BSC IN MANAGEMENT WITH ENTRPRENEURSHIP

MN 2615
FUNDAMENTALS OF ENTREPRENEURSHIP

Block 5- Session 2

Entrepreneurial Finance

Professor Paul Robson

Learning Outcomes

• Understand Pecking Order Theory

• To identify the full list of sources of finance that are

available for Small and Medium Sized Enterprises
(SMEs) and larger sized firms.

• Understand the advantages and disadvantages of

using each source.

• Understand the terms credit rationed, credit

constrained & discouraged borrowers.

• An appreciation of the evidence on access to finance.

 Sources of Finance

Three main sources of finance

•Owners capital/equity (personal savings, re-mortgages,

redundancy, sale of assets, family & friends).
•Borrowings/debt finance.
•Retained profits within the business.

Internal or external
• Internal sources: owners capital and profits.
• External sources: External equity, bank loans,
other borrowings and credit, soft loans, grants.
Pecking Order Theory

•Pecking Order Theory (POT) assumes

entrepreneurs recognise which sources of finance
are available and can rank them (Myers, 1984;
Myers and Majluf, 1984).

•Internal sources used until exhausted.

•Next, debt finance pursued.

•Next, equity finance.

Why most New Ventures Need Funding

Three Reasons Start-Ups Need Funding

 Sources of Finance
Sources of Finance
(Deakins & Freel, 2002)
SOURCE

INTERNAL EXTERNAL

RETAINED PERSONAL DEBT ALT.

EQUITY
PROFITS SOURCES FINANCE
SOURCES

VENTURE EQUITY TRADE BANK HP &

CAPITAL MKTS CREDIT FINANCE LEASING
 BUSINESS ANGELS
They are generally wealthy, entrepreneurial individuals, who
provide capital in return for a proportion of your company’s shares.

Advantages
•Capital for growth.

•More disciplined company.

•Additional finance can then be made available from

other sources such as banks.

•Business angels bring wisdom as well as money, such

as how to run a successful business or an intimate
knowledge of your industry.
 BUSINESS ANGELS
Disadvantages
•Business angels want fast growth & high returns

•Exit plan for business angels needed

•Loss of control

•A need to work with the business angels

 VENTURE CAPITALISTS
• Venture capital companies make larger investments
than BAs - typically starting at £500k.

• Suitable for bigger companies with more complex

plans

• A VC tends to be aggressive in order to produce the

best returns so they can raise their next fund.

• A more formal relationship than with BAs.

• Due diligence of VC investments will be more

expensive for your business
Advantages of Venture Capital

• VCs can Provide Guidance & Expertise.

• VCs Can Connect Startups with

Additional Resources, Connections,
and Hiring.

• Source of Financing and Rapid Growth.

• You Don’t Have to Repay the Money.

• VC Firms are Easy to Find.

Disadvantages of Venture Capital

• Loss of Control and Ownership Status.

• Bottom Line Ties to Results (May Require Very High

ROI).

• May Add a VC-Tied Member to Team.

• They May Refuse to Sign an NDA.

• Due to Risk, VCs May Take a Long Time to Decide to

Invest.

• VCs May Mot Release All Funds up Front.

Business Angels and Venture Capital

• BAs and VCs use a wide range of assessment

criteria.

• Dragons Den, the popular BBC television

programme provides good examples of what BAs
and VCs are looking for in making potential
investments.

Reflections
• What are the Dragons looking for when they
interview/talk to entrepreneurs?

• What are their investment criteria?

 Business Angels and Venture Capital

• Would you have invested in the same businesses

as the Dragons?

• How Peter Jones and Deborah Meaden close deals

• https://www.youtube.com/watch?v=X7vj0IY_jpE
(Peter Jones)

• https://www.youtube.com/watch?v=9iKLfQak8g
4 (Deborah Meaden)
 Finance and SMEs

• Main source of external finance for the bulk of UK SMEs

is bank debt.

• Increasingly, this appears to be of a short-term nature

(i.e. overdrafts, term loans < 3-5yrs and credit cards).

• Banks acts, essentially, as investors…consequently, the

opportunity must be able to demonstrate that future
cash-flows will enable repayment.

• Many commentators argue that a ‘Finance Gap’ exists

and that small firms are credit rationed.
 BANK OVERDRAFT

• An overdraft is an extension of credit from a lending

institution when an account reaches zero.

• An overdraft allows the firm to continue withdrawing

money even if the account has no funds in it or not
enough to cover the withdrawal.

• Basically, overdraft means that the bank allows firms

to borrow a set amount of money.

