MBA management

Entrepreneurial Finance Topics:

Introduction


Entrepreneurs tend to prioritize their sources of funds. Start from the funds that are cheapest and easiest to access, they move on to the costlier and more difficult sources of finance. At the top of the list, there would be self-generated funds that can be spread for the business. Then they would get in touch with friends and family. This is a great source of funds but is fraught with danger. In case things go bad, personal relationships might get ruined.

Entrepreneurial finance consists of venture capital and private equity funding involving an entrepreneur who holds a high proportion of the equity of his or her enterprise. This contrasts sharply with classic investment or corporate finance and also with the main features of the private equity class of MFIs.

According to Janet Kiholm Smith and Richard L. Smith, “ Just as corporate finance is concerned with financial decision- making by managers of public corporations entrepreneurial finance is concerned with financial decision- making by entrepreneurs who are undertaking new ventures”.

If the venture needs further infusion of funds, the entrepreneur will tap the banks and Non- Banking Financial Companies (NBFCs) for debt financing. Most entrepreneurs prefer debt financing equity financing. The main disadvantages of equity financing that are overcome in debt financing are as follows:

1) Dilution of Shareholding: After taking on venture capital, the entrepreneur owns less of the firm and even the profits have to be shared.

2) Increased Third- Party Governance: Few entrepreneurs are happy with having to comply to a large number of norms and regulations.

3) Increased External Controls: In debt financing the entrepreneur has to incorporate the views of other investors before taking a decision.

4) Increased Commitment to stated strategy: While taking on external equity, the entrepreneur may have committed to a specific strategy. Changes in long-term strategy may be restricted by the agreement signed by the entrepreneur and the equity investors.

Principles of Entrepreneurial Finance


Entrepreneurial finance draws its basic principles from both entrepreneurship and finance. The seven principles are :

1) Real, human and financial capital must be rented from owners,
2) Risk and expected reward go hand in hand,
3) While accounting is the language of business, cash is the currency,
4) New venture financing involves search, negotiation and privacy,
5) A venture’s financial objective is to increase value,
6) It is dangerous to assume that people act against their own self-interests, and
7) Venture character and reputation can be assets or liabilities.

Role of Entrepreneurial Finance


Entrepreneurial finance is the application of financial tools and techniques to the planning, funding, operations and valuation of an entrepreneurial venture. Entrepreneurial finance focuses on the financial management of a venture as it moves through its lifecycle, beginning with its development stages and continuing through to when the entrepreneur exists or harvests the venture. Nearly every entrepreneurial firm will face major operating and financial problems during its early years, making entrepreneurial finance and the practice of sound financial management critical to the survival and success of the venture.

Most entrepreneurial firms will need to re-group and re-structure one or more times in order to succeed. Financial distress occurs when cash flow is insufficient to meet current liability obligations. Alleviating financial distress usually requires r-structuring operations and assets or re-structuring loan interest and scheduled principal payments. Anticipating and avoiding financial distress is one of the main reasons to study and apply entrepreneurial finance.

Generating Cash flows is the responsibility of all areas of the venture- marketing, production/engineering, research and development, distribution, human resources and finance/ accounting. However, the entrepreneur and financial manager must help other members of the entrepreneurial team relate their actions to the growth of cash flow and value. The financial manager is normally responsible for keeping the venture’s financial records, preparing its financial statements forward for one to two years. The venture needs adequate cash to survive the short-run. Financial plans indicate whether the venture is expecting a cash shortage .If so, the entrepreneur should seek additional financing to avert the shortage. Long-term financial planning typically involves projecting annual statements five years forward. While the reliability of longer- term projections may be lower, it is still important to anticipate large financial needs as soon as possible. Meeting those needs may dictate several rounds of financing in the first few years of operations.

The financial manager is responsible for monitoring the firm’s operating efficiency and financial performance over time. Every successful venture must eventually produce operating profits and free cash flows. While it is common for a new venture to operate at a loss and deplete its cash reserves, it cannot continue indefinitely in that state.

In summary, financial management in an entrepreneurial venture involves record keeping, financial planning monitoring the venture’s us of assets and arranging for any necessary financing. Of course, the bottom line of all these efforts is increasing the venture’s value.

Difference between Entrepreneurial Finance and Bank


However, the very nature of entrepreneurship prevents start-ups and their financiers from writings complete contracts in which obligations are specified in all relevant conceivable future contingents. Thus, optimal contracts in which obligations are specified in all relevant conceivable future contingents. Thus optimal contracts between entrepreneurial firms in knowledge- based industries and their financiers differ from those between venture capitalists and banks for four main reasons:

1) Because venture capitalists take an equity-linked stake in the firms finance, they also share in both upside and downside risks. Whereas banks can profit from financing projects only by a repayment of their credits, venture capitalists can also benefit from an increased firm value that may exceed the amount of credits offered by banks.

2) Venture capitalists also can and to undertake the projects without the original entrepreneur. This creates the double moral hazard problem; entrepreneurs may under-invest in their firm after receiving the necessary financial resources, but also the venture capitalist has an incentive to replace the entrepreneur. Though banks cannot credibly commit to contributing to the managing of the firm, the technical expertise of venture capitalists enables them to replace the original founder with a new and more appropriate CEO.

3) The role played by venture capitalists in staging the investments serves to reduce agency and verifiability problems. After their initial investment, venture capitalists provide entrepreneurs with access to consultants and accountants, play active roles as monitors and provide information for other stakeholders in the firm.

