Ways That A Business Endeavor Can Be Financed
Entrepreneurs start out with a vision. This vision needs to be fuelled for it to be transformed into reality. Right from the inception cash flow should be sufficient enough. It is important to use the right finance mix and choose the appropriate source of capital for the business. Sources of capital can be classified broadly into two types: debt and equity. The debt to equity ratio varies from firm to firm as well as business vertical to the other. When a company is new it doesn’t have market reputation and the sources that are available then is different from when it has established itself in the marketplace. When the business is in the embryonic stage the primary funds would be investing one’s own wealth. This is the case because unless one invests in themselves other will not. It is similar to having faith in oneself. Moving on to the debt options which is usually available throughout the business life. However they come with their own set of risks. The higher the risk in the business, the more the rate of return. The biggest risk in this method is that there is a deadline when the payment has to be made. If one defaults the payment then the entrepreneur will be faced by not so nice consequences. Out of the numerous sources capital available one must consider carefully keeping in mind their pros and cons and zero upon the right source for them. It is not necessary that what worked for one firm will work for the other.
No idea can be made into a reality without cash or capital or funds. Fund management is one of the most important aspects involved in running any kind of empire. It is important for an entrepreneur to choose the right way to fund their business; they must carefully weigh their options and use the most optimum solution. As the company grows and they get a good reputation the options available open up and making it even more crucial for the company to adopt the best mix.
Let’s try to understand the different phases of the business and the difference in the capital requirements.
LIFE CYCLE OF A BUSINESS
There are four phases that any business, industry or product has to pass. There is no exception and the four phases are as follows
These four phases remain the same as we move across various industries as well as businesses. The only thing that changes is the duration of each phase and the scale. The embryonic stage being the first stage is where everything starts from. It is a critical stage where evolve a business idea into something more and help the business succeed. The market has to be attractive where the product or service is to be launched. It is not possible to bring in a product into a market where it wouldn’t be accepted. The product or service needs to be reasonably priced. It is impossible to find a market place where there is no competition unless one enjoys the first mover’s advantage; hence there should be a combat plan ready to tackle the competitors. The plan should be practical and such that it can be implemented. Every plan should be backed by the management. It is essential for the top management to support the plan and be able to implement it.
Stages within the embryonic phase:
While starting up many of the people underestimate the time taken they expect to things to happen soon. However in the study carried out by me. A survey of 120 ventures was conducted and found the average to be 8 years of time required for the business to generate positive cash flow and to start making profits. However, many of the people quote 6-14 years of time frame.
Most of us would disagree to these statistics. The reason for the same would be that that the businesses which take a shorter time to establish are the ones which most spoken about and publicized. There is one more exception to this rule and this would be the ones who take a franchisee. This is so because the idea feasibility stages have already been done by the company who gives the franchisee. Thus the pioneering work is already complete and the path for the rest becomes easier.
As the business moves from one phase to the other phase, the risk comes down but it also increases the exit barriers for the business as does the cash requirement. But the credibility of the firm increases and thus the debt options becomes available for the firm. Initially it is difficult to raise money from the market as it doesn’t have market credibility.
There has to be a trade off between the perceived risk and the rewards that would be obtained. Thus it has been seen that the higher the risk with the project there are fewer sources of capital and thus the rate at which one borrows goes up significantly. But lower the risk there are more options and the return is also not high as the previous one.
If we take the cash requirement; as stated earlier it increases as we move from one phase to the next phase. One of the thumb rules that is followed in the industry is that as the business moves from phase to the next phase the cash requirement goes up by a factor of 5 or 10. It has been noticed that the commercialization phase is the most expensive of all.
Businessmen can calculate approximately the funds necessary for their novel commerce by reviewing the financial projections. While investigating the projections and the fund flow report, it becomes apparent how much cash will be required and at what time. The businessmen may offer a little of the necessary money, and associates and relatives may aid with humble investments. Government grants and bootstrapping can also provide essential investment to start a business enterprise. The majority of the positive-growth firms that anticipate growth of a noteworthy size will call for external funds from expert investors. Normally, some stages of investment will be necessary over the time of the commerce.
