The following is an interview with Kim Stewart, SVP, Working Capital Solutions Advisor, BB&T for my Entrepreneurial Feasibility Analysis graduate course. Kim and I became acquainted in 2016. We discuss entrepreneurial financing.
Q. What is your role in banking as it relates to “investment” in small business?
A. I work in an area of the bank that provides various solutions to companies that need working capital financing to support their on-going business activity or growth.
Q. What role do you now or have you in the past played in determining financing support for an entrepreneurial venture?
A. I have in the past worked in a banking environment where we would provide working capital lines of credit down to a minimum of $1MM, which may likely be too high of a minimum for many entrepreneurs that are “start-up” ventures, but I was still able to work with many entrepreneurial companies. I am involved in working with the customers on the front end in determining what their financing need is and how best to structure a financing solution.
Q. How is bank “investment” in small business different than, say angel investment? Does a bank often provide seed or startup investment?
A. It is inaccurate to say that banks invest in small business in the normal course of their operations. Providing financing is not investing, and for that reason, banks have to be stringent about identifying the risks and appropriately mitigating those risks. Traditional banks are paid a reasonable rate of interest for the use of funds as opposed to having an opportunity to participate in the upside of a business venture. There are ways that banks can work through the Small Business Association (SBA) to provide funding for a start-up investment, and there may be banks that are willing to take more risks on start-up ventures, but they would generally be interested in opportunities where the entrepreneur had a track record of successful ventures and had some capital to invest in the venture.
Q. How might bank financing requirements of an entrepreneurial venture differ from an angel investor?
A. Both are going to underwrite the risk of success or failure of the venture and the likelihood of being repaid in the event the venture fails, but an angel investor is not bound by regulation regarding the amount of interest and fees that they can charge and will often require some percentage of ownership of the company as a part of the investment, therefore they have the ability to get compensated for taking a higher level of risk.
Underwriting the risk involved in providing credit to a business will include considering primary and secondary sources of repayment. The primary source of repayment is generally cash flow generated by the operations of the company and to underwrite this involves a complete knowledge and understanding of the company’s operations, the industry in which they operate, the capital required to operate the business, financial analysis of historical operations, management strengths, ownership structure, etc. The secondary sources of repayment are generally liquidation of collateral and financial support provided by guarantors. These sources would also need to be fully reviewed to assess how much support they are capable of providing in the event the primary source is inadequate.
Q. What are the top three things you look for when considering an “investment” partnership with an entrepreneur? Why are these three things the most important to you?
A. I am going to reword to say that when I am reviewing an opportunity to provide financing to an entrepreneur, the three things that I am most focused on are going to be the strength of management in regards to knowledge of their industry and ability to execute as borne out by historical success, the amount of equity that the entrepreneur is able to put into the venture, and the strength of the sources of repayment.
Q. How important is a formalized business plan for a venture when a bank is considering an “investment?”
A. I can’t overstate how important a formalized detailed business plan that included realistic forecasts would be in obtaining a serious audience with a financial institution.
Q. What are the three most important financial measures (statements, ratios, etc.)?
A. There has to be confidence that management can produce accurate and timely financial information, not only to the lender but also that they are paying attention to the business factors that will indicate that they are successfully executing on the business plan. It is not uncommon for a start-up venture to take some time to be profitable, therefore it is critical that you understand their sources of capital and how long their horizon is to reach profitability. Generally, even those ventures that turn out very successful take longer to get there than was estimated by the owner/entrepreneur.
Financial performance and attention to the statements is important, but it has to be combined with a boots-on-the-ground familiarity with management and the company.
Q. How does a bank, for example, use ratios to identify potential problem areas of a borrower’s performance when compared to an industry sector? Which ratios are most important and why?
