Financing Requirements - Newbe Enterprises - Research Paper Example

? Financing Options Lecturer Prime Financial Consultants, Ainsdale Cresent, Middlesex. May Newbe Enterprises, Fifth Street, Rochester, New York. Dear Sir, RE: Financing Options I am hereby writing in response to your concern regarding the best financing option you should pursue to facilitate taking your business to the mass market. In this letter, I have explained the financing requirements, which I consider crucial for you to understand before making you final decision. I have also presented the various financing options you may consider pursuing together with their advantages and disadvantages. Finally, I have recommended the best financing options you should consider. Financing Requirements Before embarking on the types of financing that should be considered, it is worth noting something on financing requirements. The entrepreneur (or business management) should determine the amount of financing that is required to carry out the intended activities (going mass market), which is necessary in planning and execution of business operations properly (Gutterman, 1994, p. 2). Presumably, Newbe had determined the amount of capital required at the initial stages of the business formation. However, it is exceedingly crucial to review initial estimates periodically owing to the fact that the scope of business activities often change with time. Further, periodic review of the initial financing (capital) estimates enables businesses to cater for unforeseen factors, such as abrupt changes in the cost of raw materials. Business financing requirements and resources for securing the required capital depend on the size of the business under consideration and the industry (line of business) in which the business under consideration is operating (Gutterman, 1994, p. 2). For example, large corporations (that are well capitalized) may obtain the required financing through the sale of shares (common or preferred stock), bonds and loan from credit facilities, such as banks (Gutterman, 1994, p. 2). Various issues should be considered before Newbe decides on the financing alternatives that it should pursue. The most pertinent issues include economic participation of the financial provider, management participation during the financing period, cost of funds to current operations, financing duration and the financing risk and security (Alterowitz and Zonderman, 2007, pp. 8-13). Probably, the degree of economic participation of the financial provider is the first decision that Newbe should make when selecting the financing strategy to pursue. Newbe should evaluate the degree of economic participation that the financial provider will have on the business enterprise during the financing period. For example, if Newbe considers common stocks as the source of required finance, the business should understand that the investors (common stock holders) would share profits with the entrepreneur while taking part in making various business decisions. On the contrary, if Newbe considers obtaining a loan from a financial provider, such as a bank, the financial provider will only demand the amount given plus interest on loan, but the provider will not be involved in decision-making. Therefore, if the decision-making procedure is a key issue that should be left to the enterprise management, Newbe should consider financial sources that do not require the financial provider to be involved in business decision-making (Alterowitz and Zonderman, 2007, p. 8). Newbe should also consider the cost of funds to current operations while deciding the financing alternative to pursue. It is apparent that every financial provider will expect full return to financial aid given in terms of cash and/or assets. In many, almost all, cases, the financial provider will demand to be compensated for the use of financial aid in terms of interest (bank loan) and dividend (stockholders) among others. Therefore, Newbe should assess how business cash flow requirements will be affected by any commitment to pay dividends or interest to financial providers. Newbe should also consider financial duration when selecting the financial strategy to pursue. Different financial aids have different durations. For example, debt financing and commercial loans, unlike equity financing, are associated with a period after which they must be fully repaid (Gutterman, 1994, p. 7). Banks may give loans on a demand basis, which means that Newbe shall repay the loan upon demand by the bank. Loan may also be short-term, implying that the loan must be repaid fully within the year. A long-term loan term implies that the loan shall be repaid sometimes after the year of funding. Therefore, Newbe should fix the funding duration in a way, which it fits into the business cycle while meeting the needs of the business. Financial risk and security should also be considered when selecting a financing strategy. Every type of financial aid is associated with some risk capital in that the financial provider assumes that, to some degree, the business will be unable to repay the amount plus interest if any (Alterowitz and Zonderman, 2007, p. 10). Therefore, the financial provider, especially commercial banks, will demand some degree of assurance from the business, in the form of assets, which will be sold in case the business fails to honor the terms of the loan. Therefore, this is a pertinent issue worth consideration by Newbe when selecting financial strategies. Strategies for Securing the Required Financing There are several alternative sources of business financing, some of which include private equity, long-term bank debt, mezzanine debt, working capital current account lines, preferred stock, convertible stock or common stock. The following section describes the aforementioned business financing alternatives with a recommendation of alternatives that Newbe should consider pursuing. Recommendation is based on Newbe’s inherent characteristics (scope of business, amount of financing required and newness of the business) and the characteristics of the financing alternatives (including their advantages and disadvantages). Common Stock Gitman and McDaniel define common stock as “the security that represents a person’s ownership interests in a business enterprise (2008, p. 438). Founders of small companies and early investors often strive to go public through Initial Public Offering (IPO), which involves selling stock to the public for the first time. Going public, through the sale of common stock, is a highly recommended financing strategy since it will help Newbe investors to recoup their investment while enabling the enterprise to raise the required financial requirement easily (Gitman and McDaniel, 2008, p. 438). Since common stock holders are the real owners of the business, they enjoy all aspects of the business including decision-making, profits and losses, which frees the entrepreneur from the worries of repaying the common stock holders in case the business makes losses. However, sale of common stock has some disadvantages. Firstly, the lengthy decision-making process prevents effective business operations, which may hinder the realization of the entrepreneur’s initial goals and objectives. Further, the entrepreneur is usually not guaranteed that the IPO will sell and raise the required financial requirements. It is also expensive to go public