Chapter 10

Financing business
ventures

Prepared by Janine Ashwell, Flinders University

 Chapter outline

• Sources of debt finance

• Sources of equity finance
• Other useful categorisations of finance sources
• Alternative sources of finance
 Learning objectives

• Identify and explain the various types of debt finance

• Identify and explain the various types of equity
finance
• List and explain other useful categorisations of
sources of finance
• Distinguish the sources of finance according to
provider, term and business life cycle
• Discuss the financing options available at different
stages of a business life cycle
 Financing new ventures

• Financing business ventures is often a major obstacle

to entrepreneurs
• Three issues to consider when seeking finance are:
- Fund-providers perspective: whether funding should
be debt, equity or a combination
- Timeframe perspective: short or long term
- Business life stages: early stage or expansion
 Fund providers perspective

• Two primary sources of finance are:

- Debt finance is funding which is borrowed from

an outside party
- Equity finance is funding provided by the
owner(s) of a business venture
 Comparing debt & equity finance

Debt finance Equity finance

No ownership Provides residual ownership
in the business

Reimbursed on a fixed date Not reimbursed

Payment of interest Payment of dividends

 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
 Term loan

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

regular periodic payments over a specified period

• 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
 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
 The ‘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
 Trade credit

• Trade credit is a company’s open account

arrangement with its suppliers
• In this situation, goods are received from the
suppliers before payment is made
• Terms of trade can influence cash flow favourably
 Leases

• Gives a business access to resources such as plant or

premises without paying full cost
• Two types exist:
– finance leases
– operating (true) leases
• Advantages include minimal up front costs,
protection against equipment obsolesce, may lessen
tax burden
 Equity finance

• The alternative to borrowing is to use the funds of

the owner(s) of the business
• Sources of equity finance include:
- Founding owners equity
- Family and friends
- Business angels
- Venture capital
 Founding 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

• Common source for start-ups

• Often willing to forgo dividends until business gains

momentum

• Often a cheaper source of funding

• Business failure can destroy personal relationships

 Business angels

• Angel investors are wealthy individuals who invest in

entrepreneurial firms and also contribute their
business skills

• Angel groups — business introduction services —

allow individuals to increase their access to
investment opportunities by giving them the
possibility of investing jointly with other angels
Accessing business angels
 Venture capital

• Venture capitalists (VCs) are independently managed,

dedicated pools of capital that focus on equity
investments in high-growth companies
• The most common types of VC firms are:
- Private, independent firms
- Affiliates or subsidiaries of a commercial bank,
investment bank or insurance company
- Subsidiaries of industrial corporations
 How does venture capital work?

• Exit strategy: 3-7 years

• Screen technical and business merits of the proposed

venture

• In 2008: 8500 funding proposals received; 963

analysed, 260 funded.
 Evaluating investments

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
 Publicly raised equity

Advantages Disadvantages
Capital for continued growth Expense

Lower cost of capital Periodic reporting

Loss of confidentiality

Increased shareholder Shareholders pressures

liquidity
Improved company image Reduced control
 Finance sources :
Timeframe perspective
• Short-term finance
– usually takes the form of a bank overdraft, trade
credit, credit card purchase, bridging finance or
bank advance (<12 months)
• Long-term finance
– can be a long-term loan or a mortgage
(>12 months)
 Life cycle 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
–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
 Life cycle 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
– Third-stage (or mezzanine) financing is provided
to achieve a critical objective, such as increasing
inventories to accomplish greater sales
– Initial public offering (IPO):
A company offers shares and lists on the stock
exchange
Financing options at different stages of
the business life cycle

Fig. 10.1
Financing challenges for start-ups and innovative
SMEs
• Equity gap: the scarce provision of equity
investments in the early stage of a firm’s growth

• The reasons for the equity gap stem both from the
supply side (the investors) and the demand side (the
entrepreneurs)
 Alternative sources of finance

Alternative sources are often referred to as

‘bootstrapping’. Sources include:
– Debt factoring: Factoring involves selling or
exchanging a business’ debts for cash at a discount
– Customers and suppliers: credit notes or advances
– Real estate and equipment: leasing
– Government and industry partners
 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
–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
 Summary

• Obtaining finance is a major difficulty to establish

and operate a small business
• Three issues to consider when seeking finance are
fund-providers perspective, timescale and business
life cycle stage
• Traditional sources of funding are debt or equity
• Additional sources include debt factoring and
government backed schemes