Subject Entrepreneurship

Segment Financial Elements

Topic Sources of New Business Financing

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Table of Contents
1. Overview
2. Bootstrapping
3. Bootstrapping Equity: Founders, Friends, Family and Fools
4. Bootstrapping: Bartering and Skunk Works
5. Primary Sources of Financing: Equity
6. Primary Sources of Financing: Debt
7. Financing: Do's and Don'ts
8. Start-up Financing for LiveREADS
9. Self-Assessment
10. Summary

1. Overview
You learned about the four basic financial needs: working capital, fixed asset
financing, one-time start-up expenses and extra cash. You also learned about the
implications of a business being overcapitalised and undercapitalised.
It is tempting to say that once the entrepreneur knows how much he or she needs
and for what, then the process of looking for financing begins. Although this is a
rational and linear way of thinking about financing, this is not how many
entrepreneurs approach financing their business. Many entrepreneurs do get started
in pre-business and early stage activity in the bootstrapping mode.
In this topic, you will learn more about bootstrapping and the various sources of
bootstrapping equity. You will also learn about the two primary sources of financing,
equity and debt.
Objectives: Sources of New Business Financing
Upon completion of this topic, you should be able to:
 explain the potential of bootstrapping to finance new ventures
 identify various sources of private financing
 describe the primary sources of finance, equity and debt

2. Bootstrapping

Bootstrapping, or starting a new business with almost no capital and little more than
the entrepreneur's own hard work and effort, is a commonly practised start-up
financing strategy. This is better illustrated in the following article.
Reading: The Value of Bootstrapping
Believing in a "big money" model of entrepreneurship, entrepreneurs often spend a
lot of time trying to attract investors instead of using wits to get their ideas off the
ground. Read the following article to learn more about bootstrapping.

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Subject Entrepreneurship
Segment Financial Elements
Topic Sources of New Business Financing

Bhidé. A. “Bootstrap finance: The Art of Start-Ups” , Harvard Business Review

(November – December 1992): 190-117.
As Bhidé notes, many businesses are started with less than $1,000 and the average
start-up capital (in 1991 when he did his study) was $10,000. Bootstrapping then
becomes a type of phased financing, except that the entrepreneur is starting from
zero. The author suggests that many entrepreneurs would be better off starting
small for the following reasons:
 Having less money forces you to set priorities.
 Starting with modest funds forces you to get into cash generating activities
early.
 Starting small allows you to make mistakes that do not cost too much.
 Proving that your concept is workable before raising big money enables you
to hold on to more of the ownership of the company.
 Less cash on hand makes it necessary to hire up-and-coming highly
motivated people, instead of highly priced and less productive talent.
This is the argument for bootstrapping and many successful firms have begun this
way, as Bhide illustrates. It is the way to go if it fits the needs of your business and
entrepreneurial orientation. The downside of bootstrapping is that you start out as an
undercapitalised firm, and although you have successes along the way, you are
never quite able to catch up and finance the growth you want to achieve.
In 2002, most seed capital and risk capital supplied to entrepreneurs by informal
investors still came in very small amounts and primarily from family and friends.

3. Bootstrapping Equity: Founders, Friends, Family and

Fools
The first source of funds for a new venture is from the founders themselves. It is
almost imperative that people put up their own money to start their businesses. This
indicates that they are serious and that they have something at risk. This is the most
basic source of start-up capital for entrepreneurs.
How much of your own money should you be prepared to invest in your own
business?
This is a complicated question. On one hand, you should be prepared to invest
everything because you send the wrong message to other investors if you hold back.
They might perceive that you do not believe you will be a success. On the other
hand, it is unreasonable to think that if you start a business, your financial future will
be "all or nothing". You should be able to keep a reasonable amount of capital out of
the business, safely set aside to protect your family and yourself. That amount will
depend on the situation, but it is reasonable and fair to set aside money for the
following:
 Children's education
 Retirement accounts (depending on your age)
 Health savings accounts and insurance
 Equity in your home (depending on the size of the home)
 Amortisation of previous personal debts
After their own money, entrepreneurs primarily go to people whom they know best
and who know and trust them: friends, family and fools. The "fools" here refer to the
sometimes unsophisticated nature of these investors. They are less likely to demand
to see a business plan. They are sometimes willing to invest despite the apparent
lack of an exit strategy that might ensure they get their money back. They