A. The most common financial ratios that are watched in a traditional commercial bank environment are balance sheet leverage, cash flow or fixed charge coverage and cash flow leverage. Balance sheet leverage measures how much equity the company has versus how much debt they have (for every dollar the owner invests, how much does he borrow). Some industries will naturally have higher leverage than others if they are capital intensive and have to invest heavily in equipment or infrastructure to operate. Cash flow coverage, debt service coverage, and fixed charge coverage all are measurements of whether the operations of the company can generate adequate cash to satisfy all of the demands on that cash. Cash flow leverage is similar to balance sheet leverage but can be used as an indicator when you have a young or rapidly growing company that doesn’t have a lot of equity built up yet, but has demonstrated the ability to generate adequate cash flow to consistent meet their obligations.
Q. What advice would your offer an entrepreneur seeking start-up or early stage financing?
A. Be prepared with your business plan, knowledge of the industry, and distinctive competencies that you bring, and identify the risks and the steps that you are taking not only to mitigate those risks but also to mitigate the loss in the event the risks are realized.
Be realistic in your expectations and understand that you are seeking risky capital and it is likely going to be more expensive and more cumbersome than traditional bank lending.
Recent research by the Ewing Marion Kauffman Foundation suggests the number of new startups grew slightly from 2014 through 2016 after hitting an all-time low in 2013 (Fairlie, Morelix, & Tareque, 2017). An upswing in activity looks promising, but the data also suggest greater challenges may lie ahead considering America’s demographic and cultural shifts. Immigrants, for example, are almost twice as likely to become entrepreneurs as those born in America, yet it appears the failure rate may be similar to native-born (Fairlie, Morelix, & Tareque). These failures might suggest the absence of a clear business plan, insufficient knowledge of basic business operations, the lack of education and training in support of entrepreneurship, or a combination of all of these factors might be preventing ongoing sustainable businesses. The small number of established businesses started by Asian, African American, and Hispanic entrepreneurs, the declines in startup activity among those under 34 and limited startup activity by women are just a few of the challenges to America’s economic growth in the coming years. It is time to think differently about entrepreneurship.
America is becoming increasingly multi-ethnic and multi-cultural. Demographers suggest the country’s racial and ethnic makeup will shift the thinking and direction of our society (Taylor, 2014). Today there seems to be an older, more conservative, more religious cohort struggling to maintain the status quo at odds with a somewhat younger, more liberal and more secular group where diversity is paramount (Taylor, 2016). Arguably this ideological and cultural divide that influences our country’s politics also transforms all aspects of our society. These ideological differences seem to make many less tolerant and, perhaps encourages others to cocoon or cluster around those most like themselves.
The cocooning and clustering of Americans appears to create a level of unintended segregation that has more to do with cultural fit than it does with skin color (Cowen, 2017). In a society that, for the most part, endeavors to be more diverse, there is an increasing “cultural segregation.” This unintended segregation, then, inadvertently creates a lack of diversity among our peer groups and affects how some think about the world, including where to live, what to do, and how to consume products and services. When surrounded with those who believe and act similarly, the result can be a staleness in thought and ideas.
This cultural segregation also limits entrepreneurial opportunity and ultimately impacts the American economy because the lack of diversity in our peer groups may well reduce exposure to those who pursue an entrepreneurial life. Unfortunately, reduced exposure to entrepreneurship typically begets reduced entrepreneurial activity (Cowen). Given the rate of startups today, it seems fewer people are exposed to entrepreneurial activity and sustainable small businesses than those who in the 1980s. There may not be a sufficient number of successful role models for young adults, women, Asian, Hispanic, and African Americans on which to model startup activity and long-term sustainable small businesses.
The 2017 Kauffman Index of Startup Activity indicated that startup activity in 2016 merely returned to 2006 activity levels. The rate of new entrepreneurs—those non-business owner adults starting a new business—has declined slightly from 2015 (Fairlie, Morelix, & Tareque, 2017). Moreover, the gain in entrepreneur activity seems to equate to single-employee companies (i.e., a “job” for the entrepreneur), and not to the job creation activity necessary for overall economic growth and stability. While the data is not presented in a cross-tabulation to allow for further analysis, it appears the greatest number of new startups in 2016 may be native-born white men, age 45+, with college educations (Fairlie, Morelix, & Tareque). The Index reports increased entrepreneurial activity among the Asian and Hispanic populations and to a smaller degree African Americans. Although this entrepreneurial growth may be keeping pace with the America’s changing demographics, it is important to remember that higher rates of startup do not necessarily translate into ongoing mature businesses (Kelley, et al., 2016). A good many startups fail. While there seems to be slight growth in startup activity in the last year, this should not suggest that increased entrepreneurial activity will necessarily translate to long-term economic growth related to such activity.
