raising capital

RAISING CAPITAL


RAISING CAPITAL

by

DAVID E. VANCE
Rutgers University School of Business, Camden, NJ, USA


Library of Congress Cataloging-in-Publication Data
A C.I.P. Catalogue record for this book is available
from the Library of Congress.
ISBN-10: 0-387-25319-X
free paper.
ISBN-13: 978-0387-25319-0

e-ISBN-10: 0-387-25320-3

Printed on acid-

e-ISBN-13: 978-0387-25320-6

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CONTENTS

Chapter 1

RISK, REWARD, SIZE AND TIME TO EXIT

Introduction 1
Understand Your Needs 2
What Is Capital? 4
Typical Sources of Capital 4
Risk, Reward, Transaction Size and Time 7
Risk Factors: Stages in a Company's Life Cycle 8
Factors Bearing on Reward 11
Transaction Size 12
Time to Exit 12

Chapter 2

SELF-HELP, THE ENTREPRENEUR'S
SOURCES

Introduction 17
Self-Reliance 17
How Much Capital is Necessary? 18
Seven Strategies to Get Start-up Capital 19

Chapter 3

BANKS

Introductions 33
The Banker State of Mind 33
Bank Facilities 34
Underwriting 37
Quality of Financial Data 44
Bank Covenants, Terms and Conditions 45
Myth and Mythology 47
Are Banks Reliable Partners? 48
Bank Debt Is Good 49


Contents

vi

Chapter 4

SMALL BUSINESS ADMINISTRATION

Introduction 55
Overview 55
Eligibility 56
Mechanics 57
Underwriting 58
Collateral 58
Personal Guarantees 59
Documentation 59
Loan Covenants 6 1
Loan Programs 6 1

Chapter 5

ASSET BASED LENDERS AND FACTORS

Introduction 69
Traditional Asset Based Lenders 69
Specialized Asset Based Lenders 7 1
Tranche B Lenders 7 1
Sale & Leaseback 74
Note Discounters 77
Factors 79

Chapter 6

BUSINESS MODELS, BUSINESS PLANS

Introduction 89
Why Is Capital Needed? 90
How Much Capital Is Needed? 92
Risks of Underestimating or Overestimating the Capital Needed 94
Market Assessment 94
Business Model 99
Marketing Plan 105
People to Execute the Plan 106

Chapter 7

ANGEL INVESTORS

Introduction 111
What is an Angel Investor? 111
Angels Go Where Others Fear to Tread 112
What is the Profile of an Angel? 113


Contents

vii

Angel Investment Criteria 114
What Rate of Return Do Angels Want? 122
Due Diligence 122
Angel Investor Advice 123
Where Are Angels Found? 125

Chapter 8

VENTURE CAPITAL

Introduction 139
Risk versus Reward 140
Who Needs Venture Capital? 141
Scope of Venture Capital Investments 141
The Structure of Venture Capital Firms 142
Venture Firm Operations 144
General Criteria for Making an Investment 144
Oversight 145
Costs of Using Venture Capital 145
Valuation 150
Exit Strategies 152
Venture Capital Search 155

Chapter 9

STRUCTURING THE DEAL

Introduction 163
Investment Agreement 165
Valuing the Company 165
EBITDA Multiplier Method 166
Revenue Multiplier Method 168
Discounted Cash Flow 169
Similar Companies 171
Modeling 174
Intellectual Property 176
Securities 177

Payoff Analysis 179
Exit Provisions 183
Other Investment Agreement Issues 187


...

vlll

Contents

Chapter 10 THE PITCH: LANDING THE INVESTOR
Introduction 197
Threshold Conditions 198
Sales 203
Time and Confidence Building 206
Financing Rounds 207
Pitch Format 208
The Deal Sheet 2 10

Chapter 11 SECURITIES REGULATON
Introduction 2 15
Security Defined 2 16
Why Are There Securities Laws? 2 16
Why Bother With Securities Laws? 2 16
Overview of the Regulatory Thicket 2 17
Exemptions from Federal Securities Law 2 17
Public Offerings versus Private Placements 2 18
Private Placements, Non-Public Offerings 220
Regulation D 222

Documentation for a Private Placement 228
State Securities Laws 23 1
Overview of State Regulation 233
Selecting a Lawyer 236

