Financial Problems Encountered by Start-up Businesses - Literature review Example

Business

• Abstract

The study emphasises on the common financial problems encountered by start-up businesses. Entrepreneurs, especially start-up entrepreneurs often encounter various financial issues related to obtaining funds, effectively managing cash flow, etc. There are different kinds of financial problems that are faced by small preparatory and start-up businesses. Legal issues might arise at any point of time which can increase overall operational costs projected by a start-up firm. ‘Unforeseen expenses’ can be regarded as a major problem that degrades expected profit margins. Financial problems also revolve around improper working capital management. When a start-up business is unable to maintain cash reserves properly for performing daily operations then long-term profitability margins cannot be acquired. The study has even reflected upon some suitable funding options for such firms. Bootstrapping is a convenient measure if personal savings can be explored for accomplishing set targets. However, angel investment and crowdfunding can also be denoted as appropriate media to generate funds, specifically for pre and start-up firms.

• Introduction

According to Brigham and Ehrhardt (2013), small businesses are subjected to wide range of operational and financial issues. In intensely competitive marketplace, it becomes important to gain competitive advantage and sustain desirable market share. It is observed that in majority cases, financial issues are certainly the main area of concern for start-up businesses (Brigham and Ehrhardt, 2013). In this study, main focus will be on analysing such financial issues and outlining potential options for funding such small start-up firms. Deakins and North (2013) mentioned that most of the financial problems encountered by firms are in context of cash-on-hand availability and revenue problems. ROI is one of the major dilemmas encountered by entrepreneurs (Deakins and North, 2013). As per Ehrhardt and Brigham (2016), ‘Entrepreneurial Finance’ is a term used for studying the concept of resource allocation, specifically in context of new ventures. Entrepreneurs must be capable enough to answer a common question, i.e. how much money should and can be raised. It helps in allocating financial resources properly so as to avoid any kind of financial shortage in the later phase of business operations (Ehrhardt and Brigham, 2016). As described by Naidu and Chand (2013), the founder of ‘Better Business Services’, Neal Jensen, clearly stated some of the common challenges faced by small start-up firms. Cash flow management can be considered as one such challenge where profit margins get minimised due to receivable collections or capital expenditures (Naidu and Chand, 2013). The study will further outline other financial problems encountered by entrepreneurs.

• Main Contents
  • Financial problems

As stated by Rosenbusch, Brinckmann and Müller (2013), the most critical issue which is encountered by a small business entrepreneur is improper cash flow management. In start-up businesses, generating high profit margins is a serious problem faced by entrepreneurs. It is evident that effective marketing and operational strategies are designed by entrepreneurs so as to ensure that high revenue margins can be secured. A start-up company needs to possess sufficient funds in order to retain wide base of employees (Rosenbusch, Brinckmann and Müller, 2013). In certain cases, funds are acquired in advance which results into a financial problem if proper profit margins are not generated by employees. For instance, if cash-on-hand becomes zero then it is highly problematic for start-up firms to sustain business operations. According to Shiller (2013), availability of funds is an essential aspect to be taken into consideration by start-up companies. It is witnessed that some start-up companies have to close their operations due to funds shortage. Another common financial problem encountered by start-up businesses is ‘unforeseen expenses’. Start-up companies can attain desirable goals and earn profit margins until there is no such occurrence of any unplanned event (Shiller, 2013). For example, certain percentage of revenue margins are usually acquired by start-up firms, unless there is any kind of lawsuit filed against the firm. As per Saarela, Jokela, Niinikoski, Muhos and Leviäkangas (2016), it is referred to as unforeseen expenses which eventually degrades profit margin of a start-up business. There are start-up companies which focus on an insurance coverage in order to avoid such unforeseen expenses. However, start-up businesses are often not able to avoid unforeseen expenses due to lack of sufficient funds. In the bottom-line operations, major changes can be observed due to increase in cost of goods, one-time government levy, etc. The scenario of short-term cash crunch can be efficiently managed only when a start-up firm is able to properly utilise available credit. Start-up businesses are subjected to a common threat of attaining long-term profitability in the marketplace (Saarela, Jokela, Niinikoski, Muhos and Leviäkangas, 2016).

