Ch.7 Growth-Stage Financing

Debt - Current Assets - answering first question (local banks - 3 quetsions)

Answers first question (Will the borrower be able to pay me back?) Because current assets (cash, securities, accounts receivable, inventory) can be turned readily into cash, this ratio imparts a sense of a company's ability to pay its bills (current liabilities) as they come due. The size of the current ratio that a healthy company needs to maintain depends on the relationship between inflows of cash and demands for cash payments. A company that has a continuous and reliable inflow of cash or other liquid assets, such as a public utility or a taxi company, may be able to meet currently maturing obligations easily despite a small current ratio—say, 1.10 (which means that the company has $1.10 in current assets for every $1.00 of current liabilities). On the other hand, a manufacturing firm with a long product-development and manufacturing cycle may need to maintain a larger current ratio. **To confirm the absolute liquidity of an organization, a bank credit analyst can modify the current ratio by eliminating from current assets all the assets that cannot be liquidated on very short notice. Typically then, this ratio, called the acid-test ratio, consists of the ratio of so-called quick assets (cash, marketable securities, and accounts receivable) to current liabilities. Inventory is left out of the calculation.** Acid-Test Ratio=Quick Assets/Current Liabilities Paradoxically, a company can have loads of choice assets—office buildings, fleets of delivery trucks, and warehouses brimming with finished-goods inventory—and still risk insolvency if its ratio of current (or quick) assets is insufficient to meet bills as they come due. Creditors don't take payment in used delivery trucks; they want cash.

Ch.7 Summary

Growth-phase entrepreneurs look to internally generated cash flow, asset-based loans, and external equity capital for financing. Bankers look to a borrower's ability to repay, character, and collateral before making a loan. The current ratio, the acid-test ratio, and the times-interest-earned ratio give lenders insights into the ability of a prospective borrower to repay a loan. Debt is generally the lowest-cost form of capital because interest payments are tax deductible; however, carrying debt makes an enterprise riskier. A public issuing of shares (initial public offering, or IPO) is a major milestone for the few entrepreneurial firms that reach it. An IPO provides a major infusion of cash to fuel growth. Maturity-phase financing for creditworthy companies may include bank loans and the sale of commercial paper, bonds, and stock. It's best to finance short-term assets with short-term financing, and long-term assets with long-term debt or shareholders' contribution.

Debt (local banks - 3 quetsions)

Most local banks will extend loans to a startup only if they are comfortable with the situation and the qualifications of the borrower. What makes bank lenders comfortable? Bankers ask three questions before they lend money, and they rarely part with their capital if they cannot obtain satisfactory answers to all three: 1.​Will the borrower be able to pay me back? 2.​Is the borrower's character such that he or she will pay me back? 3.​If the borrower fails to repay me, what marketable assets can I get my hands on? *In seeking an answer to the first question, a banker will evaluate the entrepreneur's skills and the business plan: Does the applicant understand the market and have a feasible plan for satisfying it? Does the entrepreneur have the experience or knowledge—or both—required to operate this type of business? Is the business plan realistic, complete, and based on reasonable assumptions? Are the plan's revenue and cost projections realistic and conservative? Because loan repayments will be made from cash flow, a lender will be particularly interested in projected cash flow. *If the business is already operating, the banker will look to the prospective borrower's current ratio to get a sense of his or her ability to repay the loan. The current ratio is represented by this simple formula: Current Ratio = Current Assets ÷ Current Liabilities*

Matching assets and fianancing

One of the principles of financing—whether the funding is to start a company, maintain its operations, or advance its growth—is to make a proper match between the assets and their associated forms of financing. The general principle is to finance current (short-term) assets with short-term financing, and long-term assets with long-term or permanent financing. Ex: The use of supplier trade credit for financing inventory, as described in chapter 6, is an example of matching short-term assets with short-term financing. The shoe-store owner matched sixty-day financing against an asset expected to be sold within that period. Similarly, companies finance their infrastructure of office space, systems, and equipment with either long-term debt or capital supplied by shareholders—more permanent forms of financing. Countless enterprises follow this principle. When states and municipalities build bridges, hockey stadiums, water treatment plants, and so forth, they typically finance them with 20-30 year bonds—financing vehicles whose maturities roughly match the productive life of the assets. To understand why this principle is important, consider first what might happen if you tried to finance the purchase of your new home (a long-term asset) with an 8 percent, nonamortizing $200,000 loan that came due in only three years. Under the terms of the loan, you'd pay $16,000 in annual interest and then would be obligated to repay the $200,000 at the end of the third year. This would be feasible if you could negotiate another loan at the end of three years to replace the one that's due and if interest rates were still affordable. But that's two ifs. Money might become so tight that you could not locate a new lender when you needed one, or the lender you found might want 10 or 12 percent. In either case, foreclosure would be likely. You couldn't operate with such a situation, and neither can a business enterprise. The opposite mismatch situation—borrowing long to finance a short-term asset—is just as bad. Some people take out second mortgages on their homes to finance a dream vacation. Such are the temptations of home equity loans. The vacation will soon be over, but the payments