• A fee is charged and interest charged on

the overdraft
 BANK OVERDRAFT

Advantages
• Handles timely mismatch of flow of funds

• Flexibility & Timely payment

• Helps in keeping a good track record

Disadvantages
• Higher interest rate & Risk of assets being seized

• Encourages lazy debt collection

• A need to stay within agreed limit

 BANK LOAN

Bank loans can be capital/principal repayment or

interest-only and can be structured to meet the
business’s needs.
Advantages
• Meets Medium & Long term needs

• Allows you to keep your business

• Temporary

• Repayment holidays(?)

• Cheaper than an overdraft

 BANK LOANS

Disadvantages
• Tough to qualify

• Risk of assets being seized

• Lack of flexibility

• Often receive less than needed/requested

• Covenants

• Costs/Fees are expensive

 LEASING/ HIRE PURCHASE (HP)

• Hire purchase (HP) or leasing is a type of asset

finance that allows firms or individuals to possess
and control an asset during an agreed term, while
paying rent or instalments covering depreciation of
the asset, and interest to cover capital costs.

• HP is a financing solution
suitable for businesses
wishing to purchase assets
without paying the full value
immediately.
 LEASING/ HIRE PURCHASE (HP)

Advantages
• Fixed rate

• Flexibility of Repayment

• Tax Efficient

Disadvantages
• More expensive

• Administrative Time

• Covenants
 CREDIT CARDS

A credit card is a plastic card issued by a financial

institution that allows its user to borrow pre-
approved funds at the point of sale in order to
complete a purchase.
Advantages

• Speed

• Borrow for Free

 CREDIT CARDS

Disadvantages

• Beware the Debt Trap

• Hidden Costs

• Pick the Right Card(s)

Activity

• What is the highest rate of interest that you can find

is charged by a credit card company?

• Which are the ‘worst’ credit cards to own?

 STOCK MARKET LISTING

Stock market listing is a way of raising long-term equity finance

for your company by offering shares to potential investors.

Three UK Stock Markets

(i) The London Stock Exchange,

(ii) Alternative Investment Market (AIM) and
(iii) PLUS
 STOCK MARKET LISTING

Advantages
• Capital to develop business

• Entrepreneurs/Investors can trade their

shares

• Higher public profile

• Possible employee share options

• Added reassurance to stakeholders.

 STOCK MARKET LISTING

Disadvantages
• The flotation process has demanding legal, regulatory,
financial and marketing aspects.

• A complex process with specialists needed.

• Costs of flotation expensive

• Corporate governance time and costs

• Greater admin/process costs & Loss of independence

• A need to answer to shareholders

 Crowdfunding

•Crowdfunding is a way for people, businesses and charities to raise

money.

•It works through individuals or organisations who invest in (or donate

to) crowdfunding projects in return for a potential profit or reward.
•Examples include: Kickstarter, Indiegogo, and GoFundMe.

•Advantages
•Loyal investors become loyal customers
•For quirky different products/services the audience is more willing to
consider and approve investment requests compared to more traditional
sources.
•A great way to attract public interest and feedback.
•Media attention may follow to provide marketing opportunities.
 Crowdfunding

Disadvantages
• No guarantee the crowdfunding company will allow/accept
your request to be included on their platform.
• You need to generate interest in your product/service and
encourage people to visit the crowdfunding platform.

• If you don’t reach your target, you don’t receive any

funds.
• If not successful, this a very public failure with damage to
reputation and brand.
• You could be too generous with the rewards and/or
investor returns you provide.
 Bank Finance and Outcomes

Did Not
Applied
Apply

Did Not Fear of Rejected Approved Approved

need Rejection (1-99%) (100%)
Finance

Finance Discouraged Credit Credit Full

Not Borrowers Constrained Rationed Finance
Sought
Finance and the Smaller Firm

• Problems arise when quantifying risk…

• To effectively evaluate, and subsequently monitor, the

• opportunity the bank requires the requisite information

• However, in the presence of uncertainty, information is

• neither perfect or costless.

