Financial Issues in New Venture Creation - Sourcing Capital - Coursework Example

Financial Issues in New Venture Creation: Sourcing Capital Name Course Tutor’s Name Date: Financial Issues in New Venture Creation: Sourcing Capital Sourcing capital for a new venture can be a simple or complex process depending on where an entrepreneur seeks to get the capital from. Self-funding is an almost straightforward processes, while debt-financing (among other external sources of capital) can be fraught with complexities. This paper will discuss the different forms of capital sources, and will identify the pros and cons of each funding source. The paper also provides examples of entrepreneurs who have used different funding sources to start businesses. Subsequent parts of the paper will identify considerations that entrepreneurs make when sourcing capital (e.g. by choosing a type of funding that will raise the amount of capital required). The paper will also identify stages of funding, investors’ choices, needs and what they can provide, and the various forms of capital. The paper concludes by noting that the decision to obtain capital from a specific source affects factors such as profitability, decision-making and governance, and the responsibilities the business has towards different stakeholders. The paper recommends that entrepreneurs should be more willing to engage in creative search for capital, weigh the options and possibilities, and pick the option that provides the business with optimal advantages. Forms of funding sources for capital Generally, there are two types of funding sources for capital: Equity financing, and debt financing (Frederick, O’Connor & Kuratko 2013). Equity financing Equity financing is capital obtained from the business owner and other investors willing to be enjoined in the profit-making, risk-taking, and possibly the loss-making processes of the business (Confederation College 2002). Frederick et al. (2013) observe that equity financing also involves an entrepreneur selling part of his ownership to other investors. The advantage of equity financing relates to improved corporate image, enhanced corporate value, enhanced liquidity and enhanced capital amount (Frederick et al. 2013). In reference to the risk-taking element that investors have to engage with in the process of affording equity capital to a business, such capital is also called risk capital (Carter, Macdonald & Cheng 1997). According to the Confederation College (2002) the business owner forms the primary source of equity financing. In other words, own money obtained from savings or from the sale of personal assets is a form of equity financing. Other finances obtained from family, friends, employees, business associates, customers, venture capital firms, public stock sale and other types of investors are the second form of equity financing (Confederation College 2002). One’s personal savings is the ideal place to get seed or the initial investment money for a business. As indicated by Carter et al. (1997), personal savings is not only the commonest source of equity financing, it is also an indicator to other investors and/or lenders of the commitment that the entrepreneur has towards the business. In some cases, and if the business is small and requires more capital than the entrepreneur can finance on his own, financing from family members and friends should be considered. Entrepreneurs should however be careful about obtaining capital from friends and family members, and should ideally develop guidelines on how the family members or friends will recover their monies. For example, the entrepreneur and the family/friends investors should maintain a strict business arrangement in relation to the money. The details of the settlement should also be discussed and documented in a contract. Alternatively, the capital can be treated as bridge financing, in which case the investors and the entrepreneur would need to develop a mutually suitable payment schedule. The third possible source of equity capital is angels. Kaiser (2009, p. 10) defines angels as “private investors who back emerging entrepreneurial companies with their money”. Notably, the angels are not always in a hurry to get back their money, and this may provide some leverage to an entrepreneur. They also add value to a business, are more permissive as investors, and are geographically dispersed (Frederick et al. 2013). The downside of angels funding is that the amount of capital sourced is relatively small, and Kaiser (2009) estimates it to be a maximum of $500,000. An entrepreneur in need of large amounts of capital may therefore be forced to consider other capital sources. Finding angels is also not an easy task, though Kaiser (2009) indicates that networking locally is an ideal way of getting to them. Frederick et al. (2013) indicate there are five types of angels namely: professional angels, micromanagement angels, enthusiast angels, entrepreneurial angels and corporate angels. The fourth source of equity finance is corporate venture capital. Such money is infused into small (or start-up) businesses by large corporations (Kaiser 2009). Frederick et al. (2013) term venture capitalists as powerful and valuable source or equity funding. In addition to the capital infusions, venture capitalists provide insight into marketing, management, networks, technical expertise, recruitment, risk management, and compliance with government regulations (Frederick et al. 2013). The venture capitalists infuse quite substantial amounts of capital (usually in the range of $3 million to $10 million), but they only do so in start-up businesses that have high potential for growth and profitability. To obtain equity funding from venture capitalists, the business plan submitted by an entrepreneur is subjected to rigorous review, and as Carter et al. (1997) notes, only a small percentage of the business plans are accepted and funded. Getting funding from venture capitalists comes at a price for the entrepreneur. For example, the entrepreneur must be willing to give up some of his managerial prerogative to the venture