The Relationship between Entrepreneurial Venture Financing and the Life Cycle of a Venture - Term Paper Example

? The relationship between entrepreneurial venture financing and the life cycle of a venture. Table of Contents Table of Contents 2 3 Introduction 3 Problem Statement- 3 Importance of paper- 4 Hypotheses- 4 Methodology 4 Funding pattern and venture life cycle 4 Correlation of funding sources and business needs 5 Seed Capital 6 Start-Up Capital 7 Sources of start-up capital- 7 First stage financing 9 Trade Credit- 10 Factoring- 10 Banks- 11 SBA Loans- 11 Financing in the development or expansionary stage 11 Private equity- 12 Mezzanine financing- 12 Equity Finance- 13 Business Alliances- 15 Commercial financing- 15 Leasing- 15 Seasoned financing 16 Recommendation 16 Reference 18 Bibliography 20 Abstract The paper highlights the varying financing requirements of the business venture at the various stages of development. It has been shown that at very inception the business has to rely on ‘seed capital’. It has also been shown how the businesses fund the opportunities at the expansionary and development stage. In the final stages i.e. at the maturity stage the businesses make use of more traditional sources like issue of additional equity or internally generated funds for financing the expansionary programs. Introduction The word ‘life cycle’ in the context of ventures is used in reference to the various stages of its evolution. The initial stages begin with the commencement of the new venture in the form of efforts and intentions of the nascent organization. This stage is accompanied by the procurement of requisite non-financial and financial resources. Here it is important to highlight that finance forms the ‘backbone’ of every venture. Even the most successful business plans may not eventually be carried out in the event of fund shortage. However, the level and form of financing required for each stage of the business is different. In the initial stages when the entrepreneur has just chalked out the plan for the initiation of the venture some amount of funds are required for assessing the viability and financial feasibility of the proposed venture. This is a part of the early stage financing required by the business. The fund that puts the business in operational mode is referred to as ‘start up capital’. The next stage of financing is for meeting the development or expansionary needs of the business (Parker, 2006, p.1). Problem Statement- The venture life cycle has an impact on the financing pattern of the business venture. In this paper it will be shown how the financing needs of the business is aligned with the various stages such that the entrepreneur can maximise the value of the business venture. Importance of paper- The paper shows that the various stages of business require varying sources of financing. While in the initial stages it may not be possible for a newly formed business to seek for outside equity or lending. In such instances the entrepreneur of the business has to arrange for funds from internal or known sources like family or friends. Again after this the business reaches the development and the growth stage. During these stages the business can seek for external sources like equity capital or venture funds. At the same time it can tap the banks and financial institutions for loans and overdraft facilities. At the maturity stage the business may not have to rely on outside sources as the retained earnings generated over the years can be used for financing the future growth and expansionary plans of the business. This paper manly highlights the importance and the use of various avenues of funds at the various business stages. This can give an entrepreneur an idea as to how to meet the funding requirements or which sources to be tapped at each stage of the business. Hypotheses- This paper assumes that the sources of funds to be employed in the various stages of the business also vary as per the strength and longevity of each stage. Methodology The paper is based on the secondary sources of data. To highlight the various types of funding requirements of the entrepreneur at the various stages of development- early or development or expansionary- various journal articles and books by noted authors have been used. An entrepreneur uses various modes of funding for the varying stages of his venture commonly referred to as the venture life cycle. Based on the data available from these sources the venture life cycle financing will be analysed. Funding pattern and venture life cycle The venture life cycle is divided into four development stages- “start-up, growth, maturity and transfer”. This is in line with the product life cycle theory which was introduced with the aim of explaining the expected product life cycle from the initial stage of design to the final stage of obsolescence. The venture life cycle is also an extension of the concept of product life cycle. The products pass through four similar phases of start-up, growth, maturity and decline. Similarly, the business venture can also be said to follow the pattern of the product life cycle. The goal at each stage of the business is maximisation of business value and profitability. Correlation of funding sources and business needs Start-up stage and funding- In this stage the firm has limited number of assets with limited or nil earnings or net positive cash flows. In this stage the venture needs funds for investing in positive NPV projects. The assets required in