Lecture 10

Financing the Business

Md. Arafat Hossain
[email protected]
Outline of lecture-10
Funding/financing the business:
1. Stages of Funding for venture capitals
2. Private Equity Market
3. Venture Capital
4. Valuing the business
5. Ratio Analysis
6. Valuation Approaches
7. Going Public
Stages of Funding
⮚ In evaluating the appropriateness of financing
alternatives, particularly angel versus venture-
capital financing,
⮚ an entrepreneur must determine the amount and
the timing of the funds required, as well as the
projected company sales and growth.
⮚ Conventional small businesses and privately held
middle-market companies tend to have a difficult
time obtaining external equity capital, especially
from the venture-capital industry.
⮚ Most venture capitalists like to invest in software,
biotechnology, or high-potential ventures like
Mark Zuckerberg’s Facebook.
⮚ The types of funding provided as the business
develops are indicated in Table 12.1. The funding
problems, as well as the cost of the funds, differ
for each type.
 Stages of Funding
1. Early-stage financing :
Early Stage financing is usually the most difficult and costly to obtain. Two types of financing are available during this stage:
1. Seed capital and
2. start-up capital.
Seed Capital:
I. Of the two, Seed capital is the most difficult financing to obtain from outside funds and
II. Is usually a relatively small amount of capital needed to prove concepts and finance feasibility studies.
III. Since venture capitalists usually have a minimum funding level of above $500,000, they are rarely involved in this type
of funding,
IV. Except in the case of high-technology ventures of entrepreneurs who have a successful track record and need a significant
amount of capital.
Start-up Capital:
V. The second type of funding is start-up financing.
VI. As the name implies, start-up financing is involved in developing and selling some initial products to determine if
commercial sales are feasible.
VII. These funds are also difficult to obtain. Angel investors are very active in these two types of financing.
 Stages of Funding
2. Development financing :
I. Expansion or development financing (the second basic financing type) is easier to obtain than early-stage financing.
II. Venture capitalists play an active role in providing funds at this stage.
III. As the firm develops, the funds for expansion are less costly.
IV. Generally, funds in the second stage are used as working capital to support initial growth.
V. In the third stage, the company is at breakeven or a positive profit level and uses the funds for major sales expansion.
VI. Funds in the fourth stage are usually used as bridge financing in the interim period as the company prepares to go public.
3. Acquisition financing or leveraged buyout financing (the third type)
VII. This is more specific in nature.
VIII.It is issued for such activities as traditional acquisitions, leveraged buyouts (management buying out the present owners),
and going private (a publicly held firm buying out existing stockholders, thereby becoming a private company).
Private Equity
Market
PRIVATE EQUITY The private equity
market, which is better called the
enterprise capital market, provides
capital for privately held ventures.
The market is composed of three
verticals as indicated in Figure 12.1—
individuals, venture capital firms, and
private equity funds.
While the size of the investment
increases from individuals to private
equity funds, the number of deals
done decreases.
 Private Equity Market
INFORMAL RISK-CAPITAL MARKET :
I. It consist of wealthy investors, often called “business angels”
II. These angels provide the funds needed in all stages of financing, particularly in start-up (first stage financing)
III. who are looking for equity-type investment opportunities in a wide variety of entrepreneurial ventures.
IV. Typically investing anywhere from $10,000 to $500,000, these angels provide the funds needed in all stages of financing, but particularly
in start-up (first-stage) financing,
V. While the individual market is the least understood with limited information, in the United States, the total amount invested in smaller
amounts is about equal to the total amount invested by the venture capital industry.
VI. The largest number of investments made in this market is done by individual investors, often called angel investors, acting alone
without any group affiliation. In the United States, these individuals are accredited investors, which means they have either $200,000
per year income and/or net worth, excluding their primary residence of $1 million or more.
VII. Sometimes, this individual gets other individuals involved so that the amount of capital per individual is reduced as well as the risk.
VIII. These individuals have no formal identification and are often found by referrals from accountants, bank officials, lawyers, and university
professors teaching in the entrepreneurship/venture finance area.
IX. One article determined that the angel money available for investment each year was about $20 billion.20 This amount was confirmed
by another study indicating that there are about 250,000 angel investors who invest an amount of $10 billion to $20 billion annually in
about 30,000 firms.
 Private Equity Market
Characteristics of informal Investors:

Crowdfunding: The final type of individual investing is crowdfunding. This is occurring in the United Kingdom and more
recently in the United States. It is different to traditional funding models in that it is based on networks and individuals and
sometimes companies. It can be used to actually pretest an idea for a product/service. Often the individuals involved in the
crowdfunding idea are very interested in the idea and its potential for success. Sometimes, as in the case of LawBite, the idea
is oversubscribed when listed on crowdfunding.
 Venture Capital
Nature of Venture Capital:
Venture capital is another misunderstood area in entrepreneurship. Some think that venture capitalists do the early-stage
financing of relatively small, rapidly growing technology companies.
I. It is more accurate to view venture capital broadly as a professionally managed pool of equity capital.
II. Frequently, the equity pool is formed from the resources of wealthy individuals or institutions who are limited partners.
III. Other principal investors in venture-capital limited partnerships are pension funds, endowment funds, and other
institutions, including foreign investors.
IV. The pool is managed by a general partner—that is, the venture-capital firm—in exchange for a percentage of the gain
realized on the investment and a fee.
V. The investments are in early-stage deals as well as second- and third-stage deals and leveraged buyouts.
VI. In fact, venture capital can best be characterized as a long-term investment discipline, usually occurring over a five-year
period, that is found in the creation of early-stage companies, the expansion and revitalization of existing businesses, and
the financing of leveraged buyouts of existing divisions of major corporations or privately owned businesses.
VII. In each investment, the venture capitalist takes an equity participation through stock, warrants, and/or convertible
securities and has an active involvement in the monitoring of each portfolio company, bringing investment, financing
planning, and business skills to the firm. The venture capitalist will often provide debt along with the equity portion of
the financing.
Venture Capital
Overview of the Venture-Capital Industry
• Although the role of venture capital was instrumental throughout the industrialization of the United States, it
did not become institutionalized until after World War II.
• Before World War II, venture-capital investment activity was a monopoly led by wealthy individuals,
investment banking syndicates, and a few family organizations with a professional manager.
• The first step toward institutionalizing the venture-capital industry took place in 1946 with the formation of
the American Research and Development Corporation (ARD) in Boston.
Types of Venture Capital firms:
Objective of Venture Capital
To be in a position to secure the funds needed, an entrepreneur must understand the
philosophy and objectives of a venture-capital firm, as well as the venture-capital
process.
The objective of a venture-capital firm is to generate long-term capital appreciation
through debt and equity investments.
To achieve this objective, the venture capitalist is willing to make any changes or
modifications necessary in the business investment. Since the objective of the
entrepreneur is the survival of the business, the objectives of the two are frequently at
odds, particularly when problems occur such as the numbers not being met.
A typical portfolio objective of venture-capital firms in terms of return criteria and
risk involved is shown in Figure 12.5.
Since there is more risk involved in financing a business earlier in its development,
more return is expected from early-stage financing (50 percent ROI)
than from acquisitions or leveraged buyouts (30 percent ROI), which are later stages
of development.
The significant risk involved and the pressure that venture-capital firms feel from their
investors (limited partners) to make safer investments with higher rates of return have
caused these firms to invest even greater amounts of their funds in later stages of
financing.
In these late-stage investments, there are lower risks, faster returns, less managerial
assistance needed, and fewer deals to be evaluated.
The venture capitalist does not necessarily seek control of a company and actually
would prefer to have the firm and the entrepreneur at the most risk.
The venture capitalist will require at least one seat on the board of directors. Once the
decision to invest is made to make sure the business succeeds.
 Expectations of Venture Capital
A venture capitalist expects a company to satisfy three general criteria before he or she will commit to the venture.
1. Management Team with Commitment:
⮚ The company needs to have a strong management team composed of individuals with solid experience and backgrounds, a strong commitment to the
company, capabilities in their specific areas of expertise, the ability to meet challenges, and the flexibility to scramble wherever necessary.
⮚ A venture capitalist would rather invest in a first-rate management team and a second-rate product than the reverse. The management team’s
commitment needs to be reflected in dollars invested in the company.
⮚ The amount varies by country while the amount of the investment is important, more telling is the size of this investment relative to the management
team’s ability to invest.
⮚ The commitment of the management team should be backed by the support of the family, particularly the spouse, of each key team player. A positive
family environment and spousal support allow the entrepreneur and team members to spend the 60 to 70 hours per week necessary to start and grow the
company.
⮚ Other principal investors in venture-capital limited partnerships are pension funds, endowment funds, and other institutions, including foreign
investors.
2. The Business Idea or the Opportunity:
⮚ The product and/or market opportunity must be unique,
⮚ Having a differential advantage or three to five unique selling propositions in a growing market.
⮚ Securing a unique market niche is essential since the product or service must be able to compete and grow during the investment period.
⮚ This uniqueness needs to be carefully spelled out in the marketing portion of the business plan and is even better when it is protected by a patent or a
trade secret.
3. Capital Appreciation or Return on investment:
⮚ The final criterion for investment is that the business opportunity must have significant capital appreciation.
⮚ The exact amount of capital appreciation varies, depending on such factors as the size of the deal, the stage of development of the company, the upside
potential, the downside risks, and the available exits.
⮚ The venture capitalist typically expects a significant percent return on investment in most investment situations.
 Locating Venture Capitalists
Locating Venture Capitalists
One of the most important decisions for the entrepreneur lies in selecting the venture-capital firm to approach. Since venture