One cannot point out even one method which is a good source of capital. There are three factors which may change the method one might use; these are: economic changes, legal as well as legislative changes. Referring to a survey conducted in 1980 known as Wisconsin study of small businesses it was concluded that one fourth of the enterprises were let down or refused by at least one person (a lender). Out of this one fourth, three fourth of them managed to get an approval from another person. Thus we can see that there are variations amongst different vendors; this difference can also affect your ability to raise funds. One’s achievement in raising capital for a novel company relies on superior scheduling, practical forecasting, and being aware of the sources available to fund one.
There are four questions that are required to be answered. These would aid is in raising capital.
What amount of capital would be required?
To fund the business how much of personal funds should be utilized?
How much money should be raised from others?
What will be the method used to convince people to invest in my business?
In order to find out the various options that are available to a firm to arrange for capital to meet their requirements various methods of analysis have been used by me. Apart from the sources of capital that are available, I have tried to find out how this varies for different stages of the life cycle.
For the purpose of finding the sources at the embryonic stage, I have interviewed Mr. Tibrewal, Managing Director of Gangotri Textiles (based out of Coimbatore; a listed company) apart from reading various articles. The interview can be found in the next analysis.
For the next stage which is the growth stage a case study analysis approach was used. Several reliable websites were looked up to aid in understanding of the case study. The case of Duncan Bannatyne was taken up by me for the same.
In the mature stage where I have taken the instance of carrying out a joint venture, a similar approach as the previous one has been undertaken by me. I have analyses the case of a Sino joint venture of General Motors. This is aided by looking up for more details in articles and the websites.
After carrying out the research by taking up different instances, the following conclusions have been drawn upon by me.
Everyone dreams to make it big, there are millions of ideas out there and only few of them are able to live their dream. One of the biggest constraints that a person faces while starting his own business is capital. There are various options that are available for new entrepreneurs to raise capital for their business. Broadly speaking capital can be divided into two; one being equity and the other being debt. However there are available options which combine the two; one being convertible debenture. It is of common knowledge that the perceived risk is related to the returns that are required. This return follows the same way as the risk of the project takes up the graph. For a company which is in its infant stage, the debt issues will be similar to the equity; the reason cited for this is that the security for a return on the investment isn’t better.
RAISING FINANCES THROUGH EQUITY
Unless one invests in their own project no one else would invest. Thus the first source of fund would be the entrepreneur himself. People from the market who are strangers would get more confidence if they see that the entrepreneur isn’t alone and is backed by his family and friends. Thus the primary source is family and friends which is also one of the cheapest sources available. There are two clear advantages in this source.
Market players gain confidence and look at the project with a more open mind
This source is very cheap
The foremost option that is available to such companies is venture capital funds. This is a perfect option for new companies as they do not possess the ability to raise money from the markets or secure loans from the bank. Statistics show that venture capitalists invest in one of four hundred opportunities available to them. Innovative technologies are their favourites. Venture capitalist offer funds in 6 stages:
Seed money is the amount required to show whether the idea would work or not. The requirement at this level is not much. Start up, as the name suggests is the stage where they are in the developing stage, the product is being developed. Further in the first round of investment it provides funds for the purpose of meeting basic requirements such as manufacturing expenses. The second round is the stage where the company is growing but is not yet making profits. The company often decides to diversify its operations and this is done in the third round. Finally to make the company accessible by the public the fourth round also known as bridge financing is undertaken.
The above is a diagrammatic representation of the structure of a venture capital firm.
An angel can be described in three words, they are benevolent celestial being. The next source of capital comes from these angels. Confused?? These are the private investors who evaluate the project and see that there is scope in it. Many a times these investors are familiar with the market and have a lot of influence; this aids the new entrepreneur. This is because these angels can not only be a source of capital but also a source of knowledge and influence. They are the ones who fund the business in the starting as they realise that the returns from the business could be good. The next question that comes to our mind is that how do we find these angels? Where can we obtain information about them? These angels can easily be found and some of the ways are listed below:
Websites such as the Go Big Network
The next source would be those of the corporate investors. These are the ones who existed even before the venture capitalists. These people invest either within their own company or outside the company. Mostly, the areas that they invested in where the ones that complemented their own business, this can be do develop a new product or invest in a new technology. For new entrepreneurs it can be advantageous if they cooperate with the market leaders. Whenever there is a new technology that is being persuaded the market leaders would rather buy it than invest in it. However such a kind of cooperation comes with its downside. It is possible that the market leader might take the entrepreneur for a ride.
