After completing this chapter, you will be able to
This chapter deals with adjusting the second business plan draft to retain, and hopefully improve, its realism, while also making it desirable to the entrepreneur and appealing to targeted investors. In some cases, a business plan should also be made to appeal to other targeted stakeholders, such as highly skilled employees who are needed, but who might not be easy to recruit unless they are offered a minority ownership position or receive reassurance from a well-written business plan.
Securing needed financing is one of the most important functions related to starting a business. This chapter describes some of the sources of financing available to start-ups.
Figure 11 – Making the Plan Appeal to Stakeholders and Desirable to the Entrepreneur (Illustration by Lee A. Swanson)
The second draft of your business plan should include realistic financial projections based on the plans outlined in the plan. As part of that exercise, you should have projected how much money you will require to start your business and to operate it over its first five years.
This stage of development focuses on the following tasks:
- Determine your medium- and longer-term goals for your business as they relate to what you want to get out of it. As you read through the following questions, consider that the answers you provide should guide the financing decisions you make now.
- Do you want to start your business and rapidly grow its value so you can profit by selling it within a short period of time to an investor?
- Do you plan to operate your business for the rest of your working life? If so, how long will that be, and what will you do with your business when you want to retire? Will you want to sell it to an investor for as high a price as you can? Will you want to pass control, and possibly ownership, to family members? Do you want to retain ownership and hire people to manage it for you? Might you want to offer ownership interests in your business to your employees over time so that they will be majority shareholders and will take control of its operations by the time you retire? What other plans do you have for your business when you retire?
- Do you want to, or will you need to, offer ownership interests in your business to attract partners or other stakeholders whose help you will need to make it thrive?
- What other decisions should you make now to help guide the financing and other choices you face?
- Entrepreneurs must make the decisions required to make their ventures desirable to them. This includes choosing the right kinds of financing options.
- Based on your goals for your business and on the amount of financing you require, identify the most desired sources of financing for your venture. You must consider how much control of your business you are willing to give up (and when you are willing to give it up), whether you expect to have adequate cash flow to be able to handle set obligations like loan payments, what financing sources will enable the growth and value accumulation you desire, and a host of other factors you need to consider to determine what financing methods will be best for you.
- An ideal business plan (1) is realistic in that it can be carried out, (2) clearly lays out plans that make the projected business outcomes desirable to the entrepreneur, and(3) is crafted to appeal to targeted investors so that they will provide the amount of money that is needed at the times it is needed.
- Incorporate the elements needed in your business plan to attract your targeted investors and make them want to invest in your company.
- It is not enough to simply identify the most desirable kinds of financing. The planned business must be structured in a way that entices targeted investors to invest in the business when the investments are needed. If you are seeking a loan, you must include the loan payments in the cash flow statement, but you might also need to identify what assets you have to pledge as security for the loan. If instead you are hoping to attract an angel investor, you should do some research to identify potential investors who have invested in your kind of business. Your business plan should then acknowledge the need for an exit strategy for angel investors and project how that exit strategy can materialize.
- Identify and analyze your venture’s critical success factors by completing what-if analyses on your financial spreadsheets. Perform what-if analyses by making copies of your financial spreadsheets and changing some key numbers, like sales increase projections, to determine what happens if your projections are off. If your venture is particularly vulnerable to the potential effects of changes to critical success factors, make needed changes to your goals, strategies, and plans in your business plan to reduce your vulnerability to critical success factors changes. Or, adjust your goals, strategies, and plans to prepare for any changes that might occur to the critical success factors.
- As you do the above, simultaneously adjust your goals, strategies, and plans in the written and financial projection parts of your plan until (1) you are satisfied that you are prepared to deal with issues that will affect your critical success factors, and (2) your projected cash flow statements, income statements, and balance sheets are realistic, consistent with healthy industry norms, and meet realistic expectations and aspirations for a healthy business.
