CHAPTER 8 THE SEARCH FOR ENTREPRENEURIAL CAPITAL

CHAPTER OUTLINE

I. The Entrepreneur’s Search for Capital

II. Debt versus Equity
A. Debt financing
1. Commercial banks
a. Advantages
b. Disadvantages
2. Other debt-financing sources
B. Equity financing
1. Public offerings
2. Private placements
III. The Venture Capital Market
A. Recent developments in venture capital
B. Dispelling venture capital myths
1. Myth 1: Venture capital firms want to own control of your company and
tell you how to run the business
2. Myth 2: Venture capitalists are satisfied with a reasonable return on
investments
3. Myth 3: Venture capitalists are quick to invest
4. Myth 4: Venture capitalists are interested in backing new ideas or high-
technology inventions—Management is a secondary consideration
5. Myth 5: Venture capitalists need only basic summary information before
they make an investment
C. Venture capitalists’ objectives
D. Criteria for evaluating new-venture proposals
1. Stage 1: Initial screening
2. Stage 2: Evaluation of the business plan
3. Stage 3: Oral presentation
4. Stage 4: Final evaluation
E. Evaluating the venture capitalist
IV. Informal Risk Capital—“Angel” Financing
A. Types of angel investors
V. Summary

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CHAPTER OBJECTIVES

1. To differentiate between debt and equity as methods of financing

2. To examine commercial loans and public stock offerings as sources of capital
3. To discuss private placements as an opportunity for equity capital
4. To study the market for venture capital and to review venture capitalists’ evaluation criteria
for new ventures
5. To discuss the importance of evaluating venture capitalists for a proper selection
6. To examine the existing informal risk-capital market (“angel capital”)

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CHAPTER SUMMARY

This chapter has examined the various forms of capital formation for entrepreneurs.
Initial consideration was given to debt and equity financing in the form of commercial banks,
trade credit, accounts receivable financing, factoring and finance companies, and various forms
of equity instruments.
Public stock offerings have advantages and disadvantages as a source of equity capital.
Although large amounts of money can be raised in short periods of time, the entrepreneur must
sacrifice a degree of control and ownership. In addition, the Securities and Exchange
Commission has myriad requirements and regulations that must be followed.
Private placements are an alternative means of raising equity capital for new ventures.
This source is often available to entrepreneurs seeking venture capital in amounts of less than
$500,000, although it is possible that up to $5 million could be raised with no more than 35
nonaccredited purchasers. The SEC’s Regulation D clearly outlines the exemptions and
requirements involved in a private placement. This placement’s greatest advantage to the
entrepreneur is limited company disclosure and only a small number of shareholders.
In recent years the venture capital market has grown dramatically. Billions of dollars are
now invested annually to seed new ventures or help fledgling enterprises grow. The individuals
who invest these funds are known as venture capitalists. A number of myths that have sprung up
about these capitalists were discussed and refuted.
Venture capitalists use a number of different criteria when evaluating new-venture
proposals. In the main these criteria focus on two areas: the entrepreneur and the investment
potential of the venture. The evaluation process typically involves four stages: initial screening,
business plan evaluation, oral presentation, and final evaluation.
In recent years informal risk capital has begun to play an important role in new-venture
financing. Everyone with money to invest in new ventures can be considered a source for this
type of capital. Some estimates put the informal risk capital pool at more than $5 billion.
Entrepreneurs who are unable to secure financing through banks or through public or private
stock offerings will typically turn to the informal risk capital market by seeking out friends,
associates, and other contacts who may have (or know of someone who has) money to invest in a
new venture.

