New Venture Financing

M.L. Teklehaimanot (Ph.D., M.Sc., BA)

Ch-2: Financing New Ventures: Sources, Considerations, Choices
 The New Venture business plan
 Sources of New venture financing
 Sequence of New venture financing
 Considerations in choosing New venture financing
 Chapter – 2

Financing New Ventures: Sources,

Considerations, Choices
Introduction
What resources do new ventures need?
 New venture (entrepreneurial) resources include:
 Operant resources (the sets of knowledge and skills);
 People, such as the management team, the board of directors, lawyers,
accountants, and consultants;
 Financial resources;
 Assets, such as plant and equipment; and
 The business plan.

What are financial resources?

 Financial resources are the funds that finance a new
venture/start-up/entrepreneurial company’s investments and operational
activities.
 They are the monies that keep the business operating. They are the monetary
values in a bank account, investment and/or as cash.
What is New venture (entrepreneurial) finance?
 It contains two basic domains: Entrepreneurship (pursuing vision by taking-risk
to initiate innovative ventures) and finance (based on proven track records and
calculated risk); thus a bit at odds.
 Financing is the process of providing funds for business activities, making
purchases, or investing.
 New venture (entrepreneurial) finance is the provision of funding to young,
innovative, growth-oriented new ventures/start-ups/entrepreneurial companies.
New venture financing refers to the process of acquiring funds ( a capital) and
making financial decisions on the use of the capital for a new venture or startup.
 In new venture financing, entrepreneurs have profitable business ideas and
others (investors) who have the money provide the entrepreneurs with the
finance to realize the business idea.
 At the core of such financing is the exchange between an entrepreneur
and an investor, where the entrepreneur receives money and in return
gives the investor a claim on the company’s future returns, based on
contract between entrepreneurs and investors. This needs a Business
Plan.
The New Venture business plan
 A new venture (start-up) business needs a well-designed and written business
plan in order to realize his/her vision, transform his/her business idea to practice
(to start and grow the business), to obtain funding, monitor the operational
activities, and measure (evaluate) achievements.
 A business plan is a formal written document containing the goals and specific
objectives of a business, the strategies/methods for attaining those goals and
objectives, and the time-frame for the achievement of the goals and objectives.
 A business plan is a document that outlines the basic concept underlying a
business and describes how that concept will be realized.
 A business plan gives shape to the entrepreneur’s dreams and hopes that have
motivated the entrepreneur to take the startup push by describing where the
entrepreneur’s idea (business) is now, where the entrepreneur wants its
business to go, and how s/he intends to get there. It is serves as a
roadmap!
 Business plan is ‘not a guarantee for the business idea/opportunity is feasible
and profitable’ but is a ‘tool to persuade investors to invest on one’s business
idea’.
 It is a mistake to write a business plan too early. However, once the business
idea is proven feasible and profitable, new venture businesses need to prepare a
sufficiently detailed, concrete and clear business plan in order to convince the
evaluator (finance provider) that the new business is feasible and promising.
 A typical business plan anchors on three things:
i) a strategic framework (or business model) that explains the business logic and
how the venture plans to create economic value.
ii) an operational planning tool (or business roadmap), that details the set
objectives, activities and actions needed to implement the opportunity.
iii)an investor presentation (or business pitch) that communicates the essence of
the venture to investors and other stakeholders.
Preparing a Business Plan (content and format)
 The business plan should give clear and concise information on all the important
aspects of the proposed new venture (It must be detail enough to provide
sufficient information but concise enough to maintain reader interest ).
 Three types of business plans are as follows:
 Summary plan: A summary business plan is 10 to 15 pages and works best for
companies that are very early in their development and are not prepared to write
a full plan.
 Full business plan: A full business plan is typically 25 to 35 pages long. This
type of plan spells out a company’s operations and plans in much more detail
than a summary business plan, and it is the format that is usually used to prepare
a business plan for an investor.
 Operational business plan: is prepared by established businesses, which is
intended primarily for an internal audience. An operational business plan is a
more detailed blueprint for a company’s operations (commonly between 40 and
100 pages).
 The business plan prepared by new venture businesses should give due
consideration to the following basic factors:
i) The opportunity should reflect the potential and the attractiveness of the
market and industry.
ii) Critical resources include not just money but also human assets (suppliers,
accountants, lawyers, investors, etc.) and hard assets (accounts receivable,
inventories, etc.). An entrepreneur should think of ways to minimize the
resources for startup.
iii)The entrepreneurial team must possess integrity, as well as breadth and
depth of experience.
iv)The financing structure: how a firm is financed (i.e., equity Vs debt) and how
the ownership percentage is shared by the founders and investors.
v) The context (or external factors) of an opportunity includes the regulatory
environment, interest rates, demographic trends, inflation, and other factors that
inevitably impact the business.
