Major Issues Related to Entrepreneurial Finance - Literature review Example

MAJOR ISSUES RELATED TO ENTERPRENEURIAL FINANCE Major Issues related to Entrepreneurial Finance The concept of entrepreneurial finance has attracted considerable attention over the years, mostly in the field of research. The term appears with increasingly and notable frequency in scholarly journals, popular press, credible websites, and books. This paper has discussed various related issues such as alternative sources of financing, financial contracting, public policy, and private equity. Research on the issues has yielded a number of significant findings and gaps that should be addressed in future to enhance comprehension and improve the field of research as well as help both the small and large firms. Finally, the last section of the paper sums up the entire paper, including the apparent gaps in literature. Major Issues related to Entrepreneurial Finance Introduction There has been development of research in the realm of entrepreneurial finance. Most researchers are now interested in surveying how numerous issues impact finance and businesses. Denis (2004) claims that entrepreneurship was initially seen to be separate from corporate finance since challenges encountered in the two domains were different. However, in the recent years, financiers have realized that both entrepreneurial situations are characterized by two major challenges, which are asymmetric information and agency dilemmas. In entrepreneurial finance, the importance of the aforementioned problems is greater; hence, need recourse to rational contractual solutions. Some of the main issues that have been discussed and need more research in this field include, but are not limited to, financial contracting, public policy, other sources of capital, and the mechanisms or dynamics related to private equity risks as well returns among others (Cumming 2012). Therefore, the main purpose of this paper is to offer a critical and detailed overview of the major issues in entrepreneurial finance. The issues discussed are not exhaustive set but, rather, they are the main areas that have been widely studied. Discussion This section focuses on discussing the major issues with regard to entrepreneurial finance such as public policy, sources of alternative financing, returns on private equity as well as the risks involved, and problems surrounding the area of financial contracts Financial Contracting Various scholarly articles have discussed in length on the issue of financial contracting in the area of entrepreneurial finance. Denis (2004) and Sahlman (2005) assert that although most of the studies have been devoted to the area of financial contracting, the question regarding the optimal contract between the financier and the creator, mostly in the area of venture capital has not been discussed fully; hence, there is a need for more research. The scholars go on to argue that information asymmetries is likely to occur; hence, resulting to major conflict of interest. This is because it is often difficult for external investors to establish the probable value and quality of technological oriented innovations. On the other hand, the entrepreneurs tend to understand the need and quality of innovation in the area of technology. Another major problem that characterizes the entrepreneurial financial firms is in relation to moral hazard whereby it is highly likely for the entrepreneurs to misallocate the funds, by spending it for their own selfish gains. For instance, it is possible for an entrepreneur to invest their funds in activities that bring little returns to the investors. As seen in Rassoul (2006) as well as Kaplan and Stromberg (2002), finance related literature has continuously evolved, and in an era where there are problems related to moral hazard, agency dilemmas, signaling, and asymmetric information, other related issues that should be researched and focused on include the nature of the contracts, numerous restrictive clauses, ways to monitor the investments, and the main costs or expenses used when financing. One of the attractive features in the research conducted in this field is that it not only explains some of the challenges regarding financial contracts but also explains and offers sound solutions. For instance, Denis (2004) proposes that the incentive contracts be designed in a manner that optimizes the reality of the entrepreneurs influence and effort as far as profits and outputs are concerned. On the same note, he claims that there is need to have control rights to determine the people who make decisions within the firm. Although the proposed strategies are rational, they are insufficient and primarily focus on the problem of moral hazard and not necessarily the information asymmetries between the entrepreneurs and the investors. There should be more literature on ways in which firms can allocate the rights of cash flow, decision rights, as well as voting control to address the major challenges within the financial contracts. There are other financial