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LECTURE NOTES

THE SEARCH FOR ENTREPRENEURIAL CAPITAL

I. The Entrepreneur’s Search for Capital

Every entrepreneur faces the challenge of finding start-up capital. There are numerous
possibilities and combinations of financial packages that may be appropriate for a
business.
II. Debt versus Equity
The use of debt to finance a new venture requires a payback of funds plus a fee, whereas
equity financing involves the sale of some of the ownership in the venture.
A. Debt financing
Debt financing is popular for short term borrowing (one year or less) for working
capital and for long term borrowing (one to five years or more) for the purchase
of property or equipment.
1. Commercial banks
a. Advantages
1. No relinquishment of ownership
2. More borrowing allows for potentially greater return on
investment.
3. During periods of low interest rates opportunity cost is
justified.
b. Disadvantages
1. Regular interest payments
2. Intensified continual cash flow problems
3. Heavy use of debt can inhibit growth and development.
2. Other debt-financing sources
a. Trade credit
1. Given by suppliers who sell goods on account
2. Must be paid in 30 to 90 days
b. Accounts receivable financing
1. Short-term financing
2. Requires collateral
c. Factoring
1. Sale of accounts receivable
d. Finance companies
1. Asset-based lenders
B. Equity financing
Requires sharing ownership and profit with the funding source.
1. Public offerings
a. Advantages
1. Size of capital amount
2. Liquidity
3. Value
4. Image
b. Disadvantages

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 1. Cost
2. Disclosure
3. Requirements
4. Shareholder pressure
2. Private placements
a. Regulation D
1. Eased reports required for selling stock
a. Rule 504a-placements of less than $500,000
b. Rule 504-placements up to $1 million
c. Rule 505-placements of up to $5 million
d. Rule 506-placements in excess of $5 million
III. The Venture Capital Market
These experienced professionals provide the following services:
1. Capital for start-up
2. Market research for marketing department
3. Management consulting
4. Contact with prospective people
5. Assistance in negotiating
6. Counseling and guidance
A. Recent developments in venture capital
2001-2004 was a downward trend in venture capital activity; however VCs
have raised their investments in later stage companies and not start-ups or
early-stage venture. So VCs are more inclined to finance companies in more
mature stages.
B. Dispelling venture capital myths
1. Myth 1: Venture capital firms want to own control of your company and
tell you how to run the business
a. They want the entrepreneur and management team to run it
profitably.
2. Myth 2: Venture capitalists are satisfied with a reasonable return on
investments
a If there is a high degree of risk, there must be a high return on
investment.
3. Myth 3: Venture capitalists are quick to invest
a. t takes a long time to raise a venture capital.
4. Myth 4: Venture capitalists are interested in backing new ideas or high-
technology inventions—Management is a secondary consideration
a. Venture capitalists back only good management.
5. Myth 5: Venture capitalists need only basic summary information before
they make an investment
a. A detailed organized business plan is a must.
C. Venture capitalists’ objectives
1. Concerned with return on investment
2. Measure the product, service, and management of a business
D. Criteria for evaluating new-venture proposals
1. Stage 1: Initial screening

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 2. Stage 2: Evaluation of the business plan
3. Stage 3: Oral presentation
4. Stage 4: Final evaluation
E. Evaluating the venture capitalist
1. Does the venture capitalist understand the proposal?
2. Is the individual familiar with the business?
3. Is the person someone with whom the entrepreneur can work?
IV. Informal Risk Capital—“Angel” Financing
Many wealthy people are looking for investment opportunities. They are referred to
as business angels or informal risk capitalists.
A. Types of angel investors
1. Corporate angels
2. Entrepreneurial angels
3. Enthusiast angels
4. Micromanagement angels
5. Professional angels
V. Summary

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SUGGESTED ANSWERS FOR DISCUSSION QUESTIONS (END-OF-CHAPTER)

