Operational Issues

Chapter 9: Financing new and

growing business ventures
 Chapter outline

• A typology of finance
• Debt finance
• Equity finance
• Alternative sources of finance
 Learning objectives

• Distinguish the sources of finance

according to provider, term and business
life cycle
• Discuss the financing options at the
different stages of the business life cycle
 Learning objectives

• Identify and explain the various types of

debt finance
• Identify and explain the various types of
equity finance
• List and explain alternative sources of
finance
 A typology of finance

• Financing is often the main obstacle

facing many intending business start-ups.
• Three main ways can be used to
categorise financing:
– fund provider perspective
– timeframe perspective
– life-stage perspective
 Debt vs equity
• Debt finance is that which is borrowed
from an outside party; equity finance is
money provided by the owner(s) of a
business venture.
• Main differences between debt and
equity:
– equity provides a residual ownership
interest in the business, whereas debt
does not
 Debt vs equity

– debt finance requires the payment of a

fixed and predetermined interest rate;
equity providers receive a variable
remuneration
– debt must be reimbursed at a fixed
date, whereas equity is not reimbursed
(unless the business goes into
liquidation)
 Debt vs equity
• Leverage : The degree to which a
business uses borrowed money, what the
debt-equity ratio measures.
• leverage, will depend upon the business
needs, and whether it can meet the
assessment criteria required by each
mode of finance.
• Leverage is not always bad: it can
increase the shareholders’ return on their
investment as there are tax advantages
associated with borrowing.
 Debt vs equity

Demand for finance usually follows a

‘pecking order’ of:
– internal equity
– short-term debt
– long-term debt
– external equity
 Short-term vs long-term finance
• Short-term finance usually takes the
form of a bank overdraft, trade credit,
credit card purchase or bank advance
(<12 months).

• Long-term finance can be a long-term

loan or a mortgage
(>12 months).
• Bridging finance (interim loans with a
short fixed term) can be used to finance
accounts receivable contracts.
 Early-stage finance vs expansion
finance

• Early stage financing covers aspects of

a new venture’s launch and early days of
trading.

– Seed financing is the small amount of

funds that is necessary for product
development, building a management
team, or completing a business plan.
Early-stage finance vs expansion
finance

– Start-up financing facilitates the

process of organising the business
structure.

– First-stage financing is additional

funds to initiate full-scale production
when initial capital has been
exhausted.
 Early-stage finance vs expansion
finance

• Expansion stage financing applies to

established enterprises where the focus
is on growth and expansion.

– Second-stage financing are funds

provided to operating firms that are
expanding and which need extra funds.
Early-stage finance vs expansion
finance

– Third-stage (or mezzanine) financing is

provided to achieve a critical objective,
such as increasing inventories to
accomplish greater sales, or building an
extra production line to meet the demand.

– Initial public offering (IPO):

A company offers shares and lists on the
stock exchange.
Financing options at different stages
of the business life cycle
 Debt finance
• Going into debt implies having an
obligation or outstanding liability to
an outside party.

• Small business often fail to obtain finance

for three main reasons:
– insufficient security
– payback term is too long
– track record of performance
is lacking
 Bank overdraft

• An overdraft is a credit arrangement

permitting the business to draw more
funds from a bank than it has in its
account.
• However, overdrafts can be recalled by the
bank whenever they wish.
• Highly flexible, overdrafts are a short-term
funding source with a number of
advantages.
 Trade credit

• Trade credit is a company’s open

account arrangements with its suppliers.
• In this situation, goods are received from
the suppliers before payment is made.
• Terms of trade can influence cash flow
favourably
 Term loan

• A term-loan is a source of long-term debt

with regular periodic payments over a
specified period (1 to 10 years).
• Interest rate can be variable or fixed,
often the loan must be secured by assets.
• Associated establishment fees and other
possible charges can affect the interest
cost structure.
 Term loan

The ‘five Cs of credit’

• Character
willingness of the debtor to meet financial
obligations.
• Capacity
the ability to meet financial obligations out of
operating cash flows.
• Contribution
the amount of money the entrepreneur is putting
into the project.
 Five Cs of credit

• Collateral
assets pledged as security.
• Conditions
general economic conditions related to
the applicant’s business (e.g. industry,
business cycle, community, fiscal
conditions).
 Leasing

• Lease: a written agreement under which

a property owner allows a tenant to use
the property for a specified period of time
and rent.
• Two types exist: Finance leases and
operating (true) leases
• Suitable for gaining access to costly
capital equipment, e.g. construction
equipment or computers
 Equity finance

• The alternative to borrowing or using

other people’s money is to use the funds
of the owners of the business.
• This may be either from the original
founder of the firm, or from other persons
who subsequently become part-owners of
the enterprise.
 Owner’s equity

• This type of equity is usually acquired

from the owner’s savings or the sale of
their personal assets.
• Funds can be used with maximum
flexibility, and invested for the long term.
 Family and friends
• Family members, friends and
friends-of-friends are the best place
to start the search for capital.

• Entrepreneurs should be cautious with

this type of financing: many cherished
friendships and family relationships have
been destroyed through inadequate
protection and provision for the possibility
of a business failure.
 Business angels
• Angel investors are wealthy individuals
who invest in entrepreneurial firms and
also contribute their business skills.

• Some business angels are members of

angel groups — business introduction
services — allowing them to increase
their access to investment opportunities
and giving them the possibility of
investing jointly with other angels to
hedge their risk.
 Venture capital

• Venture capitalists (VCs) are

independently managed, dedicated pools
of capital that focus on equity investments
in high-growth companies.
 Venture capital

• When considering an investment, VCs

always take into account:
– The team
– The industry
– The business model and technology
– Market opportunities
– The exit strategy
 Publicly raised equity

• Initial Public Offering (IPO), ‘flotation’,

‘going public’ and ‘listing’ are just some of
the terms used when a company obtains
a quotation on a stock market.
• A flotation has its inception long before
the first day of trading.
• An issuer must undergo numerous
procedures, from the decision to proceed
with an IPO, right through to listing.
The four main stages of an initial
public offering
 Advantages of going public

• Capital for continued growth

• Lower cost of capital
• Increased shareholder liquidity
• Improved company image
 Disadvantages of going public

• Expense
• Loss of confidentiality
• Periodic reporting
• Reduced control
• Shareholder pressures
 Alternative sources of finance

Debt factoring
• Factoring involves selling or exchanging a
business’ debts for cash at a discount.
• Factoring would be suitable to a SME with
the following attributes:
– Sales are on credit and not for cash
Alternative sources of finance

– The business has continuous trading

with established customers
– No unusual selling terms apply
(e.g. consignment sales, guarantees)
 Alternative sources of finance

Government-backed schemes
• These schemes display one or several of
the following criteria:
– They are focused on a specific
stage of the firm’s development –
seed, start-up or expansion.
Alternative sources of finance

– They mostly aim to support SMEs, and

size to qualify for funding can be
determined in different ways.
– They usually target specific industries
(e.g. biotechnology, electronics) and
often focus on R&D and the
commercialisation of innovation.