Chapter 14

CHOICE OF FINANCING

Material from ENTREPRENEURIAL FINANCE: STRATEGY, VALUATION, AND DEAL STRUCTURE, by Janet Kiholm Smith, Richard L. Smith, and Richard T. Bliss, © by Stanford University, all rights
reserved. Instructors may make copies of PowerPoint Presentation contained herein for classroom distribution only. Any further reproduction, distribution, or use of this material, in any way or
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 Learning Objectives
• Understand the factors that influence the financing
choice
• Explain why immediacy of financial need limits financing
alternatives and planning yields more alternatives and
less expensive ones
• Understand why the financing choice depends on size of
need, duration, and incentive effects of different
financing structures
• Evaluate alternatives in light of the venture’s financial
condition, development stage, and capabilities of capital
providers

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 Learning Objectives (cont’d.)
• Identify advantages and disadvantages of relational
financing arrangements such as strategic partnering and
franchising
• Explain how and why financial distress affects available
financing
• Understand how collateral, relationships, and reputations
affect available financing
• Recognize that financing involves negotiation between
parties with different incentives to complete a deal quickly
or to slow negotiations
• Avoid financing missteps in dealing with market downturns

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Financing Alternatives

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 Basic Considerations That Affect
Financing Choices
• If prospective investors agree about the
venture’s prospects, external financing is
preferred to financing by the entrepreneur
• If the entrepreneur and investor have
symmetric expectations about future
prospects, financing that shifts risk to the
investor increases the value of the
entrepreneur’s claim

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 Other Considerations That Affect
Financing Choices
• Value of monitoring and advisory functions
• Venture’s taxable status
• Costs/benefits of subsidized financing (e.g.,
SBA loans)
• Potential for value creation through staging

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 An Overview of the
Financing Decision Process

• Four critical questions link financial needs to

choice of financing.
1. Is there an immediate (urgent) need for financing?
2. Is the near-term financing need large?
3. Is the near-term financing need permanent?
4. How does the financing need in the near-term
relate to the cumulative need for financing?

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 First Step: Assess the Current Stage and
Condition of the Venture
• The stage of development
• Development stage and financing options for
high-risk ventures
• The value of outside advice
• The asset base

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 Seed /Start-up Stage
• No revenue and few tangible assets
• Dominant form of financing is equity from
founder, friends, and family
• Bootstrapping is common
• High-potential ventures may have access to
outside capital

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Figure 14.2, Panel (a)

The Financing Decision Process

Panel (a)

Seed/Start-up venture
(no revenue; f ew
tangible assets)

Equity
1. Existing shareholders Is the need 1. Existing shareholders
2. Friends and f amily immediate and 2. Friends and f amily
3. Bootstrapping Yes urgent? Debt
1. Bootstrapping
No
Small
Equity
1. Angel investors
How big is the 2. Venture capital
f inancing need? 3. Strategic partner
Debt
1. Loan
Large 2. SBA/government programs

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 Early-Growth Stage
• Low, but rapidly growing revenue
• Some tangible assets
• No profit or operating cash flow
• Growth capital can be debt or equity
• Additional funding sources that are tied to
their operations

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Figure 14.2, Panel (b)
The Financing Decision Process
Panel (b)
Early growth stage venture
(small but growing revenue;
some tangible assets)
1. Existing shareholders
2. Friends and f amily
3. Bootstrapping
Is the need
4. Stretch payables
immediate and
5. Accelerate collections Yes
urgent?
6. Factor A/R
7.Asset-backed loan (NWC, PP&E)
No Small
How big is the
f inancing need?
Large
Equity
1. Existing shareholders
2. Friends and f amily
3. Angel investors
Debt
1. Bootstrapping
2. SBA/government programs
Other
1. Stretch payables
2. Accelerate collections
3. Factor A/R
Equity
1. Angel investors
2. Equity private placement
3. Venture capital
4. IPO
5. Strategic partner
Debt
1. Term/revolving loan
2. Asset-backed loan (NWC, PP&E)
3. Vendor f inancing
4. Customer f inancing
Other
1. Factor A/R
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 Late-Stage/Expansion
• Revenue growth slows
• The firm has significant assets and positive
operating cash flow
• The need for external financing should be
moderating
• Smaller amounts of equity may come from
VCs or through private placement
• Operating cash flows make debt more likely