this stage are different from the future requirements. In the early stages when the business does not have any proven market it is forced to rely on the friends or family or from the contributions made by the owner himself. Growth stage and funding- In this stage the business initiates investments in growth opportunities with the aid of some financial arrangements. Here the ratio of the assets value to the firm value is high as compared to the start-up stage. The funding requirement in this phase is met from sources like bank loans. Other than bank loans the other funding sources include grants, business profits, leasing options and partnerships. Maturity stage and financing- In this stage the value of available growth options is less than the existing value of assets as compared to the start up and growth stage. The business venture is in the low growth or moderate stage as most of the cash flow requirements of the business venture are generated through internal sources. The potential financing sources in this phase include banks, licensing, joint ventures, partners and new investors. Transfer stage and financing- In the stagnant or transfer stage of the business the number of growth opportunities is limited. There is high market competition and potential market is small. The firms can expand by diversifying themselves i.e. by investing in new technology and product lines (Titus & Robins, 2005). Seed Capital Many business entrepreneurs have plans which may take several years to materialise into something constructive. Nevertheless these business plans may involve huge amount of investment. For these endeavours the entrepreneurs cannot seek financing from outside sources. If the entrepreneur is convinced about the plan then it is prudent to invest his own funds. Some of the business entrepreneurs rely on a modest amount of initial investments and rely mainly on the customer revenues and sales. This concept emerged towards the end of the 1990s at the time of a surge in the venture capital financing. This option assured the founders of a healthy stake in the business venture. The growth in sales and business profitability raise the chances of acquisition of seed capital. (Nour, 2009, p.33). Usually the business ventures face a lot of problems in raising money for early stage financing. In fact even the businesses having a niche market and enjoying a competitive advantage face numerous problems in raising funds and hastening growth. For this reason most of the businesses raise funds from family members or friends. As per Fuenzalida, Mongrut & Nash (2007) there is a methodology for the reduction of asymmetric information. This methodology comprises of 4 stages “prospective stage, risk analysis stage, strategic stage and communication stage”. The basic principle of the initial three stages is that a mere estimation of the firm seeking seed capital is not enough to reduce the problems relating to information asymmetry, this merely helps in estimating the problem. Instead a strategic approach must be used to showcase the business angels that the various possible business scenarios have been carefully assessed and strategies have been devised for risk reduction and profit enhancement. Moreover the business angels can be involved in the “risk analysis stage” as this will further lower the problems relating to information asymmetry between the two parties (Mongrut, 2010). In general seed capital refers to the money required for bringing a business into existence. This may include the acquisition of business premises or acquiring patents on an intellectual property or to design a prototype. One can look upon it as a term that describes the process that the keeper of a garden goes through at the time of plantation of seeds knowing at the very outset that only some of the seeds would make it to the stage of maturity. The financial contributions required at the beginning can come from various sources such as friends or family or from the entrepreneur himself. This can also come from some private individuals or some philanthropic sources like trusts (Bloomfield, 2005, p.3). Start-Up Capital Start up capital is often difficult to raise in the case of small businesses. This type of capital is needed for starting a new business or for the purpose of a major business expansion. The associated costs include equipment, new machinery and marketing. The unavailability of start-up capital can result in the nipping of a revolutionary products or idea in the bud. The communities which do not have an access to the transition capital or start-up capital are always in a disadvantageous position when it comes to attracting innovative businesses or expanding the existing businesses (Lyons & Hamlin, 2001, p.27). Sources of start-up capital- Friends and family- On an estimate nearly 85% of the new business capital is raised from this source. This is regarded as the friendliest sources of financing as the providers of funds here do not demand for their money in time of dry business spell. Banks- With the advancement of the modern financial system the banks also get a close consideration when it comes to financing a new business although merely 15% of the new businesses approach the banks. This is mainly because the banks lend only when there is a strong business proposal. The other not so popular methods of meeting the needs of start up financing are credit cards and defer payments (Phillips, 2009, p.55). Source: (Leach & Melicher, 2009, p.29). The start-up financing corresponds