Debt Market and Venture Capital as a Method of Funding Companies - Assignment Example

FINANCIAL MANAGEMENT (Student Name) (Course No.) (Lecturer) (University) (Date) Question 1 Venture capital as a method of funding companies With the rising number of entrepreneurs and innovators, major problem often results when these businesses are not able to finance their activities. Moreover, the market is becoming more competitive that these newly established businesses are facing challenges of attracting investors and financiers. Unfortunately, many financial institutions are coming on board to offer financial services to businesses with higher rates and unrealistic business proposals. Proper business ideas and proposals tend to attract many business financiers. It is from this background that many financial institutions are investing in the venture capital to support the growing businesses. Commonly referred to as VC, venture capital plays an integral part in the upcoming businesses through provision of support in terms of monetary value. Such capitals do not only offer financial to the startup firms but also small business with the objective of growing their scope of operations but also lack the adequate potential. In most cases, the agreement between the business entity and financial institutions offering VC is perceived to be of long-term growth (Gregoriou, Kooli, & Kräussl, 2007, 153). These sources of capital play important role in funding new business ventures and accessing capital markets. Even though such agreements entail entering into high-risk investment to the investor, the potentials could offer above-average returns. Besides financial support, VC also includes offering managerial and technical expertise the business. In most cases, the sources of venture capital often comes from groups wealthy investors, banking institutions, and other financial institutions that draw their finances from partnerships. VC is becoming a popular method of raising capital among the emerging companies and business ventures that have limited history of operation. In addition, businesses engaging in VC do not have the ability of raising funds through issuance of debts. Contrary to the traditional methods of acquiring funds, VC has numerous shortcomings to the entrepreneurs. In matters relating to decision-making within the company, the venture capitalist must have the say, which most cases might end up influencing the performance of the business besides altering organizational objectives (Brealey, Myers, & Allen, 2014, 125). Moreover, the venture capitalist have to acquire a portion of the equity in the business returns which lower the profit ploughed back into the business and the general performance of the newly established businesses. The major objective of the VC is to help in addressing the funding needs of the companies. These funds sometimes are required for the purpose of increasing the size and asset development. Organizations that seek funding from the VC cannot seek funds from traditional sources like the banks and public shares. Investors offers VC for companies inform of cash in exchange for shares and active participation in the management of the business entities. There are numerous differences between VC and traditional sources of finances in that it mainly focuses on young and high-growth companies. Moreover, such institutions invest in equity capital instead of provision of funds for debt purposes and taking higher risks in exchanging for the purpose of potential higher returns (Brigham & Houston, 2004, 118). Building transformative new companies require more than ideas. Therefore, when companies are looking for investors to assist in raising finances, they mostly seek assistance from the venture capitalists who have longtime investment history with their companies. Looking at VC from outside it seems easier and simple; however, current statistics indicate that most businesses acquiring funds from VC fails due to several reasons. Successful industries Capital venture as an industry has been able fulfill the dreams of many business entities. Considering a case of Passion Capital, which is one of the most successful VC in London, is currently shifting its attention from ideas to quality of teams upon startup. In other words, the organization started as an institution of backing ideas but has become a talent agency aiming at bringing entrepreneurs with ability together. According to the institution, if VC bets its funds on ideas backed by weak teams, such teams are not able to adapt to the changing market trends. The major strategy that has been used by Passion Capital is creation of space for the funded companies to establish their headquarters. As a result, the organized received surprising positive results of hosting its startups within its location. Through creation of the atmosphere that is friendly and supportive for its startups, Passion Capital has been able to provide both the required insight and networking opportunities for its startups. First Round Capital is another institution that has successfully invested in VC in San Francisco. The company was able to set aside $606.17 million to help several organizations realize their dream. The organization deal in commercial services using software programmes. For example, the organization funded augury projects that offered diagnostic platforms, which enabled various facility owners and service providers to deploy quicker, cost effective, and scalable predictive maintenance methods. Consequently, these services have helped to reduce environmental impacts, energy consumption, and cost of operation. Furthermore, the institution also offers better financial services to its partners through an online platform. These platforms have been able to offer consumers credit and leasing options for purchasing high-cost goods over time and avoiding late payments. There are individuals who also benefited from the investments by the VC. Some of them include Mark Zuckerberg, Steve Jobs, and Sergey Brin. Their startups and glory had been supported by the venture capitalists. Well-known VC firms like Kleiner Perkins and Sequoia have been able to cultivate a branded mystique with their ability to find and fund most successful startup companies. There is no possibility of VC existence without the existence of the entrepreneurs yet the entrepreneurs often feel like they are in backseats while dealing with VCs. Costs and risks of the Initial Public Offering (IPO) Regardless of the organizational reason to raise funds through offering shares to the public, there are numerous risks involved and there is need to address them before and during the transactions. The associated with IPO are many and related to