Funding New Ventures

Abstract

This article will focus on the different sources of funding for new ventures, especially small businesses. One of the greatest challenges for new ventures is the ability to secure capital that will allow the company to grow. There is no magic formula, and the management team will need to evaluate and assess which options are beneficial for the company. Each business will need to weigh the pros and cons of each option in order to determine what would be best. There are two options that these businesses may consider: debt financing and equity capital. The role of commercial banks, the Small Business Administration, angel investors, and venture capitalists will be introduced and discussed.

Overview

One of the greatest challenges for new ventures is the ability to secure capital for investments that will allow the company to grow. All projects will reach a point at which sufficient cash flow is necessary in order to attain the next level. It could be after a period of time or it could be because the venture is popular and the company is growing at a rapid rate due to demand. Regardless of the situation, the company's management team will need to determine when and how they will invest in efforts such as purchasing new equipment, hiring new staff, and putting more money into marketing initiatives. Raising money can be a difficult task if the company has not established a reputation or is still new.

When determining the amount of capital needed, the decision makers must analyze the situation and decide how much and what type of capital is required. Since the situation is not the same for all businesses, there is no magical formula. Some businesses may only need short-term financing for items such as salaries and inventory, while other businesses may need long-term financing for major items such as office space and equipment. Each business must develop a customized plan that will meet its unique needs.

Securing capital is a choice made after weighing the pros and cons of various options. There are three popular means of obtaining funding for new ventures: borrowing from financial institutions, partnering with venture capitalists, and selling equity/ownership in exchange for a share of the revenue (Goel & Hasan, 2004). All financing options can be classified into one of two categories: debt financing or equity capital.

Debt financing includes bank loans, personal and family contributions, and financing from agencies such as the Small Business Administration. Loans are often secured by some type of collateral in the company and are paid off over a period of time with interest. On the other hand, venture capitalists and angel investors provide funding in the form of equity capital. Both are given ownership in the company in exchange for money. Pierce (2005) offers some advice that may be of assistance when assessing which option may be best for the company. Some of the tips include:

• A Small Business Administration program may not be the best option if the company needs less than $50,000.
• Debt financing is usually cheaper and easier to find than equity capital. Debt financing requires that the borrower make monthly payments regardless of whether or not the business has a positive cash flow.
• While equity investors do not expect much, if any, return in the early business stages, they require information regarding a company’s status. In addition, they expect the company to meet established goals.
• Most business types can usually acquire debt financing, but businesses with fast growth and high potential are usually the recipients of equity capital.
• Angel investors tend to invest money in companies that are within a fifty-mile radius, and the amounts of funding tend to be in the range of $25,000 and $250,000. Angel investors may be friends, family, customers, suppliers, brokers, or competitors.
• It is difficult to secure venture capital funding, even in a good economy.

Applications

Two Options of Financing. Debt financing and equity capital options both require the business owner to complete detailed documentation prior to the award of financing. The owner should be prepared to produce quarterly balance sheets, background information on the company, and projections.

Debt Financing: Commercial Banks. If the company cannot finance the expansion through personal investments, the management team will need to develop a business plan that meets the criteria for potential lenders. Commercial banks may be the first choice, especially if the owner has a relationship with a specific lender. Since traditional lenders tend to be conservative, good rapport and an established relationship will be beneficial when applying for a loan. It is important for potential borrowers to understand the mindset of potential lenders. Most lenders tend to focus on five important factors when deciding whether or not to extend credit, and business owners need to be prepared to address them. The five factors are:

1. Character — What are your personal characteristics? Are you ethical and have a good reputation? Will you do everything possible to pay the loan back?
2. Capacity — Will your business be able to generate sufficient cash flow to pay the loan back? Do you have access to other income?
3. Collateral — Do you have collateral to cover the loan in the event that the venture does not perform well? Is there a qualified individual willing to cosign on the loan?
4. Conditions — Have you researched the environment to see if there are any circumstances that could negatively impact your business (i.e., nature of product, competition)? How will you deal with these situations if they arise?
5. Capital — What are you personally willing to invest in the venture? Most lenders are not willing to invest in ventures if you have not made a major investment in the future of the project. Why should they invest in the venture if you are not willing or able to?

Small Business Administration (SBA). If a commercial bank is not an alternative and the entity is a small business, the Small Business Administration may be another option. The business must satisfy the agency's criteria and not be able to secure financing from other sources. The Small Business Administration (SBA) is an independent agency of the federal government, and it is responsible for assistance to small businesses in the United States. There are four types of assistance this agency can offer, and they are advocacy, management, procurement, and financial assistance. Financial assistance can be granted through the agency's investment programs, business loan programs, disaster loan programs, and bonding for contractors.