to the start-up stage in the life cycle of the venture. This is the financing that transcends the venture from a viable or feasible business opportunity to the stage of sales and production. This form of financing is aimed at the ventures with a strong management team, sound business plan and model. The assets remaining in the possession of the entrepreneur after meeting the seed capital requirements can serve as start-up financing source. The start-up ventures should also approach the other formal sources of financing other than the family or friends. Although the business starts generating revenue in this stage however the amount of this inflow is much less than the requirement of financial capital. For this reason most of the new businesses have to seek for equity financing from outside the business. The equity capital in this respect is contributed by the venture capitalists. As this amount is invested in the early stages it runs a huge risk of loss of entire amount of investment. On the other side the risk associated with this highly risky investment is matched by the extraordinary high returns that the venture capitalists may earn in the event of a success of the venture. The investor of the venture capital requires the venture to opt for a formal organization with a view to reduce the risk associated with the amount of venture funds invested in the business. The two main sources of formal external capital for the businesses in the start-up stage are venture capitalists and business angels. The business angels include the wealthy individuals who function as a private or informal investor who offer funds for the small business set-ups. The business angels may be referred as informal investors but this does not imply that they are uninformed investors. This is because most of the business angels are highly qualified and self made millionaires and thus possess substantial business acumen and expertise. This form of investors invests in the products, technologies and services with past experience and personal interest. Unlike the business angels the venture capitalists form a part of the formal venture capital firm to acquire and distribute the funds raised to the new and upcoming ventures. The capital raised by the venture capital firms is invested in multiple ventures in a bid to lower the possibility of total loss of invested venture funds (Leach & Melicher, 2009, p.29; Broude & Levangie, n.d.). First stage financing In the life cycle of a venture the survival stage is very critical as it determines whether the business will float and generate value or be shut down and liquidated. The first round of financing refers to outside equity in the form of venture capital funds. This is used to fill the gap between the revenue and expenditures & overall investments. Though, the business is able to generate some revenues in the start-up stage, the bid to acquire a higher market share results in deficit. The business requires funds at this stage for meeting the expenditures relating to marketing and other investments for bringing the business in full operating conditions in the commercial market. Based on the type of the business the requirement of the first stage financing may arise in the last lap of the start-up stage. The ventures at this stage seek funds from various sources. For instance the customers as well as the suppliers form an important source of financing. The business ventures request their suppliers to arrange for trade credit by way of which the business gets the facility to pay for the services consumed on the current date at a later date in the future (Leach & Melicher, 2009, p.29). Trade Credit- After the start of the business and the resumption of the purchase and sale of goods it may need assistance in the form of cash flows which is availed by the use of trade credit extended by the business suppliers in the due business course. On a close examination of this form of credit facility it seems to be a type of informal loan granted by the supplier without the formal procedures relating to negotiation, application, auditing etc required in the case of other forms of capital sources. Through the prudent use of this form of credit a business venture can secure the additional capital requirements without having to depend on the equity investors or the lenders. This source of financing is especially good when the funding requirement is both small as well as for a short duration. Trade credit should be used prudently. The easy availability of this form of credit is especially a welcome in times of limited capital needs. If this type of financing is used irresponsibly then this can ruin the relations with the business suppliers. Along with this it will jeopardise the situation by denying access to competitive suppliers in the market (Vinturella & Erickson, 2003, p.57). Factoring- Factoring offers the ways for the financing of the business receivables and also facilitates the receivables collection. These services form a critical part of the financial services market in the case of developed economies and gained popularity in the developing economies towards the beginning of the 1990s. Factoring broadly refers to the arrangement by way of which the firm sells the receivables arising on the credit sale of goods to ‘factor’ or a financial intermediary. Due to this the ownership title of the goods or services is transmitted to the factor. After this the activities ranging from credit control to collection of debt from the debtor or