since Newbe will have to undergo costs associated with paying fees to investment bankers, accountants, attorneys, and printers. Once Newbe goes public, it shall be highly scrutinized by common stock holders, regulators and security analysts, which will require revealing crucial information, such as financial plans, product details, financial data, operating data, and operating strategies. Revelation of such crucial information is risky since it may get into the hands of competitors at the disadvantage of Newbe. Preferred Stock Preferred stock is another method through which Newbe can raise the required capital where the business sells shares (preferred stock) to willing investors. Like common stock, investors are usually paid in terms of dividends. However, preferred stock, like debt financing, will plunge Newbe into financial risk since the business enterprise will be obliged to pay preferred stock holders a fixed payment (Gitman and McDaniel, 2008, p. 439). In other words, preferred stock holders, unlike common stock holders, are not real business owners. In case the business goes bankrupt and wishes to sell its assets, preferred stock holders must be paid before common stock holders, including the entrepreneur himself. Therefore, considering that Newbe is a young business enterprise, preferred stock is not a recommended financial strategy to pursue. Long-term Bank Debt Debt financing is considered long-term if takes more than one year to mature (Graham and Smart, 2011, p. 402). Newbe can secure long-term debt by engaging into a negotiation with a commercial bank. Long-term is an easy and fast way of obtaining required capital as compared to common and preferred stock. The process may take a very short time (say a week) or very long time depending on the loan requirements, such as the strength of the business credit worth (Gitman and McDaniel, 2008, p. 436). A majority of long-term debt financing involve various covenants, some of which are positive (specifying the things that the borrower must do during the debt period) while others are negative (imposing limitations on the borrower during the debt period). Some of the crucial covenants are listed below (Graham and Smart, 2011, pp. 403-404). Positive covenants The debt provider (bank) may require Newbe to maintain life insurance policies on key employees without whom Newbe’s future is plunged into doubt. The bank may require Newbe to maintain a threshold net working capital since inadequate liquidity often leads to default. Newbe will be required to supply the bank with audited financial statements periodically to assess its capacity to pay the loan. Negative covenants Newbe may be prevented, by the bank, to sell receivables, since the sale of receivables may result into long-term cash shortages especially if Newbe its proceedings to meet current financial obligations. The bank may impose restrictions on Newbe’s fixed assets especially with respect to asset liquidation, encumbrance and acquisition since these could make Newbe unable to pay the debt. Newbe may be prohibited from entering into business agreements with other firms, such as merger and consolidation since such a movement may be associated with certain financial and operating risk, thereby being unable to pay the debt effectively. Newbe may also be prohibited (or a limitation imposed), by the bank, salary increment for specific employees as a way of ensuring that that Newbe is able to pay the debt. Therefore, it is apparent that long-term debt is associated with various prohibitions and limitations that may prevent Newbe from carrying out its business operations effectively. In addition to the aforementioned covenants, Newbe will have to pay the loan through agreed principal (based on a greed amount and time intervals) plus loan interest (Graham and Smart, 2011, p. 405). In other words, long-term debt will be an added expense to the business, which must be avoided whenever possible. Therefore, long-term debt is not a recommended financial strategy, and Newbe should consider this option only if other options, such as common stocks have been unsuccessful. Private Equity Private equity involves selling equity securities to investors without going public (publicly trading) (Stowell, 2010). Private equity, like common and preferred stock, is a fast way of raising required capital since private investors, venture capitals or private equity firms will provide capital to Newbe to carry out its intended business operations. However, the investors usually have their own goals, investment strategies and preferences when providing the financial aid. In most cases, investors under the private equity arrangement invest in already existing or mature enterprises. Therefore, Newbe qualifies for this financial strategy since it is already in existence. However, private investors often come with specific goals and preferences and often impose control in the business (Stowell, 2010). However, if their preferences and goals are in line with Newbe’s preferences and goals, such an arrangement will ensure growth of the business since the investors must try everything possible to increase profits. Therefore, private equity is a highly recommended financing strategy for Newbe. Mezzanine Debt Mezzanine debt is also referred to as preferred equity or subordinate debt, which is a preferred form of private equity, just like preferred stock (Stowell, 2010). Mezzanine debt is often used by young companies that are unable to raise financial requirements through other means, such as bank loans (Stowell, 2010). This form of financing will enable Newbe to obtain the required financial requirement easily and speedily owing to the fact that mezzanine debts are usually high-cost forms of investment. However, like preferred stock, holders of mezzanine debt are usually paid a high rate of return since their investment is usually associated with high risks (Stowell, 2010). Considering that Newbe is still a young enterprise, mezzanine debts would not be a recommended financial option to pursue. Conclusion Two financial options have been recommended since they are less likely to plunge Newbe into a financial risk: common stock and private equity. To obtain required capital through common stock, Newbe should apply for the sale of its shares through IPO from the stock exchange market. The shares will be open for buying, by the public, who will become the new owners of the publicly traded enterprise. In the case of private equity, Newbe should encourage investors to buy securities from the enterprise. The investors may include members of its executive management, private investors, venture capitals or private equity firms. Sincerely Yours, Prime Financial Consultants References Alterowitz, R., and Zonderman, J. (2007). Financing Your Business Made Easy. Entrepreneur Media, Inc., pp. 8-13. Gitman, L. J., and McDaniel, C. (2008). The Future of Business: The Essentials, Fourth Edition. Mason, USA: South Western Cengage Learning, pp. 436-439. Graham, J., and Smart, S. (2011). Introduction to Corporate Finance, Third Edition. Mason, USA: South Western Cengage Learning, pp. 402-405. Gutterman, A. S. (1994). The Legal Considerations in Business Financing: A Guide for Corporate Management. Westport: Quorum Books, pp. 2-7 Stowell, D. (2010). An Introduction to Investment Banks, Hedge Funds, and Private Equity: The New Paradigm. Academic Press. Read More