The Optimal Financing Strategy of Business Entrepreneurs - Essay Example

THE OPTIMAL FINANCING STRATEGY OF BUSINESS ENTREPRENEURS [Insert al Affiliation] Introduction Private and economic sector growth relies heavily on finances available to the specific sectors, particularly, the option of financing business activities. The country requirements cannot be plausibly provided for by the state on its own and individuals should establish themselves as major workings in competitive and fit economic conditions. Entrepreneurship is, therefore, a process of innovativeness, creativity and invention to come up with new methods of realizing several predetermined business goals. It often encompasses coming up with newly found ideas a production of goods and services. A lot of time and effort is customarily required. Entrepreneurship requires people who are risk-takers, hardworking, persevering, desiring to achieve, ambitious, brave and creative to come up with these ideas. A person with entrepreneurial skills will invent a unique method of creativity and creating a product by use of the new idea. According to Fairchild (2011), an entrepreneur uses the accessible technological advancement to come up with an invention. Available tools and technologies will be of great essence by an entrepreneur to come up with a method pertinent to the production of a good or a service that will steer the economy upwards, benefit through creation of self-employment and to the society in general by offering employment opportunities and other befits that result from entrepreneurship such as provision of goods and services that were not provided before, economy of scales among others. The entrepreneur usually takes the risk of the victory or letdown of the new undertaking and the resolve to reap the plunder. Additionally, entrepreneurship is, therefore, a risky venture that opts to be handled with great care in spite of the rewards that are expected. A person innovate and invent an idea (entrepreneur) obtains the likelihood that the invention will succeed making him or her to direct ones resources to make the idea a success (Bergemann & Hege, 1998). There is always a fear of making mistakes and failing, but ambitious people do not easily give up and there are motivated towards achieving the set goal (Hall, 1992). For an enterprise to start, the owners must acquire capital to finance the business operations through various sources as discussed below. Financing sources To begin with, the owner’s capital is an important source of capital especially for sole traders in starting the business. For instance, in case there is a shortfall on cash flow forecast, the business owners could invest more money in the business. Secondly ploughing back the profit is another important source of finance for businesses. The basic source of funding for corporations is through retained earnings after paying the dividends to shareholders and hopeful of bringing the most money in the company. An equally significant source of funding, especially for companies that are listed in the stock exchange market, is equity financing through issue of various types of shares comprising of ordinary shares, preference shares, redeemable or irredeemable shares among others. This is usually done through selling a part of the business to generate capital for the business. The ordinary shareholders often become the owners of the business while preference shareholders are the creditor to the company. Some stocks of preference shares can be converted into common shares; the shareholders acquire the business ownership after conversion. The benefit of this is that investors or business subscribers do not require interest payments like in debt- financing like the case of bondholders do. The drawback is that further profits are divided among all the shareholders. An important source of debt-financing to the business is through overdraft which is a form of a short-term loan from a bank. A business becomes overdrawn when it draws extra cash is withdrawn from the account than the amount in it hence leaving a downbeat balance of cash in customer’s account. According to Mansfield (1995), this source of finance is usually a crucial source of cheap financing, but a main shortcoming of this alternative is that a high rate of interest charged on the amount overdrawn, and will not only allow an overdraft if they believe the business is credit worthy (Bergemann & Hege, 1998). Another setback is that the bank might demand payments of an overdraft in case they require the amount due causing companies to be exiled from business in case the bank has withdrawn overdraft facility. These are usually the major drawbacks of this type of financing. Nonetheless, for short term borrowing, an overdraft is often the ideal solution, and many businesses often have a rolling (ongoing) overdraft agreement with the bank. This then is often the ideal solution for upcoming short term cash flow problems. Bank loan is another source of debt financing by a business. A fixed amount, say $10, 0000 for a fixed period of time, for example, 10 years. The chief hitch of this source of financing is that the lenders usually charge high interest on this which is paid periodically mostly on a monthly basis. This may lead to further liquidity problems of a company. Another drawback of this is that a lender especially a bank will likely lend in