For A-Plus Writer Only

References

Hisrich, R.D., Peters, M.P. , & Shepherd, D.A. (2013). Entrepreneurship (Laureate Custom

Education). New York: McGraw-Hill Irwin.

Custom Create Edition LAUREATE EDUCATION INC

316 I Entrepreneurship -'-' -- ~------ --------- --- - ---------------- ----- ·-------·--- ---------- ---- ·-· ---------- ----

SOURCES OF CAPITAL

1 To identify the types of financing available.

2

To understand the role of commercial banks in financing new ventures, the types of loans available, and bank lending decisions.

3 To discuss Small Business Administration (SBA) loans.

4 To understand the aspects of research and development limited partnerships.

5 To discuss government grants, particularly Small Business Innovation Research grants.

6 To understand the role of private placement as a source of funds.

I Entrepreneurship, Eighth Edition I 317 ~--~ --- -------------- --r---- ---

OPENING PROFILE

SCOTT WALKER

Some entrepreneurs are born and others are created through focus, energy, and de-

sire. Scott Walker is the latter style, developing his own lifelong learning curriculum in

creating opportunities and taking risks.

Walker was born an Air Force brat; his family was posted at stations across the coun-

try throughout his childhood. This training, including six

different grade schools and three high schools in three

different states, gave him the ability to get along any-

where, to be comfortable with different types of people,

and to be self-sufficient. Walker brought these capabilities to a series of start-up com-

panies, including one very successful financial technology firm.

After receiving a BA from Utah State University in 1977, Walker selected a graduate

school that would initiate his career as an entrepreneur. Thunderbird, the Garvin

School of International Management, provided an environment for learning how an

interesting idea can become a business-as well as exposure to the broader world as

represented by students and faculty from around the globe. Walker graduated in 1981

with an MBA.

The banking world and its activity in mergers and acquisitions was the first profes-

sional stop for Walker. Based in Dallas, he centered much of his effort on the oil and

gas industry, including working with T. Boone Pickens, the notorious corporate raider

of the 1980s, and his Mesa Petroleum Co. Pickens prided himself on being able to see

undervalued assets and subsequently make a profit when outside parties and the mar-

ket recognized that value. That lesson was not lost on Walker. Nor was the idea that

businesses need to be responsive to their shareholders and stakeholders, even if they

have to be dragged to that realization-as Pickens did to staid management teams

with his hostile takeover bids.

After a number of years in banking with such firms as Lloyd's Bank and GE Capital,

Walker noticed that many of the people he respected in this industry were leaving to

work on riskier, more nontraditional and stimulating ventures. This appealed to

Walker, playing to his strengths and providing a new channel for his energy. However,

he did not feel that he understood all the details of how to successfully build a new

venture, so he searched for an established entrepreneur who could show him the basics.

305

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306 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

That person was William Conley, a friend and successful serial business builder, who

was starting an Internet backbone infrastructure company to provide Internet points

of presence, or POPs. Walker was the second employee and CFO of the fledgling tech-

nology firm in 1995. After one year of hard work with few paychecks, the firm was sold

to GTE. It remains a portion of the Internet backbone today.

While that first taste of risk taking was exhilarating, Walker returned to the corpo-

rate world as CFO of Precept Business Services, a $200 million company. He gathered

useful experience in the process of taking a company public, as he was instrumental in

achieving that status for Precept through an S-4 registration, where securities are

issued in a business combination transaction.

When Conley again touched base with Walker in 1998, he was ready for a new chal-

lenge. This opportunity was [the establishment of] a not-for-profit [educational assis-

tance] company. This company, one2one Learn ing Foundation, provided individualized

curriculum programs for children not enrolled in traditional public or private institu-

tions. While serving as CFO of the foundation, Walker was approached by Clint Norton,

another friend, to assist with the sale of a small company Norton's father had invested

in three years earlier.

After a short time, it became clear to Walker that the ongoing talks were not going

to lead to a transaction with the buyer and he requested a 30-day leave from his cur-

rent responsibilities to clean up the company and find someone else to buy it. Once in-

side, he discovered that there was a great concept hiding inside this poorly managed

company, which was called TelePay. The firm provided large recurring billers with a

way to have their consumers pay their bills using an automated telephone service

known as interactive voice response, or IVR (the "press 1 for ... " technology). A wide

range of payment choices, including credit cards, ATM debit cards, and ACH or elec-

tronic checks, was offered to provide not only speed but also great flexibility for the

consumer. The revenue model for TelePay reflected the "many small slices" nature of

the transaction industry-the consumers paid a small incremental fee above the

amount owed for the convenience of not writing a check or visiting an office. The

biller did not pay for the setup or ongoing maintenance of the service.

Walker recognized the potential and joined it as president and CEO in early 1999,

when there were only four employees. This was the chance to put all that he had

learned as an apprentice into his own company. He saw that TelePay had very loya l

clients despite a number of nagging technical glitches, so his first decision was to com-

pletely rebuild the system on a single software platform. The key to success was to

ensure that the resulting architecture would scale up from 1,000 transactions to 10 mil-

lion transactions. His second act was to bring on a senior sales executive who could

leverage the loyalty of the existing customers into references for new prospects. This

expensive investment required trusting that the person could deliver new clients

quickly. On advice from Conley, Walker hired the right person. Both early decisions

proved correct: the company's infrastructure has readily grown with the client base,

and two of its initial four employees, as well as the sales executive, remain with the

company today.

Entrepreneurship, Eighth Edition 1 319 --- --·--·--···-------··---- - ~ ------ --

CHAPTER 11 SOURCES OF CAPITAL 307

After renaming the company BillMatrix Corporation, the team started to develop

a stellar client list. Walker built out the senior executive staff, adding a COO, CFO,

and both client and consumer support personnel. The company has been cash flow

positive since the first month of his tenure and revenue has grown over 100 percent

year after year, every year. Because of its cash flow, the company has not required

venture capital for growth, thereby keeping the majority control of the company

and all of the decision-making processes in the hands of the senior executives.

Walker's ability to make skillful choices, based upon what is good for the business

and good for the clients (but not necessarily those with the least risk), has created a strong organization.

The company has been at the forefront in applying new technology to electronic

bill payments since its restart by Walker in 1999. Internet-based payments were added

to the telephone service as use of that channel is now expected by consumers.

Multiple technologies are used for real-time connectivity to client systems for data ver-

ification and immediate posting of payments. A self-service client information portal

delivers real-time payment data to client personnel. The company continually looks to

add other innovations to its service as they become available.

BillMatrix serves a diverse client base of over 125 companies today, including

those in the utilities, telecom, insurance, and consumer finance industries . Walker's

organization has over 175 employees and a strong reputation for operational excel-

lence and exceptional client service in the electronic payments industry. His mantra

to the employees is: "We handle two of the most important things for our clients-

their money and their customers. We must always act with the highest ethics and

integrity."

In 2005, the electronic payments industry was considered a hot area and the time

was ripe for maximizing the va lue of an acquisition. Walker led the company in a buy-

out process with a large number of interested parties. The resulting transaction was an

acquisition of BiiiMatrix by Fiserv Inc. (NASDAQ: FISV) of Brookfield, Wisconsin, for

$350 million in August 2005. This was the second largest acquisition in dollar value for

Fiserv, which has built itself primarily by acquisition into a $3.4 billion company with

over 16,000 clients worldwide and 22,000 employees. BiiiMatrix is serving as the cor-

nerstone of Fiserv's greater role in the overall payment business, a growth engine for

its core business of financial technology and services.

In early 2006, Walker was meeting with an old friend, Jim Tehan. Jim was com-

plaining about all of the problems he had with contract fillers. Jim owned a sun care

line, Aloe Gator. After listening to his problems, Walker concluded that all these prob-

lems were correctible, and he and Tehan decided at that time to acquire an existing

contract filler. They looked at a company-Nature's Formula (about $16+ million revenues)-one of the largest operations in North Texas. The company's largest cus-

tomer was Victoria's Secret ($12 million contract) . Since the deal could not be closed in

August 2006, over dinner that night with three other individuals, Walker made the de-

cision to build a contract filler company from scratch. In November, a lease was signed

on 90,000 square feet of empty warehouse space. Offices, mechanical and production

320 I '"'""""'".rship -··-----1---------·

308 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

debt financing

Obtaining borrowed

funds for the company

rooms, and a warehouse were built utilizing both new and used equipment. The co m-

pany, ProCore Laboratories, was open for business in early March 2007, and the f irst

official product batch was filled in early April. Positive cash flow was achieved by De-

cember that year. The major difference between ProCore and all the rest of the indus-

try was that the company employed an internal operating system to manage an d

monitor by batch.

The focus of ProCore is on quality and partnership. The company has quality stan-

dards that will not be compromised. The company proved that if it could provide

consistent product quality in every batch, customer sales will increase. First yea r

(2007) revenues were around $1.26 million and in 2008, $8.5 million; projected rev-

enues in 2009 are $25+ million. Tehan's goal is to build the company to $500+ millio n

in revenues. Some of Walker's "must have" basic principles applied in this start-up :

integrity, no debt, ethics, above-standard quality, a solid management team (espe-

cially the entrepreneur in charge), and the ability to pay bills on time. ProCore's rep-

utation spread quickly throughout the industry. As a result, the company rarely

needs to seek out new customers as many come directly to the company. ProCore is

now the largest contract filler in North Texas. In this time of economic turmoil, the

company is flourishing while many of its competitors have shut down operations.

