{"id":604,"date":"2021-05-03T12:24:52","date_gmt":"2021-05-03T16:24:52","guid":{"rendered":"https:\/\/pressbooks.library.upei.ca\/startup\/chapter\/13-finance\/"},"modified":"2021-05-03T17:41:57","modified_gmt":"2021-05-03T21:41:57","slug":"13-finance","status":"publish","type":"chapter","link":"https:\/\/pressbooks.library.upei.ca\/startup\/chapter\/13-finance\/","title":{"raw":"13\/ Finance","rendered":"13\/ Finance"},"content":{"raw":"
\r\n

Adapted from Entrepreneurship. \u00a92020 Rice University. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution 4.0 International License (CC BY 4.0).<\/em><\/p>\r\n

\"image\"<\/p>\r\n

SOURCE: Energepic<\/span><\/a>\u00a0<\/a>.<\/p>\r\n\r\n

<\/a>Overview: Entrepreneurial Finance<\/h2>\r\n
\r\n

Learning Objectives<\/p>\r\n\r\n<\/header>\r\n

\r\n

Distinguish between financing and accounting<\/p>\r\nDescribe common financing strategies for different stages of the company lifecycle: personal savings, personal loans, friends and family, crowdfunding, angel investors, venture capitalists, self-sustaining, private equity sales, and initial public offering\r\n

Explain debt and equity financing and the advantages and disadvantages of each<\/p>\r\n\r\n<\/div>\r\n<\/div>\r\n

The case of iBackPack shows that entrepreneurial success is not guaranteed simply because a company can secure funds. Funds<\/strong> are the capital to get a business, or idea, off the ground. But funding cannot make up for a lack of experience, poor management, or a product with no viable market. Securing funding is one of the first steps for starting a business.<\/p>\r\n

Let us begin by exploring the financial needs and funding considerations for a simple organization. Imagine that you and your college roommate have started your own band. In the past, you have always played in a school band where the school provided the instruments. Thus, you will need to start by purchasing or leasing your own equipment. You and your roommate identify the necessities (guitars, drums, microphones, amplifiers, and so on). In your excitement, you browse for these items online, adding to your shopping cart as you select equipment. You soon realize that even the most basic equipment could cost several thousand dollars. Do you have this much money available to make the purchase right now? Do you have other funding resources, such as loans or credit? Should you consider leasing most or all the instruments and equipment? Would family or friends want to invest in your venture? What are the benefits and risks associated with these funding options?<\/p>\r\n

This same basic inquiry and analysis should be completed as part of every business plan. First, you must determine the basic requirements for starting the business. What kinds of equipment will you need? How much labour and what type of skills? What facilities or locations would you require making this business a reality? Second, how much do these items cost? If you do not possess an amount of money equal to the total expected cost, you will need to determine how to fund the excess amount.<\/p>\r\n

Once a new business plan has been developed or a potential acquisition has been identified, it is time to think about\u00a0financing<\/strong>, which is raising money for an intended purpose. Here, the purpose is to launch a new business. Typically, those who can provide financing want to be assured that they could, at least potentially, be repaid in a short period, which requires a way that investors and business owners can communicate how that financing would happen. This brings us to accounting, which is the system business owners used to summarize, manage, and communicate a business\u2019s financial operations and performance. The output of accounting comprises financial statements, discussed in\u00a0Accounting Basics for Entrepreneurs<\/span><\/a>. Accounting provides a common language that allows business owners to understand and decide about their venture that are based on financial data, and enables investors looking at multiple investment options to make easier comparisons and investment decisions.<\/p>\r\n\r\n

<\/a>Entrepreneurial Funding across the Company Lifecycle<\/h2>\r\n

An entrepreneur may pursue one or more different funding. Identifying the lifecycle stage of the business venture can help entrepreneurs decide which funding opportunities are most appropriate for their situation.<\/p>\r\n

From inception through successful operations, a business\u2019s funding grows generally through three stages: seed stage, early-stage, and maturity (see Figure below). A\u00a0seed<\/strong> stage<\/strong>\u00a0company is the earliest point in its lifecycle. It is based on a founder\u2019s idea for a new product or service. Nurtured correctly, it will eventually grow into an operational business, much as an acorn can grow into a mighty oak, hence the name \u201cseed\u201d stage. Typically, ventures at this stage are not yet generating revenue, and the founders have not yet converted their idea into a saleable product. The personal savings of the founder, plus perhaps a few small investments from family members, usually make up the initial funding of companies at the seed stage. Before an outsider invests in a business, they will typically expect an entrepreneur to have exhausted F&F financing<\/strong> (friends and family financing) to reduce risk and instill confidence in the business\u2019s potential success.<\/p>\r\n

After investments from close personal sources, the business idea may build traction and attract the attention of an angel investor.\u00a0Angel investors<\/strong>\u00a0are wealthy, private individuals seeking investment options with a greater potential return than is traditionally expected on publicly traded stocks, albeit with much greater risk. For that reason, they must be investors accredited by the federal\u00a0Securities and Exchange Commission\u00a0(SEC) and they must meet a net worth or income test. Nonaccredited investors are allowed in certain limited circumstances to invest in security-based crowdfunding for startup companies. Among the investment opportunities angel investors look at are startup and early-stage companies. Angel investors and funds have boomed in the past ten years, and angel groups exist in every state.<\/p>\r\n<\/a>Figure 1. Business Funding Stages<\/small>\r\n

\"image\"<\/p>\r\n

An\u00a0early<\/strong>-<\/strong>stage<\/strong>\u00a0company has begun development of its product. It may be a technical proof of concept that still requires adjustments before it is customer ready. It may also be a first-generation model of the product that is securing some sales but requires modifications for large-scale production and manufacturing. At this stage, the company\u2019s investors may now include a few outsider investors, including venture capitalists.<\/p>\r\n

