COMSATS University Islamabad, Virtual Campus

MGT403 Entrepreneurship

Lecture 20 Handouts

Types of capital and their resources

Raising Capital

Capital is a crucial element in the process of creating new ventures; yet raising the money to launch a new
business venture has always been a challenge for entrepreneurs. Raising capital to launch or expand a
business is a challenge. At the start of the business, the capital required is known as “seed money”. Before
starting business, it is important to identify that what choices you have to finance the business as it is
observed that many entrepreneurs are caught in the “credit crunch.”

The “Secrets” to Successful Financing

1. Choosing the right sources of capital for a business can be just as important as choosing the right
form of ownership or the right location. It is a decision that will influence a company for a lifetime,
so entrepreneurs must weigh their options carefully before committing to a particular funding
source.
2. The money is out there; the key is knowing where to look. Entrepreneurs must do their
homework before they set out to raise money for their ventures.
3. Raising money takes time and effort. Sometimes entrepreneurs are surprised at the energy and
the time required to raise the capital needed to feed their cash-hungry, growing businesses. The
process usually includes lots of promising leads, most of which turn out to be dead-ends. Meetings
with and presentations to lots of potential investors and lenders can crowd out the time needed to
manage a growing company
4. Creativity counts. Entrepreneurs have to be as creative in their searches for capital as they are in
developing their business ideas.
5. The World Wide Web puts at entrepreneurs’ fingertips vast resources of information that can
lead to financing; use it. The Web often offers entrepreneurs, especially those looking for
relatively small amounts of money, the opportunity to discover sources of funds that they
otherwise might miss.
6. Be thoroughly prepared before approaching potential lenders and investors. In the hunt for
capital, tracking down leads is tough enough; don’t blow a potential deal. Be ready to present your
business idea to potential lenders and investors in a clear, concise, convincing way
7. Entrepreneurs cannot overestimate the importance of making sure that the “chemistry” among
themselves, their companies, and their funding sources is a good one. Too many entrepreneurs
get into financial deals because they needed the money to keep their businesses growing, only to
discover that their plans do not match those of their financial partners.

Layered Financing
Rather than rely primarily on a single source of funds as they have in the past, entrepreneurs must piece
together capital from multiple sources, a method known as layered financing. They have discovered that
raising capital successfully requires them to cast a wide net to capture the financing they need to launch
their businesses.
Types of Capital

Capital is any form of wealth employed to produce more wealth. It exists in many forms in a typical
business, including cash, inventory, plant, and equipment. Entrepreneurs need three different types of
capital, as follows:

1. Fixed Capital is needed to purchase a company’s permanent or fixed assets such as buildings, land,
computers, and equipment. Money invested in these fixed assets tends to be frozen because it
cannot be used for any other purpose. Typically, large sums of money are involved in purchasing
fixed assets, and credit terms usually are lengthy. Lenders of fixed capital expect the assets
purchased to improve the efficiency and, thus, the profitability of the business and to create
improved cash flow that ensures repayment.
2. Working Capital represents a business’s temporary funds; it is the capital used to support a
company’s normal short-term operations. Accountants define working capital as current assets
minus current liabilities. The need for working capital arises because of the uneven flow of cash
into and out of the business due to normal seasonal fluctuations.
3. Growth Capital unlike working capital is not related to the seasonal fluctuations of a small
business. Instead, growth capital requirements surface when an existing business is expanding or
changing its primary direction.

Equity Capital represents the personal investment of the owner (or owners) in a business and is
sometimes called risk capital because these investors assume the primary risk of losing their funds if the
business fails. To entrepreneurs, the primary advantage of equity capital is that it does not have to be
repaid like a loan does. Equity investors are entitled to share in the company’s earnings (if there are any)
and usually to have a voice in the company’s future direction. The primary disadvantage of equity capital
is that the entrepreneur must give up some or sometimes even most of the ownership in the business to
outsiders. To avoid having to give up majority control of their companies early on, entrepreneurs should
strive to launch their companies with the smallest amount of money possible.

Debt Capital is the financing that a small business owner has borrowed and must repay with interest. Very
few entrepreneurs have adequate personal savings needed to finance the complete start-up costs of a
small business; many of them must rely on some form of debt capital to launch their companies. Lenders
of capital are more numerous than investors, although small business loans can be just as difficult (if not
more difficult) to obtain. Although borrowed capital allows entrepreneurs to maintain complete
ownership of their businesses, it must be carried as a liability on the balance sheet as well as be repaid
with interest at some point in the future.

Sources of Equity Financing

1. Personal savings:
It is the first place an entrepreneur should look for money. It is the most common source of equity capital
for starting a business as outside investors and lenders also expect entrepreneurs to put some of their own
capital into the business before investing theirs.

2. Friends and family members:

After emptying their own pockets, entrepreneurs should turn to those most likely to invest in the business:
friends and family members. They should be careful as inherent dangers lurk in family/friendly business
deals, especially those that flop.

