CHAPTER 6: BUSINESS FINANCING

INTRODUCTION

Sourcing money may be done for a variety of reasons. Traditional areas of need may be for capital asset
acquisition- new machinery or the construction of a new building. The development of new products can
be costly but capital may be required. Such developments are financed internally, whereas capital for the
acquisition of machinery may come from external sources.

Financial Requirements

All businesses need money to finance a host of different requirements. In looking at the types and
adequacy of funds available, it is important to match the use of the funds with appropriate funding
methods.

Permanent Capital: The permanent capital base of a small firm usually comes from equity
investment in shares in a limited company or share company, or personal loans to form partners or to
invest in sole proprietorship

Working Capital : It is short-term finance. Most small firms need working capital to bridge the gap
between when they get paid, and when they have to pay their suppliers and their overhead costs.

Asset Finance: It is medium to long term finance. The purchase of tangible assets is usually financed
on a longer-term basis, from 3 to 10 years, or more depending on the useful life of the asset.
Sources of Financing

Financial resources are essential for business, but particular requirements change as an enterprise grows.
Obtaining those resources in the amount needed and at the time needed can be difficult for entrepreneurial
ventures because they are generally considered more risky than established enterprises.

Internal Sources (Equity capital) : Owner’s capital or owner’s equity represents the personal
investment of the owner(s) in a business and it is sometimes called risk capital because these investors
assume the primary risk of losing their funds if the business fails. However, if the venture succeeds, they
also share in the benefit.

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Sources of Equity Capital

1. Personal saving: The first place entrepreneurs should take for startup money is in their own pockets.
As a general rule, entrepreneurs should provide at least half of the start- up funds in the form of equity
capital.

2. Friends and relatives: After emptying their own pockets, entrepreneurs should turn to friends and
relatives who might be willing to invest in the business. The entrepreneur is expected to describe the
opportunities and threats of the business.

3. Partners: An entrepreneur can choose to take on a partner to expand the capital formation of the
proposed business.

4. Public stock sale (going public): In some case, entrepreneurs can go public by selling share of stock in
their corporation to outsiders. This is an effective method of raising large amounts of capital.

Angels: These are private investors (or angles) who are wealthy individuals, often entrepreneurs, who
invest in the startup business in exchange for equity stake in these businesses.

6. Venture capital companies: Are private, for profit organizations that purchase equity positions in
young business expecting high return and high growth potential opportunity. They provide start -up
capital, development funds or expansion funds.

External Sources (Debt capital)

Borrowed capital or debt capital is the external financing that small business owner has borrowed and
must repay with interest. There are different sources as discussed here below:

Commercial banks: Commercial banks are by far the most frequently used source for short term debt by
the entrepreneur. In most cases, commercial banks give short term loans (repayable within one year or
less) and medium term loan (maturing in above one year but less than five years), long term loans
(maturing in more than five years).

Trade Credit: It is credit given by suppliers who sell goods on account. This credit is reflected on
the entrepreneur’s balance sheet as account payable and in most cases it must be paid in 30 to 90 or
more days.

Equipment Suppliers: Most equipment vendors encourage business owners to purchase their
equipment by offering to finance the purchase.

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 Account receivable financing: It is a short term financing that involves either the pledge of
receivables as collateral for a loan.

Credit unions: Credit unions are non-profit cooperatives that promote savings and provide credit to
their members. But credit unions do not make loans to just any one; to qualify for a loan an
entrepreneur must be a member.

Bonds: A bond is a long term contract in which the issuer, who is the borrower, agrees to make
principal and interest payments on specific date to the holder of the bond. Bonds have always been a
popular source of debt financing for large companies in the western world
Lease Financing

Lease financing is one of the important sources of medium- and long-term financing where the owner
of an asset gives another person, the right to use that asset against periodical payments. The owner of
the asset is known as lessor and the user is called lessee.

Types of Lease

Finance Lease : It is the lease where the lessor transfers substantially all the risks and rewards of
ownership of assets to the lessee for lease rentals.
Operating Lease : Lease other than finance lease is called operating lease. Here risks and rewards
incidental to the ownership of asset are not transferred by the lessor to the lessee.
Traditional Financing in Ethiopian (Equib/Idir, Etc.)

While Ethiopia has one of the least-developed formal financial sectors in the world, it possessed a
rich tradition in indigenous, community-based groups such as savings and credit associations and
insurance like societies. These "iqub" and "idir" groups provide a source of credit and insurance
outside the formal sector but much rooted in Ethiopian society.

The contributions of these groups, especially iqub, to economic growth is difficult to quantify but can
be assumed to play an important role. Iqub is a traditional means of saving in Ethiopia and exists
completely outside the formal financial system. An iqub is a form of savings.

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Crowd Funding : Crowd funding is a method of raising capital through the collective effort of
friends, family, customers, and individual investors or even from the general public.

How is Crowd Funding Different?

