Business Funding Sources Article

Business Funding Sources and Business Capital Considerations

Article Outline:

I. Business Capital Needs, Pitfalls and Considerations

A. Business Capital Needs

B. Capital Funding Pitfalls to Avoid

C. Business Capital Considerations

II. Forms & Sources of Commercial Finance

A. Overview of Commercial Loans: Forms & Sources

B. Short-Term & Long-Term Commercial Finance

C. Internal & External Sources of Business Finance

1. Overview

2. Internal Sources of Business Capital

3. External Sources of Business Capital & Finance

a. Suppliers & Trade Credit

b. Debt Capital Overview

c. Bank & Commercial Lender Finance

d. Equity & Venture Capital Finance

i. Overview: Venture Capital’s Hot Buttons

ii. Venture Capital Process, Strategies & Objectives

iii. Venture Capital Structure & Terms

e. Alternative Forms of Business Finance

III. Conclusion

Overview

This article is Part Two of a three part series about business finance. Please review the Part One article, Financing a Small Business, before reading this article. After reading this article, we recommend reading the Part Three article, How to Analyze Funding Sources & Strategies for Your Business.

You are developing your Business Plan and analyzing your capital requirements, so now you have to determine where to get your Capital and at what price. This Article is divided into Two Main Sections:

• Section One: Business Capital Needs, Pitfalls and Considerations

You need to understand clearly how Capital works; what your Capital and Business Finance Needs are; the Capital and Commercial Loan Pitfalls to avoid; and how to Analyze Your Capital Needs, to determine the right Capital Finance Structure for your Business, before determining what sources and forms of Commercial Finance are applicable and suited for your Business.

• Section Two: Forms & Sources of Commercial Finance

With your Business Capital Finance Analysis completed, it is good to understand the Forms and Sources of Commercial Loans in the marketplace so you can determine the right mix of financial products to meet your Business Finance & Capital Strategy.

I. Business Capital Needs, Pitfalls & Considerations

A. Business Capital Needs: There are many reasons why a Business needs additional Capital. Some of them are (often in combination):

1. Cost Saving Opportunities:

a. Obtaining better Equipment which will lower production costs, stream line operations, and results in reduced operating expenses.

b. Taking advantage of Quantity Discounts or Increasing Stock prior to a supplier’s price increases, to realize substantial savings on your Inventory Purchases.

2. Growth & Expansion:

a. Take advantage of developed Opportunities.

b. Growth translates into a larger volume of Receivables and bigger inventories.

c. Need to hold larger sums of Cash to meet obligations with outside vendors and internal business needs.

d. Expand new branches, new products or increased capacities.

3. Inventory Control:

a. Seasonal events which demand building up inventories and staffing in advance- receivables may not be fully collected until well after the season ends.

b. Mismanagement of Assets have allowed Inventory and Accounts Receivables to be over or under stocked.

4. Economic Conditions Change:

a. Sales and profits have declined temporarily.

b. Due to changing Economics, customers are slower and longer to pay.

5. Cash Crunch:

a. Can’t meet current repayment of obligations and debts.

b. Failing to keep sufficient Retained Earnings in the Business.

B. Capital Funding Pitfalls to Avoid:

1. Not using Financial Professionals and Business Consultants to determine the appropriate Business Finance Vehicles and Structures.

2. The Company’s long-term goals have changed, and its Finance Strategy hasn’t been modified to reflect the changes.

3. Confusing short-term with long-term Capital needs, thereby, using inappropriate Finance Instruments and Products.

4. Unaware of changes in Financial Product Offerings and Terms in the Marketplace.

5. Lack of banking and funding relationship.

6. Lack of long-term and short-term planning.

7. Poorly conceived or executed Capital Structure and Finance Strategy.

8. Equity Finance that has severe Anti-Dilution Provisions; expensive terms in convertible debt, grants, warrants and options; securities law compliance issues; and too many unsophisticated investors.

9. R & D Structures and Joint Ventures/ Partnerships which cause equity dilution, cash flow drains and expensive licensing agreements.

10. Involved with a Finance Structure which hampers acquisitions, growth or Public offering alternatives.

11. Capital & Finance Instruments which aren’t customized to a company’s specific requirements.

12. Not utilizing specialized Accountants, Attorneys and Finance Professionals to: formulate long-term and short-term finance strategies and objectives; save considerable time and money in finding appropriate funding instruments and sources; provide realistic transaction and terms perspectives and outlooks; and put together an effective Funding Negotiation Team and Process.

13. Not being involved in the Finance Strategy Implementation enough and relying on loan brokers and finance intermediaries who don’t know your Short-Term and Long-Term Funding Needs and Requirements adequately.

C. Business Capital Considerations:

Things to consider when formulating and analyzing your Business Finance Strategy:

1. Short-Term Financing Strategy:

a. Inventory Control

b. Working Capital & Cash Needs

c. Accounts Receivables Management

d. Accounts Payable Management

e. Contingency Fund

f. Opportunity Fund

2. Long-Term Finance Strategy:

a. Equity split arrangements with Founders, Management, Key Employees, Partners and Investors.

b. Does Present Business Financing meet Long-Term Objectives?

c. Securities Law Compliance.

d. Liquidity needs and requirements.

e. Good fit with Investor Groups and Venture Capital Firms who can help meet long term finance goals and bring needed resources to bear.

f. Adequately planning Financing Rounds and Stages in your Company’s Growth Plans. Too many rounds or stages without adequate levels of Capital Infusions can increase transactional costs, absorb too much of your Company’s time, inhibit timely development when needed, cause a strain of low cash reserves and reduce future finance bargaining leverage.

