Development Cooperation Handbook/Designing and Managing Programmes/Programme Structure and Capitalization
This was prepared for a business plan of a profit company and need to be wriretten for the programme plan of an NGO managers must have a strong understanding of the method of funding that is most appropriate for their project/program. This module discusses the options for capital, the advantages of each, and the methods for estimating capital requirements. In addition, structuring a financing deal and term sheets are discussed.
At this point in the project/program plan, the audience has a thorough concept of what the project/program will entail. They should understand the project/program’s history, the products and services it will offer, the target market that the product is aimed at and the marketing efforts that will be used, the structure of the organization, and the overall goals for the manager and the organization. At this point in the plan, the manager must state what their project/program requires, allowing the reader to decide if they would like to participate.
Most project/program plans are written with the goal of securing some sort of financing or investment to fun the organization’s growth. As a result, this section typically details the amount of funds needed by the organization, also called capital that will enable the project/program to meet its goals. In a planning sense, this is one of the most critical portions of the plan. managers have to adequately estimate how many resources are necessary for the project/program to succeed. An organization that is undercapitalized will be severely handicapped in its initial years of operation. Alternately, a project/program that requests an exorbitant amount of funds from investors will look questionable to most that read the plan.
Raising capital is not an easy task for an manager. Not only does it require them to ask for financial resources from others, but also in exchange for these resources, managers must typically give up some portion of ownership in the organization or assume a certain amount of debt. Therefore, managers should be extremely selective and careful when deciding what level of capital they need, what sources of capital are ideal, and where to look for it. Each of these questions can have a wide impact on the future of the organization and it’s likelihood of success. In order to select the appropriate form of capital for an organization, managers must understand the two sources of capital: debt and equity.
Sources of Capital – Debt Financing
Debt financing is an extremely common form of getting money for new project/programs. Debt financing is the borrowing of funds from individuals or institutions with an agreement that it will be paid back over an agreed upon time period and with an agreed upon interest rate.
Organizations use short-term financing to cover operations, maintain sales and inventory, and other short-term effects. These sources are key for start-up project/programs
- Friends and Relatives – Often people who have a close relationship with the manager are willing to “volunteer” funds to help finance the early stages of a project/program. These agreements are often informal without any concrete repayment schedule. However, these funds can strain personal relationships and can cause substantial pressure.
- Trade Credits – As mentioned earlier, vendors may agree to certain trade credits, allowing the startup to acquire resources and pay them back at a later date.
- Leasing – organizations that lease instead of purchasing assets receive the full benefit of the asset with an agreement to pay for it over time.
- Bank Line of Credit – Some managers with a proven track record can secure a line of credit from the bank. This allows them to borrow funds short-term on a continual basis.
- Asset-based Lending – organizations with concrete assets like receivables and inventory can use them to secure a loan from another institution.
Organizations use long-term financing for larger capital investments that will reap benefits for years to come. These funding options are typically not available to project/program without a proven track record.
- Bonds – organizations can sell bonds that require repayment over a fixed period and at a fixed rate.
- Debentures – organizations can also borrow from banks and other lenders with a fixed interest rate and repayment schedule.
Equity financing is a frequently used method of financing emerging enterprises. Equity financing involves attracting funds by offering partial ownership in the enterprise. In return for their investment, investors expect the organization to perform well and deliver an adequate return over the life of the organization.
Ownership in an organization is usually provided in the form of stock. The organization issues shares of stock that represent a piece of ownership in the organization. Ownership of shares of stock entitles the stockholder to dividends and to other rights of ownership, such as voting rights. There are two main types of stock: preferred and common.
- Preferred Stock – Stock that has priority over an organization's common stock in the distribution of dividends and assets. Preferred stock enables its owners to more rights than common stock. Preferred stock carries greater voting power and a larger voice in the direction of the organization. In addition, in the distribution of dividends, preferred stockholders receive theirs before common stockholders, providing a greater opportunity for return on their investment. Finally, should the organization fail and the assets are liquidated, the preferred stockholders are compensated prior to common stockholders.
- Common Stock – Conversely, capital stock is secondary to preferred stock in the distribution of dividends and often of assets. While common stockholders still can vote and have a voice in the management of the organization, their impact is weaker than the voice of preferred stockholders. They are last in line for dividends and the proceeds from the sale of assets in the event of liquidation. Common stock is the most commonly traded form of stock and is much more liquid than preferred stock.
Debt vs. Equity
Debt and equity are extremely different forms of financing, each offering its own advantages and disadvantages.
- Debt financing allows managers to maintain control and ownership over their enterprise.
- The potential cost of capital financing can be very low if the organization has a favorable interest rate and can maintain strong sales.
- Financing from banks can be very scarce. Banks must be sure that their investments will be repaid. As such, they are often reluctant to loan large sums to unproven project/programs.
- Bank covenants on loans may require that the organization maintain certain thresholds like sales levels, accounts receivables, or inventory levels. Failure to meet these covenants can result in defaulting despite the fact that the organization is making payments.
- Debt financing requires that an organization make regular payments to lenders. These can take away much needed cash flow from operations.
- Equity investors do not expect repayment of their funds. They benefit directly from the success of the project/program.
- Investors understand their investments may fail and are taking a risk along with the manager.
- Investors can be an excellent source of information and referrals.
- Equity financing relinquishes control of portions of the organization. managers are forced to hand over large pieces of ownership, especially at earlier stages of the organization’s life.
- Owners may have different agendas or visions for the organization that conflict with the managers.
- Large investments are difficult to obtain from individuals.
