FINANCING THE NEW

VENTURE
Chapter 5
LEARNING OBJCETIVES
At the end of the chapter you will able to:
• Identify the types of financing available
• Understand the role of commercial banks in financing the
new venture, type of loans available and bank lending
decisions
• Understand the Saving and Co-operative model as source
of funding
• Explain the basic stages of venture funding
• To discuss the nature of the venture-capital industry and
the venture capital decision process
 DEBT OR EQUITY FINANCING
• Different sources of Capital are generally used at different
times in the life of the venture.
Debt Financing
Debt financing involves an interest – bearing instrument,
usually a loan, the payment of which is only indirectly related
to sales and profit’.
1. Debt financing (also called asset-based financing)
requires some asset to be used as collateral).
*Collateral is any asset held as security for the repayment of
a loan, to be forfeited in the event of default of payment
1. The entrepreneur has to pay back the amount of funds
borrowed plus a fee, expressed in terms of interests
2. Short-term money is used to provide working capital
 DEBT OR EQUITY FINANCING
• Different sources of Capital are generally used at different
times in the life of the venture.
Debt financing
4. Long term debt (lasting more than a year) is
frequently used to purchase some asset, with part of
the value of the asset is being used as collateral;
5. Debt has the advantage of letting the entrepreneur
retain a large ownership position and have greater
return on equity;
6. If the debt is too great payments become difficult to
make and growth is inhibited
DEBT OR EQUITY FINANCING
Equity financing
• This type of financing does not require collateral but does offer
the investor some form of ownership in the venture.
• In this case, the entrepreur raises capital through the sale of
shares.
• The characteristics of equity finance include the following:
1. The investor shares in the profit of the venture.
2. Key factors in choosing the type of the financing are
availability of funds, assets of the venture and prevailing
interest rates
3. Usually combination of debt and equity financing is used
4. The equity may be entirely provided by the owner or may
require multiple owners
DEBT OR EQUITY FINANCING
Equity financing
4. This equity funding provides the basis for debt
financing, which makes up the capital structure of
the venture.
5. The disadvantage is that it introduces loss of
complete ownership of the venture
INTERNAL AND EXTERNAL FUNDS
• The most often used type of funds is internally generated
funds
1. These funds come from the sources within the
company, such as profits, sale of the assets,
reduction in the working capital, and accounts
receivable.
2. The start-up years usually involve ploughing all the
profits back into the venture.
3. Sometimes little –used can be sold or leased.
4. Assets, whenever possible, should be on the rental
basis, not on ownership basis.
INTERNAL AND EXTERNAL FUNDS
• The most often used type of funds is internally generated
funds
5. One short term internal source of funds is reducing
short-term assets or through extended payments
from suppliers
6. Another method is by collecting accounts receivable
more quickly
INTERNAL AND EXTERNAL FUNDS
External sources
1. Alternative sources should be evaluated by:
a. Length of time the funds are available.
b. Costs involved.
c. Amount of control lost.
2. The more frequently used sources of funds are
discussed below:
 PERSONAL FUNDS
• Few new ventures were started without the personal funds
of the entrepreneur.
• In terms of cost and control these are the least expensive
• They are essential in attracting outside funding
• Outside investors want the entrepreneur to demonstrate
financial commitment.
• This level of commitment is reflected in the percentage of
total assets available the entrepreneur has committed;
• An outside investor wants an entrepreneur to have
committed all available assets
• It is not the amount, but the fact that all monies
available are committed that makes outside investors feel
comfortable
 FAMILY AND FRIENDS
• After the entrepreneur, family and friends are the next
most important source of capital
• Family and friends provide small amount of equity funding
for the new venture
a. It is relatively easy to obtain money from family and
friends;
b. However, the amount of money provided may be small.
c. If it is in the form of equity funding, the family
member or friend has an ownership position in the
venture.
d. If they have direct input into operations of the venture,
it may have a negative effect on employees or profits.
 FAMILY AND FRIENDS
• To avoid potential future problems, the entrepreneur must
present the positive and negative aspects and the nature of
the risks of the investment.
• To minimize any future problems, keep the business arrangements
strictly business
• Any loan should specify the rate of interest and the proposed
repayment schedule.
