Chapter 10. Getting Financing or Funding

The Importance of Getting Financing or Funding

Entrepreneurs need to have as full an understanding as possible of the alternatives that are available in regard to raising money. And raising money is a balancing art. Although a venture may need to raise money to survive, its founders usually don't want to deal with people who don't understand or care about their long-term goals.

Why Most New Ventures Need Funding

There are three reasons that most entrepreneurial ventures need to raise money during their early life:

Cash Flow Challenges

Inventory must be purchased, employees must be trained and paid, and advertising must be paid for before cash is generated from sales.

Capital Investments

The cost of buying real estate, building facilities, and purchasing equipment typically exceeds a firm's ability to provide funds for these needs on its own.

Lengthy Product Development Cycles

Some products are under development for years before they generate earnings. The up-front costs often exceed a firm's ability to fund these activities on its own.

Sources of Personal Financing

Typically,the seed money that gets a company off the ground comes from the fonder's own pockets. There are three categories of sources of money in this area:

Personal Funds

Involves both financial equity. Sweat equity represents the value of the time and effort that founder puts into a firm.

Friends and Family

Often comes in the form of loans or investments, but can also involve outright gifts, foregone or delayed compensation, or reduced or free rent.

Bootstrapping

Finding ways to avoid the need for external financing through creativity, ingenuity, thriftiness, cost-cutting, obtaining grants or any other means.

Preparing to Raise Debt or Equity Financing

The most important thing an entrepreneur must do at this point is to determine precisely with the company needs and the most appropriate source to use to obtain those funds. These are the steps of preparation for debt or equity financing:

• Step 1: Determine precisely how much money is needed.
• Step 2: Determine the most appropriate type of financing or funding.
• Step 3: Develop a strategy for engaging potential investors or bankers.

Sources of Equity Funding

The primary disadvantage of equity funding is that the firm's owners relinquish part of their ownership interest and may lose some control. Unlike a loan, the money received from an equity investor doesn't have to be paid back. The investor receives a return on the investment through dividend payments and by selling the stock. 

Here are the three most common forms of equity funding:

Business Angels

Business angels are individuals who invest their personal capital directly in start-ups. The term angel was first used in conjunction with finance to describe wealthy New Yorkers who invested in Broadway plays. Business angels are valuable because of their willingness to make relatively small investments.

Venture Capital

Venture Capital is money that is invested by venture capital firms in start-ups and small businesses with exceptional growth potential. The majority of venture capital money goes to follow-on funding for businesses that were originally funded by angel investors, government programs, or by some other means. The investors who invest in venture capital funds are called limited partners. The venture capitalists, who manage the fund, are called general partners.

Initial Public Offering

An IPO is the first sale of stock by a firm to the public. Any later public issuance of shares is referred to as a secondary market offering. Most entrepreneurial firms that go public trade on NASDAQ , which is weighted heavily toward technology, biotech, and small-company stocks. An IPO is an important milestone for a firm. Typically, a firm is not able to go public until it has demonstrated that it is viable and has a bright future.

A variation of IPO is a private placement, which is the direct sale of an issue of securities to a large institutional investor. When a private placement is initiated,,there is no public offering, and no prospectus is prepared.

Sources of Debt Financing

Debt financing involves getting a loan or selling corporate bonds. There are two common types of loans. 

• Single-purpose loan, in which a specific amount of money is borrowed that must be repaid in a fixed amount of time with interest.
• Line of credit, in which a borrowing "cap" is established and borrowers can use the credit at their discretion.

There are two major advantages to obtaining a loan as opposed to equity funding. The first is that none of the ownership of the firm is surrendered. The second is that interest payments on a loan are tax deductible, in contrast to dividend payments made to investors, which are not.

There are two major disadvantages of getting a loan. The first is that it must be repaid, which may be difficult in a start-up venture in which the entrepreneur is focused on getting the company off the ground. The second is that lenders often impose strict conditions on loans and insist on ample collateral to fully protect their investment. 