Business Loan Programs

• There are three loan programs; the Small Business Administration sets the guidelines while other entities, such as lenders, community development organizations, and microlending institutions, make the loans to small businesses. In order to reduce the risk to these entities, the SBA will guarantee the loans. In reality, an SBA loan is a commercial loan with SBA requirements and guaranty.

Investment Programs

• In 1958, Congress created a program for the group of privately owned and managed investment firms recognized by the Small Business Administration as Small Business Investment Companies (SBICs) called the SBIC Program. SBICs partner with the government and use their own capital with funds borrowed at reduced rates to provide venture capital to small businesses.

Bonding Programs

• According to the Small Business Administration, “the Surety Bond Guarantee (SBG) Program was developed to provide small and minority contractors with contracting opportunities for which they would not otherwise bid” (SBA, 2007). The Small Business Administration (SBA) can guarantee bonds for contracts up to $6.5 million, covering bid, performance, and payment bonds for small contractors.

Equity Capital: Venture Capitalists. Venture capital is usually available for start-up companies with a product or idea that may be risky but has a high potential of yielding above-average profits. Funds are invested in ventures that have not been discovered. The money may come from wealthy individuals, government-sponsored Small Business Investment Corporations (SBICs), insurance companies, and corporations. It is more difficult to obtain financing from venture capitalists. A company must provide a formal proposal such as a business plan so that the venture capitalist may conduct a thorough evaluation of the company's records. Venture capitalists only approve a small percentage of the proposals that they receive, and they tend to favor innovative technological ventures.

Funding may be invested throughout the company's life cycle, with funding being provided at both the beginning and the later stages of growth. Venture capitalists may invest at different stages. Some firms may invest before the idea has been fully developed, while others may provide funding during the early stages of the company's life. However, there is a group of venture capitalists who specialize in assisting companies when they have reached the point at which the company needs financing in order to expand the business.

Angel Investors. Many firms receive some type of funding prior to seeking capital from venture capitalists. Angel investors have been identified as one source that entrepreneurs may reach out to for assistance (Gompers, 1995). Including angel investors in the early stages of financing could improve the chances of receiving venture capital financing. Madill, Haines, and Riding (2005) conducted a study with small businesses and found that “57 percent of the firms that had received angel investor financing had also received financing from venture capitalists.” Firms that did not receive angel investing in the early stages (approximately 10 percent of the firms in the study) did not obtain venture capital funding. It appears that angel investor financing is a significant factor in obtaining venture capital funding. Since obtaining venture capital tends to be difficult, businesses can benefit from the contacts and experience of angel investors in order to prepare for a venture capital application and evaluation. The intervention of an angel investor may make the company appear more attractive to the venture capitalists.

Regardless of how a company decides to finance the venture, it will have to make an agreement that is beneficial to the investor since they are the ones providing the money. Therefore, it is important to select a choice that benefits the business in the long run. Initial decisions may set the tone for future deals. Advani (2006) has provided some recommendations to consider when determining what will work best. These suggestions include:

• Don't give pro-rata rights to your first investors. If your first investor is given pro-rata rights, chances are your future investors will want the same agreement. It would be wise to balance the needs of your early investors to protect their stake in the company with how attractive the company will be to future investors.
• Avoid giving too many people the right to be overly involved. If too many people are involved, it could create a bureaucracy and make it difficult for decisions to be made in a timely manner. In addition, the daily tasks of a business may be prolonged due to the need for multiple authorization signatures.
• Beware of any limits placed on management compensation. Some investors may place a cap on the earning potential of senior management personnel. This type of action could create a problem with human resource needs such as attracting and hiring quality talent to run and grow the business.
• Request a cure period. Many investors will request representation for every legal agreement to protect themselves if the management of a company is not in compliance with laws, licenses, and regulations that govern the operation of the business. Although all parties may have good intentions, errors do occur. If a "cure period" is added to the financing agreement, the entrepreneur will have the opportunity to find a solution to the problem within a given period of time (i.e., two to four weeks).
• Restrict your share restrictions. Having unrestricted shares is often a good negotiating factor with future investors. Therefore, it would be wise to evaluate any requests to restrict the sale of shares owned by the founders or management team.

Issues

Making the Choice. In a perfect world, the business will be able to fund the venture. However, this is seldom the case. Most businesses will have to make a choice—will they incur debt, or will they sell equity in the company? There are advantages and disadvantages for each type of source.

If the owner of a business decides to personally finance the venture, a loan or credit card financing may be a solution. There is an opportunity to secure competitive interest rates, and the terms of the loan are clear. Many owners have a desire to maintain control, and lenders are not a part of the company. They do not seek control and are only interested in businesses paying on time with interest. Although the owner maintains control of the business, there could be potential problems if the venture does not generate enough income to cover the basic cost of running the business and making the payments.