g. Formulate an Investor/ Venture Capital Profile which meets your Company’s Long-Term goals.

h. Raising too much Capital or the wrong type of Capital in the Initial Round without using reasonably Staged Funding Strategy. Too much Capital is as expensive as too little capital, causing similar cash strains on the business. Not finding a good mix between Debt and Equity Finance can create a severe strain on cash flow (too much Debt) or hamper future long term profitability (too much Equity or the terms are too expensive).

i. Linking your Strategic Plan’s Objectives, Goals, Milestones and Performance with your Equity Funding Rounds’ timing, terms and amounts. Ensure you are not just trying to reach your Financial Goals but also meeting Managements’ Milestones. Venture Capital’s performance outlook (when considering another round of funding) may not be solely reliant on Financial Performance, as much as, concerns about whether management is reaching its prescribed goals and milestones (quantitative and qualitative).

j. Link Your Finance Strategy’s Funding Rounds and Events to your Strategic Plan’s growth objectives so that your Business Valuation has increased to a level which allows you to significantly reduce the risk for follow on funding from Investors and Commercial Lenders.

3. Well Designed Investor Profile:

a. Does the investor share your Company’s Vision, Mission and objectives?

b. Do your liquidity goals coincide with the Investor?

c. Does the Investor bring the added expertise and resources your Company needs to be successful?

d. Does the Investor have too many other commitments?

e. Will the Investor be a long term of short term partner?

f. Can the Investor provide additional capital if required?

g. Is the prospective Investor Group well connected in your Industry? Have Credibility in your Industry? What contacts do they have and how can they assist you in developing important relationships?

h. Low quality Investors can lower your Company’s credibility in your business Community and discourage future Investor participation.

i. Unsophisticated Individual Investors:

i. Can have too many demands on your Executives & Managers.

ii. Can cause interference with Company Operations.

iii. Won’t stick through the tough times.

iv. Can be more risk adverse than they originally indicated.

v. Can create litigation issues.

vi. Can be slow in making additional capital infusions.

vii. Can discourage Sophisticated Investors from coming.

viii. Can be too many individual Investors to effectively manage.

Note: Groups of Professional Investors or Venture Capital Firms can often alleviate the above problems.

4. Supplier & Industry Relationships:

a. Will your Lenders, Investors, Joint Venture of Strategic Partners adversely affect potential customer or supplier relationships?

b. Can any of your Suppliers, Vendors or Industry Relationships be an investor in your Company? Fit?

c. Is your Company viewed by any of your Suppliers, Vendors or Alliances as an acquisition target? Will they thwart any other potential investor interest? Will it adversely affect a public offering potential?

5. Financing Structure:

a. Is it closely aligned and a result of your Strategic Plan’s Objectives and Goals?

b. Is it flexible?

c. Is there room for negotiation?

d. What control and performance mechanisms are parts of the structure?

e. Have you run various Debt & Equity mix combinations and scenarios to see the effect on your Cash Flow and Profit & Loss?

6. Financing Cost Considerations:

a. Points

b. Commitment Fee

c. Loan Broker Fee

d. Legal Fees

e. Accounting Fees

f. Consultant Fees

g. Equity Compensation

h. Warrants

i. Options

j. Due Diligence Fees

k. Appraisal & Valuation Fees

l. Guarantees

m. Insurance

n. Misc Costs in Loan Conditions

o. Pre payment Penalties

p. Covenants

q. Advances

r. Default Provisions

s. Interest Only

t. Pay down Schedule

u. Interest Rate

v. Loan to Value or Cost

7. Financing Alternatives Impact on Financial Statements, Cash Flow, Accounting & Taxes:

a. Debt Service/ Debt Capacity

b. Dividends

c. Equity Agreements

d. Redemptions

e. Sinking Funds

f. Licensing Fees

g. Royalty Payments

h. Debt to Equity Ratio

i. Working Capital Flow

j. Acid Test Ratio

k. Return on Equity

l. Cost of Debt

m. Cost of Equity Capital

n. Zeta Score

Note: For a detailed explanation of the above Financial Ratios, Formulas and Calculations please see ABC Business Consulting’s Comprehensive Business Plan Guide & Workbook.

8. Funding Schedule & Deadlines:

a. Is your Funding Schedule in synch with your Company’s Strategic Plan?

b. Is your funding schedule set up to maximize your valuation, thereby, minimizing dilution and lending/ investment risk?

c. Is your funding schedule set up to coincide with major Company Milestones?

d. Contingency Plans

e. How flexible is your Plan? Back up Alternatives?

9. Executive and Management Time and Role Requirements:

a. Who is to be involved in the financing process?

b. Roles to be assumed?

c. Time constraints.

d. Use of a Consultant?