the buyer comes under the direct control of the factor. In the case of a factoring service which is non-recourse, in the event of a failure of payment by the debtor the losses have to be borne by the factor (Khan, 2008, p.11.23). Banks- For raising debt finance the banks serve as the most sought after sources by the firms. The banks are risk averse and hence are very cautious at the time of granting loan facilities. For this reason a nascent business venture may face may find it difficult to obtain this form of financing unless the entrepreneur can pledge his personal collaterals. Usually, the commercial banks are more involved in giving out business loans as compared to their regular savings counterpart. Therefore it is important to keep these differences in mind before selecting the target bank for the purpose of the loan (Titus & Robins, 2005). SBA Loans- An important funding source for the small sized business ventures in United States is US Small Business Administration (SBA). The business ventures which are not able to access loans from the financial institutions have to depend on the loan programs offered by SBA. An important component of the loan program under SBA is its “7(a) Loan program” which accounts for the loan guarantees offered to various small businesses. The main advantage of this type of loan is that the business ventures can avail the facility of repaying the loan over a long time period. For loans on equipments and for the working capital needs and for the acquisition of real estate and major business equipments, an enterprise can tap this source for availing loans for maturities of 10 years (Titus & Robins, 2005). Financing in the development or expansionary stage A growing business enterprise with stable business operations can fund through internally generated funds and other types of investments which the firm is able to access at this stage by virtue of its established value, operating history and inventory availability and credit background. The various forms of financing in this stage include- private equity, mezzanine financing, retained earnings, equity capital. Private equity- This mode of financing involves the equity provision for the business ventures that are not listed on any stock exchange. The private equity financing can be tapped for developing new technologies and products, expansion of working capital, making new acquisitions or for strengthening the balance sheet of the business. As per KPMG (2001) the private equity can be classified into three broad classes which are development capital, venture capital and funding of buy-outs. The assistance from private equity in the initial stages comes in the form of venture capital. The venture capitalists provide seed capital and also offer financial assistance in the start-up stage. In the expansionary or development stage the private equity assistance comes in the form of development capital. Here the funds are granted for the business ventures in the break-even stage or in times of trading profitability. In the later stages the private equity assistance comes in the form of buyout capital. Here these investors facilitate the takeover of the business by the company management from the owners. Unlike development and venture capital the buyout proceeds go towards settling the claims of business owners (Ebony Consulting International (Pty) Ltd, n.d.). Mezzanine financing- It is difficult to classify mezzanine debt as the distinction between equity and debt gets blurred at this financing level. Mostly this form of financing is a mix of equity and debt. The term ‘mezzanine financing’ is so called as it lies between the “floor of equity” and the “ceiling of senior secured debt”. A common type of mezzanine financing is ‘intermediate-term note’ which is unsecured in nature and is accompanied by stock warrants. The coupons paid on this note may be paid in the form of cash or in kind. In the latter case the company distributes note in lieu of cash. Besides increasing leverage this leads to a rise in the equity stake of the company through the issue of warrants. However, the mezzanine financing may not always be in the debt form as in some cases it may be issued as preferred stock. In such a case the preferred stock carries a fixed dividend payment and also carries ‘the right to conversion’ into the common stock of the company. The crux of the matter is that the mezzanine financing acts as filler between the company’s senior debt and its equity investors (Anson, 2009, p.449). Source: (Anson, 2009, p.449). Mezzanine finance companies charge 12% to 20% on account of the unsecured nature of the financing. This makes it subordinate to the other secured financing sources hence the name subordinate debt. Though this form of financing is not similar to venture capital it usually involves acquiring a small stake in the business (Alterowitz, et al., 2006, p.129). Equity Finance- The enterprise size and its stage of development or growth influence the financial needs and also determine the probable sources of finance. The equity mode of financing is important for the fledgling high risk and high growth business enterprises (Falkena , et al., n.d. p.2). The old companies raise the equity by ploughing back the earnings of the business in the form retained earnings. On the other hand the new companies have to depend on the capital contributed by the owner. The diversified companies that are relatively old can also finance their research and development activities by with the