Chapter 12 PUBLIC OFFERINGS
Introduction 24 1
The Decision to Go Public 242
Investment Banks 245
Pricing Securities 247
Mechanics of an Initial Public Offering 25 1
Market Makers 254
IPO Road Show 254
Investment Bank Fees 255
Underwriter's Duty 257
Lock-ups: Getting Rich Slowly 258
Requirements to be Listed on Major Stock Exchanges 259
Going Private 262


Contents

Chapter 13 SMALL PUBLIC OFFERINGS
Introduction 267
Regulation of Small Public Offerings 267
State Regulation 27 1
Means of Stock Distribution 274

Chapter 14 SMALL BUSINESS INVESTMENT
COMPANIES

Introduction 287
Characteristics of SBIC Investments 288
Eligibility for SBIC Funding 292
Restrictions on SBIC Operations 293
How SBICs Raise Capital and Are Structured 293
Finding an SBIC 296
What Will an SBIC Need to Know? 298

Chapter 15 INTERNAL SOURCES OF CASH
Introduction 305
How Much Capital Is Appropriate? 306
The Cash Cycle 308
Accounts Receivable 308
Inventory 3 13
Plant, Property and Equipment 3 16
Accounts Payable 3 17

Chapter 16 BONDS
Introduction 32 1
General Characteristics of Bonds 322
Risk Minimization 322
Bond Structure 325
Federal Regulation of Bond Sales 33 1
Risk Management Strategies 333
Early Bond Redemption 336
Sinking Fund 337
Junk Bonds 338
Bond Sales in Secondary Markets 340

x

Contents

Chapter 17 COMMERCIAL PAPER
Introduction 345
Securities Regulation and the Definition of Commercial Paper 346
Who Can Issue Commercial Paper? 346
Cost of Commercial Paper 347
Managing Short Term Financial Risk 349
Managing a Commercial Paper Operation 349
Maturity Strategies 350

Chapter 18 OTHER FINANCING VEHICLES
Introduction 353
Syndicated Loans 353
Bridge Loans 354
Mezzanine Financing 355
Securitization 355
Private Investment in Public Entities (PIPES) 357
Bankruptcy and Super Priority Loans 359
Government Grants and Loans 361

Appendix A
Appendix B
Appendix C
Appendix D
Appendix E
Index 371

Future Value Interest Factor 365
Future Value Interest Factor for an Annuity 366
Present Value Interest Factor 367
Present Value Interest Factor for an Annuity 368
CD Table of Contents 369


PREFACE

All companies from the smallest to the largest need capital. Access to
capital constrains growth in good times and is necessary to survive in bad
times. Most business people think of banks when they need capital, but banks
only lend to companies that fit within a narrow range of parameters. If a
company is too small, too young, growing too fast, has an unusual product, or
is in the wrong industry, banks will not provide credit. Banks change lending
criteria as the economy changes and change industry preference as often as
they merge. Banks also constrain a company's strategic options through
conditions on loans called bank covenants. Fortunately, there is a spectrum of
non-bank capital sources that fit the needs of almost every company, whether
weak or strong, large or small.
The entrepreneur should be cautious about considering any capital
sources in isolation. For example, venture capital is often cited as the way to
grow a company, but venture capitalists (VCs) rarely invest in companies that
do not already have capital from other sources. So the material leading up to
the chapter on venture capital is an essential part of the roadmap for anyone
who wants to use venture capital. The chapters after venture capital are
important because VCs typically exit an investment within five to eight years,
so a company must have a strategy to fund that exit. The point is that
strategies for raising capital interlock over the course of a company's life.
The choices a company makes in one part of its life cycle can limit what it can

do in the future or on the other hand, the choices it makes can open new
possibilities.
Chapter one discusses the four primary factors that determine the
most appropriate source of capital for any given company: risk, reward, size
and time to exit. Not all capital sources have the same risk tolerance or reward
demand. Transaction size is important because some sources are limited as to
the amount of capital they can provide whereas other sources are not
economical below a certain size. Time to exit is an important concept because
no capital provider wants its money tied up indefinitely. Some money is more
patient that other money. Unless a company's needs exactly match a capital
source's preferences, funds will not flow.


