In the first part we explained why banks do not scramble to finance your entrepreneurial projects. From this observation, it is useful to understand how to finance our projects according to their levels of evolution. We consider that an economic activity has a life cycle of 5 stages: the start-up phase, expansion, strong growth, maturity and decline. Each stage of the life cycle is characterized by different investment opportunities, strengths, weaknesses and appropriate sources of finance.
Project Life Cycle Stages
Start-Up Phase
At this stage, the activity is still being launched and in search of its first customers; customers on which it will build its reputation. Generally at this phase, investment needs exceed the available financial resources. The activity does not yet necessarily derive its value from its profitability and / or growth, but from the potential of its market, the prowess of its product, and the credibility that one grants to its promoter. The biggest risk is the outright failure of the activity. Given the existential risk ran by projects in the start-up phase, its funding must come from the founder, family and friends.
Expansion Phase
During this phase, the activity begins to have some success by earning the loyalty of its first customers and building a reputation. The activity resulting from the project needs to expand to capture the early majority of its target clientele; those who get wind of products positive feedback from earlier customers. At this stage, investment needs are still abundant compared to the available financial resources. Its key success factors come from its organic growth in sales, its ability to achieve margins and access to external capital. Its risk would be to succumb to the competition due to the low entry barriers on the market. The project at this phase are more likely to get expansion funding from venture capital funds as the activity often do not release (enough) stable margins to qualify for bank loans. At this stage of development, the venture capital funds have the advantage of not only providing equity financing but also to benefit from its business network and its expertise in assisting companies in their situations.
High Growth Phase
High growth businesses are beginning to conquer mass customers for their markets. Cash surpluses become substantial enough to finance investment needs. The key success factors become the sustainability of growth and the improvement of operational margins. The danger is to have unsustainable growth and/or insufficient margins. It is at this evolutionary phase that an activity can legitimately start to incur debt from retail banks and other credit institutions in addition to their personal equity contributions.
Maturity Phase
During this phase, the business reached its critical size and conquered a large portion of its target clientele. The business faces modest turnover growth (between 0 and 5% per year). The accumulated cash surpluses over the years have resulted in it having financial resources in excess of investment needs. The key success factors in this phase come from asset productivity, the ability to absorb debt, optimize capital structures, and the efficiently management working capital. The main risk would be the status quo of a management team that refuses to review its strategy to seize additional growth opportunities. It is for the activities in this phase that the commercial banks roll out the red carpet because their credit default risk are the lowest given their hard earned reputations, their accumulated liquid assets and the stability of their earnings. Credit request are usually for working capital reinforcement. These activities may also benefit from equity contributions from stock market for those who choose the IPO route or private equity funds. Basically, these activities no longer really need external capital to finance themselves. Financing choices are based more strategic grounds than the necessity to survive.
Decline Phase
During the decline, customers give in to the competitors and losses reappear, the turnover decreases. Investment choices evaporate. The survival factor becomes the potential resources to derived from the liquidation of non-productive assets, which must be sufficient to reduce the debt and reinvest elsewhere. The worst dangers at this stage are the reality denials of the management teams, and ultimately bankruptcies. Activities at this stage may find solace with the private equity and turnaround funds which are specialist of recovery of activity through direct equity investments.
By Arnold A. KAMANKE