FINANCE BASICS FOR MBA

FINANCE BASICS FOR MBA

FIRST-STAGE FINANCING

˗     DEBT-EQUITY

SECOND-STAGE FINANCING

PARTNERSHIP

The term “plan” rears its ugly head when you start to figure out your financial needs. To successfully raise money for your business, you need to have a plan, as well as a backup plan and probably even a backup backup plan in today's business environment. Because your chances of getting it right the first time or two are very slim. The goal is a funding plan that will guide your search and help you make wise financial decisions.

A funding plan is really quite simple, it has four steps:

1)     Carefully determine exactly what your company needs to research your goals. You have to plan for several stages of growth and financing initially: you want to have enough cash to launch the business and survive until the company is generating enough revenues to cover expenses. Beyond that, you'll establish some milestones such as: multiple customer segments, multiple products and so forth

2)     Target your potential sources for each stage of financing, based on the needs you calculate for each stage. You can decide what kind of money you need and who could potentially be the supplier. Remember! Recognize that some first round money sources will want to be paid back or cashed out, get their investments back: in other words, before the next round of financing. So make sure that you plan for it.

3)     With the multi-stage plan defined, look at the various tasks you have to undertake to achieve your financing goals and get started before you need the money. Raising money takes time, so you shouldn't wait until you need it when it will be too late. For example: if you need briben investors, called angels, for your second round financing, you must start networking now. Angels don't just drop from the heavens when you need them. It takes time to build a business relationship so that you feel comfortable approaching the person about your financing needs and the person feels comfortable listening.

4)     Keep tabs on your progress against the timeline you set. If you're significantly off from your projections, you may need to reevaluate your plan. Perhaps you were a bit too aggressive in your expectations. Keep in mind that you're in a hurry, investors aren't. So allow for some slack in your overall plan. The kind of money you need to raise and the sources you need to consider depend on where you are in the life cycle of your company: every business goes through several stages, each with different financial requirements. The following list explains the three stages of financial need:

¾    The first stage this stage covers the  period of time from the conception of the product or service through early startup. This is where the business concept is tested to make sure that customers want what you're offering.

¾    The second stage this stage takes over when the concept is proven and your company is ready to grow to the next level by entering a new market, introducing new products or developing multiple locations.

¾    The third stage, you reach the third stage when your company is looking for a liquidity event. So investors can cash out or you want to acquire another company or be acquired by another company.

Each of these stages has different requirements and accomplishes different goals. Remember! You should know that high technology and internet companies often compress these three stages into very short time frames sometimes: months and possibly even skipping the first stage altogether. What this illustrates is that: to assess your financial needs, you need to understand the nature of the industry in which you're operating, the type of business you have and your attractiveness as a company to the capital markets.

 

FIRST-STAGE FINANCING

You know that you're in the first stage of starting your business when the easiest and most likely source of money comes from your own savings and friends, family and folks, in other words: people who believe in you and your business plan. Entrepreneurs aren't bootstrappers because they want to be, they do it because they have to. Bootstrapping means: finding money and resources, anything and everything they need by any means possible including begging, borrowing and bartering.

First stage money is hard to come by for several reasons:

·        New ventures don't have a track record, so everything that investors and lenders see in the business plan is pure speculation on the part of the entrepreneur.

·        New ventures often fail, so they represent perhaps the riskiest investments of all.

·        Most new ventures have no intellectual property rights, proprietary assets or secrets that would give them a competitive advantage in the marketplace.

·        The founders of the venture themselves often don't have a track record of successful business endeavors.

·        Most startups are merely metoo ventures, in other words: they haven't identified a significant unfair advantage that makes them valuable to customers and investors.

For these reasons and more, entrepreneurs have to bootstrap, rely on their own resources and the kindness of friends and family or anybody else who will listen to their stories. Remember bootstrapping for a new venture has three key principles:

1)     Hire as few employees as possible. Employees are the single biggest expense of most businesses.

2)     Lease share and barter everything that you can.

When you lease facilities and equipment, you avoid tying up precious capital that you could use to produce your product or service.

Bartering also has become a popular way to acquire needed resources. In the barter arrangement, you exchange a product or service that your company offers or something you need from another company

3)     Use other people's money. You can ethically use other people's money in many ways: getting customers to pay quickly is one way; convincing suppliers to give you more time to pay is another.