Following the words of Atherton (2012), the liquidity level of a start-up company needs to be high enough so as to address any kind of uncertainties. Long-term profitability can only be achieved by such start-up businesses when its overall liquidity is certainly not threatened by any kind of change in operational costs (Atherton, 2012). As per Taylor (2015), small start-up businesses are often not able to determine the proper source for attracting money in order to commercialise the abstract entrepreneurial idea. Such financial issues are mainly encountered by small pre businesses. At the preparatory stage, it is difficult to attract investors for funding a particular project. Entrepreneurs of small pre businesses are mainly focused on attracting investors which leads to a major financial problem in relation to demand for large equity stakes. Investors are always concerned about gaining high returns from these small start-up companies (Taylor, 2015). As indicated by Wonglimpiyarat (2013), start-up businesses need to be adequately capitalised so as to ensure that any kind of future obligations can be effectively addressed through sufficient cash reserves. During recessionary times, start-up businesses are often not able to exhibit proper cash management. It can be referred to as slow movement of cash into the business along with lack of leniency on behalf of creditors in terms of extending time-frame to pay back. Bankers are usually not much liberal when it comes to lending policies, particularly for small start-up businesses. At the preparatory stage, securing a business loan can be denoted as a financial issue. Fund generation is a key problem encountered by entrepreneurs at this phase. In 2015, the rate of business loan sanction in case of small businesses has gradually increased (Wonglimpiyarat, 2013). Hence, the trend is expected to benefit owners of start-up businesses who are looking forward towards obtaining extra capital.

A financial plan needs to be framed by any start-up business which comprises of forecasted sales growth, start-up costs, etc. According to Stucki (2014), in the preparatory stage, if suitable components are not added to calculate start-up costs then it shall lead to lack of funds in the later phase. For small preparatory businesses, underestimating operational costs along with miscalculating break-even point can be regarded as major financial problems. To be more precise, when operational costs are neglected then it adversely affects business operations in later time-period in terms of low profit margins and lack of sufficient funds. During the preparatory stage, entrepreneurs often fail to distinguish between variable and fixed costs (Stucki, 2014). There is wrong assumption drawn that cost factors will remain constant even with the growth of sales margin. As per Quaye and Sarbah (2014), a miscalculated break-even point influence start-up companies to promise high returns to investors much above their expectations. The working capital management can be considered as a financial problem encountered by start-up businesses. There are some key components encompassed within working capital, such as payment policies, inventory costs, credit, etc. The cash needed to sustain daily operations would not be available if credit policies are not in favour of start-up businesses (Quaye and Sarbah, 2014). In many cases, start-up businesses are not able to formulate effective strategies for managing inventory holding costs which leads to improper working capital management.

• • Critical commentary on identified financial problems

A critical exploration conducted by Hull and Daniel (2012) on the financial problems experienced by the small scale industries revealed that they faced issues in accessing credit. Such financial issues arise because offering credit experiences increased loan processing and legal fees, high interest rates and credit cost insurance along with travelling expenses that are faced while searching for the credit (Hull and Daniel, 2012). In contrast, researchers such as Cole, Nicholas and Rudik (2013) revealed that a major financial problem faced by the small firms is the information asymmetry at the time of raising finance in which the small scale companies are not capable to prove their investment quality (Cole, Nicholas and Rudik, 2013). Haldane and Ross (2013) stated that the managers of small organisations often face issues due to lack of financial sophistication as they are generally specialist in offering services and not in the area of finance (Haldane and Ross, 2013).

According to Coad and Tamvada (2012) lack of access to the credit facilities is among the universally indicated major financial issues for the micro and small organisations (Coad and Tamvada, 2012). Contradicting the statement, researchers such as Brammer, Hoejmose and Marchant (2012) explained that in several cases where credit is easily accessible by means of banks, the small scale organisations might deal with lack of freedom for selecting funding options as the lending conditions of the financial institution can force firms to purchase heavy equipments (Brammer, Hoejmose and Marchant, 2012). Considering this, researchers namely, Hull and Daniel (2012) indicated that lack of access to the extended period credit for the small organisations forces them to depend on the short-term finance incurring high costs (Hull and Daniel, 2012).