1. Using Figure 8.1 describe some of the sources of capital available to entrepreneurs, and
discuss how they correlate to the varying levels of risk involved with each stage of the
venture.
Figure 8.1 not in chapter draft
2. What are the benefits and drawbacks of equity and of debt financing? Briefly discuss
both.
One major benefit of equity is that there is no legal obligation to repay the principal
amount or pay interest on it. There are two types of equity financing: public offerings and
private placements. By going public you can raise large sums of capital in a short time.
Other advantages include liquidity, value on stock, and image. Along with advantages there
are disadvantages, which include cost, disclosure requirements, and shareholder pressure.
Private placements allow selling stock to private parties. Debt financing involves a payback
of the funds plus a fee for the use of the money. Advantages are: no relinquishment of
ownership, greater return on equity; and low interest rates. Disadvantages include: regular
interest payments, possible cash flow problems because of payback responsibility, and heavy
use of debt which can inhibit growth and development.
3. Identify and describe four types of debt financing.
(1) Commercial banks⎯This is the most common source. Most bank loans are secured by
receivables, inventory, or other assets.
(2) Trade credit⎯Credit given by suppliers.
(3) Factoring⎯The sale of accounts receivable at a discounted value; under a standard
agreement the factor will buy the client’s receivables outright.
(4) Finance companies⎯Asset-based lenders who loan money against assets such as
receivables, inventories, and equipment.
4. If a new venture has its choice between long-term debt and equity financing, which
would you recommend? Why?
I would recommend equity financing because it would give the entrepreneur the chance
to start off the small business with a big debt. Long-term debt matures in five years, which
isn’t adequate time for the business to show a large profit. Also, long-term debt is used
mainly to finance the purchase of property or equipment.
5. Why would a venture capitalist be more interested in buying a convertible debenture
for $50,000 than in lending the new business $50,000 at a 10 percent interest rate?
With a convertible debenture the venture capitalist would have an opportunity to own
stock in the company whereas the loan would not offer that opportunity.
6. What are some of the advantages of going public? What are some of the disadvantages?
Advantages Disadvantages
Size of capital amount Cost
Liquidity Disclosure
Value Requirements
Image Shareholder pressure

7. What is the objective of Regulation D?

Regulation D eases the regulations for reports and statements required for selling stock to
private parties.

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8. If a person inherited $100,000 and decided to buy stock in a new venture through a
private placement, how would Regulation D affect this investor?
There are no special disclosure/information requirements and no limits on the kind or
type of purchasers.
9. How large is the venture capital pool today? Is it growing or shrinking?
Venture Capital reversed a three year downward trend by investing $20.9 billion into
2,876 deals in 2004. Venture capitalists invested $29.4 billion into 3,8313 deals in 2007.
However, it should be understood that the Venture Capitalists (commonly referred to as VCs)
raised their investments in later stage companies and not start ups or early stage ventures.
10. Is it easier or more difficult to get new-venture financing today? Why?
It is more difficult to get new-venture financing because smaller start-up investments are
drying up. More money is being allocated to salvaging or turning around problem ventures.
Also, venture capital funds lack professionals who have experience with start-ups and first-
stage ventures.
11. Some entrepreneurs do not like to seek new-venture financing because they feel that
venture capitalists are greedy. In your opinion, is this true? Do these capitalists want
too much?
No, when venture capitalists invest in a business they are taking a very high risk and they
should be compensated for the risk.
12. Identify and describe three objectives of venture capitalists.
Security and payback: VCs want to invest in sound companies and expect the companies
to be successful; Return on investment: they expect a large ROI ;
Management team—VCs usually want to work with a team with good credentials
and experience
13. How would a venture capitalist use Figure 8.2 to evaluate an investment? Use an
illustration in your answer.
Figure 8.2 not in book draft
14. Identify and describe four of the most common criteria venture capitalists use to
evaluate a proposal.
1. Capable of sustained intense effort⎯Will the entrepreneur be able to cope with bad times
of the business?
2. Thoroughly familiar with the market⎯Does the entrepreneur know enough about the
market to operate in it?
3. At least ten times return in 5-10 years⎯Will the business profits show a return 10 times
the amount it started showing?
4. Demonstrated leadership in past⎯Has the owner held any leadership roles?

15. Of what practical value is Table 8.3 to new-venture entrepreneurs?

Table 8.3 would allow the new-venture capitalist and the owner to see how much return
on investment the venture capitalist would get from the business.
16. In a new-venture evaluation, what are the four stages through which a proposal
typically goes? Describe each in detail.
(1) Initial screening⎯This is a quick review of the basic venture to see if it meets the
venture capitalist’s particular interest.
(2) Evaluation of the business plan⎯This is a detailed reading of the plan done in order to
evaluate the factors mentioned earlier.