With ProCore, Walker proved that it is more about the philosophy of running a com-

pany versus having direct experience in the industry. Since ProCore is now up and

running and the foundation has been built, Walker is now taking the next step-

jumping into a new industry: distribution.

Today, Walker is dedicated to being an "entrepreneurial philanthropist." While he

is a generous monetary donor to his alma mater-Thunderbird School of Global

Management-he also provides the more important gift of time with students who are

looking for the same knowledge he needed early in his career. His goal is to help the next

generation get a quicker start on their ventures by sharing his knowledge about how to

build a strong business around a good idea. Among his many talents, Scott Walker under-

stands how to successfully finance and capitalize a venture, the focus of this chapter.

AN OVERVIEW One of the most difficult problems in the new venture creation process is obtaining financ- ing. For the entrepreneur, available fmancing needs to be considered from the perspective of debt versus equity and using internal versus external funds.

Debt or Equity Financing Two types of financing need to be considered: debt financing and equity financing. Debt financing is a financing method involving an interest-bearing instrument, usually a loan, the payment of which is only indirectly related to the sales and profits of the venture.

quity financing

o· taining funds for the ::lDmpany in exchange for awnership

·---------

I

Entrepreneurship, Eighth Edition I 321 ·--------+~--

CHAPTER 11 SOURCES OF CAPITAL 309

Typically, debt financing (also called asset-based financing) requires that some asset (such as a car, house, plant, machine, or land) be used as collateral.

Debt financing requires the entrepreneur to pay back the amount of funds borrowed as well as a fee expressed in terms of the interest rate. There can also be an additional fee, sometimes referred to as points, for using or being able to borrow the money. If the financ- ing is short term (less than one year), the money is usually used to provide working capital to finance inventory, accounts receivable, or the operation of the business. The funds are typically repaid from the resulting sales and profits during the year. Long-term debt (last- ing more than one year) is frequently used to purchase some asset such as a piece of machinery, land, or a building, with part of the value of the asset (usually from 50 to 80 per- cent of the total value) being used as collateral for the long-term loan. Particularly when interest rates are low, debt (as opposed to equity) financing allows the entrepreneur tore- tain a larger ownership portion in the venture and have a greater return on the equity. The entrepreneur needs to be careful that the debt is not so large that regular interest payments become difficult if not impossible to make, a situation that will inhibit growth and develop- ment and possibly end in bankruptcy.

Equity financing does not require collateral and offers the investor some form of owner- ship position in the venture. The investor shares in the profits of the venture, as well as any disposition of its assets on a pro rata basis based on the percentage of the business owned. Key factors favoring the use of one type of financing over another are the availability of funds, the assets of the venture, and the prevailing interest rates. Usually, an entrepreneur meets fmancial needs by employing a combination of debt and equity financing.

All ventures will have some equity, as all ventures are owned by some person or institu- tion. Although the owner may sometimes not be directly involved in the day-to-day manage- ment of the venture, there is always equity funding involved that is provided by the owner. The amount of equity involved will of course vary by the nature and size of the venture. In some cases, the equity may be entirely provided by the owner, such as in a small ice cream stand or pushcart in the mall or at a sporting event. Larger ventures may require multiple owners, including private investors and venture capitalists. This equity funding provides the basis for debt funding, which together make up the capital structure of the venture.

Internal or External Funds Financing is also available from both internal and external funds. The funds most frequently employed are internally generated funds. Internally generated funds can come from several sources within the company: profits, sale of assets, reduction in working capital, extended payment terms, and accounts receivable. In every new venture, the start-up years involve putting all the profits back into the venture; even outside equity investors do not expect any payback in these early years. The needed funds can sometimes be obtained by selling little- used assets. Assets, whenever possible, should be on a rental basis (preferably on a lease with an option to buy), not an ownership basis, as long as there is not a high level of infla- tion and the rental terms are favorable. This will help the entrepreneur conserve cash, a prac- tice that is particularly critical during the start-up phase of the company's operation.

A short-term, internal source of funds can be obtained by reducing short-term assets: inventory, cash, and other working-capital items. Sometimes an entrepreneur can generate the needed cash for a period of 30 to 60 days through extended payment terms from suppliers. Although care must be taken to ensure good supplier relations and continuous sources of supply, taking a few extra days to pay can generate needed short-term funds. A final method of internally generating funds is collecting bills (accounts receivable) more quickly. Key account holders should not be irritated by implementation of this practice, as

322 I Entrepreneurship

310 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

[ TABLE 11 .1 Guide for Alternative Sources of Financing

Length of Time Cost Control

Fixed Floating Percent Short Long Rate Rate of Voting

Source of Financing Term Term Debt Debt Profits Equity Covenants Rights

Self

Family and friends

Suppliers and trade credit

Commercial banks

Government loan programs

R&D limited partnerships

Private investors (angels)

Venture capital

Private equity placements

Public equity offerings

Other government programs

certain customers have established payment practices. Mass merchandisers, for example, pay their bills to supplying companies in 60 to 90 days, regardless of a supplying company 's accounts receivable policy, the size of the company, or the discount offered for prompt payment. If a company wants this mass merchandiser to carry its product, it will have to abide by this payment schedule.

One entrepreneur who is very successful at leveraging the discounts from vendors is home product distributor Jeff Schreiber. Schreiber always tries to take advantage of any dis- counts for prompt payments, and he obtained over $15,000 in early payment savings in 2002 alone. 1

The other general source of funds is external to the venture. Alternative sources of exter- nal financing need to be evaluated on three bases: the length of time the funds are available, the costs involved, and the amount of company control lost. In selecting the best source of funds, each of the sources indicated in Table 11 .1 needs to be evaluated along these three di- mensions. The more frequently used sources of funds (self, family and friends, commercial banks, R&D limited partnerships, government loan programs and grants, venture capital, and private placement) indicated in the table are discussed at length in the following pages. The firms in the "Entrepreneur 2003 Hot 100" list got start-up capital from savings (61 percent), private investors (31 percent), friends and family (18 percent), home equity lines of credit (17 percent), bank loans (16 percent), credit cards (10 percent), the sale of another business (1 percent), SBA loans (1 percent), and other sources (2 percent).

Whenever an entrepreneur deals with items external to the firm, particularly with peo- ple and institutions that could become stakeholders, ethical dilemmas can sometimes occur.

PERSONAL FUNDS Few, if any, new ventures are started without the personal funds of the entrepreneur. Not only are these the least expensive funds in terms of cost and control, but they are absolutely essential in attracting outside funding, particularly from banks, private investors, and venture capitalists. The typical sources of personal funds include savings, life insurance, or

'"'"'""'""';,. "·''".";"' I 323 ----~--- -- - - --- ·-· -· -- -··- ······--·--·· --· ----------~----~·-

AS SEEN IN BUSINESSWEEK

SHOW ME THE MONEYMEN

Adeo Ressi has long had a problem with authority fi gures. When he was in college, at the University of Pennsylvania, he ran an environmental newspaper called The Green Times. He tried to turn in copies of th e paper as his senior thesis, but his professor w ouldn't accept them. Ressi dug in his heels and re- fu sed to submit a traditional thesis. He never did get a degree. "He's always done his own thing," says younger brother Alex Ressi.

With his latest venture, Adeo Ressi is taking on the Establishment once again. A year ago, the 35-year- ol d New Yorker started up TheFunded.com, a Web site that lets entrepreneurs anonymously rank, re- vi ew, and post comments about venture capital firms . As an entrepreneur who has started numerous com-

an ies, Ressi saw a need to shine a spotlight on the previously secretive industry. "Venture capital defi- itely needed a kick in the pants," he says.

It's certainly getting one. TheFunded has become - e talk of Silicon Valley, as venture firms have come · for increasing scrutiny and in many cases harsh crit- . ism . One recent winter day, in a cramped confer- en ce room in his Greenwich Village office, Ressi

ecked his way through the site, waving his long arms and poking at the computer screen. "They stole as much information as they could about my business," ·eads one recent post. "It was a very unfriendly at-

osphere," reads another. Ressi points to a third com- en t about a venture employee who was 40 minutes

a e for an appointment, didn't apologize, and then as obnoxious. "How much you wanna bet that guy

; ets fired in a few months?" he says. The idea for TheFunded was born out of Ressi's ex-

~rience at Game Trust, the developer of online ;ames he founded in 2002. Ressi says he had lined up = S 10 million investment from Softbank Capital for a : on d round of funding. But in February, 2005, on - e day the deal was supposed to close, Softbank -= ... lied its offer. The withdrawal set in motion a chain

of events that ended 18 months later with one of Game Trust's new investors trying to boot Ressi out of the company.

The coup failed, but Ressi knew he had to do something. So over the winter in 2006, he built TheFunded.com. The idea was to create a place to help him evaluate venture capitalists in case he needed to raise money in the future. The site struck a chord with other entrepreneurs, and Ressi quickly signed up hundreds of members, who began posting juicy stories under titles such as "The Truth about Matrix Partners."

TheFunded.com isn't a big money maker. Ressi pulls in revenue by selling advertising, as well as $400-a-year subscriptions, typically to the institutional investors who put money into venture funds. To date, Ressi claims 450 subscribers. He says the site is profitable and reve nue "will easily hit seven figures" this year.

Venture firms are pressuring Ressi for more in- volvement and influence. George Zachary, a partner at Charles River Ventures who counts himself as a friend of Ressi's, says TheFunded should forbid anony- mous posts. "There should be more transparency," he says. "Anonymous comments allow people to make up stuff."

