CHAPTER SIX

BUSINESS FINANCING

Financial Requirements: All businesses need money to finance a host of

different requirements.

 Permanent Capital: The permanent capital base of a small firm usually

comes from equity investment.

 Working Capital: A manufacturer or small firm selling to other businesses

will have to offer credit terms, and the resulting debtors will need to be
financed.
 Asset Finance: It is medium to long term finance. The purchase of tangible
assets is usually financed on a longer-term basis, from 3 to 10 years, or more
depending on the useful life of the asset.
 Sources of Financing
Businesses obtain cash through two general sources, equity or debt, and both can
be obtained from literally hundreds of different sources.
1. Internal Sources (Equity capital): it is personal investment of the owner(s) in a
business
Sources of Equity Capital
 Personal saving: The first place entrepreneurs should take for startup money is
in their own pockets. As a general rule, entrepreneurs should provide at least
half of the start- up funds in the form of equity capital.
 Friends and relatives: After emptying their own pockets, entrepreneurs should
turn to friends and relatives.
 Partners: choose to take on a partner to expand the capital formation
 Public stock sale (going public): go public by selling share of stock in their
corporation to outsiders. This is an effective method of raising large amounts of
capital.
 Angels: These are private investors who are wealthy individuals, often
entrepreneurs, who invest in the startup business in exchange for equity
stake in these businesses.
 Venture capital companies: Are private, for profit organizations that purchase
equity positions in young business expecting high return and high growth
potential opportunity. They provide start -up capital, development funds or
expansion funds.
Comparison of Angles and Venture Capitalist
Angels Venture Capitalists (VCs)
• Individuals who wish to assist others in • Finance, small scale new technology
their business venture, and any risky idea.
• Usually found through networks, • Funds are more specialized versus
• Reasonable expectations on equity homogeneous
position and ROI, • High expectations of equity position
• Often passive, but realistic perspective and ROI,
about business venture,
Exit strategy is important,
2. External Sources (Debt capital)
 Commercial banks: Commercial banks are by far the most frequently used
source for short term debt by the entrepreneur. To secure a bank loan, an
entrepreneur typically will have to answer a number of questions, together
with descriptive commentaries.
 What do you plan to do with the money?
 When do you need it?
 How much do you need?
 For how long do you need it?
 How will you repay the loan?
Bank Lending Decision:-Most bankers refer to the five C’s of credit in making
lending decision. The five C’s are capital, capacity, collateral, character, and
conditions.
1. Capital: A small business must have a stable capital base before a bank will
grant a loan.
2. Capacity: The bank must be convinced of the firm’s ability to meet its
regular financial obligations and to repay the bank loan.
3. Collateral: It includes any assets the owner pledges to the bank as security
for repayment of the loan.
4. Character: Before approving a loan to a small business, the banker must
be satisfied with the owner’s character. The evaluation of character
frequently is based on intangible factors such as honesty, competence,
willingness to negotiate with the bank.
5. Conditions: Banks consider the factors relating to the business operation
such as potential growth in the market, competition, location, and loan
purpose.

Another important condition influencing the banker’s decision is the shape

of the overall economy including interest rate levels, inflation rate, and
demand for money.
The higher a small business scores on these five Cs, the greater its chance will
be of receiving a loan. In the Ethiopian context, collateral is very critical.
 Micro Finances: provide financial services mainly to the poor ,micro and
small enterprises
 Trade Credit: It is credit given by suppliers who sell goods on account. This
credit is reflected on the entrepreneur’s balance sheet as account payable
and in most cases it must be paid in 30 to 90 or more days.
 Equipment Suppliers: Most equipment vendors encourage business owners
to purchase their equipment by offering to finance the purchase.
 Account receivable financing: It is a short term financing that involves
either the pledge of receivables as collateral for a loan.
 Credit unions: are non-profit cooperatives that promote savings and
provide credit to their members. But credit unions do not make loans to
just any one; to qualify for a loan an entrepreneur must be a member.
 Bonds: A bond is a long term contract in which the issuer, who is the
borrower, agrees to make principal and interest payments on specific
date to the holder of the bond.
Lease Financing
It is one of the important sources of medium- and long-term financing
where the owner of an asset gives another person, the right to use that
asset against periodical payments. The owner of the asset is known as
lessor and the user is called lessee. The periodical payment made by the
lessee to the lessor is known as lease rental.
 Types of Lease

Depending upon the transfer of risk and rewards to the lessee, the period of

lease and the number of parties to the transaction, lease financing can be

classified into two categories. Finance lease and operating lease.

