Growing Your Company: Financing Growth

Posted on November 13, 2012

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Part 3 of 3 part series - by Dave Gauthier
 
Parts 1 and 2 of this blog reviewed some of the barriers to growing a company and provided tips for preparing a business plan to guide your growth strategy. This final installment will review the importance of financial literacy and capital planning and introduce you to various sources of investment capital that could assist with growth.
 

Use Financial Information to Make Decisions

Many entrepreneurs are intimidated by financial statements and outsource financial duties to others. Although accountants, book keepers and administrators may provide valuable service in producing actual financial statements, entrepreneurs need to be able to understand what these statements mean and be able to make their own decisions based on that information. If you do not believe that it’s important to become financially literate, consider the following:

Industry Canada reports that only 55% of truly small businesses (less than $30K in revenues per year) survive after 3 years and only 36.1% survive after 5 years.
• Of the seven pitfalls of business noted by Patricia Schafer, four are related to poor financial literacy.

As a company grows, monitoring the financial health of the business can’t wait for quarterly, semi-annual or annual meetings with your accountant. A good financial tracking and reporting system is vital in providing up-to-date information that can be used to make important decisions and plan for the future. Many of these are easy to use and can greatly simplify efforts as a company grows compared to manual or spreadsheet financial tracking.

Financial statements are an important communication tool for investors, business-to-business relationships, and for entrepreneurs themselves. Learning the language of finances is crucial for every entrepreneur so they can make decisions, even if they are relying on someone else (internal or external) to generate the information for them. Financial statements do not involve any complex mathematics. They are simply a way of categorizing what your company owns (assets), how much it owes to others (liabilities), how much cash it earns (revenues), how much cash it uses to produce those earnings (expenses), and how much profit is created in the process. By understanding how these elements interact, entrepreneurs can make important decisions regarding how to move forward.

Develop a Capital Plan

Once a company determines how it intends to grow and develop, it needs to decide how to finance that growth and development. There are numerous ways of financing a business, such as reinvesting profits, drawing down periodically on a line of credit from a financial institution, private equity investment, etc. Depending on a company’s particular circumstances and stage of development, the types and amounts of capital available will differ. A capital plan is simply a strategy for ensuring that sources of financing have a reasonable chance of being in place at the appropriate time.

Generally, types of investment can be classified as debt or equity.
Senior or secured debt is typical of bank financing. It is often available for a 3-5 year term and the financial institution will have first charge on assets in case of default. Typical interest rates are 1% to 3% above prime. Longer term financing may be available for some assets, such as property.
Subordinated debt is usually longer term (5 to 7 years) and takes second charge on assets. Since the debt is not secured, interest rates are often higher, in the range of 12% or more. Although some financial institutions offer specialized subordinated debt programs, they are more typically used by private equity firms.
Equity investments are actual ownership interests in the company. The investor may purchase common shares with similar rights to the entrepreneur, or preferred shares, which will give them additional rights. Private Fund Managers typically use a combination of subordinated debt and equity.

Various types of financing may be available at different stages of business growth. Each type of investor will require a different approach, so it is important to understand their needs and what they are looking for in an investment opportunity. Below is a brief description of various investment sources.

Types of Investors

Friends and family are often good sources of seed capital up to approximately $100,000 as either debt or equity. Business associates, such as lawyers and accountants, may be part friend or part angel.Angel investors are typically high net worth individuals who have an interest in providing capital to early stage companies in the form of either subordinated debt or equity. This type of investor tends to be more patient that a financial institution and does not always require collateral as security on a loan.

Angels are increasingly becoming organized into syndicates that invest between $100K and $1M in high growth opportunities. These angel syndicates are increasingly operating like early stage venture capital firms, with more emphasis on strong due diligence and expectation of return on investment.

As discussed above, banks and financial institutions lend based on asset security (company assets or personal assets). Commercial lending is often limited to percentage of total financing needed, depending on asset re-sale value. Cash flow history, solid future projections and debt to equity ratios are important considerations and existing sales, customer orders or expressions of interest are all positive factors when negotiating debt. Leasing is a form of debt financing and should be examined as an alternative to purchasing certain assets.
Commercial partners (e.g. distributors, technology development partners, potential future acquirers of the company) may also be potential sources of capital during this period. Types of financing and partnerships vary, but could include:
• deposits or pre-paying for orders;
• in-kind research and development to improve products with some sharing of value upon commercialization;
• licensing; or
• payments for exclusive distribution of particular market segments

Licensing is a contractual method of developing and exploiting intellectual property by transferring the right of use to third parties without the transfer of ownership. Virtually any proprietary product or service may be the subject of a licensing agreement.