contracting issues that have been immensely discussed in literature such as the type of covenants in the contract, security issued, and the control as well as the ownership rights. For instance, when there are vast information asymmetries, there is a need to utilize the preferred securities in order to force the entrepreneurs to focus on the firm’s business plan (Denis 2004). Although such measure can be used to correct the issue of asymmetry, it is incomplete since it does not discuss the conversion feature that is mostly seen in contracts, relating to venture capital. Most of the literature has discussed the issue of convertibles. For instance, Hellman and Puri (2002, pp. 170-172) affirm that convertibles are important in making exit decisions and allocating rights to cash flow. It is then apparent that the issue of financial contracting is significant in entrepreneurial finance and there should be more research to come up with more solutions since the ones suggested are not sufficient. Returns on Private Equities and Risks Involved The private equity field has grown extensively over the years. According to Kaplan and Schoar (2000), commitments related to partnerships on venture capital heightened from $10 billion in the year 1991 to approximately $ 180 billion in 2000. However, it is unfortunate that there is little work that has been published, focusing on the returns and risks of private equity. The main challenge has been the unavailability of data. Nevertheless, some scholars have given a limelight on the issue of returns as well as risks with regard to private equity. For instance, Cochrane (2005), using the VentureOne database, examines in great detail on some of the risks as well as returns in entrepreneurial finance. The article reports on the shares as well as investments that are sold. This means that returns can be calculated in case there are exits such as the firm going public or goes out of business. In that case, the scenario creates a bias on the basis of sample selection since it means that only successful firms choose to go public. As for the companies that remain private, their returns are not calculated. In his model, Cochrane does a tremendous job since he focuses on circumventing the selection bias by using the maximum probable procedures to measure the dynamics and the likelihood of a firm going public and the point at which the company runs out of business. Cochrane finds out that one of the main problems is that returns are usually volatile, though at later stages they are less risky. Consequently, with the volatility, the alphas as well as the arithmetic returns are higher. In contrast, unlike Cochrane (2005) who analyzes projects related to venture capital, Kaplan and Schoar (2000) examine the venture capital funds returns. One of the challenges that is apparent is that the venture capital funds are organized on the basis of limited partnerships. As a result, the researcher is forced to wait to measure on the returns until the investors are paid. The evidence in Kaplan and Schoar (2000) and Cochrane (2005) reveals that the investments in private equity are unlikely to earn more returns. However, the articles fail to take into account on the fact that risk portfolios of the firms as well as the timing with regard to the cash flows play a major role and they are determinant to the rate of risks or returns. It is then sound to argue that although there has been development in the area of private equity and its relationship to entrepreneurial finance, knowledge on the dynamics of returns is unsatisfactory. Analysis on the field is complicated since there is lack of enough data and selection biases in the datasets that are available. For that reason, it is uncertain on whether public equity returns are different from private equity. This calls for more research to be conducted in order to examine if there are differences. In case there are no differences, additional work should aim at discussing the main motives of entrepreneurial investments, regarding substandard risk-return tradeoffs. On the other hand, in case there are differences, more research should focus on whether the divergences represent compensation for illiquidity, the failure to diversify, and for the non-financial services that are offered by venture capitalists. Although the articles have critically discussed the issue of financing contracts, they are gaps since the role of institutional as well as the legal environments in developing optimal financial contracts have not been exhausted; hence, a need for more research. Issues of Public Policy It is undoubtedly that innovations are significant for entrepreneurial firms in enhancing development. Therefore, if entrepreneurial businesses are significant components in guaranteeing economic development, then, public policy ought to be geared towards motivating the activity and making sure there is a competitive edge. Most of the studies have examined ways in which public policies can be shaped in order to stimulate the financing of entrepreneurial