the domicile legal environment. Currently, areas of legal environment have been heightened through regulatory scrutiny and enhanced corporate governance. Several emphasis has been placed on compliance with the ever-changing financial regulations, independence, rigor of fiduciary due diligence, and transparency. In IPO, the risks are often divided into four main categories including regulatory, shareholder-related, counterpart, and employee risks. It is important to note that once a business acquires funds through IPO, it is subject to government and public scrutiny while might end up exposing business plans to the potential competitors. Furthermore, the company might become subject to shareholder suits whether the warrant has been issues or not. Such lawsuits might be based on allegations relating to self-trading leading to questioning of the executive compensations and managerial decisions. As a result, the business is likely to experience expensive and time-consuming problems for publicly traded firm. IPO preparations are quite expensive, time consuming, and complex processes since it requires professions from legal and accounting disciplines. During the duration of preparation, business and market conditions might change radically which is not propitious time for IPO leading ineffectiveness of the entire process. Another challenge is the pressure relating to profitability in each quarter. When the company fails to meet the required target, these circumstances often result in reduction in the stock prices. Consequently, reduction in stock prices might stimulate further dumping and erosion of equity values. Market risk is another problem associated with IPO. Market prices of shares are prone to changes. The values might move up or based on various market conditions like micro-economic conditions, government policies, investment conditions, and prevailing interest rates. The prices of share are highly volatile thus increasing susceptibility of the business to liquidity risk. Fluctuation in the market prices might result in some share remaining especially those held with the founders and early investors. These shares might not be sold through public markets due to their resale restrictions and limitations making them subject to lock-up agreements. Even though IPO shares could be listed on the national exchange and become freely saleable, the volume of trade might be limited because of challenges posed by supply and demand in the sale of shares. Another risk associated with IPO is the market overhang. When doing an IPO, the company is only registering and selling a given number of shares. Therefore, some shares would remain outstanding in which most of them might be restricted from trading. As the restrictions expire on the remaining shares, market prices could decline due to potential increase in the supply, which could be sold. When the organization raises funds through the IPO, then it is crucial that it works towards achieving the requirements of the investors. In cases where the business increasingly incurs losses or poor earnings, the investors might be disappointed and begin to claim their shares. Such activities often compromise the operations of the companies and in some cases result in organizational fall. To some extent, IPO could lead to changes in the pension plans. These changes might as well cause the employees to bring the claims against the organizational management. Another risk associated with IPO is the insider trading or the post-IPO in which the directors trade their shares before official commencement of IPO. Such practices often lead to regulatory investigations on the alleged insider trading, resulting in fines, legal costs, and imprisonment. Risks associated with Venture Futures’ investment in Biotech and strategies of reducing exposure If Venture Future Pty Limited needs to invests in the biotech industry as the venture capitalist, it is important to understand the underlying risks associated with such business activities and how to manage them. VC in most cases provides financial cushions for the business. Just from their nature, VC investments are very risky since it involves offering unsecured loans to the startup companies and business entities, which are not in a position of acquiring traditional loans. In some cases, they are referred to as the angel investors since companies view them as angels who provide funds in return for future profits (Rogoff, 2004, 97). If Venture Future were to invest in biotech, then it would have to enforce certain strategies to ensure that it does not invest in risky business or incur losses. Establishing effective and reliable management team Management team plays a significant role in ensuring the success of any business opportunity. Considering the age of the Biotech Limited, its success and ability to attract more VCs would depend on the efficiency and commitment of management team. Ideally, all VC often look for companies run by the management team with a track record of success. Therefore, if the organization were to limit losses and risks associated with investing in Biotech Limited, the initial precaution would be to ensure that the management team is qualified and have the ability of achieving the desired goals. It is not guaranteed that the management would yield the desired goals, it is crucial to ensure that their decisions are valid and of quality for the success of the company. Diversification of investments Diversification is the key to lowering risk portfolio associated with investing in a company as a VC. Since Biotech Limited is a smaller company that aims to grow, the results of the investments in such cases are not quite familiar; hence, Venture Future Limited should consider diversifying its investments in other industries as well to minimize the risks of investing in one company. This would assist the company to spread its capital across different companies (Reuvid, 2011, 122). Investment all the assets in which the company has equities might pose more risks than investing in a combination of investment opportunities. Before deciding on how to diversify its assets across other industries, it is important that the company seek professional advice from the experts on how to divides its assets of it lacks the required knowledge on investment. Employ the use of Stop Loss (SL) method to reduce risks In most cases, organizations take obvious steps in preventing stock losses. At the same time, most businesses do not appreciate the essence of putting a stock loss order to reduce the stock losses. Stop loss order is a method of instructing other institutions to sell the stocks when they reach certain prices. From this background, reduction in the level of exposure