10. Funding Venture / Project / Company Overview & Fact Sheet: Suggested format for targeting Commercial Lenders:

a. Company Profile

b. Product & Service Description

c. Experience & Track Record

d. Market

e. Financial

f. Due Diligence

II. Forms & Sources of Commercial Finance

A. Overview of different Forms & Sources of Commercial Loans:

1. Debt:

a. Term Loan

b. Revolving Debt

c. Credit Lines

d. Notes & Debentures

e. Secured & Unsecured

f. Recourse & Non-Recourse

2. Equity:

a. Private Placements

b. Pure Equity Stake

c. Common Stock

d. Preferred Shares

e. Convertible Debt / Preferred

f. Convertible Notes & Debentures

3. Factoring & Accounts Receivable Finance / Inventory Finance

4. Equipment / Machinery Lease Finance:

a. Sale- Lease Back

b. Leveraged Leases

5. Royalty, Joint Venture & Equity R & D Funding

6. Government Based Funding Programs:

a. SBA Guarantees

b. Industrial development bond finance

c. Grant Programs

d. Start-Up Incubators

e. SBIC

f. IMF

g. World Bank

7. Alternative Forms of Business Finance:

a. Joint Ventures

b. Strategic Alliances

c. Contractual Collaborations

d. Licensing, Distributing & Manufacturing Agreements

e. Customer & Supplier Advances & Finance

f. Warrants & Options in Equity offered to your Company’s Lenders, Lessors, Servicers, Customers, Suppliers, Vendors, etc.

B. Short-Term & Long-Term Commercial Finance

1. Short-Term: Generally, finance needs of less than one year.

a. Assets that turnover quickly such as Accounts Receivables and Inventory. 30-60 Day Terms.

b. Seasonal Finance Needs.

c. Work-In-Progress Inventory Finance: i.e. Builders, Contractors.

d. Working Capital

e. Rolling Line of Credit

f. Manufacturer & Wholesaler Receivables & Inventory Finance: 60-90-120 Day Terms

g. Contingency Fund

h. Opportunity Fund

2. Long-Term: Generally Business Finance needs of more than 1 year.

a. Fixed Assets: Property, Plant, Equipment

b. Short Term Finance Requirements that recur on a Regular Basis.

c. Short Term Needs that better dealt with as a Long Term Outlook.*

d. Funding to provide consistent, steady, increasing Sales and Profits year to year.

*: Keep in mind the Matching Rule: short term needs = short term funding and long term needs = long term funding, but sometimes adapting this rule for your particular circumstances is necessary.

C. Internal & External Sources of Business Capital

1. Overview:

a. Founders’, Principals’, Management Cash

b. Business Associates

c. Family

d. Individual Investors

e. Venture Capital

f. Investment Banks

g. Banks & Credit Unions

h. Business Finance Companies

i. Lease Finance Companies

j. Suppliers/ Customers/ Industry Lenders

k. Joint Ventures & Strategic Partnerships

l. Commercial Loan Brokers

m. Professional Legal & Accounting Intermediaries

n. Government Grants, Loans & Guarantees

2. Internal Sources of Business Capital:

a. Cash Flows

b. Accelerating Receivables Collections

c. Changing Collection Terms

d. Disposing of Surplus Inventory

e. Retained Earnings

f. Cost Cutting & Cost Saving Strategies

g. Change Accounts Payable Terms

h. Asset Management: Disposing of old or poor performing Assets

i. Cost Control Mechanisms

j. Budgeting Process

k. Productivity Measures

l. Personal Investments of Company Principals

3. External Sources of Business Capital & Finance:

a. Suppliers/ Customers Trade Credit: Strategies:

i. Extension to Invoice Pay Dates

ii. Cash Discounts for Early Payment

iii. Make Payment on last day due if no Cash Discount is allowed

iv. Extend Payment Terms: i.e. 30 days after the end of the month verses 30 days from receipt, buying you an average of 15 days.

v. Need a Capital increase in 60-90 days to meet demand.

vi. Reduce Delinquency Late Fees

vii. Issuing a Note (promise to pay) for a shipment, with a prescribed later date payment plan. Readily available and fast. Less red-tape. Use for limited time frames. Don’t hurt Supplier & Customer relationships.

b. Debt Capital Overview:

i. Term: 30-60-90-120 Day Term

1-5-10-15 Year Term

ii. Bank Line of Credit: Secured & Unsecured

iii. Real Estate Loans

iv. Equipment/ Machinery Purchase

v. Inventory Finance

vi. Accounts Receivables Factoring/ Assignments

c. Bank/ Commercial Lender Finance:

i. Local Banks/ Community Banks

ii. Credit Unions: often much more personal than Banks

iii. Bank Finance can be slow

iv. Loan Package is critical to successful, timely Bank Finance.

v. Develop strong relationships with Bankers. If your Banker can’t help your Company with a Finance need, he or she knows who can.

vi. Deal with at Least the Vice President level at the Bank or Credit Union.

vii. Use local / Community Banks for Regional needs and Large Banks for National & International needs.

viii. Understand the Bank’s lending process so you can facilitate your loan’s progress.

ix. Network with Bank Presidents at Chamber of Commerce and Industry Events

x. Consider Syndication for large deal. Hire Syndication Group.

xi. Banking is a lot about Trust & Track Record.

xii. Network with Attorneys & Accountants to find the right Banker for your Company’s needs.

xiii. Use Trade Associations for strong Banking referrals.

xiv. Find Banks that use SBA Guarantees to reduce risk and leverage Loan to Value & Loan to Cost.

xv. Don’t go with the cheapest terms; go with the right Banking relationship and financial products for your Business. The Long-Term payoff is much better.

xvi. Look for Long-Term relationships. Make your Banker an integral part of your business. Invite and include your Banker at Company Events and Announcements. Send your Banker Business updates on a consistent basis. Include your Banker when giving Suppliers and Customers Company tours.

xvii. Work with Banks that can customize terms for your Commercial Loan Requirements.

xviii. Understand how to use the Zeta Scoring System to your advantage- please see ABC Business Consulting’s Business Plan Workbook for a detailed explanation and related formulas on the Bank Zeta Scoring System.