Ressi retorts: "Anonymity provides entrepreneurs with a comfortable environment to speak their minds freely."

TheFunded could create long-term challenges for Ressi. As a frenetic entrepreneur, he likely will try to raise venture money for one of his future startups. But it may be tough to persuade VCs to cut him a check after he has so publicly taken on the industry Establishment. "Yes," he says with a smile, "it will be difficult."

Source: Reprinted from the January 21, 2008 issue of Business Week by special permission, copyright © 2008 by The McGraw-Hill Companies, Inc. , "Show Me the Moneymen," by Spencer E. Ante, Business Week, Issue 4067, pp. 54-58.

mortgage on a house or car. These outside providers of capital feel that the entrepreneur may not be sufficiently committed to the venture if he or she does not have money invested. As one venture capitalist succinctly said, "I want the entrepreneurs so financially commit- ted that when the going gets tough, they will work through the problems and not throw the keys to the company on my desk."

311

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312 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

This level of commitment is reflected in the percentage of total assets available entrepreneur has committed, not necessarily in the amount of money committed. Ar.. side investor wants an entrepreneur to have committed all available assets, an indi that he or she truly believes in the venture and will work all the hours necessary to success. Whether this is $1,000, $100,000, or $250,000 depends on the assets available. =- -trepreneurs should always remember that it is not the amount but rather the fac t th monies available are committed that makes outside investors feel comfortable with - commitment level and therefore more willing to invest.

FAMILY AND FRIENDS After the entrepreneur, family and friends are a common source of capital for a new v' They are most likely to invest due to their relationship with the entrepreneur. This overcome one portion of uncertainty felt by impersonal investors-knowledge of the preneur. Family and friends provide a small amount of equity funding for new ven: reflecting in part the small amount of capital needed for most new ventures. Althougl:;. relatively easy to obtain money from family and friends, like all sources of capital, there positive and negative aspects. Although the amount of money provided may be small, · ~ in the form of equity financing, the family members or friends then have an own position in the venture and all rights and privileges of that position. This may make them::: they have a direct input into the operations of the venture, which may have a negative e~ on employees, facilities, or sales and profits. Although this possibility must be gu.a:-2.=: against as much as possible, frequently family and friends are not problem investors fact are more patient than other investors in desiring a return on their investment.

To avoid problems in the future, the entrepreneur must present the positive and ne6 aspects and the nature of the risks of the investment opportunity to try to minimize the n=-= ative impact on the relationships with family and friends should problems occur. One that helps to minimize possible difficulties is to keep the business arrangements str:i~ business. Any loans or investments from family or friends should be treated in the businesslike manner as if the financing were from an impersonal investor. Any loan s specify the rate of interest and the proposed repayment schedule of interest and princ7"r The timing of any future dividends must be disclosed in terms of an equity investrn the family or friend is treated the same as any investor, potential future conflicts ca::. avoided. It is also beneficial to the entrepreneur to settle everything up front and in wri..;__= It is amazing how short memories become when money is involved. All the details o"- financing must be agreed upon before the money is put into the venture. Such thine- the amount of money involved, the terms of the money, the rights and responsibilities o=- investor, and what happens if the business fails must all be agreed upon and written cL A formal agreement with all these items helps avoid future problems.

Finally, the entrepreneur should carefully consider the impact of the investment o family member or friend before it is accepted. Particular concern should be paid to hardships that might result should the business fail. Each family member or friend sh be investing in the venture because they think it is a good investment, not because they == obligated.

COMMERCJAL BANKS Commercial banks are by far the source of short-term funds most frequently used by entrepreneur when collateral is available. The funds provided are in the form of deb!: :::- nancing and, as such, require some tangible guaranty or collateral-some asset with Ya.c~:

asset base for l~ans Tangible collateral valued

at more than the amount

of money borrowed

I Entrepreneurship, Eighth Edition I 325 -· ----·--- --·- ·----- ----- ·-··------+-- ---·- -·-

CHAPTER 11 SOURCESOFCAPITAL 313

This collateral can be in the form of business assets (land, equipment, or the building of the venture), personal assets (the entrepreneur's house, car, land, stock, or bonds), or the assets of the cosigner of the note.

Types of Bank Loans There are several types of bank loans available. To ensure repayment, these loans are based on the assets or the cash flow of the venture. The asset base for loans is usually accounts receivable, inventory, equipment, or real estate.

Accounts Receivable Loans Accounts receivable provide a good basis for a loan, espe- cially if the customer base is well known and creditworthy. For those creditworthy cus- tomers, a bank may finance up to 80 percent of the value of their accounts receivable. When customers such as the government are involved, an entrepreneur can develop a factoring arrangement whereby the factor (the bank) actually "buys" the accounts receivable at a value below the face value of the sale and collects the money directly from the account. In this case, if any of the receivables is not collectible, the factor (the bank) sustains the loss, not the business. The cost of factoring the accounts receivable is of course higher than the cost of securing a loan against the accounts receivable without factoring being involved, since the bank has more risk when factoring. The costs of factoring involve the interest charge on the amount of money advanced until the time the accounts receivable are col- lected, the commission covering the actual collection, and protection against possible uncollectible accounts.

Inventory Loans Inventory is another of the firm's assets that is often a basis for a loan, particularly when the inventory is liquid and can be easily sold. Usually, the finished goods inventory can be financed for up to 50 percent of its value. Trust receipts are a unique type of inventory loan used to finance floor plans of retailers, such as automobile and appliance dealers. In trust receipts, the bank advances a large percentage of the invoice price of the goods and is paid on a pro rata basis as the inventory is sold.

Equipment Loans Equipment can be used to secure longer-term financing, usually on a 3- to 10-year basis. Equipment financing can fall into any of several categories: fi- nancing the purchase of new equipment, financing used equipment already owned by the company, sale-leaseback financing, or lease financing. When new equipment is be- ing purchased or presently owned equipment is used as collateral, usually 50 to 80 per- cent of the value of the equipment can be financed depending on its salability. Given the entrepreneur's tendency to rent rather than own, sale-leaseback or lease financing of equipment is widely used. In the sale-leaseback arrangement, the entrepreneur "sells" the equipment to a lender and then leases it back for the life of the equipment to ensure its continued use. In lease financing, the company acquires the use of the equip- ment through a small down payment and a guarantee to make a specified number of payments over a period of time. The total amount paid is the selling price plus the finance charges .

Real Estate Loans Real estate is also frequently used in asset-based financing. This mortgage financing is usually easily obtained to finance a company's land, plant, or another building, often up to 75 percent of its value.

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314 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

conventional bank loan

Standard way banks lend

money to companies

Cash Flow Financing

The other type of debt financing frequently provided by commercial banks and other fi- nancial institutions is cash flow financing. These conventional bank loans include lines of credit, installment loans, straight commercial loans, long-term loans, and character loans. Lines of credit financing is perhaps the form of cash flow financing most fre- quently used by entrepreneurs. In arranging for a line of credit to be used as needed, the company pays a "commitment fee" to ensure that the commercial bank will make the loan when requested and then pays interest on any outstanding funds borrowed from the bank. Frequently, the loan must be repaid or reduced to a certain agreed-upon level on a periodic basis.

Installment Loans Installment loans can also be obtained by a venture with a track record of sales and profits . These short-term funds are frequently used to cover working capital needs for a period of time, such as when seasonal financing is needed. These loans are usually for 30 to 40 days.

Straight Commercial Loans A hybrid of the installment loan is the straight com- mercial loan, by which funds are advanced to the company for 30 to 90 days. These self-liquidating loans are frequently used for seasonal financing and for building up inventories.

Long-Term Loans When a longer time period for use of the money is required, long -term loans are used . These loans (usually available only to strong, mature compa- nies) can make funds available for up to 10 years . The debt incurred is usually rep aid according to a fixed interest and principal schedule. The principal, however, can some- times start being repaid in the second or third year of the loan, with only interest paid the first year.

Character Loans When the business itself does not have the assets to support a lo an. the entrepreneur may need a character (personal) loan. These loans frequently mus have the assets of the entrepreneur or other individual pledged as collateral or the loan cosigned by another individual. Assets that are frequently pledged include cars, homes. land, and securities . One entrepreneur's father pledged a $50,000 certificate of deposi- as collateral for his son's $40,000 loan. In extremely rare instances, the entrepreneur can obtain money on an unsecured basis for a short time when a high credit standing has been established.

Bank Lending Decisions

One problem for the entrepreneur is determining how to successfully secure a loan from the bank. Banks are generally cautious in lending money, particularly to new ventures , since they do not want to incur bad loans. Regardless of geographic location, commercial loar. decisions are made only after the loan officer and loan committee do a careful review of the borrower and the financial track record of the business. These decisions are based on bo quantifiable information and subjective judgments. 2

The bank lending decisions are made according to the five Cs of lending: character. capacity, capital, collateral, and conditions. Past financial statements (balance sheets an · income statements) are reviewed in terms of key profitability and credit ratios, invento . turnover, aging of accounts receivable, the entrepreneur's capital invested, and commitmerr::

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CHAPTER 11 SOURCESOFCAPITAL 315

to the business. Future projections on market size, sales, and profitability are also evalu- ated to determine the ability to repay the loan. Several questions are usually raised re- garding this ability. Does the entrepreneur expect to be carried by the loan for an ex- tended period of time? If problems occur, is the entrepreneur committed enough to spend the effort necessary to make the business a success? Does the business have a unique dif- ferential advantage in a growth market? What are the downside risks? Is there protection (such as life insurance on key personnel and insurance on the plant and equipment) against disasters?