• The entrepreneur should settle everything up front and in writing
• A formal agreement specifying funding details often helps avoid
future problems
• The entrepreneur should carefully consider the kind of
influence the family member or friend may have on the
investment before it is accepted
 COMMERCIAL BANKS
• Commercial banks are most frequently used as a source
of short-term funds
• This is debt financing and requires some collateral
This collateral can be business assets, personal assets
or the assets of the consigner of the note
• Types of bank loans
1. Accounts receivable loans
a. Accounts receivable provide a good basis for a
loan, especially if the customer base is
creditworthy
b. A bank may finance up to 80% of the value of
accounts receivable
COMMERCIAL BANKS
1. Accounts receivable loans
c. A factoring arrangement can be developed
whereby the factor (bank) actually buys the
accounts and collects the money.
d. If any receivables are not collectible, the
factor sustains the loss, not the business.
e. The cost of factoring is higher than the cost
of securing a loan against the accounts
receivable.
 COMMERCIAL BANKS
2. Inventory loans
a. Inventory is often a basis for a loan, particularly when
inventory is liquid and can be sold easily.
b. Finished goods inventory can be finished up to 50% of
value
c. Trust receipts are a type of inventory loan used to
finance floor plans of retailers such as auto dealers.
d. The bank advances a large percentage of the invoice
price of goods and the venture is paid a pro rata basis
as the inventory is sold
 COMMERCIAL BANKS
3. Equipment loans
a. Equipment can be used to secure longer term financing
of up to 3 to 10 years
b. When new equipment is bought, 50 to 80% of value
can be financed;
c. In sale –leaseback financing the entrepreneur “sells”
the equipment to a lender and then leases it back.
4. Real estate loans
• Are easily obtained to finance land, plan or building,
usually up to 75% of the value.
 COMMERCIAL BANKS
5. Cash flow Financing
5.1 Cash flow financing, or conventional bank loans,
include lines of credit, instalment loans straight commercial
loans long-term loans and character loans
a. Lines of credit are the most frequently used;
b. The company pays a “commitment fee” at the start
then pays interest on outstanding borrowed funds
5.2 Instalment loans
a. Instalment loan can be obtained by a going venture
with a track record of sales and profits
b. The funds are used to cover working capital needs,
usually for 30 to 40 days
 COMMERCIAL BANKS
5.3 Straight commercial loans
a) In this hybrid of the instalment loan, funds are
advanced to the company for 30 to 90 days.
b) These self-liquidation loans are used for seasonal
financing.
5.4 Long term loans
a) These loans are usually only available to more mature
companies;
b) Funds are available for up to 10 years with debt repaid
according to a fixed interest and principle schedule
 COMMERCIAL BANKS
5.5 Character loans
a) When the business does not have assets to support a
loan, the entrepreneur many need a character loan.
b) The loans must have assets of an individual pledged as
collateral or have the loan consigned by another.
6. Bank lending Decisions
6.1 Banks are very cautious in lending money, particularly
to new ventures.
a) Commercial loan are made only for after the loan officer
does a careful review of the borrower
b) Decisions are made based on the quantifiable and
subjective judgements.
 COMMERCIAL BANKS
6.2 Bank lending decisions can be summarized by the
five Cs – Character, Capacity, Capital, Collateral and
Conditions.
a) Past financial statements are reviewed in terms of key
ratios and the entrepreneur’s capital invested.
b) Future projections are based on market size, sales and
profitability are evaluated.
c) Intuitive factors – Character and capacity are also taken
into account and become more important when there is
a little or no track record.
 COMMERCIAL BANKS
6.3 The loan application format is generally a
“mini” business plan.
a) This provides the loan officer with information
on the creditworthiness of the individual and
the ability of the venture to repay the loan.
b) Presenting a positive business image and
following procedure are important in obtaining
the funds.
COMMERCIAL BANKS

6.4 The entrepreneur should borrow the maximum

amount possible that can be repaid , as long as the
prevailing interest rates and terms are satisfactory.
a) Care must be taken to ensure that all ventures will
generate enough cash flow to repay the interest and
principal on the loan;
b) The entrepreneur should evaluate the track record and
lending policies of several banks in the area.
Activity 5.1

• The university has offered university SRC to run the

refectory operations. The students representatives had
decided to approach the commercial banks for loans
• Discuss five types of bank loans the SRC might be
offered?
• Explain to the SRC the difference between debt
financing and equity financing
• Explain which one is preferable.
