Lecture 4 notes

Raising Capital
- Raising capital to launch or expand a business is a challenge.
- Many entrepreneurs are caught in credit crunch.
- Choosing the right sources of capital is a decision that will have a significant
impact on the company for a lifetime.
- Raising funds needs to creative in terms of identifying sources of funds while
developing the business idea.
- Entrepreneurs need to be thoroughly prepared before approaching lenders
and investors.

Financing a business
- Entrepreneurs must have a wide role to obtain financing for their businesses.
- Layered financing – piecing together capital from multiple sources.

Types of capital
- Fixed: to purchase fixed assets of the business.
- Working: to support the operations of business.
- Growth: to expand or change the direction of business.

Equity capital
- Personal investment of owners in business.
- Investors will lose money if business fails.
- Does not have to repaid with interest like loans but entrepreneur must give
some ownership of the business to the investor.

Debt capital
- Must be repaid with interest.
- Is reflected as a lib=ability on company’s balance sheet.
- Can be difficult to obtain like equity financing, but there are a number of
sources of debt financing.
- Can be expensive, especially for small business.

Source of equity financing

- Personal savings
- Friends and Family members
- Business Angels
- Partners
- Venture capital companies
- Corporate venture capital
- Going public
Personal saving
- The first place entrepreneur should look for money.
- The most common source of equity capital for starting a business.
- The investors and lenders expect entrepreneurs to put some of their capital
they make any make investment.

Friends and Family members

- After using own capital, entrepreneurs generally approach family and friends.
- Some important guidelines:
 Consider the impact of the investment on everyone involved.
 Keep the arrangements "strictly business.”
 Prepare a business plan.
 Settle the details up front.
 Never accept more than investors can afford to lose.
 Draft a written contract.
 Treat the funds as bridge financing.
 Prepare a payment schedule that suits both parties.
 Have an exit strategy.

Business Angels
- Wealthy individuals who invesr in emerging entrepreneurial companies in
exchange for equity ownership stake.
- An excellent source of “patient mony” for entrepreneurs who needing
relatively small amount.
- Angels are willing to invest in the early stages of business.
- How to find business angels:
 Networking
 Look nearby – with 50 to 10 mile.
 Informal angel clusters and networks.
Partners
- Giving up personal control
- Diluting ownership
- Sharing profits

Venture capital companies

- Venture capital companies provide capital to businesses exhibiting high-
growth and high-profit potential in exchange for an equity stake.
- Venture capital companies rigorously review the business plans.
- Venture capital companies invest in business across several stages in most
cases.
- Venture capital companies look for businesses that have competent
management, competitive edge, operating in growth industry, have viable
exit strategy, and intangible factors.

Corporate Venture capital

- Large corporations across the world invest in start-up businesses.
 - In addition to capital, corporate partners many bring marketing and technical
expertise.

Going Public
- Initial Public Offering (IPO): When a company raises capital by selling sharing
of its stock to public for the first time.
- Successful IPO candidates have:
 Consistently high growth rates
 Strong record of earnings
 3 to 5 years of audited financials
 Good position in the industry
 Sound management team with relevant experience

Sources of debt capital

1. Commercial banks
2. Asset-backed lenders
3. Issuing bonds
4. Vendor financing (trade credit)
5. Equipment finance companies
6. Commercial finance companies
7. Saving and loan associations
8. Stockbrokers
9. Credit unions
10. Small business investment companies
11. Small business lending companies

1. Commercial banks
- Short-term loans:
 home equity loans
 commercial loans
 lines of credit
 Floor planning
- Immediate and long-term loans
- Common reasons banks reject the loan applications:
 Our bank does not lend to small business.
 I don’t have enough information about your business.
 I am not sure why do you need money.
 Your cash flows do not justify your loan request.
 You do not have adequate collateral to cover loan amount.
 Your business does not support the loan on its own.
2. Asset-backed lenders
- Businesses can borrow money by providing their collateral or other assets
such as receivable (receivable financing), inventories (inventory financing).
- Lenders lend certain % of asset’s value which is called advance rate.

3. Other resources
- Issue bonds
- Vendor financing (trade credit)
 - Equipment finance companies
- Commercial finance companies
- Saving and loan associations
- Stock brokers
- Credit unions
- Small business investment companies
- Small business lending companies

Key differences between equity and debt financing

- Debt is company's liability which needs to repaid after a specific period while
equity remains for long-term with company.
- Debt is borrowed while equity is the capital owned by company.
- Debt holders are creditors while equity holders are owners of company.
- Return on debt is interest while return on equity is dividend (when equity is
raised through issuing shares).
- Debt can be secured or unsecured while equity is unsecured.

Advantages and disadvantages of equity and debt financing

Advantage of equity financing:

- Less risk
- Credit problems
- Cash flow
- Long-term financing

Disadvantages of equity financing:

- Cost
- Loss of control
- Potential conflict of interest
- Level of difficulty (e.g., IPO)

Advantages of debt financing:

- Control
- Taxes
- Predictability

Disadvantages of debt financing:

- Qualifications
- Fixed payments
- Cash flow
- Collateral

Calculating cost of equity

- Cost of equity is the return that investors require on their investment in the
firm.
- It can be through two methods:
 Dividends (Dividend valuation model and dividend growth model)
  Capital Asset Pricing Model

Dividends methods
- Dividend valuation model:

- Dividend growth model:

Capital asset pricing model methods

- Capital asset pricing model formula:
Cost of preferred stock
- Capital asset pricing model formula:

Cost of Debt

-
- After tax cost of debt:
After Tax Cost of Debt = Cost of debt ( 1- Tax )

Weighted average cost of capital (WACC)

- Weighted average cost of capital (WACC) is the weighted average of cost of equity
and the after tax cost of debt.
Conclusion
- Capital is key for entrepreneurs.
- In the face of capital crunch, entrepreneurs’ needs for capital have never
been great.
- Both equity financing and debt financing have advantages and
disadvantages.