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Subject Entrepreneurship
Segment Financial Elements
Topic Sources of New Business Financing

frequently will require less than market-adjusted risk rates of return. If this were a
subject about investing strategy, we would recommend that these investors act more
like professional investors. However, they are not professional investors by
definition. As you have already seen, this is the most popular source of financing in
the United States and probably the most popular source in the world.
Reading: "Love Money"
Getting money from family and friends is often the best or only way to get seed
capital for most of new ventures. Read the article below about the issues involved in
borrowing from family and friends.
"What's Love Got To Do With It?", Profit vol. 26 issue 2 (May 2007): A11-13
While reading the article, reflect on the questions below.
 How did various entrepreneurs deal with the people from whom they
borrowed money?
 What are some of the ways in which both, the borrower and the lender, can
protect their interests?
The article illustrates that there is a potential strain on the relationship of the
borrower and the lenders, if dealings are not on a professional footing amongst
them. However, with proper measures, it can be very rewarding for the borrower as
well as the lender. Use of legal contracts and notes of repayment can serve to keep
all dealings business-like and prevent any misunderstandings amongst the borrower
and the lenders.

4. Bootstrapping: Bartering and Skunk Works

In the context of bootstrapping, there are also some non-traditional ways to finance
a business, such as bartering or the use of skunk works. Let us review them in the
presentation below.

Bartering and Skunk Works

Let us learn more about Bartering and Skunk Works.
Bartering
The propensity to truck, barter and exchange one thing for another, is common to all
men, and to be found in no other race of animals. As quoted by Adam Smith in 1776.
Bartering means trading some product or service that you have for some product or
service that another company has, and no cash is exchanged. Small businesses just
getting started use this technique with some frequency.
Let us look at an example.
Bartering is the oldest form of trade. However, it is a modern entrepreneurial
phenomenon too. Dyana Klein runs a doggie day care centre in San Jose California.
When she was short on cash, she resorted to bartering to fulfil her bills. Now, she
provides $25,000 worth of services in exchange for $25,000 worth of services. Read
the article San Jose Area Entrepreneurs Turn to Bartering to learn how the barter
system works.

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Subject Entrepreneurship
Segment Financial Elements
Topic Sources of New Business Financing

Skunk Works
What is Skunk Works?
A skunk work can be defined as using borrowed resources and assets. Skunk Works
are found in larger businesses that are trying to encourage people to start
intrapreneurial ventures. The companies allow and enable employees to borrow
resources such as offices, equipment, people or money from ongoing operations to
experiment and develop innovative new products and services. The normal practice
to obtain capital for new enterprises in larger companies is obtained through the
capital budgeting process, which is an expenditures plan where a business identifies
its capital needs, likely funding, impact of new capital investments and accounting
system for those capital investments.
Let us look at an example.
Cisco Systems is one of the largest companies in the world, and at one point in the
year 2000, it had the highest market valuation of publicly listed company. It is
difficult to continue to be innovative in such a large bureaucracy environment.
However, Cisco requires innovation to stay on top. Therefore, they use the skunk
works mode of intrapreneurship. Read the article Net processor design team tells of
skunk works ingenuity' How Cisco beat chip world to net to see how this is done.

Note : This discussion on Bartering and Skunk Works references the following:
 Oanh Ha, K. “San Jose, Calif.-Area Entrepreneurs Turn to Bartering”, Knight
Ridder Tribune Business News (5 August 2003): 1
 Cisco Systems
 Matsumoto, C., “How Cisco beat chip world to net”, Electronic Engineering
Times issue 1137 (23 Oct 2000): 1-2

5. Primary Sources of Financing: Equity

When approaching investors, whether professional or not, there are two basic
vehicles to receive financing. These are through some form of claim on ownership
(equity) or some sort of loan or promise to repay (debt). The basic of these are
covered in pages 261-275 of the eTextbook. Once entrepreneurs move past the
bootstrapping mode, the investors tend to be more serious about risk and return
issues, and the deals definitely get more complicated.
Let us first look at some common sources of financing through equity in the
presentation below.

Sources of Financing Through Equity

Common sources of financing through equity are Private investors, Venture capital,
and Public capital. Let us review each of these in detail.
Private Investors
In every society and community, there are wealthy individuals who are looking for
business opportunity investments. Sometimes, these people are referred to as
angels because they deliver money from heaven for entrepreneurs. Private investors