In order to avoid a "backlash of no cash," a business may determine that selling shares of equity would be the best way of securing working capital. This alternative could alleviate some of the stress associated with starting a new venture as well as provide the company an opportunity to grow at a quicker rate. However, the business will be required to give the investors some control and profits. Angel investors may want to take a role in the company, but venture capitalists will probably want to remain in the background as silent partners. If the venture is not successful, the investor loses. Therefore, angel investors and venture capitalists will probably require a higher return on investment than a conventional lender since the risks are greater.

Conclusion

There are many sources of capital for funding new ventures with potential. Securing capital for the venture requires the business to develop a business plan, forecast financial projections, and be knowledgeable about the sources of financial support.

"Given the importance of new business creation to global innovation and economic growth, an understanding of how people successfully obtain financing to pursue entrepreneurial opportunities is important" (Shane & Cable, p. 379). As the global economy becomes increasing integrated, the role of entrepreneurs will continue to be significant, and it will be important to make sure they are successful. One factor of success will be tied to the company's ability to finance its growth. Debt financing and venture capital have been identified as two options that a business can use to obtain financing. Entrepreneurs and small business owners will need to research and prepare the necessary documentation to secure financing from the various sources in these two options.

Terms and Concepts

Angel Investors: Individual that provides capital, contacts, and expertise to one or more start-up company.

Capital: Usually measured in units of money, capital is referred to as tangible investment goods.

Commercial Bank: Bank which takes deposits, makes loans, and offers additional related services; while accepting of individual business, commercial banks seek out business customers.

Debt Financing: “When a firm raises money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise to repay principal and interest on the debt” (Schulman, 2007).

Equity: Funds provided to a business by the sale of stock.

Equity Capital: Money invested in a business by owners, stockholders, or others who share in profits.

Financial Institutions: An institution that places funds collected from the public in financial assets like deposits, loans, and bonds, rather than tangible property.

Investments: The procurement of a share in a financial vehicle so as to garner returns; simply, using money to make more money.

Non-profit micro lenders: Lenders who offer small loans to people locked out of the banking system. The main purpose is to help start or expand small businesses that generate income.

Patient Capital: Funding given without the expectation of short-term returns; long-term situation.

Pro-rata Rights: The investor is given the right to maintain ownership in the company through future investment rounds.

Share: Representation of a unit of monetary interest within a corporation, mutual fund, or limited partnership.

Small Business Administration: A federal agency that makes loans to small businesses.

Small Business Financial Exchange: A data repository, affiliated with Equifax, that collects loan, lease, line of credit, and credit card data to evaluate small business performance.

Start-up: A business venture in its earliest stage of development.

Venture: Often refers to a start-up or enterprise company that is associated with somewhat elevated levels of risk.

Venture Capitalists: Investors that support start-up ventures or small businesses wishing to expand through the provision of capital; start-up ventures and small businesses are not traditionally given access to public funding.

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Suggested Reading

Belleflamme, P., Lambert, T., & Schwienbacher, A. (2014). Crowdfunding: Tapping the right crowd. Journal of Business Venturing, 29, 585–609. Retrieved from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=98771053&site=ehost-live.

Bruno, A., & Tyebjee, T. (1985). The entrepreneur's search for capital. Journal of Business Venturing, 1, 61–75. Retrieved from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5109062&site=ehost-live.

Churchill, N., & Lewis, V. (1986). Bank lending to new and growing enterprises. Journal of Business Venturing, 1, 193–207. Retrieved from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5126563&site=ehost-live.

Hall, J., & Hofer, C. (1993). Venture capitalists' decision criteria in new venture evaluation. Journal of Business Venturing, 8, 25–43. Retrieved from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5126568&site=ehost-live.

Homburg, C., Hahn, A., Bornemann, T., Sander, P. (2014). The role of chief marketing officers for venture capital funding: Endowing new ventures with marketing legitimacy. Journal of Marketing Research, 51(5), 624–644. Retrieved from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=98472601&site=ehost-live&scope=site.

Hustedde, R., & Pulver, G. (1992). Factors affecting equity capital acquisition: The demand side. Journal of Business Venturing, 7, 363–375. Retrieved from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5114068&site=ehost-live.

Mollick, E. (2014). The dynamics of crowdfunding: An exploratory study. Journal of Business Venturing, 29, 1–16. Retrieved from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=91847363.

Neely, L., & Van Auken, H. (2012). An examination of small firm bootstrap financing and use of debt. Journal of Developmental Entrepreneurship, 17. Retrieved from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=77059302.

Phillips Erb, K. (2015). Debt, equity and startup money. Forbes.com, 7. Retrieved December 28, 2016, from EBSCO online database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=109220016&site=ehost-live&scope=site