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15.1 Life Cycle of a Firm

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objective

  1. Describe potential sources of investment for a growing firm.

Many companies are founded with no more capital than what a propriator has on hand. Some will use inherited money or resources saved from a successful career in another occupation. A mortgaged house is often the collateral used to provide the initial funding for a myriad of small businesses. A propriator will invest their sweat equityAn owner of a company investing in a company by working for long hours with little or no initial compensation. in the form of working for long hours with little or no initial compensation, as the fledgling business demands a reinvestment of initial profits. In this embryonic stage, many small businesses fail or stagnate, but some will thrive and grow, leading to different problems and needs.

An owner of a small but growing business will often face the question of how quickly growth can be sustained. Conservative growth might cause lost business to competitors or foregone sales from customers whose demand can’t be met. Aggressive growth demands more capital and can potentially lead to over-reaching and a stretching of resources too thinly. Fortunately, developed economies can provide sources of capital for growing businesses to the potential benefit of current owners and new investors.

The first avenue for many entrepreneurs seeking capital is a small business loan from a bank. By taking on debt for a negotiated interest rate and repayment schedule, a cash-hungry business can expand without a reduction in an owner’s control. Many banks also provide services for small businesses, such as treasury management, payroll administration, or bill collection services.

Particularly in service type professions, partnerships are also way for businesses to expand, bringing in capital, more skilled labor, or both. Lawyers, doctors, accountants, and dentists, among others, are common partnership candidates, as a growing customer base can tax the professional and capital resources of a sole proprietor. Sometimes partners bring a different skill set than the existing owners, perhaps managing the “business” end of operations. And some partners will prefer to be “silent” partners, contributing capital only but enjoying the limited liability of such an arrangement.

Venture capital (VC)Firms that seek out investments in young companies, typically matching with investors who are looking for a private equity arrangement. firms are a different avenue for start-ups; these firms seek out investments in young companies, typically matching with investors who are looking for a private equity arrangement. Different VC firms specialize in different types of companies, and can also specialize in different stages of a company’s growth. For example, some firms focus on the first rounds of funding (sometimes called “A” round financingThe earliest rounds of venture funding.) and some provide mezzanine financingVenture funding after the earliest round of venture funding, typically a hybrid of debt that can potentially be converted to equity. (typically a hybrid of debt that can potentially be converted to equity). Other venture capital firms specialize on distressed companies, making investments with the intention of turning around the business to make it again successful.

As a company continues to grow, other avenues of capital become possibilities. Bonds can be issued, either through a private placement to large investors (typically pensions, endowments, or similar investment funds) or publicly. A public bond issuance in the US requires registration with the SEC, and is typically underwritten by investment banks (often as part of a syndicate of banks).

While shares of stock can be privately placed, a milestone for large companies comes when their shares are first registered with the SEC (or other authority, outside the US) and offered for public sale through a process called the initial public offering (IPO)When shares of a corporation are first registered with the SEC (or other authority, outside the US) and offered for public sale.. Since the cost of meeting regulations, including annual and quarterly reports, can be prohibitive, a corporation needs a certain level of maturity to make a successful IPO a possibility. After “going public”, VC firms and other early investors can more easily exit their ownership positions, typically after a required holding period. At this stage, though relatively mature, a company might still grow at a fast pace, but has access through many different avenues of capital.

Key Takeaways

  • Proprietors and partners supply the capital for very young companies, often in the form of “sweat” equity.
  • Bank loans and venture capital funding can bring in capital for a growing business.
  • Public issues of bonds and stocks are the sources of capital for maturing companies.

Exercises

  1. Frances owns a bake shop. A new dessert he recently developed is meeting with great customer demand, and he would like to consider expanding his operations. Contrast some financing possibilities for Frances, discussing which is most feasible.