capitalists who want to play an active role in the management. The entrepreneur must also be willing to prove that his business has a competent management, that it is based in an industry which is growing, and that the business has a competitive edge (Kaiser 2009). The venture capitalists also look for a viable exit strategy, ideally one which enables them to recover most of the investment channelled to a business. Going public through an initial public offering (IPO) is also another way of obtaining equity capital. In an IPO, the company sells part of its stocks to the public (Kaiser 2009). IPOs enable companies to raise large (often targeted) amounts of capital. IPOs also enable companies to improve their corporate image since getting IPO approval requires a company to get regulatory and supervisory approval from the relevant authorities. A company that raises equity through an IPO is also listed in a stock exchange, thus enhancing its capacity to access future financing (e.g. through a rights issue). Using an IPO to raise equity also has its share of disadvantages. Specifically, the founder’s ownership is diluted, the founder losses control and privacy, he is required to report to regulatory and supervisory authorities, and he has to be accountable to shareholders. Additionally, companies that raise money through IPO are subject to pressure from the shareholders to perform well in the short-term (Kaiser 2009). Examples of people who used equity financing in start-up businesses include Mark Zuckerberg, the Facebook CEO, and Jeff Bezos, the founder entrepreneur and CEO of Amazon.com. Debt financing Frederick et al. (2013) define debt financing as a form of secured financing where an entrepreneur obtains funds which are paid back with an interest. The borrowed money can be formal (e.g. bank loans) or informal (e.g. money borrowed from relatives). In formal debt financing, the borrowed money is repaid with interest. The issue of interest in informal debt financing however depends on the negotiations between the borrower and the lender. According to Kaiser (2009), debt financing is reflected as a liability in the new company’s balance sheet. Notably, debt financing is not easy to secure, especially because most institutional lenders require the entrepreneur to prove that the business is viable, and/or present collateral for the loan. Debt financing can also be expensive – especially for start-up business with reference to the risks the business faces (Kaiser 2009). Commercial banks and asset-based lenders are the commonest sources of debt finances. Others include commercial finance companies, equipment supplies, trade credit, credit unions, insurance companies, stock brokerage firms, and savings and loans associations among others. When using debt financing, the entrepreneur does not relinquish ownership (Frederick et al. 2013). Additionally, more borrowing has the potential of earning the entrepreneur more return on his equity. Examples of companies that use debt financing include American Airlines Inc, which in July 2013 added a $500 million loan to the $1.5 billion loan it had obtained in June 2013. Another example is found in Hudson’s Bay Co – a leading department store in Canada, which had obtained $2.8 billion to purchase another luxury retailer in 2013 (Natarajan 2013). Stages of funding It is highly unlikely that a start-up business venture would attract investor confidence without first having a sound financial base. The following section describes the stages of funding, as used by entrepreneurs. i. Early stage finance (Seed): Usually, this is the money used to conduct market research and develop the product. Seed capital can be obtained from the entrepreneur’s own savings or input from friends or relatives (MBA Knowledge Base 2013). Seed capital can also be obtained through equity or debt financing. ii. Later stage finance: The second stage of funding is required for the purposes of expanding, developing, managing, bridging and making finance turnarounds possible (MBA Knowledge Base 2013). This stage of financing is needed after the early stage finance has had an effect, and has probably run out. In later stage finance phase, capital can be obtained from angel investors who find the business idea viable. Such kind of funding is made possible by networks, thus making it possible for entrepreneurs to tap into the wealth of people (friends or a network of family and friends). In return, the angel investors buy into the company’s equity (MBA Knowledge Base 2013). iii. Early stage finance: Early stage finance occurs when the entrepreneur, through the utilisation of capital obtained in stages i and ii above, has developed a proven product, has started marketing and has even started commercial production. At this stage, the company may not have started to make profits. Early stage finance is necessary to cover market expansion, de-risk the business and cater for acquisition costs. Some of the investors interested in early stage finance are venture capital (VC) financiers. VC financiers are risk-averse and as such, they invest in companies that have a sound financial base (possibly having passed through stages i and ii above), and having an assurance that the business will be successful and profitable (MBA Knowledge Base 2013). iv. Second stage finance: Second stage finance occurs when a company that has a developed product, a management team, and one that generates sales does not generate sufficient surplus revenue to cater for its needs (MBA Knowledge Base, 2013). Second stage financing occurs in firms that had previously received external capital. Cost overruns and low sales performance are just some of the negative reasons why second stage financing occurs. On the positive side however, second stage finance may be needed to enhance production in order to meet increasing demand in a product and to enhance growth in response to increased stocks and receivables (MBA Knowledge Base 2013). v. Later stage finance: This stage of financing is needed where a firm has an established production of commercial products, has good profitability, capital