PROBLEMS OF RAISING FINANCE

This topic will introduce you to the difficult part of starting a business that of raising
money and solution to business finance.

Expected learning objectives:

By the end of this topic the learners should be able to:

(a) State various problems of raising money

(b) Discuss the solutions to venture finance problems.

Why it is difficult to raise money?

Most entrepreneurs would say the most difficult part of starting a business is raising
money. One of the difficulties of raising money is:

1. Information Asymmetry problems/Monopoly in supply of information

The fact that entrepreneurs have to reorganize information about their business
opportunities that investors don’t have or cant recognize creates three problems for
raising money.

(a) Entrepreneurs are reluctant to disclose information to investors requiring investors to

make decisions on limited information. Entrepreneurs need to keep the information that
they have about their opportunities and their approaches to exploit them. If other people
learned this information then they could pursue their opportunities. So entrepreneurs
don’t want to tell investors how much about their opportunities or ways of exploiting
then; lest the investors exploit the opportunities without them.

(b) The information advantage that entrepreneurs have makes it possible for them to take
advantage of investors. Entrepreneurs can use their superior information to obtain capital
from investors and use it for their own benefit instead of the benefit of the company.

(c) The investors limited information about the entrepreneurs and the opportunity creates the
potential for a problem called adverse selection – Adverse selection occurs when
someone is unable to distinguish between the people, one who has a desired ability, and
the other who doesn’t because it is not possible to distinguish between the two people.
The one without the desired quality has an incentive to misrepresent her attributes and
say that she has the desired quality. E.g some entrepreneurs have what it takes to build a
successful new company and some don’t. if investors cant tell one from the other those
without the ability to build successful companies will minimize the behavior of the others
to get financing for instance they will pretend to possess skills, change a premium to pay
for the losses incurred from backing the wrong people because talented entrepreneurs
don’t want to pay the premium, they withdraw from the financing market leaving only
the entrepreneurs that investors don’t want to back, creating adverse selection.
2. Uncertainty problems

Investors also face a variety of problems because new ventures are very uncertain.

(a) First, they have to make judgements about the value of opportunities and the ability of
entrepreneurs on the basis of very little actual evidence. The factors that determine those
ventures that will become valuable investments things like the demand for the new
product. The financial performance of the firm, ability of the entrepreneur to manage the
company cannot be known for certain until after entrepreneurs obtain financing and
exploit their opportunities because these things cannot occur without the investment of
someone’s capital. If the entrepreneur doesn’t have a potential technology or a long track
record of building successful businesses (which most ventures don’t have), then the
investor has to make a decision about the venture on the basis of very little hard evidence.
Making the financing decision very risky.

(b) Secondly, entrepreneurs and investors often disagree about the value of new ventures
because new ventures are uncertain. No one really knows for sure how profitable – if of
all a new venture will be. So investors make their financing decision on the basis of their
own perceptions about the profitability and attractiveness of ventures which are always
lower than those of the entrepreneur.

(c) Thirdly, investors want to make sure that entrepreneurs will pay up if their ventures prove
not to be valuable, especially if they are lending money to the venture that way, the
investor is risking less. So investors ask entrepreneurs to provide collateral, or something
of value that can be sold if the ventures fail.

Solutions to venture finance problems

1. Self financing
When you raise money to finance a new venture, investors will want you to invest
your own money in the venture as well. One need to put own money in a venture
before raising funds from the other investors.

2. Contract provisions
To protect themselves against the problems that uncertainty and information
asymmetry creates, investors include a variety of provisions in their contracts with
entrepreneurs, first they include covenants on entrepreneur’s behaviour.
Covenants are restrictions on someone’s actions. Common covenants in new
venture finance include precluding the entrepreneurs from purchasing or selling
assets or shares without investors permissions as well as mandatory redemption
rights which require the entrepreneurs to return the investors capital at anytime.
Secondly investors employ convertible securities or financial instruments that
allow investors to convert preferred stock which gets preferential treatment in the
event of liquidation.
3. Specialisation
To better choose which new ventures to invest in and to manage those investment
often they are made, investors in new firms tend to specialize in two ways.
First, they specialize by industry e.g. some on software industry and others
biotechnology.
Second, many investors specialize by the stages of development of the venture
with some investors concentrating on making small investments very early in the
times of new firms and others focusing on making larger late stage investment.
Specialisation helps investors by providing them with contracts among suppliers,
customers and experts who can help evaluate the ventures that they are thinking
of backing and ensure that the ventures are on the right track once they have
invested in them.