RAISING FINANCES THROUGH DEBT
Finance mix always consists of equity and debt. The proportion of the two varies according to the industry that the business firm would operate in besides many other factors. When it comes to debt it can either be for a short while called as short term debt or for a longer duration called as long term debt. The entrepreneur gets the right to utilise the money the way he/she wants to but only for the period of time that is specified in the agreement in return of paying certain interest amount at regular intervals of time.
There is an agreement that is drawn up and all the terms are agreed upon in that. There are two types of loans that can be undertaken:
Secured loans- there is a collateral which backs up the loan and that the payment will be paid
Unsecured loan- there is no guarantee as such the only guarantee is the cash flow itself
Taking the case of the unsecured loans, in this there is no guaranteeing hence the decision whether to give money or not is purely based on the forecasted cash flow. To assist this decision the EBIT and the leverage ratios are seen. The secured loans are backed up by any asset which is marketable.
It is tricky to finance the project only by debt when the business is only starting. This is because there is high risk involved in it and no market reputation the chances of not repayment are higher. But it is easier once the company enters the later stages of the life cycle. However there are various methods that are used to finance the project though debt when a company is starting out. Some of them are discussed below:
One of the most well-liked options available is the mezzanine loan. The name originates from what it stands for: it is in between debt and equity. This method arises from the difficulty that people face securing loans from the bank. This is a perfect method to avoid dilution. These providers have a right which is higher than the shareholders.
The sources of these mezzanine loans are from specialized entities, commercial banks and insurance companies. This is an unsecured loan and hence it is given to companies which have a relationship with customers already or have already started. They can also be given to those companies which are ready for sales. Since it is unsecured loans the procedure that has been adapted by these providers are akin to that by the venture capitalist to screen out the projects.
The interest rate is decided based on two factors; one being the perceived risk and the other being the equity component. It is normally greater by 10% when compared with analogous loans. The range would be anywhere from 15% to 30%. In case the debenture has been issued and according to the forecast there is going to be negative cash flow during the earlier stages then there is a provision where the interest payment can be deferred and this interest would be accumulated later. In the scenario that the firm in unable to meet the payment date the terms on the loan can be changed. The changes that can be made are as follows:
The next type of debt would be in the form of bridge loans. These are those funds that can be used to fund the day to day activities or the current activities. It is a kind of short term loan and is available for less than a year. Bridge loans are used as a general mechanism for support between financial rounds devoid of necessitating of set valuation.
While we talk about a firm starting out, there are various stages in this initial stage itself. Depending on which stage the company is it can choose the debt instrument. One of the most common ways that has been found is leasing out the plant and machinery that would be required by the firm. Bank financing is another common source in which a line of credit is obtained from the bank. Finally the entrepreneur may obtain short term loans to finance the working capital requirements.
GANGOTRI TEXTILES-AN INTERVIEW
This section contains the excerpts from the interview with Mr. Manoj Kumar Tibrewal. The primary reason why he decided to enter the textile industry was because this industry was the second largest industry in the country. This industry not only formed 8% of the gross domestic product but also 20% of the cumulative industrial yield. The major objectives of the company for this project were to:
To produce 10,112 kg of polyester cotton yarn in a day
To produce 10,205 kg of cotton yarn in a day
Weaving and processing plant of standard ability of 51,000 metres/day
For the purpose of men and women trouser a modern garment unit
For the purpose of generating energy setting up 6 wind energy generators.
Gangotri Textiles decided to take a route in which they would fund major of their expenses through borrowings. The debt to equity ratio was found out to be 3.5, this was very high and the risk of the business also increased multi-fold because of their decision to follow this capital structure.
