Sources of finance (Or where can we get money from?)

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1 Sources of finance (Or where can we get money from?) Why do we need finance? 1. Setting up a business 2. Need to finance our day-to-day activities 3. Expansion 4. Research into new products 5. Special situations such as a fall in sales. Business Plan Once a need to raise finance has been identified it is then necessary to prepare a business plan. If management intend to turn around a business or start a new phase of growth, a business plan is an important tool to articulate their ideas while convincing investors and other people to support it. The business plan should be updated regularly to assist in forward planning. There are many potential contents of a business plan. The European Venture Capital Association suggest the following: - Profiles of company founders directors and other key managers; - Statistics relating to sales and markets; - Names of potential customers and anticipated demand; - Names of, information about and assessment of competitors; - Financial information required to support specific projects (for example, major capital investment or new product development); - Research and development information; - Production process and sources of supply; - Information on requirements for factory and plant; - Magazine and newspaper articles about the business and industry; - Regulations and laws that could affect the business product and process protection (patents, copyrights, trademarks). The challenge for management in preparing a business plan is to communicate their ideas clearly and succinctly. The very process of researching and writing the business plan should help clarify ideas and identify gaps in management information about their business, competitors and the market. Where does finance come from? There are two areas of finance. Internal (from within the company), and external (from outside the organisation.). It can also be classified depending upon how long you need it for. INTERNAL Profit. If a business is trading profitably, then some of the profit can be used to fund expansion. (Profit can go to three places 1. Taxation, 2. Dividends, 3. Retained in the business.). This is a good source of finance for existing companies (as no interest has to be paid), but of no use to new ones. Care must be taken with it however, because profit is not the same as cash. Also the owners of a business may resent not getting a large dividend, because the firm thinks it needs the money to grow. Sale of assets. An organisation may find itself with assets (things of value) that it no longer wants. These can be sold to raise finance for new ventures. The drawback is, obviously, that you loose the use of that asset because you no longer own it.

2 Sale and lease back. One way around not having the use of the asset anymore is sale and lease back. The asset is sold, and then the firm rents it back from the new owner. This can get expensive in the longer term. Reductions in WORKING CAPITAL. Working capital is the money used to run the business on a day-to-day basis (to pay the bills, wages etc). Finance can be squeezed from working capital, by holding less stock, chasing up debtors (People who you money), or paying your creditors (People you owe money to) later. There are several dangers with this though. Firstly, the problem of overtrading, that is still making a profit, but not having enough money to pay your day-to-day bills. This is what bankruptcy is! It is the reason most businesses fail. Secondly, the firm may get a bad reputation as a late payer, and find it hard to get credit in the future. Finally, customers may go elsewhere if they are not getting the length of credit that they think they deserve. In general then, these have no direct cost to the business, but there are still risks and draw backs, and is only available for established firms. External Long term Sale of shares (Equity finance) All limited companies issue shares when they first form. The capital raised will be used to by essential items to get the business up and running. If they then want to expand both private (ltd) and public (PLC) limited companies can sell extra shares to raise extra finance. Private limited companies. They can sell more shares to existing shareholders. This will not change the ownership of the company, provided they all buy in the same proportion as already owned. WHY WOULD THEY WANT TO DO THIS? Ans: To allow their initial investment (the business) to expand. They could also decide to go public, that is, seek a listing on the stock exchange. This, obviously, has the potential to raise far more money than just selling to existing shareholders (As there are loads more potential buyers of shares). There are two options by prospectus, which advertises the shares and invites people to apply for them. This is an expensive method, but does mean a wider share ownership. It is normal for a merchant bank to underwrite such an offer. This means they will guarantee to buy any unsold shares. They do, of course, charge for this service. The second option is to place the shares with institutional investors. This is a cheaper option, but means a smaller number of more powerful shareholders. Ordinary (equity) shares Ordinary shares are issued to the owners of a company. The ordinary shares of UK companies typically have a nominal or 'face' value (usually something like 1 or 5Op, but shares with a nominal value of 1p, 2p or 2Sp are not uncommon). However, it is important to understand that the market value of a company's shares has little (if any) relationship to their nominal or face value. The market value of a company's shares is determined by the price another investor is prepared to pay for them. In the case of publicly-quoted companies, this is reflected in the market value of the ordinary shares traded on the stock exchange (the "share price"). Once a PLC is formed, it can raise further money by selling shares in two ways. Firstly by a Rights issue. This means selling shares to existing shareholders, depending upon how many shares they already own. These shares are sold at a discount to the market price of the shares to encourage people to purchase them. This means the ownership of the company does not change. They could, instead, just sell more sells to whoever wants them. But this dilutes the current ownership.