Cole, Nicholas and Rudik (2013) investigated that despite the small scale organisations have strong credit interest still profit orientation of the commercial financial institutions may prevent them from offering adequate credit to these small enterprises as they have small loan needs for which the cost of loan processing is high as compared to the amount of loan (Cole, Nicholas and Rudik, 2013). Haldane and Ross (2013) revealed that venture capital serves as a type of financing in which funds are gathered from investors and are re-invested in the risky small organisations. High risks and uncertainty is associated with the venture capital investments done by start-up businesses. In this kind of investments when external finance is offered to small enterprises agency problem might arise between the venture capitalist and the business owner if one among them lacks adequate skills for making suitable production decisions (Haldane and Ross, 2013).

Although numerous explorations such as of Coad and Tamvada (2012) revealed that the small scale businesses deal with financial issues related to the credit costs, information availability on finance and collateral needs, very few research works have considered all these financial issues together (Coad and Tamvada, 2012). Research of Brammer, Hoejmose and Marchant (2012) explored that the small business deal with huge financial challenges as compared to the large enterprises for the range of issues faced by these companies in start-up and expansion financing (Brammer, Hoejmose and Marchant, 2012). Supporting the research, Hull and Daniel (2012) further revealed that in several nations particularly in the developed countries, lending in the small businesses stay limited as the financial institutions are apprehensive regarding offering credit to these enterprises because of high risks associated with their businesses, small portfolios and increased transaction expenses (Hull and Daniel, 2012).

According to Coad and Tamvada (2012) being there are so many problems associated with the funding of start-ups, if the amount is borrowed from the private equity firms or venture capitalists, then they will also provide with the guidance and consultation. This can also alter the business decision as well as make it more efficient. They can also provide critical ideas regarding many legal and other personal matters (Coad and Tamvada, 2012). On this matter Brammer, Hoejmose and Marchant (2012) suggested that if the debt financing is opted then the lender will not interfere in the management of the company. Other than this, the interest will also save taxes and the company will know in advance the interest as well as the principle amount to pay (Brammer, Hoejmose and Marchant, 2012).

• • Potential options

As described by Bender (2013), the small start-up businesses are operating in a completely new economic landscape. Small businesses have been the key driver behind economic growth. In case of start-up businesses, generating sufficient funds is always considered to be a major challenge. However, there are some potential options by which such small start-up businesses can be easily funded. Firstly, bootstrapping is a suitable option by which pre and start-up firms do not need to encounter the financial problem of distributing expected returns (Bender, 2013). As per Cohn (2013), self-financing is the most appropriate approach since it helps to reduce time required while applying for a business loan. The term ‘bootstrapping’ is also known as self-funding. There are many entrepreneurs who utilise personal savings so as to establish their business idea. The major advantage of self-funding is that it helps to retain equity within the business organisation (Cohn, 2013). An entrepreneur is definitely not beholden to any other individual if one opts for the bootstrapping method. According to Wasserman (2012), external financing is another potential option for funding such firms. There are various options that are categorised as external financing methods. For instance, obtaining funds from friends and family can be another measure for funding such businesses. In certain scenarios, obtaining a business loan might be a troublesome process which can be ignored by gaining financial support from friends and family members (Wasserman, 2012). As mentioned by Hendricks (2013), the investment conditions and interest rates can be altered in such funding option which is not possible in bank loans. It is important for start-up firms to explore other options apart from bank loans, since it is a time-consuming process and often do not deliver desirable outcomes. The major disadvantage of bank loan option is that it requires significant amount of effort and time to secure. On the other hand, start-up business owners also need to put business and personal assets at risk along with paying interest (Hendricks, 2013).

As described by Intellecap (2012), angel investment is an appropriate option for funding small start-up firms. The angel investors are considered to be ones who possess sufficient surplus cash. It is witnessed that angel investors are inclined towards funding interesting projects with a high projected sales growth. Angel investment is a relatively better option for such firms since it involves flexible lending options. In small start-up businesses, the risk level is comparatively higher which might restrict financial institutions from approving loans (Intellecap, 2012). However, private investors such as angel investors prefer undertaking high business risks, provided they are able to obtain higher returns. As per Welsh Government (2015), angel investors can be attracted only by structured and transparent business plan. Venture capital is a potential option in context of funding small start-up firms. They are referred to as professionally managed funds. Venture capitalists usually invest in those companies which have a high potential for growth. It is a way of corporate financing, specifically in case of small start-up firms with an effective business idea. Venture capitalists not only provide funds to such firms but are also actively indulged in providing strategic advice (Welsh Government, 2015).