4)     Debt

Debt is a financing source that is unfortunately near and dear to many an entrepreneur's heart. You know all those credit card offers that you get in the mail? Many small businesses don't throw them away. Instead, they've started using credit cards as their credit line for quick cash. It's an expensive route, but in a banking environment that isn't always generous to small businesses going into debt--sometimes is the only route that owners can take.

5)     Commercial banks

Banks aren't very favorable sources of first stage money for new companies. Which isn't surprising when you consider that a banker's first concern is how a borrower will pay back the loan or credit line. If a startup company has little or no track record of sales and most new companies don't, and it's offering the bank only projected sales (in other words, blue sky), a banker won't have much confidence that repayment is possible.

Bankers operate under very strict guidelines, termed the five c's: character, capacity, capital, collateral and conditions. With no track record and only an estimate of expected sales, a new company has already violated at least two of the five c's (capital and capacity).

But what if you can show a track record from a previous business or from your personal financial status that's strong enough to warrant alone. Depending on how  you negotiate the deal, you'll receive either a secured or an unsecured note. We're betting that the note will be secured, meaning that getting the loan will require some form of collateral. Collateral is an asset of equivalent value that you pledge against the note, such as: your house or a savings account.

If you don't repay the loan, the bank has the right to repossess or foreclose on the asset. But even if that happens, your financial obligations don't stop. Just because you've lost the collateral for defaulting on the loan, doesn't mean that you aren't still liable for the loan amount. Most bankers will ask you to personally guarantee any loan you take out, which means that in addition to any business assets, you're also pledging your personal assets against the loan should you default.

Try to avoid this situation if at all possible. Of course savvy bankers want to cover themselves anyway possible and they're holding all the cards when you really need the dough. Take the following quiz before making a trip to the commercial bank: to see whether you and your business are ready to apply for a business loan:

¾    Does your management team have the skills and expertise to execute your business strategy?

¾    Does your company's financial picture look healthy: positive cash flow, reasonable profit, some assets?

¾    Does your personal financial statement look positive?

¾    Can you identify your first source of repayment of the loan?

¾    Do you have a second source for repayment?

¾    Do you have additional security that you can use to collateralize the loan?

¾    Do you clearly understand how your business and your industry work?

¾    Can you demonstrate your character and trustworthiness?

Make sure that you can answer yes to all these questions before you approach your banker. Set yourself up for success.

6)     Government sources

You can turn to governmental agencies to help fund your startup business. Which is a good thing, because it enables you to borrow back some of your tax that went into government programs to support small businesses.

Be forewarned however, that anytime you borrow from the government, you'll be dealing with a lot of paperwork and time-consuming procedures. Remember! It takes money to make money. Furthermore, the government moves at glacial speeds to respond to requests.

7)     Equity

When you seek equity sources of capital, you're asking people to invest in your company in exchange for ownership interests. Which means that you're willing to share ownership of your business. If you're wondering why you would do this, ask yourself the following: would you rather have total ownership of a company that struggles to get off the ground or majority ownership in a company that's really going places? We hope you answered the latter. Remember! It takes money to make money. When you give people equity stakes in your company, you give them the right to attend shareholder meetings and voice their opinions. So you must choose your equity stakeholders wisely.

Equity provides the investor or owner with four basic rights:

¾    The right to control the business

The person who has the majority of the stock controls. What happens to the business that's certainly true in a privately held company, in which the founder controls who gets stock and how much. In a publicly held company by contrast, shares are bought and sold on a stock exchange. So a group of people joining together can hold the majority shares and control the company. That group may or may not include the founder.

¾    The right to dividends

Depending on how you set up your stockholder agreements, most shareholders in an equity situation are entitled to dividends if and when the company declares them. Dividends are a distribution of earnings to the shareholders.

This is a critical point. Because most early stage companies don't distribute dividends, instead they retain earnings o grow the company which is a very prudent decision. Remember! Entrepreneurs shouldn't seek money from investors who want dividends before the company is well established.

¾    The right to vote

Assuming your investors received common stock, they're entitled to vote at the annual shareholders meeting on such issues as the election of directors and  officers and the direction of the company. In most cases, venture capitalists, professional investors, demand preferred stock. Which gives them preference in a liquidation over the common stockholders.