1. Finance Lease: It is the lease where the lessor transfers substantially all the

risks and rewards of ownership of assets to the lessee for lease rentals.

Finance lease has two phases: The first one is called primary period. This is non-

cancellable period and in this period, the lessor recovers his total investment

through lease rental. The primary period may last for indefinite period of time.
 features of finance lease

 A finance lease is a device that gives the lessee a right to use an

asset.

 The lease rental charged by the lessor during the primary period

of lease is sufficient to recover his/her investment.

 Lessee is responsible for the maintenance of asset.

 No asset-based risk and rewards are taken by lessor.

 Such type of lease is non-cancellable; the lessor’s investment is

assured.
2. Operating Lease: Here risks and rewards incidental to the ownership of asset are

not transferred by the lessor to the lessee. Operating lease has the following

features:

 The lease term is much lower than the economic life of the asset

 The lessee has the right to terminate the lease by giving a short notice and no

penalty is charged for that

 The lessor provides the technical knowhow of the leased asset to the lessee

 Risks and rewards incidental to the ownership of asset are borne by the lessor

 Lessor has to depend on leasing of an asset to different lessee for recovery of

his/her investment
 Advantages and Disadvantages of Lease Financing
The advantages of lease financing from the point of view of lessor are
summarized below:
 Assured Regular Income: Lessor gets lease rental by leasing an asset during
the period of lease which is an assured and regular income.
 Preservation of Ownership: In case of finance lease, the lessor transfers all
the risk and rewards incidental to ownership to the lessee without the
transfer of ownership of asset. Hence the owner­ship lies with the lessor.
 Benefit of Tax: As ownership lies with the lessor, tax benefit is enjoyed by
the lessor by way of depreciation in respect of leased asset.
 High Profitability: The business of leasing is highly profitable since the rate
of return based on lease rental, is much higher than the interest payable on
financing the asset.
 High Potentiality of Growth: The demand for leasing is steadily increasing because
it is one of the cost efficient forms of financing. Economic growth can be maintained
even during the period of depression. Thus, the growth potentiality of leasing is
much higher as compared to other forms of business.
 Recovery of Investment: In case of finance lease, the lessor can recover the total
investment through lease rentals.
Lessor suffers from certain limitations which are discussed below
 Unprofitable in Case of Inflation: Lessor gets fixed amount of lease rental every
year and they cannot increase this even if the cost of asset goes up.
 Double Taxation: Sales tax may be charged twice. First at the time of purchase of
asset and second at the time of leasing the asset.
 Greater Chance of Damage of Asset: As ownership is not transferred, the lessee
uses the asset carelessly and there is a great chance that asset cannot be useable
after the expiry of primary period of lease.
 Traditional Financing in Ethiopian (Equib/Edir, Etc.)

Crowd Funding
It is a method of raising capital through the collective effort of friends, family,
customers, and individual investors or even from the general public.

How is Crowd Funding Different?

Traditionally, if you want to raise capital to start a business or launch a new

product, you would need to pack up your business plan, market research, and
prototypes, and then shop your idea around to a limited pool or wealthy
individuals or institutions. These funding sources included banks, angel
investors, and venture capital firms, really limiting your options to a few key
players.
 The Benefits of Crowd funding
Reach: By using a crowd funding platform like Fundable, you have access to
thousands of accredited investors who can see, interact with, and share your
fund raising campaign.
Presentation: By creating a crowd funding campaign, you go through the
invaluable process of looking at your business from the top level its history,
traction, offerings, addressable market, value proposition, and more and
boiling it down into a polished, easily digestible package.
PR & Marketing: From launch to close, you can share and promote your
campaign through social media, email newsletters, and other online marketing
tactics.
Validation of Concept: Presenting your concept or business to the masses
affords an excellent opportunity to validate and refine your offering.
As potential investors begin to express interest and ask questions, you’ll quickly
see if there’s something missing that would make them more likely to buy in.
Efficiency: One of the best things about online crowd funding is its ability to
centralize and streamline your fund raising efforts.
Types of Crowd Funding

