LECTURE SEVEN: FINANCING A BUSINESS VENTURE

Lecture Outline

1.1    Introduction

1.2    Objectives

1.3    Overview of Business Financing

1.4    Debt Financing

1.5    Equity Financing

1.6    Sources of Business Finance

1.7    Considerations in choosing Sources of Finance

1.8    Factors Constraining Financing of Business

1.9    Principles of Fundraising

1.10    Summary

1.11    Further Readings

7.1 Introduction
Once you prepare a business plan, the next challenge is to mobilize
resources for the implementation of the plan. A good business plan which is
not backed by adequate resources is only a dream. A business requires
different types of capital including financial, physical capital, social capital,
human capital, intellectual capital. These are necessary to ensure the idea
is actualized. Financial capital will more often than not facilitate
acquisition of the other types of capital. This lecture therefore focuses on
mobilizing financial capital for a business.

7.2 Objectives

 6.2 Objectives
By the end of this lecture, you should be able to

1. Explain the types of financing of a business - debt and equity

2. Discuss challenges facing entrepreneurs in raising capital for

their business

3. Determine the various sources of financial capital for

entrepreneurs

7.3 Overview of Business Financing

How business start-ups are financed is one of the most fundamental
questions of enterprise a new business venture. Financial capital is one of
the necessary resources required for enterprises to form and subsequently
operate.

The importance of the financing decision of new businesses consequentially

has important implications for the economy; given the role new enterprise
plays in employment growth, competition, innovation and export potential.

Additionally, capital decisions and the use of debt and equity at start up
have been shown to have important implications for the operations of the
business, risk of failure, firm performance and the potential of the
business to expand in the future.

In deciding how to finance your business, you need to consider certain

questions: How much control of your new business can you comfortably give
up? Which facts that will debt and equity financiers be interested in? How
do debt and equity requirements differ? How highly leveraged do you want
your company to be? (the higher the amount borrowed compared to the
amount of equity, the higher the leverage).

7.4 Debt Financing

Debt is a direct obligation to pay something (cash) to someone (an investor
or lender). In exchange for having lent you money. An investor will expect
to be paid interest. Obviously, this means that you will repay more money
that you have borrowed. Therefore, an important feature of debt financing
is the interest rate you will be charged.

Interest Rate and Risk

The interest rate usually reflects the level of risk the investor is undertaking
by lending you money. Investors will charge you lower interest rates if they
feel there is a low risk of debt's not being repaid. Investors will raise
interest rates if they are concerned about your ability to repay the debt or
if you have a history of slow payments to lenders as shown on your personal
or business credit reports.

What do debt lenders look for?

A debt lender will evaluate your loan request by considering answers to

several key questions: Can you offer reasonable evidence of repayment
ability either established earnings (for an existing business) or income
(profit & loss) projections (for a new business)? Do you have sufficient
management experience to operate the business?

Do you have enough equity in the business? Equity provides what lenders call
a cushion for creditors. Do you have a reasonable amount of collateral
(assets to be acquired, residential property equity, etc)?

Advantages of Debt Financing

 Control of your company

 Financial freedom

Disadvantages of Debt Financing

 Having to make monthly payments on a loan.

 The difficulty in obtaining them.

7.5 Equity Financing

Equity financing involves no direct obligation to repay any funds. It involves
selling a partial interest in your business. What do equity investors look for?
Equity investors buy part of your company by supplying some of the capital
your business requires. They are interested in the business's long-term
success and future profitability. Equity investors can resell their interest in
your company to other investors.

Advantages of Equity Financing

 No repayment of the money invested by them (unless a payoff

agreement is made at the time of investment).
 This can be important when cash is at a premium.
 Also, your idea for making your business successful may carry more
weight with a potential equity investor than with a debt investor.
 In addition, can be a good source of advice and contacts for your
business.

Disadvantages of Equity Financing

 You give up some control over your business.

 You may find your equity investors do not always agree with your
plans for the business.
 Tends to be very complicated and invariably will require the advice
of lawyers and accountants.

7.6 Sources of Capital

1. Entrepreneur's own capital. This may be from personal savings,
redundancy package, sale of own assets.
2. Informal investors. May be from family, friends, etc. Expectations on
returns and when they will gain is negotiated informally.
3. Informal capital networks. Based on groups of people sharing some
situation e.g. displaced, alien etc. Examples of these are the informal
Asian community networks in Kenya.
4. Business angels. These are individuals or small groups of individuals
who offer capital for new ventures.
5. Retained earnings. Profit ploughed back into the business for existing
businesses
6. Commercial bank loans. These could be normal lending programs or
special lending programs. May include: overdraft, loan for purchase
of asset, working capital
7. Microfinance Institutions. - these have grown to become major
players in financing sector. Their focus on SMEs and sometimes
specific segments of the population make them unique institutions
supporting entrepreneurship.
8. Venture capital. They fund new innovative businesses in return for
ownership stake. Operate more like mutual trust funds.
 9. Public floatation. Regulated by the Capital Markets Authority.
Conditions apply.
10. Government - through development finance institutions e.g. ICDC,
IDB, AFC, etc.

7.7 Considerations in Choice of Source of Finance

1. Suitability. The type of funds should harmonize with the kind of use it
is being sought for.
2. Volume and stability of income. This will determine your ability to
repay.
3. Control. The source should leave the owner with ability to have
reasonable control over the business.
4. Flexibility. The source should be adjustable as need arises.
5. Economic factors e.g. level of business activity, capital markets, tax
developments.
6. Characteristics of industry e.g. seasonality, level of competition,
regulation, growth potential.
7. Characteristics of business including legal form, size, status in the
industry, credit status.

 7.8 Factors Constraining Lending to Enterprises in Kenya

1. Inadequate pool of loanable funds. Due to insufficient savings
occasioned by more consumption than saving (note: changed
situation).
2. Heavy government borrowing - to finance budget deficit - this leads
to further reduction in loanable funds.
3. Stringent financial regulations - introduced by central bank of Kenya
as part of the financial regulatory framework. This has restricted
entry of smaller banks and increased requirements for borrowing.
4. Underdeveloped financial infrastructures - like venture capitalism
and capital market.
5. Restrictive regulations by the Capital Market Authority.

 7.9 Principles of Fund Raising

1. Ability to ask - be clear about what you want from the financier (a
good business plan will help to do this).
2. Personal approach - decisions are based on relationships, cultivate a
trust relationship.
3. Credibility - good PR and credibility is extremely critical.
4. Understanding the financier's needs.
5. Target the right person who will make the decision.
6. Right timing.
7. 80/20 rule.
8. Negotiate carefully all agreements - avoid over-committing yourself.
 

7.10 Summary

 Summary
This chapter examined the challenges of raising finances for a
business. It discusses the dual concepts of debt and equity as
well as the possible sources of finances for a business. It
examines the issues that entrepreneurs need to consider
before making a choice of a particular form of financing.

 Intext Question
i. Distinguish between debt and equity financing

ii. Discuss the stages challenges of raising finances for a

start-up

iii. Discuss the factors constraining lending in Kenya today.

 Activity 7.1
Collect a brochure on and SME financing product from one of
the financial institution in your local township. Identify the
conditions indicated and discuss with two to five
entrepreneurs on their comments about the product.

7.11 References

 7.11 References
1. Walker, E.W. & William Petty. 1996. Financial Management
of the small Firm. New Jersey: Prentice Hall.

2. Johnson, Susan and Ben Rogaly. 1997. Microfinance and

Poverty Reduction. UK/Ireland: Oxfam Publications.