Online lenders (growth-stage financing)

Over the past decade, a growing number of online lenders such as Kabbage, OnDeck, and Funding Circle have begun to compete for local banks' share of the small business and entrepreneurial lending market both in the US and throughout the world, most markedly in China. By 2015, some 20 percent of small-employer firms in the US reported applying for funding from an online lender. Though most were approved for at least some credit, they reported lower satisfaction than those who had worked with a small bank or credit union. Other new and growing forms of financing come from peer-to-peer lending networks such as Lending Club and Prosper

Other forms of external financing

So far, there is supplier trade credit, bank loan, and common stock issues - all important forms of external financing. Today's mature corp. is also used a few other important forms of financing: Commerical paper Bonds Preferred stock

Local banks (Equity and Beyond)

are also important sources of external financing as growth continues

Most companies never (Equity and Beyond)

get beyond this early phase of growth, they either get acquired or fail

companies who have succeeded (Equity and Beyond)

have access to a broader spectrum of financing opportunities - in particular, the public stock market. The prospect of even greater growth is a powerful lure to equity investors, who hope tp buy shares while shares are still cheap and the company is unrecognized.

During the growth stage

your business expands its sales and develops a growing base of customers. As a result, you'll need more capital—for expanding your operation, hiring and training new employees, and even acquiring other small businesses. Your company may already be generating some positive cash flows that can help finance these initiatives, but you'll probably need more cash if your growth is strong or if your strategy is to build brand visibility. Having now proven your business's credibility, though, you can generally tap external capital more easily than you could in the startup phase. For slow- to moderate-growth firms, much of that capital comes from bank debt. If your business is likely to grow large quickly, on the other hand, you will need to obtain equity capital

SBA Loans

The SBA manages three loan programs intended to help small businesses owned by US citizens obtain financing. The administration itself does not grant loans; rather, it sets guidelines for loans, and its partners (lenders, community development organizations, and microlending institutions) make the loans. What makes these deals palatable to financial institutions is that the SBA guarantees repayment up to certain levels, eliminating some of the lender's risk. Certain legislation passed in the wake of the 2008 recession to stimulate small-business development made these loans even more attractive to both lenders and borrowers.

Growth in businesses (Equity and Beyond)

The business now has a confidence-inspiring record of producing revenues and paying its bills. Its current and times-interest-earned ratios are favorable. And it has assets that it can pledge as collateral for asset-based loans or leases. The company may also have grown so much that it has outgrown the lending capacity of its local bank, in which case the company can move upstream to a large money-center bank.

Equity and Beyond

The counterweight to heavy debt is owners' equity. Equity capital is obtained through the sale of shares to investors, including the entrepreneur. The typical entrepreneurial enterprise in the growth phase is neither large enough nor proven enough to become a public company—that is, to launch an initial public offering (IPO) of shares. As a result, it cannot tap broader equity markets. If the company is in a hot growth industry, or if it is close to producing a breakthrough with some game-changing product, it may gain the attention of a VC firm or an angel investor. If this private investor likes the looks of the business, it may make a sizable capital contribution. But it is relatively unusual for an early-phase company to generate this kind of capital

Debt (Growth-Stage Financing)

When your company is growing, you often obtain your debt capital from local banks. Banks are often reluctant to offer long-term loans to small firms. Bankers are justifiably nervous about making long-term or unsecured loans to startup businesses, because the failure rate is high. They are more eager to extend short-term demand loans, seasonal lines of credit, and single-purpose loans for machinery and equipment. Small businesses tend to be more successful getting loans from small community banks rather than from larger banks, and they report more satisfaction working with these local lenders as well. Even then, small businesses typically take out fairly small bank loans: 54 percent of small firms hold less than $100,000 in debt

Assuming that the mature company is creditworthy (Growth not Lasting)

Assuming that the mature company is creditworthy, it has many options for obtaining additional external funds. For short-term needs, it can issue commercial paper (explained later in the chapter), tap its bank line of credit, or negotiate a term loan with a bank or other financial institutions, such as insurance companies and pension funds. The mature company can use its existing assets and cash flow as collateral to lower the cost of loans. Alternatively, the company can obtain significant funds through sale-and-leaseback arrangements. The healthy, mature company also enjoys access to public capital markets for debt (bonds) and equity capital (stock). Here, timing is all-important. The company naturally wants to sell its bonds when interest rates are low and sell its shares when share prices are high.

