FINANCING Some Tools and Tricks of the Trade

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FINANCINGSome Tools and Tricks of the Trade
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FINANCING

• THREE RULES
• According to Aristotle Onassis (Greek Shipping
  Magnate and Jackie Kennedys Second Husband)
• Borrow as Much OPM (Other Peoples Money) as You
  can
• ALWAYS Pay Back the OPM and
• ALWAYS have a TAN!

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VENTURE CAPITAL

• Startups Financing Dilemma
• No Verifiable Cash Flows or Tangible Assets rule
  out Debt
• How to Encourage Innovation while Maintaining
  Control Necessary to Maximize Return and
  Minimize Risk
• Venture Capital is Approach for Startups with (1)
  Managerial Expertise, (2) Scale and (3)
  Verifiable Innovation

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VENTURE CAPITAL
If Retained Earnings or Debt not Options, Only
Choice is Equity Financing
PROBLEM How to Provide Incentives and Controls
using Voting Rights and Other Devices
SOLUTION Preferred Stock - Before IPO
Dividends After IPO Convert to Common
Stock Directors Strategic Decision
Control Employment Contracts
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VENTURE CAPITAL

• Organizational Form Limited Partnership
• Limited Partner Investors usually Pension
  Funds (Private/Public)
• General Partners select Portfolio Company
  Investments, Negotiate Terms and Monitor

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VENTURE CAPITAL

• Myths
• VCs dominate Private Equity Market
• Fact Account for less than 1
• Finance Range of Industry Types Nationwide
• Fact Most Investments are in High-Tech or
  Bio-science Industries in Californias
  Silicon Valley or Boston area

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VENTURE CAPITAL

• Myths
• VCs expect to Earn 700 Rate of Return in 2 to 3
  Years
• Fact VCs aim to harvest their Investments
  in 7 to 10 Years (but do try to earn 700)
• Governments invest because VCs perceived as
  Win-Win Eye-Popping Rates of Return and
  High-Paying Jobs
• Fact Total Returns usually around 25 Less
  than half of Firms survive more than 3 years

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VENTURE CAPITAL

• Myths
• VC Investments fit Small Business Financing
  Needs
• Fact Typical VC Investment is about 5 Million
• THE BIG QUESTION If Typical Business Startup
  needs only about 18,000 (Nike founded with 550
  from Phil Knight) then
• IS CHASING VENTURE CAPITAL A SMART USE OF YOUR
  TIME AND ENERGY?

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FINANCING

• STARTS WITH BUDGETING
• CAPITAL Cash Needed to Start Business, Product
  or Project
• Includes Working Capital, Owner Expenses and
  Contingencies
• OPERATING Net Cash Flows from Running
  Business, Product or Project

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A STRATEGY FOR GETTING FINANCED

• THE PROBLEM Show that Product, Business or
  Project will have VALUE
• When Values Amount is Known, Risk is Reduced
  and Bankers and Investors will be interested,
  but
• Whats the Value of Something thats not yet been
  Built, Purchased or Sold?

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WHAT IS ITS VALUE?

• Isnt IT the Amounts and Reliability of the
  Firms (or Products or Projects) Future Cash
  Flows?
• So if Amounts of Future Cash Flows, and their
  Certainty (RISK?), can be predicted, something
  VALUABLE has been created. Right?

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A LITTLE WRINKLE

• If its Uncertain (RISKY) whether Future Cash
  Flows will appear at Precise Time and in Exact
  Amounts that have been Predicted, shouldnt they
  be DISCOUNTED?
• And could this Discount be expressed as a
  RATE (Call it a DISCOUNT RATE) that is used
  to measure VALUE?

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THE RECIPE

• Return OF Investment Repayment Risk
• Internal Risks affecting Investments Repayment
• Adverse Selection Bad Investment Choice
  despite Good Management
• Moral Hazard Incompetent Management causes
  Good Investment to Fail

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THE RECIPE

• Return ON Investment Time Issues
• External Issues affecting Investments
  Repayment
• Inflation makes Future Dollars worth less than
  Current Dollars (Inflation Risk)
• Unable to Switch to other, possibly more
  lucrative Deals (Opportunity Cost)

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BAKE AT 350 FOR 1 HOUR
Future Value (1 r)n

• Present Value

• r Discount Rate and n Number of
  Periods

Dividing by One (1) is Return OF Investment
Dividing by Discount Rate is Return ON Investment
Technical Name Present Value of Lump
Sum Remember Dividing something up means
Making it Smaller (Discounting)
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IS ANYTHING OF THIS USEFUL?
THREE TOOLS OF THE TRADE Net Present Value (Need
to Know) Loan-to-Value Debt-Service-Coverage
Ratio Nice to Know
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NET PRESENT VALUE

• Determine Present Value of Future Cash Flows
  using Discount Rate
• Compare Present Value with Initial Investment
  Amount (Capital Budget/Start-up Amount)
• Difference equals NET
  PRESENT VALUE

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DECISION RULES

• If NPV is NEGATIVE (Present Value of Future
  Cash Flows LESS than Initial Investment),
  REJECT Opportunity (Value insufficient to
  justify Capital Outlay)
• If NPV is POSITIVE (Present Value of Future Cash
  Flows GREATER than Initial Investment), APPROVE
  Opportunity (Value justifies Capital Outlay)

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Loan-to-Value Ratio

• Compute Present Value using Only Discount Rate
  (Now Called a Capitalization Rate) and
  Stabilized Annual Cash Flow
• Result might be Market Value but as of When?
• Compute Ratio of Loan Amount to Market Value
  (Loan-to-Value Ratio)
• Rules Institutional Lenders use Not-to- Exceed
  Ratios 75 for Commercial Loans or 80 for
  Residential Loans

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Debt-Service-Coverage Ratio

• ORIENTATION Cash-Flow (Capacity to Pay) not
  Liquidation (Value-Based)
• Business/Commercial
• Forecast Stabilized Annual Cash Flow
• Compute Ratio of Cash Flow to Debt Payments
  (Cash Flow divided by Debt Service)
• Desired Range 130 or More
• Residential Divide Pre-Tax Income by Loan
  Payments, Property Taxes and Insurance
• Target 3-to-1 Ratio

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FINANCING

• CAPITAL STRUCTURE
• Sources of Funds
• Internal Retained Earnings or Bootstrapping
• External Debt or Equity
• Amounts and Timing
• Claims Cash Flow or Governance

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AND IN CONCLUSION

• Sticking to Fundamentals Is and Will Always be
  Best Rule
• Well-conceived Opportunities always get
  Financed
• Success in Getting Financed determined by
  Quality of Strategy
• Risk always Financeable Resolving Uncertainty
  is Entrepreneurs Challenge