Financial Bootstrapping in New Venture - Literature review Example

Financial Bootstrapping in new venture Introduction It has been frequently noticed that small ventures face constraints regarding financing from traditional sources due to high transactional costs and asymmetrical information. Most small firms respond to these issues through various creative financing approaches such as bootstrapping, which help them in avoiding immediate need of external financing such as long-term debt (Ekanem, 2005). Additionally, the great recession of 2008 also contributed significantly towards reluctance of financial institutions towards funding new businesses. As a consequence of the recession, risk aversion for venture capitalists, banks and angel investors is observed to be alike. In this regard, bootstrapping is considered as an art of generating cash flow while minimising overall operational expenses (Ebben and Johnson, 2006). In the following section, financial bootstrapping and its role in new venture has been assessed critically and discussed in an elaborate manner. What is bootstrapping? Bootstrapping is essentially an entrepreneurial financial strategy which implies implementation of various methods for acquiring resource needs of an organisation without relying extensively on external sources of long term finance from shareholders and debt holders. According to Harrison, Mason and Girling (2004), bootstrapping strategies can be summarised into two forms. The first strategy involves, applying creative measures for acquiring finance without raising equity capital from traditional sources and recourse to financial institutions. The second approach involves, adopting strategies that helps in elimination or minimisation of fund needs by securing resources at minimum or no cost. Considering the nature of financial bootstrapping, the phenomenon is extensively used to either reduce requirement of financial capital or determine various alternative sources of financing. According to Winborg and Landstorm (2001), bootstrapping is a highly unconventional and creative method and is developed by combining various combinations of techniques that allows business owners to take advantage of personal source of finance, improves inflow of capital and minimises overall financial requirements. Generally, these methods range from contribution of personal earning by the entrepreneur, sharing of common non-critical resources with other firms to bartering of goods and services. Studies suggest that, the bootstrapping methods are not limited to new firms only; this method is adopted by various small firms as well. Research suggests that despite limited literary work, bootstrapping is widely implemented in technology and non-technology based companies in different industries (Auken, 2005; Carter and Auken, 2005). Relationship between bootstrapping and firm’s financial condition Different authors have identified a number of bootstrapping methods which are adopted by various firms, but it is necessary to determine whether adopted bootstrapping method shares any relationship with the existing financial condition of a firm. Additionally, it is also necessary to understand whether adopted bootstrapping measure alleviate the constraints for which it has been adopted. Freear, Sohl and Wetzel (1995) in their study classified bootstrapping in two categories, namely, product development and business development. Since bootstrapping strategies primarily aims at minimisation of financial requirements, the relevant techniques regarding limiting initial start-up costs include selection of industry where capital requirement is relatively low, employing low cost workforce, greater involvement of family members in business, seeking extended credit terms, renting or buying second-hand machineries, renting small work space or operating from home and contracting state owned enterprises. Various methods of bootstrapping In this regard, Winborg and Landstrom (2001) performed exploratory research and determined 25 specific bootstrapping methods which can be further clubbed in six different categories namely, owner financing methods (identified direct and indirect sources of resources from owner and manager), minimisation of accounts receivables (methods that help in quick mobilisation of receivables), joint utilisation (sharing and borrowing resources with other businesses including equipments and manpower), delayed payment (involve different kind of negotiations) and subsidy financing ( availing subsidies from government organisations). The groups of financial bootstrapping techniques that has been discussed by Winborg and Landstrom (2001) are use of credit card of manager, short term loan from friend and family members, withholding of salary of owner as well as of manager, part-time working with other firms, assigning jobs to relatives for non-market salary, ending business with delaying debtors, speeding of routines through invoicing, applying interest on overdue payments, applying same payment conditions for all consumers, sharing and borrowing equipments, coordinating purchase with other businesses, owning equipments that is common with other businesses, adopting barter practice instead of purchasing and selling, leasing of equipments and non-living resources, delay payment to suppliers, delay payment of certain taxes, routines for minimisation of stock, negotiating best conditions with suppliers, subsidy from government organisations, greater emphasis on cash payment through cash discounts, raising capital through factoring and sharing premises and employees with similar or