MODULE 6

SOURCE AND ALLOCATION

OF FUNDS

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 METHODS/APPROACHES OF ENTERING INTO BUSINESS

• This module covers the following;

a. Approaches / methods of entering into business
b. Structuring new business
c. Sources of capital for entrepreneurs

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A. METHODS/APPROACHES OF ENTERING INTO A BUSINESS

• There are different Methods/approaches of

entering into business such as:
a) Starting from the scratch
b) Buying an ongoing business &
c) Franchising
• Therefore it is very important to understand the
right time to start up a new business, to buy an
ongoing business or acquiring franchise.

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 I) STARTING FROM THE SCRATCH
There are times when conditions are just right to
start up a new business. This might be the case if:
– the market has expanded to the extent that existing
businesses can't cope with the demand
– the needs of customers are not being met due to
poor, inefficient service or products
– a new product or service has been developed and is
backed by down-to-earth market research that
indicates it's a likely winner
– entrepreneur have an idea for a business that have
estimated to be viable.
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Advantages of Starting from the scratch

• Lower start-up costs - Depending on the type of

business entrepreneur start, costs may be lower
than a franchise where there is no up-front
purchasing fee or supply costs
• Independence - entrepreneur make all decisions
and create all business systems
• Site selection - entrepreneur choose where to
locate the business and what marketing
procedures to follow
• No baggage/ no past experience - There is no
history to overcome when starting a new venture
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Disadvantages

• High commitment - Starting a own business

requires a higher commitment of time and
energy
• High risk - Success depends totally on
entrepreneurs and their business talents
• Delayed profitability - Where the market may
not already be established, it may take longer to
become profitable
• Limited financing - Financing for a new business
is more difficult to obtain
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II) Buying ongoing/existing business
• For some entrepreneurs, buying an existing
business represents less of a risk than starting a
new business from scratch. While the opportunity
may be less risky in some aspects, they must
perform due diligence to ensure that they are fully
aware of the terms of the purchase.
• The buyer should examine;
– the physical condition of the business (eg assets & location)
– the potential for goods/services (eg competitor & market
analysis)
– legal aspects and financial condition of that business
(eg transfer of rights & financial position)
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 Advantages of buying an existing business

• Some of the groundwork to get the business up and

running will have been done.
• It may be easier to obtain finance as the business will have
a proven track record.
• A market for the product or service will have already been
demonstrated.
• There may be established customers, a reliable income, a
reputation to capitalize and build on and a useful network
of contacts.
• A business plan and marketing method should already be
in place.
• Existing employees should have experience entrepreneur
can draw on.
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 Disadvantages of buying an existing business

• Entrepreneur often need to invest a large amount up front, and

will also have to budget for professional fees for solicitors,
surveyors, accountants etc.
• Will probably also need several months' worth of working capital
to assist with cash flow.
• If the business has been neglected it may need to invest quite a bit
more on top of the purchase price to give it the best chance of
success.
• It may need to honour or renegotiate any outstanding contracts
the previous owner leaves in place.
• Also need to consider why the current owner is selling up and
how this might impact the business and your taking it over.
• It's possible current staff may not be happy with a new boss, or the
business might have been run badly and staff morale may be low.
• Possibility of buying obsolete stock.
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III) FRANCHASING
• This referred to the arrangement where one party ( the
franchiser) grants another party (the franchisee) the
right to use its trademark or trade name as well as
certain business systems and processes to produce and
market a good/service according to certain
specifications.
• The franchisee usually pays a one-time franchise fee plus
a percentage of sales revenue as royalty and gains like;
– Immediate name recognition
– Tried and tested products
– Standard building design
– Detailed techniques in running and promoting the business
– Training of employees
– Ongoing help in promoting and upgrading of the products
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Advantages of Franchising
• The risk of business failure is reduced by franchising.
• Products and services will have already established a
market share. Therefore there will be no need for market
testing.
• Franchisee can use a recognized brand name and trade
mark.
• May benefit from any advertising or promotion by the
owner of the franchise - the 'franchisor'.
• The franchisor gives support – i.e a complete package
including training, help setting up the business, a manual
telling how to run the business and ongoing advice.
• No prior experience is needed as the training received from
the franchisor .
• A franchise enables a small business to compete with big
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businesses,
Disadvantages of franchising
• Costs may be higher than expected. As well as the initial costs of
buying the franchise, one pay continuing management service
fees and may have to agree to buy products from the franchisor.
• The franchise agreement usually includes restrictions on how to
run the business.
• May find that after time ongoing franchisor monitoring
becomes disturbing
• The franchisor might go out of business.
• Franchisee may find it difficult to sell franchise - can only sell it
to someone approved by the franchisor.
• All profits (a percentage of sales) are usually shared with the
franchisor.
• The inflexible nature of a franchise may restrict their ability to
introduce changes to the business to respond to the market or
make the business grow. 12
 C: SOURCES OF CAPITAL FOR
ENTREPRENEURS
Introduction
• Every entrepreneur planning a new venture confronts
the dilemma of where to find startup and business
running capital. Choosing the right sources of capital for
a business can just be as important as choosing the right
form of ownership, so entrepreneurs must weigh their
options carefully before committing to particular funding
source.
• Entrepreneurs must understand which sources of
funding are best suited to the various stages of a
company’s growth and then taking time to learn how
those sources work are essential to success. 13
 Categories of funds for entrepreneurs
• Normally there are two main categories of funds to
entrepreneurs. These are:
i. Equity financing
ii. Debt financing
• Both debt and equity financing are important ways
for businesses to obtain capital to fund their
operations. Deciding which to use or emphasize,
depends on the long-term goals of the business and
the amount of control managers wish to maintain.
• Ideally, experts suggest that businesses use both
debt and equity (i.e debt-to-equity ratio) financing in
a commercially acceptable ratio. 14
 I: EQUITY FINANCING

