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Small
Business Financing - Some Guidelines |
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Venture Capital Financing
Some Considerations Prior to Seeking Venture Capital (VC) Financing:
Appropriateness of Seeking VC Financing
- VCs tend to invest in high technology ventures.
- VCs are less interested in financing start-up firms than in financing
established, ongoing firms in which they can invest at least $5M.
- VCs put a very small percentage of their funds into seed capital
for start-up firms. In such cases, the VC investment is usually
at least $2M.
- Start-up firms typically require smaller amounts of capital
and thus do not meet a $5M minimum VC investment threshold.
- Start-up firms require more VC business counsel; the limited
number of VC partners provides a natural limit on the number
of startups in which VCs can invest.
- If the firm's management is not comfortable with the VCs withdrawing
its investment in the firm within 3 to 5 years, as well as the
prospect of possibly making an initial public offering within
that time, then perhaps VC financing is not the best possible
choice for the firm.
Some Necessary Preliminary Preparation
- Put a strong management team into place.
- VCs require proposers to demonstrate a capable and experienced
management team.
- VCs have little desire to run a company.
- VCs recognize that they invest in many businesses and
therefore are not likely to know as much about each particular
business as the people in those firms in which they invest.
- Accordingly, VCs tend to play the role of sounding board,
critic, and try to ask the right questions regarding:
strategic planning, operations, and hiring key personnel.
- Successful and experienced management will have a higher
likelihood of raising the required capital than management
with simply a 'great idea.'
- VCs expect companies to use formal financial and planning procedures.
- Put a strong accounting system into place.
- This will also provide the VC with timely financial data to
evaluate the prospective investment.
- Develop a complete, credible Business Plan, and update it
at least annually.
Expect VC Factfinding Prior to Investing
- VCs will do most of the following prior to investing:
Internal to the Firm
- Meet with the firm's key management to assess management's understanding
of the venture, the industry, problem areas, as well as observe
how the firm's managers interact with one another.
- Talk with the firm's chief accountant to determine applicability
and credibility of the firm's financial data.
- Analyze pro forma financial data and estimate potential value
of the investment at the time of expected VC exit from the investment.
- Tour the firm's facilities.
External to the Firm
- Query the firm's existing and potential customers.
- Consult technology experts regarding the venture's technology.
- Contact the firm's existing outside investors.
- Commission formal market studies by outside consultants.
- Contact the firm's suppliers.
- Contact the firm's outside legal counsel.
- Contact the firm's competitors.
- Check management's references regarding prior positions with
other firms, and contact management's other former business associates.
- Query the firm's bankers. (However, the banks are not considered
reliable sources if the firm owes them money.)
- Contact other VCs to gain knowledge and explore the possibilities
for syndicating to share investment risk.
Expect VC Strong Oversight Subsequent to Investing
- VCs provide intensive oversight of the firms in their investment portfolios.
- VCs serve on the firm's boards of directors. In many cases, the
VC will retain a seat on the board even after exiting the
investment.
- VCs involve themselves in the firm's strategic decisions.
- VCs frequently contact the firm's key personnel.
- VCs frequently pay informal visits to firms in the VC's
portfolio.
- VCs may periodically meet with the firm's customers and
suppliers.
- Accordingly, VCs prefer to invest in firms within a short drive
away from the VCs location. Therefore, where a firm locates could
impact its ability to attract VC financing.
- Major VC centers: Silicon Valley, Boston, Southwest.
Plan on the Inevitable VC 'Exit' From the Investment
- VCs are less patient than other equity investors. They seek to 'exit'
an investment within 3 to 5 years. Exiting the investment is how
the VC makes its money.
- Exiting is usually achieved by the firm going public, being
acquired, being re-capitalized, finding a substitute investor
for the VC, or buyback of the VC's investment by the firm.