3 Do existing shareholders have to take up their rights to buy new shares? In a word - no. Shareholders who do not wish to take up their rights may sell them on the stock market or via the firm making the rights issue, either to other existing shareholders or new shareholders. The buyer then has the right to take up the shares on the same basis as the seller Other factors to consider in rights issues In addition to the price at which a rights issue is offered, there are several other factors that need to be considered: Issue Costs Rights issues are a relatively cheap way of raising capital for a quoted company since the costs of preparing a brochure, underwriting commission or press advertising involved in a new issue of shares are largely avoided. However, it still costs money to complete a rights issue. Issue costs are often estimated at around 4% on equity funds raised of around 2 million raised. However, as many of the costs of the rights issue are fixed (e.g. accountants and lawyers fees) the % cost falls as the sum raised increases. Shareholder reactions Shareholders may react badly to firms continually making rights issues as they are forced either to take up their rights or sell them. They may sell their shares in the company, driving down the market price Control Unless large numbers of existing shareholders sell their rights to new shareholders there should be little impact in terms of control of the business by existing shareholders There are loads of issues connected with this option. Firstly, it may well mean that the original owners loose control of their business. However, as a private limited company, it may well be difficult for the shareholders to spend their wealth. They own a successful company, but can only spend their salary. Which, whilst being large, almost certainly will not be anywhere near as much as their wealth. (They own this valuable thing, the company, but can not spend that money as it is in the form of shares.) Converting to a PLC will allow them to sell their shares (or usually just some of them), and buy the sports cars, mansions, yachts, Lear jets etc that they have always dreamed of. Because the owners of PLCs are not involved in the day to day running of the company, they will expect large dividends as a reward for holding shares. This means that there will be less retained profit for investment in the business than there would be if it were a private limited company. Owners of a private limited company tend to see their future and the company s as being much more tightly linked. PLC s have more status than Ltd s. For some being a director of a PLC may provide them with the status they require. BANK LOANS This is the same as an individual borrowing money. It can be at either a fixed or variable interest rate. A business may have to provide collateral or security for the loan. This means if they do not pay it back, the lender has the right to sell specified assets of the organisation to recoup its debt. Debentures or bonds These are long-term loans (usually 25 years), and receive a fixed rate of interest. These are often sold on by the lender, in the same way shares are bought and sold.

4 DEBT Vs EQUITY Which is right for which organisation? Debt As no shares are sold, the ownership of the company is undiluted. Loans will be repaid eventually Lenders have no voting rights on company policy Equity It never has to be repaid, unlike a loan Dividends do not have to be paid, unlike interest on a loan, which MUST be repaid. This makes equity more suitable for risky projects, if the returns are less certain. Venture Capital These are firms (often funded by the Government), which specialise in raising finance for more risky ventures. They are prepared to invest in organisations that banks are not willing to lend to because, as well as lending money to the business; they usually take a stake in the ownership of the business (shares). This means if the business is successful, their shareholding will be extremely valuable (If the business fails it will be worth stuff all!). These possible high rewards mean they can take greater risks. They also take a part in running the business (advice; contacts; support), which may be an added attraction (or not!) to start-ups. It is not without its risks for the business. If it fails to meet targets set by venture capitalist, then the VC will take bigger and bigger slices of the firm s equity. They may also look to float on the stock exchange more quickly than the original owners would want in order to get their money back. You will, as always need to evaluate what is right (or more likely to be preferred) by the owners in the case study) What kind of businesses are attractive to venture capitalists? Venture capitalist prefer to invest in "entrepreneurial businesses". This does not necessarily mean small or new businesses. Rather, it is more about the investment's aspirations and potential for growth, rather than by current size. Such businesses are aiming to grow rapidly to a significant size. As a rule of thumb, unless a business can offer the prospect of significant turnover growth within five years, it is unlikely to be of interest to a venture capital firm. Venture capital investors are only interested in companies with high growth prospects, which are managed by experienced and ambitious teams who are capable of turning their business plan into reality. For how long do venture capitalists invest in a business? Venture capital firms usually look to retain their investment for between three and seven years or more. The term of the investment is often linked to the growth profile of the business. Investments in more mature businesses, where the business performance can be improved quicker and easier, are often sold sooner than investments in early-stage or technology companies where it takes time to develop the business model. Where do venture capital firms obtain their money? Just as management teams compete for finance, so do venture capital firms. They raise their funds from several sources. To obtain their funds, venture capital firms have to demonstrate a good track record and the prospect of producing returns greater than can be achieved through fixed interest or quoted equity investments. Most UK venture capital firms raise their funds for investment from external sources, mainly institutional investors, such as pension funds and insurance companies.