 FINANCING THE BUSINESS
• Timing and amount of Financing Needed
• Conventional small businesses have more difficulty obtaining
external equity capital;
• Venture capital forms likes to invest in high-potential
ventures
• Three basic stages of Funding.
1. Early-stage financing is the most difficult and costly
to obtain
• Seed capital, the most difficult to obtain from outside
sources, is usually a small amount needed to provide
concepts.
• Venture capital firms are rarely involved in this type of
financing, except for high-tech ventures of entrepreneurs
with a successful track record.
• Start-up financing is involved in developing and testing
initial products to determine sales feasibility.
FINANCING THE BUSINESS
2. Expansion or development financing is easier to
obtain
• Funds for expansion are less costly;
• As the firm develops, funds in the second stage are
used as working capital supporting initial growth.
• In the third stage, the company is at break-even level
and uses the funds for sales expansion.
• Fourth stage funds are bridge financing before the firm
goes public.
FINANCING THE BUSINESS
3. Acquisition or leveraged buyout financing, is used
for :
• Traditional acquisitions
• Leverage buyouts (management buying out the present
owners)
• Going private (a publicly held firm buying out existing
stockholders, thereby becoming a private company);
FINANCING THE BUSINESS
• The risk-capital markets are the informal risk –capital
market, venture-capital and public–equity market
• All the three markets can be a source of funds for high
potential ventures
• The public equity market is available only for high –
potential ventures.
• The venture capital market provides some first –
stage funding, but the venture must need the
minimum level of capital E9.5million
• The best source for first stage financing is the informal
risk–capital market.
 INFORMAL RISK CAPITAL MARKET
• The informal risk–capital market is a group of wealthy “business
angels” – who are looking for equity investment opportunities
i. Angels provide funds for all stages of financing, but
particularly start-up financing
ii. The informal investment market has the largest pool of the
risk capital of risk capital
iii. In one survey 87% of investors buying private placements
were individual investors or personal trusts;
iv. Previous studies indicated that informal market provides 15%
of capital funds required while venture capitalist offered
between 12-15%.
 INFORMAL RISK CAPITAL MARKET
• Characteristics of informal Investors
• They tend to be well educated, with many graduate
degrees.
• The firms receiving investment funds are usually within
one day’s travel;
• Business angels make one deal or two deals a year,
averaging E3.15 million
• Type of preferred Investments
• Angels generally prefer manufacturing of both industrial
and consumer products, energy, service and
retail/wholesale trade;
• Returns expected to decrease as the number of years in
business increases.
• Angels have longer investment horizons, typically 7 to 10
years, than venture capitalists (5 years)
INFORMAL RISK CAPITAL MARKET
• Investment opportunities are rejected where there
is:
• An inadequate risk/return ratio;
• An inadequate management team
• A lack of interest in the business area;
• The principals are not committed to the venture
 VENTURE CAPITAL
• Nature of venture capital
• Some venture capitalists are thought of as providing
early-stage financing of small, growing technology
companies
• Venture capitalist is more broadly a professionally
managed equity pool formed from resources of
wealthy limited partners
• Other investors are pension funds, endowments and
other institutions.
• The pool is managed by a general partner – the
venture capital firm – in exchange for a percentage
of the gain realized.
 VENTURE CAPITAL
• Venture capital is a long –term investment discipline in
the creation of early-stage companies, the expansion of
existing companies and the financing leveraged buyout
• The venture capitalist takes an equity participation
through stock, warrants and convertible securities
and has an active involvement in each company
ACTIVITY 5.2
• Explain three stages on funding the new business
• Discuss four characteristics of business angels
• Describe venture capitalists
 COOPERATIVE FINANCING
• According to the Cooperatives Act of 2003, a co-operative
is an association of people duly registered, who have
voluntarily come together to achieve a common end
through the formation of a democratically controlled
organisation, making equitable contributions to the
capital required and accepting a fair share of the risks
and benefits of the undertaking in which the members
actively participate.
COOPERATIVE FINANCING
• In the context of business firms, finance encompasses all
aspects of raising and using cash and related funds for
the long-run and short-run purposes of a firm.
• Finance includes cash management (taking in and
expending cash), extending and using trade credit
(accounts receivable and accounts payable), investing in
long-run assets (e.g., property, plant and equipment) and
short-run assets (e.g., inventory), raising funds (e.g.,
short- and long-term debt, preferred equity and common
equity) and returning funds to debt holders (principle and
interest) and investors (dividends and stock retirement).
