Financing the Corporation
This article focuses on how to finance a corporation. One of the greatest challenges for new ventures is the ability to secure capital that will allow the corporation to grow. There is no magic formula, and the management team will need to evaluate and assess which options are beneficial for the company. Each business will need to weigh the pros and cons of each option in order to determine what would be best. There are two options that these businesses may consider. The two types of financing — debt financing and equity capital — are explored. The role of commercial banks, the Small Business Administration, angel investors, and venture capitalists is introduced and discussed.
Keywords Angel Investors; Capital; Commercial Banks; Cure Period; Debt Financing; Equity Capital; Financial Institutions; Investments; Pro-rata Rights; Share; Small Business Administration; Startup; Venture; Venture Capitalists
Finance: Financing the Corporation
Corporations believe in the success of their dream, and they expect their ventures to take off and expand. One of the greatest challenges for new ventures is the ability to secure capital for investments that will allow the company to grow. All projects will reach a crossroad where sufficient cash flow is necessary in order to go to the next level. It could be after a period of time or it could be because the venture was so popular and the company is growing at a rapid rate due to demand. Regardless of the situation, the company's management team will need to determine when and how they will invest in the future through, for example, purchasing new equipment, hiring new staff or putting more money into marketing initiatives. Raising money can be a difficult task if the company has not established a reputation or is still new.
When determining the amount of capital needed, the decision makers must analyze the situation and decide how much and what type of capital is required. Since the situation is not the same for all businesses, there is no magical formula. Some businesses may only need short term financing for items such as salaries and inventory; whereas, other businesses may need long term financing for major items such as office space and equipment. Each business must develop a customized plan that will meet its unique needs.
Securing capital is a choice made after weighing the pros and cons of various options. There are three popular sources for obtaining funding for new ventures: borrowing from financial institutions, partnering with venture capitalists, and selling equity and possession in order to obtain a share of the revenue (Goel & Hasan, 2004). All financing options can be classified into two categories: debt financing and equity capital.
- Debt financing may include bank loans, personal and family contributions and financing from agencies such as the Small Business Administration. Loans are often secured by some type of collateral in the company and are paid off over a period of time with interest.
- On the other hand, venture capitalists and angel investors provide funding in the form of equity capital.
Pierce (2005) offers some advice which may be of assistance when assessing which option may be best for the company. Some of the tips include:
- A Small Business Administration program may not be the best option if the company needs less than $50,000.
- Debt financing is often less expensive and easier to obtain than equity capital. Financing the venture via debt entails the responsibility of making monthly payments regardless of whether the business has an affirmative cash flow.
- Equity investors assume that there will be very little return during the beginning stages of the profession, but need additional research about the business’ development. In addition, they assume that the company will definitely succeed in achieving the aforementioned aims and objectives.
- Debt financing is often offered to all forms of corporations. However, equity capital tends to be reserved for companies with quick and significant growth potential.
- Angel investors tend to invest money in companies that are within a 50-mile radius, and the amounts of funding tend to be in the range of $25,000 and $250,000. Angel investors may be companions, relatives, customers, suppliers, financial experts or even competitors.
- It is difficult to secure venture capital funding, even in a good economy.
Two Options of Financing
Debt financing and equity capital options both require the financial professionals of an organization to complete detailed documentation prior to the award of financing. The finance team should be prepared to produce quarterly balance sheets, background information on the company and projections.
If the company cannot finance the expansion through personal investments, the management team will need to develop a business plan that meets the criteria for potential lenders. Commercial banks may be the first choice, especially if the owner has a relationship with a specific lender. Since traditional lenders tend to be conservative, good rapport and an established relationship will be beneficial when applying for a loan. According to the University of Maine's Cooperative Extension, a 1980 Wisconsin study of smaller corporations discovered that 25% of the companies that underwent the interview process were denied at first, but 75% of them were approved when they submitted their proposal to another group. It is important for potential borrowers to understand the mindset of potential lenders. Most lenders tend to focus on five important factors when deciding whether or not to extend credit, and business owners need to be prepared to address them. The five factors are:
- Character — what are your personal characteristics? Are you ethical and have a good reputation? Will you do everything possible to pay the loan back?
- Capacity — will your business be able to generate sufficient cash flow to pay the loan back? Do you have access to other income?
- Collateral — do you have collateral to cover the loan in the event the venture does not perform well? Is there a qualified individual willing to co-sign on the loan?
- Conditions — have you researched the environment to see if there are any circumstances that could negatively impact your business (i.e. nature of product, competition)? How will you deal with these situations if they arise?
- Capital — what are you personally willing to invest in the venture? Most lenders are not willing to invest in ventures if you have not made a major investment in the future of the project. Why should they invest in the venture if you are not willing or able to?
Debt Financing: To Diversify or Not?
Colla, Ippolito, and Li (2013), looking at debt structure using a newer, comprehensive database of types of debt employed by public U.S. firms, found that 85% of the sample firms borrow "predominantly with one type of debt, and the degree of debt specialization varies widely across different subsamples." Large, rated firms tend to diversify across multiple debt types, while small, unrated firms specialize in fewer types. The authors showed that firms employing few types of debt "have higher bankruptcy costs, are more opaque, and lack access to some segments of the debt markets" (Colla, Ippolito, & Li, 2013).
Venture capital is usually available for start-up companies with a product or idea that may be risky, but has a high potential of yielding above average profits. Funds are invested in ventures that have not been discovered. The money may come from wealthy individuals, government sponsored Small Business Investment Corporations (SBICs), insurance companies, and corporations. It is more difficult to obtain financing from venture capitalists. A company must provide a formal proposal such as a business plan so that the venture capitalist may conduct a thorough evaluation of the company's records. Venture capitalists only approve a small percentage of the proposals that they receive, and they tend to favor innovative technical ventures.
Funding may be invested throughout the company's life cycle with funding being provided at both the beginning and later stages of growth. Venture capitalists may invest at different stages. Some firms may invest before the idea has been fully developed while others may provide funding during the early stages of the company's life. However, there is a group of venture capitalists who specialize in assisting companies when they have reached the point when the company needs financing in order to expand the business.
Many firms receive some type of funding prior to seeking capital from venture capitalists. Angel Investors have been identified as one source that entrepreneurs may reach out to for assistance (Gompers, 1995). "In a nationwide survey of more than 3,000 individual angel investors conducted by the Angel Capital Association, more than 96 percent predict they'll invest in at least one new company in 2007. Also, 77 percent expect to invest in three to nine startups, and five percent think they'll fund 10 or more new companies" (Edelhauser, 2007). This is good news for entrepreneurs with a dream.
Including angel investors in the early stages of financing could improve the changes of receiving venture capital financing. Madill, Haines and Rlding (2005) conducted a study with small businesses and found that “57% of the firms that had received angel investor financing had also received financing from venture capitalists. Firms that did not receive angel” investing in the early stages (approximately 10% of the firms in the study) did not obtain venture capital funding (Madill, et. al., 2005, “Abstract”). It appears that angel investor...
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