20140829084700_Topic 8 Financing a New Small Business

STUDY GUIDE BMSB5103 Small Business Management

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Topic 8: Financing a New Small Business

Learning Outcomes

By the end of this topic, you should be able to:

1. Explain why most entrepreneurial ventures need to raise money during their early life;

2. Identify the three sources of personal financing available to entrepreneurs;

3. Discuss the difference between equity funding and debt financing;

4. Describe how the nature of a firm affects its financing sources;

5. Identify typical sources of financing used at the outset of a new venture;

6. Distinguish among the different government loan programmes available to small companies; and

7. Explain when large companies and public stock offerings can be sources of financing.

Topic Overview

This topic focuses on the important topic of getting financing or funding. It begins by describing why most new ventures need funding. Sources of personal financing, which includes an entrepreneur using his or her personal funds, bootstrapping and borrowing from friends and family, which are common occurrence in start-up firms are then followed. Strategies for preparing to raise debt or equity financing are also discussed. The topic also focuses on the primary ways that entrepreneurs raise money: equity funding or debt financing. The common sources of both equity funding and debt financing are highlighted. The topic concludes with a discussion of creative sources of financing and funding, which includes leasing, government grants, other grant programmes and strategic partners.


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Focus Areas and Assigned Readings

Focus Areas Assigned Readings

8.1 Importance of Getting Financing or Funding (a) Why Most Ventures Need Funding (b) Sources of Personal Financing (c) Preparing to Raise Debt or Equity

Financing

Moore et al. (2010). Chapter 12, pp 309-311 Extra Readings: Barringer and Ireland (2011). Chapter 10, pp 339-342; Schaper et al.(2012). Chapter 9, pp 220-223; Scarborough (2012). Chapter 14 pp 467-469.

8.2 Sources of Equity Funding (a) Business Angels (b) Venture Capital (c) Initial Public Offering


8.3 Sources of Debt Financing (a) Commercial Banks (b) CGC Guaranteed Loans (c) Other Sources of Debt Financing


8.4 Creative Sources of Financing and Funding (a) Leasing (b) SME Corp Grant (c) Programmes (d) Other Grant Programmes (e) Strategic Partners

Moore et al. (2010). Chapter 12, pp 312-316 Extra Readings: Barringer and Ireland (2011). Chapter 10, pp 358-360; Schaper et al.(2012). Chapter 9, pp 234-238.

Other Sources 1. Developing a pricing strategy

http://www2.owen.vanderbilt.edu/mike.shor/courses/pricing/syllabus.pdf

2. Understanding pricing objectives and strategies http://pubs.cas.psu.edu/freepubs/pdfs/ua441.pdf

3. Pricing strategieshttp://www2.owen.vanderbilt.edu/mike.shor/courses/pricing/syllabus.pdf


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Content Summary

8.1 Importance of Getting Financing or Funding x Why Most New Ventures Need Funding There are three reasons that most new firms need to raise money during their early life:

(a) Cash Flow Challenges: Inventory must be purchased, employees must be trained and paid, and advertising must be paid for beforecash is generated from sales.

(b) Cash Investments: The cost of buying real estate, building facilities,and purchasing equipment typically exceeds a firms ability to provide funds for these needs on its own.

(c) Lengthy Product Development Cycles: Some products are under development for years before they generate earnings. The upfront costs often exceed a firms ability to fund these activities on its own.

x Source of Personal Financing (a) Typically, the seed money that gets a company off the ground

comes from the founders themselves from personal savings, mortgages, credit cards and by tapping into the cash value of life insurance.

(b) Friends and family are the second source of funds for many new ventures.

(c) This form of contribution often comes in the form of loans or investments but can also involve outright gifts, forgone or delayed compensation, or reduced fees or rent.

(d) Another source of seed money for new ventures is referred to as bootstrapping. This is the use of creativity, ingenuity and any means possible to obtain resources other than borrowing money or raising capital from traditional sources.

x Preparing to Raise Debt or Equity Financing At least three steps are involved:

(a) Step 1: Determine precisely how much money the company needs

(b) Step 2: Determine the most appropriate type of financing or funding


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(c) Step 3: Develop a strategy for engaging potential investors or bankers

8.2 Sources of Equity Funding x Business Angels These are individuals who invest their personal capital directly in start-ups.

(a) The prototypical business angel is about 50 years old, has high income and wealth, is well educated, has succeeded as an entrepreneur, and is interested in the start-up process.

(b) The number of angel investors in the US has increased dramatically over the past decade, partly because of the high returns some report.

(c) Business angels are valuable because of their willingness to make relatively small investments. This gives access to equity funding to a start-up that needs just US$50,000 rather than the US$1 million minimum investment that most venture capitalists require.

x Venture Capital (a) Venture capital is money that is invested by venture capital

firms in start-ups and small businesses with exceptional growth potential.