 COOPERATIVE FINANCING
• Cash and related funds are the life blood of any firm.
If their flow is not handled properly, the firm suffers.
If the flow is handled well, the firm is in a position to
prosper.
• The finance function within a firm ensures to the
extent possible that the flow of funds fully supports
the needs of the business for successful
performance.
WHY COOPERATIVES NEED MONEY
• The fundamental principles of cooperatives clearly
indicate that members use and own the cooperative.
• The user role does not entail anything more than normal
patronage of any business.
• If you buy from the cooperative (or any other type of
business), you need to pay for what you buy, or if you sell
to a cooperative (and/or other type of business), the
cooperative needs to pay you.
• There is nothing unusual or unique about this member
role in terms of finance versus buying/selling to another
type of business.
WHY COOPERATIVES NEED MONEY
• The owner role of the cooperative member does require
different commitment in terms of financial
responsibilities.
• As owners, members are the primary source of ownership
(equity) funds for the cooperative.
• Members must thus invest in their cooperative and not
merely use or patronize it.
• In other words, members who do business with other
firms can just do buying or selling, but in order to do
business with their cooperative, they must invest as well.
WHY COOPERATIVES NEED MONEY
• Traditionally, cooperatives make the investment rather
easy for members. When members join an existing
cooperative, they may be required to invest a nominal
amount and then agree to invest over time by allowing
the cooperative to keep or retain a portion of each year’s
cooperative earnings as equity capital.
• However, if a cooperative is just being formed, the
required member investment may be significant and
needed up front to give the cooperative the money to
build the business.
WHY MEMBERS NEED TO INVEST MONEY
• Why do cooperatives need this member investment? Like
any business, a cooperative needs to have adequate funds
to pay bills, make investments in assets and have
reserves for risk management.
• In any standard business (proprietary, partnership or
corporate), the owners have to be ultimate providers of
the funds that are needed, over and above what gets
generated by the normal flow of internal business
operations.
• In this sense, cooperatives are no different than other
businesses. The difference is that member-users are the
only source of equity capital for a cooperative.
WHY MEMBERS NEED TO INVEST MONEY
• Other types of business, particularly public corporations,
can raise equity funds from any willing investors.
Cooperatives can only get these funds from member-
users.
• Members are thus owners at risk and not just users.
• The good news here is that dividing the ownership equity
among many members makes it easier and less risky to
finance the cooperative than if only one or a few members
tried to do it on their own.
COOPERATIVE-LEVEL PROFITS
• Historically, cooperatives were thought of as “non-profit”
or “not-for-profit” organizations. These terms confuse the
original notion of the operation-at-cost principle with
profit-generating ability.
• Like all businesses, cooperatives need to generate profit
to survive and prosper. They are never in business merely
to break even.
• Like all businesses, cooperatives create revenues through
sales and have expenses. The difference between
revenues and expenses is profit or net income just like
any standard business would have.
COOPERATIVE-LEVEL PROFITS
• Because of the operation-at-cost principle,
cooperatives have historically used a variety of other
terms for profit or net income, including net
patronage income, net savings, etc. If the label means
revenues minus expenses, then the amount
represents profit whatever the words used.
• Again, like all businesses, a cooperative’s income
statement provides the numbers related to its
operating profit. Net income allocated and distributed
to members on the basis of patronage is called a
patronage refund.
COOPERATIVE-LEVEL PROFITS
• Patronage refunds are shown on the income
statement mostly near the very bottom of the
statement after all other costs and revenues have
been reported.
• If any dividends are declared on capital, they too will
be shown on the income statement, but remember
most cooperatives do not pay dividends to common
equity capital.
 COOPERATIVE-LEVEL PROFITS
• One type of marketing strategy is that cooperatives do
not have a traditional “bottom line” for net income—a
pooling cooperative. Pooling cooperatives, in effect, pool
all the revenues from selling members’ crops and then
deduct costs from the total pool.
• The result represents the payment for the members’
crops and thus traditional net income (revenues minus
costs) allows equals zero. This is the ultimate
implementation of the operation-at-cost principle.
 COOPERATIVE-LEVEL PROFITS
• But even pooling cooperatives must raise equity over
time. For investment purposes, they retain a form of
equity capital often called a “capital retain” to raise
equity.
• Capital retains will show up on the income statement
as net income even though it is a planned amount
rather than a true residual of revenue minus expenses.