non-similar organisations (Smith, 2009). Advantages and practices related to bootstrapping for minimisation of start-up costs Bootstrap financing involve a number of advantages, some of these are primarily related to start-up costs. It has been observed that, bootstrapping enhances the net intangible worth of a business as investors are mostly attracted towards those ventures that have negligible debt and unclear equity position. With no short term and long term debts, the entrepreneur will not have to bear interest related costs on borrowed fund. Bootstrapping helps entrepreneur in locating opportunities related to profit building and implementing innovation in the business to a greater extent. The bootstrapping methods are explained as follows. Trade credit Trade credit is the process of selling goods or inventories to buyers on credit terms instead of instant cash payment. Generally, suppliers provide trade credit of certain period (30days, 60days or 90days) to their regular consumers without charging any kind of interest. However, new businesses may face difficult availing trade credits due to newness in the industry and lack of trust factor. New buyers are usually asked by suppliers to make instant payment, advance payment or cash on delivery. For convincing suppliers to provide credit, business owners need to provide assurance so as to establish their credibility. Trade credit is considered as a relatively fair practice of raising fund during initial start-up but an entrepreneur needs to negotiate appropriately with suppliers. In this regard, an appropriate strategy can be preparation of properly planned financial statement and present it to the suppliers. Trade credit also helps in minimising the cost of working capital, as most of daily inventory costs form the working capital of the firm. However, under no circumstance, a business owner should consider it as a long term solution and should be implemented only during initial phase of the business (Winborg, 2009). Cost of Trade Credit The cost of trade credit can be relatively high depending upon the terms of credit policy that has been availed from the suppliers. For instance, if a supplier provides two percent discount on payment within ten days of 30 day credit period, then the venture has two choices: either availing two percent discount or make delayed payment after twenty days. From a long term perspective (annually), availing two percent discount on every supply will enable the venture to earn a total of 36 percent of discount on the total cost. Beside cash discounts, the business owner must take in consider other factors such as penalties associate with late payment (Payment beyond agreed period of credit terms). Generally these charges are one or two percent of net purchase in a month. On an annualised basis, missed terms can make a business pay 12 to 24 percent more than the actual cost. Effective utilisation of trade credit involves appropriate planning, so that unnecessary costs can be avoided by availing cash discounts and late penalties are also avoided. Alongside, cost and benefits of trade credit should be balanced in such a manner that no additional fund is borrowed for managing cost of working capital (Winborg, 2009). Factoring Factoring is a very common financing method adopted by firms to enhance their liquidity position. In invoice factoring, a firm generally sells off its account receivables to buyers such as commercial financing companies for raising capital. These companies buy the invoice at a discounted price so that the business can have capital, a little less than the actual value of the receivables. Factoring does not require notification to debtors and the business owner can conduct invoice factoring at any point of time. Factoring is generally not recommended as a certain part of the earning is lost due to discounting factor but it is a very useful financial tool when a firm is undercapitalized. Generally, issues related to undercapitalisation is often observed at start-up firms where factoring can be implemented by owners. Factoring helps in reducing internal cost associated with maintenance of the receivables such as bookkeeping, verification and collection. Alongside, it frees up fund that the firm can make better utilisation in a strategic manner. Through factoring, new firms will be able to raise fund for various operations without worrying about the customer to make payment (Ebben, 2009). Customers Customers are often considered as essential source of bootstrap financing and there are different ways of extracting benefits from these assets. One of the useful techniques of obtaining fund from consumers is to have them write letter of credit to the business. A new business having large order from a consumer will be benefited significantly by letter of credit as it will help the firm to have certain security on behalf of the consumer. Alongside, the business will not have to invest anything from its own fund regarding purchasing of resources and other payments as the owner can use the letter of credit as source of security to the suppliers. It has been observed that, financial bootstrapping through customer funding helps in developing strategic roadmap for a new venture. Relying on upfront payment is not a new concept but generally used by new firms only or by firms that are involve in heavy investment regarding consumer products. Consumer financing can be obtained by selling the basic product idea to the consumer. Consumer financing can also be obtained by implementing matchmaker model where the business is responsible for bringing together buyers