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 (3) Oral presentation⎯The entrepreneur will verbally present the plan to the venture
capitalist.
(4) Final evaluation⎯After analyzing the plan and visiting with suppliers, customers,
consultants, and others, the venture capitalist will make a final decision.
17. An entrepreneur is in the process of contacting three different venture capitalists and
asking each to evaluate her new business proposal. What questions should she be able
to answer about each of the three?
1. Does the venture capital firm in fact invest in your industry?
2. What is it like to work with this venture capital firm?
3. What experience does the partner doing your deal have, and what is his/her clout within
the firm?
4. How much time will the partner spend with your company if you run into trouble?
5. How healthy is the venture capital fund and how much has been invested?
6. Are the investment goals of the venture capitalist consistent with your own?
7. Have the venture firm and the partner championing your deal been through any economic
downturns?
18. An entrepreneur of a new venture has had no success in getting financing from formal
venture capitalists. He now has decided to turn to the informal risk capital market.
Who is in this market? How would you recommend the entrepreneur contact these
individuals?
This type of investor is someone who has already made his/her money and now seeks out
promising young entrepreneurs to support financially. They contact these individuals
through a network of friends. Also, many states are formulating venture capital networks,
which attempt to link informal investors with entrepreneurs and their new or growing
ventures.
19. How likely is it that the informal risk capital market will grow during the next five
years? Defend your answer.
The informal risk capital market will continue to grow and expand especially since
various states are making serious efforts to establish networks that bring together potential
entrepreneurs and informal investors.
20. Of all the sources of capital formation, which is ideal? Why?
The most ideal source of capital formation is informal risk capital. They are more
concerned with nonfinancial returns such as creation of jobs in areas of high unemployment,
development of technology for social needs, urban revitalization, minority or disadvantaged
assistance, and personal satisfaction in assisting entrepreneurs.

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TEACHING NOTES FOR END-OF-CHAPTER EXERCISE

EXPERIENTIAL EXERCISE: ANALYZING THE FUNDING SOURCES

This exercise is designed to help the student develop a better understanding about funding
sources. A list of funding sources is given, and the student is asked to write down what the text
says about its relation to small business. The student is then asked to go out into the field and
interview an actual example of that source and record what their relationships are like with small
firms.

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TEACHING NOTE FOR END-OF-CHAPTER CASE

CASE 8.1: LOOKING FOR CAPITAL

1. Would a commercial banker be willing to lend money to the Abramses? How much?
On what do you base your answer?
A commercial bank would not loan the Abramses the total amount. It would only loan a
portion. The most it would loan would be $4,000 in addition to the already available $6,000.
This is based on the fact that banks tend to loan conservatively, even to existing firms. Since
the Abramses mention no collateral other than inventory, the bank must assume that at
liquidation the books may only bring 5 to 10 cents on the dollar, $14,000 to $28,000. The
Abramses are also asking for a medium-term loan for an expanded product line. Banks
prefer short-term, highly secure loans. Since the Abramses sales are increasing steadily, the
bank would probably consider this small loan because there is collateral, but a large, long-
term loan would be seen as out of the question.
2. Would this venture have any appeal for a venture capitalist? Why?
Most venture capitalists would not be interested in the Abramses venture. Their business
does not yield the return on investment sought by most capitalists. Venture capitalists
generally target a 30 to 60 percent annual return for second stage developments. The Abrams
have not even reached break-even after a year in business.
3. If you were advising the Abramses, how would you recommend they go about seeking
additional capital? Be complete in your answer.
Make a dual recommendation to the Abramses. They should draw from their existing
line of bank credit to meet immediate needs only. By not borrowing more than absolutely
necessary, they will not put the added burden of repayment on an already fragile financial
situation.
Secondly, they should seek the additional capital needed for expansion from the informal
risk capital pool. Since the Abramses are in a business that has very loyal, involved
customers, they probably could find an individual to invest. The capital needed is not an
amount that would be prohibitive to a wealthy person.

CASE 8.2: THE $3 MILLION VENTURE

1. What would be the benefits of raising the $3 million through a private placement?
What would be the benefits of raising the money through a venture capitalist?
The sale of stock can be made to 35 non-accredited purchasers and to an unlimited
number of accredited purchasers. Thus, the benefit of using a private placement is to gain
equity investment from a larger number of people.
A venture capitalist offers the advantage of securing the entire amount ($3 million) from
one source. This guarantees the needed capital without the great deal of paper work that a
private placement would require.
2. Of the two above approaches, which would be best for Charles? Why?
Due to the number of interested customers that would purchase stock in the new ventures,
Charles should pursue the private placement instead of a venture capitalist. The amount of
ownership given up to a venture capitalist may be too great and there is a question of
investment by a venture capital firm in Charles’s type of business.