Determining an organization’s capital requirements is a complex task that involves a combination of investigation and intuition, as well as a substantial amount of luck. This is because the manager is essentially forecasting the future, and no matter how much research and planning is done in advance, the outcome is always left to chance. Therefore, the goal of an manager is to make the best estimate possible for the organization.
The first place to start is to determine the funds needed to acquire the tangible assets necessary to start operations. These tangible assets can include equipment to manufactures goods, inventory and raw materials, real estate, etc. These costs can be determined with a fair amount of accuracy. The manager can determine what is needed and seek out cost estimates from suppliers to determine the total anticipated costs. Some managers even include documentation from suppliers on the costs of needed materials in the appendix to illustrate to the reader that they have thoroughly researched.
The next step is to estimate the working capital required to maintain operations until the organization generates operating income. An organization's working capital is the money it has available to meet current obligations (those due in less than a year). This is determined by subtracting the current liabilities from the current assets. Working capital is critical in young organizations since they do not yet have the sales to generate their own cash for operations. Working capital estimates are difficult. They come directly out of the projected cash flow statement in the financial plan, which will be discussed in the next module.
In addition to working capital and tangible assets, managers must estimate some contingency capital. These funds can be used if there are initial shortfalls in cash projections or other unanticipated problems or opportunities. This is extremely difficult to project, since the uses of these funds are all unexpected. Therefore, is generally better for the manager to place this estimate higher rather than lower.
Structuring the Deal
Once the capital requirements for the project/program have been determined, the managers must determine the best way to structure the deal with potential investors or lenders. This is a crucial step for an organization. Mistakes made here can leave the managers working diligently for an organization they own very little of. Vice versa, deals also bring new voices into the management of the organization, which can affect operations. Therefore, managers must be especially careful in this phase and follow these simple steps:
- Consult a Trusted Expert – The issues involved in selecting a legal form and structuring investment deals are complicated. They combine tax and legal implications with other related matters. Therefore, managers must be sure to secure a strong, well-respected lawyer and accountant. This is often a difficult task for managers since they often cannot afford the best services. However, many professional advisors who specialize in managerial organizations are willing to make concessions to managers. These can include delayed billing, reduced rates, or even providing services for an equity stake in the project/program.
- Don’t Negotiate in the Plan – Receiving an investment or loan is a negotiating process. As a result, if an manager states they need $100,000 and are willing to give up 30% of the project/program, then the investor takes this as the basis point for negotiations. As a result, the manager will often be forced down to a level of investment or equity level that they hadn’t anticipated. The managers should stake what capital they are looking for, but leave the terms of the deal open for negotiation.
- Avoid Complicated Deals – Often managers try to include many different lenders and investors with a variety of different capital sources. The result is a complicated mix of owners and lenders that can cause havoc with the managers and the management of the organization. Therefore, managers are wise to stick to a simple plan with minimal types of capital sources.
Investors and lenders will not provide funding for a project/program without some sort of timeline or progress report through which they can check the project/program’s success. In addition, this schedule provides managers with a set of goals and accomplishments to work towards in order to maintain the level of progress expected. The milestones section for the project/program plan is intended to present this timeline. Milestones include any major event in a project/program’s development and the timeframe within which it is likely to occur.
managers typically offer dates in this timeline in a generic manner rather than as specific calendar dates. For example, an organization may state it plans to reach profitability within the first quarter of the following year instead of saying by February 1. This allows some flexibility on the part of the manager. Some key events include securing financing commitments, completing a product prototype, obtaining regulatory approval, first market test, initiation of production or sales, and attaining break-even performance. The milestones needed vary depending on the nature of the project/program.
When compiling the milestone schedule, managers should remember the following:
- Progress occurs much more slowly than anticipated especially when an outside party is involved.
- An adequate margin for unexpected delays should be included to provide a cushion in case of crises.
- managers must be sure their schedule of milestones is ambition but attainable so that the odds of success are high.
- Milestones should be concrete and easily measurable. For example, instead of saying they will have strong sales by a certain date, managers should state how many units they want to sell.
Once a deal has been negotiated between an investor or lender and the organization, the details of the agreement are highlighted in the term sheet. The tern sheet is, essentially, the contract binding both parties to the agreement. As a result, it is critical that the manager insures that the term sheet is accurate and comprehensive and that no information or clauses have been left out. Again, managers should engage the services of a trusted professional lawyer to help draw up a term sheet.
Determining the capitalization needed for an organization and then negotiating with lenders and investors is one of the most difficult parts of starting a project/program. managers have to be wary of making any deal that could hurt their project/program in the long term. On the other hand, raising capital can be extremely difficult, and investors are often desperate for much needed funds. As a result, the following mistakes are often made. However, managers can protect themselves from many of these issues by being diligent and levelheaded in the process.
- Failure to recognize significant milestones – Often managers overlook key milestones that are clear to others, like the completion of a prototype or the beginning of a marketing/sales push. This will make potential investors and lenders thing they are unprepared.
- Milestones are unrealistic – Everyone wants to see their project/program succeed. However, by setting milestones that are clearly unrealistic, managers will scare away and potential capital.
- Unwillingness to provide investors with a voice – Many managers want to secure investors but are unwilling to give them a voice in the organization through a board position or other key concessions. managers must be sure to look for investors that share their vision and management style to avoid potential conflicts.
- Asking for too much money – Many managers want their project/programs to have every advantage, including a large cushion of cash to sustain operations for some time. However, this can make investors feel that the managers are starting on a level much grander than is necessary.
- Believing that everything will go as scheduled – There are always surprises for organizations. These can come with the negotiations with investors or in the pursuit of key milestones. managers must remain flexible, and search for creative solutions to problems as they arise.