Here are two interesting observations I have made about financing. First, lenders readily offer money to businesses and individuals when they least need it, and ignore or frustrate them when they most need it. So it may be prudent to secure financing facilities, such as bank overdrafts, when you do not need it. Second, entrepreneurs exhibit a very interesting and somewhat puzzling attitude of refusing to give up some control over their business in return for financing, even at the cost of forfeiting profitable projects (projects with positive Net Present Value). I am puzzled at this behaviour because, to me, it is at odds with the risk-taking nature and bottom-line focus of entrepreneurs. The effect of this attitude suggests that, to these entrepreneurs at least, a 100% ownership of a US$100,000 firm is preferred to 50% of a US$10M firm.
Regarding my second observation, I recall two instances in particular, when I worked with entrepreneurs outside the country on business expansion and succession planning. Both gentlemen were successful and seasoned entrepreneurs who had built multi-million dollar businesses from the ground-up and were nearing retirement. One was in the construction industry, who besides the challenges of running a seasonal business (mostly during summer), was beginning to face significant price-competition from large firms. He needed cash to retool and diversify his operations, and also to design and execute a marketing strategy. The other gentleman was an equipment manufacturer who had the unique opportunity to increase his global presence due to successful product innovation. Yet for both of these entrepreneurs, giving up some control of their business in return for funding was too high a price to pay so they abandoned their projects. The story is no different from my recent experience with an entrepreneur here at home who has built an impressive business and was contemplating expanding it. After almost 6 months of work, including developing a valuation model and preparing the necessary information memorandum for fund raising, the client decided to abandon the project for exactly the same reason of not wanting to give up some control.
Clearly, financing decisions require good planning and have significant consequences, including giving up some control. So whether you are a new or existing business intending to raise funds, it is imperative to be familiar with the basics of financing in order to understand your options and their associated risks. This is important even when you choose to secure independent professional advice to help in your fund raising efforts.
Your choice of financing generally depends on three key factors namely; the stage and type of business, the size and use of the funds, and firm-specific factors including industry , competition, ownership of intellectual property, and the risk tolerance of the business owners/ managers . Let’s explore these further.
The stage of the business refers to whether the business is new, growing, mature or declining. These impacts on the risk profile of the business. A new business with a proven concept is less risky than one without, and a growing business less risky than a mature or declining one. The organic yet strategic growth phases of some businesses, including most of the world-class technology firms like Google, Microsoft and Dell computers, starts as a hobby, grows into a sole proprietorship, then into a partnership, becomes privately incorporated before ending up as a publicly traded company. The use of the term hobby here places little emphasises on the thought of having fun, but more on the concepts of passion and focus, and an environment where the power of an idea is first tested. Each of these phases requires special financing considerations. Usually, the individual funds his own hobby till he becomes entrepreneurial and so registers it as a sole proprietorship. Spending time and money to register it demonstrates to everybody, particularly prospective investors, that he is serious and ready to take the business to the next level. At that point, he can confidently approach friends and family for soft loans “love funds” to grow his business. If it is a service business, these funds may help to advertise and grow his client base. For a manufacturing business, these funds may support his prove of concept development, such as product prototype. Once the potential of the service or product is proven, the friends and family will often convert their funds into equity and become partners. In a partnership, legal documentation of every decision becomes very important. Usually, more business success at this stage means more money is required to sustain the operations as the business may burn cash very quickly to invest in plant, property and equipment (PPE) and working capital; including purchasing inventory and financing accounts receivables. These investments must be financed using the appropriate financing vehicle. After exhausting available “love funds”, the business now approaches other investors including banks and venture capital.