oriented organizations. Some of the studies focus on those policies that promote the enhancement of markets in order to finance new ventures whereas others examine policies that are related to direct financing. Coelho, de Meza and Reyniers (2004) discuss the issue of public policy in the area of entrepreneurial finance. They argue that the public’s understanding on the ideal policies that can help in financing entrepreneurship is limited since the government has failed to finance entrepreneurial activities and ventures in their respective nations. Lack of meticulous evaluation and misaligned incentives have plagued the sector of finance and entrepreneurship. The researchers allege that there is a link between choices with regard to public policy and the enhancement of venture financing as well as related markets. Correspondingly, Kortum and Lerner (2000) claim that public policy and entrepreneurial finance are interlinked. They examine the various types of tax incentives and policies that help entrepreneurial finance across the globe such as research and development tax policies, capital gains, stock options taxation, and double treatise of taxation. The best tax mechanism that affects the venture capital market is capital gains, whereby, there is a direct causality between venture capital and lower taxation of capital gains. The capital gain tax policy is beneficial since it offers incentives for the private investors to contribute enough capital and venture in entrepreneurial firms. However, its major drawback is that it offers lower tax revenue. A closer look at the impact of tax policies on the activities of the entrepreneurs show that progressive scheduling of tax tends to tax profit at a higher margin than the extent to which the losses are deducted. Lerner (2006) and Lantz and Sahut (2009) emphasize that policymakers in the US have made an effort to encourage entrepreneurial investments, using angel networks. The attempts rest on the grounds that public effort to develop venture capital finance is inadequate. Lerner observes that the venture capitalists only finance few firms; thus, the investments are concentrated in one geographical area. Of course, as Lerner argues out, the financing patterns can be explained by passing smaller investments since the returns are low. In that case, efforts to enhance small investments is seen to be insufficient in some organizations or locations; thus, market solutions offer an alternative to public policy related efforts. Lerner cites the development of programs related to entrepreneur-in-residence, incubators, and the heightened willingness of the investors to fund seed the ventures as solid solutions to ensuring innovation. It is evident that issues related to public policy have a major impact on entrepreneurial finance. Although the articles have discussed the downsides of the policies, they have not sufficiently come up with remedies or alternatives to solve the underlying challenges; hence, there should be more literature in future. Alternative Sources of Financing Pare, Redis and Sahut (2009) insist that studies on the role of alternative sources of financing such as corporate ventures, individual operators or Business Angels make it possible to enhance the public’s knowledge on how new ventures can be funded. Such research allows people to look closely into the optimal balance, the main sources of funding among the budding firms, and understand ways in which corporate ventures can be perfectly integrated in the balance. Likewise, Mason and Harrison (2002) argue that one of the most significant issues that is facing entrepreneurial organizations is their aptitude to access capital. For that reason, the entrepreneurs rely on angel investors, venture capital funds, and the corporate investors. The three sources contribute a substantial amount of finance. For instance, in the year 2000, it was estimated that the size of the angel market was roughly $100 billion whereas that of the venture capital was approximately $48.3 billion (Cummin 2012, p.392). However, Mason and Harrison (2002) maintain that statistics on the venture capital are hard to obtain and the revealed data tends to measure only the financing activities of the venture capital based programs. Therefore, this is a major issue; thus, related statistics should be perceived as lower bound with regard to the main role of corporations in funding ventures. The existence of numerous sources of capital leads to the question on whether or not the source of financing matters to the entrepreneurial firm. With regard to the sources of capital, most of the studies have discussed primarily on the role of venture capitalists because of the vast data that is available. However, few studies have documented the responsibility of corporate as well as the angel investors. Mason and Harrison (2002) assert that venture capitalists play a major role in the firms that they invest in since they provide strategic advice, mentor people, provide innovative products as well as services and assist in the recruitment