4. Geographically localized investing

Investors can limit their investments to local entrepreneurs. First, localized
investing makes it easier to for investors to get heavily involved in new
companies. This is important because investors want entrepreneurs to give them
regular updates about their ventures and often have to step into the day to day
operations of new firms if something starts to go wrong.
Also, local investing makes it easier to pick the right companies to back investors
find it easier to develop a network of sources of information about good startups if
they focus on a constrained area.

Syndication

Many investors in new ventures particularly venture capitalists and business angels,
syndicate, or get other investors to form in them in making investments. Syndication
allows investors to diversify their risks by putting smaller amounts of money into a
variety of companies rather than putting large sums of money into one or two firms.
Syndication also helps gather information about entrepreneurs and investors. Both things
help investors to make better investment decisions.

Activity

(a) Consider the sources of business finance and relate them to business that you know.
(b) Explain the following difficulties of raising money and entrepreneurs normally face:
(i) Information Asymmetry problems
(ii) Uncertainty problems

SOURCES OF ENTREPRENEURSHIP FINANCE

This main objective of this topic is to explore the various sources of finance to an
entrepreneur, the sources of finance through the evolution of the entrepreneurial firm and
the five Cs of lending.

Expected learning objectives

 By the end of this topic, the learners should be able to:

(a) Distinguish between debt and equity finance

(b) Classify the debt finance
(c) Discuss the sources of finance through the evolution of the entrepreneurial firm.

Sources

Internal External

Retained Personal sources, Equity Debt Alternative

profits family and relatives sources

Venture Equity Trade Bank HP &

Finance markets credit finance leasing

1. Internal and External Sources

Finance is available both internal and external funds. The type of funds mostly
frequently employed is internally generated funds.
Sources of internal funds include:-

(i) Profits
(ii) Sale of Assets
(iii) Reduction in working capital
(iv) Extended payment terms
(v) Accounts receivables

In every new venture the start up years involve putting all the profits back into the
venture, even outside equity investors do not expect any payback in these early years.
The needed funds can sometimes be obtained by selling little used assets. Assets
whenever possible should be on a rental basis (preferably on a lease with an option to buy
especially if the rental terms are favourable. This will help the entrepreneur conserve
cash, a practice that is particularly critical during the start-up phase of the company’s
operation.
 A short term internal sources of funds can be obtained by reducing short term assets;
inventory, cash and other working items, sometimes an entrepreneur can generate the
needed cash for a period of 30 to 60 days thus extended payment terms from suppliers.
Although care must be taken to ensure good supplier relationship and continuous sources
of supply, taking a few extra days in paying can generate needed short term funds.

A final method of internally generating funds is collecting bills (accounts receivable)

more quickly. Key account holders should not be irritated by implementation of this
practice, as certain customers have established payment practices.

2. External Sources

Alternative sources of external financing need to be evaluated on three bases:

(i) The length of time the funds are available.

(ii) Costs involved – company has borrowed in floating value or fixed rate.
(iii) And the amount of company control cost. Control can be in form of
Equity, covenants and voting rights.

Sources e.g

(i) Self
(ii) Family and friends
(iii) Commercial banks
(iv) Research and Development limited partnership
(v) Venture capitalist
Private placement
Factoring
Trade debtors
Credit cards

DEBT Vs EQUITY

Debt finance – involves a payback of the funds plus a fees (interest) for the use of
money.
Equity finance – involves the sale of some of the ownership in the venture.

Is money invested in the venture with no legal obligation for EPS to repay the principal
amount or pay interest on it. It requires no repayment in the form of debt. It requires
sharing the ownership and profits.

Debt finance – it places a burden of repayment and interest on the entrepreneur while
equity financing forces the entrepreneur to relinquish some degree of control.
In the extreme, the choice for the entrepreneur is:
 (i) To take on debt without giving up ownership in the venture.
(ii) To relinquish a percentage of ownership in order to avoid having to
borrow.