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3. What would you recommend that Charles do now? Briefly outline a plan of action that
he can use in getting the financing process started.
Charles could pursue a private placement for a portion of the money needed ($2 million,
for example). Then, he could secure a loan from the bank for the remaining amount ($1
million). Thus, he would keep the venture balanced between equity and debt, however, the
equity side would be stronger.

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SMALL BUSINESS AND ENTREPRENEURSHIP RESOURCE CENTER

Sources:
Question 1:
How to Apply for a SBA Loan.(How To: The Source to Better Your Business).
Inside Business 10.2 (Feb 2008): p58(1).

Question 2:
Money Matters: Using Sound Resources, You Can Find Capital for Your Business.
(FINANCING). Carolyn M. Brown.
Black Enterprise 38.4 (Nov 2007): p101 (1).

Questions:

1. How do you apply for an SBA loan, and how can a company prepare properly for the
loan proposal?

A. Her The SBA doesn't make direct loans to consumers, so one way to get such a loan is to
connect with a local lender who has an established history and the necessary expertise with
SBA loans, says Brian A. Fisher, vice president of commercial and business banking at
FirstMerit Bank.

SBA loans are attractive options for new businesses because there can be flexibility with the
terms and required equity, Fisher says.

"The first step in applying for a loan, which will eventually be guaranteed by the SBA, is to
look for a bank that's a SBA-preferred lender," Fisher says. "Those banks, like FirstMerit,
have already been authorized to submit loans on its behalf, the underwriting is sufficient and
the bank is in good standing with the SBA."

Next, assemble a team of trusted advisers. "That should include a banker, accountant,
attorney, insurance agent and, in many cases in Northeast Ohio, a small-business
development center," Fisher says.

Your team can help develop your business plan, which is necessary for a loan proposal. It
should cover three big questions a lender will likely ask: How much money do you need?
Why do you need it? How will you be paying it back?

"An ideal borrower is really a prepared borrower who has taken the time to research his or
her strengths and weaknesses as a potential business owner," Fisher says. "He or she has also
taken the time to research the market, the product and similar companies (potential
competitors)," says Fisher.

In addition, it's important for the borrower to have good credit. "How one handles his or her
personal credit is an indication of how that person will handle the business and the business'
credit. It's a strong indicator of how that loan is going to perform," he says.

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 While the timetable for the loan process varies with the complexity of the deal and
preparedness of the borrower, it's possible to complete the process in 30 days or less.

2. Securing access to adequate financing has become more difficult over the past 10 years.
What are some resources for small business financing?

A. The Capital Resources:

* Angel Investors: Typically among the earliest sources of funding for budding
entrepreneurs. Such investors are available to finance your business and believe in your
vision just as much as you do. They provide seed capital ranging from a few thousand dollars
to as much as $1 million. Angel Capital Association, www.angelcapitalassociation.org

* Interpersonal Funding: Private monies from friends and family, a fast and easy source.
Terms are usually more lax than with other forms of borrowed capital. Receipts should be
drawn up to show the exchange and any stipulations for repayment. Circle Lending,
www.circlelending.com

* Loans: The Small Business Administration offers various loan programs. Its Community
Express Program grants loans from $5,000 to $50,000 in conjunction with preferred lenders
(www.blxonline.com/Products_Community_Express.cfm). Small Business Administration,
www.sba.gov

* Micro lending: For startups without access to traditional financing. Regional and national
nonprofit groups make loans from as little as $500 up to $35,000, and repayment terms are
less stringent. Lenders may also offer financial and business workshops. Each organization
has its own lending requirements. ACCION USA, www.accionusa.org

* Venture Capitalists: The least likely source of funds for startups, according to NSBA
president Todd McCrackin. He says venture capitalists tend to shy away from very new
businesses and rarely invest less than $5 million at a time. National Association of
Investment Companies, www.naicvc.Corn ; National Venture Capital Association,
www.nvca.org

Where to go for help:

* Association of Small Business Development Centers, www.asbdc-us.org
* National Business Association, www.nationalbusiness.org
* SCORE (Service Corps of Retired Executives), www.score.org
* The Minority Business Development Agency, www.mbda.gov

Books
Raising Capital for Dummies by Joseph W. Bartlett and Peter Economy (For Dummies;
$24.99).

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