5 Venture capital firms' investment preferences may be affected by the source of their funds. Many funds raised from external sources are structured as Limited Partnerships and usually have a fixed life of 10 years. Within this period the funds invest the money committed to them and by the end of the 10 years they will have had to return the investors' original money, plus any additional returns made. This generally requires the investments to be sold, or to be in the form of quoted shares, before the end of the fund. Venture Capital Trusts (VCT's) are quoted vehicles that aim to encourage investment in smaller unlisted (unquoted and AIM quoted companies) UK companies by offering private investors tax incentives in return for a five-year investment commitment. The first were launched in Autumn 1995 and are mainly managed by UK venture capital firms. If funds are obtained from a VCT, there may be some restrictions regarding the company's future development within the first few years. What is involved in the investment process? The investment process, from reviewing the business plan to actually investing in a proposition, can take a venture capitalist anything from one month to one year but typically it takes between 3 and 6 months. There are always exceptions to the rule and deals can be done in extremely short time frames. Much depends on the quality of information provided and made available. The key stage of the investment process is the initial evaluation of a business plan. Most approaches to venture capitalists are rejected at this stage. In considering the business plan, the venture capitalist will consider several principal aspects: - Is the product or service commercially viable? - Does the company have potential for sustained growth? - Does management have the ability to exploit this potential and control the company through the growth phases? - Does the possible reward justify the risk? - Does the potential financial return on the investment meet their investment criteria? Medium term See loans above, as these are often for 5 years. Hire Purchase: Similar to a loan, used for purchasing assets, provided by the firm selling the asset, rather than say a bank. You do not actually own the asset until the final payment is made. This means the asset can be repossessed with ease if you fail to keep up the payments. Leasing: Again, to purchase assets, commonly company cars, but could be anything. You pay a regular sum to the lease company and then get to use the asset. You never own the asset. But, because you never actually own it, when something goes wrong you can just phone the lease company and they will sort it out for you. It stops you having to worry about depreciation, or investing loads in an asset and then it becoming obsolete 20 minuets latter. Short term Overdraft: Spending more in your bank account than you have (a negative bank balance) up to an agreed limit. This is expensive. Banks charge a lot for this, especially if you don t ask their permission first. It is handy for short-term problems.

6 Trade Credit: Stock purchased for sale and not paid for until a month or two latter. This has no interest cost, and so is excellent for buying raw materials, especially as most firms would aim to have sold the goods on to their customers before payment is due. Factoring: If a firm sells goods on credit it may run into cash-flow problems while waiting for payment. This is where factoring comes in. You sell the debt to a factoring firm who pay you, say, 80% of the value of the debt now1. Then, when payment is made, the factoring company receives 100% of the debt. That is how they make their profit. This is expensive as well. Credit Cards (Source for credit cards: ) So what? This is a perennial topic for exam questions. It is not difficult, but you do need to link the source of finance to the business in the case study. For example, will the owners be willing to tolerate less control over their business? What is important for the business? What will the finance be used for? How long is it needed for? How much is required? Also do not forget things like joint ventures, and franchise agreements if a firm is short of cash and wants to expand rapidly. The same questions as above need to be asked.

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