Why Sources Of Start-Up Finance Are Changing 13
WHYSOURCES OF START-UP FINANCE ARE CHANGING
WhySources of Start-Up Finance Are Changing
Start-upcompanies refer to those companies or entrepreneurial ventures stillin the phase of development and market research (Klačmer Čalopa etal., 2014, p. 19). According to Klačmer Čalopa et al. (2014, p.19),start-ups are usually associated with high-tech projects, butnecessarily. The reason they are usually associated with high-tech isthat their product is in most cases software which is easy to produceand reproduce. Start-ups have garnered substantial attention in manycountries as major engines for economic growth. A common view amongmany people and nations is that these business ventures control a bigshare of job creation, economic growth, and innovation. As such, manyeconomies and policy makers in various economies fuel a lot ofresources into efforts of establishing and growing start-up ventures.Therefore, it also follows that the possibility of such ventures togrow and succeed has also risen in many countries (Söderblom et al.,2013, p. 2).
Giventhe increased attention given to these ventures and the change inmethods of investment, sources of financing have also had to change.Research has also indicated that entrepreneurs who possess pastexperience in start-ups have higher chances of raising more funds fortheir ventures than those who do not. Start-ups are interestingventures to investors with the ability to accelerate theirdevelopment by contributing in the form of investment or throughbusiness relationships. One of the major steps involved in start-upsis securing enough financial resources for the achievement of companygoals. Without the necessary financial support growth in start-ups islikely to be stalled and only capable of progressing at a very lowrate. According to Klačmer Čalopa et al. (2014, p.25), lack offinances is one of the major obstacles entrepreneurs face in newventures. This essay seeks to discuss how and why sources offinancing for start-ups are changing, early stage finance mechanisms,stages of new venture development, sequences of new venturefinancing, and theoretical arguments for one particular source ofstart-up finance.
BusinessAngels and Other Early Stage Finance Mechanisms
Ata time of such intense globalization, many methods of financingstart-ups have come up. According to Klačmer Čalopa et al. (2014,p.25), these methods can be classified into formal and informal. Onthe international platform, research has determined that the idea offinancial markets funding start-up companies that show potential ofgrowth and success is being embraced on a greater scale. This ideagoes several decades back and has been studied and proven to beefficient. Another research carried out in 54 countries indicatedthat the total amount of money invested in start-up companies istightly linked to the level of development of a country. Theimplication here is that the more developed a country is, the more itis likely to invest in start-ups. Research also indicates that thenature and course of a business are highly affected by the source offinancial support whether internal or external (Kerr & Nanda,2014, p. 1).
Generallyspeaking, start-up companies can receive financial support from manydifferent sources depending on the country in question. This sectionwill define and analyze some of the commonest sources in use today.Under this section, the first early stage finance mechanism that willbe studied is business angels. Business angels refer to individualswho provide risk capital to unlisted companies that they have nofamilial links to. It has become common knowledge that theseindividuals play a central role to the growth of new ventures. Theyform part of vital stakeholders to high-potential ventures. Businessangels contribute finances as well as personal networks and businessskills acquired overs time of conducting business (Politis, 2008, p.127). Business angels commonly get involved with the firms theyinvest in by being members of the board. They are individuals whohave a genuine entrepreneurial career background and sufficientknow-how in business and are expected to share with the start-upventure. Traditionally, they work closely with their portfolio firmsas a way of promoting and protecting their own interests. Studies inthe US, the UK, Germany, Australia, and Japan have indicated thatmost business angels have at some point had a start-up experience.Most of them have also made their fortune through cash-outs in theirown investments. Even previous experience of business angles variesamong countries, there is a steady trend pointing to the samebackground in as far as start-up and young companies are concerned(Politis, 2008, p. 128-9).
Anotherimportant source of financial support for start-ups during the earlystages is crowdfunding. Crowdfunding is the exact of business angels.Whereas business angels contribute large amounts of finances intobusinesses singly, crowdfunding involves an entrepreneur raisinglarge amounts of money from many people with each individualcontributing small amounts (Belleflamme et al., 2013, p. 1). Themoney can be collected by meeting the crowd itself or through theinternet so that it is called online crowdfunding (Macht &Weatherstone, n.p, 2014). Crowdfunding can be classified into twotypes that are, entrepreneurs soliciting individuals to eitheradvance a fixed amount of cash in exchange for share of futureproceeds or to pre-order the product. The option of soliciting thecrowd to pre-order a product is commonly used in cases where thecapital required is much smaller compared to the market size. Theother option of promising to give equity into the company in futureis preferred in cases where the capital requirement is much bigger.The two methods of crowdfunding present the entrepreneur with twodifferent sets of benefits and shortcomings that make it essential tochoose which one to go for wisely. If the pre-ordering option ischosen, the entrepreneur is forced to price-discriminate betweencrowdfunders and normal consumers, but as need for finances grows,need to distort the pricing scheme arises. The result is that pricesreach a maximum point beyond which it causes profitability ofpre-ordering to fall below acceptable levels. When that happens,pre-ordering becomes unattractive. On the other hand, profit sharingbecomes more attractive as the need for finances rises. This isbecause the entrepreneur gets access to more money yet the proportionof profits to be given out in future remains constant.