 The goal of a well-designed, outlined and written business plan is
to find a win-win deal.
Business Plan Outline
Business Plan Outline
New venture Business Plan differs from business plans of existing companies,
because:
 Predicting the future is not easy for New venture businesses
 Every business plan is based on a set of assumptions about the future. The future is more
predictable and the bases for the assumptions are more reliable for an existing company
compared a start-up.
 For instance, sales projections for an established business generally can be based on
prior experience, whereas those for a new venture must be based on imagination,
economic modeling, and analogy to other similar ventures du to lack of track records.
 Convincing investors and other stakeholders need due diligence
 For existing companies, their financial performance is easily demonstrable. However, new
ventures don’t have any business performance to show, as they are starting. To convince,
they have to clearly present their idea, demonstrate the opportunity through due
investigation of the economic, the particular market, and credibly and convincingly forecast
the financial projections.
 The accuracy and credibility of a new venture plan depend on a number of
critical assumptions and critical reasoning:
 How long will it take to develop a marketable service or product?
 If development efforts are successful, how much will the service or product
cost, and at what price can it be sold?
 How large is the market? What market share can the venture expect to
achieve?
 What strategies will it employ to penetrate, grow and succeed in the market?
 What exit mechanisms are available if the new venture fails?
 New venture business plan should be specific and realistic in objectives
 New ventures are start-ups with no previous history. To avoid uncertainties and
swinging in their business strategies, and set suitable monitoring and evaluation
mechanisms, they have to specifically and realistically set their objectives.
 New venture business plan is largely for external purpose
 While the business plan of an existing company is predominantly for internal
consumption, new venture plan is for external users to scrutinize it and make
financing decision accordingly.
Sources of New venture financing
 Once the entrepreneurial idea (business opportunity) is evaluated for its
feasibility and a business plan is prepared, the next step is to identify financing
sources. The most common sources of finance include:
1) Bootstrapping (personal saving/resources):
 Bootstrapping describes a situation in which an entrepreneur starts a company
with little capital, relying on money other than outside investments. An
individual is said to be bootstrapping when they attempt to found and build a
company from personal finances or the operating revenues of the new company.
 As bootstrapping is founding and running a company using only personal
finances or operating revenue, it allows the entrepreneur to maintain more
control, but it also can increase financial strain.
 Bootstrap financing does not depend on investor assessment of the merits of the
opportunity or assets of the venture.
Note: Bootstrapping is the process of building a business from scratch without
attracting investment or with minimal external capital.
 Studies show that personal savings is the most important early financing
source.
 Entrepreneurs can also secure personal loan (working capital – current liability)
from suppliers (trade credits) who supply inventories on credit bases.
2) Family and friends:
 In some literature, the finance obtained from family and friends is regards as
bootstrap financing.
 Family and friends who have developed a sense of trustworthiness, reliability,
and confidence on the ability of the entrepreneur to chase his/her vision and
seize an opportunity provide him/her with start-up (seed) money to establish a
new venture business.
 These group of fund providers do not often have the capacity to evaluate the
feasibility and profitability of the entrepreneur’s idea (business opportunity).
Rather, they provide the fund based on their trust, experience or due to
compelling family relationship.
Note: The fund from family and friends can be in the form of a gift (donation) or
loan.
3) Angel investors:
 Angel investors are the most common and vital source of new venture financing.
 They are freelancer investors who become willing to invest a relatively small
amount of money in new business ideas or early-stage projects over either a
short or long time period.
 Angel investors are generally wealthy individuals or retired company executives
who invest directly in small firms owned by others. They are often leaders in
their own field who not only contribute their experience and network of contacts
but also their technical and/or management knowledge and experience.
 They often provide seed capital to develop an idea to the point where formal
outside financing becomes feasible.
4) Crowdfunding:
 Crowdfunding is a way of raising money from a large number of people (the
public) to finance new business ideas and projects and businesses. Startup or
growing companies use crowdfunding as a way of accessing alternative funds.
4) Business incubator:
 A business incubator (also known as “accelerators”) is an organization that
helps startup companies and individual entrepreneurs to develop their businesses
by providing a full-scale range of services starting with management
training and office space and ending with venture capital financing.
5) Venture capital:
 For financing requirements beyond seed capital, the entrepreneur can turn to
organized providers of venture capital (“VC”).
 A Venture capital is a form of private equity financing that is provided by
venture capital firms or funds to startups, early-stage, and emerging companies
that have been deemed to have high growth potential or which have
demonstrated high growth.