A\u00a0venture capitalist<\/strong>\u00a0is an individual or investment firm that specializes in funding early-stage companies. Venture capitalists differ from angel investors in two ways. First, a venture capital firm typically operates as a full-time active investment business, whereas an angel investor may be a retired executive or business owner with significant savings to invest. Venture capital firms operate at a higher level of sophistication, often specializing in certain industries and with the ability to leverage industry expertise to invest with more knowledge. Typically, venture capitalists will invest higher amounts than angel investors, although this trend may shift as larger angel groups and \u201csuper angels\u201d invest in venture rounds.<\/p>\r\n

Private equity investment\u00a0is a rapidly growing sector and generally invests later than venture capitalists. Private equity investors either take a public company private or invest in private companies (hence the term \u201cprivate equity\u201d). The ultimate goals of private equity investors are generally taking a private company public through an initial public offering (IPO) or by adding debt or equity to the company\u2019s balance sheet and helping it improve sales and\/or profits to sell it to a larger company in its sector.<\/p>\r\n

Companies in the\u00a0mature stage<\/strong>\u00a0have reached commercial viability. They are operating in the manner described in the business plan: providing value to customers, generating sales, and collecting customer payments in a timely manner. Companies at this stage should be self-sufficient, requiring little to no outside investment to maintain current operations. For a product company, this means manufacturing a product at scale, in enormous volumes. For a software company or app provider, this means generating sales of the software or subscriptions under a SaaS model (Software as a Service) and possibly securing advertising revenue from access to the user base.<\/p>\r\n

Companies at the mature stage have different financing needs from those in the previous two stages, where the focus was on building the product and creating a sales\/manufacturing infrastructure. Mature companies have reached a consistent level of sales but may seek to expand into new markets or regions. Typically, this requires significant investment because the proposed expansion can often mirror the present level of operations. An expansion at this level may cause doubling the size of the business. To access this amount of capital, mature companies may consider selling a portion of the company, either to a private equity group or through an IPO.<\/p>\r\n

An\u00a0initial public offering (IPO)<\/strong>\u00a0occurs when a first-time company offers ownership shares for sale on a public stock exchange, such as the\u00a0New York Stock Exchange. Before a company executes an IPO, it is privately held, usually by its founders and other private investors. Once the shares are available to the public through a stock exchange, the company is considered being publicly held. This process typically involves an investment banking firm that will guide the company. Investment bankers will solicit institutional investors, such as\u00a0State Street\u00a0or\u00a0Goldman Sachs, which will sell those shares to individual investors. The investment banking firm typically takes a percentage of the funds raised as its fee. Benefits with an IPO is that the company gains access to a massive audience of potential investors, but the downside is owners giving up more ownership in the business and subject to many costly regulatory requirements. The IPO process is highly regulated by the SEC, which requires companies to provide comprehensive information upfront to potential investors before completing the IPO. These publicly traded companies must also publish quarterly financial statements, which are required to be audited by an independent accounting firm. If the company does not meet investors\u2019 expectations, the value of the company can decline, further hindering its future growth options.<\/p>\r\n

A business\u2019s lifecycle stage influences its funding strategies and so does its industry. Different industries have varying financing needs and opportunities. For example, if you were interested in opening a pizzeria, you would need a physical location, pizza ovens, and furniture so customers could dine there. These requirements translate into monthly rent on a restaurant location and the purchase of physical assets (i.e. ovens and furniture). This type of business requires a higher investment in physical equipment than a service business, such as a website development firm. A website developer could work from home and potentially begin a business with minor investment in physical resources, but with a significant investment of their own time. Essentially, the web developer\u2019s initial funding requirement would simply be several months\u2019 worth of living expenses until the business is self-sufficient.<\/p>\r\n

Once we understand where a business is in its lifecycle and which industry it operates in, we can get a sense of its funding requirements. Business owners can gain funding through different avenues, each with its own advantages and disadvantages (see\u00a0Special Funding Strategies<\/span><\/a>)<\/span>.<\/p>\r\n\r\n

<\/a>Types of Financing<\/h2>\r\n

Although many types of individuals and organizations can provide funds to a business, these funds typically fall into two categories: debt and equity financing (see Table below). Entrepreneurs should consider the advantages and disadvantages of each type as they determine which sources to pursue to support their venture\u2019s immediate and long-term goals.<\/p>\r\n<\/a>Table 1. Debt vs. Equity Financing<\/small>\r\n\r\n\r\n\r\n\r\n\r\n\r\n
\r\n

<\/p>\r\n<\/td>\r\n

\r\n

Debt Financing<\/strong><\/p>\r\n<\/td>\r\n

\r\n

Equity Financing<\/strong><\/p>\r\n<\/td>\r\n<\/tr>\r\n

\r\n

Ownership<\/strong><\/p>\r\n<\/td>\r\n

\r\n

Lender does not own stake in company<\/p>\r\n<\/td>\r\n

\r\n

Lender owns stake in company<\/p>\r\n<\/td>\r\n<\/tr>\r\n

\r\n

Cash<\/strong><\/p>\r\n<\/td>\r\n

\r\n

Requires early and regular cash outflow<\/p>\r\n<\/td>\r\n

\r\n

No immediate cash outflow<\/p>\r\n<\/td>\r\n<\/tr>\r\n

<\/td>\r\n<\/td>\r\n<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n

<\/a>Debt Financing<\/h2>\r\n

Debt financing<\/strong>\u00a0is borrowing funds from another party. Ultimately, this money must be repaid to the lender, usually with interest (the fee for borrowing someone else\u2019s money). Debt financing may be secured from many sources: banks, credit cards, or family and friends, to name a few. The maturity date of the debt (when it must be repaid in full), the payment amounts and schedule over the period from securement to maturity, and the interest rate can vary widely among loans and sources. You should weigh all these elements when considering financing.<\/p>\r\n