It is important to keep in mind that a modest increase in startup activity does not always translate into sustainable business ventures that provide jobs and opportunities within their communities. The lack of sustainability creates challenges to entrepreneurial activity across the board. For example, the lower number of startups among women and those under 34 might suggest a lack of opportunity and training, rather than a lack of interest (Kelley, et al., 2016). The lack of established businesses, particularly among Asian, Hispanic, and African Americans might suggest the need for training and support in ongoing business operations. For example, training might include courses on how do to identify a market opportunity, fundamentals of business operations and management, how to price products and services, how do develop a market, and much more. Support might come in the way of hands-on mentors who are interested helping the entrepreneur achieve success or perhaps more start-up incubators designed specifically to educate, serve, and support those classes of entrepreneurs not well served at present.
It seems clear that targeted support and intervention is necessary to ensure the long-term viability of entrepreneurial ventures. The vicious cycle of creation and failure of startups suggests the entrepreneurial approach that American’s have deployed for more than two-hundred years may not be as efficient as it could be. This applies in particular to younger adults and women, where startup interest is lagging, and to Asian and Hispanic entrepreneurs where the sustainability seems underperforming when compared to the immigration rate.
It is essential to create a foundation for greater entrepreneurial successes as the country evolves culturally. This new foundation requires different thinking and approaches to encourage stronger startups and enable growth and sustainability for the nation’s small businesses. America’s long-term economic viability may depend, in part, on the long run growth and success of all of its entrepreneurs.
Cowen, T. (2017). The Complacent Class: The self-defeating quest for the American Dream. New York: St. Martin’s Press.
Fairlie, R., Morelix, A., & Tareque, I. (2017). 2017 Kauffman Index of Startup Activity. Kansas City: Ewing Marion Kauffman Foundation. Retrieved June 17, 2017, from http://www.kauffman.org/kauffman-index/reporting/~/media/c9831094536646528ab012dcbd1f83be.ashx
Kelley, D., Ali, A., Brush, C., Corbett, A., Daniels, C., Kim, P. H., . . . Rogoff, E. (2016). Global Entrepreneurship Monitor: 2015 United States Report. Babson College. Retrieved from http://www.gemconsortium.org/report/49562
Taylor, P. (2014). Next America: The New Us. Retrieved January 14, 2016, from pewresearch.org: http://www.pewresearch.org/next-america/#Immigration-Is-Driving-Our-Demographic-Makeover
Taylor, P. (2016, January 27). The demographic trends shaping American politics in 2016 and beyond. Retrieved June 17, 2017, from pewresearch.org: http://www.pewresearch.org/fact-tank/2016/01/27/the-demographic-trends-shaping-american-politics-in-2016-and-beyond/
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This post is the last of seven posts about angel investment in entrepreneurial ventures.
Angel Investors are likely to want to know an entrepreneur’s exit plan from the beginning. While those exit plans may change as the business moves from its seed or start-up phases into something more mature, the entrepreneur who understands the need to formulate a positive (e.g., profitable) exit strategy from the beginning is likely to have greater interest and engagement from the investor. Considering this, let’s examine the more common positive ways angel’s exit an investment:
A walking harvest allows the investor to take distributions on a regular basis from the company (Amis & Stevenson, 2001). Assuming the business has good cash flow, this may be an easy way for an entrepreneur to secure the investment needed while minimizing the need for a valuation, as might be required with other exit strategies. Entrepreneurs should keep in mind that this might be viewed as debt financing and an investor may desire a high degree of involvement to ensure sufficient cash flow is available to meet the mutually agreed upon distribution plan.