Although the answers to these questions and the analysis of the company's records al- low the loan officer to assess the quantitative aspects of the loan decision, the intuitive fac- tors, particularly the first two Cs--character and capacity-are also taken into account. This part of the loan decision-the gut feeling- is the most difficult part to assess. The en- trepreneur must present his or her capabilities and the prospects for the company in a way that elicits a positive response from the lender. This intuitive part of the loan decision be- comes even more important when there is little or no track record, limited experience in financial management, a nonproprietary product or service (one not protected by a patent or license), or few assets available.

Some of the concerns of the loan officer and the loan committee can be reduced by pro- viding a good loan application. While the specific loan application format of each bank dif- fers to some extent, generally the application format is a "mini" business plan that consists of an executive summary, business description, owner/manager profiles, business projec- tions, financial statements, amount and use of the loan, and repayment schedule. This information provides the loan officer and loan committee with insight into the creditworthi- ness of the individual and the venture as well as the ability of the venture to make enough sales and profit to repay the loan and the interest. The entrepreneur should evaluate several alternative banks, select the one that has had positive loan experience in the particular busi- ness area, call for an appointment, and then carefully present the case for the loan to the loan officer. Presenting a positive business image and following the established protocol are necessary to obtain a loan from a commercial bank.

Generally, the entrepreneur should borrow the maximum amount that can possibly be repaid as long as the prevailing interest rates and the terms, conditions, and restrictions of the loan are satisfactory. It is essential that the venture generate enough cash flow to repay the interest and principal on the loan in a timely manner. The entrepreneur should evaluate the track record and lending procedures of several banks to secure the money needed on the most favorable terms available. This "bank shopping procedure" will provide the needed funds at the most favorable rates.

ROLE OF THE SBA IN SMALL-BUSINESS FINANCING Frequently, an entrepreneur is missing the necessary track record, assets, or some other ingredient to obtain a commercial bank loan. When the entrepreneur is unable to secure a regular commercial bank loan, an alternative is a guaranty from the Small Business Admin- istration (SBA). The SBA offers numerous loan programs to assist small businesses. In each of these, the SBA is primarily a guarantor of loans made by private and other institu- tions. The Basic 7(a) Loan Guaranty is the SBA's primary business loan program. This pro- gram helps qualified small businesses obtain financing when they cannot obtain business loans through regular lending channels . The proceeds from such a loan can be used for a variety of business purposes, such as working capital; machinery and equipment; furniture and fixtures; land and building; leasehold improvements; and even, under some conditions, debt refinancing.

........._

328 I '""'P~'""h;p -~-- -~---------- ------~-----·---------~------------~----------------·-

• ETHICS

WE NEED AN ETHICS CZAR

Energy Czar. Health Reform Czar. Technology Czar. Green Czar. President Barack Obama continues to line up an impressive array of policy leaders to tackle our ever-mounting social and economic problems. Tough times call for creative solutions, and the President is right to look for the best and the brightest to heal our battered economy and bruised infrastructure.

But there is one kind of problem the Obama Ad- ministration has yet to tackle, even though it may be the most pervasive one of all. It is a distressing issue about which everyone complains but no one has been able to address effectively: The widespread fail- ure of our leaders-and the rest of us-to take ethics seriously.

WHAT WE NEED IS AN ETHICS CZAR According to the annual USA Today/Gallup Poll, less than one American in four rates highly the ethical standards of business executives, attorneys, members of Congress, or stockbrokers. Bankers had it espe- cially rough in the latest poll: Their approval rating fell from 35% to 23%. Even before the Blagojevich scandal hit the news, only 22% of Americans held state governors in high esteem.

A contempt for ethics lies at the heart of almost every top story of the day: Yankee hitter Alex Rodriguez admitting to steroid use, investor Bernard L. Madoff confessing to running the largest Ponzi scheme in history, a report by the Josephson Institute stating that 64% of high school students cheat and 30% steal. As I have argued repeatedly in this column, however, striving to live an ethical life isn't just the right thing to do; it's the smart thing to do, too.

I THEREFORE PROPOSE MY TOP NOMINEE FOR ETHICS CZAR: YOU That's right. Whether you're the CEO of a globa l c::·- poration, a midlevel manager, or an entreprene- striking out in this difficult economy, you are the~ _ who should set high standards in your organ izati::·- and do your level best to live up to them.

In fact, being the ethics czar applies not jus: - how you lead your organization, but also to how}::_ lead your life. I hereby offer six simple rules fore-- cal leadership at work, with your family and frie and in your community.

A CODE OF CONDUCT FOR ETHICS CZARS 1. Lead by Example. The most effective way to p. -

mote ethical behavior is to demonstrate it in a that you do. When members of your team see that you tell the truth when it would be easie, ·- be dishonest, or react to a stressful situation v,rr-.: compassion rather than hostility, or own up to your mistakes rather than blaming someone e ·- they not only have a model for making the rig- choices-they have the motivation to do it, t Anyone can take the low road, but it takes a ,......_ son of character to take the high road cons is- tentlY< or at least attempt to do so. Show your team that you are such a person.

2. Praise Generously. When was the last time yo told someone she was doing a good job? Yes, i:"~ important for managers to let employees kno when they've gotten off track. But it may be e>oe- more important to tell people when they've do.-:

To get a 7(a) loan, the entrepreneur must be eligible. While repayment ability from cash flow of the business is of course essential, other criteria include good character, man".:- ment capability, collateral, and owner's equity contribution. Eligibility factors for all - loans include size, type ofbusiness, use of proceeds, and the availability of funds from -- sources. All owners of 20 percent or more are required to personally guarantee SBA lo

316

The SBA 7(a) loan program has a maximum loan amount of $2 million with the SB..-.. maximum exposure of $1 million. In the case of a $2 million loan, the maximum tee to the lender by the SBA will be $1 million or 50 percent. Though the interest rate5 the loan are negotiated between the borrower and the lender, they are subject to

'""'''"'""h;p, Hgh<h Ed;,;oo I 329 ------------------·-----·------------------------- -- ---- --- ---- -- ----------- -i--··- ----

something right. After all, people will give you their best if they feel appreciated. One of the many useful lessons I picked up at the Gallup Insti- tute for Leadership is the value of writing brief notes to those who have done something benefi- cial for me. Even a one-line e-mail saying some- thing like, "You handled that situation brilliantly," will make someone's day. As long as it comes from the heart, a little praise goes a long way.

3. Criticize to Build Up, Not Break Down. Many of us view criticism as something we'd rather not give or receive. But this misses its real aim, which is to bring out the best in others and not merely instill feel- ings of guilt or remorse. It is appropriate for peo- ple to feel bad when they have done something wrong. Good managers know, however, that criti- cism is most effective when it leaves someone in- spired to do better rather than stuck in feelings of inadequacy. It's in your own interest to take mean- ingful criticism seriously when you receive it, too.

<+. Be Kind, Unwind. The better angels of our nature are often the first casualties in the war of eco- nomic survival we're all fighting now. More than ever, it makes sense for managers to build stress- busters into the work week. Take the group out to lunch or have a brown-bag day for your team in the conference room with no work allowed. Let the staff go home early from time to time or celebrate their birthdays away from the office for the full day. Encourage team members to use, not hoard, their vacation days.

5. Punish Fairly. One measure of good managers is the extent to which anger influences the way they punish employees. It is human to be upset when a person you manage and trust lets you down, but you can and should rise above that anger, look objectively at what has occurred, and

decide what the appropriate response should be. It's especially important to put aside whatever emotional turmoil you're going through that is unrelated to the problem at hand.

It's also critical to avoid favoritism when met- ing out punishment. There is no surer way to lower your team's morale than to give one errant employee a free pass after you have punished another employee who made the same mistake.

6. If It Is to Be, It's Up to Thee. When you see people doing things they shouldn't, take action. For ex- ample, when employees come to work with the flu, sending them home is fair, it prevents harm, and it demonstrates that you care. Avoiding the matter helps no one, including you. If you over- hear colleagues discussing confidential informa- tion in a public place, mention your concerns rather than ignoring the situation. If you get bad customer service, telling the manager instead of quietly seething about it means you at least have a shot at getting a positive result.

Don't assume problems will take care of themselves. They won't. It often takes very little effort to make a big difference. It does, however, take courage, and this is where you come in, since others may not step up to the plate.

You can't solve every problem in the world, but living by the above guidelines will make your own corner of the world a more dignified place to be.

You just may end up being the most effective czar of them all.

Source: Reprinted from March 13, 2009 issue of Business Week by special permission, copyright © 2009 by The McGraw-Hill Companies, Inc., "We Need an Ethics Czar to Battle a Wide- spread Breakdown in Standards," by Bruce Weinstein, PhD, Business Week magazine: www.businessweek.com/managing/ content/mar2009/ca20090313_8691 03.htm.

maximums, which are pegged to the prime rate and may be fixed or variable. For example, a fixed-rate loan of $50,000 or more must not exceed prime plus 2.25 percent if the matu- rity is less than seven years.

