Funding Theory for a Startup

Hello dear readers.

In this article I would like to dwell on such important points as an assessment of the need for borrowed funds, a decision on their involvement, effective forms of organizing a start-up company and the cost of attracted resources.

Determining the need for financial resources

In the beginning, it is necessary to determine the need for financial resources. That is, the cumulative amount of funds necessary to ensure all stages of the project.
There are 3 generally accepted methods for assessing the need for cash:

1. Balance - the definition of the required amount of assets that allow you to start an activity. Moreover, the composition of assets has its own characteristics: there are no long-term assets in the composition of non-current assets; in the composition of working capital - receivables. The need for cash (on the current account) is calculated on the basis of the planning of labor costs, advance and tax payments, and marketing on the basis of a 3-month requirement.
2. The method of analogies - based on the amount of resources used in similar projects. At the same time, the existing requirements and differences of projects are highlighted. If an investor is often confronted with a direction similar to yours, he may use this scheme. For a startup, this is the worst option.
3. The specific capital intensity - the simplest of the methods, is based on the calculation of the indicator of the capital intensity of production per 1 unit of production.

On Forms of Startup Company Organization

From the investor’s point of view, any “startup = venture” is an axiom, so to speak. Thus, it is necessary to begin to clarify what a venture is.
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Venture is a small business engaged in experimental development or other high-tech work, thanks to which risky projects are carried out.

Thus, for an investor, 3 forms of financing your startup will be rational:

1. Reorganization of your company into a venture enterprise in which the equity capital (hereinafter, the UK) will be based on the mutual participation of the investor (s) and yours.
2. Reorganization of your company into a joint-stock company with a subsequent increase in the insurance company through the issue of ordinary shares.
3. Lending your project.

The first 2 options are more preferable for a startup; they lack regress on the borrower, in case of failure you owe nothing to anyone. You risk only invested funds. However, there may be a loss of control over the project and the company as a whole. In the case of loans, the investor will offer you the participation of personal real estate, for example - a mortgage, which can turn into big problems for you.

Sources of financial resources

In world practice, there are 2 main branches to raise funds:

1. Internal sources (retained earnings, revaluation of fixed assets).
2. External sources (issuing shares, issuing bonds, obtaining loans).

In this article I will focus only on the consideration of external sources of raising funds.

Determining the cost of attracted resources

Before directly estimating the cost of borrowed resources, it is necessary to emphasize that the cost of resources for the borrower! = Income of the lender. This is due to the fact that the cost of resources for the borrower is adjusted by the amount of the tax shield.

Tax shield - the effect arising from the restructuring of the company's capital. It lies in the fact that the amount of corporate tax, which is subject to equity capital, is reduced due to an increase in the share of borrowed capital. Trite, tax shields - the planned savings in tax payments.

Cost of debt financing sources

The cost of raising capital as a result of issuing bonds (irrevocable and with a fixed income coupon) is calculated on the basis of the equation determining their market value:

P = ∑ ((CF * (1 - h) / (1 + r) ^ t) + N / (1 + r) ^ T

CF - regular amounts paid on coupons of bonds (coupon payments);
N is the nominal value of the bond;
T is the maturity period of the bond;
t is the period;
r -% rate;
h - the rate of income tax;
R - the value of the bond.

Simplified solution of this equation for r:

r = (N * q * (1 - h) + (N - P) / T) / (N + P) / 2

r is the percentage value of attracted resources on the bond;
h - the rate of income tax;
q - the amount of coupon payments;
- expenses on issue;

Cost of equity sources

To estimate the value of these sources, it is advisable to divide them into:

Share capital in the form of preferred shares - since they are paid a fixed percentage of the nominal value, the cost is calculated:

rPA = Dpa / (P-Zr)

Dpa - dividend payments for the year;
- the market price of the share at the time of valuation.
Sp - the cost of placing on one share.

Share capital in the form of ordinary shares

ra = (D1 / (P-3p)) + q

In the case of uniformly accelerated growth (the formula is simplified by using the equation of perpetuation) the dividend formula will be:

ra = D1 / ((1-q) -Zp)

Due to the fact that this formula does not take into account the risk of the company, it is advisable to use the CAPM model.

ra = rb + β (rm - rb)

rb - risk free rate;
β is the beta coefficient;
rm - market rate.

Conclusion

Thus, we reviewed the main methods for assessing the need for financial resources, effective forms of organizing a start-up company and learned how to calculate the cost of attracted resources on the terms of issuing bonds and additional issue of shares.

PS In case of any questions regarding the presentation of the article, venture and project financing, I will be happy to help you with them.

PPS All definitions are taken from the site - Wikipedia.

PPPS If articles of this format will appeal to the community, then in the next article I will talk about how an investor evaluates start-up projects, what indicators he focuses on and how he reduces his risks.