xii

Preface

Chapter two discusses the problems an entrepreneur has raising
enough capital to develop a concept into a company or create a financial track
record that can be used to leverage other capital. It also discusses seven
sources of capital an entrepreneur can access before he or she qualify for his
or her first business loan.
Chapter three discusses banks and their world view. This provides a
base line against which to measure other capital sources. Chapter four
discusses Small Business Administration loans which are actually bank loans
guaranteed by the federal government.
Chapter five discusses asset based lenders which are often lenders of
last resort when a bank cuts off a company's credit. Banks focus on a
company's current and future profitability, but asset based lenders focus on
whether a company has enough assets to guarantee loan repayment. Included

in this broad category are commercial credit companies, tranche B or junior
lenders, and factors.
Chapter six discusses business models and business plans. Those
providing capital want to know that a company has a well thought out
business plan. In many books, the business plan boils down to inserting text
under standardized headings. In this book, the business plan focuses on
identifying customers, their numbers and their consumption patterns. It
combines a pragmatic customer focus with economic models that test whether
plans are viable before resources are committed.
Chapter seven discusses angel investors. These wealthy, private
individuals are often the first to invest in a company after friends and family.
The chapter explores what angels look for in terms of the entrepreneur, the
company and its products, a deal's structure and whether the investment
meshes with the angel's personal preferences. It also discusses where and how
to find an angel.
Chapter eight discusses what it takes to get venture capital. Less than
one percent of companies qualify for venture capital and venture capitalists
invest for limited periods of time typically five to eight years before they exit.
Venture capital is one of the most expensive sources of capital and venture
capital deals are usually structured so that if the owner entrepreneur fails to
perform, he or she can be removed. On the other hand, venture capitalists
drive companies very hard and can create great wealth in the process.
Chapter nine discusses structuring the private equity investment.
Entrepreneurs want to give little and get a lot and investors want to give little
and demand a lot. This chapter helps the entrepreneur understand the types of
demands an investor is likely to make, those which are reasonable, those
which are unreasonable, and it provides an analytical framework for deciding
how much equity the owner must give up to close a deal.
Chapter ten discusses pitching, the art of making the case that an
investor should invest in a company. The entrepreneur should understand that

he or she is competing with a large number of alternative investments and


Preface

...

Xlll

proper preparation is necessary to attract investor interest. The topics covered
in this chapter include formal and informal pitching and ways the
entrepreneur can build confidence in himself or herself and his or her
company.
Raising capital is one of the most highly regulated aspects of
business. At the federal level, the Securities and Exchange Commission
(SEC) has the dominant role, but every state has its own securities law as
well. Chapter eleven provides a broad overview of securities regulation and a
more detailed analysis of private placements. It also discusses instances
where federal securities law pre-empts a state's right to regulate securities.
Securities offered to the public must be registered with the SEC. A
company's initial public offering (IPO) is often the most difficult because of
lack experience issuing securities and because the investing public lacks
information about the company. Chapter twelve discusses the steps needed to
go public, methods for valuing a company's shares, the purpose of the IPO
road show, underwriter's fees and services, and lock-ups. This chapter also
discusses the criteria for listing a company's stock on a major exchange.
Traditional IPOs are only cost effective for very large companies
because of the complexity and expense of registration. However, securities
law provides simplified registration for small public offerings. Chapter
thirteen discusses simplified registration, the characteristics of companies that

are good candidates for a small public offering, and how a company can
distribute its stock.
Small Business Investment Companies (SBICs) are one of the best
kept secrets in capital markets. They can provide more capital than angel
investors, but do not need the high growth rates required by venture capital
firms. Chapter fourteen compares SBICs to venture capital firms in terms of
investment size and industry preference. It also describes the information
SBICs need to make a funding decision and how to find an SBIC.
By the time most entrepreneurs are ready to exit their business
thorough a sale or public offering, they have given away most of their equity
to investors. One reason is that business owners tie up cash in under
producing assets such as accounts receivable, inventory and plant and
equipment. Chapter fifteen discusses how a company can tell whether it is
over investing in assets and how to squeeze cash from exiting assets. Every
dollar an owner can squeeze out of assets is a dollar he or she does not have to
raise from an investor.
Large companies can bypass banks and borrow money by issuing
bonds to the public. Bonds are superior to bank loans because they can be
structured to have longer maturities than bank debt, lower interest rates and
fewer covenants that limit management action. Chapter sixteen discusses the
mechanics of issuing bonds as well as strategies for lowering a bond's risk
and consequently the amount of interest a company must pay to attract buyers.


xiv

Preface

Commercial paper is a mechanism for top rated companies to raise
large amounts of capital in public markets without having to register with the

SEC. Commercial paper is the least expensive form of capital and costs far
less than bank credit. Chapter seventeen discusses what qualifies as
commercial paper and the mechanics of using it.
Financiers are very creative and have designed a number of vehicles
to raise capital for specialized purposes. Chapter eighteen discusses several of
these vehicles including syndicated loans, super priority loans, bridge loans,
mezzanine financing, asset securitization, and private investment in public
entities (PIPES).
In summary, this book embraces a broad spectrum of financing
sources. Capital is available for almost every kind of company, large or small,
weak or strong, if a business person knows where to look, what to expect, and
how to ask for it.