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Subject Entrepreneurship
Segment Financial Elements
Topic Sources of New Business Financing

also work in groups; pooling their money to act as mini mutual funds for
investments. This money can be used for anything, but is frequently used to prove
the concept that the business works.
Private investors usually will take stock in the new company because this leads to
higher returns than a simple loan would. Sometimes, they combine stock and a
regular payment in a hybrid investment called a convertible preferred.
Venture Capital
Venture capital is professionally managed money, invested in potentially high growth
businesses. It is not usually available for small businesses, businesses without
significant growth potential or first stage start up businesses. Although some venture
capitalists will provide seed capital if the business has long term potential.
Venture capitalists are sometimes needed to get a thriving small business to the next
round of growth. However, entrepreneurs are particularly wary of most venture
capitalists because of their business practices. Venture capitalists drive a hard
bargain and are usually savvier than the entrepreneurs when it comes to financing
deals. After being burned in the Internet bubble burst of 2000, venture capital firms
have become very heavy handed about their investments. They enforce tough
contract clauses, suing their investments, and even suing each other. However, a
perceptive entrepreneur can negotiate with venture capital firms.
Despite their tough reputation, some venture capital firms have softer sides. Read
about Village Ventures, a venture capital firm, in the article It takes a village to
identify a true venture capital bargain. These venture capitalists believe that all
investing is local, and so they are moving to smaller cities and towns for their
operations.
Public Capital
Public capital means selling stock on a recognised stock exchange. It makes your
company a public company. The rules and regulations of each country and stock
exchange are very varied. However, going public is often seen as the ultimate goal of
the high growth oriented entrepreneur. Money raised from a public sale of equity can
be used for anything, but investors usually prefer that the financing be used to grow
the business and make it larger. Growing businesses can achieve economies of scale
and scope that can make earning grow at increasing rates, and this makes the stock
go up.
Public equity is also an important exit strategy because it finally enables all the
equity investors who have put money into the venture along the way to become
liquid by selling their investment or stock to the highest bidder.
However, going public has its costs and that includes losing control of the business.
Read the article The Sarbanes Oxley solution, new corporate governance standards
redefine directorsand officers liability to understand the complete implications of
going public. It indicates that going public is a step that requires very careful
analysis and consideration. The reporting requirements are steep and complex.

Note : This discussion on Private Investors, Venture Capital and Public Capital
references the following:
 Village Ventures
 Andy, S. “The Village Vanguard”, Fortune 142 issue 2 (10 Jul 2000): 154-157

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Subject Entrepreneurship
Segment Financial Elements
Topic Sources of New Business Financing

 Royster, G.D. “The Sarbanes-Oxley Solution”, Best's Review 104 issue 5 (Sept
2003): 45-48
 “US Corporate-Disclosure Law Confuses Lawyers Outside US”, PR Newswire
(15 Sept 2003): 1
Reflection: Sarbanes-Oxley Law
In the United States, the recently passed Sarbanes-Oxley law makes reporting and
governance requirements steeper than ever. Even though Sarbanes-Oxley is a
statute of the United States, it affects businesses around the world.
In a recent survey of international lawyers, it was discovered that there are major
concerns that the requirements of Sarbanes-Oxley infringe on other nations' laws
and sovereignty. To learn more about the implications of this law, read the article
‘U.S. Corporate-Disclosure Law Confuses Lawyers Outside U.S. LexisNexis-IBA
Survey Reveals Attorneys Fear Extraterritorial Nature of Sarbanes-Oxley Act.’ listed
below.

6. Primary Sources of Financing: Debt

We have discussed various sources of financing through equity. Let us now review
some sources of financing through debt in the presentation below.

Sources of Financing Through Debt

Founders, friends, family and fools
Founders, friends, family and fools frequently lend money for start ups, in addition to
investing by purchasing equity. The entrepreneurs themselves can lend money to
their own business. They would do this so that if the business has trouble paying its
creditors, they would be in line for some repayment. If all they held was stock in
their company, they could not be repaid. In order to prevent entrepreneurs from
abusing this, many countries have securities laws that will recognise a loan from
"insiders" as equity if the firm has too little equity otherwise.
Banks
Banks are in business to lend money. In some countries, banks are allowed to take
equity investments as well. Bank debt is frequently in the form of inventory loans,
working capital loans, lines of credit and letters of credit. Banks are seldom in the
business of loaning money to start up companies because the primary concern of the
bank is steady cash flow to repay the debt. Start up companies seldom have steady
cash flow so banks do not lend to them.
Insurance companies
Insurance companies have large pools of cash available for investing and can help
the entrepreneurial company secure physical assets, such as land, plant and
equipment with collateralised loans. These have to be relatively big in order to be
attractive to insurance companies. However, as long as there is substantial collateral,
these deals are possible.
Leasing companies
Leasing companies help entrepreneurs lease or rent equipment, machines, machine
tools, cars and trucks and whatever physical assets an entrepreneur might need for
the venture. Because these leases are contracts that require regular obligations to
pay, they are considered debt instruments.

