Sources of Capital for Entrepreneurs

The Search for Capital

  • Sources of capital include:
    • Commercial loans
    • Public offerings
    • Private placement: selling stocks or bonds to a private investor.
    • Convertible debentures: long term debts issues by a company converted into shares.
    • Venture capital
    • Informal risk capital
  • Can be a combination of sources

Bootstrapping

  • Bootstrapping: The practice of starting and growing a business using one's own resources, rather than relying on external funding like venture capital or loans, to build a new company.
  • Strategic bootstrapping includes:
    • Delaying payments
    • Private-owner financed
    • Minimized capital
    • Relationship oriented
    • Subsidy oriented: benefits given by governments or friends.

Advantages and Disadvantages of Bootstrapping

  • Advantages:
    • Cost: It is inexpensive
    • Control: No external investors
    • Concentration: Can focus on business
  • Disadvantages:
    • Cash: May need more funds
    • Equity: If more than one founder
    • Risk: Higher due to lack of funds
    • Stress: Due to money from friends and family

Debt versus Equity Financing

  • Debt Financing:
    • Secured financing of a new venture that involves a payback of the funds plus a fee (interest) for the use of the money.
  • Equity Financing:
    • Involves the sale (exchange) of some of the ownership interest in the venture in return for an unsecured investment in the firm.

Commercial Loans

  • Commercial Banks:
    • Make one- to five-year, intermediate-term loans secured by collateral (receivables, inventories, or other assets).
    • Questions in securing a loan:
      • What do you plan to do with the money?
      • How much do you need?
      • When do you need it?
      • How long will you need it?
      • How will you repay the loan?

Debt Financing

  • Advantages:
    • No relinquishment of ownership is required.
    • More borrowing allows for potentially greater return on equity.
    • Low interest rates reduce the opportunity cost of borrowing.
  • Disadvantages:
    • Regular (monthly) interest payments are required.
    • Cash-flow problems can intensify because of payback responsibilities.
    • Heavy use of debt can inhibit growth and development.

Peer-to-Peer Lending (P2P)

  • Peer-to-peer (P2P) lending is money between unrelated individuals, or “peers,” without going through a bank.
    • Are often Internet-based sites that pool money from investors willing to lend capital at agreed-upon rates.
    • Fees are applied for brokering and servicing loans.
  • Possible Dangers
    • Low funding success rate
    • Business plan disclosure to the public
    • No ongoing counseling relationship
    • Potential tax liability

Other Debt-Financing Sources

  • Trade Credit
    • Credit given by suppliers who sell goods on account.
  • Accounts Receivable Financing
    • Short-term financing that involves either the pledge of receivables as collateral for a loan or the sale of receivables at a discounted value.
  • Factoring
    • Sale of accounts receivable at discounted values.
  • Finance Companies
    • Asset-based lenders that lend money against assets such as equipment, inventory, and receivables.

Equity Financing

  • Gives investors a share of the ownership:
    • Loan with warrants provide the investor with the right to buy stock at a fixed price at some future date.
    • Convertible debentures are unsecured loans that can be converted into stock.
    • Preferred stock is equity that gives investors a preferred place among the creditors in the event the venture is dissolved.
    • Common stock is the most basic form of ownership; stock issues often are sold through public or private offerings.

Public Offerings

  • “Going public” refers to a corporation’s raising capital through the sale of its securities on the stock markets.
  • Initial public offerings (IPOs): New issues of common stock.
  • Advantages
    • Size of capital amount
    • Liquidity
    • Value
    • Image
  • Disadvantages
    • Costs
    • Disclosure
    • Requirements
    • Shareholder pressure

The Rise of Special Purpose Acquisition Companies

  • Special purpose acquisition company (SPAC)
    • Formed to raise capital through IPO to merge with an existing company.
    • Growing industry with 8080 billion raised in 2020 and 9696 billion in 2021.
    • Raise IPO money, then have two years to complete acquisition or merger, or liquidate and return money.
    • IPO involves high cost, detailed disclosure, paperwork requirements, shareholder pressure for earnings.