capitalists tend to specialize both geographically and by industry (manufacturing industrial products or consumer products,
high technology, or service) and by size and stage of investment, the entrepreneur should approach only those venture
capitalists that may have an interest in their investment opportunity based on these criteria.
Where do you find this venture capitalist:
⮚ Most venture capital firms belong to the National Venture Capital Association and are listed on its Web site
(www.nvca.org).
⮚ An entrepreneur should carefully research the names and addresses of prospective venture-capital firms that might have an
interest in their particular investment opportunity.
⮚ There are also regional and national venture-capital associations. For a nominal fee or none at all, these associations will
frequently e-mail the entrepreneur a directory of their members, the types of businesses their members invest in, and any
investment restrictions.
⮚ Whenever possible, the entrepreneur should be introduced to the venture capitalist. Bankers, accountants, lawyers, and
professors are good sources for these introductions.
Approaching
Venture
Capitalists
Guideline for Dealing with
Venture Capitalists:
 Valuing the Business
Valuing the Business: A problem confronting the entrepreneur in obtaining outside equity funds, whether from the informal
investor market (the angels) or from the formal venture-capital industry, is determining the value of the company.
This valuation is at the core of determining how much ownership an investor is entitled to for a certain amount of funding for
the venture.
This is determined by considering the factors in valuation. This, as well as other aspects of securing funding, has a potential
for ethical conflict that must be carefully handled.
Factors in Valuation:
There are eight factors that vary by situation the entrepreneur should consider when valuing the venture.
i. The first factor, and the starting point in any valuation, is the nature and history of the business. The characteristics of the
venture and the industry in which it operates are fundamental aspects in every evaluation process. The history of the
company from its inception provides information on the strength and diversity of the company’s operations, the risks
involved, and the company’s ability to withstand adverse conditions.
ii. The valuation process needs to consider the outlook of the economy in general as well as the outlook for the particular
industry. This second factor involves an examination of the financial data of the venture compared with those of other
companies in the industry. Management’s capability now and in the future is assessed, as well as the future market for the
company’s products or services. Will these markets grow, decline, or stabilize, and in what economic conditions?
 Valuing the Business
iii. The third factor is the book value (net value) of the stock of the company and the overall financial condition of the
business. The book value (often called owner’s equity) is the acquisition cost (less accumulated depreciation) minus
liabilities. Frequently, the book value is not a good indication of fair market value, as balance sheet items are almost
always carried at cost, not market value. The value of plant and equipment, for example, carried on the books at cost less
depreciation may be low due to the use of an accelerated depreciation method or other market factors, making the assets
more valuable than indicated in the book value figures. Land, particularly, is usually reflected lower than fair market
value. For valuation, the balance sheet needs to be adjusted to reflect the higher values of the assets, particularly land, so
that a more realistic company worth is determined. A good valuation should also value operating and nonoperating assets
separately and then combine the two into the total fair market value. A thorough valuation involves comparing balance
sheets and profit and loss statements for the past three years or the number of years the company has been in business if
fewer than three years.
iv. While book value develops the benchmark, the future earning capacity of the company, the fourth factor, is the most
important factor in valuation. Previous years’ earnings are generally not simply averaged but weighted, with the most
recent earnings receiving the highest weighting. Income by product line is analyzed to judge future profitability and
value. Special attention should be paid to depreciation, nonrecurring expense, officers’ salaries, rental expense, and
historical trends.
v. The fifth valuation factor is the dividend-paying capacity of the venture. Since the entrepreneur in a new venture
typically pays little if any in dividends, it is the future capacity to pay dividends rather than actual dividend payments
made that is important. The dividend paying capacity needs to be capitalized.
vi. An assessment of goodwill and other intangibles of the venture is the sixth valuation factor. These intangible assets
usually cannot be valued without reference to the tangible assets of the venture.
 Valuing the Business
vii. The seventh factor in valuation involves assessing any previous sale of equity. Previous equity transactions and their
valuations accurately represent future sales particularly if recent. Motives regarding the new sale (if other than arriving at
a fair price) and any change in economic or financial conditions during the intermittent period should be considered.
viii. The final valuation factor is the market price of equity of companies engaged in the same or similar lines of business.
This factor is used in the specific valuation method discussed later in this section. The critical issue is the degree of
similarity between the publicly traded company and the company being valued.
 Ratio Analysis
Ratio Analysis:
Calculations of financial ratios can also be used as an analytical and control mechanism to test the financial well-being of a new venture.
These ratios serve as a measure of the financial strengths and weaknesses of the venture, but should be used with caution since they are
only one control measure for interpreting the financial success of the venture.
There is no single set of ratios that should be used, nor are there standard definitions for all ratios.
However, there are industry rules of thumb that the entrepreneur can use to interpret the financial data. Ratio analysis is typically used on
actual financial results but can also provide the entrepreneur with some sense of where problems exist in the pro forma statements as well.
Liquidity Ratios:
Current Ratio: This ratio is commonly used to measure the short-term solvency of the venture or its ability to meet its short-term debts. The
current liabilities must be covered from cash or its equivalent; otherwise, the entrepreneur will need to borrow money to meet these
obligations.
The formula and calculation of this ratio when current assets are $94,500 and current liabilities are $13,600 is:

While a ratio of 2:1 is generally considered favorable, the entrepreneur should also compare this ratio with any industry standards.
One interpretation of this result is that for every $1.00 of current debt, the company has $6.96 of current assets to cover it.
This ratio indicates that the company is liquid and can likely meet any of its obligations even if there were a sudden emergency that would
drain existing cash.
 Ratio Analysis
Liquidity Ratios:
Acid Test Ratio: This is a more rigorous test of the short-term liquidity of the venture because it eliminates inventory, which is the least liquid
current asset. The formula given the same current assets and liabilities and inventory of $1,200 is:

The result from this ratio suggests that the venture is very liquid since it has assets convertible to cash of $6.90 for every dollar of short-term
obligations. Usually a 1:1 ratio is considered favorable in most industries
Activity Ratios
Average Collection Period: This ratio indicates the average number of days it takes to convert accounts receivable into cash. This ratio helps
the entrepreneur gauge the liquidity of accounts receivable or the ability of the venture to collect from its customers. Using the formula with
accounts receivable of $52,000 and sales of $1,264,000 results in:

This particular result needs to be compared with industry standards since collection will vary considerably. However, if the invoices indicate a
20-day payment required, then one could conclude that most customers pay on time.
 Ratio Analysis
Activity Ratios:
Inventory Turnover: This ratio measures the efficiency of the venture in managing and selling its inventory. A high turnover is a favorable
sign indicating that the venture is able to sell its inventory quickly. There could be a danger with a very high turnover that the venture is
understocked, which could result in lost orders. Managing inventory is very important to the cash flow and profitability of a new venture.
The calculation of this ratio when the cost of goods sold is $632,000 and the inventory is $4,200 is:

This would appear to be a good turnover as long as the entrepreneur feels that he or she is not losing sales because of understocking
inventory
Leverage Ratios:
Debt Ratio: Many new ventures will use debt to finance the venture. The debt ratio helps the entrepreneur to assess the firm’s ability to
meet all its obligations (short and long term). It is also a measure of risk because debt also consists of a fixed commitment in the form of
interest and principal repayments. With total liabilities of $13,600 and total assets of $152,300, the debt ratio:

This result indicates that the venture has financed 8.9 percent of its assets with debt. On paper this looks very good, but it also needs to be
compared with industry data.
 Ratio Analysis
Leverage Ratios:
Debt to Equity: This ratio assesses the firm’s capital structure. It provides a measure of risk to creditors by considering the funds invested by
creditors (debt) and investors (equity). The higher the percentage of debt, the greater the degree of risk to any of the creditors. The
calculation of this ratio using the same total liabilities, with stockholder’s equity being $148,700, is:

Profitability Ratios:
Net Profit Margin: This ratio represents the venture’s ability to translate sales into profits. You can also use gross profit instead of net profit
to provide another measure of profitability. In either case, it is important to know what is reasonable in your industry as well as to measure
these ratios over time. The ratio and calculation when net profit is $16,300 and net sales are $1,264,000 is:

The net profit margin for MPP Plastics, although low for an established firm, is also a great concern for a new venture. Many new ventures
do not incur profits until the second or third year. In this case, we have a favorable profit situation.
Return on Investment: The return on investment measures the ability of the venture to manage its total investment in assets. You can also
calculate a return on equity, which substitutes stockholders’ equity for total assets in the following formula and indicates the ability of the
venture in generating a return to the stockholders. The formula and calculation of the return on investment when total assets are $152,300
and net profit is $16,300 is
 Ratio Analysis
Profitability Ratios:
Return on Investment: The return on investment measures the ability of the venture to manage its total investment in assets. You can also
calculate a return on equity, which substitutes stockholders’ equity for total assets in the following formula and indicates the ability of the
venture in generating a return to the stockholders. The formula and calculation of the return on investment when total assets are $152,300
and net profit is $16,300 is:

The result of this calculation will also need to be compared with industry data. However, the positive conclusion is that the firm has earned a
profit in its second year and has returned 10.7 percent on its asset investment.
General Valuation Approaches There are several general valuation approaches that can be used in valuing the venture. One of the most widely used approaches assesses comparable publicly held
companies and the prices of these companies’ securities. This search for a similar company is both an art and a science. First, the company must be classified in a certain industry, since companies in the
same industry share similar markets, problems, economies, and potential of sales and earnings. The review of all publicly traded companies in this industry classification should evaluate size, amount of
diversity, dividends, leverage, and growth potential until the most similar company is identified. This method is inaccurate when a truly comparable company is not found. A second widely used valuation
approach is the present value of future cash flow. This method adjusts the value of the cash flow of the business for the time value of money and the business and economic risks. Since only cash (or cash
equivalents) can be used in reinvestment, this valuation approach generally gives more accurate results than profits. With this method, the sales and earnings are projected back to the time of the
valuation decision when shares of the company are offered for sale. The period between the valuation and sale dates is determined, and the potential dividend payout and expected price-earnings ratio or
liquidation value at the end of the period are calculated. Finally, a rate of return desired by investors is established, less a discount rate for failure to meet those expectations. Another valuation method,
used only for insurance purposes or in very unique circumstances, is known as replacement value. This method is used when, for example, there is a unique asset involved that the buyer really wants. The
valuation of the venture is based on the amount of money it would take to replace (or reproduce) that asset or another important asset or system of the venture. The book value approach uses the
adjusted book value, or net tangible asset value, to determine the firm’s worth. Adjusted book value is obtained by making the necessary adjustments to the stated book value by taking into account any
depreciation (or appreciation) of plant and equipment and real estate, as well as necessary inventory adjustments that result from the accounting methods employed
 Valuation Approaches
General Valuation Approaches: There are several general valuation approaches that can be used in valuing the venture.
1. One of the most widely used approaches assesses comparable publicly held companies and the prices of these companies’ securities.
This search for a similar company is both an art and a science. First, the company must be classified in a certain industry, since
companies in the same industry share similar markets, problems, economies, and potential of sales and earnings. The review of all
publicly traded companies in this industry classification should evaluate size, amount of diversity, dividends, leverage, and growth
potential until the most similar company is identified. This method is inaccurate when a truly comparable company is not found.
2. A second widely used valuation approach is the present value of future cash flow. This method adjusts the value of the cash flow of the
business for the time value of money and the business and economic risks. Since only cash (or cash equivalents) can be used in
reinvestment, this valuation approach generally gives more accurate results than profits. With this method, the sales and earnings are
projected back to the time of the valuation decision when shares of the company are offered for sale. The period between the valuation
and sale dates is determined, and the potential dividend payout and expected price-earnings ratio or liquidation value at the end of the
period are calculated. Finally, a rate of return desired by investors is established, less a discount rate for failure to meet those
expectations.
3. Another valuation method, used only for insurance purposes or in very unique circumstances, is known as replacement value. This
method is used when, for example, there is a unique asset involved that the buyer really wants. The valuation of the venture is based on
the amount of money it would take to replace (or reproduce) that asset or another important asset or system of the venture.
4. The book value approach uses the adjusted book value, or net tangible asset value, to determine the firm’s worth. Adjusted book value
is obtained by making the necessary adjustments to the stated book value by taking into account any depreciation (or appreciation) of
plant and equipment and real estate, as well as necessary inventory adjustments that result from the accounting methods employed
 Going Public
Going public occurs when the entrepreneur and other equity owners of the venture offer and sell some part of the company to the public
through a registration statement filed with the securities commission of the country.
In the United States(and also in Bangladesh), this is the Securities and Exchange Commission (SEC) pursuant to the Securities Act. The
resulting capital infusion to the company from the increased number of stockholders and outstanding shares of stock provides the company
with financial resources and generally with a relatively liquid investment vehicle.
Consequently, the company will have greater access to capital markets in the future and a more objective picture of the public’s perception
of the value of the business.
However, given the reporting requirements, the increased number of stockholders (owners), and the costs involved, the entrepreneur must
carefully evaluate the advantages and disadvantages of going public before initiating the process.
Thank you