of top executives. They also certify the value of firms in the market and offer solid governance. On the same note, Hellman and Puri (2002) agree that venture capitalists play a profound role in developing business plans, assisting the firms during the acquisition process, designing compensation plans for the workers, and facilitating in strategic partnerships. Using 173 budding companies, Hellman and Puri (2002) confirm that venture capitalists help in developing new companies and offering strong support with regard to building the internal structures of the firm. This means that firms that obtain such source of financing are likely to professionalize and develop an inclusive culture, logical human resource policy, and adopt effective stock option related plans. According to Kelly and Hay (2003) there are few volumes of academic research that have focused on the role of angel investors. It is determined that the angel investments are smaller and are mostly found within the young firms. Although they do not have an extensive role as that of venture capitalists, the angel investors serve a significant networking role in assisting the organizations receive funding. Nevertheless, they are likely to offer support to the entrepreneurs in case they are in close proximity. Collectively, research shows that angels serve an essential duty in funding start-up firms and rather than competing with the venture capitalists, they play a complementary role in offering a financing bridge. Hellman and Puri (2002) also focuses on corporate venture financing, arguing that they offer substantial support to big firms though they have numerous structural drawbacks. This is because they lack a well stated mission and are not fully committed to the corporation. In that case, corporate venture financing is hindered by increased conflict of interest between the entrepreneurial venture and the corporation. The above articles on the alternative sources of capital have helped in analyzing the main sources, implying that venture capitalists are the best. Despite giving the strengths as well as the weaknesses of each source, they have failed to offer means in which the shortcomings can be corrected in order to benefit both the small and large firms. Summary/Conclusion Entrepreneurial finance is continuously developing in the field of research. The research and articles surveyed in this paper present a significant extension of literature, regarding financial economics. Most of the research and issues in the area of finance focus on alternative sources of financing, financial contracts, public policies, and the risks as well as returns of private equity. The paper has highlighted areas in which there is insufficient understanding; hence, a need for more research. For instance, there is substantial segmentation, regarding the provision of capital to the start-up firms from venture capital and angel investors. A thorough analysis on the alternative sources of financing will allow greater comprehension of the main factors that drive segmentation when providing for budding firms. There is also need for more research in understanding the importance of legal as well as institutional settings when determining optimal finance contracts. Similarly, most of the volumes have focused on the US firms; yet, private equity and venture capital markets are developing in other nations as well. Therefore, there is a gap and a need to address the major issues in the area of entrepreneurial finance to yield more insights. Reference List Coelho, de Meza & Reyniers, 2004, “Irrational Exuberance, Entrepreneurial Finance and Public Policy”, International Tax and Public Finance, vol. 11, no.4, pp. 391-417. Cochrane, J, 2005, “The Risk and Return of Venture Capital”, Journal of Financial Economics, vol. 75, no.1, pp. 3-52. Cumming, D, 2012, the Oxford Handbook of Entrepreneurial Finance, Oxford: Oxford University Press. Denis, D, 2004, “Entrepreneurial Finance: an Overview of the Issues and Evidence”, Journal of Corporate Finance, vol. 10, no. 2, pp. 301-326. Hellman, T & Puri, M, 2002, “Venture Capital and the Professionalization of Start-up Firms”, Journal of Finance, vol.57, pp. 169-197. Kaplan, S & Schoar, A 2000, “How do Venture Capitalists Choose Investments?” Working Paper, University of Chicago, [Online] Available at < http://www.google.com/url?q=http://www.hec.fr/heccontent/download/3629/101265/version/2/file/71.pdf&sa=U&ei=o3e_VP6OJYj7ywPWjIFg&ved=0CBoQFjAB&sig2=AK1iUgTuzzTuztO7I-p8Cw&usg=AFQjCNElRE8fgckQzafErZlabtTLM2KvBA>[viewed 14 Jan 2015] Kaplan, S.N & Stromberg, P, 2002, “Financial Contracting Theory meets the Real World: an Empirical Analysis of Venture Capital Contracts”, Review of Economic Studies, vol. 1, pp. 1-35. Kelly, P & Hay, M, 2003, “Business Angel Contracts: the Influence of Context”, Venture Capital, vol. 5, no.4, pp. 287-312. Kortum, S & Lerner, J, 2000, “Assessing the Contribution of Venture Capital to Innovation”, Rand Journal of Economics, vol. 31, pp. 674-692. 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