- Before deciding to seek VC financing, the firm should be wary
of a potential conflict of interest between the goals of the VC
and the goals of the firm. The best time for the VC to exit may
not coincide with the best time for the firm to be forced into
one of the exiting transactions.
Venture Capitalist Investment Criteria:
Venture Concept
- VCs seek uniqueness in the product/service concept.
- Product/service must offer a significant competitive advantage.
- Product/service concept must already work or can be brought
to market within 2 to 3 years.
Return on Investment
- Must be significant potential for earnings growth.
- VC expects minimum return on investment (ROI) of over 30%/year.
- Earnings growth potential may come from rapidly growing
market, increasing market share, or significant cost cutting.
- The venture must demonstrate a high absolute potential return (i.e.,
volume of dollars) in addition to a percentage ROI in excess of 30%/year.
- VCs avoid financing small investments that offer low absolute
returns even if their rates of return are high.
- However, venture must not have unreasonably high capital
investment requirements which can adversely impact ROI and
represents unacceptably large financial exposure even given
VC syndicating.
- Be mindful that VCs tend to be very conservative investors because:
- VCs invest other people's money; more than half of the money
invested by VC's comes from pension funds.
- The investment must have a clear 'exit' opportunity for the
VC within a 3 to 5 year period.
Top Management
- VCs key on the capabilities and track record of the firm's management
team. Specifically, VCs invest in people rather than in ideas
or physical assets.
- Key management must objectively demonstrate high personal integrity.
- Key management must demonstrate success in similar positons
at prior firms if seeking early stage financing.
- Key management must demonstrate success in current position
if seeking later stage financing.
- Key management must demonstrate a thorough understanding of
the business and the particular venture.
- Key management must demonstrate ability to identify risk and
develop plans to deal with risk.
- Key managers must exhibit leadership and appropriate management
experience.
Relative Merits of Venture Capital Financing:
Some Advantages
- In addition to financing, VCs provide the firm with business counsel,
discipline, image in the business community, and access to critical
networks.
- VCs serve as a sounding board for the firm's management decision-making.
- VCs ensure a profit orientation of the firm.
- VCs force management to focus on a limited number of well-defined
objectives.
- VCs often discipline management decision making to be
in accordance with the objectives of an acceptable business
plan.
- VC networks are a valuable source of strategic planning
information.
- VCs join in discussions with the firm's bankers and customers.
This gives the firm and its products a certain credibility.
- VCs have access to networks with knowledge of potential
available managers.
- VCs have access to networks of other potential financiers.
- VC networks can help find acquisitions or corporate partners
for the firm.
- VC financing offers confidentiality regarding commercially sensitive
information.
Some Possible Disadvantages
- VCs can apply pressures to the firm's management since VC money is
invested at various stages of business development. The pressure
is exacerbated since finding new investors is more difficult when
the old (i.e., the VCs) investors are unwilling to invest additional
funds in the firm.
- Often the firm's board of directors is controlled by the VCs.
- Sometimes VCs decide who will manage the firm and may get involved
with interviewing candidates for key management positions.
- VCs are unlikely to get involved with middle managers; if they
do, this could be a sign of an investment in trouble.
- VCs business counsel is not as effective regarding firms in
industries outside of the VC's experience base. Therefore, the
firm should target appropriately experienced VCs.
- VCs usually have contractual rights giving them control in case
the venture fails to perform adequately.
Access to Venture Capital Community:
- VCs generally wait for proposals to come to them; accordingly, VCs
develop a network of referrers.
- Most proposals funded by VCs are the result of referrals.
- Referrer network includes: commercial bankers, investment bankers,
investors in the VC fund, managers of firms already in the
VCs investment portfolio, consultants having provided prior
services to the VC, and the VCs colleagues.
- Referrer is more likely to understand the type of investments
the particular VC might find attractive.
- VC typically has confidence in the referrer's judgment.
- National Venture Capital Association 703-524-2549 for referrals
to VC's.
- Some VC's now promote themselves by offering information via
Internet.