growth and expanding yield, has a reputable market position and a basic marketing strategy. The money obtained at this stage is used in expanding the firm’s market (MBA Knowledge Base 2013). According to MBA Knowledge Base (2013), later stage financing has four subdivisions namely: development/expansion finance – meant to increase a firm’s profits through the attainment of economies of scale; replacement finance – obtained through substituting shareholder, hence changing the firm’s ownership; buyout financing – providing managers with the finances needed to purchase shares in the company they manage; and turnaround finance – given through the provision of competent management, which a firm may be lacking. In most cases, the management is provided by a venture capitalist (MBA Knowledge Base 2013). What do investors want from investments? In addition to the assurance that they will get their money back, investors look for the following aspects in an investment. First, they want to be convinced that the investment has a potential for good returns. In other words, for every dollar an investor puts into a company, he wants to get several dollars more in return in future. Some investors may also want to be caught in the excitement of building a successful product, while others may want be inspired to invest in a project/or product that has the potential to develop communities (Ward 2013). Investors also want a competent management team in the firm seeking their input. In a competent management team, the investors trust that their resources are in the hand of competent, knowledgeable and trustworthy people. Investors also want a business plan that reflects the vision and mission of the company as well as other issues like financial projections, marketing plans and specific characteristics about the targeted market. Some investors also want to be actively involved in the development of the business and as such, the entrepreneur needs to give them the opportunity to do so. Finally, investors want a practical exit strategy which indicates how they can reap from their investments and leave the company if the need to do so arises (Ward 2013). How investors choose investments According to Coplan (2009), investors consider many aspects of the business before investing therein. The viability of the business is topmost in the considerations. The business viability is judged through a review of the company goals (e.g. how the company intends to use the money it gets from investors) (Coplan 2009). Investors also choose an investment that has good (or at least promising) business characteristics (e.g. good management, good product and good marketing strategy) (Confederation College 2002). Positive growth expectations, a good economic environment, and prevailing investment trends are also factors that affect the choice that investors make. Additionally, and as the Confederation College (2002) notes, favourable tax considerations make some investments more favourable to investors. In addition to finances, investors can bring in new knowledge and expertise into a company (Carter et al. 1997). Additionally, they can advise the management on how well to run the company. Moreover, some investors (e.g. angels and venture capitalists) can also provide a start-up business with industry connections (Carter et al. 1997). Types of capital According to Goodwin (2003), there are five types of capital namely: i. Financial capital: Money invested in a business with the intention of producing more money for the investors. ii. Natural capital: A natural resource that plays a role in an economically productive process (e.g. if naturally available water is used in economic production of goods). iii. Produced capital: Things made by human beings, which play a role in the economic production process (e.g. roads, telephones, money transfers etc). iv. Human capital: The skills, knowledge and capacity present in human beings, and which make significant contributions towards economic production. v. Social capital: The stock of mutual understanding, trust, shared values, and social knowledge that facilitates coordination of economic activities in a social setup. Source: (Goodwin 2003) In conclusion, it is important to note that the decision to obtain capital from a specific source affects the company for its entire duration of existence. It affects such factors as profitability, decision-making and governance, and the responsibilities that the business has towards different stakeholders. Additionally, it is important to note that entrepreneurs need to understand that capital is available from different sources, but getting it from the right source is what matters. For example, venture capitalists may provide huge amounts of equity financing, but if one cannot get them to finance the company, he/she must consider other options such as debt financing. Finally, it is worth noting that creativity counts; entrepreneurs have to be willing to engage in creative search for capital, weigh the options and possibilities, and pick the option that provides the business with optimal advantages while minimising the disadvantages. References Carter, S, Macdonald, N & Cheng, D 1997, Basic finance for marketers, UN, Rome. Confederation College 2002, Small business, Productive Publications, London. Coplan, J H 2009, ‘Raising capital: Equity vs. debt’, Bloomberg Business Week Magazine, viewed 22 august 2013, . Frederick, H., O’Connor, A & Kuratko, D 2013, Entrepreneurship: Theory, process, practice, 3rd edition, Cengage Learning, South Melbourne. Goodwin, N R 2003, ‘Five kinds of capital: useful concepts for sustainable development’, Global Development and Environment Institute, Working Paper, no. 03-07, pp. 1-14. Kaiser, U 2009, ‘A primer in entrepreneurship’, Institute of Strategy and Business Economics, pp. 1-29. MBA Knowledge Base 2013, ‘Stages of venture capital financing’, viewed 22 August 2013, Natarajan, S 2013, ‘American airlines adds to DIP loan; magic Newco refinancing debt’, Bloomberg, . Ward, S 2013, ‘Attracting angel investors’, about.com, viewed 22 August 2013, . Read More