• Equity financing involves the sale of some of the

ownership in the venture.
• Equity financing takes the form of money obtained
from investors in exchange for an ownership share
in the business. Such funds may come from
savings, friends and family members of the
business owner, wealthy "angel" investors, or
venture capital firms.
• Sources of Equity Financing include:
a) Personal savings
b) Friends and family members
c) Angels
d) Venture capital companies 15
Equity financing…………

a) Personal Savings
• The first place an entrepreneur should look
for start up money is in their own pockets.
• Investors expect the entrepreneur to put
some of her own capital into the business
before investing theirs. If an entrepreneur is
not willing to risk his own money, potential
investors are not likely to risk their money in
the business either.

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Equity financing……….

b) Friends and Family Members

• After emptying their pockets, most
entrepreneurs look for friends and family
members who might be willing to invest in a
business venture. Because of their relationship
with the founder these people are most likely
to invest.

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Equity financing…………

c) Angels
• Angels – are private investors who emerging
entrepreneurial companies with their own
money.
• Angles invest in businesses for more than purely
economic reasons (because they have a
personal interest in the industry) and they are
willing to put money into companies in the
earliest stages, long before venture capital firms
and institutional investors jump in.
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Equity financing………..
d) Corporate Venture Capital
• Large corporations have gotten into the
business of financing small companies e.g. 30%
of all venture capital investments come from
corporations.
• When evaluating potential investments,
venture capitalists look for the following
features: Competent management,
Competitive frame, Growth industry & viable
exit strategy
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 Advantages of Equity financing

• No repayment. The business is not obligated

to repay the money.
• Immunity. Equity finance protects the business
during the time of economic downturn since
investor share profit and loss.
• Better performance. Presence of the ever-
watching of investors keeps the management
to perform at their best.
• Equity expands borrowing power
• Equity spreads risk of failure
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 Disadvantages of Equity financing

• An excessive reliance on equity financing may indicate

that a business is not using its capital in the most
productive manner. Means that an entrepreneur must
give up some ownership in the company to outside
investors.
• Loss of decision making power. This is due to interference
of shareholders in decision making. Eg. Electing the
director board requires approval of shareholders.
• Is called risk capital because investors assume the risk of
losing their money if the business fails
• Dilutes ownership and independence
• Raising equity finance is demanding, costly and time
consuming
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II: DEBT FINANCING

• Debt financing takes the form of loans that

must be repaid over time, usually with interest.
Businesses can borrow money over the short
term (less than one year) or long term (more
than one year) but must be repaid with interest.
• Sources of Debt Capital
a) Commercial banks
b) Trade credit
c) Commercial finance companies
d) Saving and loan associations
e) Credit unions
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Debt financing……….

a) Commercial banks
• Normally Commercial bank makes a large
number of intermediate term loans (i.e. for one
to five years) and long term loan (for more than
five years). In most cases, the banks need to
know about the 4C’s mentioned below:
• Collateral
• Capacity of the business
• Condition of the business and
• Character of the loan applicant
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Debt financing………

b) Trade credit is credit given by suppliers who

sell goods on account. This credit is reflected
on the entrepreneur’s balance sheet as
accounts payable, and in most cases it must be
paid in 30 to 90 days. Suppliers typically offer
this credit as a way of attracting new
customers.

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Debt financing………
c) Finance companies are asset based lenders
that lend money against assets such as
receivables, inventory, and equipment. The
advantage of dealing with a commercial
finance company is that it often will make
loans that banks will not. The interest rate
varies from 2 to 6 percent over that charged
by a bank. New ventures that are unable to
raise money from banks and factors often turn
to finance companies.
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Advantages of debt financing

• No surrendering of ownership
• During periods of low interest rates, the
opportunity cost is justified since the cost of
borrowing is low.
• No loss of ownership control with debt
financing
• Easier to obtain than equity capital

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Disadvantages of debt financing

• Regular (monthly) interest payments are

required.
• Continual cash flow problems can be increased
because of payback responsibilities.
• Increased paperwork requirements and lender
monitoring
• Total risk on part of the owner
• Heavy use of debt can inhibit growth and
development of a venture.

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