Most of the loans have the same guarantee features. The SBA can guarantee 85 percent of the loan for loans of $150,000 or less and 75 percent for loans between $150,000 and $1 million. Some differences occur in SBA Express loans (maximum guarantee of 50 per- cent) and export working capital loans (maximum guarantee of 90 percent). To help offset the costs of the SBA loan programs, lenders are charged a guaranty and servicing fee for each approved loan. These fees can be passed on to the borrower and vary depending on the amount of the loan.

317

I 330 I Entrepreneurship

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318 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

research and developmenJ

limited partnerships

Money given to a finn for developing a technology

that involves a tax shelter

limited partner A party in a partnership agreement that usually

supplies money and has

a few responsibilities

general partner The overall coordinating party

in a partnership agreement

In addition to the 7(a) loan program, the SBA has several other programs. The 504loan program provides fixed-rate financing to enable small businesses to acquire machinery, equipment, or even real estate in order to expand or modernize. The maximum of the pro- gram is usually $1 million, and the loan can take a variety of forms, including a loan from a Community Development Company (CDC) backed by a 100 percent SEA-guaranteed debenture.

Another more recent SBA loan program that many entrepreneurs have used is the SBA Microloan, a 7(m) loan program. This program provides short-term loans of up to $35,000 to small businesses for working capital or the purchase of inventory, supplies , furniture, fixtures, machinery, or equipment. The loan cannot be used to pay existing debts . The small business receives the loan from a bank or other organization, with the loan being guaranteed in full by the SBA. The SBA also provides such loans as Home and Personal Property Disaster Loans, Physical Disaster Business Loans, and Military Reservist Economic Injury Disaster Loans. The entrepreneur should check with the SBA to see whether a loan program is available, if a loan cannot be obtained without the SBA guarantee.

RESEARCH AND DEVELOPMENT LIMITED PARTNERSHIPS Research and development limited partnerships are another possible source of funds for entrepreneurs in high-technology areas. This method of financing provides funds from investors looking for tax shelters. A typical R&D partnership arrangement involves a sponsoring company developing the technology with funds being provided by a limited partnership of individual investors . R&D limited partnerships are particularly good when the project involves a high degree of risk and significant expense in doing the basic research and development, since the risks, as well as the ensuing rewards , are shared.

Major Elements The three major components of any R&D limited partnership are the contract, the sponsor- ing company, and the limited partnership. The contract specifies the agreement between the sponsoring company and the limited partnership, whereby the sponsoring company agrees to use the funds provided to conduct the proposed research and development that hopefully will result in a marketable technology for the partnership. The sponsoring company does not guarantee results but rather performs the work on a best-effort basis, being compen- sated by the partnership on either a fixed-fee or a cost-plus arrangement. The typical con- tract has several key features. The first is that the liability for any loss incurred is borne by the limited partners. Second, there are some tax advantages to both the limited partnership and the sponsoring company.

The second component involved in this contract is the limited partners. Similar to the stockholders of a corporation, the limited partners have limited liability but are not a total taxable entity. Consequently, any tax benefits of the losses in the early stages of the R&D limited partnership are passed directly to the limited partners, offsetting other in- come and reducing the partners' total taxable incomes. When the technology is success- fully developed in later years, the partners share in the profits. In some instances, these profits for tax purposes are at the lower capital gains tax rate as opposed to the ordinary income rate.

The final component, the sponsoring company, acts as the general partner developing the technology. The sponsoring company usually has the base technology but needs funds

[ Entrepreneurship, Eighth Edition ! 331

---- --······-·· ·-···-··----------------·-·--j~--~-- 1

CHAPTER11 SOURCESOFCAPITAL 319

to further develop and modify it for commercial success. It is this base technology that the company is offering to the partnership in exchange for money. The sponsoring company usually retains the rights to use this base technology to develop other products and to use the developed technology in the future for a license fee. Sometimes, a cross-licensing agreement is established whereby the partnership allows the company to use the technology for developing other products .

Procedure

An R&D limited partnership generally progresses through three stages: the funding stage, the development stage, and the exit stage. In the funding stage, a contract is established between the sponsoring company and limited partners, and the money is invested for the proposed R&D effort. All the terms and conditions of ownership, as well as the scope of the research, are carefully documented.

In the development stage, the sponsoring company performs the actual research, using the funds from the limited partners. If the technology is subsequently successfully devel- oped, the exit stage commences, in which the sponsoring company and the limited partners commercially reap the benefits of the effort. There are three basic types of arrangements for doing this: equity partnerships, royalty partnerships, and joint ventures .

In the typical equity partnership arrangement, the sponsoring company and the limited partners form a new, jointly owned corporation. On the basis of the formula established in the original agreement, the limited partners' interest can be transferred to equity in the new corporation on a tax-free basis. An alternative is to incorporate the R&D limited partnership itself and then either merge it into the sponsoring company or continue as a new entity.

A possible alternative to the equity partnership arrangement is a royalty partnership. In this situation, a royalty based on the sale of the products developed from the technology is paid by the sponsoring company to the R&D limited partnership. The royalty rates typi- cally range from 6 to 10 percent of gross sales and often decrease at certain established sales levels. Frequently, an upper limit, or cap, is placed on the cumulative royalties paid.

A final exit arrangement is through a joint venture. Here the sponsoring company and the partners form a joint venture to manufacture and market the products developed from the technology. Usually, the agreement allows the company to buy out the partnership in- terest in the joint venture at a specified time or when a specified volume of sales and profit has been reached.

Benefits and Costs As with any fmancing arrangement, the entrepreneur must carefully assess the appropriate- ness of establishing an R&D limited partnership in terms of the benefits and costs involved. Among the several benefits is that an R&D limited partnership provides the funds needed with a minimum amount of equity dilution while reducing the risks involved. In addition, the sponsoring company's financial statements are strengthened through the attraction of outside capital.

There are some costs involved in this financial arrangement. Typically, it is more ex- pensive to establish than conventional financing. First, time and money are expended. An R&D limited partnership frequently takes a minimum of six months to establish and $50,000 in professional fees. These can increase to a year and $400,000 in costs for a major effort. And the track record is not as good, as most R&D limited partnerships are unsuc- cessful. Second, the restrictions placed on the technology can be substantial. To give up

I 332 ! Entrepreneurship

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320 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

SBIR grants program Grants from the U.S.

government to small

technology-based

businesses

the technology developed as a by-product of the primary effort may be too high a price· pay for the funds. Third, the exit from the partnership may be too complex and involve toe much fiduciary responsibility. These costs and benefits need to be evaluated in light o: other financial alternatives available before an R&D limited partnership is chosen as funding vehicle.

Examples In spite of the many costs involved, there are numerous examples of successful R& limited partnerships . Syntex Corporation raised $23.5 million in an R&D limited partner- ship to develop five medical diagnostic products . Genentech was so successful in devel - oping human growth hormone and gamma interferon products from its first $55 millio R&D limited partnership that it raised $32 million through a second partnership six months later to develop a tissue-type plasminogen activator. Trilogy Limited raisee $55 million to develop a high-performance computer. And the list goes on. Indeed, R&D lim- ited partnerships offer one financial alternative to fund the development of a venture 's technology.

GOVERNMENT GRANTS The entrepreneur can sometimes obtain federal grant money to develop and launch an in- novative idea. The Small Business Innovation Research (SBIR) program, designed for the small business, was created as part of the Small Business Innovation Development Act. The act requires that all federal agencies with R&D budgets in excess of $100 million a war, a portion of their R&D funds to small businesses through the SBIR grants program. This act not only provides an opportunity for small businesses to obtain research and develop- ment money but also offers a uniform method by which each participating agency solicits. evaluates, and selects the research proposals for funding.

Eleven federal agencies are involved in the program (see Table 11.2). Each agency devel- ops topics and publishes solicitations describing the R&D topic it will fund . Small businesses

TABLE 11.2 Federal Agencies Participating in Small Business Innovation Research Program

• Department of Defense (DOD)

• Nationa l Aerona utics and Space Administration (NASA)

• Department of Energy (DOE)

• Department of Health and Human Services (DHHS)

• Nationa l Science Foundation (NSF)

• U.S. Department of Agriculture (USDA)

• Department of Transportation (DOT)

• Nuclear Regulatory Commission (NRC)

• Environmental Protection Agency (EPA)

• Department of Education (DOED)

• Department of Commerce (DOC)

333 Entrepreneurship, Eighth Edition t - - -- - --- ---- - ---- - -·-----

AS SEEN IN BUSINESSWEEK

FROM 401(k) NEST EGG TO SEED MONEY

Michael Amstein decided to strike out on his own last year, leaving behind his job as an executive at an ambulance company. The 43-year-old Denver native carefully weighed the pros and cons of var- ious franchise options and eventually decided to open a Nestle Toll House Cafe at a local mall. But when he applied for loans, Amstein couldn't come up with enough collateral and was rejected. Un- daunted, he turned to BeneTrends, a firm that helps entrepreneurs tap into their 401 (k)s without incurring a tax penalty. After paying $4,500, Amstein unlocked $100,000 from his account and bought the cookie shop. "I was nervous about starting something," says Amstein. "But I took a leap of faith, and it has worked out."

