Acquiring Venture Capital: Financing Preferences of Startups

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Paula Kokare
Project Manager, Switzerland

Acquiring Venture Capital: Financing Preferences of Startups

Small firms, especially startups, face significant difficulties acquiring external funds due to various reasons. Unlike mature firms.
Sanyal and Mann (2010) researched 4200 US based start-ups to determine financing specifics of new enterprises. Overall, startups were observed to make use of bootstrapping, owners' internal equity and short term debt, such as overdraft and credit card debt, as the primarily source of funding. The authors proved certain characteristics determine the capital structure of new ventures:
  1. TANGIBLE ASSET BASE: Startups with higher tangible capital bases will have better access to and higher usage of external debt financing. With the increase in capital base, the usage of external debt in the form of bank loans and credit cards increases the most significantly. External equity financing is used the least often by such firms.
  2. INTANGIBLE ASSET BASE: If a business possesses high levels of intangible assets, such as IP rights and trademarks; and the owner brings specific knowledge, skills and capital to the firm, asset specificity is high. This means that assets are not transferable, have low liquidation value and represent a high risk for debt providers. Therefore, entrepreneurs of such firms would reach out more often for external equity instead.
  3. OWNERSHIP STRUCTURE: Team-run start-ups will very likely use their own funds more extensively and have network of angels and VC firms to support them in return for equity. Hence, minimal usage of external debt.
  4. OWNER CHARACTERISTICS: Start-ups with financially educated owners will have lower likelihood of involving external equity providers (VC funds and Business Angels). Instead they will be able to arrange banks lending or government funding (debt).
  5. HIGH TECH: High-tech companies are researched to rely more on external equity financing rather than using their own internal financing.
  6. SIZE AND LOCATION: Very small and home-based enterprises use their financing, short-term debt, e.g. credit card and overdraft facilities more often. This is mainly caused by information unavailability about these ventures.
Sources:
Modigliani, F. & Miller, M. H. (1958) "The Cost of Capital, Corporation Finance and the Theory of Investment" American Economic Review Vol.48 pp. 261– 297
Myers, S. and Majluf, N. (1984) "Corporate Financing and Investment Decisions when Firms have Information that Investors do not Have" Journal of Financial Economics 13(2) pp.187-221.
Sanyal, P. and Mann, C. (2010) "The Financial Structure of Startup Firms: The Role of Assets, Information, and Entrepreneur Characteristics" Boston: Federal Reserve Bank of Boston.

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