(b) Venture capital firms are limited partnerships of money managers who raise money in funds to invest in start-ups and growing firms. The funds, or pools of money, are raised from wealthy individuals, pension plans, university endowments, foreign investors, and similar sources.

(c) Many entrepreneurs get discouraged when they are repeatedly rejected for venture capital funding, even though they may have an excellent business plan. Venture capitalists are looking for the home run and so reject the majority of the proposals they consider.

x Initial Public Offering (a) An IPO is the first sale of stock by a firm to the public. When a

company goes public, its stock is typically traded on one of the major stock exchanges.

(b) Firms decided to go public for the following reasons: (1) it is a way to raise equity capital to fund current and future operations; (2) an IPO raises a firms public profile; (3) an IPO is a liquidity


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event; and (4) an IPO creates another form of currency for a firm (liquid stock).

(c) Although there are many advantages to going public, it is a complicated and expensive process. The first step is to hire an investment bank. An investment bank is an institution, such as Credit Suisse First Boston, that acts as an underwriter or agent for a firm issuing securities. The investment bank acts as the firms advocate and adviser and walks it through the process of going public.

8.3 Sources of Debt Financing

x Commercial Banks (a) Historically, commercial banks have not been viewed as

practical sources of financing for start-up firms. This sentiment is not a knock against banks, it is just that banks are risk adverse, and financing start-ups is risky business.

(b) There are two reasons that banks have historically been reluctant to lend money to start-ups.

(i) First, as mentioned previously, banks are risk adverse. In addition, banks frequently have internal controls and regulatory restrictions prohibiting them from making high-risk loans.

(ii) Second, lending to small firms is not as profitable as lending to large firms. In many instances, it is simply not worth a bankers time to do the due diligence necessary to determine the entrepreneurs risk profile.

x CGC Guaranteed Loans (a) Many banks in Malaysia participate in the CGC Guaranteed

Loan Programme. They are an important source of funding for small businesses in general.

(b) Almost all small businesses are eligible to apply for an CGC guaranteed loan.

(c) The CGC can guarantee as much as 85 percent (debt to equity) on loans up to $150,000 and 75% on loans of over $150,000.

(d) In most cases, the maximum guarantee is $1.5 million.


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x Other Sources of Debt Financing (a) There are a variety of other avenues that business owners can

pursue

(b) to borrow money.

(c) Credit cards, although easy to obtain, should be used sparingly.

(d) One source that is getting quite a bit of attention is Prosper.com.

8.4 Creative Sources of Financing and Funding x Leasing: A lease is a written agreement in which the owner of a piece of property allows an individual or business to use the property for a specified period of time in exchange for payments. x SME Corp Grant Programmes: A wide range of grants and development programmes is offered to small business in Malaysia by SME Corp. Please visit this website to explore more: http://www.smecorp.gov.my/v4/ x Other Grant Programmes: Almost all ministries in Malaysia provide grants and funding directly or indirectly for small business. x Strategic Partners: These are another source of capital for new ventures. Indeed, strategic partners often play a critical role in helping young firms fund their operations and round out their business models. Biotechnology, for example, relies heavily on partners for financial support.

Study Questions

1. To what extent do entrepreneurs rely on their personal funds and funds from friends and families to finance their ventures? What are the three rules of thumb that a business owner should follow when asking friends and family members for start-up funds?

2. Describe the three steps involved in properly preparing to raise debt or equity financing.

3. Briefly describe the difference between equity funding and debt financing. Discuss advantages and disadvantages of these two types of funding.

4. Describe what is meant by the term venture capital. Where do venture capital firms get their money? What types of firms do venture capitalists commonly want to fund? Why?

5. Describe the nature of business angel funding. What types of people typically become business angels, and what is the unique role that business angels play in the process of funding entrepreneurial firms?


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6. Based on this case study, answer the question that follows.

FRUSTRATED LOOK

Ed Sayers just returned from a meeting with his banker with a frustrated look on his face. He tosses his keys on the kitchen counter and tells his wife, I just cant understand where my banker is coming from. I have a great idea for a new firm but the bank isnt interested in helping me with a loan. Tomorrow, Im going to visit a couple of other banks to see if I have better luck.

Source: Barringer and Ireland (2010), Chapter 10

(a) Do you think Ed will have any better luck with the second and third bank he visits? Why?

7. Based on this case study, answer the questions that follow.

BANK DEMANDING GUARANTEE

Sidek is the owner-manager of Bikar Products, a small metal stamper based in Klang, Selangor. Sidek has a long-term relationship with his banker. But recently his firm ran into financial difficulty and the bank is demanding that Sidek personally guarantee 100 percent of the companys loans. Sidek would prefer not to do so but is not sure that he has a choice.

Source: Adapted from Moore et al. 2010, Chapter 12

(a) Should Sidek be surprised by the banks demand for a personal guarantee? Why?

(b) What would you advise Sidek to do?

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20140829084700_Topic 8 Financing a New Small Business