Entrepreneurial Minds - Essay Example

Running Head: Getting Financing Getting Financing [Institute’s Getting Financing Introduction With any doubts, entrepreneurialminds and entrepreneurs themselves are a blessing for any society, community, nation, or economy. These people are the drivers of creativity, competitiveness, creators of an increased GDP and employment (Bygrave & Zacharakis, 2010). However, becoming an entrepreneur is a challenging and tough process in itself. One of the most important questions that most of the people ask when they are starting any business venture or company is regarding financing. Debt financing and equity financing are the two obvious options. This paper focuses on the pros and cons of each and attempts to explore that in which situations either one of them is the most feasible. Discussion Debt Financing As the name suggests, debt financing is borrowing money from some financial institutions, usually a bank, which you will have to repay after a certain period with interest. Entrepreneurs may borrow money for short term, which means for less than a year. Usually short-term loans are for financing working capital requirements, operational activities, filling the gaps in accounts receivables and inventory (Horne & Wachowicz, 2008). On the other hand, long-term loans, which are for more than one year, are usually the ones that entrepreneurs usually look for to finance their assets, capital, land, buildings, machinery and other costs of starting a business venture. Clearly, debt financing has certain advantages. Firstly, the interest that is paid on these loans is tax deductible thus providing a tax advantage (Bygrave & Zacharakis, 2010). Secondly, as we will see that equity financing provides a part of ownership in the business to its financers, however, the same is not the case with debt financing. Lenders, unlike shareholders, do not get any ownership in the business and thus the entrepreneur retains the sole control of the business (Shim & Siegel, 2008). Thirdly, the entrepreneur usually will get many options with regard to the maturity time and the amount of interest payable per month or per year. Lastly, compared with equity financing, debt financing is less hassle and less time consuming, whereas it may take months for someone to appear on a stock exchange list and getting enough shareholders (Brigham & Ehrhardt, 2008). However, the disadvantages of debt financing are significant as well. Firstly, unexpected changes in interest rates due to economic downturns, at times, create a disaster for borrowers (Horne & Wachowicz, 2008). Moreover, even if these economic downturns of macro environment events fail to alter the revenue and only affect the revenue generated by the business then still it is not a good sign for an entrepreneur. This is because if the at any point in time the gross profit of the company falls below the interest payments then the company is technically insolvent and bankrupt. If the same happens then the bank deserves all right to confiscate all the assets that have been kept as a guarantee or collateral (Horne & Wachowicz, 2008). Moreover, that would severely affect your credit ranking for future borrowing. Secondly, a business venture with too much debt is highly unattractive to other future investors who would refrain from investing (Stim & Guerin, 2008). Equity Financing Equity financing is selling a part of ownership of your business in exchange for investment. The size of ownership would depend on the size of investment provided by the investor. The same happens through providing the share of the company thus the shareholders become the owners of the company. The business owner and shareholders then become responsible for sharing the profits and facing the risks together. The element of debt, quite understandably, is not present here and so there are no interest payments but the profits have to be shared with the investors who usually are the shareholders, venture capitalists or angel investors (Shim & Siegel, 2008). Statistics show that most businesses prefer equity financing to debt financing because of some obvious advantages (Brigham & Ehrhardt, 2008). Firstly, where debt financing can be extremely risky, equity financing is considerably safer and since you do not have to repay any interest so, you cannot go bankrupt in times of economic downturns that easily. In addition, if the company is running in loss for a year or so then you are not obliged to pay back your investors. Secondly, if investors may also provide with valuable suggestions and assistance for the business to grow since they are now major stakeholders in the company. The figure presented below is the data of more than 500 large sized US firms and it shows that over the past decade the trend towards equity financing is on an increase. Important here to note is that the decline in the recent years is mostly due to the financial crunch. Source: Bygrave & Zacharakis, 2010 However, even equity financing comes with strings attached. If a company has opted for complete equity financing, this is an indication that they are risk-averse and quite understandably, the business might not grow at a substantial rate in a result (Brigham & Ehrhardt, 2008). It also indicates that the venture has failed to utilize its capital resources efficiently. Moreover, equity financing also means that the entrepreneur loses the sole control of business and now he or she is bound to ask or refer to the other investors in case he or she wants to make crucial changes to the company. Thirdly, the whole process of equity financing is time consuming, demanding and costly. One may have to wait for months before they can attract some investors. Investors may be very demanding and may seek a lot of information. Moreover, considering the regulatory compliances, companies waste substantial amount of their time, energy and money for meeting those (Bygrave & Zacharakis, 2010). Making a choice between debt or equity As mentioned earlier, making a choice between these is one of the must complex decisions that financial managers or entrepreneurs have to face. Most companies do not rely entirely on either one of those; instead, they prefer to have a mix of both of these. This is where the term “debt to equity ratio” comes from (Stim & Guerin, 2008). It is important to note that the bottom line here is the risk that a company is able or willing to take. A high debt to equity ratio is the best option when the entrepreneur is willing to take risk, can get interest on low interest rates, having longer maturity, and is highly confident about the profits that he is going to earn over the period. This way the business venture would enjoy the tax advantage as well. However, in case if the entrepreneur is unsure about the economic conditions or thinks that other macro environmental factors may affect the profit stream of the company then he should go with a low debt to equity ratio. It also not bad an option to start by equity financing and once the company has generated a consistent stream of profits then it can easily finance other needs through debt servicing (Shim & Siegel, 2008). A research conducted in the year 2000 with over 600 Chinese companies also revealed that as the companies grow they tend to rely more heavily on external debt as shown in the figure below. Entrepreneurs should also consider their own long-term goals and vision while deciding on the method of financing (Brigham & Ehrhardt, 2008). At some point in time, a company financed with equity, will face a situation where in a board of directors meeting, a disagreement over a certain issue will cause problems. If an entrepreneur cannot take it, desire autonomy, and full control over his business then he probably should work hard consider debt financing only (Stim & Guerin, 2008). However, if an entrepreneur’s major objective is to minimize risk and making sure that he stays in the business even at the cost of rapid growth then equity financing should be at the top of the list for such entrepreneurs (Bygrave & Zacharakis, 2010). Conclusion Therefore, the decision of prioritizing financing method must take place after long and careful consideration and observation. Suggestions from friends, entrepreneurs, and business-minded people may provide insights. Besides, a through analysis of all macro environmental factors like political, legal, technological, social, demographical and other factors, business viability, business idea, risk-averseness, current and future interest rates, future uncertainty, nature and preference of the entrepreneur, long-term goals, vision of the owner and others is extremely important (Brigham & Ehrhardt, 2008). References Brigham, Eugene F., & Ehrhardt, Michael C. (2008). Financial management: theory and practice. Cengage Learning. Bygrave, William D., & Zacharakis, Andrew. (2010). Entrepreneurship. John Wiley and Sons. Horne, James C. Van., & Wachowicz, John M. (2008). Fundamentals of Financial Management. Prentice Hall. Shim, Jae K., & Siegel, Joel G. (2008). Financial Management. Barrons Educational Series. Stim, Richard, & Guerin, Lisa. (2008). Wow! Im in Business: a Crash Course in Business Basics. Nolo. Read More