ACKNOWLEDGEMENTS
I would like thank Carolyn Nelson who reviewed and commented on
the first eight chapters of this book. I would like to give special thanks
Jeremiah Williams who did an outstanding job of proofing, checking
equations, and making suggestions as to how to polish the book's format.
I would also like to thank the hundred and fifty graduate and undergraduate students who have used, commented on, and vetted various editions
of this text. Their comments, questions and criticisms have helped sharpen
explanations and integrate what has been a fragmented body of knowledge
about a variety of capital sources into continuum of strategic options. Their
relentless probing as to why things work as they do has helped unite theory
and practice. Anything good about this book I owe to them. The faults are my
own.


Chapter 1

RISK, REWARD, SIZE AND TIME TO EXIT

INTRODUCTION
Businesses from street vendors to billion dollar multinationals need
capital to grow, even to exist. Many businesses look to banks for capital, but
banks only lend to companies that fit a narrow profile and banks are not
always the most cost effective or reliable source of funds.
The objective of this book is to equip entrepreneurs, as well as
corporate executives, with an understanding of the options they have in
raising capital, how they can find funding, and reasonable expectations about
what it takes to close a deal. The important thing to know is that there are
many alternatives to banks. Some are more expensive than others in terms of
cash payments, equity and loss of control.
This book discusses more than a dozen alternatives to traditional
bank loans. Some only work for the biggest, most creditworthy companies,
others are designed for companies on the brink of failure. Some capital
sources provide permanent financing, while others provide financing for as
short as a day.
Raising capital is difficult because the company seeking it and the
source providing it must fit together like a lock and key. If they do not, funds
will not flow. The best capital source for any company will depend on four
factors: (i) risk, or creditworthiness of the company, (ii) reward which is how
much the company must pay, (iii) transaction size, some sources cannot
provide large amounts of capital, others are too expensive to raise small
amounts, and (iv) the time to exit, that is the time until the source wants its
money back.
A good way to understand the interaction of these factors is to
consider the plight of the entrepreneur from the time he or she starts a

2

Raising Capital

company until that company grows to the point where it requires hundreds of
millions in capital. Let us start at the beginning.
Entrepreneurs have special problems raising capital because they
generally do not fit into the tried and true, steady state mold that banks prefer.
Rather than rely on banks, entrepreneurs must live off the land and find
capital when and where they can. As a company grows from start-up to early
stage, to rapid growth, to maturity, its capital needs will change, and so will
the best source of capital.
In this chapter we will list some of those alternatives, but more
important we will set the foundation for deciding which capital source is best
for any particular company. Business people are very competitive and they
can succeed in any game where they know the rules.

UNDERSTAND YOUR NEEDS
Capital is an indispensable fuel for growth because of timing
differences between expenditures and customer payments. For capital goods
such as plant and equipment, this timing difference may be years. For
inventory, that delay might be weeks or months. Capital is also important for
product development because expenditures must be made .long before
products are shipped and customers pay. Capital is also important to fund
marketing and advertising and to develop a sales force.
One of the most important rules in raising capital is that a company
must understand itself and its needs at a deep level. Those providing capital
will probe that understanding and if they find it lacking they will walk away.
Two key questions capital suppliers will ask are: (i) why is the money
needed? and (ii) how much is needed?