• Not all marketing cooperatives operate as pools in this
way. It is most common in fruit and vegetable
cooperatives.
HOW COOPERATIVES MAKE AND PAY OUT
PROFITS?
• Every cooperative has to struggle with the proper balance between
cooperative-level profits (net income and patronage refunds) and
member-level profits.
• Some suggestions can be made to guide these key cooperative
financial decisions.
1. Cooperatives should attempt to create a significant amount
of their returns at the cooperative level.
• The ability to more objectively measure these returns provides the
motivation for this recommendation. The subjectivity of
measurement and variability of return evaluation makes reliance
on member level returns an uncertain proposition for cooperatives
and for members. Members may even get confused about where
their returns are coming from.
HOW COOPERATIVES MAKE AND PAY OUT
PROFITS?
• For example, when a member receives a price differential for
products sold, is the price differential based on the member’s
own activities, e.g., attempts to grow quality into a crop or
livestock, or the cooperative’s activities to get members fairly
treated in the market?
• If a cooperative offers market prices at the time of purchase
or sale, then the more objective, measurable patronage
refunds that come at the end of the cooperative’s operating
year will include price differentials and eliminate confusion
for the cooperative and its members.
HOW COOPERATIVES MAKE AND PAY OUT
PROFITS?
• Pooling cooperatives that force their net income to zero
will have an especially tough time meeting this guideline.
However, such cooperatives can focus on communicating
with members about the implicit split between what the
member does and what the cooperative does in creating
profits.
• A corollary to this guideline is that cooperatives should
maximize the amount of their net income that ultimately
comes back to the member as patronage refunds and
dividends.
• Unfortunately, cooperatives can pursue options that will
not fully allocate net income to members or will postpone
the actual receipt of cash for long periods of time. These
practices reduce the realized returns of members, and
their use should be managed carefully.
HOW COOPERATIVES MAKE AND PAY OUT PROFITS?
2. Cooperatives should attempt to measure the member-
level returns.
• However subjective and member specific these returns may
be, these returns are legitimately generated by the
cooperative.
• The cooperative needs to track these returns even if it is only
done periodically through member surveys or member focus
groups, and then the cooperative should promote their
findings with all members.
• These means of assessing member-level returns are highly
qualitative and mostly subjective (just as the returns
themselves are).
HOW COOPERATIVES MAKE AND PAY OUT PROFITS?
2. Cooperatives should attempt to measure the member-
level returns.
• However, these methods will help place some legitimate
bounds on the value of such returns and thus assist in
highlighting their existence and importance to members.
• Failure to make some attempt at assessment will result in
members undervaluing the cooperative.
HOW COOPERATIVES MAKE AND PAY OUT
PROFITS?
3. Cooperatives should scrutinize closely any
investments or activities that are being justified solely
or, nearly so, on the basis of service differentials, the
value of existence or the value of risk management.
• As has been argued, these returns are the most subjective
for members to evaluate and vary most broadly from
member to member.
• Over reliance on such investments or activities would
seem to significantly increase the chances that members
misperceive the value of a cooperative.
• This does not mean that these sources of return should
be ignored or undervalued. It does mean that their value
should be examined very closely to ensure that such value
really exists and is not just illusionary.
HOW COOPERATIVES MAKE AND PAY OUT
PROFITS?
4. Cooperative financial performance cannot
be measured solely on the basis of financial
statements and standard financial ratios.
• Member-level returns are real even if they are
difficult to measure. If cooperatives act only on
the basis of cooperative level returns, they will
merely make the exact same decisions as non-
cooperatives.
• Membership would become valueless, i.e., the
decision to patronize and to invest might as well
be made separately rather than jointly.
HOW COOPERATIVES MAKE AND PAY OUT
PROFITS?
5. Cooperative financial performance cannot
be measured solely on the basis of financial
statements and standard financial ratios.
• Cooperative financial decisions must take into
account member-level returns if they are to be
made appropriately.
• Even then, these returns can be understated by
the financial statements if price, service and
risk differentials impose costs at the
cooperative level with the benefits only being
realized at the member level.
ACTIVITY 5.3
• Asibonane it’s a new cooperative located at Vuvulane. The
cooperative pay dividends suing both capital funds and
savings annual.
1. Explain to the executive Board why the co-operative
should consider doing investments?
2. Explain how cooperative could make Profits
The end