Two key things must occur to successfully raise this capital. First, the business must have a full-fledged business plan, which is more than a concept paper with which it might have been operating up to this point. The plan should clearly articulate the business model and the strength of its management team. It must clearly itemize all the business assets, document any sales to date and lay out at least a 3-year projected financials (income statement, balance sheet, cash flow statement) together with all underlying assumptions. Importantly, the plan should state the amount and use of the funding required. It must clearly identify the target clients and lay out a solid marketing strategy for the business. Second, the business must be incorporated with authorized shares to be issued. These could be common shares or preferred shares. Equity investors will take either of these shares whereas creditors, like microfinance firms and banks, often demand a form of guarantee or collateral for their investment. They could also request for debt with convertible features. For them, often times, the incorporation status of the business makes little to no difference from a risk capacity perspective. They will want the business and or its principals to pledge some assets as security. I must mention that in other jurisdictions, where the cost of setting up and operating an incorporated business is much higher than that of a sole proprietorship and partnership, the collateral requirements are less stringent for incorporated firms except if the business is a greenfield. Judging from their constant requirement for collateral, some as high as 100%, one gets the impression that some of our banks are not in the business of taking risk.
Negotiating with venture capitalists is also a serious business. You could easily lose control of the business if care is not taken to understand every clause or condition agreed to in a financing contract. This risk is so real that it justifies seeking professional support. It is also the reason some refer to venture capital providers as “Vulture” capitalist. The final stage of going public is an elaborate process so we shall discuss it in detail in subsequent articles. However, suffice it to say that, private companies become public when they raise funds from the general public. They can raise equity by selling shares or raise debt by selling bonds.
The second key consideration for making your financing decision relates to the size and use of the funding. Generally, whereas the amount of money you need determines who you approach, the intended use of funds informs where you raise your funding from, either from the money market (short-term) or the capital market (long-term). Regarding the source of funds, I have already made the point that small start-ups will first approach friends and family, then banks, before speaking to venture capitalists as their financing needs increase with business growth. On the other hand, big businesses usually look to financing institutions like banks, insurance firms, and private equity firms, both local and international. The documentation and other processes involved in raising large funds is specialized and involving, so firms typically engage the services of investment bankers. Private debt can be obtained from the corporate finance desk of major banks. They often have different financing ceilings for each sector of the economy. On the other hand, there are locally-based international institutions that provide private equity. Like their debt counterparts, these private equity Funds are industry specific and often have financing floors, meaning they do not consider financing below a certain minimum amount. Most of the international Funds do not consider financing below US$10M. To a large extent, this deal-size restriction, explains the limited presence and activity of these private equity institutions in our markets.
The use of funds criteria has to do with correctly matching the life of the financing instrument and the asset being financed. Any timing difference between the source and use of funds causes strain on the firm’s cash flow. Consequently, to properly manage liquidity and investment risk, the rule of thumb is to raise long-term funds for long-term investments and short-term funds for short-term investments.. As an example, a firm should use bank overdraft to finance account receivables, bank loans for medium term capital investments, and issue equity or bonds for long-term investments such as to purchase Plant, Property and Equipment (PPE). Unfortunately, our corporate bond market is virtually non-existent to support this long-term investment matching.
Finally, the broad category of firm-specific factors must be given equal attention in making any financing decision. These factors may include the industry type, level of competition, ownership of intellectual property, the risk tolerance of the business owners/managers. There are two lenses the firm can use to evaluate the impact of these factors on its financing decision. The first lens -risk lens- looks at how these factors impact the firm’s ability to meet its financial obligations under any proposed funding. As an example, given the growing industry practice of credit purchases in the household appliance business, a firm seeking debt financing in this industry must answer the question ‘will I have enough cashflow to meet the periodic interest and principal payment obligation under debt financing?’ The second lens – value lens- looks at the impact of these factors on the firm’s valuation. The question to be asked here is ‘does this proposed funding increase the firm’s valuation?’ This perspective goes to the heart of financing decisions and the role of management. Finance contends that the objective value of management is to maximize the value of the firm. Accordingly, any decisions, whether investment or financing, must add value to the firm, otherwise it is suboptimal. So, the type of financing chosen must consider all firm-specific factors in order to maximize the firm’s value. The theory of capital structure contends that the right mix of financing employed by a firm minimizes the firm’s weighted average cost of capital and consequently maximizes its value. Finding this perfect financing mix is easier said than done.