Why Does the Company Need Capital?
If a business doesn't have a well thought-out idea of what it is going
to use the capital for, no one will provide it. Those providing capital want to
know if the company's object is to:
Reach cash flow "break-even?' Cash flow break-even is the
i)
point at which a company generates more cash than it needs to sustain
operations.
Fund Research & Development? Research and development
ii)
is essential to keep technology companies from falling behind. However, a
company is more likely to get funding for a specific project than for research


Risk, Reward, Size and Time to Exit

3

generally because pure research may be perceived as an unfocused drain on
resources.
iii)
Facilitate superior growth? Superior growth comes from
reinvesting in the company through advanced manufacturing technology, new
plant capacity, etc.
Dominate the market? Market domination can take the form
iv)
of a ubiquitous distribution system, heavy advertising, or superior products
and services.
Buy a competitor? Buying a competitor can be a strategic

v)
step in expanding into a new territory, acquiring patents and technology, or
increasing market share.
Stay alive? If the objective is simply to stay alive, the
vi)
investor will ask how much will be necessary to reach cash flow break-even.
Will the investor be faced with a demand for continued cash infusions to save
his or her initial investment?
vii)
To pay old bills? Payment of old bills doesn't generate new
revenue and as a result will probably not attract more capital. One
entrepreneur asked for advice on raising $50,000 to pay himself a back-salary
for the year he spent developing his idea. His chance of raising capital is zero.
Unless a company has a well articulated reason for raising capital and
can demonstrate that capital is going to create new wealth, it is unlikely to
attract funding.

How Much Is Needed?
An investor or lender needs to know that a company has a well
thought out idea of the amount of capital it needs to reach its goals. This is
important because investors and lenders want to understand the maximum
amount they will have to risk. They want to know that the entrepreneur
won't come back, asking for another infusion of cash to rescue the investor's
initial investment. More importantly, they want to know that achieving stated
goals will put the company in a position to either pay back loans or add
significant value to an equity investment.
In chapter 6, we will explore how to estimate the amount of cash that
a company should ask for. We will also discuss the concept of contingencies.
Business never unfolds exactly according to plan, so it is necessary to build
reasonable contingencies into any estimate of the amount to be raised.

Knowing the exact amount of capital needed is important because
there are risks to raising too much or too little capital. The risk in raising too


4

Raising Capital

much capital is that company owners will give up more equity than necessary
or agree to pay excess fees and interest. The risk of raising too little capital is
that a company may not be able to achieve its stated goals. That means it
may have to return to the marketplace at a time when conditions are
unfavorable, and capital suppliers may use that disadvantage to squeeze
additional concessions from the owners. Lack of adequate funding can also
result in the inability to pay bills as they come due which could push a
company in bankruptcy.

WHAT IS CAPITAL?
Assets are the resources a company has to use. It includes: cash,
accounts receivable, inventory, cars, trucks, furniture, equipment, patents,
copyrights, land and other things of value in which the company has an
ownership interest. Capital is how assets are financed. There are two forms
of capital debt and equity. Debt is money borrowed from someone else.
Equity is the money the owners have invested in a company. Examples of
debt include accounts payable, unpaid wages and taxes, bank loans, and
mortgages. Equity is what would be left over if all assets were sold at book
value and the money raised was use to pay off debt. Accountants embody this
principal in the accounting equation Eq 1.1. Liabilities is the accounting term
for debt.
Assets = Liabilities + Equity

Eq.l.1

When people talk about raising capital for a venture, they could be
talking about borrowing money, which will become a liability, or they could
be talking about accepting money in return for a share of ownership, which is
equity. Profit earned by the company, and not paid out as dividends is a kind
of equity called retained earnings.
As a general rule, raising capital by selling an ownership interest in a
company is more costly than borrowing money. Interest paid on debt is tax
deductible lowering the cost of debt. Equity is expensive because it reduces
the return of the original investors.

TYPICAL SOURCES OF CAPTIAL
The sources of capital that are available to a company will depend on
its maturity, profitability and other factors. However, it is instructive to look
at capital sources for small businesses.


Risk, Reward, Size and Time to Exit

5

Figure 1-1 is an Analysis of Start Up Funding for 328 fast growing
manufacturing and service companies.' Note that 92 percent of start up
companies used non-bank sources.
Figure 1-1 Analysis of Start Up Funding for Manufacturing Companies
Owner, Friends & Family
Investors
Bank Loans

Suppliers & Customers
Note: percentages do not equal 100% because most companies use multiple sources

Figure 1-2, is an Analysis of Sources of Seed Money for Inc. 500
Inc. is a magazine that tracks the fastest growing small
companies, and by implication, Inc. 500 companies are relatively successful.
This analysis shows a somewhat different mix of capital sources. Almost of
86 percent of funding came from non-bank sources.

Figure 1-2 Sources of Seed Capital for Inc. 500 Companies
Personal Savings
Bank Loans
Family
Employees / Partners
Friends
Venture Capital
Mortgaged Property
Government Guaranteed Loans
Other
Note: Percentages do not equal 100% because most companies use multiple sources.

