This chapter is focused on the funding sources and what to expect from each. In some instances you will find a blurring of terms regarding whether the topic is really a source of capital or a financing instrument. Nonetheless, we have done our best to clarify the differences and provide the information required to understand the alternatives. Figure 5.1 provides a broad overview of the types and sources of funding, and the range of rates of return they target based on their particular business model and risk profile. To support our experiences and assumptions, we solicited the funding sources listed in Part Three of this handbook for their actual data regarding the range of values they use in modeling an investment or loan.
These targeted rates are what you can expect to pay third parties depending on the financial strength of your company, its stage, its industry, the overall credibility of the plan, and risk associated with your business. These annual rates of return are not the realized return on investment of these sources or instruments; these are the modeled or planned returns at the outset of the transaction with your company. The overall actual or realized rates of return for most investors or lenders range from a loss to 25 percent, and the 25 percent is rare over the long term. From time to time there are big winners that make many times their investment-a recent example is Google. The media tends to focus on the high-profile successes and fails to mention the failures, thus leading to the perception that success is the norm rather than the exception. The difference between the planned returns shown in Figure 5.1 and the actual returns indicated in Table 5.1 is a result of the costs and risks associated with the particular portfolio of investments. We are presenting this information to set your expectations and establish a level of realism as you traverse the financing process.
To provide an overview and further set the stage for the detailed discussions to follow, Figure 5.2 highlights the funding sources and the company stages in which they are most likely to invest or lend.
FIGURE 5.1 Range of Expected Annual Rates of Return Based on Deal Structure
As Modeled by the Investor/Lender at the Time of the Transaction
There are usually actions that can be taken on a short-term or on a temporary basis to create cash or funding to bridge to a more permanent solution. It is important to understand and identify what the permanent capital structure is for the stage, size, and industry of your company in evaluating the viability of the interim step. Further, it is important to understand the motivation and business model of the various funding sources, so that you can best position your company to obtain funding from these sources as well as negotiate a favorable cost of capital (relative to the norm for that type of source).
FIGURE 5.2 Funding Sources by Stage
Y = Yes, P = Possible depending on company characteristics and industry.
We begin our discussion with bootstrapping and then transition to other source alternatives.
Bootstrapping is the term used for nontraditional funding of a company using a series of interim techniques and sources to move from one company stage to another. Bootstrapping somehow implies funding a business when it is not supposed to be funded or in a way that is not expected to work. The technique is routinely used by start-up or early stage businesses that do not have institutional or professional investors, keeping in mind that the great majority of start-up and emerging growth companies do not obtain funding from institutional or professional investors. From the perspective of the entrepreneur or businessperson, bootstrapping may be viewed as a resourceful or creative way to address the financial need of the business for an interim period using the cash flow of the business and minimizing the use of external capital until the cash flow of the business can support ongoing operations. Given that excess funds are rarely available in this situation, bootstrapping may have the benefit of instilling financial discipline in the company's leadership team and processes as they focus on managing cash flow and all of the influencing factors; they grow accustomed to running a tight operation. The downside of bootstrapping is that cash flow decisions can take precedence over business decisions that may be in the long-term best interest of building value. In addition, it takes considerable effort and persistence to implement some of the techniques discussed, so it may distract from the daily management of operations. Lastly, in some industries and markets, it is just not feasible to bootstrap. In reality, bootstrapping can be an effective way to discipline the management team and process, given that excess capital in the hands of inexperienced business people often leads to waste and failure, as we saw in the 1999-2000 Internet bonanza.
Bootstrapping may be a mix of the following techniques, some of which appear to be simply common sense. The cost of bootstrapping is often implicit in the relationship of the participants versus explicit in regard to payment. A key to successful bootstrapping is accurate cash flow management and forecasting. You will see that many of the techniques discussed involve the timing of payments; if you can not accurately and consistently present a realistic cash plan to those supporting the business, you will not have the credibility required to maintain the cash flow juggle inherent in bootstrapping. The result is a failed company in many instances.
Another key to bootstrapping is maintaining a solid credit history and having good credit references. This does not mean that you can not have special arrangements or extended terms. What it does mean is that you make credible commitments and you meet those commitments. If you find your company in the position of missing a commitment, pick up the phone or arrange a meeting with those affected and let them know in advance that you can not do what you said and be prepared to recalibrate their expectations and to provide an updated commitment.