Guidelines for family and friendship financing:

Following factors should be mainly considered for family and friendship financing:
 Consider the impact of the investment on everyone involved.
 Keep the arrangement “strictly business.”
 Settle the details up front.
  Never accept more than investors can afford to lose.
 Create a written contract.
 Develop a payment schedule that suits both parties.
 Have an exit plan.

3. Angels:
Frequently, the next stop on the road to business financing is private investors. These private investors
(“angels”) are wealthy individuals, often entrepreneurs themselves, who invest in business start-ups in
exchange for equity stakes in the companies.

Patient money is the investors’ willingness to make a financial investment in a business with no
expectation of turning a quick profit. Instead, the investor is willing to forgo an immediate return in
anticipation of more substantial returns down the road. The typical angel:

 Invests in companies at the seed or startup stages.

 Accepts 10 percent of the proposals presented to him.
 Makes an average of two investments every three years.
 Has invested an average of $80,000 in 3.5 businesses.
 90 percent are satisfied with their investments.

4. Partners
Partners may bring in capital, expertise and complimentary skills. Partners may be general partners (with
unlimited liability) or sleeping partners (with limited liability).

5. Corporations
It has been estimated that about 20 percent of all venture capital investments come from corporations and
about 300 large corporations across the globe invest in start-up companies.Corporate partners may share
marketing and technical expertise.

6. Venture capital companies

Venture capital companies are private, for-profit organizations that assemble pools of capital and then use
them to purchase equity positions in young businesses they believe have high growth and high-profit
potential. Many venture capitalists focus their investments in specific industries with which they are
familiar. Venture capitalists typically purchase between 20 percent and 40 percent of a company but in
some cases will buy 70 percent or more.

Most often, venture capitalists invest in a company across several stages. On average, 98 percent of
venture capital goes to:
 Early stage investments (companies in the early stages of development).
 Expansion stage investments (companies in the rapid growth phase).
 Only 2 percent of venture capital goes to businesses in the startup or seed phase.
Venture Capital Companies mainly look for: competent management, competitive edge, growth industry,
viable exit strategy & for other intangible factors.

7. Public stock sale

Initial public offering (IPO) refers to situation when a company raises capital by selling shares of its stock to
the public for the first time. There are several advantages and disadvantages which associated with
company’s decision of “going public”.

Advantages of “Going Public”

 Ability to raise large amounts of capital.
 Improved corporate image.
 Improved access to future financing.
 Attracting and retaining key employees.
  Using stock for acquisitions.
 Listing on a stock exchange.

Disadvantages of “Going Public”

 Dilution of founder’s ownership.
 Loss of control.
 Loss of privacy.
 Reporting to the SEC.
 Filing expenses.
 Accountability to shareholders.
 Pressure for short-term performance.

Sources of Debt Capital:

 Commercial banks
Commercial banks are the very heart of the financial market for small businesses, providing the
greatest number and variety of loans to small companies. Banks tend to be conservative in their
lending practices and prefer to make loans to established small businesses rather than to high-risk
start-ups. It usually offers:

a. Short-term loans, extended for less than one year, are the most common type of commercial loan
banks make to small companies. These funds typically are used to replenish the working capital
account to finance the purchase of more inventories, boost output, finance credit sales to
customers, or take advantage of cash discounts. There are several types of short-term loans.
Business owners use commercial loans for a specific expenditure to buy a particular piece of
equipment or to make a specific purchase, and terms usually require repayment as a lump sum
within three to six months.

b. Lines of credit, one of the most common requests entrepreneurs make of banks and commercial
finance companies is to establish a commercial line of credit, a short-term loan with a pre-set limit
that provides much-needed cash flow for day-to-day operations.

c. Intermediate and Long-Term Loans, banks primarily are lenders of short-term capital to small
businesses, although they will make certain intermediate and long-term loans. Intermediate and
long-term loans, which are normally secured by collateral, are extended for one year or longer and
are normally used to increase, fixed- and growth capital balances. Small companies often face a
greater challenge qualifying for intermediate- and long-term loans because of the increased risk to
which they expose the bank.

d. Asset based lenders are usually smaller commercial banks, commercial finance companies,
specialty lenders, or divisions of bank holding companies that allow small businesses to borrow
money by pledging otherwise idle assets, such as accounts receivable, inventory, or purchase
orders, as collateral. This method of financing works especially well for manufacturers,
wholesalers, distributors, and other companies that have significant stocks of inventory or
accounts receivable.

e. Vendor financing (trade credit)

Many small companies borrow money from their vendors and suppliers in the form of trade credit.
Because of its ready availability, trade credit is an extremely important source of financing to most
entrepreneurs. When banks refuse to lend money to a start-up business because they see it as a
high credit risk, an entrepreneur may be able to turn to trade credit for capital. Getting vendors to
extend credit in the form of delayed payments usually is much easier for small businesses than
obtaining bank financing.
 f. Equipment suppliers
Most equipment vendors encourage business owners to purchase their equipment by offering to finance
the purchase. This method of financing is similar to trade credit but with slightly different terms. Usually,
equipment vendors offer reasonable credit terms with only a modest down payment, with the balance
financed over the life of the equipment (often several years).