In most cases a combination of debt and equity proves most appropriate.

Requirements a company must meet before it can raise debt finance

(i) The company must provide a summary of history of the business and its
nature. This is used to assess the risk of the company the risk of the company’s
business line.
(ii) Details of management – names, ages, qualification and experience of
managers and directors. If these are of questionable integrity, such a company
may not get debt finance.
(iii) To produce five years audited accounts which will reflect the company’s
financial ability to serve debt finance.
(iv) The purpose of the loan must be:
(a) Within the lender’s priority
(b) Within the government areas of priority for development purposes.
(v) Furnish lenders with cash flow forecast and proposed trend of repayment.
(vi) Major shareholders of the company must give consent to the loan.
(vii) Details of the company’s present bankers in particular those with which
the company as overdraft facilities.
(viii) Details of products or services produced by the company (their nature).
(ix) Details of the investment or venture to be undertaken – how it is to be
financed and the expected annual returns. This assesses the risk of the investment
hence the cost of finance.

Limitations of Debt Finance/Disadvantages of using Debt Finance to the Company

(i) Interest is a legal obligation and failure to pay it may lead the company
into receivership and consequently liquidation.
(ii) Using debt finance entails conditions and restrictions as to its use and this
makes it non-flexible finance which can only be invested in those ventures
approved by the lenders.
(iii) It is not usually long-term finance and the payment of principal leaves the
company in financial strain and may cause liquidity problems to the company.
(iv) This finance calls for a security i.e it is usually secured against a collateral
security which may be rare or lenders may restrict the use of such asset thus
reducing the company’s operations and thus its profit.
(v) The lenders usually insist that the security be comprehensively insured
which will compound the cost of this finance as it will entail and implicit cost to
the company.
(vi) The nature of the management also may limit the availability of this
finance because bankers may be selective in their management analysis as to who
should get their money and who should not.
 (vii) The Central Bank can limit the availability of this finance through credit
squeeze which will lower the supply of this finance on capital and money
markets.

Advantages of Using Debt Financing

(i) Most debt financing is short-term and as such it will not burden the
company’s cost of financing for long, i.e the cost is short-lived.
(ii) The use of debt finance does not necessarily entail dilution of control to
existing shareholders as these shareholders may only lose the control if the
company has used 67% of debt finance in its financing i.e in its total capital
employed.
(iii) It is usually invested in liable ventures whose return is higher than its cost,
thus it is used with a good investment policy.
(iv) This finance does not call for a lot of formalities in its use in as much as it
does not involve a lot of floatation costs.
(v) This finance is raised fast thus is compatible with abrupt but viable
ventures as and when they raise.
(vi) Some of debt finance are accompanied by technical assistance to preserve
the investment in particular foreign debt finance.
(vii) Usually it is raised subject to the approval of the lenders and in this case
the lenders will first accept the ventures in which this finance will be invested
thus chances of its misuse are slim.

Characteristics of Debt Finance

(i) It is a fixed return finance i.e interest on debt is fixed regardless of the
profits made by the company.
(ii) Interest on debt finance is a legal obligation on the part of the company to
pay and failure to pay it may lead the company into receivership in the extreme.
(iii) It is usually given on conditions and restrictions except for overdrafts.
(iv) It carries a first claim on profits and assets before other finances.
(v) It does not carry voting rights and as such it does not participate in the
decision making process of the company.
(vi) Its use raises the company’s gearing level.
(vii) It is usually a secured type of finance.
(viii) Interest on debt finance is a tax-allowable expense.
(ix) Debt finance is dangerous because it has the ability to force the company
into receivership if not repaid in time.

Classification of Debt Finance

1. Short-term finance
This ranges from 1 month up to 4 years and is given to customers known to the
bank or to lenders. The agreement of this loan will mention both the repayment
 of principal interest, and for interest it must identify whether it is simple or
compound interest.

2. Medium-term Finance
This finance will be in the business for a period ranging between 4 – 7 years.
This term is relative and will depend upon the nature of the business. This type of
loan is used for investment purposes and is usually secured but the security should
not be sensitive to the company’s operations.