The advantage of debt financing is that the debtor pays back a specific amount. When repaid, the creditor releases all claims to its ownership in the business. The disadvantage is that repayment of the loan typically begins immediately or after a short grace period, so the startup faces a quick cash outflow requirement, which can be challenging.<\/p>\r\n

One source of debt financing for entrepreneurs is the\u00a0Small Business Administration (SBA), a government agency founded as part of the Small Business Act of 1963, whose mission is to \u201caid, counsel, assist and protect, where possible, the interests of small business concerns.\u201d178<\/a><\/sup>\u00a0The SBA partners with lending institutions such as banks and credit unions to guarantee loans for small businesses. The SBA typically guarantees up to 85% of the amount loaned. Whereas banks are traditionally wary of lending to new businesses because they are unproven, the SBA guarantee takes on some of the risk that the bank would normally be exposed to, providing more incentive to the lending institution to finance an entrepreneurial venture.<\/p>\r\n

To illustrate an SBA\u00a0loan, let us consider the 7(a) Small Loan program. Loans backed by the SBA typically fall into one of two categories: working capital and fixed assets.\u00a0Working capital<\/strong>\u00a0is simply the funds a business has available for day-to-day operations. If a business has only enough money to pay bills that are currently due, that means it has no working capital, a precarious position for a business to be in. A business in this position may want to secure a loan to help see it through leaner times.\u00a0Fixed assets<\/strong>\u00a0are major purchases like land, buildings, equipment, and so on. The amounts required for fixed assets would be significantly higher than a working capital loan, which might cover just a few months\u2019 expenses. As we will see, loan requirements made under the 7(a) Small Loan program are based on loan amounts.<\/p>\r\n

For loans over $25,000, the SBA requires lenders to demand collateral.\u00a0Collateral<\/strong>\u00a0is value that a business owner pledges to secure a loan, meaning that the bank has something to take if the owner cannot repay the loan. Thus, in approving a larger loan, a bank might ask you to offer your home or other investments to secure the loan. In a real estate loan, the property you are buying is the collateral. Loans for larger purchases can be less risky for a bank, but this can vary widely from property to property. A loan that does not require collateral is referred to as unsecured.<\/p>\r\n

\"image\"<\/p>\r\n

SOURCE: Anthony <\/span>Shkraba<\/span><\/a>.<\/p>\r\n

To see how a business owner might use an SBA loan, let us return to the example of a pizzeria. Not all businesses own the buildings where they operate; in fact, many businesses simply rent their space from a landlord. Here, a smaller loan would be needed than if the business owner were buying a building. If the prospective pizzeria owner could identify a location available for rent that had been a restaurant, they might need only to make superficial improvements before opening to customers. This is a case where the smaller, collateral-free type of SBA loan would make sense. Some funds would be allocated for improvements, such as fresh paint, furniture, and signage. The rest could pay employees or rent until the pizzeria has sufficient customer sales to cover costs.<\/p>\r\n

Besides smaller loans, this SBA program also allows for loans up to $350,000. Above the $25,000 threshold, the lending bank must follow its own established collateral procedures. It can be difficult for a new business to provide collateral for a larger loan if it does not have significant assets to secure the loan. For this reason, many SBA loans include the purchase of real estate. Real estate can be accepted as collateral because it cannot move and holds it value yearly. For the pizzeria, an aspiring business owner could take advantage of this higher level of lending when the business is buying the property where the pizzeria will be. Here, most loan proceeds will probably go toward the purchase price of the property. Both the high and low tiers of the SBA loan program are examples of debt financing. In\u00a0Special Funding Strategies<\/span><\/a>, we will look at how debt financing differs from equity financing.<\/p>\r\n\r\n

<\/a>Equity Financing<\/h2>\r\n

In terms of investment opportunities, equity investments are those that involve purchasing an ownership stake in a company, usually through shares of stock in a corporation. Unlike debts that will be repaid and thus provide closure to the investment,\u00a0equity financing<\/strong>\u00a0is financing provided in exchange for part ownership in the business. Like debt financing, equity financing can come from unique sources, including friends and family, or more sophisticated investors. You may have seen this type of financing on the TV show\u00a0Shark Tank<\/em>. Contestants on the series pitch a new business idea to raise money to start or expand their business. If the \u201csharks\u201d (investors) want to invest in the idea, they will make an offer for an ownership stake. For example, they might offer to give the entrepreneur $200,000 for a return of 40% ownership of the business.<\/p>\r\n

The advantage of equity financing is that there is no immediate cash flow requirement to repay the funds, as there is with debt financing. The drawback of equity financing is that the investor in our example is entitled to 40% of the profits for all future years unless the business owner repurchases the ownership interest, typically at a much higher\u00a0valuation<\/strong>, an estimate of worth, usually described in relation to the price an investor would pay to acquire the entire company.<\/p>\r\n

This is illustrated in the real-life example of the ride-sharing company\u00a0Uber. An early investor in the company was\u00a0Benchmark Capital, with an initial investment of $12 million in Uber in exchange for stock. That stock, as of its IPO date in May 2019, was valued at over $6 billion, which is the price that the founders would have to pay to get Benchmark\u2019s share back.<\/p>\r\n

Some financing sources are neither debt nor equity, such as gifts from family members, funds from crowdfunding websites such as\u00a0Kickstarter, and grants from governments, trusts, or individuals. The advantages and disadvantages of these sources are discussed in\u00a0Special Funding Strategies<\/span><\/a>.<\/p>\r\n\r\n

<\/a>Special Funding Strategies<\/h2>\r\n

\"image\"<\/p>\r\n

SOURCE: Matthias Zomer<\/span><\/a>.<\/p>\r\n\r\n

\r\n

Learning Objectives<\/p>\r\n\r\n<\/header>\r\n

\r\n

Identify funding strategies used by charitable organizations<\/p>\r\nDescribe financing opportunities available to startups\r\n\r\nDefine bootstrapping\r\n

