Topic 7

Financing new and

growing business ventures

Prepared by Thierry Volery

Swiss Institute of Entrepreneurship and Small Business
University of St Gallen
 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
 A typology of finance
• Three main ways can be used to categorise
financing:
– fund provider perspective (equity and debt)

– timeframe perspective ( long and short term)

– life-stage perspective ( early stage vs expansion)

 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
 Debt vs equity
• Main differences between debt and equity:
– equity provides a residual ownership interest in
the business, whereas debt does not
– 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
• The degree to which a business is utilising
borrowed money, or leverage, will
depend upon the business needs, and
whether it can meet the assessment
criteria required by each mode of finance
 Debt vs equity
• 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’(hierarchical order) of:
– internal equity – owners contribution

– short-term debt

– long-term debt

– external equity – shareholders investments

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)
Short-term vs long-term finance
• Bridging finance
– (interim loans with a short fixed term) can be
used to finance accounts receivable
contracts, which are risk free but delayed for
1 -3 months.
 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
– 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
– 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

Figure 9.1
Financing challenges for start-ups
and innovative SMEs
• The entrepreneurs' search for funding has
become harder in recent years with the
opening of the "equity gap" — a scarcity of
ready sources of outside financing in the
early stage of a firm's growth
• These reasons for the equity gap stem
both from the supply side (the investors)
and the demand side (the entrepreneurs)
Equity gap: the supply side
• On the supply side, the equity gap exists
because two well-trawled sources of
finance - owners savings and VC funds -no
longer overlap
• Information asymmetries mean that VCs
can face significant costs in identifying
suitable investment opportunities
Equity gap: the demand side
• Entrepreneurs are often reluctant to dilute
their ownership or cede a share of control to
equity investors and instead try to borrow or
accept limits to the firm's growth
• Being able to understand the concerns and
needs of investors is essential for
entrepreneurs who try to obtain risk capital
financing
 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
 Bank overdraft
• 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
 Five Cs of credit
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

– 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 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
 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
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
Alternative sources of finance
• Factoring would be suitable to a SME
with the following attributes:
– sales are on credit and not for cash

– 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
– 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
• There are three major issues to consider
when seeking financing:
– whether the venture should be funded
through debt, equity or a combination of both
– whether the funding is needed on a short-
term or long-term timeframe
– what point in the business life cycle the firm is
at (early stage or expansion)
 Summary
• The first type of finance is debt, which
includes short-term options such as a
bank overdraft and trade credit, as well
as long-term products such as leasing,
term loans and loan capital
• The second type of finance is equity in
the form of owner’s equity, retained
profits, family and friends funding,
business angels investments, venture
capital and publicly raised equity
 Summary
• It is possible to identify four main types of
alternative financing:
– debt factoring

– advances from customers

– leasing

– government-backed schemes