3. Long-term Finance
This is a rare finance and is only raised by financially strong companies. It will
be in the business for a period of 7 years and above. This finance is used to
purchase fixed assets in particular during the early stages of a company’s
development. It is always secured with a long-term fixed asset, usually land or
buildings.

Sources of finance through the evolution of the entrepreneurial firm

Founders,
High Venture
friends Business No financial
level of capitalist
and angels corporations
investme s
family
nt risk
assumed Equity
by markets
investor

Commercial
banks

Low
Seed Start-up Early start Establishes

Types

1. Personal funds/savings
The single most important source of capital for new ventures is the entrepreneurs
own savings. Researchers have shown that approximately 70 per cent of all
entrepreneurs finance their new business with their own capital.
Personal funds are cost expensive funds in terms of cost and control, but they are
absolutely essential in attracting outside funding, particularly from banks, private
investors and venture capitalists.
2. Family and friends
Family and friends are a common source of funds for a new venture. They are
most likely to invest due to their relationship with the entrepreneur. Family and
friends provide a small amount of equity funding for new ventures, reflecting in
part the small amount of needed for most new ventures.

In order to avoid problems in the future, the entrepreneurs must present the
positive and negative aspects and the nature of the risks of the investment
opportunity to try to minimize the negative impact on the relationship with family
and friends should problems occur. One thing that helps to minimize the possible
difficulties is to keep the business arrangements strictly business. Any loans or
investments from family or friends should be treated in the same business like
manner as if the financing were from an impersonal investor. Any loan should
specify the rate of interest and the proposed repayment schedule of interest and
principal.

3. Commercial Banks
Commercial banks are by far the sources of short term funds most frequently used
by the entrepreneur when collateral is available. The funds provided are in the
form of debt financing and as such require some tangible collateral – some asset
with value.

Types of bank loans

There are several types of bank loans available. To ensure repayment, these loans are
based on the assets or the cash flow of the venture. The asset base for loans is usually
account receivable, inventory, equipment or real estate.

(i) Accounts Receivable Loans

They provide a good basis for a loan, especially if the customer base is well
known and creditworthy. For those creditworthy customers, a bank may finance
up to 80% of the value of their accounts receivable. When customers such as the
government are involved, an entrepreneur can develop a factoring arrangement
whereby the factor (bank) actually buys the accounts receivable as a value below
the face value of the sale and collects the money directly from the account. In this
case, if any of the receivables is not collectible, the factor (bank) sustains the loss,
not the business.

(ii) Inventory Loans

Inventory is another of the firm’s assets that is often a basis for a loan.
Particularly when the inventory is liquid and can be easily sold.

(iii) Equipment loans

Equipment can be used to secure longer term financing usually on a 3-10 year
basis. Equipment can be used to secure longer term financial usually on a 3-10
year basis. Equipment financing can fall into any of several categories.
 - Financing the purchase of new equipment
- Financing used equipment already earned by the company
When new equipment is being purchased or presently owned by equipment is
used as collateral, usually 50 to 80% of the value of the equipment can be
financed depending on its stability.

(iv) Real Estate Loans

Real estate is also frequently used in asset-based financing. The mortgage
financing is usually easily obtained to finance a company’s land, plant or other
building, often up to 95% of its value.

Cash flow financing

These conventional bank loans include lines of credit, instalment loans, straight
commercial loans, long term loans and character loans.

(i) Line of credit financing

Mostly used entrepreneur in arranging for a line of credit to be used as needed.
The company pays a commitment fee to ensure that the commercial bank will
make the loan when requested and then pays interest on any outstanding funds
borrowed from the bank.

(ii) Instalment loans

Can also be obtained by a venture with a record of sales and profits. These short
term funds are frequently used to cover working capital needs for a period of time
such as when seasonal financing is needed. These loans are usually for 30 to 40
days.

(iii) Straight Commercial Loans

A hybrid of the instalment loan is the straight commercial loan by which funds are
advanced to the company for 30 to 90 days. They are usually for seasonal
financing and for building up inventories.

(iv) Long term loans

When a longer time period for use of the money is required, long term loans are
used. These loans (usually available only to strong, mature companies) can make
funds available for up to 10 years. The debt incurred is usually repaid according
to a fixed interest and principle schedule.