The 3 primary types are donation-based, rewards-based, and equity crow

funding.
1. Donation-Based Crowd Funding: there is no financial return to the investors
or contributors as donation-based crowd funding. Common donation-based
crowd funding initiatives include fund raising for disaster relief, charities,
nonprofits, and medical bills.
2. Rewards-Based Crowd Funding: involves individuals contributing to your
business in exchange for a “reward,” typically a form of the product or service
your company offers. Even though this method offers backers a reward, it’s
still generally considered a subset of donation-based crowd funding since
there is no financial or equity return.
3. Equity-Based Crowd Funding: Unlike the donation-based and rewards-
based methods, equity-based crowd funding allows contributors to become
part-owners of your company by trading capital for equity shares

4. Debt: Debt-based donations are peer-to-peer (P2P) lending, which is a

form of crowd funding. In debt-based donations, the money pledged by

backers is a loan and must be repaid with interest by a certain deadline.

 CHAPTER 7
MANAGING GROWTH AND TRANSITION

New Venture Expansion Strategies

Methods of Growth: The most common place methods by which small

companies increase their business are increasing product inventory or services
rendered without making wholesale changes to facilities or other operational
components.

Common routes of small business expansion include the following common

options:
 Growth through acquisition of another existing business (almost always
smaller in size)
 Offering franchise/license ownership to other entrepreneurs,
 Licensing of intellectual property to third parties, (license for the use of
certain innovative models on fee basis may be given to certain
companies). This is very common for Software products.

 Establishment of business agreements with distributorships and/or

dealerships

 Pursuing new marketing routes

 Joining industry cooperatives to achieve savings in certain common areas

of operation, including advertising and purchasing,

 public stock offerings (selling shares to investors and to the general

public),

Employee stock ownership plans (entrepreneurs may give/sell shares to

employees as incentive for motivation.
 The Ansoff Matrix – Growth Strategy
What is our business growth strategy in relation to new or existing markets
and products?
The Ansoff Matrix is a strategic-planning tool that provides a framework to help
executives, senior managers, and marketers devise strategies for future growth.
 Market penetration / consumption: The firm seeks to achieve growth with
existing products in their current/existing market segments, aiming to
increase market share. This is a low risk strategy because of the high
experience
 Market development: The firm seeks growth by pushing its existing products
into new market segments. Market development has medium to high risk.
 Product development: The firm develops new products targeted to its
existing market segments. characterized by medium to high risk due to lack of
experience about the new product.
 Diversification: The firm grows by developing new products for new markets.
 There are two types of diversification
 Related diversification and unrelated diversification: In this the business
remains in the same industry in which it is currently operating. For example, a
cake manufacturer diversifies into fresh-juice manufacturing.
 Unrelated diversification, there are usually no previous industry relations or
market experiences.
 Business Ethics and Social Responsibility

Three Approaches to Corporate Responsibility: From this money-centered

perspective, insofar as business ethics are important, they apply to moral

dilemmas arising as the struggle for profit proceeds. These dilemmas include:

“What obligations do organizations have to ensure that individuals seeking

employment or promotion are treated fairly?” “How should conflicts of

interest be handled?” and “What kind of advertising strategy should be

pursued?” “What pricing strategy should be pursued?”

Now there are large sets of issues that need to be confronted and managed

outside of and independent of the struggle for money.