Private Placements

  • Regulation D; Direct Public Offerings (DPO)
    • Securities and Exchange Commission (SEC) regulations for reports and statements required when selling stock to private parties—friends, employees, customers, relatives, and professionals.
    • Defines three separate exemptions, based on the amount of money being raised:
      • Rule 504—placements up to 11 million
      • Rule 505—placements of up to 55 million
      • Rule 506—placements in excess of 55 million

Private Placements

  • Accredited Purchaser
    • Regulation D uses the term accredited purchaser.
    • Institutional investors with more than 55 million in assets.
    • Any person (& spouse) who buys at least 150,000150,000 of the offered security and whose net worth is at least five times the purchase price.
    • Any person (& spouse) who has a net worth in excess of 11 million at the time of purchase.

Sophisticated Investors

  • Wealthy individuals who invest regularly in new and early- and late-stage ventures are called sophisticated investors.
  • Are knowledgeable about the technical and commercial opportunities and risks of the business in which they invest.

Regulations A and A+

  • Between private financing and public offerings
  • Regulation A
    • Limits what a company can raise to 55 million.
    • Does not limit offering to accredited investors.
    • Does not require audited financials or S-1 registration.
  • Regulation A+
    • Provides an exemption from extensive public registration for smaller issuances.
    • Securities sold publicly by general solicitation and traded.

Crowdfunding

  • Crowdfunding seeks funding for ventures by raising monetary contributions from a large number of people, usually via the Internet.
  • Three Principal Parts:
    • The entrepreneur proposes the idea and/or venture to be funded.
    • The individual or groups who support the idea.
    • A moderating organization (the “platform”) that brings the parties together to launch the idea.

Crowdfunding

  • Two Distinct Forms:
    • Rewards Crowdfunding—The entrepreneur seeks a target amount of funding to launch a business concept without incurring debt or sacrificing equity and, in return for the donation, the entrepreneur provides some type of gift or incentive.
    • Equity Crowdfunding—The entrepreneur shares equity in the venture, usually in its early stages, in exchange for the money pledged.

Crowdfunding

  • Potential concerns:
    • Reputation
    • Intellectual property (IP) protection
    • Investor management
    • Public fear
  • Benefits:
    • Funding
    • Profile
    • Marketing
    • Engagement
    • Feedback

The Venture Capital Market

  • Venture Capitalists: Valuable and powerful sources of equity funding for new ventures. They provide:
    • Capital for start-ups and expansion
    • Market research and strategy
    • Management-consulting, audits, and evaluation
    • Contacts—customers, suppliers, and businesspeople
    • Assistance in negotiating technical agreements
    • Help in establishing management and accounting controls
    • Help in employee recruitment and employee agreements
    • Help in risk management and with insurance programs
    • Counseling and guidance in complying with government regulations

Recent Developments

  • After decline in 2008, in 2021, venture capital invested about 330330 billion in the United States, largely in the Internet, health care, telecommunications, and software.
  • Such investments dropped in 2022 and 2023 due to inflation and over-valuations in earlier years.

Increase in Early-Stage Funding

  • Becoming more likely to invest in early-stage businesses:
    • More ease and efficiencies to launch a venture
    • Increase in incubators and accelerators
    • Lower infrastructure costs with cloud-based computing
    • Shorter product cycles
    • Can now sell to global consumers
    • Equity crowdfunding
    • College graduates more sophisticated with technology

Trends in Venture Capital

  • Dominant investor class changing to pension institutions
  • Becoming more global with offices worldwide
  • More specialized
  • Syndicated deals are emerging
  • More time/money on salvaging problem ventures
  • Provide advice and counsel in addition to cash
  • Corporate venture capital (CVC) growing

Scattering Venture Capital Myths

  • Myth 1: Venture capital firms want to own control of your company and tell you how to run the business.
  • Myth 2: Venture capitalists are satisfied with a reasonable return on investments.
  • Myth 3: Venture capitalists are quick to invest.
  • Myth 4: Venture capitalists are interested in backing new ideas or high-technology inventions—management is a secondary consideration.
  • Myth 5: Venture capitalists need only basic summary information before they make an investment.

Venture Capitalists’ Objectives

  • Focused on return on investment.
  • Weight risk and potential return
  • Measure product/service and the management
  • Return expectations vary based on market potential, management’s investment in company.
  • Annual goal of 20 to 30 percent is common.