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Subject Entrepreneurship
Segment Financial Elements
Topic Sources of New Business Financing

You have learned about various sources of new venture financing. Now, attempt this
exercise to determine how best to use financing from various sources to fulfil your
business needs.

Key Features of the Discounted Cash Flow (DCF) Model

Let us read about Stephanie, who has quit her job as a fashion designer to start her
very own line of silk ties and scarves.
As each stage of development in her new business venture is described, you need to
identify the source of financing that is best suited for funding the needs in that
stage.
1. Stage 1, Having made a business plan, Stephanie takes the first steps
towards putting her plan into action. She hires her first employees, a couple
of tailors and rents a small workshop to start her venture.
2. Stage 2, Stephanie starts selling her ties and scarves to a few local
boutiques. They do well and she starts receiving more orders. She now needs
to expand and hire a marketing specialist and move to a larger work area.
3. Stage 3, As the sales pick up in the local market, Stephanie makes her first
breakthrough. She gets her first large order from a national department
store. She now needs to start a factory to get ready to meet the demand for
such a large order.
4. Stage 4, Stephanie needs additional equipment for her new factory in order
to increase production capacity. She also needs to address distribution and
requires more lorries to deliver her merchandise to various stores.
5. Stage 5, Stephanie is supplying her products to various department stores at
an ever increasing rate. However, more and more of her finances are being
tied up in inventory and work in progress. She needs to finance her
operational requirements.
6. Stage 6, Stephanie's silk ties and scarves are now being sold nationwide. She
has expanded her business to a range of clothing accessories. Her first retail
store is a big success. She wants to build the business and open 50 more
stores in the next two years.
Now that you have reviewed the stages, let us see whether you identified the correct
source of financing.
1. Stage 1, Having made a business plan, Stephanie takes the first steps
towards putting her plan into action. She hires her first employees, a couple
of tailors and rents a small workshop to start her venture. Here, the source of
financing is inside equity. Inside equity or bootstrapping is the best way to
finance the smaller needs of a new venture at the time of its start up. It not
only helps the entrepreneur to start quickly but also indicates commitment to
future outside investors and provides the right incentives and motivation for
business owners.
2. Stage 2, Stephanie starts selling her ties and scarves to a few local
boutiques. They do well and she starts receiving more orders. She now needs
to expand and hire a marketing specialist and move to a larger work area.
Here, the source of financing is Private Investors. When expanding a new
venture, private investors or angels are a good source for financing the
expansion. Such investors can also lend their positive reputations to the
business to attract other investors.
3. Stage 3, As the sales pick up in the local market, Stephanie makes her first
breakthrough. She gets her first large order from a national department
store. She now needs to start a factory to get ready to meet the demand for

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Subject Entrepreneurship
Segment Financial Elements
Topic Sources of New Business Financing

such a large order. Here, the source of financing is Venture capital. Not only
can venture capitalists often come up with additional money when needed,
they can also provide advice and important industry contacts for a business.
4. Stage 4, Stephanie needs additional equipment for her new factory in order
to increase production capacity. She also needs to address distribution and
requires more lorries to deliver her merchandise to various stores. Here, the
source of financing is Leasing companies. If equipment requires a large spend
of money, it is a good option to lease it from a leasing company and utilise
your finances for other crucial expenditure. This will also help spread out your
expenditure.
5. Stage 5, Stephanie is supplying her products to various department stores at
an ever increasing rate. However, more and more of her finances are being
tied up in inventory and work in progress. She needs to finance her
operational requirements. Here, the source of financing is banks. When the
business is on its way to being well established, banks are a good source of
financing as banks are most concerned with how the money is going to be put
to use and how the loan will be repaid. Bank debt is frequently in the form of
inventory and working capital loans.
6. Stage 6, Stephanie's silk ties and scarves are now being sold nationwide. She
has expanded her business to a range of clothing accessories. Her first retail
store is a big success. She wants to build the business and open 50 more
stores in the next two years. Here, the source of financing is Public capital.
Going public is a source for large amounts of additional cash as well as
increased public awareness of the company. Money raised from a public sale
of equity can be used to grow the business and make it larger.
What did we learn from this example?
Let's do a quick recap.
 Inside equity or bootstrapping is the best way to finance the smaller needs of
a new venture at the time of its start up. It not only helps the entrepreneur to
start quickly but also indicates commitment to future outside investors and
provides the right incentives and motivation for business owners.
 Private investors or angels are a good source for financing the expansion.
Such investors can also lend their positive reputations to the business to
attract other investors.
 Venture capitalists often come up with additional money when needed. In
addition, they can also provide advice and important industry contacts for a
business.
 If equipment requires a large spend of money, it is a good option to lease it
from a leasing company and utilise your finances for other crucial
expenditure. This will also help spread out your expenditure.
 Banks are a good source of financing when the business is on its way to being
well established. This is because banks are most concerned with how the
money is going to be put to use and how the loan will be repaid. Bank debt is
frequently in the form of inventory and working capital loans.
 Going public is a source for large amounts of additional cash as well as
increased public awareness of the company. Money raised from a public sale
of equity can be used to grow the business and make it larger.