 Approaches to Corporate Responsibility
There are three theoretical approaches to these new responsibilities:
1. Corporate social responsibility (CSR)
2. The triple bottom line
3. Stakeholder theory

Corporate Social Responsibility (CSR)

corporate social responsibility (CSR) is composed of four obligations:
i. The economic responsibility to make money: Required by simple
economics, this obligation is the business version of the human survival
instinct (to live we have to eat).
ii. The legal responsibility to adhere/obey/follow to rules and regulations. Like
the previous, this responsibility is not controversial. What proponents of CSR
argue, however, is that this obligation must be understood as a proactive
duty.
iii. The ethical responsibility to do what’s right even when not required by
the letter or spirit of the law. This is the theory’s keystone obligation, and it
depends on a coherent corporate culture that views the business itself as a
citizen in society, with the kind of obligations that citizenship normally entails.
iv. The philanthropic responsibility to contribute to society’s projects even
when they’re independent of the particular business. A lawyer driving home
from work may spot the local children gathered around an impoverished area
stand and sense an obligation to buy food to contribute to the neighborhood
project. Similarly, a law firm may volunteer access to their offices for an
afternoon every year so some local schoolchildren may take a field trip to
discover what lawyers do all day.
2. The Triple Bottom Line: It is a form of corporate social responsibility
dictating that corporate leaders formulate bottom-line results not only in
economic terms (costs versus revenue) but also in terms of company effects
in the social realm, and with respect to the environment.
The notion of sustainability is very specific. At the intersection of ethics and economics,
sustainability means the long-term maintenance of balance. As elaborated by here below how
the balance is defined and achieved economically, socially, and environmentally:
 Business Ethics Principles

There are certain universal ethical principles that managers of enterprises

must adhere to.

The following list of principles incorporates the characteristics and values that
most people associate with ethical behavior.
1. Honesty. Ethical executives are honest and truthful in all their dealings and
they do not deliberately mislead or deceive others by misrepresentations,
overstatements, partial truths, selective omissions, or any other means.
2. Integrity. Ethical executives demonstrate personal integrity and the courage
of their convictions by doing what they think is right even when there is
great pressure to do otherwise; they are principled, honorable and upright;
they will fight for their beliefs. They will not sacrifice principle for suitability,
be hypocritical, or unscrupulous.
3. Promise-Keeping & Trustworthiness. Ethical executives are worthy of trust.
They are candid and forthcoming in supplying relevant information and
correcting misapprehensions of fact, and they make every reasonable effort to
fulfill the letter and spirit of their promises and commitments.
4. Loyalty. Ethical executives are worthy of trust, demonstrate fidelity and loyalty
to persons and institutions by friendship in adversity, support and devotion to
duty; they do not use or disclose information learned in confidence for personal
advantage
5. Fairness. Ethical executives are fair and just in all dealings; they do not exercise
power arbitrarily, and do not use overreaching nor offensive means to gain or
maintain any advantage nor take undue advantage of another’s mistakes or
difficulties.
6. Concern for Others. Ethical executives are caring, compassionate, benevolent
and kind; they like the Golden Rule.
7. Respect for Others. Ethical executives demonstrate respect for the human dignity,
autonomy, privacy, rights, and interests of all those who have a stake in their decisions;
they are courteous and treat all people with equal respect and dignity regardless of sex,
race or national origin.
8. Law Abiding. Ethical executives abide by laws, rules and regulations relating to their
business activities.
9. Commitment to Excellence. Ethical executives pursue excellence in performing their
duties, are well informed and prepared, and constantly endeavor to increase their
proficiency in all areas of responsibility.
10. Leadership. Ethical executives are conscious of the responsibilities and opportunities
of their position of leadership and seek to be positive ethical role models by their own
conduct and by helping to create an environment in which principled reasoning and
ethical decision making are highly prized.
11. Reputation and Morale. Ethical executives seek to protect and build the

company’s good reputation and the morale of its employees by engaging

in no conduct that might undermine respect and by taking whatever

actions are necessary to correct or prevent inappropriate conduct of

others.

12. Accountability. Ethical executives acknowledge and accept personal

accountability for the ethical quality of their decisions and omissions to

themselves, their colleagues, their companies, and their communities.

END OF
THE
COURSE