- See also: Yahoo! at http://www.yahoo.com/business.
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Private Market Angel
Financing
Characteristics of Angel Financiers:
- Angels are silent, private investors who provide start-up firms with
seed money financing in exchange for equity or a percentage of revenues.
- Angels provide seed money for firms too young or too small to
qualify for bank loans, venture capital, or public offerings;
they prefer to invest at the early stage of a venture.
- Angel networks are oriented to bio-tech and other high-tech
companies.
- Angels typically invest in ventures involving markets and technologies
with which they are familiar.
- Angels typically invest in ventures close to home within one
day's drive.
- Angels tend to co-invest with trusted friends and business associates.
- Angels are active investors, serving on a working Board of Directors
or providing guidance through an informal consulting/monitoring
role.
Angel Investment Criteria:
- The primary difference between VCs and angels is that angels will
accept a longer payback horizon and are willing to settle for
a smaller return - 20% to 25%/year compared to the VCs expected
ROI of 30% to 35% or more per year.
- A round of angel financing is typically less than $1M and more
usually less than $500K.
- Venture exit horizons for angels tend to be 5 years to 10 years
or more.
- Firms do not have to demonstrate profitability; they must demonstrate,
however, strong market prospects and strong management.
- Angels often take bigger risks or accept lower rewards when
they are attracted by the nonfinancial characteristics of an entrepreneur's
proposal.
- Angels' investment terms and conditions tend to be briefer and
more informal than those of venture capitalists.
Access to Angel Networks:
- There are no directories of private investor angels, no public records
of their investment transactions.
- The private investor angel market tends to be regional rather
than local or national.
- Angel networks are typically run by non-profit groups.
- Most angel networks originate from college campuses, business
incubators, state economic development agencies, and other
nonprofit entities.
- A large number of universities have established angel networks
to match entrepreneurs with investors.
- VCs are also a source of information regarding locating
angels.
- Firms can join an angel network for a nominal fee. Firm provides
its vital statistics: type of business, market potential, amount
of funding required. The angel network distributes this information,
but keeps the company name anonymous. The firm's name is revealed
if an investor is interested.
- A possible information source regarding angel networks is the
National Business Incubation Association
at 740-593-4331.
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Alternative Sources
of Financing
Commercial Banks:
- Commercial banks are one of the cheapest sources of borrowing for
small companies, typically charging interest rates just one to two points
above prime for small business loans.
- Small firms should seek banks where small business loans are a
priority, not a sideline.
- Small banks make most of their loans to small business customers.
- Small community banks are an excellent source for loans
less than $1M.
- To find a small business friendly bank, obtain Small
Business Lending in the United States, published
by the SBA.
- In financing ventures, commercial banks typically seek security
in the form of the business owners personal assets.
- Be mindful that bankers will query why alternative sources of
financing are apparently not being successfully pursued.
- Most start up firms cannot attract bank loans because they cannot
demonstrate sufficient assets and a healthy financial track record
or any financial history at all.
Strategic Alliances:
- An alternative to VC financing or more debt is a strategic alliance
with another firm; the two companies must have different, complementary
strengths.
- A strategic alliance, as a source of financing, can benefit both firms.
- For example, it can be an access to new markets for one, and access
to manufacturing capability for the other.
- Most corporate partners seek to buy into smaller companies
and use them as R&D arms.
- In a strategic alliance, each partner entity retains its own identity.
- A 'joint venture' is a type of strategic alliance in which a separate
legal entity is formed for the same purposes.
- Strategic alliances can be arranged by third party intermediaries.
Private Market Financing Other Than Angels:
- Private equity markets typically provide small amounts of money ranging
from $8M to $25M per venture.
- Private equity interests typically take an ownership position
of between 10% and 30% of the firm.
- Private equity investors include: insurance companies, pension
funds, high net worth individuals, and foreign investors.