• Information Asymmetries.
Finance and the Smaller Firm

• Information asymmetries are likely to:

• Create scope for Moral Hazard

…and…

• Lead to Adverse Selection or high Agency Costs

Products sought in previous 3 years (%
values)
Mezzanine finance
International trade finance
Crowdfunding platform
P2P lending
Equity from another individual or organisation
Invoice finance or factoring (asset based)
Something else
Loans from another individual/organisation
Government scheme
Commercial mortgage
Trust/Charity funding
Equity from directors or friends or family
Private lending/ finance company
Government/Local government grants
Family/friend loan
Loans from directors
Bank loan
Leasing/hire purchase
Credit card finance
Bank overdraft
0 5 10 15 20 25 30 35 40 45

Source: IPSO MORI British Business Bank (2018)

 Source of Information

Notes: 2017 Survey conducted between 30th August and 7th

November 2017 by IPSO MORI for the British Business Bank.
Source: IPSO MORI British Business Bank (2018)
See: https://www.british-business-bank.co.uk/wp-
content/uploads/2018/02/2017-Business-Finance-Survey-FINAL-
SMEs.pdf
Products sought in previous 3 years
Bank overdraft 40
Credit card finance 35
Leasing/hire purchase 29
Bank loan 25
Loans from directors 11
Family/friend loan 10
Government/Local government
grants 9

Private lending/ finance company 6

Equity from directors or friends or
family 6
Trust/Charity funding 5
Commercial mortgage 4
Government scheme 4
Loans from another
individual/organisation 4
Something else 4
Invoice finance or factoring (asset
based) 3
Equity from another individual or
organisation 2
P2P lending 2
Crowdfunding platform 1
Source: IPSO MORI British
International trade finance 1
Mezzanine finance 0.1 Business Bank (2018)
Forms of finance currently used (2017)
Equity from another/organisatin
Finance from Government scheme 42% are not currently using any
Loans from another individual /organisation form of finance
Trust/Charity funding
Invoice finance or factoring (asset based)
88% of those not currently using
any form of external finance have
Private lending/finance company
not used any form of external
Commercial mortgage finance in the last five years.
Government/Local government grants
Equity from directors or friends or family
Loans from friends/family Source: IPSO MORI British
Loans from directors Business Bank (2018)
Bank loan/mortgage
Leasing/hire purchase
Bank overdraft
Credit card finance
0 5 10 15 20 25 30 35
 Forms of finance currently used
(2017)
Credit card finance 30
Bank overdraft 27
Leasing/hire purchase 15
Bank loan/mortgage 11
Loans from directors 8
Loans from friends/family 8

Equity from directors or friends or family 6

Government/Local government grants 4

Commercial mortgage 4
Private lending/finance company 4

Invoice finance or factoring (asset based) 3

Trust/Charity funding 3

Loans from another individual /organisation 2

Finance from Government scheme 2
Equity from another/organisation 2

Notes: 2017 Survey conducted between 30th August and 7th November 2017 by IPSO MORI for the British Business
Bank.
Source: IPSO MORI British Business Bank (2018)
 Table 3: When last sought external finance

Response %
Have not sought external
finance 31
Within last 12 months 19
Over 1 year, up to 2 years ago 7
Over 2 years, up to 3 years ago 11
Over 3 years, up to 5 years ago 4
More than 5 years ago 20
Don't know/Refused 8

Base = all SMEs (n=2,070 in 2017). Question A11a (single code, prompted).
Source: British Business Bank (2018)
 Table 4: Whether successful in obtaining finance from first
provider, loans/mortgages, over period 2012-2016
Offered Offered Rejected Turned Other
All Smaller Offer Down response
% Amount % % % or Don’t
Know %

2016 80 8 1 7 4
2015 65 14 9 11 1
2014 81 8 4 5 2
2012 70 6 4 18 2
Base = all SMEs that sought bank loans/mortgages in the last 3 years (n=168 in 2016, n=
208 in 2015, n=112 in 2014, and n=185 in 2012). Question A30 (single code, prompted.
Source: British Business Bank (2017).
Table 5: What was done next if not offered full amount – 2012 -2016
Give Up Talk to Negotiate Used An Other Don’t
or cancel Another With Existing % Know
Plans Provider Provider form of %
% % % Finance
%
2016 38 19 17 5 4 1
2015 34 12 7 13 29 5
2014 38 15 23 26 17 5
2012 38 23 30 11 17 1
Base = offered smaller amount/worse terms/turned down/didn’t accept finance (n=82 in 2016, n=109
in 2015, n=52 in 2014, and n=154 in 2012). Question A32 (single code, prompted).
Source: British Business Bank (2017).
 Sources of Finance
A. Personal financing:

The founders
Family, friends and fools (informal investors)

B. External financing:

Debt financing
Equity financing
C. Bootstrapping – a way to reduce the need for external financing

Barringer and Ireland (2008) recommend that once the kind of

financing required is carefully identified, if there is a need for debt or
equity financing, a pre-prepared business plan is required.
 Sources of Finance