Arguably, the major loophole in approaching venture capitalists is that they are more focused on obtaining high profitability margins. According to NITI (2015), at the preparatory stage, venture capitalists cannot be accessed rather they participate in business operations during the start-up phase. Start-up businesses are mostly inclined towards obtaining short-term gains. In this context, venture capital is the most suitable option since it is centred towards shorter investment horizon (NITI, 2015). Sweat equity is an alternative source of funding which can be explored by start-up businesses. In any business start-up there are certain resources or services which need to be purchased. Sweat equity is all about giving service providers some portion of business equity, rather than cash. Arguably, such funding option is suitable only when start-up business operations are completely based on such service. As mentioned by Weinstein (2013), crowdfunding is a new funding option which is being used by majority of start-up businesses. It is about generating funds indirectly from the public. Equity based crowdfunding can be utilised by such firms in order to resolve major financial problems. It facilitates seeking investment from wide range of investors by exchanging business equity. Crowdfunding enables a firm to explore various funding options, rather than relying on some limited investors or banks (Weinstein, 2013). The potential funding options are those where risk of high return is relatively low, such as self-financing, angel investment, crowdfunding, etc.

• Conclusion

From the above study, it can be concluded that financial challenges are faced by majority of start-up businesses. At the preparatory stage, entrepreneurs find difficulty in selecting the most appropriate fund generating option. The New York Times Company (2016) clearly stated that miscalculated break-even point would also restrict small preparatory firms from convincing investors to fund a particular project. However, the intensity of financial challenges tends to increase when a business organisation reaches the start-up phase (The New York Times Company, 2016). The study has revealed critical analysis of various financial problems which are encountered by small start-up firms. According to Lieber (2014), cash flow management appears to be a common financial issue faced by start-up companies. It can be stated that such firms lack proper expertise to efficiently manage funds and allocate resources accordingly. When cash reserves are not properly managed then it eventually restricts start-up firms from generating desirable profit margins (Lieber, 2014). There are problems observed in case of working capital management because payment and credit policies vary across established and start-up companies. As stated by Tabbitt (2014), for start-up firms, more funds are required to implement operational strategies along with acquiring customers. Hence, improper cash flow management is expected at this phase. In any circumstance, unforeseen expenses cannot be avoided by companies which in turn increases overall operational costs (Tabbitt, 2014). The potential funding options for such firms is either to focus on self-financing or approach angel investors.

• Recommendations

The entire study was centred towards understanding the financial problems linked with a start-up business. It is advisable that a proper business plan needs to be structured, prior to approaching any investor. A structured business plan is required in order to influence investors for obtaining funds. For a graduate, it shall be difficult to focus on self-financing option. The recommended approach is to consult some angel investors. It is usually observed that recent graduates have innovative ideas that can attract wide array of angel investors. To be more precise, angle investment would also enable a recent graduate to invest in highly risky projects. The identified financial problems can be avoided by focusing on working capital management. A young entrepreneur needs to maintain buffer funds so that business operations can be sustained even during financial crisis scenario. According to Huang, Lai and Lo (2012), a certain percentage needs to be added with calculated operational costs in order to address any kind of unforeseen expenses. Working capital management is all about smooth flow of funds in order to efficiently meet daily operational needs (Huang, Lai and Lo, 2012). The recommended measure is to take opinion from industry experts regarding ways to maintain cash reserves. It is also recommended that a recent graduate needs to avoid such investment deals which involves higher percentage of business assets to be kept as security. As per Caan (2013), experience plays a vital role in order to successfully manage such risky business ventures (Caan, 2013). A recent graduate might lack proper knowledge about venture capital, crowdfunding, etc. Hence, the recommended funding option is obtaining funds from family and friends. A start-up business basically constitutes high risk factors, therefore, high returns should not be ensured to investors. When family and friends are involved in the start-up venture, then it becomes easier to manage funds without any such fear of losing on business assets.