Financing A New Business Venture
Key Points to Consider
Why do entrepreneurs need to raise money to grow?
How does a startup venture determine how much capital is required to get going?
What is the difference between debt and equity financing?
Why is an executive summary important to in the potential investor?
What are some of the problems with personal and family loans to entrepreneurs?
What is an angel investor? How do they decide and consider their investments?
What is venture capital? What impact does venture capital have on the economy?
How does angel investing differ from venture capital?
What do venture capitalists provide entrepreneurs, other than money?
What are some important “deal-points” to an entrepreneur? To an investor?
How do entrepreneurs finance their new ventures? The most successful entrepreneurs turn to the venture capital industry. The entrepreneur brings fresh ideas, management skills, and personal commitment while the venture capitalists (VCs) bring cash. Venture capital is provided by professionals who invest alongside management in young, rapidly growing companies that have the potential to develop into significant ventures.
The venture capital industry in the U.S. has grown to a size that could only be imagined in years past. The venture capital contribution to U.S. jobs, economic growth, and technological progress has climbed steadily over the last few years. Questions of how to raise money, when to raise money, and how to work with venture capitalists are frequent topics of concern with entrepreneurs today. This unit will describe some common sources of capital, provide information about the venture capital market, and offer guidance in approaching the venture capitalists and presenting the business plan.
Growth is an unavoidable fact of successful businesses. Growth due to an increase in sales requires product; in turn, additional product requires inputs like labor, inventory, raw materials, plant, property, and equipment. Since internally generated funds typically won’t meet all expansion needs, most startups depend on outside capital to finance growth. In some instances, the entrepreneur may find that the new business does not begin to earn a profit until 2 or 3 years down the road. The entrepreneur therefore revolves around securing the necessary capital to pioneer a new venture through the “financial Death Valley” and sustain the desired growth rate of the venture.
Financing the fast-growing venture tends be a time-consuming, complex task to the entrepreneur—who is most likely working heads-downs on the daily needs. Typically, financing a new venture employs a combination of debt and equity financing. Debt is presumed to be lower-risk capital because it is repaid according to a set schedule of principal and interest. Debt financing involves an interest-bearing instrument usually called a loan. The payment is only indirectly related to the sales and profits of the new venture and typically, debt financing (also known as asset-based financing) requires some asset—for instance a vehicle, house, or other property/land—that will be used as collateral. Generally, lenders will allow ventures to borrow against their expected ability to generate the cash to repay the loan.
The entrepreneur with a new idea for launching a business, and when turned down by a bank, will often turn to a wealthy individual or several friends to back the business venture. In the U.S. these “angel investors” commit some $30-60 billion per year in small businesses. But before receiving such “angelic support” many questions must first be answered. Certain critical elements must be present in a business plan before the venture will receive financing. And those who wish to be successful in dealing with outside investors should spend the time and effort to understand the objectives of their potential investors. Academic research on this topic has shown that in all too many cases startups don’t get financed because the entrepreneur is not familiar with an investor’s industry preferences, requirements, and specialization; risks, protection against losses; participation in management; or with the investor’s “harvesting options” or “exit goals.”
A good relationship between the entrepreneur and the venture capitalist is a vital element in a successful venture. Understanding this partnership is a necessary first step for the prospective entrepreneur. The entrepreneur must be prepared to compete successfully for the venture capitalists’ dollars. It will be the task of the entrepreneur to select and approach the VC, most often with a complete business plan and strategic focus that supports an oral presentation. The presentation must demonstrate management’s competence in knowing the following: (1) earning power/operating cash flows of the venture, (2) the potential terminal value of the business at exiting, (3) the value of the business model underlying the venture, (4) industry competitors and competitive advantages, and (5) how the management team intends to assess risks and create contingency plans.
When meeting with VCs, the entrepreneurs need to be well prepared and “know their business numbers cold.” Few analytical terms are more widely used and, at the same time, more poorly understood than the term cash flow. The cash flowing into a business venture is not the same as accounting profit. It is important for entrepreneurs to make weekly and monthly projections of cash received and disbursed. Such financial forecasts that relate to the future are called financial pro formas. This forecasting procedure is very difficult and perhaps that is why most entrepreneurs avoid it. As Mark Twain once said: “The art of prophecy is very difficult, especially with respect to the future.”
Financial management is the cornerstone of the scorekeeping system for these investing and profit-making activities. A cash flow statement can help the entrepreneur come up with realistic estimates, determine financial requirements, understand the financial strategy framework, and craft a fund-raising strategy. The cash flow statement, also known as the statement of cash flows, is one of the most important financial planning tools that a startup venture can prepare for the business plan. It is used to provide the entrepreneur with a clearer insight into the venture’s cash management strategy: where funds come from and how they are disbursed; the amount of cash available; the amount of additional funds needed (AFN) to grow; and the general financial well-being of the new venture.
Finally, a well-prepared cash flow statement should also track the company’s burn rate and top line revenue flow of cash into the business venture, which helps the investors recognize the true value of the venture. They prefer to see positive cash flows from operations, not just continual injections of cash and/or equity. A good financial plan for investors should not only show profit and cash flows; it should show how the business will pay back the money and make more money in the future. A comprehensive, investor-oriented business plan with complete financials will not guarantee success to the entrepreneur in raising funds for growing, but the lack of such financials will ensure failure.