Chapter six

Financing the New Venture

 Source of fund to Financing the New Venture

 There are two sources of capital to finance a new business

venture which are debt and equity financing.
 1. Debt Financing(External financing)

 The use of debt to finance a new venture involves a

payback of the funds plus a fee (interest) for the use of the

money.

 On the basis of repayment debt financing is categorized

into short term and long term debt.

 Short-term borrowing: is a debt which repays back with in one year
or less.
 It is often required for working capital and is repaid out of the
proceeds from sales.

 Long –term debt: is loans which repay back to the owner with in one
to five years or long-term loans maturing in more than five years.

 Most of the time, it is used to finance the purchase of property or

equipment.

.
 To secure a bank loan, an entrepreneur typically will have to answer a

number of questions like:

1. What do you to plan to do with the money?

• Banks seek the most secure venture possible.

2. How much do you need?

• The more precisely the entrepreneur can answer this

question; the more likely the loan will be granted.

3. When do you need it?

• Never hurry to the bank with immediate requests for
money with no plan.
4. How long will you need it?
• The shorter the period of time the entrepreneur needs the
money, the more likely he or she is to get the loan.
5. How will you repay the loan?

• This is the most important question.

• What if plans go awry?

• Can other income be diverted to pay off the loan?

• Does collateral exist?

• Even if a quantity of fixed assets exists, the bank may be unimpressed
because it knows from experience that assets sold at a liquidation
auction bring only a fraction of their value.
 To determine the best source for raising capital needed in a
particular situation, the following five questions should be
considered.
 What are the benefits of a loan in relation to its costs? (cost)
 Which loan source exposes the business to the lowest
degree of risk? (risk)
 Will conditions imposed by a loan source reduce flexibility
in seeking additional capital, or in using capital generated
through operations according to the owner’s best judgment?
(flexibility)
 Could the owner’s control of the business be adversely
affected? Could the loss of control prevent the
entrepreneur from making operating decisions that are in
the best interests of the business? (control)
 Which financial sources are available to the business?
(Availability)
 Cost:
 The cost of a loan is usually measured by its impact on the earnings
of the present owners, not simply the increased expenses incurred
by that business.
 Consider a company that is deciding between a 20,000 loans at
10% interest or selling 25% of the shares in the business to raise
20,000.
 The business expects to pay interest of 2,000 on the loan per year,
which would reduce its net income by 2,000 before taxes.
 If the business expects to earn 30,000, interest expenses would
reduce earnings to 28,000.
 In the equity alternative, the net income would be 30,000,
since there would be no interest expenses.
 However, only 22,500 would be applicable to the present
owners since 7,500 (30,000 x 25%) would represent the
participation of new shareholders.
 Therefore, the income of the business under the equity
alternative would be higher, but the benefit of the (main)
owner would be less.
 Internal sources, such as the sale or liquidation of assets,
could lead to a loss of revenue following inventory
disposal or added operating costs if machinery was sold
to generate cash.
 In reaching a decision, it is important to consider all
relevant costs for each source of finance.
 Risk: There are several types of risk involved in raising capital.
Use of trade credit could lead to supplier dissatisfaction and
possible damage to your credit standing.
 Since borrowed money must be repaid with interest, debt capital
imposes obligations upon the cash flow of the business that must be
met to avoid default.
 A default could cause a number of actions, such as forfeiture of
collateral or forced bankruptcy.
 The only money source that involves no risk to the business is
equity capital, since the equity investor, and not the business, is
assuming the risk.
 Flexibility:

 Total reliance on profits to meet capital needs could cause

a business to be overly cautious in extending credit or
purchasing inventory.
 These restrictions might lead to lost sales.
 Use of trade credit from suppliers as a major capital
source can make a business overly dependent upon a few
suppliers, and unable to take advantage of better prices
from other suppliers.
 Control:

 The use of internal financing and trade credit is unlikely to

have any impact upon the control of the business by the
present owners.
 Equity investors are normally entitled to some degree of
control in the company’s operations. Lenders do not
ordinarily participate in the affairs of the business, nor are
they legally entitled to a vote in limited company matters,
as are shareholders.
 Lending officer’s concerns
 Often a bank lending officer refuses or “declines” a loan
request. Foremost in the lender’s mind is the question:
“Can the firm pay back this loan?”
 The lender may refuse the loan because the owner hastily
and haphazardly prepared the loan application under
pressure.
 As a result, the lending officer detects an air of instability
and lack of planning in the owner’s description of his or
her business affairs.
 When an entrepreneur’s request for a loan is turned down,
the loan applicant should accept the refusal gracefully,
and eliminate weaknesses before applying for a loan in
the future.
 Advantages and Disadvantages of Debt Financing
Advantages
 No give up of ownership is required.
 More borrowing allows for potentially greater return on equity.
 During periods of low interest rates, the opportunity cost is justified
since the cost of borrowing is low.
Disadvantages
 Regular (monthly) interest payments are required.
 Continual cash-flow problems can be intensified because of payback
responsibility.
 Heavy uses of debt can inhibit growth and development.
 2. Equity financing
 Equity financing involves the sale of some of the ownership in the
venture.
 Unlike debt financing which requires the repayment of borrowed
money with interest on principal

 is money invested in the venture with no legal obligation for

entrepreneurs to repay the principal amount or pay interest on it.
 It does, however, require sharing the ownership and profits with the
funding source.
 Since no repayment is required, equity capital can be much safe for
new ventures than debt financing
In general, Equity capital can be raised through two major sources:

Public Offerings: refers to a corporation’s raising capital through the

sale of securities on the public markets.

Private Placements: is through the private placement of securities.

• Small ventures often use this approach.

 Production and Human Resource Management
a) Managing the Production Operation
 Production operation emphasizes the transformation of input in to out
put or products.

 Managing the transformation process pays particular attention to four

specific functions: design, scheduling, operation and
transformation control.
b) Managing quality of products
 Quality has often been defined as the “totality of features and characteristics
of a product or service that beer on its ability to satisfy stated or implied
needs.

 The customer is the key perceiver of quality because the purchase decision
determines the success of the organization itself.

 It is more difficult to evaluate quality than quantity.

 And often quality is judged on subjective opinions rather than on

objectively based data.

 Fine quality products lead to customer good will and satisfaction that
manifest them selves in the form of repeat sales, loyal customers and
clients and testimonial to prospective customers or clients

 policy, information, engineering and design, materials equipment people and

field support are different factors affecting the quality of products
c) Risk management
What is risk?
risk is “a condition in which there is a possibility of an adverse
deviation from a desired outcome that is expected or hoped for.
Types of business risk:
1. Market risk:
 is the uncertainty associated with an investment decision.
2. Pure risk:
 is used to describe a situation where only loss or no loss can occur

 Owning property, for instance, creates the possibility of loss due to

fire or severe weather; the only outcomes are loss or no loss.
3. Property Risks:
 Property –oriented risks involve tangible and highly visible assets.
 When these physical assets are lost or destroyed, they are quickly
missed.
4. Personnel risk-
 personnel oriented risk or losses occur through the action of
employees.
 The three primary types of personnel oriented risks are dishonesty of
current employees, competition from former employees and loss of
key executives.
5. Customer risk-
 is risk associated to customers legal claims as a result of on-premises
injuries and product liability.

 Although customers are the sources of profit for small businesses,

they are also source of an ever-increasing amount of business risk.
The Process of Risk Management
• Five steps are required to implement risk management and its goal of
preserving a firm’s assets and earning power:
Step 1: Identify risks.
Step 2: Evaluate risks.
Step 3: Select methods to manage risk.
a) Risk control
 is designed to minimize loss through avoidance and/or
reduction.
 Risk avoidance is achieved by choosing not to engage in a
hazardous activity.
 Risk reduction on the other hand focuses on decrease the
frequency, severity, or unpredictability of losses.
b) Risk financing,:
 focuses on making funds available for losses that cannot be
managed by risk control
 it involves transferring the risk or retaining the risk.
Risk transfer:
 is accomplished largely through buying insurance and making
contractual arrangements that transfer the risk to others.
Risk retention:
 occurs when a firm does not take action to avoid, reduce, or
transfer a risk and, thus, exposes itself to the risk.
 One common form of risk retention is self-insurance

 Self-insurance program designates funds to individual loss

categories such as property, healthcare, or workers’
compensation.
Step 4: Implement the decision.
Step 5: Evaluate and review.
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