Chapter 15

Choice of Financing

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 Learning Objectives
• Factors that influence the choice of financing.
• Effects of immediacy on the range of alternatives.
• Effects of size and duration of need on the range of
alternatives.
• Effects of financial condition and stage of development
on the range of alternatives.
• Advantages and disadvantages of relational financing.
• Why financial distress affects availability of financing.
• The difference between financial distress and failure.
• Effects of collateral, reputation, and relationships on
availability of financing.
• How bilateral negotiation affects deal terms and timing.
©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15
 A Partial List of Financing Sources for
New Ventures and Private Business
• Asset-based Lending • Registered Initial Public
• Business Angels Offering
• Capital Leasing • Research and
(Venture Leasing) Development Limited
• Commercial Bank Partnerships
Lending (various forms) • Relational Investing or
• Corporate Strategic Partnering
Entrepreneurship • Royalty Financing
• Customer Financing • Self (bootstrapping)
• Direct Public Offering • Small Business
• Economic Development Administration
Financing
Program Financing
©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15
 A Partial List of Financing Sources for
New Ventures and Private Business
• Employee-provided • Small Business
Financing Investment Company
• Equity Private Financing
Placement • Term Loan
• Export/Import Bank • Vendor Financing
Financing • Venture Capital
• Factoring
• Franchising
• Friends and Family
• Public Debt Issue

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

 Basic Factors Affecting
Financing
• Capital Providers can diversify their risk at lower cost
• Cost of managing external capital
– Expectation of periodic reporting
– Negotiation and transaction costs
• Leverage is good
– Well diversified investors do not need to be compensated for
bearing non-market risk
– Investor benefits by using equity for financing
• Resource providers benefit from functions that enhance value
– Monitoring and advising can destroy value, however
• Taxes can affect financing choice, depending on organizational
form
– Debt has different effects than equity
– Timing of taxation can be of benefit to parties
– If tax benefits cannot be achieved, it affects decision
 Factors That Affect the
Choice of Financing
• Financial needs of the venture
• Stage of Development
• Financial Condition
• Product-Market Considerations
• Organizational Considerations
• Track Record/Reputation/Relationships

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

 Steps in Determining
Financing
• Step 1 Assess Needs of venture
• Step 2 Assess Current Condition of Venture
• Step 3 Assess Relation Between Financing choices
and Organizational Structure
 Financial Needs of the
Venture
• Immediacy of the need
– Based on time required for negotiation
• Personal relationships help with trust
– Immediate  timing constrains choice
– Near-term  Milestone based
– Cumulative  Connects near-term and ultimate needs
• Limits
– Ability of source to respond
– Negotiation time
– Regulation
– Near term financing is expensive
– Prior financing may limit subsequent financing

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

 Financial Needs of the
Venture
• Size of the immediate need
– Friends, angels, SBA/Development, IPO
– One cannot use a source that does not have the capacity
• Duration of the immediate need
– Shouldn’t use short term sources for long-term needs or vice
versa
– Transactions costs for short-term sources are lower due to
less due-diligence
– Short-term  debt secured by assets
– Sale of assets (AR) or sale and lease-back
– Vendor Financing is expensive because payments can be
delayed
– Long-term financing (except for passive equity) usually
comes with more restrictions
 Financial Needs of the
Venture
• Cumulative need
– Early financing should be arranged so as to avoid
the effects of covenants or to allow subsequent
financing rounds
– If long-term needs are expected to be lower,
arrange to pay off near term financing without
penalty later
 Current Condition of Venture
• Stage of Development
• Value of outside advice to firm
• Organizational Structure and tax status
• Track Record
• Level and Stability of earnings and cash flows
• Asset base - Collateralization
• Existing financing
 Current Condition - Stage of
Development
• Ability to create stable cash flow  Debt
• Completeness of the management team
• Ease of communicating the venture’s merit
• Value of managerial/consulting services
• Importance of flexibility/adaptability

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

 Current Condition - Financial
Condition
• Risk/Return characteristics of the venture
• Taxable income status
• Operating cash flow status
• Time to a liquidity event
• Transferability of tax benefits to investors
• Available collateral
• Cash flow cycle

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

 Financing Distressed Firms
• Financial distress is not the same as need for cash
– Distress = disappointing investors
– Violation of covenants
– Defaulted on repayment obligations
– Inability to carry out plans
– Missed milestones
• Distress means not able to meet expectations
– Failure undermines credibility and increases cost of
capital and increases likelihood of investor failsafe
• Turning around a distressed firm is more difficult than
an initial funding event
– One exception is bankruptcy protection
 Product-market and
Organizational Considerations
• Importance of rapid growth as a part of product-
market strategy
• Nature and importance of relationship with a supplier
or distributor
• Dedication of distributors to the product
• Cost s and benefits of centralization of control

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

 Track Record/
Reputation/relationships
• Track record of the venture
• Importance of future financing needs
• Past failure or financial distress
• Likely failure in the near future
• Reputation of the entrepreneur
• Relationships with financing sources

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

 Figure 15-2

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15

 Figure 15-3

©2003, Entrepreneurial Finance, Smith and Kiholm Smith Chapter 15