Entrepreneurial finance is the study of value and resource allocation, applied to new ventures. It addresses key questions which challenge all entrepreneurs: how much money can and should be raised; when should it be raised and from whom; what is a reasonable valuation of the startup; and how should funding contracts and exit decisions be structured.
The problem
Depending on the industry and aspirations of the entrepreneur(s) they may need to attract money to fully commercialize their concepts. Thus they must find investors – such as their friends and family, a bank, an angel investor, a venture capital fund, a public stock offering or some other source of financing. When dealing with most classic sources of funding, entrepreneurs face numerous challenges: skepticism towards the business and financial plans, requests for large equity stakes, tight control and managerial influence and limited understanding of the characteristic of growth process that start-ups experience.
On the other hand, entrepreneurs must understand the four basic problems that can limit investors' willingness to invest capital: Uncertainty about the future: in terms of start-ups development possibilities, market and industry trends. The greater the uncertainty of a venture or project, the greater the distribution of possible outcomes. Information gaps: differences in what various players know about a company's investment decisions. "Soft Assets": these assets are unique and rarely have markets that allow for the measure of their value. Thus, lenders are less willing to provide credit against such an asset. Volatility of current market conditions: financial and product markets can change overnight, affecting a venture's current value and its potential profitability.
History
Venture capital as the business of investing in new or young companies with innovative ideas emerged as a prominent branch of Entrepreneurial finance in the beginning of the 20th century. Wealthy families such as the Vanderbilt family, the Rockefeller family and the Bessemer family began private investing in private companies. One of the first venture capital firms, J.H. Whitney & Company, was founded in 1946 and is still in business today. The formation of the American Research and Development Foundation (ARDC) by General Georges F. Doriot institutionalized venture capital after the Second World War. In 1958, the Small Business Investment Companies (SBIC) license enabled finance companies to leverage federal US funds to lend to growing companies. Further regulatory changes in the USA –namely the reduction of capital gains tax and the ERISA pension reforms- boosted venture capital in the 1970s. During the 1980s and 1990s, the venture capital industry grew in importance and experienced high volatility in returns. Despite this cyclicality and crisis such as Dot Com; venture capital has consistently performed better than most other financial investments and continues to attract new investors.
Sources of entrepreneurial financing
Financial bootstrapping
Financial Bootstrapping is a term used to cover different methods for avoiding using the financial resources of external investors. It involves risks for the founders but allows for more freedom to develop the venture. Different types of financial bootstrapping include Owner financing, Sweat equity, Minimization of accounts payable, joint utilization, minimization of inventory, delaying payment, subsidy finance and personal debt.
External financing
Businesses often need more capital than owners are able to provide. Hence, they source financing from external investors: angel investment, venture capital, as well as with less prevalent crowdfunding, hedge funds, and alternative asset management. While owning equity in a private company may be generally grouped under the term private equity, this term is often used to describe growth, buyout or turnaround investments in traditional sectors and industries.
Business angels
A business angel is a private investor that invests part of his or her own wealth and time in early-stage innovative companies. It is estimated that angel investment amounts to three times venture capital. Its beginnings can be traced to Frederick Terman, widely credited to be the "Father of Silicon Valley" (together with William Shockley), who invested $500 to help starting up the venture of Bill Hewlett and Fred Packard.