A partial sale allows an investor to exit a company when the business is successful, but the prospects of sale are not good. In these cases, the investor might sell their shares to management for cash or via a buyout agreement, or sell their shares to an investment company that specializes in smaller transactions (Amis & Stevenson, 2001). This approach allows the investor to get out of an otherwise illiquid investment with some gains. For the entrepreneur, however, it might be a nightmare because he or she might end up with a partner that might not be a good relationship fit.
Initial Public Offering (IPO)
Initial Public Offerings (IPOs) are not an exit strategy in and of themselves. IPOs are a financing event that allows an early investor to convert what may otherwise be an illiquid investment to a more liquid investment when the company’s shares are offered to the public. The investor may or may not sell once the company goes public. However, they do have the option of choosing when to do so at the point where they have created the most value for themselves (Amis & Stevenson, 2001). The investor might make this choice based on the initial investment and the sale price of the stock on the open market.
IPOs can be good for entrepreneurs to grow wealth and visibility, but the vehicle may not be ideal for the investor. Since investors are prevented from selling stock for six months after the IPO, their post-IPO valuation may decrease, and they might have to wait a long time to recover any financial gains initially planned from the IPO itself (Amis & Stevenson, 2001). Entrepreneurs should keep this in mind if an IPO is a planned and legitimately possible exit strategy for the business.
In a financial sale, investors exit when a company is sold for cash. In this case, the buyers consider the company value based on current and expected cash flows where multiples are predictable (Amis & Stevenson, 2001). The upside for an angel is that the purchase is made in cash and they should, hopefully, see a return on their initial investment. An entrepreneur will likely also benefit from this strategy; however, planning for a financial sale at the outset can be a challenge because markets change and the intended and possible “buyer(s)” may not be in the position to execute a purchase when the entrepreneur is ready to sell the business. It is also important to keep in mind that an investor will likely play an active role in the sale process and he or she will want to find a deal to maximize their return. In some cases, this may result in lost sale opportunities should the investor not believe the performance gains of their investment is sufficient.
A strategic sale is one where the entrepreneurial venture is acquired by a player in the industry who seeks the acquisition to gain some industry advantage. This type of exit is good for the investor because the buyer may pay a value that exceeds cash flow and assets because it desires the competitive advantage it may realize from the purchase (Amis & Stevenson, 2001). In such an arrangement, the entrepreneur will likely receive cash for the deal, but may also secure a job contract or a consulting arrangement with the new company. Unless the financial terms warrant it, entrepreneurs should be wary of non-compete arrangements in such deals which prevent work within the industry of expertise for an extended period.
In addition to the positive exits above, there are also possible negative exits. Bankruptcy is the most common, with the options being Chapter 13 or Chapter 7. Chapter 13 provides the opportunity to reorganize the company’s debt, but it means the investment is significantly reduced, if not eliminated (Amis & Stevenson, 2001). The investor may see a return over time, but it is dependent on the workout strategy planned and allowed by the courts. In the case of Chapter 7, the business and its assets are liquidated (Amis & Stevenson). Investors will likely see no return after the companies debts are satisfied.
It is critical that entrepreneurs plan positive exit strategy when pitching angel investors. Investors understand the risk of investment and also know that markets change and what’s was once intended may be derailed, possibly redirected or entirely reset. Therefore, it may be advantageous for the entrepreneur to create and explore multiple exit scenarios to use when approaching different investors. This strategy may be better than a “single window” exit in that it allows the investor to think about how various options might impact their initial investment (Mahapatra, 2014). Moreover, doing so gives the entrepreneur a better understanding of the nuances of exit strategies and demonstrates to the prospective investor the entrepreneur’s thinking about business. Positive exits are about mutual wins. And the best way exit positively is to lay the groundwork from the beginning.
Amis, D., & Stevenson, H. (2001). Winning Angels: The Seven Fundamentals of Early-Stage Investing. London: Pearson Education Limited.
Mahapatra, T. (2014). The Exit Phase of Individual Angels, Angel Syndicates, and Corporate Angels. Journal of Management Research, 14(2), 87-100.
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