 VC funds are organized as limited partnerships in which the limited partners
provide almost all of the capital and the general partner is responsible for
managing the fund, including investment selection, working with entrepreneurs,
and harvesting the investments.
 VC mostly focuses on high-risk ventures with high-growth, potential return.
 Because VC funds involve small numbers of investors (the limited partners) and
the investors (financial institution or general partners) are presumed to be
sophisticated enough not to require government oversight, VC funds are exempt
from the key regulations of the securities industry.
Note: A venture capitalist investment in a new venture if it is within an industry
sector where the venture capitalist has expertise.
 Access finance (was the first venture capital in Ethiopia).
6) Asset-based Lenders:
 Asset-based lenders, or “secured lenders,” provide debt capital to businesses
that have assets that can serve as collateral.
 The lender is not relying on the venture’s cash flow for repayment but on the
ability of the venture to liquidate business assets for debt servicing if necessary.
 Loans may be secured by accounts receivable, inventory, equipment, real estate,
or other assets with verifiable market/liquidation values.
7) Venture leasing:
 Venture leasing is a special case of leasing as leases to ventures are often subject
to considerable risk.
 Venture leasing is the leasing of plant and equipment (assets key to the
operation of the venture) to revenue-generating but not-profitable companies
backed by institutional venture funds.
Note: The ownership right of the leased Asset remains with the lessor until the
lessee makes full payment of the lease.
 In Ethiopia, Microfinance institutions provide lease financing to MSEs
while DBE provides lease financing to Medium and large enterprises.
8) Government Programs:
 Many countries have established government-supported programs to provide
loans and other financing for start-ups, small firms, and firms with growth
potential and to support R&D.
 Financial access for MSEs in Ethiopia
9) Factoring:
 When a business offers trade credit, it generates accounts receivable. In lieu of
borrowing to finance the receivables, the venture may be able to sell the
accounts receivable to a factor.
 A factor is a specialist who buys accounts receivable and manages the collection
activities.
 Factoring comes in two basic types: with and without recourse. If factoring is
without recourse and a customer of the venture does not pay its bill, the factor
absorbs the loss. Factoring with recourse means that if the customer does not
pay, the factor can collect from the venture directly.
10) Franchising:
 Franchising is another way to finance growth. In business format franchising,
such as a fast food restaurant, Hotel, Oil company, textile, etc franchise, the
franchisor establishes a business format and offers franchising opportunities to
prospective franchisees.
 The franchisee invests in a facility in a particular locality. The facility carries the
franchisor’s brand and must conform to the general standards of the franchise
network.
 Franchisors provide a range of services that can include site selection, training,
product supply, marketing, and assistance in arranging financing.
Note: The franchisee pays a franchise fee and makes periodic payments that are
partly based on revenues.
11) Mezzanine Capital:
 Mezzanine financing usually refers to capital raised after the firm has
established a record of positive net income with revenues approaching some
level of threshold.
 Mezzanine capital is a total hybrid form of raising funds that lie between equity
and debt financing structures. This method is mostly in case of emergency
requirements of capital.
 Some VC firms and other types of private equity firms offer this type of
financing. The financing generally is a hybrid that has characteristics of senior
debt and common equity.
 A frequently used type of mezzanine financing is subordinated debt with an
equity “sweetener” or warrants. Warrants entitle the holder to buy shares of the
firm’s common stock at a stated price for a period of time.
12) Debt financing:
 When a company borrows money to be paid back at a future date with interest it
is known as debt financing. It could be in the form of a secured as well as an
unsecured loan. A firm takes up a loan to either finance a working capital or an
acquisition of asset.
 Debt financing may make sense for a rapidly growing venture.
 There are two primary reasons for using debt to finance growth:
 First, because interest payments are tax deductible, debt may be less
expensive than equity for a firm that has consistent earnings.
 Second, debt holders usually cannot vote. Therefore, equity owners do
not lose voting control if debt is issued.
Note:
 Cash flow is required for interest and principal payments
 Debt is a contractual obligation, so in the event of bankruptcy bondholders
have priority over equity owners.
13) Initial public offering (IPO):
 In an IPO, the issuing company raises capital by selling registered equity shares
to the public via a formal offering for the first time.
 IPOs provide a very small fraction of overall new venture funding
 Provides exit for VCs and other investors in high-risk, high-growth ventures
Later-Stage Financing Alternatives
 Leveraged buyout (LBO):
 A leveraged buyout (LBO) is the acquisition of another company using a
significant amount of borrowed money (debt) to meet the cost of acquisition.