Describe the advantages and disadvantages of bootstrapping<\/p>\r\n\r\n<\/div>\r\n<\/div>\r\n

It is important to recognize that not all startups are Silicon Valley tech companies. These companies create high-profile products, such as applications and websites, which can take years to become profitable or even generate revenue. Much more common are the small businesses founded every day by entrepreneurs seeking to create value in their local communities. Not all startups are founded with a profit motive in mind.<\/p>\r\n

Charitable organizations<\/strong>, or certain non-profit companies, are often founded for altruistic purposes, such as advancing the arts, education, and science; protecting the natural environment; providing disaster relief; and defending human rights (see Table below).<\/p>\r\n<\/a>Table 2. Charitable Missions and Example Organizations<\/small>\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n\r\n
\r\n

Mission<\/strong><\/p>\r\n<\/td>\r\n

\r\n

Examples<\/strong><\/p>\r\n<\/td>\r\n<\/tr>\r\n

\r\n

Advance education<\/p>\r\n<\/td>\r\n

\r\n

Teach for America, Khan Academy<\/p>\r\n<\/td>\r\n<\/tr>\r\n

\r\n

Protect the natural environment<\/p>\r\n<\/td>\r\n

\r\n

Sierra Club, Wildlife Conservation Society<\/p>\r\n<\/td>\r\n<\/tr>\r\n

\r\n

Defend human rights<\/p>\r\n<\/td>\r\n

\r\n

Amnesty International, Human Rights Watch<\/p>\r\n<\/td>\r\n<\/tr>\r\n

\r\n

Provide disaster relief<\/p>\r\n<\/td>\r\n

\r\n

American Red Cross<\/p>\r\n<\/td>\r\n<\/tr>\r\n

\r\n

Support the arts<\/p>\r\n<\/td>\r\n

\r\n

Metropolitan Museum of Art, Americans for the Arts<\/p>\r\n<\/td>\r\n<\/tr>\r\n

<\/td>\r\n<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n

These goals supersede the profit motive that a traditional company would have. As a result, the funding strategies of these enterprises often differ dramatically from those of standard for-profit businesses. Without the emphasis on profit, it\u2019s difficult to provide for the cost of ongoing operations. Thus, these organizations must develop a\u00a0sustainable strategy<\/strong>, one that can maintain the organization\u2019s financial stability.<\/p>\r\n

In the United States, such organizations can qualify for\u00a0tax-exempt status<\/strong>, meaning that if there is a profit from operations, it is not typically subject to taxes. Organizations seeking this exemption must apply to the\u00a0Internal Revenue Service\u00a0for tax-exempt status and provide information about what kind of mission the organization carries out (charitable, scientific, educational, and so on).<\/p>\r\n

Consider a museum. What is its purpose? Traditional companies provide a product or service to their customers for payment and typically fill a need their customers have. A grocery store sells food because human beings need to eat food to survive. Although viewing paintings and sculptures is not a physical requirement for life, this experience arguably enriches our lives and helps educate and shape our society. That is why museums are founded. Consider the original mission statement of the\u00a0Metropolitan Museum of Art\u00a0(commonly known as the \u201cMet\u201d) in New York City (see Figure below).179<\/a><\/sup><\/p>\r\n<\/a>Figure 2. NYMMA Mission Statement<\/small>\r\n

\"image\"<\/p>\r\n

SOURCE: The mission statement of New York\u2019s Metropolitan Museum of Art. (attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license)<\/em>.<\/em><\/p>\r\n

This is a different goal than most small businesses (providing a product or service for a profit) and, as a result, requires different financing strategies, such as a combination of program services, donations, and grants.<\/p>\r\n

\"image\"Go to the Internal Revenue Service\u2019s website and look at the\u00a0most recently updated Pub 334 Tax Guide for Small Business<\/span><\/a>\u00a0to learn more about the rules for income tax preparation for a small business.<\/p>\r\n\r\n

<\/a>Program Services<\/h2>\r\n

Program services<\/strong>\u00a0are the basic offerings that a non-profit organization provides that result in revenue, although not typically enough to cover the overall cost of running the organization. These services most closely resemble the customer interactions of a traditional business. The organization provides a product or service for a customer\u2019s money.<\/p>\r\n

In our museum example, program services could take a few different forms. First, the museum likely charges a fee for admission to view the artwork and artifacts. The individual ticket price multiplied by the number of museum visitors equals the museum\u2019s ticket revenue. An established museum will have a sense of how many visitors it has on average and create a budget accordingly.<\/p>\r\n

Another source of program service revenue for a museum could take the form of hands-on educational activities or events with guest speakers or presenters. Often museums will host local artists, or their own employees might conduct art classes or special-topic tours. These events and activities typically have a charge (revenue) beyond the regular admission cost.<\/p>\r\n

Despite these revenue-generating activities, non-profit organizations still face many funding challenges in covering all the operating costs of a normal business, such as employee wages, facility costs, and advertising. Thus, they need many sources of income. To illustrate, the Met\u2019s 2018 program service income only made up 2.3% of its total revenue for the year.180<\/a><\/sup><\/p>\r\n\r\n

<\/a>Donations<\/h2>\r\n

One benefit to a business with a charitable mission is inherent public support, which can foster community involvement above and beyond patronage. For non-profits, this can translate into a willingness to donate money to the organization. A\u00a0donation<\/strong>\u00a0is a financial gift with no expectation of repayment or receiving anything in return. A traditional business must provide something valuable to create a customer exchange: Their customers demand value for their hard-earned money.<\/p>\r\n

The\u00a0benefactors\u00a0of a charitable organization want to help further the mission of the organization. This type of entity (whether it is a museum, a hospital, or the\u00a0Red Cross) relies on the goodwill of community supporters. For the Met, with a low percentage of revenue generated by program services, donations, and charitable gifts are vital to the organization\u2019s\u00a0financial viability<\/strong>.<\/p>\r\n\r\n

