Part A

1.0

Introduction

2.0

Option for raising Additional Capital

3.0

2.1

Profits

2.2

Debt Financing

2.3

Equity Financing

Conclusion

References

Part B
1.0

Introduction

2.0

Alternatives to Manage The Foreign Exchange Risks

2.1

Alter 1

2.2

Alter 2

2.3

Alter 3

2.4

Alter 4

2.5

Alter 5

3.0

Calculation

4.0

Conclusion

References

Debt financing is generally considered to be an inexpensive source of

capital for business, especially when compared to equity, which involves
giving up part of the ownership of the company.
Unfortunately, very little debt financing is available to early-stage
entrepreneurs, because lenders expect loans to be paid back in a predefined and timely manner with interest. Furthermore, lenders expect
borrowers to demonstrate their credit-worthiness by providing collateral,
which in essence guarantees repayment. When buying a car or house, the
asset itself is the collateral. Due to their inherent high risk and lack of
liquidity, early-stage companies are not considered sufficient collateral
for debt financing.
Loans from friends and family are often used as pre-seed capital for
start-up ventures. This debt is attractive because it often is available
without interest and entrepreneur is not required to repay loans on any
pre-arranged schedule. While particularly useful in the initial stages of a
company, this source of funding is usually only available in small
quantities, that is, less than $25,000.
Credit-card debt is available to many entrepreneurs and is collateralized
by the earning capability of the borrower. This debt has the advantage of
minimum repayment schedules that can be spread over months and
years. This form of debt, however, is generally very expensive and is also
normally available only in total volume of less than $25,000 for each
individual.

High Growth, Big Borrowing

Many high-growth companies require more than $100,000 of capital to
achieve the positive cash flow necessary to grow on internally generated
funds. For these entrepreneurs, the primary sources of capital are equity

investments, which requires giving up partial ownership of the venture

in exchange for the funds necessary to grow the company.
The most common sources of equity capital are angel investors and
venture capitalists. (I myself am an angel, having invested in some 25
early-stage companies, after selling my own company, Solid State
Dielectrics, Inc. to E. I. DuPont Nemours in 1982). However, we often
hear about two other forms of debt financing for entrepreneurs, namely,
convertible debt provided by early-stage equity investors, and bank loans
to venture-backed companies. What follows is an examination of each of
these sources of capital.

Convertible Debt from Equity Sources

It is not uncommon for equity investors to structure early-stage
investments as convertible debt. Since the conversion from debt to equity
is almost always at the option of the lender, most entrepreneurs consider
this a form of equity investment and therefore an expensive source of
capital.
Convertible debt has all the rights of debt financing, requires reasonable
interest payments (often deferred), and can be converted to common or
preferred stock, depending on the structure of the deal, at the pleasure of
investors, usually upon triggers signaled by the success of the company.
The value of the company at conversion is predetermined and is often
based on a modest discount to the pricing of a future round of
investment. Conversion is often triggered when the company closes a
substantially larger round of equity investment, usually from venture
capitalists.
Investors insist upon, or agree to, convertible debt financing for a
number of reasons. Debt is a lower risk investment than equity, that is,

in the case of the liquidation of the company, lenders are ahead of

shareholders for repayment. All debt generally must be repaid prior to
any liquidation to shareholders. Convertible debt instruments allow
lender/investors to enjoy a modest return on investment as interest
(often deferred) with all the upside opportunity of shareholder after
conversion. Structuring a convertible debt financing is relatively easy;
hence, legal fees for completing this form of investment are substantially
lower than conventional equity investments. Much of the legal expense is
deferred until the time of conversion, which is usually at the time of the
closing of a subsequent round of equity investment.
Bridge loans are often structured as convertible debt. Bridge loans are
debt usually funded by earlier investors to provide the entrepreneur with
sufficient cash to bridge the time gap between running out of earlier
raised capital and the closing of a round of new funding for the company.
Since new investors prefer that all new funds be used to grow the
company (and not to repay debt), bridge loans are often converted into
debt at the closing of the next subsequent round of equity financing.

Convertible Debt: Compromise and

Convenience
In general, convertible debt is often a compromise between
entrepreneurs and investors, when they cannot agree upon a valuation
for the company at the time the loan is closed. In this case, the investor
believes the company is worth less than does the entrepreneur. They
agree to a convertible loan, which is priced at the closing of the next
subsequent round of equity investment and a discount, usually 10
percent to 30 percent of the valuation of that next round of investment.

Some angel investors prefer this form of investment, as they fear

investing at too high a valuation, only to see a subsequent institutional
investor price their deal at a lower valuation, resulting in very
unfavorable dilution to the earlier stage investor. These can also be
considered bridge loans to the next round of investment.
Convertible notes are also a convenience to investors, since they
generally remove the risk of equity investments at valuations that prove
to be too high. However, in many cases, pricing the conversion at a small
discount to the next round can be unfair to the early-stage investor, when
closing the next round takes much longer than anticipated, or when the
valuation of the company is growing rapidly. One could conclude then
that convertible debt limits both the downside risk and upside potential
for these investors.