Figure 1-3 is an analysis of the funding sources of companies with up
to 500 employees.3 This survey shows that as companies grow, they have
access to a much broader array of funding sources.


Raising Capital
Figure 1-3
Analysis of Funding Sources for Businesses with up to 500 Employees
Credit Cards

Commercial Banks
Leasing
Vendor / Supplier Credit
Asset Based Lenders
Personal or Home Equity Bank Loans
Angel Investors
Private Loan
Small Business Administration Loan
Selling / Pledging Accounts Receivable
Private Placement of Stock
Venture Capital
IPO
Other

50%
43%
24%
23%
20%
19%
19%
18%
6%
3%
2%
2%
1%
1%

Note: Percentages do not add to 100% because companies use multiple sources.

These surveys tell similar, though not identical stories. However,
they share a number of common elements. See Figure 1-4, Composite
Analysis of Start-up Funding. One element is that self-help, rather than banks
or funds from professional investors dominate. Self-help includes: personal
savings, loans from friends and family, credit cards and home equity loans.
Another common element is that few companies have gotten funds from
government sources.
Figure 1-4 Composite Analysis of Start-up Funding; Sources
Figure 1-1 Figure 1-2 Figure 1-3
Range
Self-Help:
Personal savings,
loans from friends
and family, credit
cards and home
home equity loans

71.0%

100.0%

69.0%

69.0%-100.0%

Banks:

13.0%

14.3%

43 .O%

13.O%-43.O%

Professional Investors:
Venture Capitalists,
Angel Investors or
Other professionals

8.0%

6.3%

61.O%

8.0%-61.O%

Government:

0.0%

0.1%

6.0%

0.0%-6.0%

All Other:

8.0%

19.8%

92.0%

8.0%-92.0%


Risk, Reward, Size and Time to Exit

RISK, REWARD, TRANSACTION SIZE AND TIME
Every financial transaction whether it is buying an insurance policy,
investing in a certificate of deposit, or buying stock involves risk, reward,
transaction size and time.4 Individual investors know the risks that he or she
is willing to take and the rewards he or she demands in return. Those with a
low risk tolerance put their money in banks, but expect low rewards in terms
of interest. Others invest in stocks with the expectation that he or she will
reap significantly higher returns than those that put their money in banks.
Transaction size also limits the options of individual investors. For example,
banks usually pay higher interest on certificates of deposit over $100,000, but
not every depositor has a $100,000. Finally, there is the issue of time to exit.
Banks usually pay higher interest to those willing to invest for the long term,
but not everyone is willing to commit funds for five or more years.
Just as individuals have risk-tolerance, reward-demands, transaction
size limitations and time preferences, so to do those supplying capital.
Businesses must realistically evaluate their risk-reward-size-time
characteristics and select a funding source that it. Otherwise the search for
funds will waste time and result in frustration.

Restating the issues as questions we must ask: How risky does the
enterprise look to the investor? For purposes of this discussion, we will call
both lenders and equity investors, investors. We must also ask: What is the
likely reward?
Few financial professionals purchase lottery tickets. Why? Even
though the potential reward for a $1 investment might be millions, the risk of
losing the investment is very high. Suppose, on the other hand, an investor
was asked to put up $100, with a one in three chance of winning $1,000? A
financial professional, certain of the odds, would probably make such an
investment. The risk of losing is still high, but the reward, relative to the risk,
is higher.
At every stage of a businesses' life cycle, investors balance risk and
reward. The riskheward assessment of a company is compared to that of
other companies and is also compared to publicly traded stocks and bonds,
bank savings accounts and U.S. Treasury Notes. Factors bearing on risk
include:

9
9

Financial Performance

9

Quality and experience of management

9

Other Risk Factors

Stage of development


Raising Capital

Stages In A Company's Life Cycle
Companies, like people are born, live and die. The bluest of the Blue
Chip companies of yesterday, are only distant memories today. The
Pennsylvania Railroad in the 1930's and1940's was the king of the hill, a sure
bet, a company people could count on. Never the less by the 1970's it went
bankrupt.
At the other end of the scale are small, start-up companies, most of
which fail in the first five years. The reasons for failure include:
(i)

Less experienced management,

(ii)

Novel, unproven, or not-fully-developed products,

(iii)

Fewer outside advisors like boards of directors, accounting or law
firms,

(iv)

Reliance on a few customers for the bulk of their sales and profits,
and

(v)

Few resources to fall back on should it make a mistake.