- Private equity deals usually get structured in the form of convertible
preferred stock. Investors are allowed options to sell their stock
back to the company at market price beginning after the fifth
year, with payout schedule over the next three successive years.
- These private 'placements' are:
- Exempt from SEC registration statements
- Not limited to SEC dollar amount limitations.
Factoring:
- Example: Small firm sells its accounts receivable at a discount. The
factor provides cash upfront (e.g., 80%) and then collects on the invoices.
Once the money is collected, the firm gets the balance minus a fee for
the factor's services. The factor's fee ranges from 1.5% to 5% of the
accounts receivable face value.
- Going to a bank for a loan can take a few months; whereas, obtaining
financing from a factor might be achieved within ten days.
- Factoring is particularly attractive for younger firms with relatively
few fixed or financial assets.
- Factors are less concerned with the firm's financial condition
since they rely on the creditworthiness of the firm's
customers.
- See 'Accounts Receivable Factoring', 'money sources', or 'factoring'
in the Yellow Pages; also, consider contacting the Commercial
Finance Trade Association: 212-594-3490.
Vendors and Customers:
- The small firm's suppliers, customers, manufacturers, and distributors
are possible sources of financing. These people have some interest
in the firm's survival.
- Accordingly, the small firm might seek to:
- Negotiate extended credit from suppliers; however, the firm must
be able to to show suppliers an ability to pay (e.g,, evidence
of a large customer order);
- Negotiate advance payments from customers;
- Exchange equity for outside services and supplies;
- Pay vendors with products or services instead of cash.
Bartering:
- The small firm might join a barter network which would enable the
firm to exchange goods/services with fellow members. There is
usually a required cash fee per transaction.
Lease:
- Operating Lease - lessor owns the equipment and enjoys any tax benefits
of ownership. Lessor is responsible for maintenance. Lessee pays
a fixed fee to use the equipment for a specific period.
- Net Lease - same as operating lease, except that the leasee
pays maintenance costs.
- Capital Lease - lease is backed with an asset, money in the
bank, or another guarantee.
- Consider contacting the Equipment Leasing Association of America
at 703-527-8655.
Licensing:
- Licensing is a form of avoiding the financing of a capital investment
if the firm's strength is technology development and it has little
desire to invest in production facilities.
- Licensing agreements should carefully specify the conditions
and limitations under which the firm's technology is being made
available and the revenues it is to receive.
SBA:
- Small Business Investment Companies (SBIC) - program established by
federal government; made up of private investment companies that provide
venture financing and management assistance to small companies.
- Government backed equity financing; securities issued by SBA and
sold on bond market.
- Proceeds from sale of the securities go to SBIC's which
then buy stock in small businesses in exchange for ownership
roles in the companies. SBICs are prohibited from taking control
of the firms.
- When the small companies are sold or go public, the SBICs
and the SBA theoretically receive a return on investment.
- Investors in the financial instruments receive quarterly interest
payments and the return of principle when the securities reach maturity.
- SBA assumes responsibility for paying interest to investors
until the SBIC is sufficiently profitable to repay the
SBA and begin making payments itself.
- SBA can guarantee up to 85% of a private loan with maximum guarantee
amount of $750K and 25 years to pay.
- SBA is attempting to make more credit available to small companies
with less paperwork. (The SBA guarantees such loans up to 90% of outstanding
balance.)
- Business borrowers have up to 11.5 years to pay most SBA loans
vs. 3 years for commercial bank loans.
- SBA loans are particularly designed to make more credit
available to women, minorities, and very small businesses.
- The SBA LowDoc program offers a simple one page application to
minimize paperwork requirements and loan processing time for small
businesses on loans up to $100K.
- Typical interest rates are 2.25% over prime.
- Designed for companies of 100 or fewer employees, and
annual sales for the three preceeding years not to exceed
$5M.
- LowDoc applications focus on the borrower's character,
credit history, and business experience.
- Loan processing time has been shortened from months
to weeks.