of risk to the Venture Future Limited would reduce. The organization should ensure that the employers at the Biotech Limited are committed to establishing the required goals and if the value of the shares increases in the market, Venture Future could sell them to reduce the impact of the future risks associated with decline in the value of the shares. Before such decisions, it is also significant to consider the evaluation process for the tolerance risk levels. In most cases, organizations put shares on stop loss order if the general stock price declines by 8 per cent. Question 2 Debt market Also identified as credit market or bond market, debt market is an environment in which businesses and financial institutions issue and trade debts securities. Primarily, it includes securities issued by the government and corporate entities for the purpose of facilitating the transfer of capital. Most trading within the debt markets occur over the counter (OTC) in organized electronic networks of trade composing both the primary and secondary markets. Primary market involves issuing and selling the debt securities by the borrowers to the lenders while secondary markets involves methods through which the investors acquire and sell debt securities that had previously been issued amongst themselves. Even though the stock market have the ability of commanding many media attention, debt market is quite bigger and fundamental to the ongoing activities within both the public and private sectors. Debt market also means a market established for trading fixed income instruments like securities that in most cases are issued by the central and state governments, state corporations and other private entities such as financial institutions. In this method of raising funds, the bond issue pays interest to the investor at the rate that is predetermined and scheduled. According to Association of Chartered Certified Accountants of Britain (2014, 107), government debt market plays an important role in the industry considering its size and liquidity. Therefore, in most occasions it used to measure credit risks of other types of market debts. Debt market often show inverse relationship with interest rates, therefore, they are used in indicating changes in interest rates or the yield curve’s shape. Advantages of debt markets Every growing business requires adequate funds to finance its operations. The main advantage of debt market is that it offers business entities and organizations the source of income to facilitate the management of their activities. Just like any other source of funding, debt market offers a pool of financial ability to existing and startup organizations. Moreover, it helps in the growth of the economy by making it possible to the financial institutions to offer mortgages to the consumers. From the investment perspective, debt markets offer fixed income payments, which gives investors another option apart from stocks and other securities. Compared to other methods of raising funds, in debt market the lenders do not have the claim to the equity in the business. Hence, if the company raises funds through such means, it has the freedom of managing its activities freely without destruction from the financing organizations. The business owners have full control of business activities and decisions since the debts do not dilute owners’ stake in the ownership of the company. Since the lender is only entitled to payments agreed upon the issuance of the loan including the interest, they have no claim on the future profits of the company. In cases where the company experiences positive investment from the loans, the owners receive huge portion of the share than they would receive if they acquired the loans through sold stock to finance company’s growth. It is possible to deduct the interest on the debt using the company’s tax return, thus lowering the actual cost of the loan that it owes the financing institution. Additionally, raising capital using the debt market is not quite complicated since the company is not required to comply with federal and state security regulations. Consequently, this method of financing business activities do not require the company to send mails to huge number of investors and holding periodic meeting since there is no involvement of the shareholders. Disadvantages of debt markets Unlike funds acquired through equity, funds from bad markets must be repaid at some point. Moreover, the debt markets offer funds on fix interest costs that often raises break-even point of the company. Consequently, during high interest cost, the company might experience difficult financial period thus risking insolvency. Without proper strategies in place, the company might find it difficult to grow due to higher cost of servicing the debts. There are often debt restrictions that might bar the company from conducting certain activities. These barriers include baring the company from accessing other alternative forms of funding and other non-core business opportunities. If the company’s debt-equity ratio is larger, then the lending and investing financial institutions might consider such company risky. Every business is limited to the amount of debt that it can carry. Another disadvantage of acquiring funds through the debt market is that the company is often required to pledge to pledge its assets as collateral to the lender. Debt markets might increase company’s risk level since companies are more sensitive to economic downturns, variability in interest rates, and changes in market conditions. Failure to fulfill the agreement, the business is prone to loss of its assets since the financing institution might reposes them to act as security. Additionally, debt markets also involves borrowing finances against the future earnings meaning that instead of the business using all the future realized profits to grow the business, the business would have to allocate the portion to debt payment. Thus, overutilization of the debt might severely limit the future cash flow and bar company’s growth. Alternative methods of raising funds Reinvesting the profit This method involves failure by the company to divide its profits as dividends but rather transfers certain portion to the reserve. In most cases, these funds are often viewed as profit ploughed back into the business. Since these funds belong to the company’s shareholders, they are regarded to be part of the ownership capital. Profit retention offers the business the ability to finance its financial activities without involving other financial institutions (Bloomfield, 2008, 231). The reserve could take a longer duration depending on the purpose in which the organization is saving. The company might utilize