Entrepreneurship: Financing a Business

CHAPTER 8: FINANCING AN ENTREPRENEURIAL BUSINESS LEARNING OUTCOMES LO 1: Determine the capital requirements of a new business. LO 2: Explain the different short-term sources of finance. LO 3: Explain the different medium-term sources of finance. LO 4: Explain...

CHAPTER 8: FINANCING AN ENTREPRENEURIAL BUSINESS LEARNING OUTCOMES LO 1: Determine the capital requirements of a new business. LO 2: Explain the different short-term sources of finance. LO 3: Explain the different medium-term sources of finance. LO 4: Explain the different long-term sources of finance. LO 5: Understand where to obtain finance for the business. LO 6: Explain how the venture capital market works. LO 7: Explain how crowdfunding can be used to finance a business. LO 8: Understand how to attract investors.  8.1 INTRODUCTION Finding finance, or gaining financial support for any new business, is one of the difficulties experienced by entrepreneurs. It is important to know what sources of finance are available and what is required from the various financial institutions such as banks, development agencies and investors. Read: WeBuyCars  8.2 DETERMINING THE FINANCIAL REQUIREMENTS OF THE BUSINESS Determining the business's financial requirements will require forecasting of the future. The basic steps involved in predicting these financing needs are the following: 1. Project the business’s sales, revenues and expenses over the planning period. 2. Estimate the levels of investment in current and fixed assets that are necessary to support the projected sales. 3. Determine the business’s financing needs throughout the planning period. 8.2 DETERMINING THE FINANCIAL REQUIREMENTS OF THE BUSINESS (continued) Figure 8.1 The financial planning process  8.3 SOURCES OF SHORT-TERM FINANCE Finance that is normally repayable or reviewed within 12 months Examples include: – Trade credit: Credit extended by one business to another in the normal course of business – Bank credit: Overdraft facility is associated with a cheque or current account facility – Short-term funds from other sources: There are numerous other lesser-known sources that may be used, but these might not be readily available to the smaller business. These include » bills of exchange » acceptance credits » factoring » customer advance payments » shipper’s finance.  8.4 SOURCES OF MEDIUM-TERM FINANCE Finance that is repayable between one and three years Examples include: – Instalment sale transaction (hire purchase): This is a credit sale in which it is agreed that the purchase price of the item will be paid in instalments. – Leasing finance: A leasing transaction is a transaction in which goods are leased at a stated sum of money at certain dates or a future date, in whole or in instalments. – Medium-term loans: These loans are normally repayable over a 24- to 60-month period and are granted to finance working capital, providing bridging finance until long-term sources of finance can be obtained, or for the acquisition of fixed assets.  8.5 SOURCES OF LONG-TERM FINANCE Long-term funding means that capital is provided for anything up to the entire lifespan of your business. Examples include: – Equity capital: The initial capital that you contribute to the business to get it started » Sole proprietorship – cannot attract equity capital as a source of long-term finance; funds limited to proprietor’s personal assets and creditworthiness » Partnerships – capital accounts » Close corporations – members’ contribution » Companies – share capital – Ordinary shares – Preference shares  8.5 SOURCES OF LONG-TERM FINANCE (continued) – Debentures: Money is borrowed from outside sources by issuing debentures. Debentures are normally printed documents that are fully negotiable and transferable. – Retained earnings: internal financing: For many businesses an important source of long-term finance takes the form of profits that are retained in the business as “reserves”, instead of being distributed as dividends. – Long-term loans/mortgage bonds: This form of finance can only be considered if the business owns immovable property that is not encumbered or only partly encumbered by a mortgage bond.  8.6 INSTITUTIONS THAT SUPPORT SMALL AND NEW BUSINESS BUSINESSES Numerous government, non-governmental and private enterprises are involved in financing new and existing businesses: Commercial banks Merchant banks Business Partners Small