and sellers such that need of capital is reduced due to little or no capital and low cost of sales (Mullins, 2014). Real estate Real estate is an effective source of bootstrapping and frequently implemented by start-up firms for having greater access to financial resources or minimise the requirement. Often firms lease their business premises so that extra cost associated with purchasing of business premises is saved. The leasing minimises start-up cost as purchasing require relatively more investment. Additionally, business owners should look for opportunities of negotiation with leaser so that payments can be made with respect to growth pattern and seasonal peaks. Another important factor should be taken in consideration that, when a business purchases its operational facilities, the initial cost will rise but the net cost will be distributed or can be financed over a period of 20 to 30 years. Additionally, the loan regarding the facility can be structured in such a manner that optimum utilisation of planned growth is implemented. The business owner can arrange for graduated payment mortgage which involve low initial payments. Other advantages of outright purchase of facilities include continuous appreciation in the value of the property. Additionally, business owners can borrow against their personal real estate for funding their new ventures (Ebben, 2009). Equipment suppliers In a start-up firm, heavy investment in equipment during the initial period of the venture is not considered appropriate because, this will result in insufficient level of working capital for the daily operations of the firm. Therefore, instead of immediate payment for the equipments, it is recommended that business owner purchase the equipments on instalment basis so that a lump sum is not paid at a time. Consequently, equipment suppliers become a significant source of financial bootstrapping. Two kind of credit contracts have been recognised which are commonly used for financing equipment purchases: 1. A conditional sales contract is a kind of contract where a purchaser does not own the title of the equipment till the total cost is paid to the seller. 2. A chattel-mortgage contract is the second kind of contract where the equipment, after delivery becomes property of the buyer; however, the seller will hold mortgage claim against the same as long as the specified amount of the contract is not paid in full. Equipment supplier as a bootstrapping financer helps a firm to have sufficient fund for initial business start-up (Ebben, 2009). Leasing Leasing is considered as an effective alternative of purchasing and is useful when business owners are engaged in new ventures. Leasing further, prevent unnecessary consumption of initial start-up cost. Leasing is beneficial to lessor as well as lessee as the lessor enjoys capital appreciation and tax benefits while the lessee does not need to bear extra cost associated with purchasing of resources. Additionally, lessee does not need to bear any maintenance cost as it is generally included in the lease package and thereby, saves certain amount of start-up cost (Lam, 2010; Ebben, 2009). Conclusion Bootstrapping is not a very recent concept but is a very unconventional one which is generally implemented by new firms. Financial bootstrapping focuses on minimisation of financial requirements of new ventures by presenting innovative opportunities to entrepreneurs. In this paper, various method of financial bootstrapping has been discussed which may prove useful for new start-ups and entrepreneurs. Reference List Auken, H. V., 2005. Differences in the Usage of Bootstrap Financing among Technology‐Based versus Nontechnology‐Based Firms. Journal of Small Business Management, 43(1), pp. 93-103. Carter, R. B. and Auken, H.V., 2005. Bootstrap financing and owners’ perceptions of their business constraints and opportunities. Entrepreneurship & Regional Development, 17(2), pp. 129-144. Ebben, J. and Johnson, A., 2006. Bootstrapping in small firms: An empirical analysis of change over time. Journal of Business Venturing, 21(6), pp. 851-865. Ebben, J. J., 2009. Bootstrapping and the financial condition of small firms. International Journal of Entrepreneurial Behaviour & Research, 15(4), pp. 346-363. Ekanem, I., 2005. ‘Bootstrapping’: the investment decision-making process in small firms. The British Accounting Review, 37(3), pp. 299-318. Freear, J., Sohl, J. E. and Wetzel, W. E., 1995. Angels: personal investors in the venture capital market. Entrepreneurship & Regional Development, 7(1), pp. 85-94. Harrison, R., Mason, C. and Girling, P., 2004. Financial bootstrapping and venture development in the software industry. Entrepreneurship & Regional Development, 16, pp. 307-333. Lam, W., 2010. Funding gap, what funding gap? Financial bootstrapping: supply, demand and creation of entrepreneurial finance. International Journal of Entrepreneurial Behaviour & Research, 16(4), pp. 268-295. Mullins, J., 2014. The Customer-Funded Business: Start, Finance, or Grow Your Company with Your Customers Cash. New Jersey: Wiley. Smith, D., 2009. Financial bootstrapping and social capital: How technology-based start-ups fund innovation. International Journal of Entrepreneurship and Innovation Management, 10(2), pp. 199-209. Winborg, J. and Landström, H., 2001. Financial bootstrapping in small businesses: examining small business managers resource acquisition behaviors. Journal of Business Venturing, 16(3), pp. 235-254. Winborg, J., 2009. Use of financial bootstrapping in new businesses: a question of last resort? Venture Capital, 11(1), pp. 71-83. Read More