case the borrower is proved to be credit-worthy. Additionally, an asset is attached to the amount lent to serve as collateral (security) for the loan. Leasing financing is correspondingly a primary source of long-term financing especially to large corporations and multinational companies. A contract of leasing can be defined as a covenant between parties contracting, that is, the lesser and the lessee in which the lessee makes periodic payments under agreed terms in the debt covenant up to maturity when the agreement lapses unless there is an option to renew the contract. There are usually two main forms of lease; finance lease and operating lease. The legal person who owns the property is the leaser and the person who rents is the lease. Think, of a person setting up business as a Parcel Delivery Service, he could hire the van he needs for delivery from the leasing company. He will have to pay regular leasing fee up to maturity when the agreement expires. At some point, the company may need to invest in big investment that will yield returns in the near future. For this reason, a time will eventually come when the company will need to acquire funds from any of the above mentioned. Borrowing from friends is also an important source of finances for small businesses especially sole proprietorship and partnerships. Individuals may be having business ideas, but to put the idea into a practical form they require starting capital which in an immediate position to have. They may thus result to borrowing from colleagues, family members and friends. A significant benefit of this financing is that the no interest is charged for borrowing, there is personal contact between the lender and the borrower thus making an efficient way of obtaining finance. Additionally, few or no formalities are involved to acquire the funds. The fundamental drawback of this source is that only small sum of money can be acquired through this method. Hybrid financing is an additional form of financing that combines equity and debt financing. The major drawback of this option of funding is about the complexity of the combination that may not be well understood making it to be questionable when making a decision about optimality of capital structure. A universal investment hypothesis postulated as Modigliani-Miller theorem that shows that in a perfect competition, the firm’s value remains unchanged even if the firm is financed entirely through borrowing, share capital or through hybrid securities (Schwienbacher, 2007). Hire purchase is another popular form of financing which is almost identical to leasing, where the hirer has an option of owning the goods after making final installment whereas under leasing the lessee do not acquire ownership after making the final payment. Hire purchase contracts can involve hiring of goods, buildings, vehicles and other physical structures. It is usually a contract of bailment that gives the hirer an option of acquisition of ownership after making final payment, but the hire can also terminate the contract at will. Government grants and aids are also sources of finance to the entrepreneurs especially companies in which the government gives grants including other methods of direct aids nation for economic development. According to Mansfield (1995), venture capital is also a financing option for an enterprise for the new businesspersons. This is usually money from the owner’s pocket that is diverting from other personal use for business use (Fairchild,2011). However, venture capital is mostly associated with putting proceeds in return for stock venture, entry in new trade or expansionary schemes (Ueda, 2004). Other source of financing includes franchising which is a scheme of business expansion. It is usually an appropriate method of lifting growth through capital expansion. Under this agreement, the franchisee pays a franchisor for the right to operate a business locally, under the franchisor’s trademark. The franchisor bears various obligations that may comprise of legal expenses, marketing costs, architect’s cost among others (Mansfield, 1995). Theoretical aspects Theoretically, above sources of finances for an enterprise have their pros and cons as we as going to see from our discussion. To begin with sources of financing have the following pros. An advantage of using equity financing as opposed to debt financing is that, the enterprise have no obligation to repay to equity-holders as opposed to debt-financing like bond requires the holder to make periodic interest payment including the principal amount at maturity. This promotes profitability of the business allowing greater magnitude to spend. Under equity financing, there are generally reduced risk associated with bankruptcy in comparison to debt financing, for instance bond or debenture financing where the creditors can lead to liquidation of the business in case the business fails to repay its debt. Under equity financing, there is ownership dilution where once you sell a share to an investor, you are, consequently, reducing ones ownership stake in the business which is considered to be a drawback. Rising of equity funds involve higher costs which include listing requirements in the stock exchange market and other regulatory costs. Additionally, stockholders demand a higher rate of return from their investment. On the other hand, debt financing has the following pros