<\/a>Grants<\/h2>\r\n

Another source of funding for non-profit organizations is grants. A\u00a0grant<\/strong>\u00a0is a financial gift given for a specific purpose by a government agency or a charitable organization such as the\u00a0Bill and Melinda Gates Foundation. Like a donation, a grant does not have to be repaid. Unlike with donations, both non-profit and for-profit organizations can compete for grants. Whereas donations are typically given without restriction to offset the general operating expenses of the organization, grants often specify how the funds are to be used. Most grant-providing entities have an agenda or purpose behind their funding. For example, the\u00a0National Institutes of Health (NIH)\u00a0provides grants \u201cto support the advancement of the NIH mission to enhance health, extend healthy lives, and reduce the burdens of illness and disability.\u201d181<\/a><\/sup>\u00a0This federal organization invests over $32 billion annually for medical research.<\/p>\r\n

Grants can be very competitive, requiring a rigorous application process. Usually, multiple organizations apply for the same grant; the organization issuing the grant reviews the many competing applications to make its selection. Grantees generally must submit audited financial statements and are required to update the grantor after the grant award to ensure proper intended use. The NIH awards almost 50,000 grants annually, most of which are competitive. Although that is an enormous number of projects to fund, only 20% of applications submitted to the NIH in 2018 were accepted.182<\/a><\/sup>\u00a0The NIH rejected four out of every five applications. For entrepreneurs, this means that when you identify a grant that is specific to your organization\u2019s mission, weigh your chances of being awarded the grant when considering it as part of your funding strategy.<\/p>\r\n

To understand grants let us further examine the NIH. The NIH Small Grant Program provides funds for activities such as the development of new research technology. This specific grant can be awarded for up to a two-year period, with funds of up to $50,000 in direct costs per year. A grant like this could provide vital support to a non-profit startup.<\/p>\r\n

Some business ventures fall somewhere between organizations completely committed to charitable work and traditional small businesses with entrepreneurs focused on social entrepreneurship. Social entrepreneurs develop products and services as solutions to societal problems. For example, the\u00a0TOMS\u00a0shoe company could create a business model through which the company gives one pair of shoes to children in need in foreign countries for every pair of shoes purchased, known as \u201cOne for One.\u201d183<\/a><\/sup><\/p>\r\n

The company\u2019s website describes the origins of both the company and this model, which are based on the experiences of its founder, Blake\u00a0Mycoskie\u00a0(see Figure below).184<\/a><\/sup><\/p>\r\n<\/a>Figure 3. TOMS Origin Story<\/small>\r\n

\"image\"<\/p>\r\n

SOURCE: The TOMS origin story provides an example of social entrepreneurship. (attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license)<\/p>\r\n

Social entrepreneurship\u00a0offers the ability to effect positive change in the world without simply relying on donations. It pairs a profitable, sustainable business model with a good cause. This combination often creates positive word-of-mouth. It gives potential customers a good feeling about the product beyond just its style or function.<\/p>\r\n\r\n

What Can You Do? Social Entrepreneurship<\/h3>\r\n

Like the founder of TOMS, sometimes in our everyday life, we are presented with an opportunity to help people. We may even find out that we are not alone in this desire to help. What opportunities to help (individuals, society, or environment) do you see in your own community? What are some ways that you could raise awareness around this issue?<\/p>\r\n\r\n

<\/a>No-Loan Finance Strategies<\/h2>\r\n

As you have learned, many startups come into being through the extensive use of debt. Although borrowing is a legitimate source of funding, it can be risky, especially if the entrepreneur is personally responsible for repayment. Some entrepreneurs max out credit cards, take out home-equity loans against their primary residences, or secure other high-interest personal loans. If the entrepreneur cannot repay the loans, the result can be repossession of equipment, home foreclosure, and other legal action.<\/p>\r\n

We now examine funding strategies attractive to many startups that do not require going into debt or exchanging ownership of the business for financial support (debt and equity financing). The financing methods described here are more creative funding strategies, including crowdfunding, bartering, and other methods.<\/p>\r\n

\"image\"<\/p>\r\n

SOURCE: Ryutaro<\/span><\/a>.<\/p>\r\n\r\n

<\/a>Crowdfunding<\/h2>\r\n

Recall the story of\u00a0iBackPack. This venture was originally funded by contributions through\u00a0Indiegogo\u00a0and Kickstarter. These websites are a form of\u00a0crowdfunding<\/strong>, which involves collecting small sums of money from many people. The people who contribute money are typically referred to as backers because they are backing the project or supporting the business idea.<\/p>\r\n

Browsing these crowdfunding websites, you will see many kinds of ventures seeking financial backing, from creating new board games to opening donut cafes. Each project identifies an overall specific funding goal in terms of a dollar amount. Some crowdfunding websites, such as\u00a0Kickstarter, implement an \u201call or nothing\u201d model in which projects do not receive any funds unless their overall funding goal is met. The amount can be exceeded, but if it is not met, the project receives nothing. For an entrepreneur using this resource, selecting an attainable funding goal must be a core part of their strategy. The funding goal must also be appropriate to the scale of the project. For example, setting a goal of $50,000 may be reasonable for launching a food truck (which could be a prototype for a full restaurant), but it is a mere fraction of the cost of constructing an entire table-service restaurant, which would come closer to $750,000. An entrepreneur entering the culinary world should consider which target would be most achievable as well as most beneficial in meeting both short- and long-term goals. Also, remember that meeting the funding goal does not ensure success of the business, as with iBackPack.<\/p>\r\n

