Economics 2116A/B Lecture Notes - Startup Company, Main Source, Share Capital

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Loan capital
This can take several forms, but the most common are a bank loan or bank overdraft.
A bank loan provides a longer-term kind of finance for a start-up, with the bank stating the
fixed period over which the loan is provided (e.g. 5 years), the rate of interest and the timing and
amount of repayments. The bank will usually require that the start-up provide some security for
the loan, although this security normally comes in the form of personal guarantees provided by
the entrepreneur. Bank loans are good for financing investment in fixed assets and are generally
at a lower rate of interest that a bank overdraft. However, they don’t provide much flexibility.
A bank overdraft is a more short-term kind of finance which is also widely used by start-ups
and small businesses. An overdraft is really a loan facility the bank lets the business “owe it
money” when the bank balance goes below zero, in return for charging a high rate of interest. As
a result, an overdraft is a flexible source of finance, in the sense that it is only used when needed.
Bank overdrafts are excellent for helping a business handle seasonal fluctuations in cash flow or
when the business runs into short-term cash flow problems (e.g. a major customer fails to pay on
time).
Two further loan-related sources of finance are worth knowing about:
Share capital outside investors
For a start-up, the main source of outside (external) investor in the share capital of a company is
friends and family of the entrepreneur. Opinions differ on whether friends and family should be
encouraged to invest in a start-up company. They may be prepared to invest substantial amounts
for a longer period of time; they may not want to get too involved in the day-to-day operation of
the business. Both of these are positives for the entrepreneur. However, there are pitfalls.
Almost inevitably, tensions develop with family and friends as fellow shareholders.
Business angels are the other main kind of external investor in a start-up company. Business
angels are professional investors who typically invest £10k - £750k. They prefer to invest in
businesses with high growth prospects. Angels tend to have made their money by setting up and
selling their own business in other words they have proven entrepreneurial expertise. In
addition to their money, Angels often make their own skills, experience and contacts available to
the company. Getting the backing of an Angel can be a significant advantage to a start-up,
although the entrepreneur needs to accept a loss of control over the business.
You will also see Venture Capital mentioned as a source of finance for start-ups. You need to
be careful here. Venture capital is a specific kind of share investment that is made by funds
managed by professional investors. Venture capitalists rarely invest in genuine start-ups or
small businesses (their minimum investment is usually over £1m, often much more). They
prefer to invest in businesses which have established themselves. Another term you may here is
“private equity” – this is just another term for venture capital.
A start-up is much more likely to receive investment from a business angel than a venture
capitalist.
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