hello this is dr. adam jae bok we've arrived at the part of the course arguably my favorite where we begin talking about finance in real detail for our entrepreneurial ventures we're going to cover a number of different topics in a series of short audio presentations we're going to discuss internally generated funding external capital sources of capital and valuation and exit and some related topics as well it's important to start by dispelling a few key misconceptions that many entrepreneurs have about financing a new business first the first misconception is that VCS and angel investors fund most businesses that's simply not true and we'll talk a little bit more about that later on but the vast majority of companies never receive VC are anal angel funding the second misconception is that banks are happy to lend to startup companies that's also generally not true while there are mechanisms to receive loans from financial institutions like banks this isn't what banks generally set out to do because it's too high risk and most loans that they provide will have a personal guarantee anyway so it's really a personal loan not a business loan a third common misconception is that the federal government's small business administration lends money to startup companies in fact the SBA doesn't really lend money to anyone what the SBA does do in some cases is guarantee loans through banks such that the bank has a lower risk associated with the loan this is a fairly complex topic which we really only touch on very briefly but it is something that you should at least be aware of the next misconception is that entrepreneurs use only one source of funding the reality is that most new ventures rely on a variety of different funding mechanisms and then finally a misconception that government grants are a plentiful source of funding for startups that's also generally not true there are many government grants out there but they tend to be very specific and focused either based on socio-demographic of the founders or based on geography specific economic areas or technology areas so it may be that there are some unique things about your venture that could make it a possible target for government funding but if you're Jenner if you're planning on starting what we would consider to be an average or normal business the odds are pretty low that there will be government funding available to you let's talk now about internally generated financing and by this we mean that funding that doesn't come from outside sources there are two different types self financing where you're using personal funds and bootstrapping where you use operational funds most people don't realize that the single largest source of funding most common source of funding for start-up companies are in fact the founders own funds usually in two specific areas personal savings that is just money you've saved up previously and credit card debt which has become a very common way of of launching a venture both of these require being relatively careful personal savings can be lost if you invest your personal money into a venture and the venture fails your money is lost as well and so you're often putting two things at risk both your job and your money and credit card debt obviously comes with some significant drawbacks the big one being that the interest rates on credit card debt can be incredibly high there are a number of different self financing options beyond personal cash there's also personal assets which you can either sell or pledge to guarantee a loan obviously credit card debt I've mentioned some entrepreneurs take out a second mortgage in order to generate funding to launch a business this is also a relatively high risk thing to do and then working a second job or doing some kind of consulting work in order to provide cash flow for the venture that you're trying to run there are some advantages to self financing it's on the whole relatively quick and easy you don't need to bring any partners everything is aligned your business funding and your personal aspirations are one in the same thing you also don't have to share profits with anyone else and if there is an exit opportunity for example to sell your business it's quite simple and no authorizations are required but there are many downsides to it one there's no outside validation one of the big advantages to bringing an outside capital is getting feedback and confirmation that your idea makes sense another disadvantage is that you have no partners to share the load and the risk there's a ton of work to be done in a startup company partners help share that not bringing an outside funding can limit how fast you can grow because you'll only you'll have resource constraints and there's a higher risk of failure if you're not diversified because you could lose as I mentioned both your savings and your job so now let's talk about the concept of bootstrapping the idea of bootstrapping is getting yourself out of a situation using only the resources that are available to you so one definition for it is the process of finding creative ways to exploit opportunities to launch it grow businesses with the limited resources that are available to most startup ventures so the idea is rather than use lots of your own cash or lots of other people's cash you find ways to run the business in extremely lean and efficient way sometimes entrepreneurs have no other choice bootstrapping can be a choice but for many entrepreneurs there's really no other way to run the business can be quite difficult to raise money especially for some types of companies it does have an advantage that it reduces ownership dilution that is rather than give ownership of the company away to investors you could retain all of that ownership yourself bootstrapping can extend the runway because every dollar saved is one less that you have to raise you're basically giving yourself a longer timeframe to build the business before you have to rely on either outside business outside investors or any other kind of fundraising mechanism and bootstrapping can be valuable because it can force hidden problems into the open it's kind of like when you reduce inventory or production processes and in an existing organization it quickly shows you where the flaws are in your process running your business lean will help you see where some of the problems with the business might be in the long run there's some pretty straightforward rules for bootstrapping the first one is just get operational quickly as fast as you can produce something and get it in front of customers your goal here is to look for very breakeven or cash generating projects you can't focus on long-term opportunities that are going to cost a lot or take a lot of time if you can offer higher value products sometimes that helps you sustain direct personal selling what does that mean well a lot of startup companies have to rely on direct sales you can't just put your stuff on the internet and have people buy it because if it's a more complex product or it's new you're probably gonna have to do some direct sales and that's expensive it's expensive in your time or the time of people that you hire higher value products means that you can effectively afford to do that if your products are very simple or very inexpensive then you probably have no options for direct selling you can't worry about hiring the perfect team right we're gonna hire the a-team the crack team that's gonna solve this problem that's a great idea but in reality if you wait too long to hire the right people you simply will never get your business launched bootstrapping often helps keep growth in check and you might think that that's a bad thing but in fact many companies grow so fast that they run out of money and they grow themselves into bankruptcy we'll talk a little bit more about that later on but the bottom line here is that growing slowly can often be advantageous it's very important that you focus on cash not profits or market share or anything else the important thing is how much cash is going out the door and how much cash is coming in the door and then finally even if you're pretty sure you're not gonna be able to get a bank loan it's a good idea to begin building relationships with a bank or with specific bankers because there's probably going to be a point in time where you might want to get a loan and at that point if you already have the relationship you'll be in a much better position to have a conversation but when a loan is actually appropriate there's many ways to bootstrap you can