Communication is a very important aspect in managing bootstrapped financing. As we introduce specific techniques and sources, keep in mind the definition of working capital: current liabilities less current assets. Also keep in mind that there is crossover in some of the techniques described and that a combination of these is often deployed.
Friends and Family Loans and Investments
In a start-up, the classic approach to funding a company is to solicit loans and investments from friends, family, and the principal's personal savings. Sometimes successful professionals are willing to invest a portion of their disposable income. These funds are typically provided on the basis of one's relationships and structured in a relatively informal fashion. These dollars usually represent the first ones invested before or around formation of the company and generally range from $1,000 to $250,000 in total from a handful of individuals.
Another common start-up funding technique is for the principals of the start-up company to engage in a business or product line similar to the business they desire to eventually build, using the revenue and income thus produced to fund their existence while they launch the real company. A classic example is when a group of engineers working for a large company desire to start a new product-focused company but do not have the funding to solely develop and market the new product. If the time to market is sufficiently long, the engineers may engage in part-time consulting to fund the base expenses of the company while spending the balance of their time developing the new product. They will work long-hour days in most instances, putting in sweat equity for a shot at launching their company. Though the consulting work is a distraction in the short term, it provides the funding to survive and invest the time and energy in the development stage of a new enterprise.
There is a counterargument that developing an alternate revenue source (or creating a hybrid business model) is less of a distraction than pursuing institutional investors or other alternatives. That was the case for Michael Shinn, founder and CEO of Secure Software Solutions in Chantilly, Virginia. "Raising capital is a tremendous time drain," says Shinn. "I was afraid we would miss the opportunity if we didn't get to market quickly." Rather than take the time to raise capital, Shinn created a hybrid company, offering consulting services while developing his computer systems security product. A blended business model is usually a no-no in most venture capitalists' books, but it worked well for Shinn. Consulting provided an instant source of revenue and proved invaluable to product development. "It let us test our product with real customers, rather than building our technology in an ivory tower, which is what guys tend to do when they get a lot of funding," says Shinn.
Customer Prepayments or Discounting Accounts Receivable
Regardless of the stage of the business, an often-viable source of funds is customer prepayments; we have seen this in start-ups and in Fortune 1000-sized companies. This involves negotiating all or partial payment by the customer in advance of providing the product or service; and may involve staged or progress payments based on completion of certain milestones. In many instances, this is one of the cheapest sources of capital for a company, especially when the customer is a larger business and the amount requested is relatively small. Prepayments are also used to manage credit risks when the customer is a smaller or less established company.
Akin to prepayment is a discount for early payment of an invoice, though much more expensive in theory. Many large companies aggressively pursue accounts receivable discounts. Keep in mind that the buyer that negotiates the price is often not motivated by accounts receivable discounts; so in negotiations do not offer the discount until after the price is set. You may be able to in effect pad the price with the cost of the discount so that you do not impact your margins and you are able to accelerate your cash flow. Typical accounts receivable discounts range from 0.5 percent to 5 percent of the invoice amount for accelerating payment from 30-40 days to 5-10 days. The range of discounts is related to the cost of money at the time of negotiations. During a period with low interest rates discounts are on the lower end of the range.
Supplier/Vendor Financing and Extended Terms
Depending on the type of purchase, many suppliers and vendors will negotiate extended payment terms or special arrangements for some period of time to build loyalty, to facilitate a sale, or to allow the customer to pursue growth. This should translate into improved cash flow.
An example: If the purchase is for a piece of equipment and the intent is to seek long-term financing via a lease or loan, consider asking the supplier to immediately provide the equipment and to provide a period of 60 to 90 days to install the equipment and obtain funding, so that you can implement and begin to use the equipment and generate cash flow, all before having to make any payments. The supplier may request, or you may offer, a small down payment to facilitate this arrangement.
Though many suppliers will not offer permanent extended payment terms, many will work with customers for a period of time by extending payments in exchange for a commitment of ongoing business. The same concept applies if your company is seen as a growth opportunity and the supplier wants your business.
