3. Market Launch and Young Growth

Equity instruments
  • As the financial viability of the (surviving) ventures becomes clearer, startups become increasingly attractive to professional investors, in particular venture capitalists (VCs):
     
    • Unlike business angels, who invest in the people and whose primary motivation might not necessarily be the maximization of financial returns, venture capitalists have a clear money focus and an equally clear timeline for their exit.
       
    • In addition to making capital available quickly, they usually also assume an active role in the company. By bringing in their network and expertise, as well as their ability to make tough and bold decisions, they can make a valuable contribution to the metamorphosis of the venture into a professionally run corporation.
       
    • The VCs' investment instrument of choice is preferred stock. The module Deal Structuring (Term Sheets) deals extensively with this form of financing. It also discusses the various relevant costs and benefits of teaming up with venture capitalists.
       
  • During these phases, some of the original business angels might keep investing, but this is often not the primary source of funding, as the required capital exceeds the financial capabilities of the typical angel. Still, (very) wealthy private individuals might be attracted to the firm and invest directly or through their family office in the growing venture. These investments often take the form of private placements, and there is an increasing number of platforms and financial institutions that try to broker such investments.

  • Joint ventures constitute another potentially interesting form of growth financing.
     
    • Take the case of a company that has developed a new technology for computer assisted surgery. That technology could have a broad range of different applications such as brain surgery, heart surgery, oral surgery, etc. Instead of pursuing all these applications on its own, the firm could form joint ventures with partners that are specialized in the various fields. The firm brings the technology in the joint venture and the partners contribute the necessary capital to develop the respective tools for the various types of surgery.
       
    • Joint ventures can also be used to integrate various elements of the product value chain. For example, instead of building up its own distribution network, a company that has developed a new cancer treatment could form a joint venture with an established player whose core competence is to distribute drugs.
        
Debt instruments

Even with first revenues flowing, firms typically have insufficient track record, tangible assets, and cash flows to access traditional debt instruments such as long-term loans or bonds. However, financing might become available in the context of trade credit, bridge loans, or factoring. In what follows, we briefly discuss these instruments:
  

Trade credit

  • A firm uses trade credit if it receives goods and services from suppliers and pays them at a later date—usually within 30 or 60 days. Thereby, trade credit factually allows firms to finance their working capital.
     
  • Especially in rapidly growing firms, trade credit is often crucial. Because of the typical time gap between payments to suppliers and cash collected from customers (the so-called Cash Conversion Cycle, which we discuss in the module Financial Analysis) growth is often associated with significant cash needs to support the firm's working capital and operating expenses. Trade credit shortens this conversion cycle and thereby reduces the cash needs associated with growth.
     
  • It is important to note that trade credit is a credit extended by a business partner, not a bank. As such, it does not carry any interest and, therefore, often looks cheap. This might be misleading, however, as many firms offer a cash discount: 
    • For example, a supplier's payment terms could be 30 days net with a cash discount of 2% for cash payments within 10 days.
    • By forfeiting the 2% discount, clients therefore receive a credit for up to 20 days. The 20-days financing cost is therefore 2%.
    • On an annualized basis, this corresponds to a financing cost of 36% (= 2/20×360)!  Such trade credit is, therefore, by no means a cheap source of financing!

   

Factoring and Accounts Receivable Financing

  • To shorten the cash conversion cycle, the firm could borrow against its accounts receivable or, more easily, it could sell its accounts receivable to a bank or another financial institution at a discount. The latter transaction is generally referred to as "factoring."
  • Instead of waiting for 30 days or more until the clients pay their bill, factoring gives the firm an immediate cash injection. 
  • Factoring has the additional benefit that the whole management of the accounts receivable is also outsourced to the buyer. 
  • As in the case of trade financing, factoring is not necessarily a cheap source of financing. Factoring companies usually charge a so-called factoring fee, which is a percentage of the gross invoice amount and which increases with the time it take for the account receivable to be paid.
  • For example, a typical factoring fee could be 0.1% per day an invoice is outstanding. For a payment period of 30 days, this therefore translates into a factoring fee of 3% (or 36% on an annualized basis).

 

Bridge loans

Another source of debt financing could be short-term bridge loans in the context of a new round of equity financing, where a bank (or another sponsor) injects money to secure the firm's liquidity until the successful completion of the financing round. Parts of the proceeds from the financing round are then used to repay the loan (or the loan is converted into new shares). 

   

Internal financing
  • The stretching of cash balances by the founders often extends until the firm reaches break even or has a solid financial foundation. This generally extends well beyond the market launch.
     
  • As soon as break even is reached and the firm's operating business generates more money than it burns, the positive operating cash flows can be used to finance growth opportunities.
     
  • Moreover, as the firm discovers its core competences over time, it could be that some of products or ideas are divested or licensed out to third parties because they are not part of the firm's core. By letting go of non-core activities, firms not only free financial resources that can be reinvested in the core, but they also free management time and scares organizational resources.