Enterprise Finance Agency (sefa) Industrial Development Corporation (IDC) Local business support centres  8.7 INFORMAL SOURCES OF FINANCE 3 Fs – family, fools and friends: It is quite often the only and last resort of start-up entrepreneurs. Stokvels: A stokvel is a savings system with any number of members. All the members contribute to it on a regular basis and all benefit from it. Stokvels have different objectives, as follows: – Savings clubs, where members contribute a fixed amount on a monthly basis to a communal account. – Loan stokvels, where members save money in an account and then lend money to members. – Investment clubs, for members to access opportunities for growth of their combined funds.  8.8 THE VENTURE CAPITAL AND PRIVATE EQUITY MARKET Private equity – Capital raised from various investors (development finance institutions, pension funds, high net-worth individuals or families) Venture capital – A form of private equity that is supplied to a business during its earliest stages of development and growth – Available from venture capital organisations and from “angel investors” 8.8 THE VENTURE CAPITAL AND PRIVATE EQUITY MARKET (continued) Figure 8.2 S-curve Source: Adapted from the website of Holland Private Equity B.V. (2009)  8.9 CROWDFUNDING “Crowdfunding is the use of small amounts of capital from a large number of individuals to finance a new business. Crowdfunding makes use of the easy accessibility of vast networks of people through social media and crowdfunding websites to bring investors and entrepreneurs together. Crowdfunding has the potential to increase entrepreneurship by expanding the pool of investors from whom funds can be raised beyond the traditional circle of owners, relatives and venture capitalists.” (Investopedia 2022)  8.10 ATTRACTING INVESTORS AND THE PRIVATE PLACEMENT OF SHARES Five key stages Stage 1: Making contact – The entrepreneur and the investor have to become aware of each other and make contact. This is also referred to as deal origination. Stage 2: Deal screening – Investors will do an initial evaluation of the proposal to see whether it fits in with the profile of their activities and/or their investment profile.  8.10 ATTRACTING INVESTORS AND THE PRIVATE PLACEMENT OF SHARES (continued) Five key stages (continued) Stage 3: Deal evaluation – The key factors to be considered in this evaluation will be the potential for the business in terms of the innovation it is offering, the conditions in the market it aims to develop, and the competitive pressures it will face. Stage 4: Deal structuring – Refers to how the initial investment will be made and how the investor will see that investment bear fruit. Stage 5: Post-deal activity – Investors usually prefer to retain a degree of involvement. 8.10 ATTRACTING INVESTORS AND THE PRIVATE PLACEMENT OF SHARES (continued) Figure 8.3 The process of attracting investors Source: Adapted from Wickham (2001: 289)  8.11 THE COST OF RAISING FINANCE Many entrepreneurs prefer to grow slowly by using internal cash flow to fund growth. Some have a fear of debt and of giving up control of the business to investors. Figure 8.4 The cost of raising finance Source: Adapted from Allen (1999)  8.11 THE COST OF RAISING FINANCE (continued) Upfront cost: The preparation of the proposal (requires input from chartered accountants, financial consultants, the entrepreneur and an investment banker) Marketing cost: Costs involved in advertising, travelling and brochures. The cost to the entrepreneur in terms of time away from the business while preparing and marketing the proposal is difficult to quantify. Back-end cost: It will depend largely on the financial intermediary or institution used in raising the finance. Back-end costs can include investment banking fees, legal fees, brokerage fees and various other fees.  8.12 INITIAL PUBLIC OFFERING “Going public”, or the initial public offering (IPO), is quite often the ultimate way of raising growth capital. There is no rule of thumb as to when a business must go public. It will need to meet the JSE’s requirements for listing, in particular the requirement of profit history for a specified number of years.  8.13 THE NATIONAL CREDIT ACT 34 OF 2005 The NCA facilitate new and protective rights for consumers for all types of credit agreements. It serves as a measure that allows consumers to make more- informed decisions before buying goods and services on credit.