With banks tightening lending, small busi- nesses, which can't borrow from the bond market li ke larger corporations, have lost one of their best sources of funding. To fill the void, a cottage in- dustry, made up of a few small companies and a bevy of independent contractors, has sprung up to help entrepreneurs turn their 401 (k)s and other t ax-deferred accounts into capital. The firms, which generally charge $4,500 to $7,500 for their services, are taking advantage of an unpublicized tax law hat allows individuals to invest their retirement

fu nds in a company. Here's how it works. An entrepreneur, aided

by the outside adviser, creates a corporation. The newly formed entity starts a 401 (k) plan, and an individual rolls over existing retirement funds into

e account. Under 401 (k) rules, the plan can pur- ch ase shares in the corporation-money that can

e plowed into a small business that sells a product or service. Those deals are considered investments, vh ich is the key. By investing the money rather

- an withdrawing it, entrepreneurs avoid trigger- . g a penalty that amounts to 10% of the assets.

The funding method has been around for years. 3 t the credit crisis has turned this once sleepy

niche into a booming business. Industry leaders Bene Trends in North Wales, Pa., and Guidant Finan- cial Group in Bellevue, Wash., say customer volume is up 30% to 35% over the past year. By compari- son, small-business loans from traditional lenders fell 30%. "There's not any kind of underwriting re- quirement," says David Nilssen, CEO of Guidant, which has helped customers unlock $1.5 billion in 401 (k) funds since its start in 2003. "You either have the capital or you don't."

Such strategies can make the difference be- tween a small business getting off the ground or not . But they come with a big risk . If the com- pany goes belly up, the nest egg will be wiped out. And the possibility of failure is great. A study at Case Western Reserve University found that more than half of startups fold within five years. "I know small business owners are in tough situations," says Alice Bredin, a small- business consultant who works with American Express. But utilizing retirement funds "is a really bad idea."

Tim and Terry Madden considered taking out a traditional loan to buy three franchises of Assist- ing Hands, which provides in-home help to the elderly and disabled. They qualified, but the Fountain Hills (Ariz.) couple didn't want to rack up huge piles of debt in a turbulent economy. Instead, the Maddens used $175,000 of their re- tirement assets, paying Guidant $5,000 to steer them through the process. "Everybody worries about taking money out of an account you've grown over the years," says Terry Madden, whose franchises are slated to open in January. "But we felt it was a calculated risk. We sleep at night."

Source: Reprinted from the December 22, 2008 issue of Business- Week by special permission, copyright© 2008 by The McGraw- Hill Companies, Inc., ''From 401(k) Nest Egg to Seed Money," by Brian Burnsed, Business Week, Issue 4113, p. 64.

321

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322 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

submit proposals directly to each agency using the required format, which is somewhat standardized, regardless of the agency. Each agency, using its established evaluation criteria, evaluates each proposal on a competitive basis and makes awards through a contract, grant, or cooperative agreement.

The SBIR grant program has three phases . Phase I awards are up to $100,000 for six months of feasibility-related experimental or theoretical research. The objective here is to determine the technical feasibility of the research effort and assess the quality of the com- pany's performance through a relatively small monetary commitment. Successful projects are then considered for further federal funding support in Phase II.

Phase II is the principal R&D effort for those projects showing the most promise at the end of Phase I. Phase II awards are up to $750,000 for 24 months of further research and development. The money is to be used to develop prototype products or services. A small business receiving a Phase II award has demonstrated good research results in Phase I, de- veloped a proposal of sound scientific and technical merit, and obtained a commitment for follow -on private-sector financing in Phase ill for commercialization.

Phase ill does not involve any direct funding from the SBIR program. Funds from the private sector or regular government procurement contracts are needed to commercialize the developed technologies in Phase ill.

Procedure Applying for an SBIR grant is a straightforward process. The government agencies partic- ipating (indicated in Table 11.2) publish solicitations describing the areas of research they will fund. Each of these annual solicitations contains documentation on the agency 's R&D objectives, proposal format, due dates, deadlines, and selection and evaluation criteria. The second step involves the submission of the proposal by a company or individual. The pro- posal, which is 25 pages maximum, follows the standard proposal format. Each agency screens the proposals it receives. Knowledgeable scientists or engineers then evaluate those that pass the screening on a technological basis. Finally, awards are granted to those proj- ects that have the best potential for commercialization. Any patent rights, research data, technical data, and software generated in the research are owned by the company or indi- vidual, not by the government.

The SBIR grant program is one viable method of obtaining funds for a technology- based entrepreneurial company that is independently owned and operated, employs 500 or fewer individuals, and has any organizational structure (corporation, partnership, sole proprietorship) .

Another grant program available to the entrepreneur is the Small Business Technology Transfer (STIR) program, which was established by the Small Business Technolo gy Transfer Act of 1992. Federal agencies with budgets over $1 billion are required to set aside 0.3 percent for small businesses. Five agencies participate in the STIR program- the Department of Defense (DOD) , the Department of Energy (DOE), the Department of Health and Human Services (DHHS), the National Aeronautics and Space Administration (NASA), and the National Science Foundation (NSF). All these, except DHHS, also par- ticipate in the SBIR program. While a comparison of the SBIR and STIR programs is found in Table 11.3, the two programs differ in two major ways: First, while in the SB IR program, the principal investigator must have his or her primary employment with the small business receiving the award. In contrast, for the duration of the project, there is no employment stipulation in the STTR program. Second, the STTR program requires re- search partners at universities or other nonprofit institutions, with at least 40 percent of the research conducted by the small business and at least 30 percent conducted by the partnering

Entrepreneurship, Eighth Edition 335

CHAPTER 11 SOURCES OF CAPITAL 323

I TABLE 11.3 Comparison of SBIR and STTR Programs Requirements

Applicant organization

Award period

Award dollar guidelines

SBIR

Small-business concern (SBC)

Phase 1-6 months, normally

Phase 11-2 years, normally

Phase 1-$100,000, normally

Phase 11-$750,000, normally

STTR

Principal investigator (PI) Employed by company more than 50% of her or his time during award.

Small-business concern (SBC)

Phase 1-1 year, normally

Phase 11-2 years, normally

Phase 1-$100,000, normally

Phase 11-$750,000, normally

Employment not stipulated.

Minimum level of effort on the project not stipulated.

The PI must spend a minimum of 10% effort on the project and have a formal appointment with or commitment to the SBC.

Subcontract/consultant costs Phase !-Total amount of contractual and consultant costs normally may not exceed 33% of total amount requested.

Phase I and Phase 11-SBC must perform at least 40% of work, and the single, partnering U.S. nonprofit research institution (RI) must perform at least 30% of the work.

Performance site

Phase II-Total amount of contractual and consultant costs normally may not exceed 50% of total amount requested.

Must be entirely in United States.

Part of research must take place in company-controlled research space.

Must be entirely in United States.

Part of research must take place in company-controlled research space and part in that of partnering U.S. research institution .

nonprofit institution. The SBIR program has a maximum of 33 percent [Phase I] and 50 percent [Phase II] in consulting costs. The procedure for obtaining an STTR award is the same as for the SBIR award.

Other Government Grants There are other grants available to the entrepreneur at the federal, state, and local levels. These take many different forms and vary greatly depending on the objectives of the level of government involved and the geographic area. Sometimes the federal and some state governments provide training grants to companies locating in and/or hiring in what has been determined to be a labor surplus area. These training grants often take the form of paying 50 percent of the salary of the employee for up to the first year, at which time the employee should be fully productive. Companies locating in these areas often get some tax reductions at the state and federal levels for a period of time.

Many of the states and cities in the United States also have grant incentive programs for developing technology and technology companies located in the particular state and/or providing jobs in labor surplus areas. Often in terms of locating or building a facility in the state or city, these incentives take the form of a tax reduction for a period of time.

Grants are also available in many countries and cities throughout the world. The entre- preneur should investigate all possible grants available, particularly in deciding where to locate his or her company.

336 I '"'"P""'""";p ~--~-~--------------- --- -- ----------------

324 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

private offering A

formalized method for

obtaining funds from

private investors

Regulation D Laws

governing a private

offering

PRIVATE PLACEMENT Another source of funds for the entrepreneur is private investors, also called angels, who may be family and friends or wealthy individuals. Individuals who handle their own sizable investments frequently use advisors such as accountants, technical experts, financial plan- ners, or lawyers in making their investment decisions . Business angels are discussed in more detail in Chapter 12.

Types of Investors An investor usually takes an equity position in the company, can influence the nature and direction of the business to some extent, and may even be involved to some degree in the business operation. The degree of involvement in the day-to-day operations of the venture is an important point for the entrepreneur to consider in selecting an investor. Some in- vestors want to be actively involved in the business; others desire at least an advisory role in the direction and operation of the venture. Still others are more passive in nature, desir- ing no active involvement in the venture at all. Each investor is primarily interested in re- covering his or her investment plus a good rate of return.

Private Offerings A formalized approach for obtaining funds from private investors is through a private offering. A private offering is different from a public offering or going public (as dis - cussed in Chapter 12) in several ways. Public offerings involve a great deal of time and expense, in large part due to the numerous regulations and requirements involved. The process of registering the securities with the Securities and Exchange Commission (SEC) is an arduous task requiring a significant number of reporting procedures once the firm has gone public. Since this process was established primarily to protect uns o- phisticated investors, a private offering is faster and less costly when a limited number of sophisticated investors are involved who have the necessary business acumen and ability to absorb risk. These sophisticated investors still need access to material infor- mation about the company and its management. What constitutes material information? Who is a sophisticated investor? How many is a limited number? Answers to these ques- tions are provided in Regulation D.