Anothermajor source of finances for start-up companies and ventures isreferred to as venture capital. Christofidis and Debande (2001, p. 1)define venture capital as a specific form of finance that is bestsuited for the needs of new or young technology-based firms. Newventures involve a lot of risk in different forms that make themunacceptable to conventional financial institutions and debtfinancing. It is these high risks that are slowly changing the waynew ventures are financed, making capital ventures the most suitable.Some of the major issues that make start-ups high-risk includenegative earnings, intangible assets, lack of a proven track record,and lack of stable research and development. Venture Capitaladdresses this gap in financing through equity participation. Thereis a steady global trend towards heavy reliance on venture capital(Christofidis & Debande, 2001, p. 1 Oakey, 2003, n.p).
Stagesof New Venture Development and Sequences of New Venture Financing
Havinggreat ideas and turning them into great business opportunities is notan easy task. Many people have great ideas but are unable to turnthem into viable business ventures that can be funded by externalparties. In summary, the first step in the process of identifyinggreat business opportunities is singling the great opportunity out ofthe many great business ideas one may have. Making this choice is thefirst step in many steps to follow later on. The steps that followthis first step are normally bundled together in what is called abusiness plan. According to Olsen and Kolvereid (1991, p. 1), thebusiness plan is a document that undergoes evolution from the time itis developed to the time it is actually completed. In some cases, itmay never be completed, but will continue undergoing evolution as itcontinues to grow with the needs of the venture in question. Normallythe business plan evolves into a business concept proposalabbreviated as BCP and into an opportunity assessment. At thevarious phases, the entrepreneur always has the choice of proceedingto the next step of the evolution or change the business into a newventure. Olsen and Kolvereid (1991, p. 1) acknowledge the idea ofpackaging business developmental stages into a business plan as beinghelpful and important. They state that in the end or in the middle ofpursuing the business plan, the entrepreneur and potential investorsget the opportunity to determine how profitable the venture really isfrom the time of inception.
Althougha business plan seems like the ultimate tool that explains the wholeprocess of development of new ventures, it may not outline the stagesproperly. Further, different researchers and institutions havediffered in the classification of the stages a new venture undergoesduring the development phase. However, there is a general sequence ofactivities that most researchers and institutions agree to. Some ofthe stages may be removed or added to suit various companies. Themajor stages are seed stage, startup stage, early stage, growthstage, and finally the exit stage or the IPO stage (Timashev, 2013,n.p). The seed stage is the initial phase of the developmentalprocess and may involve acquiring finances to be directed towardsdeveloping the product, researching the market, building themanagement team and developing the business plan. In most cases, atthis stage, the company does not have any established commercialoperations. Funds are very necessary at this stage to help in thepre-startup R&D, developing the product and testing it. Thestartup stage is thinly differentiated from the seed stage andinvolves assembling the management team, analyzing the competition,identifying customers, and advancing beyond prototypes to fullyscalable products. The early stage requires funds for the actualproduction activities, but on a small scale. Normally there are someoperations going on but not on a commercial scale. A lot of fundingis required at this stage and if a firm has many companies in thisstage, then if care is not taken, it is likely to run into financialdifficulties (Schwarzkopf, 2005, p.2-5).
Thegrowth stage is now where the firm is experiencing much growth into afull-fledged company operating at high capacity. Companies startproducing in bulk and target mass markets as they expand sales andmarketing. Revenue at this point starts to grow very fast andinternal systems start to be developed and made more effective. Ownermanagement can be changed at this time to allow for more expertiseand experience from professional managers so that the firm canbenefit maximally. Most firms are ready to be made into publicventures at this point. The IPO stage marks the final stage of newventure development as the company is made into a publicly tradedcompany to allow for more financial support from investors all overthe world (Schwarzkopf, 2005, p. 2-5).
Besidesthe new venture development phases discussed above, Marmer, Hermannand Berman (2011) suggested another model, which includes discovery,validation, efficiency, scale, profit maximization, and finallyrenewal or decline. The discovery stage involves determining whetherit is sensible to solve the problem detected in the market or not.The company also determines if there are interested parties who willuse the solution that will be developed. This phase is approximatedto last between 5 to 7 months
Thevarious stages of development are associated with funding dependingon the activity the company is involved with. The first stage whichis the problem/solution fit tries to determine the existence of aproblem and the suitability of the solution the company has for it.The solution to the problem is normally not of much concern at thisstage because even though it may be simple, its implementation may bevery expensive and sophisticated. The problem must be aligned to thesolution to avoid giving customers something that will not be usefulto them. The problem is also determined for solvability before thesolution is developed. The second phase is called the product/marketfit, and it tries to determine if the proposed product or service isactually what customers want. The necessity of solving the problem isalso determined at this stage. The final stage addresses the issue ofscale of production, expansion and growth. At this stage, everythingis expanded ranging from employee base, income, customer base, andscale of production (Klačmer Čalopa, 2014, p. 20).
