Financing the Pre-production stage

It should be noted that the discussion presented here is greatly simplified. Where the business is large, and the requirements for outside financing are substantial (e.g. a Leveraged Buy-out) the financing plan would be prepared by professionals.

The financial plan is intended to identify the financial requirements of the business. If it is determined that outside sources of capital is required, then the financial plan will include:

In other words, the financial plan is intended to identify where and how the required financing will be obtained.

Clearly, it is necessary to insure that adequate financial resources are available before initiating any large capital expenditures. Proceeding prematurely generally results in the project being completed in a much reduced form or abandoned altogether.

Even though a project might be economically sound it is imperative that an appropriate capital structure be maintained. It has already been stated that a sound capital structure will result in a competitive business that is able to provide an adequate return on invested capital. On the other hand, a weak capital structure can result in a cash starved business that is uncompetitive and ultimately fails.

Sources of capital

There are basically two sources of capital available to the business:

Debt financing This includes financial institutions such as chartered banks, credit unions, and trust companies.
Equity financing This includes private investors and government agencies.

 The key to proper financing is to find a suitable financing structure which utilizes these broad range of capital sources and matches them to the project so that the risks/reward trade-off makes sense.

Using lenders as a source of capital

In general, lenders consider the following two factors when reviewing a loan application:

  1. The cash flow form the business, and
  2. the security available (Net Worth)

When considering approaching outside lenders, it should be kept in mind that lenders generally look for greater net worth as the lending risk increases.

Developing a strategy to obtain adequate financing can be broken down into the following five steps.

  1. Determine the amount and type of financing required.
  2. Identify and rank the financing sources in terms of which level they are interested in (i.e. debt or equity).
  3. Prepare a financing proposal and approach the lenders
  4. Negotiate the terms of the deal with each lender.
  5. Close the deal.

Once the amount and type of financing has been determined and all potential lenders have been identified and ranked, the financing plan can be prepared.

Raising Equity

Equity capital will be required at all stages of the new product development process. They can be grouped into three broad categories:

Concept stage Owner’s capital, friends, relatives, and angles
Pre-production stage Venture capital (sometimes called seed capital or small capital)
Commercialization stage Large Capital (typically raised in the public markets)

Different types of investors are attracted to different stages of the process. For example, venture capitalists typically look for companies that have a well developed concept but need seed capital to test the product in the marketplace. They expect to cash out when the project reaches the commercialization stage.

Raising capital at each stage requires an understanding of the basic needs of the investor. The equity instruments that are used to fund a company must meet four criteria:

  1. The financing instrument must be attractive to the investor so that the funds will be available when required.
  2. The financing instrument must provide liquidity for the investor.
  3. The features of the instrument must not put the Company into a financial straight jacket.
  4. The additional funds must not result in a change of control.