Basic Financing Principles
Unlike not-for-profit organizations, for-profit businesses are typically unable to rely upon government funding or private grant sources to meet their cash requirements. Therefore, they generally must raise capital by either selling equity or borrowing debt in order to finance their activities. A few of the major uses of cash by for-profit businesses are described below:
- Businesses must incur start-up expenses, such as for research and development, in order to first make the product or service ready for sale to customers.
- For ongoing operations, the cash expenses to run the business and produce the product or deliver the service must generally be paid before the cash income from sale of the product or service will be received.
- When the business is growing, the need for cash is often the greatest because the investment necessary to achieve growth usually occurs before the generation of revenue from new sales.
Risk vs. Reward
The basic rule for all business financing is that there is a direct relationship between risk and expected reward — that is, investors or lenders expect higher returns on their money when the risk of losing their money is high, and accept lower returns on their money when the risk of losing their money is low. Two additional factors often affect start-up financing:
- The risk of losing money in a start-up business is generally greater than the risk of losing money in an established business.
- The risk of losing money that is not secured — or backed — by assets of the business (such as inventory, receivables from customers, equipment or real estate) is greater than the risk of losing money that is secured by such assets. (The equivalent distinction in personal finance is that between a home mortgage loan, which is secured by the borrower’s house, and credit card debt, which has no such security.)
Debt vs. Equity
The two basic building blocks of corporate finance are debt and equity. In general terms, from the financier’s point-of-view, the major differences between debt and equity are as follows:
- Debt entitles the holder to receive back a fixed amount of money, plus interest at a specific rate, at a specific time.
- Equity allows the holder to receive back an unlimited return on its investment depending upon the success of the business. The two basic types of equity are described below:
- Common stock – does not entitle the holder to any specific return, but provides the unlimited right to share (based on percentage ownership) in the eventual success of the business.
- Preferred stock – shares the best features of debt and common stock, in that it first entitles the holder to receive back a fixed amount of money plus a specific return, and then provides the holder the unlimited right to share (based on percentage ownership) in the eventual success of the business. Convertible preferred stock is similar to regular preferred stock except that it may be converted into common stock in the future on specified terms.
- Repayment priority – in case the company goes out of business, this important factor entitles the holders of debt to be paid before those of preferred stock, and the holders of preferred stock to be paid before those of common stock.
In practice, the difference between debt and equity is really a continuum, since an unlimited variety of instruments can be created that blend the basic features of debt and equity in different ways.
From the point-of-view of the business (rather than the financier), debt is ordinarily considered more risky than equity because the business is obligated to repay the debt at a specific time, when it may be inconvenient or impossible to do so. However, if the business is successful, debt is considered less “expensive” than equity because the debt holder is only entitled to a fixed payment rather than an unlimited participation in the success of the business.
The Importance of Venture Capital Financing
Venture capital financing is an important type of financing for early-stage businesses, which typically need funds before they have assets to obtain sufficient asset-based financing, and before they are large enough to raise public financing. Venture capital firms generally purchase convertible preferred stock in the companies in which they invest, in order to reduce their risk relative to the entrepreneurs but still be entitled to participate in the success of the business.
Venture capital usually refers to financing provided by the 2,000 or so traditional venture capital firms in the country, as opposed to early-stage equity financing provided by less formal (often individual) investors, who are sometimes called “angel investors” or “adventure capitalists.” In fact, traditional venture capital financing is a small fraction of total new venture financing in the U.S. However, since traditional venture capitalists comprise the most prominent and sophisticated group of investors that provide capital for emerging business opportunities, their activities in a particular industry are often regarded as important predictions about the future of that industry.Traditional venture capital investments typically have high risks of loss associated with them, and therefore must offer similarly high opportunities for success to attract the attention of the venture capital investor. Venture capitalists earn their livings by identifying emerging opportunities, companies and industries that they believe will achieve extraordinary success over the next five years or so. Accordingly, venture capitalist attention to a particular industry is often a sign that the targeted industry is likely to expand in the coming years.Venture capitalists often assist companies in which they have invested to go public or be sold to a larger business once the companies have achieved sufficient size. In addition, venture-backed companies may decide to expand themselves by acquiring other businesses. For this reason, an increase in venture capital investment in an industry today is often associated with an increase in public offering and merger & acquisition activity in that industry in a few years.