Entrepreneurs vying for crowdfunding usually employ some common tactics. First, they often post an introductory video that explains the project goal and the specific value proposition (i.e. a chef might seek $75,000 to open a food truck specializing in a relatively unknown cuisine). Second, the entrepreneur provides a more detailed written summary of the project, often including specific items that the funding will pay for, such as $50,000 for a vehicle, $10,000 for graphic design and vehicle decals, and $15,000 for kitchen equipment for the truck. Last is the reward structure, which is what entices visitors to the site to fund the project, offering a return beyond their own passion for the venture. The\u00a0reward structure\u00a0establishes different levels of funding and ties a specific reward to each level. For example, for a contribution of $5, the chef might thank the backer on social media; for $25, the backer would get a t-shirt and a hat featuring the food truck\u2019s logo; for $100, the backer would get five free meals when the food truck opens. Fees for these crowdfunding sites vary from 5% to 8%. Kickstarter now requires physical products or prototypes for some startups, as well as a short video to help represent and \u201csell\u201d the product.<\/p>\r\n

Although this financing source offers a lot of flexibility, businesses using crowdfunding can run into trouble. Certain funding levels and rewards may have limits. For example, a reward structure might offer backers contributing $1,000 a trip to the grand opening of the food truck, including airfare and hotel. These top-tier rewards can generate a lot of excitement, but the expense of flying people around the country and providing accommodations could become unmanageable. One research study stated that 84% of Kickstarter\u2019s top projects delivered their rewards late.185<\/a><\/sup><\/p>\r\n

The advantage of crowdfunding is that the business receives cash up-front to launch. The downside is that the reward requires a future payment to the backers. This payment may be as branded merchandise, meals, or even events or travel, so it is important for entrepreneurs to set aside part of the investment money to fund the rewards. Depending solely on generating the reward funds out of future sales is a risk that might cause upsetting the fans who made the business possible. Since crowdfunding is managed online, another risk is upsetting the project\u2019s vocal supporters. Crowdfunding usually provides only a \u201ckick start\u201d for a startup, most seed stage companies need additional funding from other sources for their first commercial launch.<\/p>\r\n

Although social media can backfire, entrepreneurs can take advantage of benefits too. Crowdfunding can allow an entrepreneur to build a community around a product before it is even sold. Like-minded fans of a product can connect with each other over the internet, in the feedback section of a website, or in shared social media posts. Backers of a project can become cheerleaders for it by sharing the idea (and their enthusiasm for it) with friends, family, and coworkers. Word-of-mouth marketing can lead to more backers or future customers after launch.<\/p>\r\n

Dozens of crowdfunding portals exist, including\u00a0WeFunder,\u00a0SeedInvest, Kickstarter, and\u00a0Crowdcube. Current SEC guidelines186<\/a><\/sup>\u00a0for issuing and investing limits granted for Title III Crowdfunding include:<\/p>\r\n

A company can raise up to $1 million in aggregate through crowdfunding offerings over a 12-month period.<\/p>\r\n

Over a 12-month period, individual investors can invest in the aggregate across all crowdfunding offerings up to:<\/p>\r\n

$2,000 or 5% of the unaccredited investors net worth or yearly income if they make less than $100,000\/year.<\/p>\r\n

10% of the lesser of their annual income or net worth, if both their annual income and net worth are equal to or more than $100,000.<\/p>\r\n\r\n

Kickstarter<\/h3>\r\n

\"image\"Visit the Kickstarter website at https:\/\/www.kickstarter.com\/<\/span><\/a> and review a few projects. What did they do well in the video pitch? What unique rewards did they offer? How would you implement a Kickstarter page for your own business idea?<\/p>\r\n\r\n

<\/a>Bartering<\/h2>\r\n

Startup companies rarely have a lot of cash assets on hand to spend, but they often have offerings that can provide value to other businesses.\u00a0Bartering<\/strong>\u00a0is a system of exchanging goods or services for other goods or services instead of for money. Let us consider the case of Shanti, a website designer who wants to start a business. She may want to have her business formally incorporated or may require other legal help, such as review of standard contracts. Hiring a lawyer outright for these services can be costly, but what if the lawyer needed something the website designer could provide?<\/p>\r\n

Whether the lawyer has just started his own business or has been established for several years, he may need a website created or have an old website redesigned and updated. This website overhaul could prove costly for the lawyer. But what if there were a way that both the lawyer and the web designer could get what they wanted with a resulting net cost of zero dollars? Bartering can achieve this. It should be noted there are accounting and tax implications involved with bartering that can prevent a net zero offset of costs.<\/p>\r\n

In a barter scenario, Shanti could create a website for the lawyer at the expense only of her time, which in the startup phase is often more abundant than actual cash. The lawyer could provide incorporation services or contract review in exchange, requiring no cash outlay. For many entrepreneurs, this type of exchange is appealing and enables them to meet business needs at a lower perceived cost. Although more mature firms can also use bartering, the opportunity cost is much higher. If a mature company cannot take on a new paying client because it is doing too much free (barter) work, it may lose out on future revenue, which might be a big loss. Startups, in contrast, often have excess capacity while they develop a customer base, so taking on barter work is often a low-risk, beneficial funding strategy.<\/p>\r\n\r\n

<\/a>Other No-Loan Funding Options<\/h2>\r\n

Beyond crowdfunding and bartering, startups have other options to help them get off the ground, such as funding competitions and pre-orders (see Figure below). Many organizations hold entrepreneurial finance contests provide financial awards to the winners. These prize funds can seed money to start a new venture. For example, the\u00a0New York City Public Library\u00a0holds an annual business plan competition called the\u00a0New York StartUP! Business Plan Competition.187<\/a><\/sup>\u00a0Applicants must complete an orientation session, attend workshops that develop skills related to the creation of a business plan, and submit a complete business plan. The first-place award yields $15,000 in prize money, which can be a splendid start toward turning an entrepreneurial idea into a business reality.<\/p>\r\n