Large companies, on the other hand, tend to survive because they
have greater resources to fall back on if they make a mistake or must weather
an economic downturn. Their revenue is spread across many clients so the
loss of one or two is not fatal. They have broad constituencies of customers,
suppliers and investors that have a stake in assuring the company succeeds,
and are frequently public companies which means they are required to
disclose and react to problems as they develop. Large companies also have
Boards of Directors, public accountants and lawyers, all of who help guide
the decision making process. The point is that size and stage of development
are important factors in determination of risk.
Different people define the stages of a company's development
somewhat differently. However, the MoneytreeTMdefinitions analyzed in
Figure 1-5, Stages of Development, are representative.


9

Risk, Reward, Size and Time t o Exit

Stage

Figure 1-5 Stage o f ~ e v e l o ~ m e n t ~
Definition
Implication

Start-up

A start-up business is one that
is purely conceptual. No sales
have been made, and there
might not even be a prototype
product.

The product or technology may
not be feasible. Costs and prices
are only broadly known. Market
acceptance is untested.

Early Stage

An early stage company may
have some venture capital, but
it is still in product development. The investment in the
company is illiquid, but there
are prospects of becoming
liquid through an IPO or
acquisition. In a Biotech or
medical device company, it
has progressed to clinical
trials.

The product may be technically
feasible, but management may
not be able to commercialize it.
Production and distribution

costs are not well defined.
Market acceptance at needed
price points is untested.

Expansion

An expansion stage company
may be shipping products or
servicing customers, but is not
generating enough revenue to
fund growth or make steady
profits.

The product has been successfully commercialized. There is
substantial customer acceptance. Costs have been refined
and price points tested.
Management has been tested

Later Stage

A later stage company is Risks are limited to external
shipping products and making factors such as competition,
a profit.
changing markets and technology.

Financial Performance
Financial analysis provides another way to measure risk. It is
important to note that different investors look for different things. Some
focus on a company's ability to generate cash on an ongoing basis. Others
focus on whether a company can pay its bills as they become due, others are

only interested in the value of assets pledged as security.
A t this point, let us consider just one measure o f financial
performance, the debt ratio. A debt ratio the percentage o f assets financed by
debt and is simply total liabilities divided by total assets. The debt ratio plus


10

Raising Capital

the percentage of assets financed by owners' equity must equal 100%. If the
debt ratio is 75%, then for every dollar of assets financed by the owners, three
dollars is financed by creditors.
Consider what would happen if a bank had to take over a company
and sell its assets. Assume a bank seized the assets of a company with a debt
ratio of 75%. Even if the assets sold for 10% below book value, and the cost
of sales, for brokers, etc. was another lo%, then net proceeds would be 80%
of assets. If total debt were only 75% of assets there would be enough to
payoff the bank and all other creditors. But what if the debt ratio were 85%
or 90% of book value? In such cases, a bank would have a hard time paying
itself and might have to compete with other creditors for funds.
Banks usually collateralize loans by taking a lien on assets such as
accounts receivable, inventory and real estate, so that they will get first
priority in liquidation. Often they used appraisers to make sure the market
value of assets is more than enough to cover all liabilities. Use of ratios such
as the debt ratio, and asset appraisal are risk management techniques.
Investors whether debt or equity, are looking for a superior return on
their investment. Trouble signs include low gross margins, insufficient
earnings before interest taxes depreciation and amortization (EBITDA,) low
sales growth, negative cash flow and losses.

Quality and Experience of Management
Although this is a tough risk factor to analyze, there are some broad
guidelines that give some indications. Owners and managers that have started
and run businesses before are perceived as less risky than those who have not.
Those with prior work experience in their industry are perceived as less risky
than those changing industries. Finally, those with an impeccable personal
credit history appear less risky than those that appear incapable of managing
their own finances.
These general guidelines aside, angel investors, venture capitalists
and others base their assessment in part on whether they think the person
requesting funds is honest, straightforward, and driven to succeed. But while
personal characteristics are important, they are rarely able to overcome
factors like lack of industry experience or a bad personal credit history.

Other Risk Factors
The risk factors discussed above are not exhaustive, but they provide
some insight as to as to the factors investors will evaluate. Other risk factors
include: competition, market maturity, the availability of patents, copyrights