Another strategy borrowed from the manufacturing and retail sectors is that of consignment. This involves a supplier providing inventory at your location for use or resale; however, your company is not invoiced or liable for the inventory until it is actually sold. In other words, title for the inventory does not transfer to you until the instant you sell that inventory. This means that the aging of the invoice due the supplier does not begin until the aging of your receivable from your customer, thus creating the potential for generating revenue with less working capital. Dell, Inc. uses this strategy and actually operates its business on negative working capital because it gets paid by its customer before it is required to pay its suppliers. 2
Customer and Supplier Barter Arrangements
As mentioned before, understanding the use of funds is critical in determining how to fund a particular need. In some cases, you will find that there is synergy between your company and that of your customers and suppliers that will allow noncash exchanges of goods and services. This noncash exchange, or barter arrangement, can have the effect of reducing the amount of capital that you may need to obtain from cash funding sources, sometimes making it easier to obtain the cash funding.
Revenue and Pricing
The contribution margin from new or incremental revenue is an often overlooked source of capital, and maybe one of your cheapest sources. A way to analyze this alternative is to determine the selling cycle of your product or service and the required working capital to generate the sale. Couple this with the probability of success in obtaining the new sale if management invested its time and energy to effect the transaction. Compare this scenario and its likelihood of happening to the time, energy, and likelihood of raising new capital. Though it may seem like harder work, and in some instances it is, consider that many management teams have never raised capital and therefore have a better chance of creating their own capital by focusing on new sales than by seeking external funds.
Let us take an example of a media and events company that primarily sells sponsorships to generate revenue. On a period basis, once fixed costs are covered, 50 to 70 percent of any new revenue flows to the bottom line, and customers in this business are accustomed to paying the sponsorship in advance. In effect, this company can raise capital by focusing its efforts on obtaining additional sponsorships instead of pursuing disinterested parties for capital. From a cost of capital perspective, keep in mind that the tax impact of incremental revenue will vary depending on the level of profitability of your particular situation.
New revenue resulting from price elasticity is another overlooked source of growth capital. As a company grows and strengthens its market position, the price decision is sometimes forgotten as the team focuses on obtaining new customers and new orders to meet their monthly and quarterly goals. After analysis of the market and competitive situation of a particular company is conducted, it may be the case that a company can increase its product or service price without any loss in sales volume as customers will continue placing orders at the increased prices. To this extent the price increase is at a percentage level that is acceptable to customers. The contribution margin from the change in price may become a new source of capital to fund investments.
As an example, let us consider a specialty industrial equipment manufacturer with annual sales of $20 million. The newly appointed president met with his sales team in a routine review and asked the question: "How many orders would we lose this year and next if we raise our price 10 percent?" To his surprise, each sales manager responded, "None." The contribution margin from this price increase was nearly 90 percent of the new revenue and generated about $1.8 million before tax of new capital to invest in growing the business during the first year!
Another example: A small communications equipment company with revenues of about $6 million and a strong market position with a niche product line was able to raise its prices 20 percent over a two-year period while dramatically increasing revenue from new orders; the company grew at more than 50 percent a year for several years. With a contribution margin of about 60 percent, this company was able to create more than $1 million in new working capital to support its growth while reducing its bank debt. The move to increase prices was not to take advantage of its customers, but rather to adjust the prices to a fair market value so that the company could reinvest the appropriate capital in the research and development (R&D) of future technologies and products to maintain its market position and build long-term value for its established customers and stakeholders.
Customer and Supplier/Vendor Investments
Depending on the relative market position and competitive nature of the product or service you provide, customers and/or vendors can be valuable sources to fund growth, particularly as it relates to product or service development. There are a number of major corporations that have venture capital or investment funds for start-up and growth companies. These major companies can make hands-off investments or establish partnerships to provide expertise in areas where the start-up or growth company is weak or lacking. Their motivation varies, but typically they have a mission to: 3
Generally, these funds are interested in expanding knowledge, technology, or product lines through their investments. These funds can provide some significant leverage and restrictions on their portfolio companies in a given market. Later in this chapter we have provided a section about strategic investors and corporate venture capital to discuss this topic in more depth.
In addition to those companies with formal venture capital or investment programs, you may seek to engage your customers or suppliers in arrangements that have the same or similar ambitions. The form which such an arrangement takes will vary, but typically can be structured as a strategic relationship such as a joint marketing initiative, distribution agreement, reseller agreement, or teaming agreement. They can also take the form of a joint venture or alliance, but these sometimes require greater scrutiny and oversight and take longer to consummate. Here are some examples.
