particularly the spouse, of each key team
player.
A positive family environment and spousal
support allow team members to spend the 60
to 70 hours per week necessary to start and grow
the company. One successful venture capitalist
makes it a point to have dinner with the
entrepreneur and spouse, and even to visit the
entrepreneur's home, before making an
investment decision. According to the venture
capitalist, I find it difficult to believe an
entrepreneur can successfully run and manage a
business and put in the necessary time when the
home environment is out of control."

2. The product and/or market opportunity must
be unique, having a differential advantage in a
growing market.
Securing a unique market niche is essential
since the product or service must be able to
compete and grow during the investment
period. This uniqueness needs to be carefully
spelled out in the marketing portion of the
business plan and is even better when it is
protected by a patent or a trade secret.

3. The business opportunity must have
significant capital appreciation.
The exact amount of capital appreciation
varies, depending on such factors as the size
of the deal, the stage of development of the
company, the upside potential, the
downside risks, and the available exits. The
venture capitalist typically expects a 40 to
60 percent return on investment in most
investment situations.


The venture-capital process that implements
these criteria is both an art and a science.
The element of art is illustrated in the
venture capitalist's intuition, gut feeling, and
creative thinking that guide the process. The
process is scientific due to the systematic
approach and data-gathering techniques
involved in the assessment.

The process starts with the venture-capital
firm establishing its philosophy and
investment objectives. The firm must decide
on the following: the composition of its
portfolio mix, including the number of start-
ups, expansion companies, and
management buyouts; the types of
industries; the geographic region for
investment; and any product or industry
specializations.

1. Preliminary Screening
2. Agreement on Principal Terms
3. Due Diligence
4. Final Approval
The preliminary screening begins with the
receipt of the business plan.
A good business plan is essential in the venture-
capital process. Most venture capitalists will not
even talk to an entrepreneur who doesn't have
one.
As the starting point, the business plan must
have a clear-cut mission and clearly stated
objectives that are supported by an in-depth
industry and market analysis and pro forma
income statements.
The executive summary is an important part of
this business plan, as it is used for initial
screening in this preliminary evaluation. Many
business plans are never evaluated beyond the
executive summary.
When evaluating the business, the venture
capitalist first determines if the deal or similar
deals have been seen previously.
The investor then determines if the proposal fits
his or her long-term policy and short-term
needs in developing a portfolio balance.
In this preliminary screening, the venture
capitalist investigates the economy of the
industry and evaluates whether he or she has the
appropriate knowledge and ability to invest in
that industry.
The investor reviews the numbers presented to
determine whether the business can reasonably
deliver the ROI required.
In addition, the credentials and capability of the
management team are evaluated to determine if
they can carry out the plan presented.

The second stage is the agreement on
principal terms between the entrepreneur
and the venture capitalist.
The venture capitalist wants a basic
understanding of the principal terms of the
deal at this stage of the process before
making the major commitment of time and
effort involved in the formal due diligence
process.

The third stage, detailed review and due
diligence, is the longest stage, involving
anywhere from one to three months.
There is a detailed review of the company's
history, the business plan, the resumes of the
individuals, their financial history, and target
market customers.
The upside potential and downside risk are
assessed, and there is a thorough evaluation of
the markets, industry, finances, suppliers,
customers, and management.


In the last stage, final approval, a
comprehensive, internal investment
memorandum is prepared.
This document reviews the venture capitalist's
findings and details the investment terms and
conditions of the investment transaction.
This information is used to prepare the formal
legal documents that both the entrepreneur
and venture capitalist will sign to finalize the
deal.

One of the most important decisions for the
entrepreneur lies in selecting which venture
capital firm to approach.
Since venture capitalists tend to specialize
either geographically by industry
(manufacturing industrial products or consumer
products, high technology, or service) or by size
and type of investment, the entrepreneur
should approach only those that may have an
interest in the investment opportunity.
Where do you find this venture capitalist?