Crowd funding is essentially the opposite of the mainstream approach to business finance. Traditionally,
if you want to raise capital to start a business or launch a new product, you would need to pack up your
business plan, market research, and prototypes, and then shop your idea around to a limited pool or
wealthy individuals or institutions. These funding sources included banks, angel investors, and venture
capital firms, really limiting your options to a few key players.

The Benefits of Crowd funding : From tapping into a wider investor pool to enjoying more
flexible fund raising options, there are a number of benefits to crowd funding over traditional methods.
Here are just a few of the many possible advantages:

Reach: By using a crowd funding platform like Fundable, you have access to thousands of accredited
investors who can see, interact with, and share your fund raising campaign.

Presentation: By creating a crowd funding campaign, you go through the invaluable process of looking
at your business from the top level its history, traction, offerings, addressable market, value proposition,
and more and boiling it down into a polished, easily digestible package.

PR & Marketing: From launch to close, you can share and promote your campaign through social
media, email newsletters, and other online marketing tactics. As you and other media outlets cover the
progress of your fund raise, you can double down by steering traffic to your website and other company
resources.

Validation of Concept: Presenting your concept or business to the masses affords an excellent
opportunity to validate and refine your offering. As potential investors begin to express interest and ask
questions, you’ll quickly see if there’s something missing that would make them more likely to buy in.

Efficiency: One of the best things about online crowd funding is its ability to centralize and streamline
your fund raising efforts. By building a single, comprehensive profile to which you can funnel all your
prospects and potential investors, you eliminate the need to pursue each of them individually. So instead
of duplicating efforts by printing documents, compiling binders, and manually updating each one when
there’s an update, you can present everything online in a much more accessible format, leaving you with
more time to run your business instead of fundraising.

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 Types of Crowd Funding : The 3 primary types are donation-based, rewards-based, and
equity crow funding.

1) Donation-Based Crowd Funding l Broadly speaking, you can think of any crowd funding
campaign in which there is no financial return to the investors or contributors as donation-based
crowd funding. Common donation-based crowd funding initiatives include fund raising for disaster
relief, charities, nonprofits, and medical bills.
2) Rewards-Based Crowd Funding : Rewards-based crowd funding involves individuals
contributing to your business in exchange for a “reward,” typically a form of the product or service
your company offers. Even though this method offers backers a reward, it’s still generally considered
a subset of donation-based crowd funding since there is no financial or equity return.
3) Equity-Based Crowd Funding :Unlike the donation-based and rewards-based methods, equity-
based crowd funding allows contributors to become part-owners of your company by trading capital
for equity shares. As equity owners, your contributors receive a financial return on their investment
and ultimately receive a share of the profits in the form of a dividend or distribution.

Micro Finances & What is Micro Finance? : Microfinance is a term used to describe
financial services, such as loans, savings, insurance and fund transfers to entrepreneurs, small businesses
and individuals who lack access to banking services with high collateral requirements. Essentially, it is
providing loans, credit, access to savings accounts – even insurance policies and money transfers to small
business owners, entrepreneurs (many of whom live in the developing world), and those who would
otherwise not have access to these resources.

Importance of MFIs

Microfinance is important because it provides resources and access to capital to the financially
underserved, such as those who are unable to get checking accounts, lines of credit, or loans from
traditional banks.

Without microfinance, these groups may have to resort to using loans or payday advances with extremely
high interest rates or even borrow money from family and friends. Microfinance helps them invest in their
businesses, and as a result, invest in themselves.

While microfinance can certainly benefit those stateside, it can also serve as an important resource for
those in the developing world.

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While some have lauded microfinance as a way to end the cycle of poverty, decrease unemployment,
increase earning power, and aid the financially marginalized, some experts say that it may not work as
well as it should, even going so far as to say it’s lost its mission. Others argue that microfinance simply
makes poverty worse since many borrowers use microloans to pay for basic necessities, or their
businesses fail, which only plunges them further into debt.

loan, and so forth and so forth. This translates into a lot more debt. However, other experts say that
microfinance can serve as a valuable tool for the financially underserved when used it properly. They also
cite the industry’s high repayment rate as proof of its effectiveness. Either way, microfinance is an
important topic in the financial realm, and if done correctly, could be a powerful tool for many.

Micro Finances in Ethiopia

Micro-finance in Ethiopia has its origin in traditional informal method used to accumulate saving and
access credit by people who lacked access to formal financial institutions. Ethiopia has also more 38
MFIs (in 2018) and practice is one of the success stories in Africa even though there are certain
limitations.

The history of formal establishment of Ethiopia Micro finance institution is limited to about less than
twenty years (since 2000). The first groups of few MFIs were established in early 1997 following the
issuance of Proclamation No. 40/1996 in July 1996. The objective of the MFIs is basically poverty
alleviation through the provision of sustainable financial services to the poor who actually do not have
access to the financial support services of other formal financial institutions.