A small service company focused on telecommuting develops relationships in its market with customers, technology suppliers, and universities as part of its ongoing business. In doing so, it sees the opportunity to develop software that provides a technology to enhance its services to the medical and public safety markets. The company engages with a team from a university to further the development of this software and begins to fund several engineers. As the project progresses, the company raises some initial outside capital from a group of angel investors that have known company management for many years. With a workable product, the company begins to pursue customers and potential contracts; this software operates on several hardware platforms. In the process of bidding on potential contracts, it becomes apparent that the software solution provides value to the hardware manufacturers and that they may benefit from a relationship with this small company to enter these markets. The small company is able to negotiate prepayment of license agreements with the hardware companies and to obtain support hardware and services to finish its development and initial deployments of the software. In effect, this small company has raised a significant amount of capital from partners that view its relationship with them as strategic-all being done through larger company marketing and R&D budgets.
Another example: A growth company with existing products and customers has a new product concept that it wishes to pursue, but needs additional capital to undertake prototyping and development. Management drafts a business plan and determines the timing of the cash flow and potential payback. By examining the use of funds, it is determined that a significant amount of the investment will be used to pay suppliers for tooling, prototyping, advertising, and certifications. A potential funding alternative is to determine how much, if anything, the existing company can invest in this initiative. The next step is approaching a few key suppliers with the business plan seeking terms that allow payment flexibility during the start-up phase and debt relief if the project fails. In return, the suppliers have the opportunity to participate in a royalty stream from the product plus a preferred supplier status as long as they maintain acceptable product quality, delivery, and agreed-upon cost reductions. We have seen this technique used successfully in the electronics, industrial, and pharmaceutical industries.
Deferred Employee Compensation
For many service- and technology-based companies, employee compensation is the single largest use of cash. During start-up or transition periods, some employees may be willing to forgo or reduce their cash compensation in exchange for future payments or other consideration. If an employee is willing to consider this concept, compensation may be deferred as a source of cash. It is recommended that a written agreement be used to clarify expectations and provide for any waivers required by law. As an alternative and if an employee can legitimately meet Internal Revenue Service (IRS) regulations, some employees may be able to become contractors to enhance their ability to be flexible in support of the company's needs. A note of caution: Ensure that the agreement between the employee or contractor and the company provides clear delineation of intellectual property rights and remedies in the event of nonpayment. Without clarity, it will be almost impossible to obtain equity funding if the employee's work product is critical in the valuation of the company.
Let us take the example of a start-up software firm that has identified a team of engineers that it plans to hire upon funding. Most start-ups will find it easier to procure investment dollars if they are actually committed to and implementing their plans versus attempting to sell a concept that they will act on post funding. To break this apparent catch-22, the start-up may consider contracting with those individuals and exchange their deliverables for deferred payment and restricted stock. During the fund-raising process, these individuals may maintain contracts with other sources of income or be employees of nonrelated companies to provide for their personal cash requirements. Upon funding, the company could convert them from contractors to full-time or part-time employees and begin to pay regular salaries. In negotiating the contractor agreement with them, we do not recommend that the expectation be set that they will be paid in full upon the company's receipt of funding. Rather, consider a payment schedule over 6 to 18 months from the date of funding-you will find this much more palatable by the investors.
In the event that your company is an ongoing business versus a startup, you may find that employees are willing to forgo or reduce their compensation in exchange for equity or deferred bonuses in addition to repayment of the amount forgone. Once again, we recommend you review this with counsel to ensure compliance with applicable laws.
Practically speaking, deferred compensation is a tricky issue. Some employees have the financial resources to defer income, but most live paycheck to paycheck. Asking employees to give up income is the equivalent to asking them to give up their lifestyle, while many are struggling to survive. This option can be of last resort! Management is asking employees to believe management's dream at all costs-and that is not a card that should be played often or lightly. Being up-front with employees is important, and if making payroll is in question, then employees should understand their risk ahead of time, not at the time of decision. Employees will question the integrity of management if faced with deferral or nothing. It is best if deferred income is the employees' idea. A word of advice: Even when things get desperate, always pay the payroll and especially the payroll taxes. The IRS is no fun to battle!