Normally, preferred stock is non-voting but in some instances the investor may demand voting rights with preferred stock (whoever supplies the money wins the right to company assets) depending on how you write up the shareholder agreements. Some shareholders could have claims on company assets in the event of dissolution of the company.

 

DEBT-EQUITY

Many factors come into play when you're deciding what kind of money you need for your Venture. The following sections take a look at some key factors to consider when contemplating the choice between debt and equity:

·        The purpose of the funds

Why do you need the money? That question sounds simple enough but few business owners really know why. They're seeking Capital beyond the very Basics to start the business, to grow the business and so on.

Certain types of capital work in some situations and not in others. For example, if you're seeking Capital to finish research and development on a new product called seed Capital, you can forget getting a loan from Banks. Most Venture Capital firms and frankly most every other kind of investor outside of riends and family. That's because rnd is a big sinkhole: it requires a lot of money without producing any return for a long time if ever.

On the other hand, if you have a successful business and are looking to grow into new markets, you probably have several funding choices. And in today's Global business environment, if you have a sexy internet business with a great business model or a high-tech Venture in the energy industry, the world of capital is yours for the asking. Well, maybe not quite that easily but you're certainly in a better position than 99 percent of other business owners.

·        Your preferences and goals for your business

As a business owner, you no doubt want to control your destiny and certainly that of your business. Some business owners aren't comfortable with debt, they're obviously not baby boomers, so loans and credit lines aren't options. Others don't want to share ownership with anyone, they want it all. So Equity isn't an option if you fall into both categories. You have a real problem: you now have to rely on your own resources and the internal cash flows of the company. That may mean that you start and grow much more slowly than you would have otherwise.

Nothing is wrong with that approach unless you're in a fast-moving industry. In that case, if you grow too slowly you'll probably miss the window of opportunity and give a competitor a chance to bypass you in the market. The important thing is that you choose the financing option that meets your personal needs and the goals of your business.

·        Your investors preferences and goals

Although your personal preferences and goals certainly are important, there by no means the only ones you have to consider. Your investors, if you choose that route, have their own goals which may be in conflict with yours. Unless you find that rare investor who has a philanthropic interest in seeing your business succeed, you'll deal with an investor who's in the deal for what it will return.

An investor is looking at three types of returns in about three to five years:

¾    Cash flow returns

A working investor or owner sometimes receives the perks of ownership, such as: an expense account, a company car, a salary and dividends.

¾    Stock appreciation

At some point, agreeable to everyone, an investor can sell off a portion or all of his or her interest in the company and harvest the capital appreciation that the business has achieved. This is a tax-free event, up to the cost basis of the original investment. Also if investors have held the stock the required length of time, they'll qualify or capital gains treatment on the gain. Which means their tax rate will be much lower.

¾    Tax benefits

In some forms of business, for example: a sub chapter as Corporation or a limited liability company LLC, losses and profits are passed through to the owners in proportion to their investment. So an investor can receive pass-through losses typical in the early years of a business and pay taxes on profits at the Investor's personal income tax rate which often is lower than the corporate rate

 

SECOND-STAGE FINANCING

Second stage or second round financing, generally is used to expand a business into new markets or new products to grow rapidly to the next level. Most businesses seek some form of expansion capital to cover the cost of building up inventories, hiring more sales people, carrying out marketing campaigns, ramping up manufacturing and so on. To name a few options in this section, we look at several ways you can raise expansion capital.

·        Getting an angel on your side.

We want to talk about angels, but the kind of angels we're talking about don't have wings and halos although, they sometimes grant wishes. In the capital acquisition arena, an angel is a private investor and part of what's known as the informal risk capital market which is the largest pool of investor money in the united states. Because the market is quite large, finding an angel doesn't seem like it would be a problem for an entrepreneur looking for funding. But it isn't that easy.

You see, angel investors aren't listed in the phone book. Frankly, they usually prefer to keep a low profile. Looking only at deals referred to them by people they trust. So the key to finding an angel investor is to get to know people who know them: professional advisor types such as attorneys, lawyers, bankers and accountants are possible sources. Other entrepreneurs are also good sources, because most angel investors have been entrepreneurs themselves. That's why they like helping other entrepreneurs by investing in their companies.