COST OF THE PROJECT
The entire project was decided to be implemented in two phases. The difference between the two phases would mainly be the capacity. The details of the project phases have been tabulated below:
All the figures are in rupees and in lakhs.
MEANS OF FINANCE
When it came to equity they took the route of public issue and in debt the route taken by them was loans from financial institutions and banks. The details have been tabulated below. The denomination will be in rupees and in lakhs
The debt has been arranged from various sources and this has been tabulated below.
THE LOAN TERMS HAVE BEEN TABULATED ABOVE
This deals with the second phase when the business is growing. In this phase the company is trying to expand its operation as well as there is an opportunity for the company to grow. To explain the various sources of finance involved in this phase I have taken up the company of Duncan Bannatyne who is one of the wealthiest people in the United Kingdom.
Let us first examine what business does he run and how he started out. After that I shall attempt to explain how he financed the growth of his company making him the richest man in the UK with his empire being valued at a little above £310 million.
This timeline shows where he invested to grow his empire and in which year. He started out by purchasing an ice cream van for £450. This meagre start was turned into Duncan’s Super Ices. When we got into the 80s he realised that there was opportunity in the residential homes so he switched. He saw this when he came to know that the government was paying rent on behalf of those who couldn’t. He sold his ice cream business also later to finance his other ventures.
In order for the business to flourish one has to identify the gap in the industry and fill that hole. This is not merely enough the entrepreneur also has to do his task better than the competitors. One always hears that it is important to have a business plan. But why is this business plan important??
Shows the start up cost
Shows the running cost
Estimated value of sales
What will the return of investment be
Knowing when and where the cash will come from
Another thing that is essential is to be fearless of taking risks. Duncan was willing to take risks. When he was still in the ice cream business; in order to increase his sales he paid £2,000 to get an exclusive place in a local park where he could attract maximum customers. This was the summer when he made a profit of £18,000 which was a huge return on investment.
Funding the growth
While choosing the sources of fund there are two things that need to be analysed. One of the two being the need which is obvious and the other being the size of the investment
Listing the internal sources of finance used by Duncan:
Sole trader: this is the kind of investment in which there is only one person who is giving the cash and he will also be the sole receiver of the profits. This is usually used by people when they are starting their business. In this case we can see that when Duncan started off with the ice cream van he was the sole investor.
Partnership: in this case the ownership doesn’t lie with only one person. More than one people share the responsibility of operation and even the profits are shared by them. This was used by Duncan when he wanted to enter into the first care home. The reason why he decided to do this was because the investment was now bigger
Limited company: this is when anyone can buy the shares of the ownership. This method was used by Duncan when he wanted to open more care houses and thus he went public.
This table shows the start up costs of all the business started by Duncan.
Listing the external sources of finance used by Duncan:
Banks are one of the most common sources of fund. This is one source that can be used in all the phases especially to assist the growth of the firm. The duration of the loans can be of three kinds. That would be long term, short term and medium term. This is decided depending on the need
Mortgages which are another kind of long term loans. This is used to buy fixed assets
For the purpose of day to day operations there are overdrafts. These fall into the category of short term loan and hence are for a certain limited time only
Like discussed earlier Duncan had invested his own personal fund of £450 to start off his ice cream business. All the profits that he had earned in the ice cream van were reinvested in the bedsits business. When it came to the first nursing home he borrowed from the bank (loan) and re mortgaged his home.
Moving to the nursing home business; In this 70% of the building costs were financed through mortgage. The problem that was faced in this was that the money would be obtained only after the house was fully built. This is how Duncan made it possible:
Apart from the profits of the ice cream business, he sold all his possessions like car, TV and stereo
Re mortgaged his home in Scarborough
For the purpose of ongoing expenses he took out numerous credit cards
This wasn’t sufficient to fund the nursing home. Seeing that he had no other option he sold of his beloved super ice business for £28,000
The total expense was £360,000. On the completion of the project it was evaluated by the band and the amount that they arrived at was £600,000. The mortgage being 70% would thus be £420,000. This shows that he was able to recover all the cash spent as well as had equity to spend for his next venture.