Another way for startups to gain financial traction is to solicit pre-orders. Consider the launch of a new book or video game. Retail stores will often solicit pre-orders, which are advance purchases of the product. Customers pay for the desired item before they even have access. For example, the entrepreneur Mitchell\u00a0Harper\u00a0raised $248,000 in funds before his product launched.188<\/a><\/sup>\u00a0This approach is not limited to existing, well-known franchises, startups can use it as well. Although established novel and video game franchises have large fan bases and often large advertising budgets, startups can still find effective strategies in this space.<\/p>\r\n<\/a>Figure 4. No-loan Funding Options<\/small>\r\n

\"image\"<\/p>\r\n

SOURCE: Entrepreneurs can explore a variety of no-loan funding options. (attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license) <\/em><\/p>\r\n

Companies with a prototype model of their product or a first manufacturing run can showcase the new product to potential customers, who may be interested enough to place an order. The company can use the funds received from these pre-orders to pay for the inventory. Besides having sales staff make sales calls, new companies can attend trade shows and exhibitions to garner interest in the product. Many new products are launched in this fashion because it allows access to many potential customers in one place.<\/p>\r\n\r\n

<\/a>Why Bootstrapping Hurts, Then Helps<\/h2>\r\n

The process of self-funding a company is typically referred to as\u00a0bootstrapping<\/strong>, based on the adage that urges us to \u201cpull ourselves up by our bootstraps.\u201d It describes a funding strategy that seeks to optimize use of personal funds and other creative strategies (such as bartering) to minimize cash outflows. In recent years, this strategy has been the fodder for shows like\u00a0Shark Tank<\/em>. These shows may make entrepreneurs think that being on TV is glamorous, or the shows may glorify the financial backing of millionaires and billionaires. We have seen that for many entrepreneurs there are drawbacks to bringing in outside investors to launch your venture. These drawbacks include loss of future profits and control of the company, among others. Potential business owners must weigh the advantages and disadvantages (both short- and long-term) for funding their specific dream.<\/p>\r\n

You have learned about financing strategies predicated on finding a willing investor or lender, but many small businesses simply do not have access to large amounts, or any amount, of capital. In these cases, aspiring business owners need lean business strategies that will yield the greatest benefit.<\/p>\r\n

\"image\"<\/p>\r\n

SOURCE: Fauxels<\/span><\/a>.<\/p>\r\n

Bootstrapping requires entrepreneurs to shed any preconceived notions of the popular-culture image of startups. Most startups do not have trendy downtown offices, foosball tables, or personal chefs. Bootstrapping reality looks more like late nights spent clipping coupons. It involves scrutinizing potential expenses and whether each cost is worth the investment. It can be a difficult and trying to process, but with no angel investors or wealthy family backers, bootstrapping is often an entrepreneur\u2019s only option. The good news is that this approach can pay substantial dividends in the long run.<\/p>\r\n\r\n

<\/a>The Basics of Bootstrapping<\/h2>\r\n

When entrepreneurs risk their life savings, they must stretch every dollar as far as possible. Having a limited amount of capital to work with requires optimizing creative strategies to get the business launched and keep it afloat. This creativity applies to bringing customers and sales in the door and to managing expenses.<\/p>\r\n

Understanding the ongoing costs of the business is key. In an interview on NPR\u2019s show\u00a0How I Built This<\/em>, Barbara\u00a0Corcoran, one investor on\u00a0Shark Tank<\/em>, shares her humble beginnings in real estate brokerage.189<\/a><\/sup>\u00a0One of things she touches on is being constantly aware of how long her money would last, given her monthly expenses. If she had $10,000 in the bank and the cost of her rent and employees was $2,500 per month, she knew that the money would last her four months. Such constant information and vigilance are required when bootstrapping a business for success.<\/p>\r\n

Employee costs are typically one of the largest expenses facing a business. Hiring traditional full-time employees can be costly; onboarding them too early can be fatal to a business\u2019s bottom line. Creative approaches to minimizing labour costs can be enormously helpful. One strategy for controlling these costs is using independent contractors (freelancers) and other part-time employees. They do not work full-time for the business and may serve other companies as well. Their compensation is generally lower than that of a full-time, salaried employee, often in part because these positions rarely come with any benefits, such as health insurance or paid time off. Using these workers to fill resource needs can help minimize costs. Once operations have stabilized, it may be possible and ideal to offer full-time employment to these individuals.<\/p>\r\n

Marketing is another key area for new business investment, but billboards, web ads, TV ads, and radio spots can be expensive. TV and radio ads can also be ineffective if they are aired during low-volume times, which is typically all that startups with lower budgets can afford. Fortunately, there are many low- or no cost marking opportunities, such as word-of-mouth marketing. Doing a good job for one customer can easily lead to referrals for more business. Some social media efforts can also provide a strong return for minimal investment, although typically it is nearly impossible to gauge an effort\u2019s potential impact or success.<\/p>\r\n

A new enterprise that is bootstrapping must also carefully manage operational expenses. At the beginning of operations, an entrepreneur can often minimize unnecessary expenses, even if that means forgoing an actual business location. Working out of a home office or a co-working space (such as\u00a0WeWork\u00a0or\u00a0Impact Hub) can lead to significant savings. Renting office space can cost hundreds or thousands of dollars a month, whereas a home office typically requires no additional investment. Depending on the location, co-working spaces can provide a single workspace and technology access for as little as $50 to $100 per month, yielding substantial savings over a dedicated office suite. In larger cities, or in locations with more amenities, the monthly costs can run between $100 and $500 per month.<\/p>\r\n

The\u00a0Boston Beer Company, which today produces the Samuel Adams line of beers, provides a classic example of minimizing these costs in its early days. When this company first started, it owned no office space, or even a brewery. It employed other breweries as contract brewers to manufacture its beer. Its founder, Jim\u00a0Koch, invested most of his time in selling to bars and restaurants, working from his car and phone booths (This was during the 1980s). His lean strategy was a successful application of the bootstrapping mindset. From its humble beginnings, the Boston Beer Company has become one of the largest American-owned breweries, ranked second based on 2018 sales volume by the Brewers Association.190<\/a><\/sup>\u00a0Whereas traditional thinking may dictate that a company must have an official office or headquarters, a bootstrapping mindset evaluates what the space would be used for and the trade-offs for its cost.<\/p>\r\n\r\n