An entrepreneur should carefully research the names
and addresses of prospective venture-capital firms
that might have an interest in the particular
investment opportunity.
There are also regional and national venture-capital
associations. For a nominal fee or none at all, these
associations will frequently send the entrepreneur a
directory that lists their members, the types of
businesses their members invest in, and any
investment restrictions.
Whenever possible, the entrepreneur should be
introduced to the venture capitalist. Bankers,
accountants, lawyers, and professors are good
sources for introductions.
A problem confronting the entrepreneur in
obtaining outside equity funds, whether from
the informal investor market (the angels) or
from the formal venture-capital industry, is
determining the value of the company.
This valuation is at the core of determining
how much ownership an investor is entitled to
for funding the venture.
This is determined by considering the factors in
valuation. This, as well as other aspects of
securing funding, has a potential for ethical
conflicts that must be carefully handled.

1. The first factor, and the starting point in any
valuation, is the nature and history of the
business .
2. The valuation process must also consider the
outlook of the economy in general as well as the
outlook for the particular industry.
3. The third factor is the book value (net value) of
the stock of the company and the overall
financial condition of the business.
4. While book value develops the benchmark,
the future earning capacity of the company, the
fourth factor, is the most important factor in
valuation .
5. The fifth valuation factor is the dividend-
paying capacity of the venture .
6. An assessment of goodwill and other
intangibles of the venture is the sixth valuation
factor .
7. The seventh factor in valuation involves
assessing any previous sale of stock .
8. The final valuation factor is the market price of
the stocks of companies engaged in the same or
similar lines of business .
Calculations of financial ratios can also be extremely
valuable as an analytical and control mechanism to test
the financial well-being of a new venture during its early
stages.
These ratios serve as a measure of the financial strengths
and weaknesses of the venture, but should be used with
caution since they are only one control measure for
interpreting the financial success of the venture.
There is no single set of ratios that must be used, nor are
there standard definitions for all ratios. However, there are
industry rules of thumb that the entrepreneur can use to
interpret the financial data.
Ratio analysis is typically used on actual financial results
but can also provide the entrepreneur with some sense of
where problems exist in the pro forma statements as well.

Current Ratio
Acid Test Ratio
This ratio is commonly used to measure the
short- term solvency of the venture or its ability
to meet its short-term debts. The current
liabilities must be covered from cash or its
equivalent; otherwise the entrepreneur will need
to borrow money to meet these obligations.
The formula and calculation of this ratio when
current assets are P108,050 and current
liabilities are P40,500 is:
Current assets / Current liabilities = 108,050 /
40,500 = 2.67 times

While a ratio of 2:1 is generally considered
favorable, the entrepreneur should also
compare this ratio with any industry standards.
One interpretation of this result is that for every
dollar of current debt, the company has P2.67 of
current assets to cover it.
This ratio indicates that company is liquid and
can likely meet any of its obligations even if
there were a sudden emergency that would
drain existing cash.

This is a more rigorous test of the short-term
liquidity of the venture because it eliminates
inventory, which is the least liquid current asset.
The formula given the same current assets and
liabilities and inventory of P10,450 is:
(Current assets-inventory) / Current liabilities =
(108,050-10,450) / 40,500 = 2.40 times
The result from this ratio suggests that the
venture is very liquid since it has assets
convertible to cash of P2.40 for every dollar of
short-term obligations. Usually a 1:1 ratio
would be considered favorable in most
industries.


Average Collection Period
Inventory Turnover
Average Collection Period
This ratio indicates the average number of days it
takes to convert accounts receivable into cash. This
ratio helps the entrepreneur to gauge the liquidity of
accounts receivable or the ability of the venture to
collect from its customers. Using the formula with
accounts receivable of P46,400 and sales of P995,000
results in:
Accounts receivable / Average daily sales = 46,400 /
(995,000/360) = 17 days
This particular result needs to be compared with
industry standards since collection will vary
considerably. However, if the invoices indicate a 20-
day payment required, then one could conclude that
most customers pay on time.



