Funding a Business Venture

Funding a Business Venture

All startups need to find a means of financing their operations. The company must explore different financing options in order to make a determination as to the best option. In the process of exploring financing options, there are a number of different financing terms that need to be understood. This paper covers some of those terms and discusses the issue of startup financing. The pros and cons of some key options are outlined and a recommendation is made with regards to the ideal source of financing for the new technology idea.

There are a number of mechanisms for the financing of a business venture. Each mechanism has its advantages and its disadvantages. These will need to be understood and considered prior to making a decision about financing.

The first financing option is the investment banker. Investment bankers are essentially brokers who put together deals, matching those with money and those in need of financing. An investment banker can put together one deal for one type of financing, or multiple deals for multiple types. The flexibility afforded by an investment banker is offset in part by the high cost, usually in the form of commissions on the deal. In addition, investment bankers seldom work with startups.

The stock market is the second method of financing. Going to the stock market allows the firm to potentially raise a significant amount of capital. This is the main benefit of the stock market, and it comes with a number of drawbacks. Going public means the firm must open its books, increasing accounting costs and even risk to the CEO and CFO, who are legally liable under Sarbanes-Oxley for the accuracy of the financial statements. In addition, going public could cause the company to cede control if it sells over 50% of its equity. Lastly, the stock market is generally not receptive to companies that do not have earnings yet.

Financial management is a general term that refers to a number of sub-disciplines. These are bound by the common theme that the company seeks to lower its financial costs of doing business, to ensure that it has money in the right place at the right time and that the company minimizes financial risk. Financial management is reflected in the firm's choice of financing, in its working capital management and in its accounting practices. There is no downside to financial management -- good financial management is an essential component of all organizations.

Risk financing refers to the provision of funds to help cover the cost of unexpected losses. Adverse events occur in business. In this business, for example, demand could be directly related to the overall health of the economy. The company could face setbacks with respect to patents or technological innovation, or new competition. Whatever the risk, the role of risk financing is a means to ensure that the firm is able to survive the adverse event.

The preferred source of funds at this point is venture capital. At present, the product is still in development and the company needs financing to bring the product to market. The term of the financing should reflect the time frame of the use of the financing, which in this case is a long-lived business, implying that equity financing is most appropriate. In addition, debt creates an obligation that must be met from the firm's cash flows. Meeting this obligation takes money away from other important tasks such as expanding the business. Debt, therefore, is not an appropriate way to finance a company that is expecting to have a high growth trajectory.

Venture capital does have its drawbacks. For example, the firm may be forced to sell more than 50% interest, and if so the company would lose control to the VC group. It is recommended that if at all possible the company does not sell so much interest so quickly. The other major drawback is that venture capital financing may be difficult to acquire if the company has no sales and no workable product. If the product is ready, financing may be available. The choice of venture capital partners is also important -- the company needs to ensure that its capital partners are a good fit with respect to their vision for the firm and its management team. A poor fit will often lead to poor results.