Financing and Equity Investment

Finance has always been a critical element of any successful business, whether it is required as seed capital for new business ventures or to meet working capital needs in established companies. Finance, capital, money or cash can all be loosely categorised as the same thing, a lack of any one of these is usually a major hindrance to the growth and success of a business.

Financing itself can be grouped into two major types, debt financing and equity financing. The former involves borrowing capital on the promise to repay that amount plus interest over a set time period. The later involves the issue of shares or stock by a company to raise capital or money, with the returns on this equity based on the success of the underlying business (Brealey & Myers, 2003; Stoakes, 2009). Debt financing generally carries a far reduced risk because it’s often only available when secured against tangible assets such as property, as opposed to the much higher risks involved for equity financing, which may only be secured against the relatively intangible ideas of the entrepreneur (Brealey & Myers, 2003; Burns, 2007).

There are a variety of sources of both debt and equity financing available to businesses and entrepreneurs, which you could loosely describe as an inversed pyramid of finance, with a decreasing range of investment sources available as the borrowing company or individual is perceived to be of higher risk.

Debt Financing
One of the key areas of business (debt) financing has traditionally come from commercial bank loans, which offer straightforward secured terms of finance. The origins of this capitalist form of cash financing, which we still see today, can be traced back centuries to the operations of Italian merchanting and banking groups in the 13th, 14th and 15th centuries (Valdez, 2000). Although transactions mostly occur electronically now and there are legal bodies to regulate banks, like the Financial Services Authority (FSA) in the UK, the idea of fixed term loan financing for new and established businesses has remained. Debt financing through commercial bank loans and overdrafts is considered a more secured form of financing, and is unsurprisingly the first point of call for those wishing to fund small and medium enterprises (SMEs) (Burns, 2007). However, debt financing through commercial banks is not always an option for young or start-up companies, which may often be refused loans on the grounds that they lack stable cashflows and the securities to underwrite the bank’s risks (Rayna & Striukova, 2009). This has left a gap in financing that has been filled by the private equity industry.

Private Equity
The private equity industry spans venture capital, expansion capital and buy-outs, providing a highly successful source of investment or alternative asset class to institutional investors and the established capital markets of the various banks. However, private equity itself focuses more on leveraged buy-outs, which restructure and refinance existing multi-enterprise firms towards a more efficient use of their existing assets, over the medium to long-term (Kaplan & Stromberg, 2009). Clearly with the need for assets and an established business, private equity does not usually invest in very early stage entrepreneurial businesses. Venture capital goes some way to addressing this gap in funding and is therefore worth turning to next.

Venture Capital
“The venture capitalists’ role is an old one. Entrepreneurs have long had ideas that require substantial capital to implement but lacked the funds to finance these projects themselves. While many entrepreneurs have used bank loans or other sources of debt financing, start-up companies that lacked substantial tangible assets, expected several years of negative earnings, and had uncertain prospects have often been forced to struggle to find alternatives. Solutions to this problem date back at least as far as Babylonian partnerships. Venture capitalists represent one solution to financing these high-risk, potentially high-reward projects.” (Gompers & Lerner, 2004: 6)

The first organisational form of venture capitalism appeared in the US in 1946, but it was only in the 1960s, however, that venture capital firms started to become particularly successful, growing rapidly in the UK since the 1980s (Murray, 1995; Rayna & Striukova, 2009). Defining venture capital can be difficult because its interpretation varies between countries. The terms “risk capital” and “venture capital” may be used interchangeably, however they both “refer to equity investments in start-up and early-growth enterprises by knowledgeable investors for the purpose of an eventual capital gain” (Cowling, Murray & Bates, 2009: 207). Additionally, it can be referred to as “independently managed, dedicated pools of capital that focus on equity or equity-linked investments in privately held, high-growth companies” (Gompers & Lerner, 2004: 17). It does not usually relate to management buy-outs or other types of private equity activity with large and established businesses.

“Venture capital can be viewed as a cycle that starts with the raising of a venture fund; proceeds through the investing in, monitoring of, and adding value to firms; continues as the venture capitalist exits successful deals and returns capital to their investors; and renews itself with the venture capitalist raising additional funds.” (Gompers & Lerner, 2004: 3)

Although venture capital has become a crucial element in the funding of companies, the increasingly large venture capitalist firms have also become reluctant to invest in small ventures with seed-stage companies. This is despite evidence showing the rapid growth potential of these risk capital enterprises in major economies (Denis, 2004). According to the BVCA (British Private Equity and Venture Capital Association) only around 30 venture capitalist firms out of 190 make early-stage investments (Rayna & Striukova, 2009).

Business Angel Investors / Networks
By contrast, what could be called the informal form of venture capital, Business Angels and Business Angel Networks, offer risk capital funding to whoever they deem fit to receive it, with typically less stringent control measures and more investment in the untested ideas of entrepreneurs and their nascent businesses (Mason & Harrison, 1997). Often ‘angel’ investors have prior relevant business experience and may take up positions on a company’s board to support a company’s management and development (HM Treasury, 2003). Business Angels provide a substantial proportion of early stage business finance, however, how much exactly is hard to tell because the term itself covers even the most informal of investments between relatives or friends (Mason & Harrison, 2002). Business angels form an important part of the high-risk finance spectrum, helping entrepreneurial small business growth and going some way to bridge the perceived equity gap.

References
• Brealey, R. A. & Myers, S. C. (2003). Principles of Corporate Finance (7th ed.). London: McGraw-Hill
• Burns, P. (2007). Entrepreneurship and Small Business (2nd ed.). Basingstoke: Palgrave MacMillan
• Cowling, M., Murray, G. & Bates, P. (2009). ‘Promoting Equity Flows into Smaller Businesses: The UK Enterprise Investment Scheme and Venture Capital Trusts,’ In Leitao, J. & Baptista, R. (eds.) Public Policies for Fostering Entrepreneurship: A European Perspective. New York: Springer
• Denis, D. J. (2004). Entrepreneurial finance: an overview of the issues and evidence. Journal of Corporate Finance, 10 301 – 326
• Gompers, P. & Lerner, J. (2004). The Venture Capital Cycle (2nd ed.). Cambridge, Massachusetts: MIT Press
• HM Treasury (2003, December). Bridging the finance gap: next steps in improving access to growth capital for small businesses (Small Business Service). http://www.hm-treasury.gov.uk/d/small_business_452.pdf
• Kaplan, S. N. & Stromberg, P. (2009). Leveraged Buyouts and Private Equity. Journal of Economic Perspectives, 23(1) 121 – 146
• Mason, C. M. & Harrison, R. T. (1997). Business Angel Networks and the Development of the Informal Venture Capital Market in the UK: Is There Still a Role for the Public Sector? Small Business Economics, 9 111 – 123
• Mason, C. M. & Harrison, R. T. (2002). Barriers to investment in the informal venture capital sector. Entrepreneurship & Regional Development, 14 271 – 287
• Murray, G. C. (1995). Evolution and change: an analysis of the first decade of the UK venture capital industry. Journal of Business Finance & Accounting, 22(8) 1077 – 1106
• Rayna, T. & Striukova, L. (2009). Public venture capital: missing link or weakest link? Int. J. Entrepreneurship and Innovation Management, 9(4) 453 – 465
• Stoakes, C. (2009). All you need to know about the City: who does what and why in London’s financial markets (2009/2010 2nd ed.). London: Longtail
• Valdez, S. (2000). An Introduction to Global Financial Markets (3rd ed.). Basingstoke: MacMillan

18 November 2011 Leave a comment