Examples of sources of financing at different stages of venture

development (Meyer and Crane, 2011) – treat with caution*:
Seed/start up stage Personal financing, bootstrapping (a very small %
get VC financing)
Development/Initial Angel investors (a very small % get VC financing)
launch stage
Expansion/growth VC financing
stage
Later (Maturity) stage VC financing, private equity investment firms, direct
investments from major corporations
Exit stage IPO of company stock (few achieve), acquisition by a
larger company

* Many businesses rely on personal sources of financing, bootstrapping or reinvest their

earnings
 Personal Financing

Personal savings

Financing from friends and family

Loan or investment?
Managing expectations
Benefits and costs
Percentage of individuals aged 18-64 who have invested in
someone else’s new business in the last 3 years, and the
distribution of relationships to the latest investee, 2009 to 2017
2009 2010 2011 2012 2013 2014 2015 2016 2017
Informal 1.2 2.9 2.4 2.6 2.1 1.9 2.3 3.2 2.9
investment rate
Relationship of latest investee (% of latest investments)
Close family 41.0 37.0 50.2 57.5 46.8 40.3 38.0 37.3 43.4
member
(spouse, parent,
sibling)
Other relative, 4.5 7.5 6.2 2.2 6.6 11.1 0.4 2.1 1.4
kin or blood
relatives
Work colleague 8.3 2.2 7.4 8.9 3.9 5.1 0.5 4.0 6.7
Friend or 35.5 48.5 28.4 23.4 38.7 25.5 39.2 38.4 28.0
neighbour
A stranger with 8.6 4.5 7.9 4.1 4.0 17.9 16.3 15.8 15.6
a good business
idea
Other 2.1 0.4 0.0 3.8 0.0 0.1 5.7 2.4 4.9
Source: GEM UK 2017 See www.aston.ac.uk/EasySiteWeb/GatewayLink.aspx?alId=375685
Relationship of Informal Investor to
Investee

GEM, Financing Report, 2004

Prevalence Rate of Informal Investors

GEM, Financing Report, 2004

 External Finance

Debt financing – a business loan (e.g. a bank loan) or line of

credit.

Equity financing – funding is provided in exchange for part

ownership of the firm (a share of the business).

Sources of equity financing: business angels, venture capital,

initial public offering (IPO)

https://www.gov.uk/business-finance-explained
 Venture Capital
Stage or round Purpose of funding

Seed funding Investment made early on to fund a prototype and

feasibility study
Start-up funding Funding is needed to start production
First-stage Funding is required to increase production capacity,
funding sales have begun
Second-stage Product is being sold successfully but firm needs to
funding expand capacity and its markets
Mezzanine Investment is required for further expansion prior to
financing launching an IPO or before a buyout
Buyout funding Funding is provided to help one company acquire
another
 How investors value the business

Investors often rely on getting comparable sales

(comps)

Valuations depend on (Meyer and Crane, 2011):

Industry sector/type
Geographic region
Stage of growth
Company performance (actual revenue and profit)

How can entrepreneurs increase the valuation of the

business?
Some examples of the dos and don’ts of
raising capital

Do …

• Sharpen you focus

• Know who you are pitching to
• Try to get referrals to investors
• Have a good advisory board
• Have a great business plan
• Line up your customer references
• Be specific about your funding requirements
Some examples of the dos and don’ts of
raising capital

Don’t …

• Have unrealistic financial projections.

• Talk about large, generic markets.
• Focus on the future at the expense of the next 12
months.
• Avoid discussing the competition or claim the business
has no competition.
Choosing the right form of financing

Entrepreneurs must be precise about how much

money they require

When choosing the appropriate form of financing, look

at (the overall risk and potential risks on the
investment):

• The state of your cash flow

• Growth potential of the business
• Quality and experience of the management team
 Barriers to accessing finance

Financial barriers may relate to demand or supply

There is a view that barriers should be managed/removed
The argument:
“Capital market imperfection[s] in which [the] performance of
a firm is adversely affect[ed] by a factor internal to the firm”
(Cressy and Olofsson, 1997: 89).
Demand-side financial barriers result when entrepreneurs are
reluctant to relinquish any control of the business to external
parties and when then are unaware of ‘available’ lending
opportunities
Demand-side barriers include: a reluctance to share equity with
outside parties
 Barriers to accessing finance

➢ The supply of financing refers to that which comes from external sources
like banks or investors

➢ The argument:
• A ‘supply-side financial constraint’ has been defined as “a capital market
imperfection that leads to a socially incorrect supply of funds to projects
[…] or the incorrect interest rate charged on funds” (Cressy and Olofsson,
1997: 89).