Today many angel investors band together in groups so that they can invest in larger deals and benefit from a shared experience. They generally have rules about how much their members must invest annually and they tend to fill the gap between friends and family money and venture capitalists vcs. One thing angels typically do that distinguishes them from vcs is to spend a lot of time mentoring the startups so that they're ready for money. They also link companies to vcs when the time is right.

Although we can't give you one complete description of what angels look like, we can say from our research that they have some common characteristics: they're usually educated males in their 40s and 50s; they typically have a net worth of more than one million dollars; they like to invest in companies near their homes so they can enjoy watching the companies grow; they seem to prefer certain types of businesses particularly in manufacturing energy and resources and service businesses. Of course they also compete with vcs for high technology businesses. They tend to make decisions more quickly than vcs and usually stay with ventures for longer periods of time.

You now have an image of an angel to go by. But don't make the mistake of thinking that all angels are alike, in fact today you may run into angels who have actually come looking for you. Trying to entice you to accept their money. A dream come true? Hardly. It's a symptom of a long bull market rising: stock market with plenty of newly rich entrepreneurs who like the idea of investing in up-and-coming young companies. These investors are looking less and less like angels and more like vcs. However, because they require more due diligence, seek a quicker return on investment time and set tougher screening criteria, angels have a much larger market now that vcs are scouting bigger deals. However many angels still find most of their deals through referrals so it all comes back to the importance of net working and becoming known within the venture community.

·        Taking the fast track with venture capitalists

Venture capitalists are placed in the same category with used car salesmen and real estate developers. Why is that? Probably because although entrepreneurs want to build great companies, venture capitalists are in business solely to make money and get out as quickly as possible. They also want the following: a huge equity interest to compensate for the risk they're taking; an enormous return on investment; a seat on your board of directors. Doesn't sound very attractive does it?

To be fair venture capital serves an important purpose: it provides the funding that fast growth companies need to expand. Warning! Although plenty of venture capital is out there for the taking, fewer than one percent of all businesses meet the very strict requirements of venture capitalists.

For high growth ventures however, vc money is an important source of funding. But it should be considered a second stage source and pursued: only if no private money is available. Some businesses: particularly high-tech businesses and those with heavy asset requirements such as plant and equipment, find it difficult to grow organically using internal cash flows. Growth is expensive and to do it effectively, you need to move quickly. There are additional people to hire, systems and controls to put in place, to manage growth and inventories, to build up in anticipation of demand by customers. All these things require large amounts of capital that most business owners don't want to divert from their current budgets. That's where vcs come in. This type of business is more attractive than a startup because it has achieved a certain level of success, some of the risk has been reduced and the business is positioned to grow.

What do vcs look for? Knowing what vcs generally look for, puts you in a better negotiating position. You'll know what's important to them and be able to address those issues in a way that makes sense to them. Most vcs are interested in three aspects in the following order:

¾    A great market

Market size in the hundreds of millions of dollars is the minimum. Billions of dollars is much better. From a fast-growing large market, a company can achieve high valuations that will give the investor the greatest possible return on investment.

¾    A great management team

Of course to take advantage of big markets you need a management team that can execute the business plan. An old  adage says that vcs would rather invest in an a team with a b product than in a b team with an a product. What that means is that people make the difference in a company. Vcs want to invest in a team that has a successful track record. Remember! Vcs also want to see a team that's fully committed to the company because a fast-growing company requires an extraordinary amount of time and effort.

¾    A great technology that you can protect

Traditionally, vcs have looked for the next great technology: product computer hardware, software, communications electronics, medical devices biotech and pharmaceuticals. For instance, they would prefer that you have patents to protect it. So your grandmother's brownie recipe probably won't qualify even if fairy tale brownies is a thriving arizona-based business.

Having said that vcs are now starting to do more of something they rarely did in the past, they're investing in non-technology companies with great protectable business models and huge growth potential. So you may not get money for your new brownies, but you may be able to create the next walmart. The reason vcs are doing this is because of the lack of great technology deals in the market.