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Figure 14.2, Panel (c)
The Financing Decision Process
Panel (c)
Late stage/Expansion
(revenue growth slows;
signif icant tangible assets and
f ree cash f low)
1. Stretch payables
2. Accelerate collections
3. Factor A/R Is the need immediate
4. Asset-backed loan (NWC, PP&E) and urgent?
Yes
5. Revolving credit line
6. Sale of equipment
No Small
How big is the
f inancing need?
Large
Equity
1. Venture capital
2. Equity private placement
3. Secondary of f ering
Debt
1. Revolving credit line
Other
1. Stretch payables
2. Accelerate collections
3. Factor A/R
Equity
1. IPO
2. Strategic partner
Debt
1. Term/revolving loan
2. Asset-backed loan (NWC, PP&E)
3. Private debt placement
4. Public debt issue
Other
1. Factor A/R
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Development Stage and Financing Options
for High-Risk Ventures
• Comparison of angels and VCs
– Average aggregate annual investment is similar
($21.5 vs. $23.4 billion)
– Angels fund 14X more deals annually on average
– VC deals are much larger on average ($6.9 million
vs. $444,000)
– Higher proportion of angel deals are seed/start-up
investments (47.3% vs. 9.4%)

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Table 14.1

Comparison of Angel Investor and Venture Capital/Private Equity Investment Styles

Angel Investors
Total Ventures Average Number Percent of
Investment Receiving Investment Seed and of Active Opportunitie
Year (billions) Funding Size Start-up Investors s Funded
2002 $15.7 36,000 $436,111 47.0% 200,000 7.10%
2003 $18.1 42,000 $430,952 52.0% 220,000 10.30%
2004 $22.5 48,000 $468,750 225,000 18.50%
2005 $23.1 49,500 $466,667 55.0% 227,000 23.00%
2006 $25.6 51,000 $501,961 46.0% 234,000 20.10%
2007 $26.0 57,120 $455,182 39.0% 258,200 14.00%
2008 $19.2 55,480 $346,071 45.0% 260,500 10.00%
Average $21.5 48,443 $443,671 47.3% 232,100 14.7%
Source: Center for Venture Research, www.unh.edu/cvr various reports.

Venture Capital Funds

Total Ventures Average Seed Start-up Number Average
Investment Receiving Investment Investment Seed Seed/Startup Seed and Expansio
Year (billions) Funding Size (millions) Startup Investment Start-up n Stage
2002 $21.0 3,125 $6,712,640 $324.4 179 $1,812,291 1.5% 56.3%
2003 $19.1 2,967 $6,437,479 $335.1 208 $1,611,058 1.8% 50.1%
2004 $22.0 3,148 $6,978,399 $458.0 221 $2,072,398 2.1% 41.6%
2005 $23.0 3,208 $7,159,289 $912.4 250 $3,649,600 4.0% 37.3%
2006 $26.3 3,746 $7,024,826 $1,233.5 379 $3,254,617 4.7% 43.0%
2007 $30.5 4,027 $7,578,346 $1,429.7 484 $2,953,926 4.7% 37.0%
2008 $28.0 3,985 $7,024,341 $1,623.9 493 $3,293,915 5.8% 37.1%
2009 $17.7 2,795 $6,325,581 $1,650.2 312 $5,289,103 9.3% 31.0%
Average $23.4 3,375 $6,905,113 $995.9 316 $2,992,113 4.2% 41.7%
Source: National Venture Capital Association, Total US Investments by Year, 2009

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17
 The Value of Outside Advice
• Can the venture benefit from the active
involvement of an outside investor?
• Is the potential benefit worth the cost (usually,
additional ownership)?
• Monitoring can add value in at least two ways
– help overcome investor concern about the
entrepreneur trying to take advantage of the financing
relationship
– enhance flexibility because an active investor can
better discern the true reasons for failure

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 The Asset Base
• Debt may be a viable choice if assets are available
to secure the loan
• Secured lending makes adverse selection and
moral hazard less likely
• A downside is that the secured lender has little
interest in the success of the venture
• The entrepreneur’s willingness to be bound by
loan covenants signals confidence in the venture

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 Second Step: Assess the Nature of the
Venture’s Financing Needs
• The influence of immediate financing needs
• The influence of near-term financing needs
• The influence of cumulative financing needs

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The Influence of Immediate Financing Needs
• Immediate financing sources should require little or no
negotiation or be preapproved
• Most equity funding is precluded (except possibly from
existing investors)
• For start-up/early-stage ventures, the only choices may
be family and friends or the entrepreneur’s personal
wealth/credit
• Established firms may be able to generate funds quickly
from their operations
– accelerate or factor receivables
– stretch payables
– credit line secured by working capital