D. Equity Capital / Venture Capital Finance:

1. Overview: Venture Capitalist’s Hot Buttons: What VC Look For:

a. Look for High-Growth opportunities.

b. Look strongly at the Entrepreneur’s Track Record.

c. Rates of Return Outlooks of 30-60% dependent upon deal risk and stage.

d. 3-5 year Investment Term on Average.

e. Needs to be good timing with the Fund’s Allocation Strategy.

f. Solid Business Plan, Executive Summary, Marketing Plan, Strategic Plan, Financials and Investment Overview are critical to gain a VC’s attention among the hundreds of opportunities being considered.

g. Play the numbers game. Two deals out of ten may only be successful so getting VC’s attention is challenging.

h. Look for unique, proprietary characteristics in your Product or Service.

i. Require Competitive Edge and Strong Barriers to Entry.

j. Collateral is less of an issue but having a Seat on your Board is often mandatory.

k. Look for excellent references and industry relationships in potential Companies.

2. Venture Capital Process, Strategies & Objectives:

Venture Capital Process:

a. It will take you 4-6 weeks to develop your Business Plan, and while you are developing your Plan, you should be researching Venture Capital Funds.

b. A typical Funding Process Timetable:

i. 4 to 6 weeks funding research while developing your Business Plan and before the Finance initiative begins.

ii. Weeks 1-2: Establish initial contact of the top 3 Venture Capital Fund picks.

iii. Week 3: Email the Long Form Version of your Executive Summary and Investment Overview to the 3 Funds.

iv. Weeks 4-6: Initial conference calls and meetings. 20-30 minute Deal Presentation.

v. Weeks 7-14: Follow Up meetings; present Business Plan, Loan Package and complete Due Diligence requirements.

vi. Week 15: Offers received.

vii. Weeks 16-22: Determine which offer is best for your Company. Negotiate Deal Terms. Accept Term Sheet. Sign Commitment.

viii. Weeks 23-24: Closing and Funding.

Note: From the time you start developing your Business Plan until you receive Venture Capital Funding will be about seven months, so ensure you have enough self-funding for your first year of start-up to give you maximum flexibility and enough time to secure a good Equity Deal.

c. Venture Capital works with their Investment Companies very closely. 3-5 years being the average time until Exit.

d. ROI for a VC Fund is over the entire pool of funds, not an individual company. So remember you are just a number to them and up to you to prove yourself with Effective Management and Solid Fiscal Performance.

e. Venture Capital looks for a Distinct and Unique Product or Service; Competitive Edge; Original or Marketable Innovation; large and growing Market Niche; Solid Management Team; and to Reduce Risk while Increasing Valuation over Time.

f. Rounds: These vary from Sector to Sector and among different VC Firms. An approximate Round Process is:

i. Round One: Usually $2-5 Million for a small start-up Company. Up to 60% VC ownership. Seed round.

ii. Round Two: Product Developed and Tested in the Market. Looking for 2 to 3 times the initial value. Development Round.

iii. Round Three: Expansion Capital. VC brings in “Zaibatsu” relationships or relationships with other Companies to help expansion. Attracting Company Talent, finding the right Market-Oriented CEO as needed.

iv. Exit Round: IPO, Sell Company, VC sells Stake or Merger.

Note: It is typical to have a different VC Firm for each round, with the earlier Venture Capitalists being bought down over time by the Company and/ or the subsequent VC Rounds. This minimizes the original VC’s risk, ensures anti-dilution and gives the Entrepreneur control back in the Company, if he does a good job. Original VC funds can and will remain until the Exit Round, which will be typically in 3-5 years but more recently up to 7 years.

g. Finding Venture Capital Funds:

i. A lot of research and networking. Utilize readily available databases to find 20 strong fits. Use your networking and connections to be “introduced” to 5. Close the deal.

ii. It is that simple and that hard.

iii. Utilize developed connections in the National Venture Capital Association.

iv. Easy Info Find is an inexpensive, very expansive, easily searched VC database.

v. Use online VC networks to establish connections but DON’T shop your deal on the Network. Excessive shopping kills VC deals faster than anything.

vi. Retain a Private Equity Law Firm specializing in your Sector. They can guide you through the VC process, as well as, be a valuable VC networking facility.

vii. Timing is everything. You may find the right fund but they are no longer funding. Ask them for a referral.

h. Venture Capital Strategies:

i. You can seek Venture Capital for any growth Phase.

ii. VC is Equity Participation through the use of Stock Ownership, Warrants, Options and Convertible Securities/ Debt.

iii. A Venture Capitalist wants just enough Control to justify the investment risk. Two of the important Risk Models VC Firms use to determine the Risk of an Opportunity are:

Risk/ Return Evaluation:

Product or Service Level:

• Level 1: Idea Stage. Not Operable. Market Assumptions.
• Level 2: Pilot/ Test Stage. Market refined.
• Level 3: Fully Developed. Few Customers. Market defined.
• Level 4: Satisfied Customers. Market Established.

Management Level:

• Level 1: Entrepreneur.
• Level 2: Few Founders.
• Level 3: Partial Management Team.
• Level 4: Full Management Team. Highly Experienced.

Note: The higher the Level from both Determinants (Product or Service & Management), the less Risk for a higher Return. 4/4 would be most desirable and cost the Entrepreneur the least. 1/1 would be the least desirable and cost the Entrepreneur the most. A 2/2 or 3/3 are good Level Combinations to shoot for prior to approaching Venture Capital if financially feasible.