help of bank loans as they can furnish business collateral as security. As per the evidence collected by Scott (2000b) with respect to the US companies falls in line with the above interpretation. It has been seen that the young companies or the companies with inexperienced business managers cannot raise external equity for the purpose of meeting the research and development related expenditures. For this reason the younger firms have to rely on own equity for the purpose of financing their operational activities (Muller & Zimmermann, 2009). The major source of finance for the firms in US debt as is evident from the vast usage of debt as compared to equity by the public firms in the country. This is line with the pecking order theory which states that the businesses must prefer debt over equity and the latter must be used only as a last resort (Arena, 2010). Source: (Muller & Zimmermann, 2009). Business Alliances- In the case of small sized businesses the business alliances in simple terminology refers to ‘bartering’ with suppliers, customers, and sometimes even business competitors. For instance a manufacturing business may get higher prices for its component parts if it uses the label showing the suppliers trademark on its final product. In order to minimise the long run costs associated with research and development. It is important to note that though the partnership arrangements are mostly with the other businesses there may be other financing sources like local community entities, non-profit entities, trade associations which may provide great opportunities for financing the expenditures relating to distribution and advertisement (Titus & Robins, 2005). Commercial financing- The commercial finance corporations give business loans. This type of financial assistance is used by the companies to borrow funds for buying machines & equipments and inventory. This form of financing can serve as a useful resource especially if the business has accessibility to sufficient collateral for pledging against the business loan. These type of financial entities provide significant amount of inventory and accounts receivable financing (Titus & Robins, 2005). Leasing- Leasing can also be a good source of long term financing for mature or growing businesses. One of the most important benefits of leasing is the fact that the initial cash outlay or the initial money shelled out to acquire an access to the usage of an asset is less in the case of leasing as compared to an outright purchase. This form of financing is especially important in the case of growing business ventures which try to derive the maximum value from the available cash resources. But the major drawback of this type of financing is that the business usually ends up paying more over the life of the asset that what it would have paid in the case of an outright purchase of the asset. The leasing can be a judicious choice based on the rate of interest, terms of leasing and estimated equipment life (Titus & Robins, 2005). Seasoned financing At the maturity stage a business venture makes use of seasoned financing. The retained earnings of the business form an important financing source for the businesses in the maturity stage. In the event of additional requirements of funds the business venture can raise loans from banks. Alternatively it can issue new stocks and bonds by taking the assistance of the investment bankers. Generally, the firms in this stage build on a market reputation which they can capitalise. By virtue of its strong reputation in the market a business can raise funds at less than market rates. A firm in the maturity stage which has already securities trading in the market can raise equity and debt by the issue of additional securities in the market. This can be in the form of FPOs (follow-on-public offering). As the growth rate of the matured firm declines to reach the growth of the overall economy, the requirement of capital of the business is not related to business survival as it faced in the start-up stages. The matured firm’s approach to financing is laden with concerns like reduction of taxes, meeting extraordinary expansion, financing mergers & acquisition deals etc. If the firm is able to establish ‘brand equity’ it can fund the expansionary deals by the issue of securities to the target investors (Leach & Melicher, 2009, p.29). Recommendation The above discussion shows that there is an ideal source of financing for each stage of the business. In the nascent stage the business venture can rely on internal sources like family and friends as at this stage the business has no credibility to raise the funds from the market. In the later stages i.e. in the growth and development stage the business can rely on external financing sources like banks and capital markets. The small sized businesses in the growth stage may not be able to raise banks loans as these loans are given on the basis of financial credibility or business collateral. As this type of business may not have access to collateral they can make use of funding sources like leasing, factoring, business alliances etc. In the maturity stage the business has build up enough credibility that can enable it to take bank loans or issue additional securities. Reference Alterowitz, R. Zonderman, J. Entrepreneur Press. (2006). Financing your business made easy. Entrepreneur Press. Anson, P.J.M. (2009). CAIA Level I: An Introduction to Core Topics in Alternative Investments. 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