Raising Entrepreneurial Capital

Chapter 2:

Options in Venture Financing– Debt Capital

Financing a Startup

Bank debt is not a major source of financing in the earliest stages of a startup.

The use of bank debt virtually always requires that some equity has come in first.

A bank will look at how much equity the entrepreneur has committed to the business as a signal of the entrepreneur’s faith in the business.

Bank Requirements

Banks usually require an operating history, supported by financial statements, of three to five years to demonstrate the viability of the business.

Roughly, a dollar of early stage equity can support a dollar of debt, if there is some additional collateral to further back the debt.

Form of Debt

Short-term debt is traditionally used for working capital needs and small equipment purchases.

Long-term debt can be used for permanent working capital needs, as well as to finance property or equipment that serves as collateral for the debt.

Lending sources

Commercial banks are the most common source of short-term debt.

Equipment manufacturers provide financing directly and through leases.

Finance companies provide direct loans and factoring of accounts receivable.

Vendors often provide financing, both through trade credit and installment sales contracts.

Lending sources cont.

Revenue based financing ties repayment to revenue

Venture financing uses the proceeds of venture capital investment as collateral for borrowing

Small Business Administration

The SBA does not loan money, but provides loan guarantees for businesses from SBA sanctioned lenders.

These guarantees make it feasible for commercial lenders to make loans that they otherwise could not make, due to the lack of credit history for a business startup.

Relationship with a Banker

A personal relationship with a banker increases the odds that the banker will be there for you should you experience unforeseen cash flow needs or other financial difficulties.

Your business banker can be a good source of advice and guidance.

Advantages of using debt

Debt does not decrease or dilute the entrepreneur's equity position, thus increasing the entrepreneur’s return on invested capital.

Debt’s fixed and low (relative to equity) cost means that if the business is highly successful, the bank’s return is still fixed and the windfall flows through to the founders.

Weighted Average Cost of Capital

WACC = Wdrd(1-T) + wsrs

Where:WACC = weighted average cost of capitalWd = the percentage (weight) of debt in the capital structurerd(1-T) = the after tax cost of borrowing

Ws = the percentage of equity in the capital structurers = the cost of equity capital

Approaching prospective lenders

First, ask yourself the following questions:

Amount needed? Highest amount of debt with which you would be comfortable?

Use of borrowed money? Means of repayment? Risk of the venture? Debt supported by current financial worth? Sources of collateral?

The Loan Package (1)

A loan package should contain a business plan, which includes

a market analysis, a projected balance sheet, profit and loss projections, and cash flow projections.

The Loan Package (2)

Include Amount of the loan, use of funds,

means of repayment, when the money will be needed, amount and type of collateral to

secure the loan, amount of equity capital that you are

personally investing in the business venture.

The Loan Package (3)

The personal information in the loan package should include

education, work history and business experience of everyone involved in the new business,

credit references, personal income tax statements for three years, and current financial statements.

The lender’s perspective

A new business is a higher risk than an existing business.

Assets of businesses that fail can not generally be easily turned into cash for repayment of the loan.

Short-term financing

Seasonal businesses that must build inventories in anticipation of selling, and that experience delays in collecting receivables, often need short-term financing e.g.

Contractors with substantial work-in-process inventories

Wholesalers and manufacturers with a major portion of their assets tied up in inventories and/or receivables

Long-term financing

Borrowing for a period greater than one year, including "intermediate debt" for periods of one to 10 years.

Often associated with the need for fixed assets such as property, plant, and equipment where the assets will be used in the business for several years.

Sources can be varied. A major piece of equipment may be financed with its vendor, while real estate is usually financed with a mortgage company.

Recurring needs

A series of short-term recurring needs should be viewed as a long-term or permanent need for capital.

Credit Lines

When a business has established itself as being credit worthy banks will often establish a line of credit (LOC) to help with cyclical needs.

The line of credit is the maximum amount that the business can borrow at any one time and is essentially a loan on demand.

Payment Schedules

Usually amortized over the life of the loan, resulting in a constant payment, with the interest portion decreasing and principal portion increasing with each successive payment.

Other schedules might use a current interest plus constant amount of principal structure, resulting in a declining payment as the loan progresses, or some long-term schedule that must be renewed annually.

Discounted Notes

In some cases, particularly in short-term borrowing, the lender may require that the interest on a note be pre-paid.

The total amount of interest due over the term of the note is then deducted from the principal before the proceeds are issued to the borrower. The note is then referred to as discounted.

Secured debt

Borrower pledges certain assets as collateral (security).

If the business defaults on the loan the lender assumes ownership of the collateral. Such claims on specific assets take effect before claims of other creditors are addressed.

In long-term borrowing, fixed assets such as real estate or equipment are usually pledged as collateral.

Unsecured debt

Loan is not secured by specific collateral but rather by the general earning power of the business.

In liquidation, the holder of an unsecured note would normally be part of a group that divides the assets left after the secured debt holders have been satisfied.

The value of assets available at that point is often zero, or at best a small percentage of what is owed.

Unsecured debt restrictions

Lender will often place certain restrictions on the business to reduce the probability of default on the loan.

Typical might be a ban on additional debt with a higher-placed claim on the assets of the business.

Such an agreement might prevent a company from financing its receivables or inventories since this would result in a prior claim against assets at liquidation.

Personal guarantees

Required by many lenders when issuing credit to new corporations.

Can protect the creditors if the business fails --- may be necessary to secure a loan.

Limited liability feature of the corporation does not apply to new ventures if a personal guarantee is necessary to secure a loan in the first place.

Interest rates

Because of the risks involved with small business, lenders often seek greater collateral while charging higher interest rates to offset their added costs of credit search and loan administration.

Banks and other commercial lending institutions normally reserve their lowest available interest rate, the so-called prime rate, for those low-risk situations such as short-term loans for major corporations.

Asset-based financing

Inventory financing is commonly used in automobile, boat and appliance retailing. As each unit is purchased by the retailer, the manufacturer is paid by the lender. The lender is repaid by the retailer when the unit is sold.

Accounts receivable financing usually means pledging, or "assigning," receivables as collateral for a loan.

“Factoring”

Accounts receivable are sold to a third party at a discount based on the ages of amounts owed. This is essentially liquidation of an asset to produce ready cash.

Factoring is sometimes considered a sign of weakness. When customers pay invoices directly to a third-party, the factor, it creates doubts about the company's financial stability and, therefore, its ability to deliver.

Trade credit

Credit extended by suppliers in the normal course of business.

Purchasers should always take full advantage of available payment terms.

Careful use may be thought of as a loan available on a relatively informal basis.

Securing Financing

Is often dependent on ability of the business to generate cash flows, by

Minimizing total capital requirements, shortening time to break even, holding down costs, growing “smartly,” and seizing opportunities.

Forecasting

Forecasting profits, thus determining when break-even will be achieved, is a critical component of the financial proposal.

Equally important is the amount of assets required to create the infrastructure to generate these profits.

It is cash flow, not profits, that will generally insure the success of the business.

Financial Forecast

Hinges on the sales forecast.

Variable costs and many asset levels are dependent on sales achieved.

In forecasting sales it is important to thoroughly understand your market, the competition, and competitors’ responses to your actions.

Break-Even Analysis

Break-even is when sales revenues equal total operating costs.

A technique for quantifying that volume, called break-even analysis, examines the interaction among fixed costs, variable costs, prices, and unit volume to determine the combination of elements in which revenues and total costs are equal.