• Supply-side financial barriers result when entrepreneurs try to raise

financing but are prevented from doing so (Winborg and Landström,
2000).
• Supply-side barriers include: a lack of access to capital (i.e. limited supply
of bank loans, equity capital) and the high cost of capital (i.e. high
interest rates, bank charges, collateral requirements).
Barriers to accessing finance

When it comes to accessing finance, certain groups may be

discriminated against – e.g. women, ethnic minorities

Research suggests that women face more barriers to accessing

equity capital than men – for three reasons (Marlow and Patton,
2005):

Most VCs are male so women are entering a male-dominated

environment.

Women, less so than men, have histories of occupying senior

management positions.

Women may be more risk adverse when it comes to the pace

of growth and in terms of taking on risky investments.
 Bootstrapping
What is bootstrapping? Bootstrapping is about finding ways to avoid the need
for external financing. Examples of bootstrapping (Winborg and Landstrom,
2000) include:
Bootstrap financing technique Bootstrap category

Leasing equipment Delaying payments

Delaying payments to suppliers
Obtaining advance customer payments Minimizing accounts
Ceasing working with customers who pay late receivable
Buying used equipment Minimizing investment
Hiring temporaries, Giving discounts for cash
Employing/obtaining loans from relatives/friends Private owner
Using personal credit cards financing
Withholding manager’s salary
Borrowing equipment Sharing resources with
Sharing office space/employees other businesses
 Bootstrapping

• Financial bootstrapping techniques used might change over

time, in the life of the business (Winborg and Landstrom
(2000).
• Advantages of bootstrap financing: may be easy to obtain,
convenient, may involve minimal requirements, no business
plan or collateral is required.
• Disadvantages of bootstrap financing: money is tight, large
amounts may be required to start-up and/or to be
competitive.
• In addition to bootstrapping, entrepreneurs can delay the
need for outside capital by managing the pace of growth.
 Conclusion

• The kind of financing required depends on a number

of factors including cash flow, the growth potential of
the business and the experience of the management
team.

• Venture capital is very difficult to attain. Business

angels may present a more viable alternative.

• Not all entrepreneurs are willing to share equity.

• Entrepreneurs should consider different ways to

reduce the amount of financing required.
 References & Further Reading
Barringer, B.R. and Ireland, R.D. (2019) Entrepreneurship: Successfully
Launching New Ventures. 6th Global Edition. Pearson, Harlow: Essex.

Deakins, D. and Freel, M.S. (2012) Entrepreneurship and Small Firms (6th
Edition) McGraw-Hill Education, London. Chapters 7 & 8.

Westhead, P., Wright, M., & McElwee, G. (2011) Entrepreneurship and Small
Business Development: Perspectives and Cases. Pearson, Harlow: Essex.
Chapter 12

Abdullazade, Z. (2020) Empirical Test of Pecking Order Theory for the US Listed Firms
(April 20, 2020). Available at
SSRN: https://ssrn.com/abstract=3583126 or http://dx.doi.org/10.2139/ssrn.3583126

Cressy, R. and Olofsson, C. (1997) European SME Financing: An Overview.

Small Business Economics, 9(2), 87-96.
https://doi.org/10.1023/A:1007921004599
 References & Further Reading

Kromidha, E. and Robson, P.J.A. (2016) ‘Social identity and signalling success
factors in online crowdfunding’, Entrepreneurship and Regional Development,
28 (9/10), 605-629 https://doi.org/10.1080/08985626.2016.1198425

Marlow, S. and Patton, D. 2005 All credit to men? Entrepreneurship, finance

and gender. Entrepreneurship Theory & Practice, 29(6), 717-735.
https://doi.org/10.1111/j.1540-6520.2005.00105

Meyer, M.H. and Crane, F.G. (2011) New Venture Creation: An Innovator’s
Guide to Entrepreneurship. Sage, Los Angeles USA.

Myers, S.C. (1984) The Capital Structure Puzzle. Journal of Finance, 39, 575-
592.
http://dx.doi.org/10.2307/2327916
 References & Further Reading

Myers, S. C., & Majluf, N. S. (1984). Corporate Financing and Investment

Decisions when Firms Have Information that Investors Do Not Have. Journal of
Financial Economics, 13, 187-221.
https://doi.org/10.1016/0304-405X(84)90023-0

Moysidou, K. and Hausberg, J.P. (2020) In crowdfunding we trust: A trust-

building model in lending crowdfunding. Journal of Small Business
Management, 58(3), 511-543.
https://doi.org/10.1080/00472778.2019.1661682

Winborg and Landstrom, (2001) Financial bootstrapping in small businesses:

Examining small business managers' resource acquisition behaviors, Journal of
Business Venturing, 16(3), 235-254. https://doi.org/10.1016/S0883-
9026(99)00055-5