From a business perspective licensing involves a weighting of the advantages of licensing against the disadvantages in comparison to alternative types of vertical distribution systems. From a strategic perspective licensing is the process of maximizing shareholder value by creating new income, cash flows and market opportunities by uncovering the hidden or underutilized value of intellectual assets and finding licensees who will pay for the privilege of having access and usage of the intellectual capital. Many of the economic, strategic benefits of licensing enjoyed by a growing company parallel the advantages of franchising, namely:
• Spreading the risk of development and distribution;
• More rapid market penetration;
• License fees and royalty income;
• Source of capital that can be used for internal growth and expansion;
• Ability to test new applications.

Failure to consider all of the costs and benefits of licensing could result in a poor, unprofitable strategic decision to license, as terms of the license agreement underestimate the licensee’s need for technical assistance and support an overestimation of the market demand for the licensor’s products and services. To avoid these problems, due diligence should be conducted by the licensor prior to any serious negotiations with the prospective licensee. This should include market research, legal steps to fully protect intellectual property and a financial analysis of the technology with respect to pricing, profit margins and cost of production and distribution. Also important is an analysis of the prospective licensee with respect to financial strength, R&D capabilities and reputation in the industry.

An extremely deep and long cash consumption period (several million dollars and several years) prior to revenue generation may be financed by a venture capital fund. Venture capital refers to a form of private equity that specializes in risky, Early Stage investment with tremendous potential for profit. In many cases, these higher risk opportunities may require a series of venture capital or private equity investments based on reaching critical milestones that indicate meaningful progress in company development. Because of the risk associated with venture capital, it is usually reserved for patentable, disruptive technologies that will have a strong competitive advantage in the marketplace and that can generate tens or hundreds of millions in revenues. Less than one per cent of companies ever receive venture capital or private equity.  

What to do if Nobody Wants to Invest

In many cases, external funding is simply not available, particularly at early stages of company development. This is not necessarily a bad thing. Focusing on good, old-fashioned paying customers and growing through re-investment of profits, supplemented with operating loans once there is a history of cash flow is a great strategy. However, it must be executed very carefully by scaling up only when orders can’t be filled, and good financial monitoring processes are needed to ensure that cash flow remains positive.

Bootstrapping is the process of finding funds and resources for your business from unusual, creative or innovative sources. Most successful entrepreneurs have strongly developed bootstrapping abilities, and finding creative ways to finance your idea is one way to demonstrate your entrepreneurial flair to future lenders or investors. Bootstrapping demonstrates resourcefulness, resilience, an ability to minimize expenditures and think creatively under stress.

Note that bootstrapping does not mean being lazy or sloppy with financing. All loans, debts, promises, and partnerships should be fully documented to avoid potential legal difficulties and problems with future investors. Too many debts, undocumented ownership, and unclear rights to intellectual property and assets can ruin a financing deal. Therefore, while you are being creative, remember to stay disciplined.

As soon as possible, begin researching government grant programs that could be suitable for your project. University researchers may have access to additional funding sources than other entrepreneurs, and many granting programs only provide a portion of the funds needed to complete a particular stage of the project. Grants are typically targeted at specific industries, such as technology-based businesses (e.g. information technology, life sciences, clean technologies, value-added agriculture, etc.). Uses of funds are often targeted at prototype development, market assessments, tax refunds and contracted research. Some grants are non-repayable, and others have some repayment required if a product is successfully commercialized.

Part 1: Barriers to Growth
Part 2: Planning for Growth

This blog is extracted from materials co-developed by David Gauthier and the Manitoba Women's Enterprise Centre for their "My Gold Mine" project, and based on concepts originally developed by the Entrepreneurial Foundation of Saskatchewan.

Dr. David Gauthier
is president & CEO of Genome Prairie
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  • Don Hrytzak

    Posted on 13/11/2012

    great article(s) Dave.