 The assets of the company being acquired are often used as collateral for the
loans, along with the assets of the acquiring company.
 Management buyout (MBO):
 An MBO involves a company's management team combining resources to
acquire all or part of the company they manage.
 Sources of New Venture Financing
R&D Start-up Early Rapid Exit
Growth Growth
Entrepreneur
Friends and Family
Angel Investors
Corporate Strategic Partner
Venture Capital
Asset-Based Lender
Venture Leasing
Government Programs
Trade Credit/Vendor Financing
Factoring
Franchising
Commercial Bank Lending
Mezzanine Lender
Public Debt
IPO
Acquisition, LBO, MBO
Sequence of New venture financing
 Bootstrap financing: At an early stage, the entrepreneur looks for ways to
finance the venture from personal savings and from borrowing where repayment
does not depend on success.
 Seed financing: from family, friends, and venture capital. Venture capital
financing starts with the seed-stage when the company is often little more than
an idea for a product or service that has the potential to develop into a successful
business down the road. Entrepreneurs spend most of this stage convincing
investors that their ideas represent a viable investment opportunity.
 Funding amounts in the seed stage are generally small, and are largely used
for things like marketing research, product development, and business
expansion, with the goal of creating a prototype to attract additional
investors.
 Start-up financing: at this stage, companies have typically completed research
and development, and are now ready to begin advertising and marketing their
product or service to potential customers.
 At this stage, businesses need a larger infusion of cash to fine tune their
products and services, expand their personnel, and officially launch their
business.
 First-stage: also called the “emerging stage,” typically coincides with the
company’s market launch, when the company is finally about to start seeing a
profit. Funds from this phase of a venture capital financing typically go to actual
product manufacturing and sales, as well as increased marketing.
 To achieve an official launch, businesses usually need a much
bigger capital investment, so the funding amounts in this stage tend
to be much higher than in previous stages.
 Expansion stage (second or third-stage financing): also commonly referred to
as the second or third stages, the expansion stage is when the company is seeing
exponential growth and needs additional funding to keep up with the demands.
 Because the business likely already has a commercially viable
product and is starting to see some profitability, venture capital
funding in the emerging stage is largely used to grow the business
even further through market expansion and product diversification.
 Bridge financing: this is a final stage of venture capital financing when
companies have reached maturity. Funding obtained here is typically used to
support activities like mergers, acquisitions, IPOs.
 At this stage, many investors choose to sell their shares and end
their relationship with the company, often receiving a significant
return on their investments.
Considerations in choosing New venture financing
 Finding and establishing a new business is a challenging process that demands
critical decisions by the entrepreneur (founder).
 Among the most critical considerations and decisions in forming a new venture
business are the following:
1) Form of organization:
 One of the early decisions an entrepreneur must make concerns the
organizational form of the venture. The choice has implications for a variety of
factors, including ability to attract financing, tax treatment, liability,
succession, and ability to attract employees.
 This question must be carefully assessed and answered: what type of
organization (sole proprietorship, general or limited partnership, limited
liability company or corporation) should I form? Why?
2) Structure of finance:
 Fund can be raised via a non-priced mechanism (e.g., bank loan or contribution
from family and friends) which does not require valuation of the company or a
priced approach (e.g., selling of shares), which requires pricing of shares and
valuation of the company.
 The entrepreneur has to decide on which approach suits his/her new venture
business best.
3) valuation:
 Valuation is a quantitative process of determining the fair value of an
asset, investment, or firm. In general, a company can be valued on its own
on an absolute basis, or else on a relative basis compared to other similar
companies or assets.
 The entrepreneur (founder) has to value its new venture business through a suitable
and realistic valuation method. Determining the value of new ventures is so difficult as
they have no records.
4) Governance:
 The act or process of governing (making and enforcing decisions) or
overseeing the control and direction of the new venture strategic and
operational activities.
 Should the venture business have board of directors? Why?
 Do you want to give investors board seats?
 Will certain decisions require specific board member approval?
 Should your investors have specific veto rights on company decisions and actions?
5) Regulatory considerations:
 Entrepreneurs and investors are confronted by a panoply of securities laws when
considering how to finance a venture and whether to raise capital in the public
markets.
 The laws governing access to the public capital markets (and to operating as a
corporation with publicly tradable equity or debt) are complex and fluid.
 For example, a government jurisdiction may require a disclosure of investors
depending on the structure of the funding and the amount of equity each
investors owns in the company. Investors may not be willing; thus challenging
to raise fund (financial strain).
 The entrepreneur (founder) has to first examine the regulatory framework
before making decisions on the organizational structure and funding
mechanism.