Bank Debt for Venture-Backed Companies

In the past decade, a few banks across the United States have been
providing debt financing for companies that have secured equity capital
from venture capitalists. The most well known is Silicon Valley Bank;
however, other banks are also sources of such debt financing. Not
surprisingly, this debt is available primarily in regions of the country
where venture capitalists are particularly active, such as Silicon Valley
and near Boston.
This debt is used by high-growth, later-stage companies to supplement
venture capital in rapidly ramping the growth of the companies, and is
often available to companies that can quickly pass the break-even point
in cash flow necessary to pay back the debt. The banks that offer this
debt depend on the due diligence of trusted venture capitalists to
validate the quality of the management team and the business plan. The

size of these loans is often proportional to the amount of venture capital

raised by the company, perhaps 20 percent to 30 percent of the amount
of equity capital, depending on the quality and maturity of the company.
This debt financing would likely be a combination of equipment loans
and a line of credit.
These banks buck the trend by lending to entrepreneurial ventures for
a number of reasons. First, they are lending in concert with known and
trusted venture capitalists. Second, in addition to relatively high business
interest rates, these bankers usually require warrant coverage, that is,
the opportunity for the lender to purchase stock later, once the company
is successful, at very attractive pricing. By making many such loans to
venture-funded companies, they can achieve an attractive supplemental
return on their investment from the equity piece (warrants) of these debt
packages. It is important to add that these banks have ongoing
relationships with venture capitalists and their limited partners and are
developing strong banking ties with exciting companies who often
become major bank customers over many years into the future.
While a few banks offer debt financing to venture-backed companies, it
is important to put this source of funding into perspective. While more
than 500,000 companies are started each year in this country, only
1,000 solicit their first round of venture capital, and only a fraction of
that 1,000 also receives bank financing from these sources. Although
bank debt is a very attractive source of funding for entrepreneurs, it is
available to only a very small number of entrepreneurs each year.
In summary, debt financing in amounts greater than $100,000 is not
available to entrepreneurs starting and growing new ventures until the
assets of the company can collateralize the loan. Some debt financing in
these amounts is available to a few selected venture-backed companies.

In a very few regions of the country, modest debt is available to

entrepreneurs from non-bank entities, but these sources are very rare
indeed. Finally, convertible debt and bridge loans are debt instruments
provided by equity investors and are considered by entrepreneurs to be a
variation of equity investments.
There are three primary ways companies finance their operations and growth
in the short-term and the long-term: profits, debt financing, and equity
financing. Profits are generated internally by the company, but debt and equity
are external and are controlled by management decision making.
Both debt and equity financing supply a company with capital, but the
similarities largely stop there. Let's break down the differences.
Debt financing
Debt financing is when a company takes out a loan or issues a bond to raise
capital. While there can be much complexity in the details of large corporate
debt deals, the fundamentals are largely similar to common household debts
already familiar with individuals. Companies can accept long-term financing to
purchase facilities, equipment, or other long-term assets, like a family takes
out a mortgage loan to purchase a house or a loan to buy a car.
Companies can also use revolving credit, similar to a credit card or home
equity line of credit, to pay for short-term capital needs like inventory,
receivables financing, or general operating expenses like payroll.
Companies report the interest payments from their debt as an operating
expense on the income statement. The principal portion of their debt
payments is not considered an expense. The reduction of debt principal
instead shows as a reduction in liabilities on the balance sheet.
Lenders have no claim to a company's profits outside of the original financing
agreement. The upside for lenders is capped from the onset of the transaction

at the interest rate, but their downside is also mitigated through loan
covenants, collateral requirements, and a senior position to be repaid should
the company face bankruptcy.
Equity financing
With equity financing, a company gives investors shares in the company's
ownership in exchange for capital. There is no promise to repay the
investment like in a loan arrangement, nor is there an interest component.
There is, however, a cost to equity capital. In order for investors to agree to
invest in the company, they expect to earn an acceptable return that justifies
the risk of the investment. That return varies over time and across industries
as investors compare the potential upside, the potential risks, and the riskreward profile of investment opportunities other than the given company. If the
company fails to meet these return expectations, investors can share their
ownership interest and move capital elsewhere, reducing the value of the
company and hampering future efforts to raise capital.
Equity investors are owners of the company, which means they have
significant upside should the company prosper in the future. The cost to their
capital is a floor, not a ceiling. That higher upside is required to reward
investors for the increased risk of equity financing, which excludes collateral
and pays equity owners last in a bankruptcy situation.
When to use debt and when to raise equity
Generally speaking, most companies will choose to raise debt financing if it
has the cash flow, the assets, and the ability to repay the debts. Companies
that either do not qualify or pose too great of a risk for lenders are better
suited to raise equity financing.
Start-ups are a great example. These companies don't have a track record,
have limited assets for collateral, and may not yet be profitable or cash flow
positive. That's too risky of a prospect for lenders. Investors, however, can

accept these risks thanks to the prospect of a huge return should the company
succeed.
Conversely, a company with an existing debt load may not be able to obtain
any new debt financing. It's similar to being denied a mortgage loan -- the
bank cannot accept the risk of weak cash flow, too much existing debt, or a
poor credit history. In these cases, companies can seek out equity investors
instead of lenders because equity investors will accept more risk if the
potential future rewards are sufficiently high.
As an investor, monitoring how a company chooses to manage their ratio of
equity and debt levels is important, as too much or too little of either can be a
bad thing. Too much debt can lead to bankruptcy. Too much equity can dilute
existing shareholders and harm returns. The key is balance.
The $15,978 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your
retirement savings. But a handful of little-known "Social Security secrets"
could help ensure a boost in your retirement income. In fact, one MarketWatch
reporter argues that if more Americans knew about this, the government would
have to shell out an extra $10 billion annually. For example: one easy, 17minute trick could pay you as much as $15,978 more... each year! Once you
learn how to take advantage of all these loopholes, we think you could retire
confidently with the peace of mind we're all after. Simply click here to discover
how you can take advantage of these strategies.
This article is part of The Motley Fool's Knowledge Center, which was created
based on the collected wisdom of a fantastic community of investors based in
the Foolsaurus. Pop on over there to learn more about our Wiki and how you
can be involved in helping the world invest, better! If you see any issues with
this page, please email us at knowledgecenter@fool.com. Thanks -- and Fool
on!

Try any of our Foolish newsletter