- SBA MicroLoan program - loans up to $25K to startup companies
in inner cities and rural areas, a large percentage of which
are owned by women and minorities
- For information on SBA backed loans call 800-827-5722.
State Agencies:
- To find available state public money, small firms might also contact
their respective state economic development agency.
- Many states have their own venture capital funds which are more
willing to work with early stage companies.
- Firms seeking seed money should have financial statements
and Business Plans prepared.
- List of state agencies to be compiled and inserted in this SBIR
Mall regarding state supported financing assistance to small businesses.
This information is available in the public library.
Initial Public Offerings (IPO) of Stock:
- Make the company visible; court the media, target trade publications
for press coverage; routinely present at industry seminars and
investment conferences.
- To launch an IPO in the public markets, select an underwriter
who is experienced in the firm's particular industry.
- Make sure that the timing is right for entering the public financial
markets:
- Ensure that an appropriately experienced board of directors and
quality management are in place.
- Investors seek companies with seasoned management.
- Be sure that strong financial accounting systems are in
place. Underwriters and stock and bond market analysts require
accurate quarterly information.
- Ensure that market conditions are conducive to acceptable
prices for the firm's securities issue.
- Be mindful that:
- Associated underwriter, attorney, and accountant's fees regarding
IPO's can very significant.
- The SEC will require disclosure of some information prior
to its approval of an IPO that is likely to be commercially
sensitive and result in some loss of competitive advantage.
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General Advice - Regardless
of Financing Source
Some Important Preliminary Actions:
Expert Advice and Factfinding
- Seek the advice of founders of successful companies in related fields.
For example, consider contacting:
- The Center for Entrepreneurial Management (a nonprofit membership
association of entrepreneurs and CEO's) at 212-925-7911.
- National Association of Small Business Investment Companies
at 202-628-5055.
- National Association for Female Executives at 212-445-6235.
- U.S. Dept. of Commerce Minority Business Development Agency
at 800-487-7389.
- Seek the advice of individuals on boards of non-profit entities.
These typically are people who have been successful in their industries
and who are trying to give something back to their community.
- Contact lawyers, accountants, bankers who specialize in serving early
stage companies; seek their expert advice.
- The probability of obtaining financing is greater when made through
an introduction by one of these professionals.
- Six months to one year before seeking financing, start developing
a list of prospective investors.
- Write letters directly to the individuals. Provide an executive
summary of the venture's Business Plan. Include facts and
figures and specifics regarding how much money is needed and
what the investment will likely be worth in five years. Close
the letter by asking for an informal meeting to discuss the
idea. Follow up with a phone call to set a date.
- The entrepreneur must make a personal effort to gain the
confidence of the potential investor.
- Engage in extensive networking - especially on the Internet.
- List the venture with a venture matching service that matches
entrepreneurs with investors.
- Create a homepage for the venture.
- The World Wide Web is the fastest growing source of business
opportunities and financing.
- Requests for funding need to be worded carefully to meet SEC requirements:
- Business Plans and executive summaries should include a statement
that they are not solicitations for sale, but are simply advertisements.
- Be mindful of legalities - Federal and state laws dictate
how offers and sales can be made and what information
must be disclosed to potential investors.
Accounting System and Financial Statements
- Firms seeking financing should have strong accounting system in place
and updated audited financial statements prepared.
- The firm should hire top notch accountants; disorderly financial
records will discourage potential investors.
- Audited financial statements for the current and past three years
are essential to investor analysis. The financial statements should
include: balance sheet, income statement, sources and uses of funds,
and statement of cash flow.
- Statement of cash flow is of particular interest to creditors
and investors since it is cash, rather than accounting
income, that is used to repay loans and pay investor dividends.
- The firm's balance sheet should reflect a debt/equity
ratio of not more than 3 to 1.
- The financial statements should appropriately value intangible
assets such as trademarks, patents, and goodwill.