When a company enters the mature phase one of the strategies it adopts is a joint venture. While starting out in a foreign country one of the best methods would be through a joint venture. In countries like Russia and China it is the most lucrative approach. The reason behind this is that the risk involved in making direct investments as well as the time factor is too high. One of the primary requisites to carry out business here is the local know who; the reason would be the rapid change in the political as well as economic climate.
Sino-foreign joint ventures have been attempted to be studied by me. The main area of research in this would be how the capital was arranged i.e. the sources of capital for such a venture. So what is a Sino-foreign joint venture??This is a joint venture where there is at least one non Chinese firm and one Chinese firm involved. These joint ventures are operated as well as located in China itself. The case that I have selected is the Shanghai General Motors Corporation.
Shanghai general motors corporation (SGMC)
When this joint venture was conceded the long term objectives of both the firm were matching and prompted towards setting up a joint venture. It was also one of the grandest ventures in China then when it came to the scale. The parties that were involved were
Shanghai Automotive Industrial Corporation(SAIC)
In order to become the dominant player in the world it was important that General Motors would start their operations in China. SAIC was trying to serve the new customers in the market of Asia and China. However it lacked in manufacturing and design expertise. This is the reason why they agreed to enter into such a kind of an alliance. This company was founded to manufacture transmissions, engines and cars designed after buick sedans. All this was previously being manufactured in North America. After observing the rise in the Chinese economy this move was taken. The purchasing power of the Chinese would increase shooting up the demand for large sedans.
Capital sources for SGMC
The automobile manufacturing itself is a capital intensive industry. The set up costs including the machines, infrastructure as well as automation would require over $1 billion. All these facilities would be novel as well as complex. The cost of starting is extremely steep.
As per the laws it isn’t possible to buy land in China, thus what the company did was lease out land under the land use grant from the government for a period of fifty years. As far as the labour requirements were concerned they were initially satisfied by the local firm which was SAIC; later there was a fully fledged human resources team in place which would take care of this category and all of their requirements as well as the company’s requirements.
The prerequisites of this firm are shown graphically below:
It was observed that there were two fundamental sources for capital inflow. They are:
Joint venture partners
Registered capital is the amount of money in other words the capital that is invested by the chief stake holders in a Sino foreign joint venture. The initial ownership rights amongst the parties would be defined by this register capital. For all the operations involved in the joint venture there would be a requirement for the corroboration of the approval as well as the application of the same, this requirement is also due fully fulfilled by the register capital. When the register capital was calculated for SGMC it amounted to $700 million. The primary stakeholders for the same were identified as SAIC as well as GM.
Now the following tables will recapitulate the sources of funds.
General Motors-China, Inc. corporation
Shanghai Automotive Industrial Corporation
Shanghai Automotive Joint Stock Company
When GM-China has mentioned it refers to the subsidiary of GM. It is a registered corporation in Delaware. This was established to serve as a link between the Shanghai general motors corporation and the General Motors. Clearly here the General Motors is the parent company.
The remaining $350 million comes from Shanghai Automotive Industrial Corporation. But as seen in the table it has been split into two: one being the SAIC itself and the other being SAJSC. The former contributes 62% and the latter 38%. The Shanghai Automotive Joint Stock Company is a listed company. This company is listed in the Shanghai Stock Exchange. When one enters the stock market we can see that this company’s shares are traded. This is a subsidiary company with SAIC being the parent company. However it is also true that it is partly owned by the public. This is possible by the stock sales. This part as a source of capital isn’t available at the present.
It is mandatory for every JV to be authorised for operation by the central government. The process of acquiring this authorisation for operation is called as registration. This along with the initial capital would be the foremost steps taken towards the operation.
Now pertaining to this case, the capital raised wouldn’t be sufficient. Hence, $821 million is taken as a loan from banks to launch the project. The previous capital would be utilised for plant and machinery. In order to obtain such a high loan it was essential to pull a few strings. The people who were involved are as follows:
Chinese banking officials
Prominent General Motors global financial partners
Shanghai general motors corporation in combination with GM( the head quarters for the same would be in the States)
The banks that were involved were both Chinese and foreign. The total number of banks involved was 39. The break up was as follows:
56% of this which amounts to $460 million came from the Chinese banks. The currencies involved were renimbi and dollars.