(v) Character loans

When the business itself does not have the assets to support a loan, the
entrepreneur may need a character (personal) loan.
These loans frequently must have the assets of the entrepreneur or other
individual pledged as security.

Banks lending decisions

One problem for the entrepreneur is determining how to successfully secure a loan from
the bank. Banks are generally cautious in lending money, particularly to new ventures,
since they do not want to incur bad loans. Commercial loan decisions are made only
after the loan officer and loan committee do a careful review of the borrower and the
financial track record of the business. These decisions are based on both quantifiable
information and subjective judgement. The bank lending decisions are made according
to the five Cs of lending.

(i) Character
(ii) Capacity
(iii) Capital
(iv)Collateral
(v) conditions

- Past financial statements (balance sheet and income statement) are remained in
terms of key profitability and credit ration, inventory turnover, aging of accounts
receivable, the entrepreneur’s capital investment and commitment to the business.

- Future projections on market size, sales and profitability are also evaluated to
determine ability to repay the loan.

- Generally, the entrepreneur should borrow the maximum amount that can be
possibly be repaid as long as the prevailing interest rates and the terms, conditions
and restrictions of the loan are satisfactory. It is essential that the venture
generate enough cash flow to repay the interest and principal on the loan on a
timely manner.

- The entrepreneur should evaluate the track record and lending procedures of
several banks in order to secure the money needed on the most favourable terms
available.

Reasons why Commercial Banks prefer to lend short-term

(i) Majority of deposits with these banks are subject to withdrawal on

demand and short-term notice these cannot be lent long-term. (The violation of
this principle led to the downfall of a number of financial institutions in 1986/87)
in Kenya.
(ii) Commercial Banks are subject to sudden credit squeeze imposed by the
Central Bank and as such they have to keep their investments in short-term
investments to meet the requirements of the Central Bank.
(iii) Short-term forecasts are usually accurate and also short-term investments
are less risky which is thus preferable to commercial banks.
(iv) Short-term investments are usually more profitable to the banks e.g.
overdrafts which carry higher rates of interest than long-term loans.
(v) Usually short-term investments are not secured e.g. overdrafts and thus are
easier and more flexible to give.
 (vi) The liquidity ratio and cash reserves ratio of Central Bank reduces
commercial banks long-term lending and as such they resort to short-term
investments and lending.

4. Research and development limited partnership (R&D)

Mostly used in high technology areas.

This method of financing provides funds from investors looking for tax shelters.
A typical R&D partnership arrangement involves a sponsoring company developing the
technology with funds being provided by a limited partnership of individual investors
R&D Limited Partnership are particular good when the project involves a high degree of
risk and significant expense in doing the basic research and development, since the risks
as well as the ensuring rewards are shared. The three major components of any R&D
Ltd. partnership are the contract the sponsoring company and the limited partnership.

The contract specifies the agreement between the sponsoring company and the limited
partnership whereby the sponsoring company agrees to use the funds provided to conduct
the proposed research and development hopefully will result in a marketable technology
for the partnership. The sponsoring company does not guarantee results but rather
performs the work on a best effort basis being compensated by the partnership on higher
a fixed-fee or a cost plus arrangement.

5. Private placement

This is by rising monthly through selling shares to the stock exchange market.
Can be sold to friends, employees, customers, relatives and local professionals for a
business to raise funds in the stock exchange it must follow the laid down regulations.

6. Trade Debtors

This acts as a source of finance in as much as the company holding such debtors can
discount them with a bank and obtain immediate finance. They can be used as security
for loans in particular overdrafts. The company can continue to sell on credit and as such
this source can be a semi-permanent source of finance.

7. Accrued Expenses

Examples of these are:

(i) Accrued electricity bills
(ii) Accrued telephone bills
(iii) Accrued water bills
(iv) Accrued rent
(v) Accrued rates

8. Credit Card Buying (Plastic Money)

These are arrangements whereby a company or an individual enters into an agreement
with a credit card organization to use their card to purchase a number of goods and
services and pay after an agreed period of time. Usually repayment carries interest
charges.

Activity
Distinguish between debt and equity finance
Write your reasons why debt finance is more preferred that equity finance.