Entrepreneurial Finance: Debt and Equity

Introduction

Entrepreneurs brainstorm and start their ventures with the primary goal of making it prosperous and progressive. However, one of the significant determinants of every enterprise’s success is entrepreneurial finance that incorporates a couple of factors and aspects. In business studies, “Entrepreneurial Finance” refers to the application and adaptation of various financial techniques and tools to the operations, funding, valuation, and planning of an entrepreneurial venture. Therefore, entrepreneurial finance can be simplified as the finances and financial practices involved when running a private enterprise. Correspondingly, the study of entrepreneurial finance can be contrasted to business finance, which focuses on critical principles such as risk analysis, financial objectives towards increasing company’s value, assets, liabilities, privacy, negotiation, and overall business management. In other words, entrepreneurial finance is a broad subject that can be conferred deeply through debt and equity. Nevertheless, using typical examples, this paper provides an extended argument for exploring how debt and equity can be used to source entrepreneurial finance.

A Model of Entrepreneurial Finance

Following the increasing demand for finance in the corporate world, most economies around the globe have offered several options and methods of not only building capital in the business, but also maximizing the existing capital. Most importantly, management of economies of scale is one of the most believed methods of increasing business performance and generating more capital. Nevertheless, it is argued that business growth is directly proportionate to entrepreneurial finance. This means that the higher the finance, the faster the business growth. Therefore, each capitalist has differing development goals that can be achieved at different stages of the business lifecycle. The path towards a successful venture is complicated mainly because of risks and other complexities. For instance, most capitalists are motivated by lifestyle factors, which lead to the external finances. Others face significant crises since they ignore the present factor to focus on the future growth plans that demand heavy financing.

Each of these stages has different financing sources and needs. For instance, it is essential to denote that most firms and entrepreneurs undergo the same cycle when it comes to entrepreneurial financing. First, the entrepreneur injects his or her savings, along with family/friends assets, to finance or run the venture in the development stages. Secondly, next financing comes from Angels and potentially Venture Capitalists. Moreover, the third financing is typically the largest, and it comes from large bank loans and venture capitalists since the enterprise is now vast.

Fraser, Bhaumik, and Wright (2015) argued that many economies have seen a significant decline in both debt and equity finance flows to SMEs. Consequently, there are concerns that the associated funding gap may be limiting firm growth and as a result constraining economic recovery. They proved that both developing and developed economies have suffered from these challenges but the United Kingdom, in particular, has shown major structural problems in the markets for both alternative sources of finance such as entrepreneurial capital and traditional bank credits. Additionally, the UK Government has established a British Business Bank, modeled on the lines of the German state-owned bank Kreditanstalt für Weideraufbau (KfW), to help improve flows of debt/equity finance to SMEs. Similarly, this similar approach has been tested and used here in Kenya through various financial products or instance, the issue of funding gaps in the country, in the provision of debt and equity, has been a persistent constraint on the development of small businesses.

Entrepreneurial Finance in Kenya

Small firms and new businesses have become an increasingly important component of economic development in Kenya. The Kenyan government through the ministry of finance and Small-Medium Enterprises collaborated and identified these gaps in the supply of small-scale equity investments from which unique financial products such as Uwezo Fund, Youth Fund, and others were introduced. Even though these products have faced major complications, there has been notable progress in boosting entrepreneurial finance across the country (Cumming, 2012). Another primary source of venture capital in Kenya is Microfinance Finances Institutions (MFIs) that have existed for over three decades. Some of the leading MFIs include Kenya Women Finance Trust (KWFT) that played a significant role in empowering women and businesses. However, recent studies have confirmed that though various tools and players have been in the markets for a while, starting and running a venture in Kenya remains to be a major challenge for many people.

According to a study done by FSD Kenya (2016), many Kenyan entrepreneurs and investors have almost similar financial problems in their businesses. In a number of the cases, banks played an important role in enabling the entrepreneur to achieve business success (FSD Kenya, 2016). Nevertheless, many of those interviewed by FSD experienced moments in their development journey where the banks were unable to provide them with the necessary finance, requiring them to look elsewhere for funds and support. The entrepreneurs felt that the banks needed to make changes to improve financing for SMEs. These suggestions are summarized, together with additional recommendations that the researchers explored came out of the study. As for this reason, economists and business analysts have sourced alternative financing options that are simple, convenient, reliable, and secure. The three main alternative financing options that are available to most Kenyan start-ups include Bitcoin-based small business loans, Africa-focused Crowdfunding, and Peer-to-peer microfinance loans. It is essential to mention that some of these products are very fresh in the market and thus they need deeper conceptual and practical studies to prove their reliability and terms of usage.

Although start-ups and venture capital finance are often linked in the public eye, bank loans are a more common source of funding to many entrepreneurial firms. Both sources share some common features. Because entrepreneurial firms are usually small and have a high risk of failure, both venture capital, and bank loans require careful monitoring of borrowers. Both types of finance use covenants to restrict the borrower’s behavior and provide additional levers of control if the firm performs poorly. These covenants are often limiting the ability of the firm to seek financing elsewhere, which ties to yet another common feature: the use of capital rationing through staged funding and credit limits as means of controlling borrowers’ ability to continue and grow their business. Despite these similarities, there are significant differences between these two types of financing. Whereas banks lend to a wide variety of firms, firms with venture capital finance tend to have very skewed return distributions, with a high probability of weak or even negative returns and a small probability of extremely high yields.