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The Influence of Near-Term Financing Needs
• Some near-term financing choices may limit flexibility
– pledging an asset as collateral precludes selling it
– stretching payables may make it harder to later ramp up
production
• Factors influencing the choice of near-term financing
– amount of financing needed
– permanency of the financing need
– long-term financing usually places more constraints on
future decisions
• Using short-term financing to fund long-term assets
can increase the uncertainty of cash flows

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• Issuance costs for debt are lower
• Debt issue costs are recurring; equity is permanent
• Debt limits flexibility more than equity
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The Influence of Cumulative Financing Needs
• If operating cash flow will soon be sufficient to fund
growth, the long-term impact of near-term financing
decisions is less important
• If cumulative cash needs are expected to be higher
than present needs, near-term financing decisions
should not impede the ability to raise capital later
• If cumulative needs are going to be lower than current
needs, financing arrangement should enable
repayment without penalty

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Financing Choices and Organizational Structure
• The relationship between financing and
strategic partnering
• Pros
– takes advantage of partner’s resources
– shifts risk to the partner
– enables entrepreneur to focus on product development
• Cons
– potential for conflicts of interest
– partner may have limited capability to distribute the
product

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Financing Choices and Organizational Structure

• The relationship between financing and

franchising
– Franchising is both a means of implementing rapid
growth and an organizational form with
decentralized decision making
– Franchising is advantageous when centralized
management cannot serve market demand as
effectively as management that is closer to the
market

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How Financial Distress Affects Financing Choices

• Why turnaround financing is different

• The influence of financial distress costs on
choice of financing

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 Why Turnaround Financing Is Different
• Financing distressed firms is different from
financing high-risk start-ups for two reasons
– the entrepreneur has already failed to achieve a level
of success consistent with projections
– the financial structures of most firms are based on a
premise that the venture will be successful
• Because of this, raising financing for a turnaround
may be more difficult than getting initial funding
• Bankruptcy may be needed to make a turnaround
feasible

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The Influence of Financial Distress Costs on
Choice of Financing
• The degree of financial distress costs depends
on the nature of the venture
• Costs of financial distress include
– resignation of key employees
– deterioration of supplier relationships
– loss of customers
• If the costs of financial distress are high,
financing choices should be made to avoid
financial distress
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How Reputations and Relationships Affect
Financing Choices
• Reputation: an intangible capital asset that
can lose value if the entrepreneur takes
advantage of a financing source
• Investors may believe the entrepreneur’s
desire to protect his reputation will preclude
opportunism
• Most new ventures cannot rely on reputation
• In the short run, survival may take precedence
over reputation
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How Reputations and Relationships Affect
Financing Choices
• Relationships allow the investor to gain private
information about the venture and the
entrepreneur
• Banks are more likely to lend to customers
with whom they have prior relationships
• Relationships increase the availability of
financing, but do not necessarily reduce the
cost

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 Avoiding Missteps and Dealing
with Market Downturns
• The investor’s perspective on timing
• Financing after a marketwide downturn in
valuations
• Going private as a response to declining
market valuations

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 The Investor’s Perspective on Timing
• In general, both parties have motivation to
complete deals quickly
• Investor may also have incentives to delay
– a standstill agreement precludes the entrepreneur
from seeking other funding
– waiting may provide the investor with additional
information about the venture’s prospects, i.e., a free
option
• The entrepreneur should understand that
financing takes time, but also be alert to
opportunism
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 Financing After a Marketwide
Downturn in Valuations
• Down-round financing can be caused by
– failure of the venture to achieve milestones
reflected in earlier valuations
– a marketwide decline in valuations
• Existing deal structure, e.g., antidilution
provisions, can impede raising new funding
• To limit the problem, keep deal structures in
early financing rounds simple
– lower valuations
– straight equity with sweeteners
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 Going Private as a Response to Declining
Market Valuations
• It is difficult for public shareholders to
negotiate a financial restructuring that might
be needed to raise additional funding
• Solution may be to repurchase the public
equity, i.e., take the company private
• Significant private equity activity in recent
years, taking public companies private

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 Choice of Financing - Summary
• The menu of financing options is long, but in reality, is
limited in any specific situation
• A number of factors affect the financing choice
– the venture’s stage and financial condition
– the immediacy, size, and permanence of the need
– existing financial arrangements
– the anticipated cumulative need for funding
• Funding options may be linked to the choice of
organizational structure
• Reputation and relationships can influence available
financing
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