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Define debt finance and equity finance. What are the distinguishing characteristics of each form of finance?
Debt finance: borrowing from third parties. Need to be repaid. Generally higher risk. Increases potential return to the owner via leveraging.
Equity Finance: money provided by the owners. Generally provided in exchange for a percentage of ownership of the business.
Why is it typically more difficult for a small business to obtain debt financing, compared to an established large business?
Small businesses generally have less tangible assets to put as collateral to obtain debt finance. Large businesses have more assets for collateral. Therefor small businesses would be considered as more risky to potential lenders.
Identify the various possible sources of equity financing
Contribution by founders of the business
Family and friends
Venture capital and private equity
Initial public offering (IPO)
Explain, using a numerical example, the notion of leveraging. What are the advantages of leveraging? What are the disadvantages of leveraging? What is it fundamentally that enables the process of leveraging to work?
- Leveraging is the degree ti which debt finances the business relative to equity, for example a business requires $100,000 to start up, $50,000 will be obtained through debt and $50,000 will be contributed as
- equity. There is an optimal level of leveraging for each business (hard to ID though). The advantage of leveraging is that it allow for the possibility of higher return of the capital invested. The disadvantage is that it will
- increase the riskiness of the business
What sort of business should invest time and effort in seeking venture capital? Explain your answer.
- New innovative or fast growing unlisted
- companies, these financiers are looking for high risk high reward opportunities.
- These opportunities would generally be considered too risky for traditional
- financiers (banks) to back. These businesses would also generally be seeking high investments, up to 10’s of millions of dollars. Venture capitalist will also generally be looking to exits a business within 3-7 years, return needs to be realised in this time.
Discuss and explain the following:
“Different sources of debt and equity finance
are more likely to be available at different stages of development of the firm; and indeed are more likely to be appropriate at different stages of development of the firm.”
- Early stage financing would include: seed
- financing (personal savings, friends, family would be main sources), start-up financing, first stage financing (when firm has exhausted initial funds).
- Expansion stage financing: second stage
- financing (business up and running, needs more money to become profitable)(business
- angels, venture capitalists and government schemes), third stage (mezzanine)
- financing (getting ready to expand in a big way)(debt financing), initial public offering (offers share to public).
- Different investors are more likely to provide finance at different stages, due to their
- own personal objectives
What are the plusses and minuses for an entrepreneur in obtaining finance for his/her business from each of the following sources? personal resources
- Advantages: retain total control and
- ownership of the business
- Disadvantages: putting your personal
- assets at risk, limited source of funding, not taking advantage of leveraging.
What are the plusses and minuses for an entrepreneur in obtaining finance for his/her business from each of the following sources? financial institutions
Advantages: increased access to funding, divesting risk, no equity lost, benefit of leveraging
Disadvantages: can be hard to obtain, pressure from banks to repay.
What are the plusses and minuses for an entrepreneur in obtaining finance for his/her business from each of the following sources? business angels
- Advantages: increased access to
- funds, divesting risk, additional expertise
- Disadvantages: giving equity away,
- angels may prove to be difficult to work with.
What are the plusses and minuses for an entrepreneur in obtaining finance for his/her business from each of the following sources? venture capitalists
- Advantages: a source of high risk
- finance, heavy scrutiny of business plan, additional expertise.
- Disadvantages: can be very time-consuming,
- difficult to obtain, may lose some control.
What are the plusses and minuses for an entrepreneur in obtaining finance for his/her business from each of the following sources? government funding
Advantages: free funds, no equity dilution
Disadvantages: time consuming and difficult to obtain, available to limited situations.
What are the plusses and minuses for an entrepreneur in obtaining finance for his/her business from each of the following sources? an initial public offering
- Advantages: access to much greater
- funding, realise value of the business, limits financial risk.
- Disadvantages: expensive process,
- dilutes ownership (to the point that no control is had by entrepreneur),
- answerable to board, increased legal and management requirements.