Bonds (Other forms of external financing)

Besides here is supplier trade credit, bank loan, and common stock issues there is this that... A bond is also a debt security (an IOU), usually issued with a fixed interest rate and a stated maturity date. The bond issuer has a contractual obligation to make periodic interest payments and to redeem the bond at its face value on maturity. Bonds may have short-, intermediate-, or long-term maturities (e.g., from one to thirty years). Generally, they pay a fixed interest rate on a semiannual basis.

Commercial paper (Other forms of external financing)

Besides here is supplier trade credit, bank loan, and common stock issues there is this that... Large corporations with high credit ratings often use the sale of commercial paper to finance their short-term requirements. They use it as a lower-cost alternative to short-term bank borrowing. Commercial paper is a short-term debt security, generally reaching maturity in 2 to 270 days. Most paper is sold at a discount from its face value and is redeemable at face value on maturity. The difference between the discounted sale price and the face value represents interest to the purchaser of the paper. Investors having temporary cash surpluses are the usual purchasers of commercial paper; for them it is a reasonably safe way to obtain a return on their idle cash.

Preferred Stock (Other forms of external financing)

Besides here is supplier trade credit, bank loan, and common stock issues there is this that... This type of equity security is similar to a bond in that it pays a stated dividend to the shareholder each year, and after the shares begin trading in the secondary market, then the share prices, like bonds, fluctuate with changes in market interest rates and the creditworthiness of the issuer. Also like bonds, preferred stock is used by some corporations as an external form of equity financing.

The right amount of debt

Carefully consider how much bank debt your company can handle. The degree to which the activities of a company are supported by liabilities and long-term debt as opposed to owners' capital contributions is called leverage. A firm that has a high proportion of debt relative to owner contributions is said to be highly leveraged. For owners, the advantage of having high debt is that returns on their actual investments can be disproportionately higher when the company makes a profit. On the other hand, high leverage is a negative when cash flows fall because the interest on debt is a contractual obligation that must be paid in bad times as well as good. A company can be forced into bankruptcy by the crush of interest payments due on its outstanding debt The debt ratio is used to assess the degree of leverage used by companies and its attendant risks. it is calculated in different ways. 2 are mentioned here. The simplest: Debt Ratio = Total Debt/Total Assets Or, you can calculate debt-to-equity ratio Debt-To-Equity Ratio=Total Liabilities/Owners' Equity aka Shareholders' Equity In general, as either of these ratios increases, the returns to owners are higher, but so too are the risks. Creditors understand this relationship extremely well and often include specific limits on the debt levels beyond which borrowers may not go without having their loans called in. Creditors also use the times-interest-earned ratio to estimate how safe it is to lend money to individual businesses. The formula for this ratio is as follows: Times-Interest-Earned Ratio = Earnings Before Interest and Taxes ÷ Interest Expense The number of times that interest payments are covered by pretax earnings, or EBIT (earnings before interest and taxes), indicates the degree to which income could fall without causing insolvency. In many cases, EBIT is not so much a test of solvency as it is a test of staying power under adversity. For example, if EBIT were to be cut in half because of a recession or another cause, would the company still have sufficient earnings to meet its interest obligations?

Maturity-Phase Financing (Growth not Lasting)

Companies cannot continue growing forever. Especially because growth eventually subsides for one or more reasons Success and profitability draw competitors into the market. Demand for the product or service is largely satisfied (market saturation). There is a shift in the technology used in the company's products—or the technology used by your customers. As the organization grows larger, it loses ambition, agility, or the ability to innovate. Whatever the cause, few companies sustain high growth rates for more than a decade. This does not mean that growth necessarily stops and that continued financing is not needed. Even saturated markets for mature products, such as automobiles, continue to expand incrementally as the population increases and as people in developing countries become more affluent and demand them. For a $1 billion enterprise, even a 3 percent growth in revenues may require additional financing. Then, too, mature companies are often involved in mergers, acquisitions, restructuring, or other activities, all of which have important financing implications.

eBay's cash flow of operations - self-financing (eBay's remarkable growth was principally financed in two ways)

