CAPE Entrepreneurship Unit 2

Module 2 – Objective 4
Lecture Notes – Describe the Sources of Funding

Objective 4 - Describe Sources of Funding

Entrepreneurial finance is the study of value and resource allocation, applied to new ventures.
It addresses key questions which challenge all entrepreneurs: how much money can and should
be raised; when should it be raised and from whom; what is a reasonable valuation of the startup;
and how should funding contracts and exit decisions be structured.

The first step in raising capital is to understand how much capital you need to raise. Successful
businesses anticipate their future cash needs, make plans and execute capital acquisition
strategies well before they find themselves in a cash crunch. Three axioms guide start-up
fundraising:
• As businesses grow, they often go through several rounds or stages of financing. These rounds
are targeted to specific phases of the company's growth and require different strategies and types
of investors.
• Raising capital is an ongoing issue for every venture.
• Capital acquisition takes time and needs to be planned accordingly.

Four critical determinants of the financial need of a venture are generally distinguished:
• Determination of projected sales, their growth, and the profitability level
• Calculation of start-up costs (one-time costs)
• Estimation of recurring costs
• Projection of working capital (inventory, credit and payment policies. This determines the cash
needed to maintain the day-to-day business)

What is funding?
Funding is the act of providing resources to finance a need, program or project. While this is
usually in the form of money, it can also take the form of effort or time from an organization or
company. Sources of funding include credits, venture capital, donations, grant savings, subsidies
and taxes.

Types of Financing/Funding

1. Equity financing
Equity financing refers to the sale of an ownership interest (e.g. shares in an enterprise) to
raise funds for business purposes. Equity financing spans a wide range of activities in
scale and scope, from a few thousand dollars raised by an entrepreneur from friends and
family, to initial public offerings (IPOs) running into the billions by companies like
Google and Facebook.

Characteristics of Ordinary Shares (equity)

 Ordinary shares have a nominal or par value. Nominal or par value is the value stated on
the coin or the note. This is the face value. Ordinary shares have voting rights, dividends
are payable on ordinary shares, the values of which are dependent on company
performance.
Dividends are an appropriation or a use of profits and are therefore payable after
corporation tax. If a company is wound up, the ordinary shareholders are the last to be
considered. It is capital having the highest risk.

2. Debt financing
Debt financing refers to funds borrowed by a firm for working capital or capital
expenditures by selling bonds, bills, or notes to individual and/or institutional investors.
The individuals or institutions lending the money thus become creditors of the firm and
often receive a security that the principal and interest on the debt will be repaid. Security
involves a form of collateral as an assurance the loan will be repaid, to be forfeited to
satisfy payment of the debt if the debtor defaults on the loan.

Sources of debt financing include loans, venture funding, and angel funding.

a. Loans
A loan is a sum of money borrowed by a company from a lender, like a bank, which
must be repaid with interest over a set period of time, allowing the business to access
funds for various purposes such as purchasing equipment, expanding operations,
managing cash flow, or covering operational costs.
Loans require security, example debentures. Now a debenture is a type of debt
instrument that is not secured by collateral and usually has a term greater than 10
years. Debentures are backed only by the credit worthiness and reputation of the
issuer.
Loans have no voting rights and interest is payable on loans. It may be fixed, variable,
rolled over. Interest on loan is an allowable expense for corporation tax and if a
company is wound up, lenders appear near the top of the list for consideration.

b. Venture Capital/Venture Funding

Venture Capital is a specialized form of equity finance used to finance costly, high-
risk, high-return technology-based innovative firms at the pre-seed, seed, start-up, and
early expansion stages of commercialization. The funds are used to develop a
company’s ideas to the stage where their commercial potential is sufficiently proven
for the venture capitalist to sell its equity in the company to another party.
Venture capitalists tend to finance firms during the early stages (when growth is
rapid) and cash out of the venture once it is established. Venture capital funds
typically operate with a ten-year model, where investments and divestments of
portfolio companies must occur within that period to generate returns for institutional
investors. At that time, the business owner may take the company public, repurchase
the investor's stock, merge, be bought by another firm, or in some circumstances
liquidates the firm. Most venture capital investment realizations are by way of a trade
sale.
 Venture capital can stimulate innovation, spur entrepreneurship, and enhance
productivity growth. The venture capital sector is an important component of national
innovation systems, playing an important role in driving innovation and supporting
skills development by providing finance and other support to turn novel ideas into
innovative outputs

c. Angel Funding
Angel funding is the practice of high-net-worth individuals investing their own time
and money in new businesses with the goal of profiting from their long-term growth.
Such investments are characterized by very high levels of risk as most companies are
in the earliest stages and will likely fail.
Angel investors are different from venture capitalists (VCs) in that VCs invest other
people’s money. Motivations are another important distinction between the two;
angels are typically interested in more than just receiving a financial return. Personal
interest, the desire to give back, and the thrill of being involved with an innovative
company are just a few of the reasons why people decide to become angel investors.
Angel investors are typically experienced professionals who can offer wisdom and
guidance to the entrepreneur and have the patience to wait for normal company
maturation. Angels can facilitate new business connections that help start-ups grow,
and they can offer insights based on deep knowledge of an industry. They provide
support and motivation to entrepreneurs to persevere when launching and growing a
business inevitably becomes very challenging.

3. Grants
There are lots of grants out there, and many of them are ideal for tech start-ups looking
for a funding boost, especially if your business is very innovative or specific. This is free
money – you do not have to pay a grant back – and the prestige. Grants are especially
good for businesses in niche industries, where there’s often less competition for the
money. However, grant proposals can take a long time to put together, there can be quite
a lot of competition, and the money has to be used for a specific purpose. It is rare that a
grant can fund the business alone – you’ll usually be expected to match at least part of the
funding with your own finance.

4. Crowdfunding
Crowdfunding in business is the practice of raising capital for a project or venture by
collecting small amounts of money from a large number of people online, typically
through dedicated platforms, where contributors may receive rewards like early access to
a product, equity in the company, or simply the satisfaction of supporting a cause,
depending on the crowdfunding model used.

5. Bequests
 In business terms, a "bequest" refers to a gift of assets, like money or property, that is
specified to be given to a person or organization after the death of the will's creator, as
outlined within a legal document like a will or trust; essentially, it's a way to distribute
assets to beneficiaries upon passing away.
Key points about bequests:
- Will-based:
Bequests are always made through a will or trust, meaning they only take effect after the
person dies.
- Can be to individuals or charities:
You can bequeath assets to family members, friends, or charitable organizations.
- Specific instructions:
A bequest can specify exactly what asset is being given and how it should be used.

6. Gifts
A gift in business financing is a transfer of money or assets to a business without the
expectation of repayment. Gifts can be a way for a business to obtain capital. Examples
of gifts in business financing include money from friends and family where a friend or
family member may offer money to help a business start.