Present Value/ Future Value Evaluation:

• Scenario: Expected ROI is 35% per year, without inflation, over 5 years. Present Value of Earnings is $4.5M. Future Value Earnings in 5 years is $15M.

• VC Equity Share is calculated: $4.5M divided by $15M = 30%.
• Maximum Investment is 10 times first year gross (expected) earnings, which in this example is about $500,000.
• Conclusions: $5M maximum investment for 30% of the Company at 3/3 Level over a 3 year period. A 1/1 Level, Seed/Start Up Investment would be a 45-50% Equity Stake, with an expected ROI of 60%.

iv. Don’ts in a Venture Capital Strategy:

• Glossy Business Plans with lots of pictures and graphics, with little substance. We call these “MBA Graduate Plans” – they look good but little teeth or substance.
• Relying too much on an intermediary or broker. VC wants to know how you think. Use a Business Consultant to help you develop a Business Plan, VC Proposals, Investment Overviews, Loan Packages and a Financial Strategy. Use an experienced Loan Broker, specializing in VC, to introduce you to VC networks. But you approach and negotiate (with the help of a Private Equity Law Firm) with VC. They are principally interested in you, the entrepreneur, the founders and management.
• Not confident. Confidence in your opportunity shows character- a major deciding factor for VC.
• Shop the deal excessively. Find 5 VC firms and approach 3. Excessive shopping dilutes a deal’s attractiveness.

v. Do’s in a VC Strategy:

• Hire an experienced Business Consultant from the very early stages of founding your Company.
• Develop a Financial Structure & Plan and correlate the Plan to a Strategy in identifying and approaching VC Firms.
• Find a VC Firm that will bring more than just money to the table: Resources, connections, strategic partnerships, etc. in your Industry.
• Experienced Management Team, backed by solid track records and successes. “Sell” your Team.
• Develop a Comprehensive Business Plan so your Business Concept is well developed.
• Be able to articulate your opportunity in 2 minutes. Then VC might give an opportunity at an initial 30 minute presentation.
• Developed Product Plan, Marketing Plan and Strategic Plan so you can demonstrate realistic, quantitative data and projections.
• Highly defined, developed Market Niches.
• Demonstrate Competitive Edge and Barriers to Entry.
• Minimize Risks: Strategic & Investment Risks.
• Grants of Stock may be the structure which Investors prefer; however, this structure can dilute your ownership significantly, while giving up some control in your Company’s decisions (depending on the amount of stock granted). By contrast, options can be used to combat the dilution and control factors, yet still make an Investor happy. Options are just as valuable as stock; can be issued in agreed amounts; and the Investor participates after the money is invested based on the agreed option price- this aligns the Investors returns with performance.
• Be flexible with negotiations. Have your Private Equity Law Firm do a run through VC Role Negotiation Session to prep your negotiating skills.
• Look for a VC’s good track record and research their funded companies. Does this meet your expectations and requirements?

vi. Venture Capital Objectives:

• It is important to research your potential Venture Capital Funds to determine exactly what they look for in an investment, what their parameters are and what they specialize in. A VC Fund will have a detailed website which will layout their Fund’s Objectives. You can also find this information in their Offering Prospectus/ Memorandum to their Investors. Below is an outline of a VC firm’s Objectives to give you an idea what to look for:

vii. Investment Objectives:

• Rate of Return expectations.
• Long- term or short- term capital appreciation.
• Early, Middle or Late Stage Companies.
• Sectors interested in.
• High growth potential.
• Liquidity Options.
• Expertise, Experience & Reputation of the Fund.
• Advisory Board Members.
• Members of the Fund.

viii. Investment Criteria:

• Evaluate in terms of Management, Product, Markets, Financials, and Business Stage.
• Highly competent and motivated management team.
• Proprietary Product or service that: meets a strong market need: Favorable price and cost relationship.
• A market which has a favorable mix of Size, Growth, Competitive Barriers and the potential for high volume sales.
• Management:

–People are the most important element in a Company’s success

–Balanced Team

–Superior Skills

–Team leader with a track record

–Ability to retain and attract talent

–Understands Planning & Control

–Can make difficult decisions

–Can work with professional advisors

–Accept assistance from the Fund Members

–Commitment to the Venture

–Clearly understands the Funds’ outlook on liquidity, rate of return and investment objectives.

–Above all, integrity, character, accountability and high business ethics

viv. Product or Service:

• Types of Products and Services in the Fund’s Sectors which are of interest.
• Competitive Edge: Cost, Quality & Performance.
• Premium prices achievable?
• High Yield Profit Margins.
• Dominate or Control a significant market share.

x. Market:

• Young, growing fast and provides opportunity
• Defined market niche.
• Dominance in that niche.
• Niche market should be small enough not to attract big company competitors, yet has a strong potential for expansion.
• Realistic Marketing Plan.
• Marketing Team Leaders should have extensive industry contacts with sales people, sales reps and distributors.

xi. Financial Outlook (these numbers are based on a technology company):

• $20M in Sales & Earnings, after taxes, within 5 years. Generate Return on Assets greater than 20%.
• Venture is not capital intensive.
• Project prices & profit margins that can cushion early round obstacles.
• Reaching Break Even in 2 years.
• If it is a capital intensive deal, should be capable of adding substantial value early on and attract later rounds of funding at higher pricing.
• Maximum of 10 to 1 return on investment for startups.
• Liquidity in 5 years for startups.
• Later stage companies: ROI of 5 to 1 in 5 years or 3 to 1 in 3 years.

xii. Stage:

• Mostly early stage but will consider later stage with high growth opportunities.
• Consider small public companies as well as private.
• Spin offs as a result of re-structuring and rejuvenation.

xiii. Operating Policies:

• Can change at the fund’s discretion
• Geography:

– Any geographic area but most companies are in the West and Silicon Valley, China, Taiwan and Singapore.