The rest came from the foreign banks. This was the remaining 44% totalling to $361 million. These banks were found to be functional in many countries like Hong Kong.
There are three reasons for the reason why this Sino joint venture differed in the capital obtainment process from the other joint ventures. The reasons are the visibility, scale and the scope of this project.
Deutsche Bank, Chase, Citicorp, BankAmerica were some of the banks that were involved in the 39 bank consortium. The only reason why a venture of this scale was able to raise a loan was the tall reputation of general motors including the size and not to forget the leverage applied to all the banks mentioned previously which happen to be their banking partners. The treasury officers were responsible for the same.
Thus summarising the sources of capital:
General Motors-China, Inc. corporation
Shanghai Automotive Industrial Corporation
Shanghai Automotive Joint Stock Company
One of the most obvious ways of raising funds is through non bank capital. When one analyses this particular venture one realises that this method was not an option for them. There were several reasons for the same but the foremost reason being that these opportunities were then limited. The option of bonds were ruled out for two reasons; the first one being that it is somehow restricted to state owned enterprises and the second reason being that the approval requirements of the government are so complex. Equity capital instruments were also not a viable option including stocks. The reasoning for this is also no different.
Moving onto the long term loans; it was encouraged by the government that these loans come from international banks. When we speak about the working capital loan it would constitute a mixture of domestic as well as international banks. This has been cleverly designed so as to increment the inflow of foreign capital to aid the economy of china. This also ensures that there is enough capital for the firms of their origin. One of the most extraordinary endeavours was the way in which this venture broke the bureaucratic obstacles because of which they were able to obtain this nice mix of foreign as well domestic aid.
After studying the market the most prominent thing is its uncertainty. In such an unstable market the company has a humungous undertaking. One out of the many things that this project stands for is the fact that the project has been fully financed. This shows the hard work that has been put in by the people to make it a reality. It also stands for the dire need of reforms when it comes to market in China.
This success has set into motion changes within the government and also will have a bearing in the government rule making aiding the new businesses. It would be a guiding light as china made a transition from state planned economy to a socialistic one.
Whenever a venture is embarked upon there are risks always attached to it. In this case the biggest risk came from the Chinese government, they were unpredictable. It is pretty obvious how the behaviour of the government can affect the company as it is up to them to promote or discourage the purchase of the products manufactured by this wonderful Sino foreign joint venture. In order to ensure the smooth working of the firm it has to be ensured that all the expectations of the government are due fully fulfilled as well as satisfied.
What was earlier thought of being the only aspect of doing business is doesn’t hold true anymore. It is important to move away from market
Perhaps the most important as well as the obvious conclusion that one arrives at is that there is no single best way to fund the business. No combination works wonders for all. Not only does the sources of capital vary with the phase with which the company is in but also depends on the industry they are in, the objectives, the market reputation, the organizational believes amongst others. It is important to understand that every business is different from the other. Thus what worked for company A will not work for company B and so on. This might be applicable to companies in the same industry also.
Based on three factors which are:
Size of the business
Need of the business
Return on investment
The appropriate financial mix is to be arrived at. One has to also carefully weigh the positive as well as negatives of every method.
The above table gives the advantages and disadvantages of various kinds of external sources of finance.
This table gives the various kinds pros and cons for internal sources of fund.
While taking into consideration all these factors there is one more very big factor that the company must consider and that is the risk they are willing to take. Not only the risk but also the ratings the company has attained. Mixing the two many options might close down or open up as per the case may be.
It is thus important to carefully evaluate all your options before arriving at the final decision. Cash flow is perhaps the most important part to sustain as well as start a business. This makes project financing all the more important.
LIMITATIONS AND FUTURE RESEARCH DIRECTIONS
One of the obstacle in this was the case studies analysed by me in the two different phases of the business did not belong to the same industry. This imposes a constraint in comparing the two. However this analysis contains only one company there is a scope of expanding the research for more than one company. Another improvement could be in the method of research by adding interviews or industrial advice for every stage.
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