Regulation D Regulation D contains (1) broad provisions designed to simplify private offerings, (2) general definitions of what constitutes a private offering, and (3) specific operating rules-Rule 504, Rule 505, and Rule 506. Regulation D requires the issuer of a private offering to file five copies of Form D with the Securities and Exchange Commission (SEC) 15 days after the first sale, every 6 months thereafter, and 30 days after the fin al sale. It also provides rules governing the notices of sale and the payment of any commis- sions involved.

The entrepreneur issuing the private offering carries the burden of proving that the exemptions granted have been met. This involves completing the necessary documenta- tion on the degree of sophistication of each potential investor. Each offering memoran- dum presented to an investor needs to be numbered and must contain instructions that the document should not be reproduced or disclosed to any other individual. The date

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that the investor (or the designated representative) reviews the company's information- that is, its books and records-as well as the date(s) of any discussion between the company and the investor need to be recorded. At the close of the offering, the offering company needs to verify and note that no persons other than those recorded were contacted re- garding the offering. The book documenting all the specifics of the offering needs to be placed in the company's permanent file. The general procedures of Regulation D are further broadened by the three rules-504, 505, and 506. Rule 504 provides the first ex- emption to a company seeking to raise a small amount of capital from numerous investors. Under Rule 504, a company can sell up to $500,000 of securities to any number of in- vestors, regardless of their sophistication, in any 12-month period. While there is no specific form of disclosure required, the issuing company cannot engage in any general solicitation or advertising. Some states do not allow investors to resell their shares unless the security is registered.

Rule 505 changes both the investors and the dollar amount of the offering. This rule per- mits the sale of $5 million of unregistered securities in the private offering in any 12-month period. These securities can be sold to any 35 investors and to an unlimited number of ac- credited investors. This eliminates the need for the sophistication test and disclosure re- quirements called for by Rule 504. What constitutes an "accredited investor"? Accredited investors include (1) institutional investors, like banks, insurance companies, investment companies, employee benefit plans containing over $5 million in assets, tax-exempt organ- izations with endowment funds of over $25 million, and private business development companies; (2) investors who purchase over $150,000 of the issuer's securities; (3) investors whose net worth is $1 million or more at the time of sale; (4) investors with incomes in excess of $200,000 in each of the last two years; and (5) directors, executive officers, and general partners of the issuing company.

Like Rule 504, Rule 505 permits no general advertising or solicitation through pub- lic media. When only accredited investors are involved, no disclosure is required under Rule 505 (similar to the issuance under Rule 504). However, if the issuance involves any unaccredited investors, additional information must be disclosed. Regardless of the amount of the offering, two-year financial statements for the two most recent years must be available unless such a disclosure requires "undue effort and expense." When this oc- curs for any issuing company other than a limited partnership, a balance sheet as of 120 days before the offering can be used instead. All companies selling private-placement securities to both accredited and unaccredited investors must furnish appropriate com- pany information to both and allow any questions to be asked before the sale. Rule 506 goes one step further than Rule 505 by allowing an issuing company to sell an unlimited number of securities to 35 investors and an unlimited number of accredited investors and relatives of issuers. Still, no general advertising or solicitation through public me- dia can be involved.

In securing any outside funding, the entrepreneur must take great care to disclose all information as accurately as possible. Investors generally have no problem with the company as long as its operations continue successfully and this success is reflected in the valuation. But if the business turns sour, both investors and regulators scrutinize the company's disclosures in minute detail to determine if any technical or securities law vi- olations occurred. When any violation of securities law is discovered, management and sometimes the company's principal equity holders can be held liable as a corporation and as individuals. When this occurs, the individual is no longer shielded by the corpo- ration and is open to significant liability and potential lawsuits. Lawsuits under securi- ties law by damaged investors have almost no statute of limitations, as the time does not

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begin until the person harmed discovers or should reasonably be expected to discover the improper disclosure. The suit may be brought in federal court in any jurisdiction ii:. which the defendant is found or lives or transacts business. An individual can file sui t as a single plaintiff or as a class action on behalf of all persons similarly affected. Couns have awarded large attorney's fees as well as settlements when any securities law viola- tion occurs. Given the number of lawsuits and the litigious nature of U.S. society, the entrepreneur needs to be extremely careful to make sure that any and all disclosures are accurate. If this is not enough of an incentive, it should be kept in mind that the SEC can take administrative, civil, or criminal action as well, without any individual lawsuit in- volved. This action can result in fines, imprisonment, or the restoration of the monie1 involved.

BOOTSTRAP FINANCING One alternative to acquiring outside capital that should be considered is bootstrap fmanc- ing. 3 This approach is particularly important at start-up and in the early years of the venture when capital from debt financing (i.e., in terms of higher interest rates) or from equity fi- nancing (i.e., in terms of loss of ownership) is more expensive.

In addition to the monetary costs, outside capital has other costs as well. First, it usu- ally takes between three and six months to raise outside capital or to find out that there is no outside capital available. During this time, the entrepreneur may not be paying enough attention to the important areas of marketing, sales, product development, and operating costs. A business usually needs capital when it can least afford the time to raise it. One company's CEO spent so much time raising capital that sales and market- ing were neglected to such an extent that the forecasted sales and profit figures on the pro forma income statements were not met for the first three years after the capital in- fusion. This led to investor concern and irritation that, in tum, required more of the CEO's time.

Second, outside capital often decreases a firm's drive for sales and profits. One success- ful manager would never hire a person as one of his commission salespeople if he or she "looked too prosperous." He felt that if a person was not hungry, he or she would not push hard to sell. The same concept could apply to outside funded companies that may have the tendency to substitute outside capital for income.

Third, the availability of capital increases the impulse to spend. It can cause a company to hire more staff before they are needed and to move into more costly facilities. A company can easily forget the basic axiom of venture creation: staying lean and mean.

Fourth, outside capital can decrease the company's flexibility. This can hamper the di- rection, drive, and creativity of the entrepreneur. Unsophisticated investors are particular! a problem as they often object to a company's moving away from the focus and direction outlined in the business plan that attracted their investment. This attitude can encumber a company to such an extent that the needed change cannot be implemented or else is imple- mented very slowly after a great deal of time and effort has been spent in consensus building. This can substantially demoralize the entrepreneur who likes the freedom of not working for someone else.

Finally, outside capital may cause disruption and problems in the venture. Capital is not provided without the expectation of a return, sometimes before the business should be giv- ing one. Also, particularly if certain equity investors are involved, the entrepreneur is under pressure to continuously grow the company so that an initial public offering can occur as soon as possible. This emphasis on short-term performance can be at the expense of the long-term success of the company.

N REVIEW

SUMMARY

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Bootstrap financing involves using any possible method for conserving cash. While some entrepreneurs can take advantage of any supplier discounts available, entrepreneurs with restricted cash flow need to take as long as possible to pay without incurring interest or late payment fees or being cut off from any future items from the supplier. The entrepre- neur should always ask about discounts for volume, frequent customer discounts, promo- tional discounts for featuring the vendor's product, and even "obsolescence money," which allows for upgrading to an enhanced product at no additional cost.

Savings can also be obtained by asking for bulk packaging instead of paying more for individually wrapped items as well as using co-op advertising with a channel member so that the cost of the advertisement is shared.

Consignment financing can also be used to help conserve cash. Some vendors allow en- trepreneurs to place a standing order for the entire amount of goods to be used over a pe- riod of time but take shipment and make payment only as needed, therefore securing the lower price of a larger order without having to carry the cost of the inventory. These are just some examples. The only possible limitation in bootstrap financing is the imagination of the entrepreneur.

In spite of the potential problems, an entrepreneur at times needs some capital to finance growth, which would be too slow or nonexistent if internal sources of funds were used. Outside capital should be sought only after all possible internal sources of funds have been explored. And when outside funds are needed and obtained, the entrepreneur should not forget to stay intimately involved with the basics of the business.

Al l business ventures require capital. Wh ile capital is needed throughout the life of a business, the new entrepreneur faces sign ificant difficu lties in acquiring capita l at start-up. Before seeking outside financing, an entrepreneur should first explore all methods of internal financing, such as using profits, sel ling unused assets, reduc ing working capital, obtaining credit from suppliers, and collecting accounts receivable promptly. After all internal sources have been exhausted, the entrepreneur may find it necessary to seek additional funds through external financing. External financing can be in the form of debt or equity. When considering external financing, the entrepre- neur needs to consider the length of time, cost, and amount of contro l of each alter- native f inancial arrangement.

Commercial bank loans are the most frequently used source of short-term external debt financing. This source of funding requires collateral, wh ich may be asset-based or may take the form of cash flow financing. In either case, banks tend to be cautious about lending and carefully weigh the five Cs: character, capacity, cap ital, col lateral, and condition. Not every entrepreneur will qualify under the bank's careful scrutiny. When this occurs, an alternative for an entrepreneur is the Small Business Administra- tion Guaranty Loan. The SBA guarantees a percentage of the loan, allowing banks to lend money to businesses that might otherwise be refused .

A specia l method of raising capital for high-technology firms is a research and de- velopment (R&D) limited partnership. A contract is formed between a sponsoring company and a limited partnership. The partnership bears the risk of the research, receiving some tax advantages and sharing in future profits, including a fee to use the

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research in developing any future products. The entrepreneur has the advantage of ac- quiring needed funds for a minimum amount of equity dilution while reducing his or her own risk in the venture.

Government grants are another alternative available to small businesses throug h the Small Business Innovation Research (SBIR) program. Businesses can apply for grants from 11 agencies. Other federal, state, and local (city) grants are often available.