• Monitoring Investments:

– Free access to management

– Fund receives Business Plan updates regularly

– Fund will not seek majority ownership or run the venture

– Help the venture attract Management to fill gaps and develop its business plan in the early stages of investment

– Board Representation

– Fund will provide expertise and assistance with securing key employees, filling management gaps, operational planning, key customer and supplier relationships, joint ventures, financing, security offerings, acquisitions and harvest strategies

xiv. Venture Capital Structure & Terms:

• Investor Investment Objectives: Please see the previous section.

–Consult the Fund’s Website and Prospectus for their Investment Objectives’ details to determine your deal strictly matches the Fund’s criteria.

• Investor Profile: Obtain additional information on the Venture Capital Firm from industry contacts and its portfolio companies.

• Structure Complexity: Often structured as purchases of Convertible Preferred Stock, with grants and contractual right.

–Negotiation of terms mostly occurs at the Term Sheet Phase (see sample term sheet following).

Often leaves open the need for future funding as circumstance dictates.

• Costs: Travel, Due Diligence, Commitment Fee, Legal, Accounting and Consulting. $25,000 to $50,000 is typical, depending on size, scope stage and complexity of the deal.
• Financial Statement, Cash Flow, Accounting & Tax Impacts:

–Early stage Companies are high risk so the pay back must be high in relation to the start-up’s assets, which often results in a Harvest goal of a Company Sale or Buy Out at a much higher valuation. Carefully determine how the intricacies of the Fund’s investment will affect your financial well-being, growth and exit strategy.

• Types of Securities:

–Most common are Common Stock, Convertible Preferred Stock and Convertible Debt Structures.

–Convertible Preferred Stock and Convertible Debt are often preferred forms of securities. Convertible Preferred allows a lower valuation of the underlying Common Stock, giving rise to inexpensive Employee Stock Option Incentive Plans. There are other accounting advantages and equity negotiation advantages to a lower valuation of Common Stock: ie. Capital Gains Tax Implications, Equity Participation, etc

• ü Convertible Preferred Stock:

–It is convertible into Common Stock per agreed on Ratios, subject to adjustment for Stock Splits, Reverse Stock Splits, Dividends, etc.

–Voting Power is equivalent to the number of Common Stock in which it can be converted.

• Liquidation Preference: Preferred stock receives all liquidation proceeds up to the original sales price of the Preferred Stock, after which the remaining liquidation proceeds are shared among Common and Preferred Stock Holders as per agreement.

–Usually no mandatory dividends or sinking fund arrangement

–Permissive redemption

• VC Constraints on a Company:

–Company Valuation

–Equity Dilution

–Amount Invested at a time

–Board Representation

• Anti-Dilution Protection:

–Price-Based: If the value of a Company fails to achieve expected levels in subsequent financing rounds, investors can seek an increase in the amount of equity for their investment.

–Adjustment triggered by a later valuation of say less than 100-120% of the prior valuation.

–Try to negotiate a less aggressive Anti-Dilution provision such as a Weighted Average Adjustment which considers both the valuation and the equity dilution involved.

–Avoid Price-Based Anti-Dilution Provisions that extend to more than one subsequent finance round, which creates dilution uncertainties for later investors.

–Beware of a Ratcheted Adjustment Provision which only considers the valuation element.

• Registration Rights:

–Demand Rights: VC obtains the right to make a Company perform a Public Offering(s).

–Piggyback Rights: VC reserves the right to participate in Public offerings initiated by the Company or others.

• Pre-emptive Rights: Investor has the right to purchase a Pro-Rata Portion of the Company Securities sold in subsequent offerings.
• Covenants & Restrictions:

–Contractual restrictions on salaries

–Restriction on outside business activities of principals and management

–Stock Repurchase if Management or Founders leave the Company within a specified time period, usually 2 to 5 years.

• Representations & Warranties:

–Company’s Valid Existence

–Accurate Due Diligence

–Accurate depiction of Company Organization & Ownership

–Company in Good Standing

–Company/ Principals have the Power & Authority to enter into the Financing transaction

–Litigation Disclosures

–Material Agreements, Contracts, Memorandums

–Contractual Default Disclosures

–Compliance with Laws, Regulations and Ordinances

–Adequate Trade Secrets, Propriety Protections, Patent Rights, License Rights and Royalty Rights necessary for Company operations

–Not infringing on the Rights of other Companies

–Property Titles

–Financial Statement Accuracy

–Good Faith Preparation of Business Plan

xv. Equity Investor’s Compensation:

• Income from Company Earnings: either as Dividends or Drawings (ie. Partnership)
• Capital Gains:

–Sale of the Company

–VC sells interest back to Company or to other Investors

• Dividend payouts are often minimized or accumulated so Company Cash Flows aren’t severely affected

–Retained Earnings realize a Greater Capital Gain for an Investor which can be more tax advantaged

–A combination of Dividend and Capital Gains payouts is common, creating a balance between Company Growth and tax advantages

• Public Offering

xvi. VC Term Sheet:

Sets forth the principal terms of the deal, normally agreed to prior to drafting the Operating Agreements. An example Term Sheet is as follows:

• Offering: 100,000 shares of Convertible Preferred Stock, Series A Represents 45% of Company’s Voting Power.
• Price per Share: $10/share; $1M in aggregate proceeds.
• Preferred Stock Voting Terms: One vote for each Common Stock Share into which the preferred is convertible on all Company matters, with the following exceptions……
• Liquidation Provision: $10/share preference over Common.
• Conversion: Subject to Anti-Dilution Adjustments.
• Anti-Dilution Terms: Weighted Average for subsequent issuances at a price below Conversion Price. Anti-Dilution protection for Stock Splits, Stock Dividends.
• Dividend Payments: 10% accrued and payable quarterly, starting at year 2.
• Redemption Procedure: Company may call Redemption at beginning of:

§ Acquisition of Company

§ IPO at excess of Redemption Price

§ 3^rd Anniversary of Issue, at the following pricing: Year 3 and prior- 110% of Conversion Price. Year 4- 108% of Conversion Price. Year 5- 104% of Conversion Price. Year 6- at Conversion Price.

• Registration Rights:

• Demand Registration: Two, at Company’s expense, for Series A Preferred. Conditions: First Demand exercisable at earlier of Company IPO or 3^rd Anniversary date of issue. Demand can’t be exercised prior to 12 months following IPO. Minimum Aggregate Proposed Offering Price of at least $3,500 per share Common Stock.
• Piggyback Registration: Conditions: Subject to cut-back at Underwriter’s Discretion. Company not required to offer opportunity to participate more than once, except for those whose holdings are at least 1% of the Company outstanding Common Stock, at time of registration.

• Representations & Warranties: Standard (please see previous section)
• Financial Information & Inspection Rights:

• Unaudited Monthly & Quarterly statements
• Audited Yearly Statements
• SEC Filings
• Stockholder Communications
• Business Plan Updates
• Visitation Rights (with notice)
• Inspect Properties
• Obtain Non-Proprietary Information on Company’s Affairs

• Board Representation: Five Members elected by Class voting. Common holders elect 2, Preferred elects 3. After Preferred Conversion, all 5 Directors elected by Common Voting as a single class.
• Pre-Emptive Rights: Right to purchase a portion of any subsequent issuance of Company Common Stock (or equivalents), based on ownership percentage of the fully diluted Company Common Stock.

E. Alternative Forms of Business Finance:

1. Boot Strap Finance & Leveraging Financial Instruments:

a. Founders Investment

b. Friends/ Family *

c. Business Associates

d. Personal Savings**

e. Leverage a Mortgage***

f. Life Insurance Loans on Cash Value**

g. Retirement Fund Loans****

h. Credit Guarantees

i. Letters of Credit

j. Pre-Commitment Letters

k. Pre-Sale Commitment Deposits

l. Insurance Guarantees

m. Customer Deposits

*: Set limits and rules; ensure done with attorneys; expectations clearly documented; worst case scenario disclosed; not at the undue expense of your friends or family.

**: Be very careful; not at the unnecessary expense or distress of your family.

***: Non-Debt Home Equity Venture Funds: Pledge your Home Equity Appreciation (or Depreciation) to an Investor who supplies cash. No loan payments, an equity deal.

****: 401(K) Small Business Financing: To avoid penalties and the personal 401(K) borrowing limit, the Business Owner transfers retirement funds to a specialty 401(K) Plan for new Businesses, which allows the Business Owner to tap the full account balance. Use of these funds is considered an investment rather than a loan. There are no limits on borrowing, and it carries no tax penalties or minimum payment limits.

Note: Company Founders need to bring at least 10% Cash to the table to start a Company successfully and 20% owner contribution is optimal. Boot Strapping and leveraging can help you get in the 10-20% Cash Contribution range. See the following sections on other Alternative Funding avenues you can utilize in the early development of your Company.

2. Joint Venture & Strategic Alliances:

a. May obviate the need for other sources of Finance.

b. Shared resources, at a lowered cost and lower risk.

c. Understand clearly the Opportunity Lost Value if pursued as separate entities.

d. Carefully evaluate:

• Each party’s objectives
• Likelihood of Success
• Appropriate Structure
• Terms
• Roles
• Determine if the Relationship is preferable to financing the deal independently.

e. Evaluate the Following Key Elements of a Joint Venture:

• Objectives
• Anti-Trust Issues
• Resources
• Funding
• Technology
• Management & Personnel
• Location & Logistics
• Corporate Culture Fit
• Form of Relationship
• Control
• Exit
• Termination
• Liquidation/ Liquidity Vehicle
• Buy-Sell Agreement

Note: See ABC Business Consulting’s Business Plan Guide & Workbook for a detailed Analysis on Joint Ventures and more details on the above JV Evaluation.

3. Angel Investors:

a. Informal, yet sophisticated investors, who specialize in early, seed investing.

b. Angels are great to use in the very early stages to develop your Company to where a Venture Capital Firm would be more apt to invest.

c. Much faster to acquire than VC money. Can obtain funds often in 1-2 months.

d. ROI expectation often less than VC; 20% annual compounded ROI is a good starting point for Angel Investment.

e. Deal can be structured any way the entrepreneur and the angel want to set it up; very flexible.

• Combination of Equity & Debt is common.

f. Angels can be located with local Newspaper ads; in VC Clubs, breakfast clubs or networking events.