- Consider including three sets of projected financial statements in your business plan to reflect the following scenarios: most likely, optimistic, and pessimistic.
|Providing context is essential in making the business plan appeal to various stakeholders.|
Entrepreneurs almost always require starting capital to move their ideas forward to the point where they can start their ventures. Determining the amount of money that is actually needed is tricky because that requirement can change as plans evolve. Other challenges include actually securing the amount desired and getting it when it is needed. If an entrepreneur is unable to secure the required amount or cannot get the funding when needed, they must develop new plans.
Once a venture begins to make cash sales or it starts to receive the money earned through credit sales, it can use those resources to fund some of its activities. Until then, it must get the money it needs through other sources.
Bootstrap financing is when entrepreneurs use their ingenuity to make their existing resources, including money and time, stretch as far as possible—usually out of necessity until they can transform their venture into one that outside investors will find appealing enough to invest in.
Entrepreneurs will almost always have to invest their own personal money into their start-up before others will give them any financial help. Sometimes entrepreneurs form businesses as partnerships or as multi-owner corporations with other entrepreneurs who also contribute their own personal funds to the venture.
Love money refers to money provided by friends and family who want to support an entrepreneur, often when they have no other ready source of funding after using as much of their own personal money as possible to support their start-up.
Grants and Start-up Prize Money
In some cases grants that do not need to be repaid might be provided by government or other agencies to support new venture start-ups. Sometimes entrepreneurs can enter business planning or similar competitions in which they might win money and other benefits, like free office or retail space or free legal or accounting services for a set period of time.
From an entrepreneur’s perspective, the cost of debt financing is the interest that they pay for the use of the money that they borrow. From an investor’s perspective, their reward, or return on debt financing, is the interest that they gain in addition to the return of the money that they lent to an entrepreneur or other borrower.
To provide some protection for the investor (lender) to enable them to accept an interest rate that is also acceptable for the entrepreneur (borrower), the borrower must often pledge collateral so that, if they do not pay back the loan along with interest as arranged, the lender has a way to get all or some of the money they are owed. If a borrower defaults on a loan, the lender can become the owner of the property pledged as collateral. A key objective for an entrepreneur seeking debt financing is to provide sufficient collateral to get the loan, but to not pledge so much that they put essential property at risk.
When entrepreneurs borrow money, they must paid it back subject to the terms of the loan. The loan terms include the specific interest rate that will be charged and the time period within which the loan needs to be repaid. There are several other terms or features of the loan that can be negotiated between lenders and borrowers. One such feature is whether the loan can be converted to equity at a particular point in time and according to certain criteria and subject to specific terms.
Sometimes debt financing can be in the form of trade credit, where a supplier provides product to a business but does not require payment for a specific length of time, or perhaps even until the business has sold the product to a customer. Another form of debt financing is customer advances. This might involve a customer paying in advance for a product or service so that the business has those funds available to use to pay its suppliers.
Advantages of Debt Financing
One advantage of debt financing is that the entrepreneur does not sacrifice ownership when they take out a loan and lose some control of their venture.
Another advantage of debt financing is the certainty of the payments the borrower needs to make during the term of the loan. If the borrower takes out a loan for $20,000 over a 5-year term at a fixed interest rate of 6.2% with a monthly payment schedule designed to pay off the entire loan by the end of its 5-year term, they know that each month they must pay $389 and that over the 5 years, they will have paid back the entire $20,000 loan amount plus a total of $3,340 in interest. With this certainty, the business can accurately budget its payback amount for this loan over the 5 years.
Yet another advantage of debt financing is that it allows companies to trade on equity. Trading on equity enhances the rate of return on common shareholders’ equity by using debt to financing asset purchases or to take other measures that are expected to cost less than the earnings generated by the action taken. For example, if a company borrows $20,000 at 6.2% interest and uses that money to purchase a machine it will use to increase its return on equity by 20%, then it is trading on equity. In this case, the company is financially better off than it would be if it had not taken out the loan. Of course, the inherent risk involved with this strategy is lowered when income streams are relatively stable.
Disadvantages of Debt Financing
A disadvantage of borrowing money is the need to report to those from whom you borrowed the money. This might be particularly true when lenders, often bankers, have interests or are subject to incentives that might not fully align with those of the borrower. For example, a lender will want assurances that they will get all of the money back that they lent, plus all of the interest owed to them during the term of the loan. A start-up entrepreneur, however, might struggle to generate the cash flow necessary to pay back all of the money owed according to the terms of the agreement.