TheoreticalArguments for One Particular Source of Start-Up Finance
Manyfirms rely heavily on venture capital during most of their earlystages of development due to many different reasons. Venture capitalhas been defined as the provision of debt and equity financing to newfirms that are privately owned. Even though venture capital forms amajor source of funding to many new ventures and companies, there islittle information known about the extent to which the support isprovided. The lack of information about this area can be attributedto many factors including the fact that there is a larger body ofresearch dedicated to the theoretical and empirical analysis of otherparts of the financial sector like real estates, stock markets,insurance, and banking than there is for venture capital financing.Secondly, venture capitalists tend to invest in privately ownedcompanies which are not subjected to the same level of reporting aspublicly held companies. Thirdly, there exists no organized secondaryexchange for venture capital investments which offers summaryinformation. Lastly, venture capitals are not placed under the samelevel of regulatory scrutiny as stock exchanges, insurance, andbanks. As a result of the reasons given above, information that comesfrom regulatory proceedings and requirements is very sparse (Amit etal., 2000, p. 2-3).
Thegap between the total funds provided by banks to support SMEs (Smalland Medium Enterprises) and the total amount required by the saidSMEs continues to widen. Banks can no longer meet the borrowingcapacity of SMEs even if they wanted to. This disparity has hadseveral downsides, but not without its advantages and benefits. Theshortage has caused many other funding sources to come up to fill thegap. For example, in the United Kingdon, the coalition government hasbeen forced to pump in more than 140 billion pounds into the banks tobe made available to SMEs. Such a move was expected to help banksthat were formerly reluctant (for good business and financialreasons) to advance credit facilities to SMEs to change theirpolicies (Davis, 2012, p. 2). Other funding sources such as onlinecrowdfunding and traditional crowdfunding also came up as a result ofthe disparity in the funding level of banks and the financialrequirements of SMEs. However, it should be noted that venturecapital did not arise as a result of the financial disparity. Infact, venture capital is a concept that emerged several decades agoby Schumpeter. Over the years of testing and polishing and as theworld goes deeper into the age of globalization, which ischaracterized by stiff competition from multi-nationals in differentcountries, venture capital is emerging as one most reliable and majorsource of funding for new ventures and companies. The transition isslow but very stable and with the formation of associations such asthe British Venture Capital Association, the transition is made morestable (Rosiello & Parris, 2009, n.p).
Wealthconstraints of most entrepreneurs are the main reason venture capitalforms the main financing basis for new ventures. Many startups arecharacterized by high levels of risk as a result of great uncertaintyconcerning returns, lack of a track record in operation, and a lackof substantial tangible assets for operations. It is also true thatmany start-up venture undergo several years of registering losses ornegative income before they finally start making profits. Even whenthey start making profits, the profits are normally too low for sometime before they pick up. The aforementioned situation makes banksand other financial intermediaries be afraid of providing financialsupport. Some of those financial institutions are prohibited fromoffering financial support to startup ventures at all. Additionally,financial institutions and intermediaries always lack the expertiseneeded in investing in young and high-risk companies (Cherif &Elouaer, 2005, p. 1).
Giventhe financial predicaments and high risks that startups face, theyare left with one option only that is, seeking the involvement ofventure capitalists. The financial support and expertise of theventure capitalists is normally received in exchange for futurerevenues in form of equity when the company finally picks and startsmaking profits. Venture capital is organized in form of companiescalled venture capital firms. Venture capitalists are given an equityposition in the firm and assume an active role in corporategovernance. In simpler terms, the investors get a sit on the board ofdirectors and actively participate in the monitoring of dailyperformance of the company. Venture capitalists offer funds in stagesso that they maintain control over the business and always leave theoption of abandoning the venture open. As such, it is a keycharacteristic of venture capitalists to never provide all thefinancial support upfront. Staging financial investment allows formonitoring and assessment before making refinancing decisions intothe venture. As such, the loss made through venture capital can bemanaged at all times (Cherif & Elouaer, 2005, p. 1).
Inconclusion, there is a general trend in sources of financing ofinnovative small-scale startup companies and ventures from banks tonon-bank sources. Banks and other conventional financial institutionsare no longer able to keep up with the high risks involved in smallinnovative scale startups, leaving venture capital firms to take overthat role. Venture capital firms provide financial assistance tocompanies during their infancy stages so that they can grow and beuseful to the steering of economic growth. Modern economies haverealized the importance of venture capital to the growth of theireconomies and have therefore continued to allocate many resources tothem. The British Venture Capital Association (BVCA) is in charge ofcoordinating the investments of venture capital firms intoBritish-based and non-British startups. According to BVCA’swebsite, Britain has been performing very well, registering positiveresults over the years.
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