ü Can find angles through attorneys, accountants, consultants, financial planners, brokers, etc.

g. Angel or VC? Here is some guidance in determining whether your finance needs require Venture Capital Investment or an Angel Investor:

• Amount of money being raised for the current round: Less than $1M should be Angel, unless you find a VC Fund that finances seed rounds and/ or you have a pre-existing relationship with a particular VC (and there’s a strong fit).
• Determine the total amount of money that needs to be raised over the life span of your Company: If you can get to good, positive cash flow for less than $3M, angels will probably be best.
• Type of Company: VC looks for enormous investment opportunity, returns and economies of scale, verses linear scale companies. Angels are less aggressive and happy with smaller companies and smaller investments.
• Experience: First-time entrepreneurs without much of a track record will find it easier to attract Angel money.
• Your Network: VC ties often come through personal and professional networks. Develop strong ties prior to approaching a VC Firm. Angels are great on referrals but not necessary.
• Hunt for your Lead Investor: Typically have 3 rounds of private finance with rounds 2 and 3 following a strong, successful lead investment. Be picky about finding the original, lead Angel.

3. Online Investor Networks & Online Lending:

a. Venture Capital Network is the original and probably the best.

b. These networks pool investor’s monies and venture opportunities.

c. Beware of proprietary protections and privacy concerns.

d. Be careful not to shop your deal excessively, as that will diminish your future success on subsequent finance rounds (private equity is a small world and they want fresh deals).

e. Can be a good stepping stone to VC Funding.

f. Often offer helpful resources, online chat rooms and professional relationship introductions.

g. Borrowing Online: The web has a lot of alternative small business finance options. One is On Deck Capital (www.ondeckcapital.com): they look more at your Company’s Cash Flow than your Credit Score and Tax Returns. They collect small daily debits instead of monthly payments.

3. Venture Contract Funding / Venture Capital Factoring:

a. Use your executed contracts and customer commitments to leverage into Cash in the Growth stages of your Company.

b. Expensive terms, but temporary duration.

4. Hard Money/ Bridge Finance / Mezzanine Finance:

a. Often Real Estate based but can cross collateralize into a variety of Assets (personal & business).

b. Higher Interest Rates; can have an Equity Participation component; can obtain funds in a few days to a month; the terms of the loan can be very limited (30 days to a year).

c. Less red tape; easier underwriting; stream-lined process.

d. Contingent on Appraisal / Valuation of Quick Sale Value.

e. Hard Money & Bridge Finance often require strong owner equity in the deal (20-30%).

f. Mezzanine Finance helps you leverage a higher LTV/LTC (80-95%), is equity based and has a high interest coupon.

g. Experience and Track Record is a must.

h. Consider them as short-term Rent Money.

i. Needs to be a lucrative deal to support the expensive terms (Interest Rates 10-18% with Equity Sharing in some instances).

5. Franchises:

a. Does the Franchise offer Coop Purchasing? This will help to free up money by driving down costs.

b. What discounts can you obtain through the Franchise? i.e. Software Purchases.

c. The Name Brand of a Franchisor can bring credibility and trustworthiness to the table when you are negotiating a Bank Loan. i.e. Is your Franchise a bankable brand?

• ü Especially applicable during bad economies when Commercial Loans are especially hard to obtain.
• ü Don’t forget about using the SBA Guarantee to reduce the Bank’s risk.

III. Conclusion

This article has been a Comprehensive Review of Funding Sources for your Business. Before reviewing the different Forms and Sources of Commercial Finance, we discussed a Business’ Capital Needs, Pitfalls and Considerations so you would be better informed as how to apply the Sources of Business Finance.

With the foundation established on how Business Capital Works, we then discussed in great detail the various Forms & Sources of Commercial Finance. We also discussed different Capital Structures, Strategies and Terms within these different Capital Funding Sources.

Most importantly, here are the key things to keep in mind when structuring and obtaining Commercial Finance:

1. Write a solid Business Plan

a. Ensure your Strategic Plan process encompasses your Product or Service Development, Marketing Analysis and Marketing Plan in order that your Financial Plans and Statements develop a Financial Strategy which is realistic and achievable. This will go a long way in obtaining the Funding your Company requires.

2. We recommend you self-fund and use private investment funds for 10-20% of the total required Company funding, using this money to initially develop your Company to a point where Venture Capital Funds and Commercial Lenders are more open to the opportunity. This will significantly shorten your Funds Acquisition time and obtain better Finance Structure and Terms. A great Finance mix could be:

a. Founders/ Angel Investors Cash: 20%

b. Venture Capital Early Stage: 20%

c. Bank Finance: 30%

d. Commercial Finance: 30%

Note: The lower the Founders/ Angel Investors Cash percentage, the more Venture Capital you will need, which in turn will require more Equity Sharing and less Control of your Company’s Board of Directors. Positioning your Company with an initial 20% Cash Investment, minimizes the strain Finance can have on a Growing Business. A 20% Cash Investment will develop your Company to the point which a VC Firm will be interested in your opportunity, leading the way to more Conservative Bank and Commercial Finance.

3. Do your own Funding Source Research.

a. Utilize networking and connections

b. Compare your results to what an experienced Loan Broker can do for you. Choose the best avenue.

4. Don’t Excessively Shop your Deal.

5. Be flexible in your Finance Negotiations but protect yourself.

6. Close the deal if it matches up with your Capital Financial Strategy.

a. If the proposed funding does not match up with your Strategy, utilize your back up sources or Explore Alternative Forms of Finance, using the Alternative finance on a short-term Bridge basis to buy you time and secure the funding better suited for your strategy.