This ratio measures the efficiency of the venture in
managing and selling its inventory. A high turnover is
a favorable sign indicating that the venture is able to
sell its inventory quickly. There could be a danger with
a very high turnover that the venture is under stocked,
which could result in lost orders. Managing inventory
is very important to the cash flow and profitability of a
new venture. The calculations of this ratio when the
cost of goods sold is P645,000 and the inventory is
P10,450 is:
Cost of goods sold / Inventory = 645,000 / 10,450 =
61.7 times
This would appear to be an excellent turnover as
long as the entrepreneur feels that he or she is not
losing sales because of under stocking inventory.

Debt Ratio
Debt to Equity

Many new ventures will incur debt as a means of
financing the start-up. The debt ratio helps the
entrepreneur to assess the firm's ability to meet all its
obligations (short and long term). It is also a measure
of risk because debt also consists of a fixed
commitment in the form of interest and principal
repayments. With total liabilities of P249,700 and
total assets of P308,500, the debt ratio is calculated
below:
Total liabilities / Total Assets = 249,700 / 308,500 = 81%
This result indicates that the venture has financed
about 81 percent of its assets with debt. On paper
this looks very reasonable but would also need to be
compared with industry data.


This ratio assesses the firm's capital structure. It
provides a measure of risk to creditors by
considering the funds invested by creditors (debt)
and investors (equity).The higher the percentage of
debt, the greater the degree of risk to any of the
creditors. The calculation of this ratio using the same
total liability with stockholder's equity being P58,750
is:
Total liabilities / Stockholders Equity = 249,700 /
58,750 = 4.25 times
This result indicates that this venture has been
financed mostly from debt. The actual investment of
the entrepreneurs or the equity base is about one-
fourth of what is owed. Thus, the equity portion
represents a cushion to the creditors.
Net Profit Margin
Return on Investment
This ratio represents the venture's ability to translate
sales into profits. You can also use gross profit instead
of net profit to provide another measure of
profitability. In either case it is important to know
what is reasonable in your industry as well as to
measure these ratios over time. The ratio and
calculation when net profit is P8,750 and the same net
sales is P995,000 is:
Net profit / Net Sales = 8,750 / 995,000 = 0.88%
The net profit margin although low for a firm,
would not be of great concern for a new venture.
Many new ventures do not incur profits until the
second or third year. In this case we have a favorable
profit situation.
Measures the ability of the venture to manage its
total investment in assets. You can also calculate a
return on equity, which substitutes stockholders
equity for total assets in the formula below and
indicates the ability of the venture in generating a
return to the stockholders. The formula and
calculation of the return on investment when total
assets are P200,400 and net profit is P8,750 is:
Net profit / Total assets = 8,750 / 200,400 = 4.4%
The result of this calculation will also need to be
compared with industry data. However, the positive
conclusion is that the firm has earned a profit in its
first year and has returned 4.4 percent on its asset
investment.

There are many other ratios that could also
be calculated. However, for a start-up these
would probably suffice for an entrepreneur
in assessing the venture's financial strengths
and weaknesses. As the firm grows, it will be
important to use these ratios in conjunction
with all other financial statements to provide
an understanding of how the firm is
performing financially.

1. One of the most widely used approaches assesses
comparable publicly held companies and the prices of
these companies' securities. This search for a similar
company is both an art and a science. First, the
company must be classified in a certain industry,
since companies in the same industry share similar
markets, problems, economies, and potential of
sales and earnings. The review of all publicly traded
companies in this industry classification should
evaluate size, amount of diversity, dividends,
leverage, and growth potential until the most similar
company is identified. This method is inaccurate when
a truly comparable company is not found.

2. A second widely used valuation approach is the
present value of future cash flow. This method adjusts the
value of the cash flow of the business for the time value of
money and the business and economic risks. Since only
cash (or cash equivalents) can be used in reinvestment,
this valuation approach generally gives more accurate
results than profits. In using this method, the sales and
earnings are projected back to the time of the valuation
decision when shares of the company are offered for
sale. The period between the valuation and sale dates is
determined, and the potential dividend payout and
expected price/earnings ratio or liquidation value at the
end of the period are calculated. Finally, a rate of return
desired by investors is established, less a discount rate for
failure to meet these expectations.