lease instead of buy you can purchase with trade credit so for example you can purchase goods and hopefully pay for them later thirty days later or even 60 days later depending on what you negotiate that's a way of conserving cash in the organization sometimes you can use other people's facilities or equipment my very first startup company which was a biotechnology company borrowed lab space from another company in town they knew that they had a little extra capacity and they were willing to let us come in there and do some of the work we needed to do sometimes you can pre-sell product to customers you can convince them that they want something badly enough that they'll pay for it in advance factoring is an option we'll talk about that in just a moment sometimes you can convert debt to revenue that's pretty rare specific to certain kinds of companies you might have taken out a loan from either friends family or a bank and you might be able to convert that into revenue by basically trading it for something that you're selling and finally you could use equity to pay vendors that is you could say I need these widgets to make my gadgets and I'm going to give you a certain number of shares of stock in my company for it I don't recommend that there have been situations where companies have been able to do that successfully but it is an incredibly complex and legally fraught thing to do so we do not generally recommend that wanted to give you a couple of quick examples one pre-selling to customers this is the tomotherapy machine developed at uw-madison by the company tomotherapy and one of the things they did is because of the expense of the machine they pre-sold it they went to hospitals they talked about what this radiotherapy machine was going to do to cure cancer and they convinced some of those hospitals to make a significant down payment in advanced at the time this machine cost about three and a half million dollars and they their very first sale came to a hospital in Canada that agreed to give them a million dollars in advance and that million dollars made it possible for them to finish the machine and then ultimately ship it so this is pre selling is something that can happen in many contexts not just technology areas but also traditional businesses as well factoring is a an example of bootstrapping that you might not be familiar with the idea here is that you sell to customers but rather than trying to get them to pay you you sell those accounts receivable to a specialized factoring firms and there are firms out there that do this and then they go out and they collect the money from your customers the advantage to this is that the factoring firm gives you cash on the spot which you might need so here's an example you've sold $1 worth of goods the factoring firm gives you 95 cents and then they go out and try to collect that dollar from your customers now you might think oh my gosh that's maybe you think that's a really good deal in reality it's quite expensive because if you imagine that you could collect that dollar a month later you're effectively paying a 60% interest rate but if you're growing very quickly this could be a very efficient way to ensure that you constantly have cash coming in the door it also avoids your expenses associated with collections and sometimes companies struggle with collecting money from customers there are also many business models that can use customer cash to finance operations that is in effect the customer is giving you the cash you need to run your business so matchmaker models like a real estate agent sometimes attorneys require a retainer fee or a deposit for their services so they get cash in advance gym membership is a classic example where you're paying a constant subscription there could be products where you do it once you have a product that's available once but then you can resell it so for example when a company like Gartner group produces a market report they don't just sell it to one customer they sell it to thousands of customers but it's the exact same report and then there are examples of scarcity models where you only have producing a few specific items and that helps ensure that the price stays high and that your customers are actively demanding the product so all of this bootstrapping and self financing kind of gets away from what's often considered the sexy side of Finance which is going out and raising private equity so I'm going to just introduce that quickly here or private Eleni way I'm going to introduce it here and then the next couple of audio presentations will go into them in more detail it's important not to fool yourself right the vast majority of venture of Capital funded companies venture capital funded companies do not succeed right so here is some data that was shown for more than 21,000 venture capital deals 65% of those did not achieve the returns that were in that did not get their money back so every dollar that went into those companies generated less than $1 out of that out again and that's because many of those companies completely and utterly failed taking venture capital does not mean you're gonna succeed all it means is that you're attempting to grow incredibly fast and taking high risks there are business models that have to have external capital anything in the life sciences is almost guaranteed to need some external capital just because of the R&D is so expensive things like enterprise software you might be surprised usually have Enterprise capital both because of the product development expense but also because of the sales and distribution requirements anything you need property plant or equipment like heavy manufacturing real estate or energy production you're probably going to have some type of external capital any idea that requires extensive long term recent research and development or large-scale infrastructure to serve customers is probably also going to need external capital there are basically two types of external capital that you can seek and in the next couple presentations we'll go into this in more detail those and you need to understand these two types and the difference between them debt and equity debt comes from banks or other lenders it generally reflects a more stable investment these are investors that have a lower risk tolerance it's a fixed sum of money for a given period of time at a certain interest rate you need to understand that the investor has limited upside they only get the interest and ultimately the principal back just like when you get ohio mortgage on a house the idea here is that there are low levels of uncertainty B there's a good expectation that they'll get their money but they still have first claim to assets upon bankruptcy this is really important to recognize when a company fails if it has debt holders they have first rights to whatever assets are left not the shareholders not the owners but any debt holders interest rates for corporate debt can range anywhere from five to fifteen percent the bigger the company the more stable it is generally the lower the interest rate that they'll pay equity is completely different it's provided by friends and family angel investors and professionals like venture capital firms equity comprises ownership debt holders do not own the business they just own the right to collect money from the business the equity holders are stockholders they actually own a stake in the company there's theoretically unlimited upside if these companies are hugely successful then the owners participate in profits and any potential exit event but that also means there's a higher risk level they can lose the full value of their principal in particular because if the company goes bankrupt any debt holders will collect first if there's no assets left after that then the equity holders would get nothing at all for early-stage companies the expected return rate on an equity investment is often fifty percent or even higher per year right so over the course of a couple of years equity investors are expecting to get three times their money back five times their money back or even more this is the price that's paid for barring risk venture capital firms manage this risk by only investing in certain sectors so that they have better expertise and can better predict which ventures are going to succeed so this is a quick starting point for thinking a little bit about finance in the next couple of audio presentations we're going to go into debt and equity in more detail talk a little bit about valuation and some related topics