<\/a>How Bootstrapping Hurts<\/h2>\r\n

Bootstrapping is not easy and fraught with tight budgeting and sacrifice, which can take its toll on an entrepreneur. One of the simplest bootstrapping strategies is to start a business by\u00a0moonlighting<\/strong> or treating your business venture as a second job. Employing this strategy, the entrepreneur continues to work at their regular job, say from 9:00 a.m. to 5:00 p.m. and then dedicates the rest of the evening and weekends to working on the business. Whereas this strategy has the obvious benefit of maintaining a comfortable level of income, this approach has a few drawbacks (see Table below). Moonlighting entrepreneurs cannot dedicate 100% of their time and energy to their new business. The time they can dedicate to it may be less efficient. After working all day at another job, a person may feel tired or burned out, so it is difficult to change gears and press forward with full productivity.<\/p>\r\n<\/a>Table 3. Bootstrapping Advantages and Disadvantages<\/small>\r\n\r\n\r\n\r\n\r\n\r\n
Advantages<\/strong><\/td>\r\nDisadvantages<\/strong><\/td>\r\n<\/tr>\r\n
\r\n

No ownership given up<\/p>\r\n

Forces creative solutions<\/p>\r\n

Keeping costs low fuels growth<\/p>\r\n<\/td>\r\n

\r\n

Slow to start<\/p>\r\n

Less glamorous<\/p>\r\n

Owner must make personal sacrifices<\/p>\r\n<\/td>\r\n<\/tr>\r\n

<\/td>\r\n<\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n

Besides the exhausting time investment, moonlighting can exact tolls on personal relationships. This strategy is easiest when an entrepreneur is in a life stage with few commitments. It may have an adverse effect on friendships, but in other life stages, this impact can be more significant. For example, it can detract from relationships with a partner\/spouse or children, in both a decrease in focus\/investment in these relationships and day-to-day challenges in worklife balance and household management for all affected. At some point, to attract serious investors, a founder will have commit to the project full-time.<\/p>\r\n

Other bootstrapping strategies include negotiating the terms for payments on expenses. When businesses sell to other businesses, the vendor allows the customer to buy on\u00a0credit<\/strong>. This means that the buyer does not have to pay at the time of purchase. Although retail customers are required to pay at the register during checkout, purchases between businesses can work on different terms, sometimes extended up to 30, 60, or 90 days. This extra time to pay for purchases can be a real advantage for businesses. When a business buys inventory on credit, it can begin selling it before it has even paid for it. For example, a clothing retailer could sell its product in stores or online and receive cash before it had to pay its vendors. Unfortunately, when a business\u2019s cash becomes tight, an ethical dilemma can arise. When a business has more bills to pay than money to pay them with, the owner will need to make tough decisions. Ultimately, when vendors will no longer sell to you on credit, or even at all. When a company can no longer buy inventory to sell to customers, it will not be long until it is out of business. An ethical entrepreneur will alert to this concern and resolve it with aboveboard business decisions.<\/p>\r\n\r\n

<\/a>How Bootstrapping Helps<\/h2>\r\n

Although\u00a0bootstrapping\u00a0can be painful in the early years of a business, it yields significant benefits for the business owner in the future. One of the most valued benefits of bootstrapping a business is the fact that the founder can maintain control of the company and typically keep 100% ownership. Although it\u2019s easy to give up ownership in an idea because ideas come freely and don\u2019t require financial sacrifice, entrepreneurs who accept an equity financing opportunity and give up a significant portion of ownership of the business may not realize the potential detrimental outcomes. What seems glamorous on\u00a0Shark Tank<\/em>\u00a0may cost a business owner more control than desired. Once you give up any amount of equity in a business, it can be difficult or expensive to get it back. Once the deal is accepted, the investor is entitled to that percentage of the profit every year the company is in business, even if that person never lifts a finger to support the enterprise. Entrepreneurs usually make those financing deals because of the benefits of the money and access to the investor\u2019s contacts. It is unlikely that Mark\u00a0Cuban\u00a0is going to roll up his sleeves in your food truck when things get tough. If you can avoid outside financing, you will maintain complete control and full ownership of the business and weigh this benefit in your financing decisions.<\/p>\r\n

Another benefit of bootstrapping is avoiding taking on debt. Whether it is credit cards or personal loans, repayment of debt can take a serious toll on any business and can be especially burdensome for new businesses. Considering that some of the debt financing sources available to entrepreneurs can bear higher-than-average interest rates, digging yourself out from underneath this financial burden is no simple task. Also, delaying outside investments allows your business to grow not only in revenue and profit but also in market value. When potential investors come along, they will consider a higher contribution for a smaller percentage in the business.<\/p>\r\n\r\n

Link to Learning<\/h3>\r\n

\"image\"One of the most common forms of debt financing is simply a credit card. Although it may seem wise to charge many of the up-front expenses and simply pay the card\u2019s minimum monthly payment, this can be a treacherous road to go down. Try the\u00a0credit card calculator<\/span><\/a>\u00a0to calculate how long it takes to pay off a credit using only the minimum payment. It may shock you. Try a few different amounts: $1,000; $5,000; and $10,000.<\/p>\r\n\r\n

<\/a>Personal Finances<\/h2>\r\n

Adapted from Fundamentals of Business: Canadian Edition by Pamplin College of Business and Virginia Tech Libraries is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted.<\/p>\r\n

\"image\"<\/p>\r\n

SOURCE: Suzy Hazelwood<\/span><\/a>.<\/p>\r\n\r\n

\r\n

Learning Objectives<\/p>\r\n\r\n<\/header>\r\n

\r\n