Preparation of a Credible Business Plan
- Firms seeking to finance a venture should prepare a well thought out
Business Plan for the venture.
- Business Plan should include pro forma financial statements for at
least three years into the future which include a detailing of the use
of the requested funds.
- Projections of future performance should be very realistic and
err on the side of conservatism, particularly regarding estimates
of future sales, prices, and all elements of operating expenses
and necessary capital investment costs.
- Provide logical support for all pro forma figures; support
pro forma figures with clear, objective evidence.
- The pro forma financial statements should reflect a target
capital structure (i.e., type of equity and type of debt).
- Ensure that the financial plan is consistent with the overall
Business Plan.
- Business Plan should:
- Present a clear picture of the venture's economics.
- Focus on cash flow to maximize attracting investors.
- Be realistic and not be overly optimistic.
- Venture weaknesses and problems should be directly addressed
- before the investor identifies them on his/her own.
- Recognize exposure to all elements of business risk and
identify plans for management of that risk.
- Reflect the factors that can create future value of the
venture.
- Identify financial goals regarding all foreseeable future financing
needs.
- Clearly define, in quantifiable terms, how the firm's planned
future activities are expected to be financed.
Exercise Common Sense:
- Consider all available forms and available sources of financing before
deciding upon seeking any particular one; be knowledgeable regarding
the advantages and disadvantages of each.
- Seek financing consistent with planning for success rather than planning
merely for survival.
- Do not underestimate financing needs:
- Be realistic from the outset, even if the capital investment
to be financed seems large.
- It is more difficult to raise financing the second time
around
- Seek financing before actually needing it and particularly when
the firm can demonstrate the strongest financial position possible.
- This preserves some leverage and facilitates the firm's negotiating
a better financing arrangement.
- Anticipate a realistic cost of capital:
- Expect equity investors to seek high returns. (e.g., returns ranging
from 25%/year to 50%/year amounting to an absolute return
of up to 5 times the investment within a 5 year period.)
- Small firms present a significant risk to creditors since
the entrepreneur inherently has little incentive to repay
debts that remain if the firm fails. This risk is reflected
in the interest rates that will be demanded by creditors.
- Consolidate the firm's debt.
- Prepare personal financial statements:
- Creditors look to past and current personal credit worthiness
of the entrepreneur as a strong indicator of the credit worthiness
of the small business venture.
- Bankers assess the extent to which an owner can be relied upon
to repay loans that his/her firm is unable to repay.
- The entrepreneur's net worth and prior credit history is critical.
- Minimize venture start-up costs.
- Use capital wisely:
- People who fail in a venture often claim they were undercapitalized;
rather, it is more likely that they did not use their capital
wisely.
- Do not be foolishly concerned with image. (e.g., do not
rent expensive offices just to act the part.)
- Keep executive salaries in check.
- Seek investors who understand the industry, the firm's products, and
the particular business venture:
- For example, venture capital groups or angels who invest primarily
in the particular industry.
- This also introduces credible, expert sources of advice
to the firm.
- Make the distinction between working capital loans to finance day-to-day
operations and capital loans to finance expansion.
- This distinction is important in negotiating appropriate terms
of the financing agreement.
- Negotiate all financing terms up front and include them
explicitly and unambiguously in the financing contracts.
- Be sure to genuinely understand the financing arrangement;
in particular, be sure to understand the long term consequences
of whatever financing arrangement is being negotiated.
- Recognize that raising capital involves a costly and time consuming
personal networking process.
- After obtaining the necessary financing, be mindful that financing
a business is a never ending process; accordingly, never quit searching
for possible investors:
- Frequently attend seminars on financing.
- Frequently network with venture capitalists, investment
bankers, other members of the financial community.
- There are numerous sources of information regarding telephone
and Internet access to investor and creditor networks that cannot
be listed here because they are profit making/ possibly profit
making. These leads can be easily found by researching financial
literature in the public library.
- BEWARE: Investment scams are hitting the Internet.
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