Here are the three most common sources of debt financing available to entrepreneurs:

Commercial Banks

Historically, commercial banks have not been viewed as practical sources of financing for start-up firms. Banks are interested in firms that have a strong cash flow, low leverage, audited financials, good management, and a healthy balance sheet. Although many new ventures have good management, few have the other characteristics, at least initially. But banks are an important source of credit for small businesses later in the life cycles.

SBA Guaranteed Loans

Approximately 50 percent of the 9.000 banks in the US participate in SBA guaranteed loan program, The program operates through private-sector lenders who provide loans that are guaranteed by the SBA. The loans are for small businesses that are unable to secure financing on reasonable terms through normal lending channels. The SBA does not currently have funding for direct loans, other than a program to fund direct loans for businesses in geographic areas that are hit by natural disasters.

Other Sources of Debt Financing

There are a variety of other avenues business owners can pursue to borrow money or obtain cash. Vendor credit (aka trade credit) is when a vendor extends credit to a business in order to allow the business tho buy its products or services up front but defer payment until later. Factoring is a financial transaction whereby a business sells its account receivable to a third party, called a factor, at a discount in exchange for cash. 

Creative Sources of Financing and Funding

Because financing and funding are difficult to obtain, particularly for start-ups, entrepreneurs often use creative ways to obtain financial resources. Here are the common creative sources of financing and funding for entrepreneurial firms:

Crowdfunding

Crowdfunding is the practice of funding a project or new venture by raising monetary contributions from a large number of people, typically via the Internet. There are two types of crowdfunding sites:

• Rewards-based crowdfunding allows entrepreneurs to raise money in exchange for some type of amenity or reward. Once a novelty, rewards-based crowdfunding has become a major source of start-up funds. 
• Equity-based crowdfunding helps businesses raise money by tapping individuals who provide funding in exchange for equity in the business.

An accredited investor is a person who is permitted to invest in higher-risk investments such as business start-ups. 

Leasing

A lease is a written agreement in which the owner of a piece of property allows an individual or business to use the property for a specified period of time in exchange for payments. The major advantage of leasing is that it enables a company to acquire the use of assets with very little or no down payment.

There are many different players in the leasing business. Some vendors lease directly to businesses. As with banks, the vendors look for lease clients with good credit backgrounds and the ability to make the lease payments. There are also venture-leasing firms that act as brokers, bringing the parties involved in a lease together. One of the responsibilities of these firms is conducting due diligence to make sure that the new ventures involved will be able to keep up with their lease payments.

SBIR and STTR Grant Programs

The Small Business Innovation Research (SBIR) and the Small Business Technology Transfer (STTR) programs are two important sources of early-stage funding technology firms. The main difference between the SBIR and the STTR programs is that the STTR program requires the participation of researches working at universities or other research institutions. 

The SBIR Program is a competitive grant program that provides over $2.5 billion per year to small businesses for early-stage and development projects. The SBIR is a three-phase program, meaning that forms that qualify have the potential to receive more than one grant to fund a particular proposal. These are the three phases:

• Phase I is a six-month feasibility study in which the business must demonstrate the technical feasibility of the proposed innovation.
• Phase II the purpose is to develop and test prototype of Phase I innovations.
• Phase III is the period during which Phase II innovations move from the research and development lab to the marketplace. 

The STTR Program is a variation of the SBIR for collaborative research and projects that involve small business and research organizations, such as universities or federal laboratories. 

Other Grant Programs

There are limited number of other grant programs available to entrepreneurs. Obtaining a grant takes a little detective work. Granting agencies are, by nature, low-key, so they normally need to be sought out. Finding a grant that fits your business is the key. One thing to be careful of is grant-related scams. Business owners often receive unsolicited letters or e-mail messages from individuals or organizations that assure them that for a fee they can help the business gain access to hundreds of business-related grants. The reality is that there aren't hundreds of business-related grants that fit any one business. Most of these types offers are a scam.

Strategic Partners

Strategic partners are another source of capital for new ventures. Indeed, strategic partners often play a critical role in helping young firms fund their operations and round out their business models. Many strategic partnerships are also formed to gain access to a particular resource or to facilitate speed to market. In exchange for access to plant and equipment and established distribution channels, new ventures bring an entrepreneurial spirit and new ideas to these partnerships. These types of arrangements can help new ventures lessen the need for financing or funding.