4) Venture capitalists take an active part in guiding the exit decision either by selling their shares directly to other firms or investors or by making an IPO.

Why ‘Entrepreneurial' Finance?
1) The uncertainty outcomes in an entrepreneurial venture increases the degree of risk to investors and therefore the difficulties in raising finance.

2) In entrepreneurial ventures, investors and the management of the enterprise are usually more inter twined than shareholders and management in large organizations. Entrepreneurs are commonly both the manager and the owner of their enterprise, raising finance from a variety of sources. In larger organizations, particularly publicly quoted ones, there is a clear separation between investors who are shareholders and those who run the business.

3) The financial markets available to entrepreneurs are more limited than those open to corporations and large institutions. Entrepreneurial ventures often have to appeal to private investors rather than stock markets to raise funds and shortages of funding opportunities are a problem for some enterprises.

4) The opportunist nature of entrepreneurial ventures, often operating with little precise knowledge of the environment, makes forecasting the financial needs of an enterprise problematic.

5) The small scale of an entrepreneurial venture at start-up, and the need to make rapid adjustments as it develops, makes uncertainty in the management of finance more likely.

6) The personal characteristics of entrepreneurs, including their resource acquisition skills and intuitive decision- making , introduce further uncertainty in financial planning and influence the type of finance acquired and thee methods used to manage it.

7) The financial statements required by statute for small businesses are usually less rigorous than the statutory reports published by large public companies.

8) Entrepreneurs tend to make less use of financial statements and controls and controls than corporate managers.

DEBT


Even though venture capital and other equity investment are often in the news, the bulk of the financial impetus to new business is provided by debt financing. There are very few deals mad involving venture capital but the vast majority of new businesses have availed of debt financing from formal and informal sources. The main formal sources of debt finance are banks and financial institutions such as state financial Corporations (SFCs) and Non-Banking Financial Companies (NBFCs).

Sources of Debt Finance

1) State Finance Corporations(SFCs): In many stats, the SFCs have accumulated huge losses and are no longer actively involved in the business of financing entrepreneurs. Some operating SFCs are even facing such a financial crunch that it is possible that our loan proposal has been Okayed and the money is sanctioned but there is no money to give. At best, the release of the money would be delayed for a long time and it would upset all our financial calculations. So, we have to be very careful before approaching the SFC for debt financing.

2) Non-Banking Finance Corporation (NBFCs): There are many NBFCs focused on equipment financing. Their procedures are very transparent and the paperwork is completed very quickly. In most cases, the rates offered by them are also very competitive, In addition to vehicles, construction equipment, motors, pumps, and fabricated components are regularly financed.

3) Banks: There are many varieties of banks operating throughout the country. There are foreign banks, nationalized banks and private banks. Lending is the primary source of income for banks. Other activities such as issuance of guarantees, drafts, transfer of money, etc., do not contribute anywhere as much as the core banking activity of lending.

The Reserve Bank of India (RBI) has identified lending to Small- Scale Industries (SSIs) as one of the priority sector advances. It is specified that priority sector lending should amount to 40 per cent of the total lending of banks, but no target has been specified for the SSIs alone. Other proactive measures by RBI include waiving requirement of collateral for small loans upto Rs. 25 lac. The RBI to encourage timely handling of applications.

Securing Debt Finance

The process of securing debt finance is very taxing. This is the entrepreneur puts all his/her cards on the table and the viability of the venture is repeatedly questioned. Bankers are bound to discover several real and imagined flaws in the business idea. The process for securing a business loan can be summarized as follows:

1) Drawing-Up the Business Plan: The business plan has to be drawn-up and the sources and uses of funds have to be determine and put-down in writing. While writing the business plan, it is necessary to determine how much loan finance is needed and when it is needed.

2) Identifying Sources of Debt Finance: There will be a number of banks in the city. Some will have the reputation of being transparent in their dealings. It is prudent to ask other business owners to rate the banks.

3) Presenting the proposal to the Bank: Initially, this has to be presented to the Branch Manager or a Disbursing Officer. The bank will have its set of forms, which have to be filled-out.

4) Going for Further Talks: If the Manger is considering your proposal favorably. You will have to go for further talks and you will need to answer some questions the bank officials will have regarding your proposed business or about the guarantees and collaterals you are pledging to the bank.

5) Working–out Details: Once the two parties have broadly agreed, details regarding amounts, schedules, interest and charges, extent of collateral and sureties pledged, etc., have to be worked-out.

6) Purpose: The bank might have preferences about the nature of the client. Some banks would prefer to deal with proprietorship concern when large sums of money are involved.

7) Safety: The bank has to satisfy itself that the borrower has the capacity to successfully manage the business he/she is engaged in and is honest. The bank wants to be sure that the money is safe in the hands of the borrower and that it is being used for the purpose for which it was taken. The bank wants to be sure that the loan will be repaid in time as per the terms agreed upon.

8) Profitability: Like any other business, the bank too is interested in making a profit. Most of the revenue generated in a bank stems from its lending. The bank will be more interested in lending to an entity that presents greater profitability. The RBI has deregulated interest rates and banks are free to fix their lending rates. The banks will also be looking at growth of a firm with an eye on increase in future with the firm. For example, a loan of Rs. 1,00,000 repaid in two years represents much lesser profits than a Rs.10,000 loan that grows to Rs. 5,00,000 after two years. However, the bank has to balance its concerns regarding the safety of the money and its profitability.
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