3. Another valuation method, used only for
insurance purposes or in very unique
circumstances, is known as replacement
value. This method is used when, for
example, there is a unique asset involved
that the buyer really wants. The valuation of
the venture is based on the amount of money
it would take to replace (or reproduce) that
asset or another important asset or system
of the venture.

4. The book value approach uses the adjusted
book value, or net tangible asset value, to
determine the firm's worth. Adjusted book value
is obtained by making the necessary
adjustments to the stated book value by taking
into account any depreciation (or appreciation)
of plant and equipment and real estate, as well
as necessary inventory adjustments that result
from the accounting methods employed. The
following basic procedure can be used:

Book value
Add (or subtract) any adjustments such as appreciation or
depreciation to arrive at figure on next line the fair market
value.
Fair market value (the sale value of the company's
assets).
Subtract all intangibles that cannot be sold, such as
goodwill
Adjusted book value
Since the book valuation approach involves simple
calculations, its use is particularly good in relatively new
businesses, in businesses where the sole owner has died or
is disabled, and in businesses with speculative or highly
unstable earnings.


5. The earnings approach is the most widely used method
of valuing a company since it provides the potential
investor with the best estimate of the probable return on
investment. The potential earnings are calculated by
weighting the most recent operating year's earnings after
they have been adjusted for any extraordinary expenses
that would not have normally occurred in the operations
of a publicly traded company. Appropriate price-earnings
multiple is then selected based on norms of the industry
and the investment risk. A higher multiple will be used for
a high-risk business and a lower multiple for a low-risk
business. For example, a low-risk business in an industry
with a seven-times-earnings multiple would be valued at
P4.2 million if the weighted average earnings over the
past three years were P0.6 million (seven times $0.6
million).

6. An extension of the earnings approach
method is the factor approach, wherein the
following three major factors are used to
determine value: earnings, dividend-paying
capacity, and book value. Appropriate
weights for the particular company being
valued are developed and multiplied by the
capitalizedvalue, resulting in an overall
weighted valuation.

7. A final valuation approach that gives the
lowest value of the business is liquidation value.
Liquidation value is often difficult to obtain,
particularly when cost and losses must be
estimated for selling the inventory,
terminating employees, collecting accounts
receivable, selling assets, and performing other
closing-down activities. Nevertheless, it is also
good for an investor to obtain a downside risk
value in appraising a company.

In addition to valuating the company and
determining the percentage of the company
that may have to be given up to obtain funding,
a critical concern for the entrepreneur is the
deal structure, or the terms of the transaction
between the entrepreneur and the funding
source.
In order to make the venture look as attractive
as possible to potential sources of funds, the
entrepreneur must understand the needs of the
investors as well as his or her own needs.
The needs of the funding sources include:
1. The rate of return required
2. The timing and form of return
3. The amount of control desired
4. The perception of the risks involved in the
particular funding opportunity.




Whereas certain investors are willing to bear
a significant amount of risk to obtain a
significant rate of return, others want less
risk and less return. Still, other investors are
more concerned about their amount of
influence and control once the investment
has been made.

The entrepreneur's needs revolve around similar
concerns, such as the degree and mechanisms of
control, the amount of financing needed, and the
goals for the particular firm. Before negotiating the
terms and structure of the deal with the venture
capitalist, the entrepreneur should assess the relative
importance of these concerns in order to negotiate
where needed.
Both the venture capitalist and entrepreneur should
feel comfortable with the final deal structure, and a
good working relationship needs to be established to
deal with any future problems

1. Interview a business loan officer at a bank to
determine the bank's lending criteria for small
businesses and for new businesses. Do they use
the five Cs? Which of the five Cs appears to be
the most important?
2. Obtain a loan application from the local
bank and categorize each question in terms of
which of the five Cs it is attempting to assess.
Search the Internet for government grants that
might be applicable.