From Blueprint To Reality: The Quest For Resources

Securing the necessary resources to transform the blueprint into a business reality is a crucial hurdle facing the aspiring entrepreneur.

From the entrepreneurs viewpoint, the ideal structure for a new business would be one that requires no commitment of capital to secure the use of necessary assets, where customers pay for the product or service in advance and suppliers provide ready access to unlimited trade credit on generous repayment terms.

Assuming sales were made on a profitable basis, there would be no need to establish a line of credit at the bank or inject equity into the business. In theory, the only problem the entrepreneur would face is deciding how best to use the cash generated from the business.

 

In reality, entrepreneurs need to consider thoroughly the financial implications of their business plans because resources will be required to: secure the use of assets necessary to make it happen; finance the on-going working capital needs of the business.

Signalling credibility

In the very early stages of venture development, access to established channels of funding such as banks, leasing companies or private investors is likely to be restricted.

To provide evidence that the business concept works and demand exists, entrepreneurs have little choice but to rely on their own personal resources, supplemented by funds from close friends and relatives so called love money.

This is not altogether surprising. Outside parties cannot be expected to provide resources to support the development of a business in the absence of any tangible support from the entrepreneur.

Establishing a business on the basis of often limited personal financial resources has been referred to as bootstrapping. The two guiding principles of successful bootstrapping are:

spend only as much time and as much capital as is needed to demonstrate credibly to other resource providers, such as banks and investors, that the opportunity is commercially feasible;

free up capital from any readily available source.

Having successfully demonstrated that there is a profitable opportunity, the financing needs of the business will often change dramatically. Building a business often implies continuing investment in plant, equipment and working capital. Ideally by this point, the entrepreneur will have established a credible track record to convince banks or investors to support the ventures development.

Securing assets

Before considering the financial implications of securing the use of assets, entrepreneurs should carefully assess the rationale for acquiring rights to them in the first place.

They should address several questions. Why is it necessary to secure the use of this particular asset? Are the qualities and attributes of the asset suitable for the ventures needs? Will the asset base provide a platform for future growth? How far in advance should we build up the venture in anticipation of rising consumer demand?

I am not suggesting that these questions can be resolved. However, it is important to be very clear about the choices made in terms of a ventures asset composition choices that bear inevitable financial implications.

Financial advisers will tell you that the value of any asset is in its use and not in its ownership. Leases where one party maintains legal title over the asset but negotiates an agreement with another to use the asset over a set period of time and for a specific consideration are an increasingly popular financing vehicle.

The lease versus buy decision is often guided by tax considerations but, irrespective of whether a business chooses to lease an asset or purchase it outright, the important point is that both routes have cash flow implications.

Most leases require payment of a deposit and involve contractual payments for use of the asset at regular intervals. Ownership reverts to the lessor at the end of the period if the lessee decides not to exercise the purchase option that is often included as part of the original lease agreement.

Similarly if an asset is bought outright and financed with debt, lenders will often finance only part of the price and require the purchaser to make up the remainder through a downpayment. In the very early stages of venture development, deposits and/or downpayments will often come from the proceeds of an equity issue.

Working capital

It is desirable for any business to get the money in before you have to pay it out. But this is impractical for many new businesses. In order to induce some customers to order, credit terms often have to be offered.

On the payables side, however, until the entrepreneur establishes a track record for prompt payment with key suppliers, the venture may have to work on a cash-only basis.

The financial implications of this are quite clear. New ventures will often require additional up-front capital to finance working capital requirements in the early days as they build credibility with key resource providers.

Financial structure

In determining the appropriate financial structure it is important that the interests of the entrepreneur, debtors and other investors are aligned to the greatest extent possible. This is a difficult exercise because each of the parties faces significant trade-offs.

Equity is a prerequisite for successfully raising debt finance. Unlike debt, which requires regular cash outlays in the form of principal repayments and interest, a discretionary element is built into most forms of equity concerning dividend payments and capital redemption.

Difficult trade-offs are faced by an entrepreneur in situations where additional equity is required to finance growth and the capital needs to be raised from outside sources. External equity providers may take steps to limit the entrepreneurs freedom by maintaining veto rights over important business decisions. In some instances, entrepreneurs may choose consciously to forgo growth to retain control over their venture.

Apart from issues related to loss of control, entrepreneurs are reluctant to raise outside equity because the perceived cost is too high relative to debt.

Most entrepreneurs consider debt finance to be cheap. After all, the return to debt holders is often fixed for substantial periods and interest costs are a tax-deductible expense.

Importantly, debt has an obvious control appeal for entrepreneurs they often consider they can obtain the necessary resources while retaining equity control.

However, debt also has drawbacks. Among other considerations, lenders look at the value of the security pledged in support of their advances and the stability and level of the cash flows the business is generating to meet ongoing interest and principal repayments.

In addition to security, lenders will often impose conditions that can restrict the freedom of action of the entrepreneur. Equity control is little consolation if the business defaults on its obligations to pay interest and principal on time. Effective control may pass to lenders in the event of default when decisions are taken by them to wind-up the operations or sell the business to recover their advances.

Here again, choosing an appropriate financial structure raises a difficult trade-off for the entrepreneur. The use of debt in the financial structure results in leverage effects to equity holders. They stand to benefit from the unlimited upside of their investment decisions that are, in turn, financed, in whole or in part, by debt holders whose return is essentially fixed.

However, employing too much debt may result in an undercapitalised business that is unable to weather downturns in operating performance. This, in turn, could impair the ventures ability to meet debt obligations to a point where its very survival might be at stake. n

Peter Kelly teaches MBA courses in entrepreneurial management at London Business School and the University of Notre Dame. He is currently pursuing his PhD at LBS and his doctoral research focuses on the informal market for venture capital in the UK