Another disadvantage of borrowing is that the business’s ownership of the property it pledged as collateral for the loan is placed at risk. For many new ventures, a loan is only possible to acquire if the owner provides their personal guarantee that the money will be paid back as determined in the loan agreement, thus putting personal property at risk.
The biggest disadvantage to debt financing for start-up entrepreneurs is that there are a limited number of lenders who are interested and able to provide loans to businesses during their early stages.
From an entrepreneur’s perspective, the cost of equity financing is the loss of some control over their venture as they must now share ownership of the business. From an investor’s perspective, their reward for purchasing an ownership interest in the business is the potential to share in the business’s anticipated future success by possibly receiving dividends (a portion of the profit that is distributed to owners) and by possibly being able to sell their ownership interest to another investor (or back to the entrepreneur) for more than the amount they purchased that ownership interest for originally.
The protection for the investor, who might be a shareholder if the ownership interest is represented in the form of shares in the business, is in the influence they can exert in the company’s decision-making processes. This influence is normally proportionate to their share of the ownership in the overall business. Equity investors normally seek to earn a competitive return on their investment that is in line with the level of risk they assume by investing in the business. The riskier the investment, the higher the return the investor expects.
The following are some potential sources of equity financing for start-up entrepreneurs.
Equity crowdfunding is a relatively new way for entrepreneurs to raise capital. This involves using online methods to promote equity interests in ventures to potential investors.
Angel investors are wealthy individuals who on their own or often along with other angel investors in a network—like the Saskatchewan Capital Network—invest in new ventures in exchange for an ownership interest in the business. Sometimes angels invest in companies in exchange for convertible debt, an investment that starts off as a loan, usually in the form of a bond, that they can exercise as an option to convert to an equity interest in the company at a particular point in time for a pre-determined number of shares. Angel investors are generally less restricted in what kinds of investments they will consider than are venture capitalists, who are using other people’s pooled money. Like venture capitalists, however, they normally undertake a rigorous due diligence process to determine whether to invest in the opportunities they are considering.
Venture capital is raised when investors pool their money. The venture capital fund is then used to very carefully invest in existing but usually young companies that are expected to experience high growth. The venture capital company does not expect to invest for long and it expects to generate a large return. For example, it might expect to invest in an opportunity for a period of up to five years and then get out of the investment with five times the money it originally invested. Of course, only some investment opportunities will generate the returns hoped for and others will return far less than expected.
Venture capitalists might exert some ownership control by influencing some business decisions in cases where they believe that by doing so they can protect their investment or cause the investment to produce greater returns, but they generally prefer to invest in companies that are going to be well-run and will not require them to be involved in decisions. Venture capitalists might also provide some assistance, such as business advice, to the companies in which they invest.
A venture round refers to a phase of financing that institutional investors like venture capitalists provide to entrepreneurs. The first phase (sometimes following a seed round in which entrepreneurs themselves provide the start-up capital and then an angel round where angel investors invest in the company) is called Series A. Subsequent venture rounds are called Series B, Series C, and so on.
In general, because venture capitalists normally invest money contributed by investors and have an obligation to assume a limited amount of risk, they usually do not invest in start-up companies.
Investors follow due diligence processes to assess the risk and potential return associated with the investments they are considering. As such, entrepreneurs should maintain a due diligence file that they can quickly draw upon when a desirable potential investor expresses an interest in their venture.
A due diligence file will include copies of many of the legal papers and other important documents that a venture has accumulated and that tell the story of the enterprise. These documents will include those related to incorporation, securities it has issued or is in the process of issuing, loans, important contracts, intellectual property documents, tax information, financial statements, and other important documentation.
Advantages of Equity Financing
One important benefit to equity financing is that it does not normally require a regular payback from cash flow. Unlike with debt financing, equity investments do not usually give rise to a regular encumbrance that can increase the difficulty a young company might have in meeting its regular monthly expenses.