profits ploughed back to expand its activities, replacing obsolete assets, and redemption of the old debts. Advantages Investment in the profit ploughed back might help the company reduce its level of dependence on the external sources of financing business activities. Overdependence on external financiers might compromise the operation of the business especially if the company is not able to receive the funds at the appropriate time. Ploughing back the profits could also assist in improving the credit worthiness of the company because it limits the amount of debts that company could owe to the financial institutions. Through investment in accumulated profits, the company might enhance its ability to stand during tough economic times and unfavorable market conditions. Besides, it offers the company the best method of adopting effective and stable dividend policy without interference from the external financial institutions. Disadvantages Profits ploughed back have the ability of negatively affecting the economy. Continuous ploughing back might create monopolies and reach levels in which they become uncontrollable and difficult to manage (Paramasivan & Subramanian, 2009, 85). Therefore, re-investment could make the company inherit all the evils that have been negatively affecting its operations. Retaining earned profits could lead to lowering of dividends. Whenever the share values decrease in the market, the management could purchase them at lower prices. Thus, ploughing back profits allow the company manipulates the share values. This method also affects the freedom of the investors since the retained profits are invested within the similar businesses. As a result, there is reduction in the loops that external investors might have invested in. Ploughing back profits encourage tax evasion, which is a violation of the laws. In most cases, earnings are retained within the company that minimizes the corporate profits thus reducing their tax liability. Equity ventures This method involves looking for financial partners who advocate for the shares of the organization profit and shares. Advantages In equity method of financing the business, the company does not have to repay the loans. In addition, both the company and the organization offering financial support share the risks associated with the business activities. Since in the method the company does not have to pay the debt, it could use the generated cash flows to grow the the company and diversify its operations. The method could also help the company to maintain a low debt-to-equity ratio. As a result, the company is able to be in a better position to acquire the loans for future operations when needed. Disadvantages Through taking equity investment, the company might end up losing partial ownership. These might as well involve losing authority over management of the business. As a result, the method of decision-making might end up affecting the quality of organizational performance. If the company acquires funds from large financial institutions, it might be quite unfortunate since these organizations always insist on changing the managerial teams (Aubrey, 2014, 219). These changes could affect the performance of the company. Whenever the company takes off, the profit realized is often shared with equity investor resulting into lesser amount being invested back into the business for the purpose of acquiring the desired growth. In some cases, long-term payments and distribution of profits could exceed what the company borrowed as the loan. Incubator Funding This is also another method of raising funds especially for the startup companies. Even though the amounts acquired through this method might be smaller, the method offers much more than just the funds but also the mentor and guidance on how to ensure that the intended business meets the expectation of the clients. Moreover, it offers a chance of networking with well-established and renowned organizations globally. At the end of the incubation process, the company would have an opportunity of presenting quality business proposals for other agencies for second phase of the funding process (Friend & Zehle, 2004, 160). Advantages This method offers the company not only the funds for running the business but also the mentorship and leadership skills required to ensure efficient and effective performance of the company. These programmes often help companies to avoid typical startup pitfalls through ensuring they arrive at quality decisions. Accessibility to large pool of the available capital while within the incubator is another advantage. In this method, incubator funding, there often several organizations and donors willing to support any positive idea. The incubators provides an inspiring environment to the incubating company which in turn encourages and inspires the work of the company that is incubating. Moreover, it offers the incubate company an opportunity to improve its business plans before official launch into the market. Disadvantages The incubators are considered part of the organization; therefore, the incubating businesses are often required to comply with organizational requirements. In addition, the organization often claim the portion of the returns until a given period before the company is allowed to enjoy all the financial gains from its investments. Recommendations It is important to consider the terms of agreement and the underlying regulations before entering into any financial agreement with the funding institutions. Assuming the company has no prior knowledge to the type of investment that it wants to invest in or has no appropriate expertise required, then would be wise to consider incubator-funding method as the best method of raising the finances. Through this method, the company has the chance of acquiring the relevant knowledge required the business and how to arrive the most effective decision. Besides the knowledge, this method offers the best networking platform to the incubating company to interact with potential clients during presentation and testing of the projects. Interaction with reputable incubators offers the company a positive brand, as a result, this method of funding tends to associate the incubating company with the identity of the incubator. By assuming that the company has no prior clients, incubation process offers immediate opportunity of to access a wide array of available market offered by the incubator company. 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Start up and run your own business: The essential guide to planning, funding and growing your new enterprise. Philadelphia: Kogan Page Ltd. Rogoff, E. G. 2004. Bankable business plans. New York: Thomson/Texere. Read More