Criteria for Evaluating New-Venture Proposals, One Study

  • Critical factors that are used in the evaluation of new ventures:
    • Timing of entry
    • Key success factor stability
    • Educational capability
    • Lead time
    • Competitive rivalry
    • Entry wedge imitation
    • Scope
    • Industry-related competence

Criteria for Evaluating New-Venture Proposals, Second Study

  • Major categories of venture capitalist screening criteria:
    • Entrepreneur’s personality
    • Entrepreneur’s experience
    • Product or service characteristics
    • Market characteristics
    • Financial considerations
    • Nature of the venture team

Factors in Venture Capitalists’ Evaluation Process

  • Attribute, Level, Definition:
    • Timing of entry:
      • Pioneer: Enters a new industry first
      • Late follower: Enters an industry late in the industry’s stage of development
    • Key success factor stability:
      • High: Requirements necessary for success will not change radically during industry development
      • Low: Requirements necessary for success will change radically during industry development
    • Educational capability:
      • High: Considerable resources and skills available to overcome market ignorance through education
      • Low: Few resources or skills available to overcome market ignorance through education
    • Lead time:
      • Long: An extended period of monopoly for the first entrant prior to competitors entering the industry
      • Short: A minimal period of monopoly for the first entrant prior to competitors entering this industry
    • Competitive rivalry:
      • High: Intense competition among industry members during industry development
      • Low: Little competition among industry members during industry development
    • Entry wedge mimicry:
      • High: Considerable imitation of the mechanisms used by other firms to enter this, or any other, industry—e.g., a franchisee
      • Low: Minimal imitation of the mechanisms used by other firms to enter this, or any other, industry—e.g., introducing a new product
    • Scope:
      • Broad: A firm that spreads its resources across a wide spectrum of the market—e.g., many segments of the market
      • Narrow: A firm that concentrates on intensively exploiting a small segment of the market—e.g., targeting a niche
    • Industry-related competence:
      • High: Venturer has considerable experience and knowledge with the industry being entered or a related industry
      • Low: Venturer has minimal experience and knowledge with the industry being entered or a related industry

Criteria for Evaluating New-Venture Proposals, Demand Side

  • Success acquiring funding related to:
    • Entrepreneur (education, experience, age)
    • Enterprise (stage, industry type, location)
    • Request (amount, business plan, capital source)
    • Source of advice (technology, business plan, funding)
  • Evaluating the business plan:
    • Proposal size
    • Financial projections
    • Investment recovery
    • Competitive advantage
    • Company management

Venture Capitalist Evaluation Process

  • Stage 1: Initial Screening
    • A quick review is done of the basic venture to see if it meets the venture capitalist’s particular interests.
  • Stage 2: Evaluation of the Business Plan
    • A detailed reading of the plan is done to evaluate the factors mentioned earlier.
  • Stage 3: Oral Presentation
    • The entrepreneur verbally presents the plan to the venture capitalist.
  • Stage 4: Final Evaluation
    • After analyzing the plan and visiting with stakeholders, the venture capitalist makes a final decision.

Evaluating the Venture Capitalist

  • Key Questions:
    • Does the venture capital firm in fact invest in your industry?
    • What is it like to work with this venture capital firm?
    • What experience does the partner doing your deal have, and what is their clout within the firm?
    • How much time will the partner spend with your company if you run into trouble?
    • How healthy is the venture capital fund, and how much has been invested?
    • Are the investment goals of the venture capitalists consistent with your own?
    • Have the venture firm and the partner championing your deal been through any economic downturns?

Informal Risk Capital: Angel Financing

  • Business Angel Financing or Angel Capital
    • Wealthy individuals looking for investment opportunities.
    • Referred to as “business angels” or informal risk capitalists.

Types of Angel Investors

  • Corporate angels
  • Entrepreneurial angels
  • Enthusiast angels
  • Micromanagement angels
  • Professional angels

Pros and Cons of Dealing with Angel Investors

  • Pros:
    1. Angels engage in smaller financial deals.
    2. Angels prefer seed stage or start-up stage.
    3. Angels invest in various industry sectors.
    4. Angels are located in local geographic areas.
    5. Angels are genuinely interested in the entrepreneur.
  • Cons:
    1. Angels offer no additional investment money.
    2. Angels cannot offer any national image.
    3. Angels lack important contacts for future leverage.
    4. Angels may want some decision making with the entrepreneur.
    5. Angels are getting more sophisticated in their investment decisions.