Second, when a firm uses equity financing, it does not need to pledge collateral, which means that the company’s assets are not placed at risk.
Another potential advantage with equity financing is that, depending upon the form of financing and who the investors are, a firm might gain valued advisers. In addition, investors who exercise their ownership rights to have a say in the operations of the company, or who otherwise provide advice and mentorship to entrepreneurs starting ventures, are usually highly motivated to help the company succeed. Investors expect to benefit only when the companies they invest in succeed, meaning that their financing incentives are aligned with those of the entrepreneur and other owners.
Disadvantages of Equity Financing
Equity financing is often more difficult to raise than debt financing. Second, when they share ownership in exchange for investment into their business, entrepreneurs give up a portion of the value that they create. If things do not go as planned, entrepreneurs can lose control of their companies to their investors.
- Personal sources (savings and other income) contributed by the business founders
- Extended personal sources (family, friends, employees, partners)
- Strategic partners, including potential customers or potential suppliers who want to have access to a business like the one proposed (and therefore might fund part of its development). For example, a building owner (supplier) might help a business develop that it considers to be a desirable tenant. Another example is when a complementary business, like a hotel, invests in a start-up, like a spa located next door, that might attract more business.
- Business Development Bank of Canada (BDC) and other institutions that specialize in supporting entrepreneurs
- BDC calls itself “Canada’s business development bank and the only financial institution dedicated exclusively to entrepreneurs” (Business Development Bank of Canada, 2016, p. 1).
- Among the services provided by BDC is start-up financing for new ventures. They provide funding for the following:
- Working capital to supplement an existing line of credit
- Fixed assets
- Fund marketing and start-up fees
- A franchise purchase
- Consulting services
(Business Development Bank of Canada, 2016)
- Angel investors
- Customers (possibly)
- They might place orders for services or products and pay for them up-front, thereby providing financing for the new business
- They might want your business to succeed so it can support their business. For example, a general contractor (future customer) might help a new plumber get started if there is a shortage of plumbers affecting the building industry in the contractor’s community
- Venture Capitalists (possibly)
- These organizations acquire pools of money to invest, so they differ from angel investors in that those making the decisions are not investing their own money—this means they usually consider investment options that have shown some success already (which isn’t usually the case in the start-up phase)
- Asset-Based Lenders (possibly)
- Lend money secured by the assets of the borrower, like the plant and equipment
- Sometimes this can be done quite creatively. For example, they might accept assets that will turn into money—like accounts receivable and inventories—as security to back up a loan.
- Small Business Investment Companies (SBICs)
- An American idea developed to bridge the gap between when small businesses need money and the time when venture capitalists might provide financing to small businesses
- SBICs are privately owned companies in the United States that are licensed by the Small Business Administration (U.S. Government) to supply equity capital, longterm loans, and management assistance to qualifying small businesses
- The Canadian equivalent is the Community Futures Corporations
- Equipment Leasing Companies
- Suppliers through Trade Credit (possibly)
- The supplier provides product now without demanding immediate payment
- This supplier will provide the product to the retailer on terms so the retailer does not need to pay the supplier for perhaps 30 or 60 or 90 days
- The retailer then can sell the product and collect the money from the customer before the retailer needs to pay supplier for it
- Factoring (possibly)
- When a business sells its accounts receivable (its invoices) to a third party (called a factor) at a discount in exchange for immediate money
- Differs from bank loan in three ways:
- The factor is interested in the value of the receivables; a bank is interested in the firm’s credit worthiness
- Factoring is not a loan: it is the purchase of a financial asset (the receivables)
- A bank loan involves two parties (lender and borrower); factoring involves three (the business, the factor, and those who owe the money)
After developing a first draft of a business plan, an entrepreneur will inevitably need to make some major adjustments to the business model and to the plans they developed to make it realistic. After that, the entrepreneur needs to shift their attention to maintaining and potentially further improving the realism of the plan while making it desirable to the entrepreneur and appealing to targeted investors. Part of this exercise is deciding upon the best type of financing that is available to the entrepreneur (if any) to ensure that they can meet their longer term goals for their business. This chapter also described some of the sources of financing available to start-ups.