Finally, the entrepreneur can seek private funding. Individual investors frequent ly require an equity position in the company and some degree of control. A less expensive and less complicated alternative to a public offering of stock is a private offering. By following the procedures of Regulation D and three of its specific rules-504, 505, and 506-an entrepreneur can sell private securities. When making a private offering, t he entrepreneur must exercise care in accurately disclosing information and adherin g precisely to the requirements of the SEC. Securities violations can lead to lawsu its against individuals as well as the corporation.

The entrepreneur needs to consider all possible sources of capital and select the one that will provide the needed funds with minimal cost and loss of control. Usually, dif - ferent sources of funds are used at various stages in the growth and development of the venture, as occurred in the case of Scott Walker, a successful entrepreneur indeed.

RESEARCH TASKS

c 1. Interview a business loan officer at a bank to determine the bank's lending criter ia for small businesses and new businesses. Does it use the five Cs? Which of the five Cs appears to be the most important? 2. Obtain a loan application from the local bank and categorize each quest ion in

terms of w hich of the five Cs it is attempting to assess.

3. Choose a type of business you would like to run . Then search the Internet for government grants that might be applicable for you and your business.

4. Interview three small-business owners about things they do (or have done) to bootstrap the financing of their business. How effective were these techniques? Be prepared to present this list to the class and describe how the techniques work.

CLASS DISCUSSION

,_tflt 1. What is the cheapest source of funds? When all other sources turn down your

request for funding, what source is most likely to say yes? Why is this the case? Is the entrepreneur exploiting a personal relat ionship with this potential source of capital? What are the consequences of using this source of capital if the business goes bankrupt?

2. Should the government provide grants for entrepreneurs starting new businesses? Should the government guarantee loans for small businesses that are missing the necessary track record, assets, or other ingredients to obtain a commercial bank loan? What benefit do we, as a nation of taxpayers, receive from such grants and loan guarantees?

3. Why don't all firms use bootstrap fi nancing? Are there any dangers with this approach? What are the benefits of having some financia l slack (e.g., some extra cash in rese rve)? What are the costs of that financial slack?

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SELECTED READINGS

Barr, Kate. (January 2, 2009). Guidance for Building a Social Enterprise. Fedgazette, vol. 21, no. 1, p. 6.

Published by the Federal Reserve Bank of Minnesota, the Fed gazette includes edu- cational commentary for the general public about the economy and investing. This article, positioned in the Community Dividend section, defines social enterprise as a fundraising strategy put in place by nonprofit organizations (e.g., Girl Scouts of America cookie sales). Kate Barr, who heads Minnesota's Nonprofits Assistance Fund, suggests helpful hints for nonprofit organizations seeking commercial fund- ing for their benevolent works. Advice such as "achieving a double bottom line" and properly assessing the organization's readiness are invaluable tips for the non- profit entrepreneur.

Cruickshank, Nancy. (January 1, 2009). Instil [sic] Confidence in Your Brand If You Want to Secure Venture Capital Funds. Revolution, p. 24.

The dot.com boom of the 1990s has convinced young entrepreneurs that whatever the gadget, discovery, innovation, or gizmo, some soul exists who will front the money. From venture capitalists to angel investors to strategic business competitors, someone out there has a nickel for you. However, with economic crunches on the horizon, the land of plenty is no longer a promised land. This article, published in a British periodical, confirms that in times of duress, if any funding is circulating, the venture capitalists are the ones who'll set the stage. The author of this opinion piece cites the coveted criteria.

Dahl, Darren. (February 2006). Facing the Capital Gap. Inc., vol. 28, no. 2, pp. 25-27. This article highlights the ever-changing climate of venture capital funding: who's en vogue, who's declasse, and which start-up firms do venture capital firms love to hate. While recognizing the volatility in investor temperaments, the author of this article chronicles the prevalent trends in venture capital deals at the start of the new millennium, and why raising $200,000 can be more difficult than raising $5 million.

Farrell, Christopher. (April 28, 2008) . How Angel Investors Get Their Wings. Business- Week, no. 112.

Angel investors invest in promising start-ups too young and raw to attract the attention and money of professional venture capitalists. The credit crunch and economic downturn have some angels feeling skittish. But others see opportu- nity. Studies show that the best time to start a business is when the economy is down. That's because entrepreneurs with good ideas will find cheaper land, labor, supplier contracts, and other ingredients that go into starting a business. Angels who back such ventures can earn impressive long-term returns-one study cites a rate of return of about 27 percent, on average, or 2.6 times the investment in 3.5 years. The risks, of course, are steep. Still, 258,200 angels pumped $26 billion into 57,120 ventures last year, according to the University of New Hampshire's Center for Venture Research. While many angels are current or former entrepre- neurs, and that background can prove invaluable, they also need to develop investing skills.

Gimmon, Eli. (2008). Entrepreneurial Team-starts and Teamwork: Taking the Investors' Perspective. Team Performance Management, vol. 14, no. 7/8, pp. 327-39.

This article includes the results of a research project, which evaluates the impor- tance of entrepreneurial teamwork in venture capitalists' decisions to fund a ven- ture. The entrepreneurial teams examined in this research are exclusively involved in high-technology pursuits, such as information technology and electronics. The author of this research is an Israeli business professor who bases his hypothesis on

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330 PART 4 FROM THE BUSINESS PLAN TO FUNDING THE VENTURE

previous evidence that teamwork has a favorable effect on the success of entrepre- neurial undertakings. The author's conclusions examine the habits of venture capitalists and angel investors from different geographical regions: U.S. investors, for example, do not value entrepreneurial teamwork as much as do British an d Israeli investors.

Kushnirovich, Nonna; Heilbrunn, Sibylle. (June 2008). Financial Funding of Immigrant Businesses. Journal of Developmental Entrepreneurship, vol. 13, no. 2, pp. 167-84.

This 2008 article includes the results of a study conducted among Israeli businesses between the years 2000 and 2005. One-hundred fifty-three of the responding businesses were owned by immigrants from the former Soviet Union, while 21 4 were owned by native Israelis. The authors of this study, faculty of Israel's Rupp in Academic Center, compare the borrowing tendencies between these two groups: immigrant- and non-immigrant-owned businesses. According to the results of the study, Israel's non-immigrant-owned businesses had more access to capital from the Israeli government, banks, and other financial institutions. Yet, the immigran t businesses tended to assume less debt and had unique sources of capital at the ir disposal.

Pineda, Yovanna. (June 2006). Sources of Finance and Reputation: Merchant Finance Groups in Argentine Industrialization, 1890-1930. Latin American Research Revie w, vol. 41, no. 2, pp. 3-30.

The author of this article is a Latin American history and economics professor at St. Michael's College in Vermont. Her research paper describes the importance of personal relationships and social status in securing business funding in turn-of-the- century Argentina. While the capitalist economies of Europe and North America were swelling with the boom of industry, Latin America, namely Argentina, was devoid of even an established banking system. The author's thesis explores how five small-business lenders managed to fund Argentina's industrial revolution, in the absence of equity and credit markets.

Rayasam, Renuka. (August 1, 2008). Who Needs Silicon Valley? Thanks to New State Programs, Companies Are Finding Funds Outside of Traditional VC Hubs. Inc., vol. 30, no. 8, pp. 10, 43-44.

California's Silicon Valley is considered the mecca of venture capital firms: progres- sive, forward-thinking individuals who recognize the importance of providing seed funds. Obviously, in times of economic downturn, these once well-recognized fon ts of wealth dehydrate and inventors are left with nowhere to turn. According to th is article, U.S. state governments are creating training programs that coach wealthy individuals on the benefits of assisting start-ups. The Wisconsin Angel Network, fo r example, has secured tax incentives for the state's wealthy individuals who choose to invest in fledgling enterprises.

Westerman, James W.; Geiger, Scott W.; Cyr, Linda A. (December 2008). Employee Eq- uity Incentives and Venture Capitalist Involvement: Examining the Effects on IPO Per- formance. Journal of Developmental Entrepreneurship, vol. 13, no. 4, pp. 409-23.

Many times entrepreneurs are hesitant to operate within the confines of other peo- ple's money. While the additional influx of cash is often welcome, seasoned entre- preneurs realize these handouts come at a price: independence. This article, for such naysayers, offers proof that accepting venture capital funding can ensure the suc- cess of a business, should it choose to go public. Also, the employees of these poten- tial initial public offering firms are in better stead if their company has receive d venture capital funding.

END NOTES

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CHAPTER 11 SOURCES OF CAPITAL 33 1

1. Crystal Detamore-Rodman, "Cash In, Cash Out," Entrepreneur (June 2003), pp. 53-54.

2. For a discussion of bank lending decisions, see A. D. Jankowicz and R. D. Hisrich, "Intuition in Smal l Business Lending Decisions," Journal of Small Business Management (July 1987), pp. 45-52; N. C. Churchil l and V. L. Lewis, "Bank Lending to New and Growing Enterprises," Journal of Business Venturing (Spring 1986), pp. 193-206; R. T. Justis, "Starting a Small Business: An Investiga- tion of the Borrowing Procedure," Journal of Small Business Management (October 1982), pp. 22-32; and L. Fe rtuck, "Survey of Small Business Lending Practices," Journal of Small Business Management (October 1982), pp. 42-48.

3. Bootstrap f inancing is discussed in Anne Murphy, "Capital Punishment," Inc. (November 1993), pp. 38-42; and Michael P. Cronin, "Paradise Lost," Inc. (November 1993), pp. 48-53.