and cons as opposed to other forms of financing, for instance equity financing as discussed below. Through debt financing, the ownership of the business is maintained by the subscribers of an enterprise as opposed to equity financing. This happens as a result of no sale of a business part to obtain capital, but ownership is maintained by the initial members of the corporation. Moreover, the government usually offers tax incentives when an enterprise is financed through debt as a result of tax reductions which is beneficial to the organization. A major drawback to debt financing is repayment as the borrower is obligated to repay the debt including the interest. This will lead to an increase in gearing thus portraying poor business performance and lower chances of survival. Additionally, this forces the business into bankruptcy hence risk of being kicked out of the market. Another key drawback to debt financing is high interest rates that are additional obligation of the business to pay above the principal payments. The business can thus be sued in the court of law for failure to make these payments (Bergemann & Hege, 1998). There is usually a negative drawback which has negative impact towards rating of credit. This may seem attractive, but practically, the company becomes leveraged upwards. Similarly, the proceeds and the security for the debt is usually a requirement for the entrepreneur to have which comprises of either tangible asset as security. This is usually absent in equity financing. Retained earnings, as a financing option, has its pros and cons. Under this method, the entrepreneurs are not required to make interest payments as the case of debt financing which help the company to have a substantial amount of cash over long the long term. Furthermore, there is no profit sharing leading to growth of the firm. However, there is dilution of retained earnings because the new investors have right to claim for the earnings in future (Hall, 1992). A key drawback to the retained earnings is the reduced dividends to the shareholders and this is an idea that majority of the investors dislike especially investors who enter the company with an idea that the corporate was self-assured to grow. What’s more, there is usually a significant reduction in the cash flow making it hard for operation of the business. This might add an additional stress to the business and lead to bankruptcy. The empirical evidence The empirical evidence on the strengths and the weaknesses of the financing option of the difference financing options are analyzed as follows. The sector of banking developmental analysis in terms of percentages from year o-4 YEARS "000" o 1 2 3 4 Own funds 24.56 24.57 25 25.2 25.26 Loans from domestic sector 20.25 40.56 50 67.9 70 Loans from abroad 23 28 36 48.09 54.22 Non-refundable donations 14 30 32 45 57 Borrowings from friends 17.2 18 26 35 46 Direct investment 14 18 25 28 37 From this model, the empirical findings show that, in the survey that was conducted enterprises got debt financing from the loans that they had applied for. Presumably from the study that was conducted it was found out that not all firms got the debt finance, that is, loans that they had applied for. Therefore, the survey conducted shows that it is difficult in determining the function of the demand just from the concluded studies. From the above drawback, it is possible to estimate the possibility of recipients of the debt finances just from the concluded studies and to make it possible for bias elimination as seen. Accordingly, the estimation for binary modeling in liaison with sample selection is evident in case the errors in the multivariate and bivariate distribution variables. Conclusion The above elucidation candidly and comprehensively indicates that there are various sources of financing as discussed above and, therefore, as an entrepreneur, it is important to note various sources of financing that suite your business. As the business grows, the entrepreneur needs to adjust to most appropriate sources of finance due to economic, political and social factors among others need to be put into consideration. From this study, it is noted that different sources of finances are usually appropriate for different businesses as discussed above. For instance, small enterprises like sole proprietorship requires sources like donations from friends, venture capital among others in opposition to equity financing which is mostly appropriate for large corporations like limited companies. References Bergemann, D. and Hege, U. 1998. "Venture capital financing, moral hazard, and learning." Journal of Banking & Finance 22(6-8): 703-735. Fairchild, R. 2011. "An entrepreneurs choice of venture capitalist or angel-financing: A behavioral game-theoretic approach." Journal of Business Venturing 26(3): 359-374. Hall, B. H. 1992. “Investment and Research and Development at the Firm Level:” Does the Source of Financing Matter? Mansfield, E. 1995. “Academic Research Underlying Industrial Innovations:” Sources, Characteristics and Financing. Schwienbacher, A. 2007. "A theoretical analysis of optimal financing strategies for different types of capital-constrained entrepreneurs." Journal of Business Venturing 22(6): 753-781. Ueda, M. 2004. "Banks versus Venture Capital: Project Evaluation, Screening, and Expropriation." The Journal of Finance 59(2): 601-621. Read More