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Subject Entrepreneurship
Segment Financial Elements
Topic Sources of New Business Financing

7. Financing: Do's and Don'ts

When looking for financing, there are some mistakes that entrepreneurs frequently
make that significantly hurt their chances of impressing potential investors. Students
and inexperienced entrepreneurs often make these mistakes when preparing their
business plans for presentation. Read the article below to learn more about why
businesses fail to get funding.
Jorgensen, B., “The dos and don'ts of fund raising”, Electronic Business 27 issue 5
(May 2001): 29
The following are some of the do's and don'ts that you should keep in mind when
looking for financing for your venture.

What you should do:

1. Emphasise the marketing of your particular technology, not the technology
itself.
2. Plan to be financially conservative, but also realistic.
3. Tailor management biographies to the development phase.
4. Demonstrate how the venture will create long-term barriers around its
customers.
5. Delineate equitable and value-added partnership terms.
6. Demonstrate your venture's past track record.
What you should NOT do:
1. Make financial projections too aggressive.
2. Present large, generic market sizes.
3. Ask investors to sign an NDA.
4. Indiscriminately incorporate investor feedback into the business plan.
5. Overemphasise partnerships with well-known companies.
6. Exclude other successful companies from the competitive analysis.

Reading: Sources of Information

One of the best sources for information about start-up and risk capital is the Inc
®
magazine. Visit the site and read some of the articles that describe examples and
techniques of new venture financing.
To learn about start-up financing in a European country, visit the European Business
Angel Network website.

8. Start-up Financing for LiveREADS

You learned that the LiveREADS entrepreneurs have already raised US$700,000 from
a series of angel investor rounds. This means that they started with just a few
wealthy investors, and as they needed more money to finance the development of

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Subject Entrepreneurship
Segment Financial Elements
Topic Sources of New Business Financing

the firm and to pay the authors' option money, they either went back to these angels
or found different wealthy individuals.
Although the case does not tell us which of these scenarios occurred, it is important
that the first set of investors were not diluted by the second and third round. Each
round of investment has the potential to make the previous rounds own less and less
of the equity. Anti-dilution provisions can account for this. Refer to Negotiable Terms
to a Financial Agreement in Chapter 8 of the eTextbook to learn more about anti-
dilution provisions.
LiveREADS now needs another $5,000,000 in financing, and they are looking towards
either a venture capital deal or the venture arm of a larger media company. Without
further analysis, it is not clear which way they should go.

9. Self-Assessment
Now, try the self-assessment questions to test your understanding of the topic. Click
the following link to open the Self-Assessment in a new window.
Self-Assessment
Q1. Which three of the following are the advantages of bootstrapping a new
business?
1. Forces the entrepreneur to set priorities
2. Encourages the entrepreneur to generate sales as quickly as possible
3. Helps the entrepreneur avoid undercapitalisation
4. Enables the entrepreneur to retain more ownership
Q2. Which of the following is NOT a likely source of funds for a brand-new small
business?
1. Investment by the founding entrepreneur
2. Investment by family and friends
3. Investment by the government
4. Investment by the public raised through the sale of stock
Q3. Which of the following is NOT a likely source of debt financing for a start-up
venture?
1. Family and friends
2. Banks
3. Insurance companies
4. Leasing companies

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Subject Entrepreneurship
Segment Financial Elements
Topic Sources of New Business Financing

10. Summary
This topic covered the following points:
 Most financing for entrepreneurial ventures comes from the founders, family,
friends and fools, usually in small amounts
 By bootstrapping the business, entrepreneurs can save current and future
financing costs, and have the business financed in an inexpensive way.
 Other sources of private financing include wealthy individuals, angels and
venture capitalists. Public financing means selling stock on a publicly traded
stock exchange.
 The two basic types of financing are debt and equity. Equity financing
requires that the entrepreneurs share in the profits of the company with
stockholders, either through dividends or capital gains. Debt financing
requires the payment of interest as specified in the debt instrument
Credits and Disclaimer
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