In many instances, implementation of an outsourcing strategy can result in an increase in working capital coupled with the positive benefit of process scalability while maintaining a variable cost structure. In some situations, outsourcing can increase a company's speed to market. A common theme is to outsource noncore elements of the business; routine processes that are outsourced in growth companies are:
While outsourcing can increase working capital, this is not always the case. It is critical to understand the motivation of the potential outsourcing partner, and each relationship should be documented with a contract that clearly delineates the terms. The selection of an outsourcing partner is usually given significant consideration and diligence, for it can have such positive and negative impacts on a business. It is critical to understand the entire cost in structuring the relationship, not just a piece-part or transaction cost. You may consider seeking a consultant or adviser who routinely structures outsourcing relationships. One source of information is the Outsourcing Institute (www.outsourcing.com).
Working Capital Management-Inventory, Accounts Receivable, and Accounts Payable
Though we have mentioned this in prior paragraphs, we deem it important enough to repeat. There is no substitution for solid management of the company's existing working capital to improve cash flow. In most companies, this translates into aggressive and timely collection of accounts receivable, appropriate timing of payment of payables, and carefully balancing inventory to minimize the company's investment while having adequate supplies to meet customer demands.
One concept we have not discussed is collection of past due receivables. Without attempting to write an entire section on accounts receivable collection, we have provided a few notes for your consideration.
Litigation takes a long time and many times does not result in collection of the cash the company needs on a timely basis. Obviously, managing credit risk up front is preferred to collection after the fact, but when a company is confronted with a customer that cannot pay, get creative.
Begin to increase communication with the customer and be willing to accept partial payments. If your company continues to sell to the customer, link delivery of product or service to payments, and get more in receipts than you ship. Lastly, determine if the customer provides a product or service that your company needs; if so, then negotiate to offset the outstanding balance.
The obvious and traditional method of financing a company is through the generation of operating profit. We already mentioned this in a prior section when we discussed revenue and pricing. The key to determining the rate of growth that can be sustained through operating profits, or self funding, is to understand the operating cash flow cycle. Many factors affect the length of a company's operating cash flow cycle: how long the company has to pay suppliers, how long inventory is held, the profit inherent in each dollar of revenue, and the length of time customers use in making payment to your company. 4 From experience, many large organizations will not allow their business units to grow faster than 10 to 15 percent annually, as a baseline measure of their ability to self fund. This is an overall guideline where businesses with higher gross margins may be allowed to grow faster than those with lower gross margins. The concept of self funding through operating profits and cash flow is core to any business, regardless of size.
There are three levers that affect the ability to self fund: cash flow velocity, cost reductions, and price increases. Control of these levers will drive the formula for determining the annual rate of growth that can be funded by internal operating cash flow. 5
In Appendix D we have provided an excellent Harvard Business Review article by Neil C. Churchill and John W. Mullins on determining how fast your or your client's company can grow based on its specific cash flow cycle.
Most entrepreneurial ventures are bootstrapped to some extent. Sources of funding come from anywhere the entrepreneur can find it. Much of the funding is through the use of services of other companies who might have an interest in the product or service if fully developed or launched. Entrepreneurs are creative, and how they structure relationships with other companies and obtain services is as varied as their personalities. Venture capitalists give high marks to entrepreneurs capable of developing these relationships. However, the critical issue for the entrepreneur is not to structure deals that could hinder growth or institutional financing in the future. A word of advice: Never lose control of the intellectual property or enter into a relationship that cannot be reshaped into an in- dependent entity capable of demonstrating growth, creating future value, and being financed.
1.. Verne Harnish, "Finding Money You Didn't Know You Had," Fortune Small Business, June 11, 2002.
3. Zenas Block and Ian C. MacMillan, Corporate Venturing (Boston: HarvardBusiness School Press, 1995).
4. Neil C. Churchill and John W. Mullins, "How Fast Can Your Company Afford to Grow?" Harvard Business Review, May 2001.
The above material is adapted from The Handbook of Financing Growth: Strategies and Capital Structure by Kenneth H. Marks, Larry E. Robbins, Gonzalo Fernandez, John P. Funkhouser. Copyright ©2005.This material is used by permission of John Wiley & Sons, Inc.