Where do you find vcs? To work with venture capital firms, you need to be able to locate them. The best way to do so is through a referral. Although many venture capital firms are listed in the phone book, the worst thing you can do when searching for capital is to start calling and sending out your business plan. Vcs see hundreds of business plans every month so the best chance you have of getting some attention is through a referral from someone who knows a vc and knows you too.

To get a referral you need to have spent a lot of time networking in your community so that eventually you can meet the people who can help you: attorneys, bankers and accountants are good places to start. This type of contact won't happen overnight. However, you have to keep working at it.

After you find a vc whose requirements mesh with your ventures capabilities, deal with that investor alone. Don't shop your business plan to several vcs at once. It's a small world and vcs don't want to feel as though they're in a bidding war for your investment opportunity. You'll discover very quickly whether a vc firm is interested or not. Vcs aren't shy about telling entrepreneurs what they think of their great ideas.

What happens after you find a vc? The first thing vcs may ask to look at is the executive summary for your business plan. If they don't find the business concept sufficiently compelling and in line with their criteria, they won't waste their time reading the rest of the business plan. If they are interested, they may call for a meeting to check out your management team to see whether you are what you say you are. You may be asked to do a formal presentation at that time and you may be asked some very pointed questions to determine how you stand up under pressure.

The first meeting is really a getting to know you meeting others; will follow as the vcs begin to do their very thorough due diligence: background checks on your team and company. If the vcs are sold on the investment, you'll move into a period of going over legal documents and negotiating what they want and what you want. Typically, what they want: wins.

The nature and terms of the investment will then appear in a term sheet. When the deal is set however, it doesn't mean that the check is in the mail. Vcs usually manage pools of investor money so they have to do their own prospectus and legal documents for their investors. All this work can take several months. So the moral of the story is: don't begin the search for vc funding too late. Completing funding will take some time.

·        Private equity firms

Today private equity firms are receiving a lot of press. What exactly are they and how are they different from venture capital firms? Private equity firms are simply investment funds that traditionally have focused only on very mature low-risk companies seeking expansion capital.

·        Public offering

Considering a public offering. If your company is in need of second stage cash, another way you can raise capital is to do a public offering. A public offering is a complex version of a private offering that's regulated by the securities and exchange commission (sec): your company agrees to sell a portion of its issued stock to the public via a stock exchange. The first time your company does this, it's termed an initial public offering (ipo).

For a growing business, nothing is more exciting or glamorous than a public offering. It can be prestigious and very lucrative among many other benefits. The public offering provides a way for founders and investors to reap the rewards of their efforts by selling off a portion of their stock:

¾    It gives your business instant clout with lenders and others who may not have given you a second look before.

¾    It's a way to raise large amounts of interest-free equity capital that you probably couldn't raise by any other means.

¾    You can use stock in the company as an incentive to attract top people to your organization.

¾    Because of the prestige of being a public company, it's easier to negotiate deals with suppliers, customers and creditors and to form strategic partnerships with other companies.

Remember! With public offerings, market timing is everything. Ipos are subject to seasonality which means that sometimes markets are favorable to them and sometimes they're not. Timing for the business is important too. One rule says: to consider an ipo when your company's need for growth capital exceeds its debt capacity.

 

PARTNERSHIP

You can use methods other than debt inequity to raise capital or find the resources necessary to grow your business. Very simply put, a strategic alliance as a partnership between two or more businesses. As well as an excellent way to share core competencies and reduce the costs of research and development, marketing, manufacturing and distribution. Strategic partners invest time, money and expertise in your company. They're really more like stakeholders. Strategic partnerships have helped many companies grow without having to raise costly outside capital and without giving up any equity.

Strategic partnerships are particularly important to companies that do business in the global market. Often you can't even do business in a country without having a partner in that country that knows how to handle business there. Alliances also are critical to small companies looking to compete in a big market.

To be successful, a strategic alliance should be a win-win situation for both companies. To make sure that you create an effective partnership, here the following advice

·        Find a partner that's financially healthy, with or without your company.

·        Find a partner whose business practices are compatible with yours and whose customers and value chain members are satisfied with their relationships with the company.

·        Find a partner that has experience in strategic alliances. Just as with a sophisticated investor, an experienced partner understands the risks and knows how to make the partnership work.

·        If possible find a company that has excess capacity so that it doesn't have to expend extra capital in plant and equipment to partner with you.