In the early days, cash flow from operations was an important source of growth financing. The company's cash-flow statement—which totals the cash flow entering and leaving the enterprise through operations, investments, and financing activities—documents the effect of internally generated financing. Shown on the image. The first row, net cash provided by operating activities, shows that the company ran some portion of its operations and paid people's salaries, taxes, and other bills (operating activities) from operating cash flow. What's more, the level of positive cash flow from operations grew substantially from year to year, helping to fund growth. Thus, an important portion of eBay's asset growth was financed internally, from its successful and profitable operations. Instead of returning even a cent of that cash to shareholders in the form of dividends, the company plowed everything back into the business. This practice is typical of fast-growing companies.

eBay's external financing - loans and the sale of ownership shares (eBay's remarkable growth was principally financed in two ways)

Internally generated cash was sufficient to finance operations in the early days, but not nearly sufficient to fund eBay's meteoric growth. Large as they were, eBay's operating cash flows paled in comparison with the cash outflows caused by in vestments during the same period. In the best of those years (2000), cash flow from operations covered slightly less than half of the investment outflow. To make up the difference, the company resorted to external financing (depicted in the line labeled "Net cash provided by financing activities" in table 7-2). eBay's financial statements, which are too voluminous to show here, indicate that almost all its external financing took the form of stockholders' capital; that is, the company and its subsidiaries raised cash by selling shares (almost all common shares) to investors. The next big capital-raising event in eBay's history was its 1998 IPO. An IPO is a major milestone in a corporation's life cycle in that the offering marks the company's transition from a private to a public enterprise. As you'll see in a later chapter, this new status opens up much larger opportunities to raise equity capital. The universe of potential capital contributors expands from the small and clubby circle of private investors to a much broader group of individual investors, mutual funds, and pension funds. An IPO also enables the existing investors, including the venture capitalists and shareholding employees, to cash in some or all of their shares—turning paper certificates into real money. eBay's Omidyar, for example, held more than forty-four million shares of his company's common stock before its IPO. In the wake of the offering and the stock price run-up in the months that followed, Omidyar became a billionaire four times over.

Debt - Having Loads of Choice Assets - answering second question (local banks - 3 questions)

Lenders generally answer the second question—"Is the borrower's character such that he or she will pay me back?"—by examining your credit history. Whether it's a car loan, a home mortgage, or a business loan, a banker will want to see evidence that you pay your bills on schedule.

IPO (Equity and Beyond)

The major milestone in the growth phase for those few enterprises that show exceptional promise. These offerings are managed by one or more investment banking firms selected by the issuing company. The investment bankers help the issuing company navigate through the strict regulatory requirements of issuing shares to the public. More important, the investment bank and its syndicate of broker-dealers (stockbrokers) provide direct access to millions of potential investors: individual investors, mutual funds, pension funds, and private money managers. "An Initial Public Offer (IPO) is the selling of securities to the public in the primary market. It is the largest source of funds with long or indefinite maturity for the company. An IPO is an important step in the growth of a business. It provides a company access to funds through the public capital market."

Debt - Third Question - Collateral (local banks - 3 questions)

The third question—"What assets can I get my hands on?"—is about collateral. Collateral is an asset pledged to the lender until such time as the loan is satisfied. In an automobile loan, for example, the lender retains title to the vehicle and makes sure that the buyer has made a sufficiently large down payment so that the lender can repossess the car, sell it, and fully reimburse itself from the proceeds if the borrower fails to make timely loan payments. Business loans are similar. The lender wants to see assets that can, if your business fails, be sold to satisfy the loan. Those assets might be current assets such as cash, inventory, and accounts receivable; they might also include fixed assets such as vehicles, buildings, and equipment. Loans backed by the SBA offer these kinds of guarantees in the business owners' stead. For more on these US government-backed loans, see the box "SBA loans." Debt is one of the lowest-cost sources of external capital because interest charges (in the US tax system) are deductible from taxable income. This deductibility, of course, doesn't do a company much good if it has no taxable income to report yet.

Financing growth at eBay

To better appreciate the sequence of financing experienced by growing entrepreneurial enterprises, consider eBay, perhaps the most successful company of the dot-com age. It exploded from a home-based hobby business to a sizable corporation in only a few years. The company's early history (1995 through 2000) illustrates the role played by various forms of financing. Glance over section in Book Growth With total assets of nearly $1.2 billion, eBay was light-years away from Omidyar's apartment operation. Where did the money come from to finance those assets? eBay's remarkable growth was principally financed in two ways: first, by cash flows from operations (self-financing) and second, by loans and the sale of ownership shares (external financing).