Debt and Equity

Debt is less risky than equity, and so the institution’s assets are less affected by its private information about the firm, reducing adverse selection problems when the institution itself needs additional funding. Since these costs are passed on to the entrepreneur in her costs of funds, she shares this preference for debt, else equal. This simple picture is complicated by the fact that, even if it is optimal to keep the entrepreneur’s firm going, there may be additional choices to be made. One of the most critical issues facing entrepreneurial firms is their ability to access capital (Denis, 2004). Because such firms are typically not yet profitable and lack tangible assets, debt financing is usually not an option. Consequently, entrepreneurs tend to rely on three primary sources of outside equity financing: venture capital funds, angel investors, and corporate investors. Venture capital funds refer to limited partnerships in which the managing partners invest on behalf of the limited partners. Corporations invest on behalf of their shareholders, for financial and strategic reasons.

The existence of multiple sources of financing raises the question of whether the source of funding matters for the entrepreneurial firm. This question is analogous to similar issues addressed in the corporate finance literature. For example, an extensive research is devoted to studying the importance of the source of debt financing. This literature generally concludes that banks are ‘‘special’’ in that they provide services such as monitoring that is not provided by other debt claimants, while non-bank private debt serves a vital role in accommodating the financing needs of firms with low credit quality. Therefore, debt vs. equity ratio is a major factor in entrepreneurial finance since it involved financing decisions. The existence of asymmetric information based on theories is used to understand market failure and examine the rising demand for financing. In overall, sourcing debt and equity have complex processes that raise other considerations in financing decisions. It is important to mention that most profitable ventures use minimal external finance while fast-growing companies with higher funding needs are usually most likely to seek foreign funds.

Debt Financing

Advantages of Debt

• Tax Deductions - Taxes have the focus under debt financing, and thus the principal and interest payments on the business loans are considered as expenses. They are then deducted from the venture’s income taxes thereby the percentage of the ownership stake is higher and reducing the cost of the loan.
• Low-interest rates - due to the tax deductions, the overall tax rate is lower. However, this win-win financial move allows both the lender and entrepreneur to enjoy tax advantage after processing the loan/debt.
• Maintain the Ownership of the venture - even after the loan is awarded, the owner has the control of his business, and the lender cannot claim equity in the company.

Disadvantages of Debt

• Collateral Requirement - the lenders, demand that specific assets of the venture are held as collateral, and usually the entrepreneur is required to guarantee the loan personally.
• Cash flow - It is not advisable to take too much a debt since it increases the chances of the company to face problems in repaying the loan especially if the cash flow declines. Therefore, no investor can make additional equity investments in a company that has too much debt.
• Fixed repayments - The principal and interests payments must be paid on a specific date without fail. This might be a problem since most firms have unpredictable cash flows.
• High-interest rates on the loans, though this might vary due to some factors.

Equity

Advantages of Equity

• Cash flow - unlike debt financing, equity financing does not take funds out of business thereby leading to the increased cash flows or capital growth.
• Long-term planning - many equity investors are interested in long-term returns thus showing the potential of future growth
• Less risk - the owner has less risk since there are no monthly loan repayments to make. This benefits the start-up venture that might not have positive cash flow

Disadvantages of Equity

• Loss of control - the owner has to give up a portion of business control to the investors thus denying him full control of decision-making
• Cost - the equity investors are expected to be given back their money thereby pressuring the owner to share the venture’s profits with the equity partners.
• Potential for conflict - not every partner agrees when making critical business decisions. Therefore, conflicts may arise along the management styles, and the owner must be ready to handle these disagreements.

Conclusion

Although it is difficult to quantify the aggregate dollar amounts of capital coming from each funding source, various estimates suggest that all three sources contribute a substantial amount of capital to entrepreneurial firms. Some of the major hindrance to accessing capital includes agency issues (Denis, 2004). Evidence of agency issues is supported by a positive relationship between leverage and tangible assets. Industry effects, relating to the availability of collateral, also affect leverage and debt maturity. Access to external finance improves with size and age supporting the idea of a financial growth life cycle. In addition, the economic cycle is vital for reliance on short-term debt increasing in a recession (Coleman et al., 2016). Under the entrepreneurial objectives, control aversion and risk perceptions are essential but are largely ignored in the studies of financing decisions.

Moreover, some progress has been made in contrast between equity and debt ratio including business planning, growth/lifestyle objectives and the importance of retaining control in models of financing decisions, which raise the explanatory power of entrepreneurial finance. Considerably, entrepreneurial cognition in financing decisions has indicated why the debt-equity ratio is high and low in some ventures. The decision to use equity or debt to finance your company ultimately comes down to how much control you wish to maintain over your business. However, an early-stage company that could take years to generate profit is likely to struggle with a high debt load. At the same time, startups have a hard time attracting venture capital until they show strong profit potential. Most experts suggest that businesses use both debt and equity, in a reasonable ratio.