Financing a business

Make the owners of the business more wealthy What does a business do Make the owners of the business more wealthy Raise Funds Invest Funds

Finance Policy RISK REWARD The value of a business is the sum of its future cash flows discounted at its cost of capital

BUSINESS LIFE CYCLE: Financing Start up Usually financed with funds of the owner (equity) or with borrowings and usually some combination of both. Share capital is likely to be issued to only a few members and the shareholders, as the owners of the company are usually also involved in the management of the Company. Angel investors are a significant and important source of funding for start ups.

BUSINESS LIFE CYCLE: Financing Growing a business To grow companies will need to make profits and retain them within the business (retained earnings). Growing companies need to seek external finance to fund assets and invest in the business to position it to be able to take advantage of opportunities.

BUSINESS LIFE CYCLE: Financing Mature Business The more mature a business the more options become available in terms of debt and equity financing Once a company becomes a PLC they have much broader access to shareholder financing, and once listed on an exchange (such as the London Stock Exchange) they can publically sell their shares Larger companies can have publicly traded debt i.e ddebentures which are usually 5-10 years with a fixed rate of interest & can be convertible

BUSINESS LIFE CYCLE: Financing Other financing available for non listed smaller companies include venture capital options including: Venture Capital Investment, Angel Investors and Private Equity Funds

Financing a business Equity / Shares Borrowings Retained profits & other sources of finance

Financing a business DEBT EQUITY

EXAMPLE COMPANY A COMPANY B Equity 180 50 Debt (11%) 20 150 Capital employed 200 Operating Profit yr 1 19 Operating Profit yr 2 22.8 Operating Profit yr 3 15.2 Taxation rate 25% What is the profit for shareholders for each of the three years?

Financing a business Equity / Shares Borrowings Retained profits & other sources of finance

Financing: Share Capital Companies issue share capital when they are first established. Shareholders own the company and bear most of the RISK. All creditors have to be paid before anything is returned to the shareholders and therefore the shareholders risk losing everything. Liability is limited to the amount invested The cost of equity is based on the required return of shareholders

Financing: the cost of Share Capital DIVIDEND – there is no requirement for dividends to be paid LIQUIDITY ISSUES – shares listed on a public exchange are more liquid PREFERENCE SHARES – usually have a fixed return and are paid before ordinary shares AIM – Alternative Investment Market IPO - Initial public offering of shares when you first list on a stock exchange

Financing a business Equity / Shares Borrowings Retained profits & other sources of finance

Financing: External Borrowings TYPES Bank Loans Debentures Finance Lease Revolving credit facility Debt factoring

Financing: External Borrowings ADVANTAGES RISKS Tax Cashflow risk Returns > Cost The more debt you have the more costly it becomes Control / Regularity of payment Flexible – ie revolving credit facility

EXAMPLe Company A has a ROCE of 10% and borrows £1m at 7% Cost of additional borrowing Additional earnings Net additional earnings

Cost of capital (WACC) WACC = (E/(E+D)* e) + (D/(E+D)*d(1-t)) The value of a business is the sum of its future cash flows discounted at its cost of capital WACC = (E/(E+D)* e) + (D/(E+D)*d(1-t))

WACC = (E/(E+D)* e) + (D/(E+D)*d(1-t)) WACC CALCULATION Cost of Equity (e) 15% Cost of Debt (d) 10% Tax (t) 30% E:D 40:60 WACC = (E/(E+D)* e) + (D/(E+D)*d(1-t))

Financing a business Equity / Shares Borrowings Retained Profits & Other Sources of finance

Financing Retained Profits Raise money for investment through making profits Net profit can be reinvested in the business or paid out as dividends It is not “free” as it has an opportunity cost Retained profits are those profits surplus to the funds needed by the business to: replace assets,working capital needs,meet interest and tax obligations, and pay dividends.

Financing Risk = Overtrading Working capital Businesses use working capital as a form of finance. They may buy on credit, they will also have to have sufficient financing to fund any credit which they allow to their customers. How to tie up less money in working capital: Collect in funds faster Pay suppliers later Hold less inventory Risk = Overtrading

Financing external investment Venture capital: Equity finance given to smaller companies, usually newer or expanding entrepreneurial businesses

Financing external investment Venture capital: Long term financing for smaller and medium sized businesses Usually invested through managed funds Often higher risk companies balanced off with the opportunity for higher growth Usually potential for high growth and need additional financial support and often expertise/support Can be used to support management buy out (MBO) a company or a new management team buy in to a company (MBI) Can also be used in a rescue scenario when a company is in trouble

Business Angel investors: Interested in investing in early stage Most significant source of start up funding estimated at £1.5bn per annum. The market is subject to a regulatory framework to protect the angel and the investor i.e angels do not take more than 30% equity Usually wealthy individuals or may invest as a syndicate Usually take a minority stake and involved themselves in the management of the business (although not the day-to-day running) https://www.ukbusinessangelsassociation.org.uk/services-for-entrepreneurs/support-and-advice/angel-investment-right-business/

Why is Angel Investing different to Venture Capital Finance: more personal (rather than through a fund), direct engagement, angels conduct due diligence and then often take an active role on the board. Angel investors are prepared to support the business through growth to exit and thus is not a investment expecting a rapid return.

Dragons Den Which business do you want to invest in…. Competitiveness Solving a problem Protected Scalability Ability to realize growth