REV: AUGUST 1, 2006
HOWARD H. STEVENSON
MICHAEL J. ROBERTS
New Venture Financing
One of the most common issues which an entrepreneur faces revolves around securing financing for the new venture. The questions of how and when to raise money and from whom are frequent topics of concern. This piece will attempt to describe some common sources of capital, and the conditions under which money is typically lent or invested.
As in most transactions, the owners of capital expect to get something in return for providing financing for the venture. In evaluating potential opportunities, the providers of funds will typically use some form of a risk/return model. That is, they will demand a higher return when they perceive a higher risk; and they will seek to maximize their return for any given level of risk. The entrepreneur’s objective, of course, is to secure financing at the lowest possible cost. The art of successful financing, therefore, lies in obtaining funds in a manner which those providers of funds view as relatively less risky.
The entrepreneur can do several things to obtain financing so it will be perceived as “less risky”: •
pledge personal or corporate assets against a loan.
promise to pay the money back in a short period of time, when the investors can judge the health of the business, rather than over the long term, when its financial strength is less certain.
give investors a preferred or priority return i.e., a disproportionately large share of early financial returns.
give investors some measure of control over the business, either through loan covenants, deal terms, or participation in management (i.e., a seat on the board).
Seek financing from investors who are knowledgeable about “the space” and therefore, more comfortable with the uncertainties inherent in that specific sector. Note that these are only a few of the possible mechanisms.
________________________________________________________________________________________________________________ This note derives from an earlier note, “Alternative Sources of Financing,” HBS No. 384-187, by Professors Howard H. Stevenson and Michael J. Roberts. This version was prepared by Professors Howard H. Stevenson and Michael J. Roberts. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.
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New Venture Financing
The liabilities side of the balance sheet itself provides a good overview of the potential sources of financing. Because this side of the balance sheet is arranged in order of increasing risk, it follows that the lowest cost forms of financing will usually be available from the higher balance sheet items.
New Venture financing provides the entrepreneur with a host of unique challenges. The highest risk capital (and therefore potentially highest return capital to the investor/highest cost capital to the entrepreneur) is at the bottom of the balance sheet as equity. When a business is in the start-up phase, it is at its riskiest point. Therefore, equity capital is usually an appropriate source of financing during this period. That is not to say that debt capital is unattractive. It may even be available when secured by assets of the business, such as a building or equipment. However, some equity is usually required to get a business...