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Table of Contents

Finance – Funding For New Business – Part 5


7. Capital Market

7.1. Risk Analysis in Capital Investing

Despite the analysis of Sykianakis (2007) relates to Balkanas, it is based on the examples of the large UK and US companies. The main focus of the work is risk analysis, assessment, and management. The most important conclusion of the article was that political risk influences capital investing process, but can be hardly estimated. Sykianakis (2007) considered foreign direct investments. Therefore, this source of information can be used as supplementary for purposes of the current research.

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Sanders Thomas Ltd (2012) provides an assessment of the practices of investing in new ventures and growth opportunities. This work will help evaluate these practices and make appropriate conclusions related effectiveness of using investments and assessments of the related risks. The Fund that was examined provides investments for the companies at different stages of the development including the initial stage. The analysis presented by Sanders Thomas Ltd (2012) can help assess the sources of funding new companies.

There are new sources of funding that are being assessed in the current age and can be tapped by new businesses. There are risks involved at both the sides: the investors and the creditors. Given the researches and the experiments, it is fair for companies to assess the level of risks of investing in a new company before deciding to do so.

7.2 Analysis of Efficiency of Capital Markets in UK

CRA International (2009) assessed the effectiveness of regulation of the securities markets in UK. The research relates the evaluation of the current situation in the capital markets in UK. The assessment of the efficiency of the capital markets helps provide sustainable growth of UK economy. CRA International (2009) linked between market regulation and cost of equity, valuation, and protection of shareholders. This article can be used for assessment of the practices related the theories used in the current research.

Mishra (n.d.) presented an evaluation of the global financial markets including the markets in developed and developing countries. Mishra (n.d.) shed light on the contemporary state of the financial markets of the world including UK from the perspective of effective resource allocation. Also, Mishra (n.d.) considered the availability of innovative financial products for the new companies in UK.

A favorable financial market condition paves ways for further investments and financing. In the UK particularly, a healthy capital market defines efficient resource allocation that can mobilize funds to invest in innovative ideas, products and services, giving impetus to funding for new businesses.

7.3 Long-Term Financing of New Companies in UK

Mullen (2012) explained that obtaining an appropriate source of financing is a kind of challenge because of lack of funding in the post-crisis period. Besides, the problem is worsened by the fact that new business owners and managers do not have enough experience to manage the financial sources. Mullen (2012) described the patterns that could be used to find the sources of financing for the new companies. Also, Mullen (2012) turned the attention of the potential business owners to the opportunities offered by government to support the new start-ups. Mullen (2012) emphasized the long-term financing as one of possible alternatives to finance the new start-ups.

Mills (n.d.) concerned the issues of raising capital for new companies. Mills (n.d.) analyzed changes in raising capital patterns in the contemporary business environment. Mills (n.d.) stated that it has become more difficult to raise capital for SME because of consequences of the financial crisis of 2007-2008. Raising capital has become more costly and time-consuming than before. Also, Mills (n.d.) made conclusions related success factors of raising capital for the new companies.

Financial crisis has not only been a problem for existing businesses but it has also halted the various opportunities that could have entered in the scene for prospective starters. The observations suggest that long term financing in new businesses is also being considered as an issue, despite the recession phase. Though risks are involved, the future prospects look good and so we might expect long term financing as one of the means of funds for new startups.

7.4 Summary

The current literature review section consists of eight parts including theoretical background, the analysis of the practices of funding SME in UK, analysis of funding new business in UK, capital investment patterns, distinguishing features of the UK capital market, risk analysis in capital investing, the analysis of efficiency of capital markets in UK, and long-term financing patterns in UK. Theoretical parts present framework for evaluation the relationships between shareholders and management of the new companies, patterns used by the new companies to choose from several investment sources, legal framework for the new companies, and the optimal combination of equity and debt that could be used by the new companies. The part related funding of SME aims to describe the typical patterns of funding in UK while the part related funding the new business evaluates the sources of financing that could be used by the new companies. The part related the capital investment patterns in UK aims to identify the types of investment that are used by the new companies in UK. Learning distinguishing features of the capital markets in UK help shed light on the sources of capital that could be used when launching new start-ups. Risk analysis in capital investing help evaluate potential risks and mitigate their negative effect on the new companies. The analysis of efficiency of the capital markets in UK help assess the most effective markets and analyze their success factors to further use when developing the investing strategies for the new companies in UK. The analysis of the long-term investment patterns could help range the sources of financing and identify the sources that could be used on initial stages of launching the new companies.

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8. Measurement variables and issues

Data for the current research will be collected by sending questionnaires to 250 existing and new entrepreneurs. Further, in-depth interviews will be conducted aiming to polish the results of the current research. A self-composed questionnaire will be send to the potential participants targeting at least 200 business owners. For this purpose the questionnaire will be sent to more than 200 persons because some of them will not be able to answer the question or maybe will not have time or desire to answer the questions. The respondents are supposed to have their own business or started up their business during the last year. The questionnaires will be sent to the participants upon arrival at an agreement for participation.

9. Research Model

9.1 Overview of Theories

The issue of problems faced by new companies is not a new one and there are several theories that could help understand them. Theories such as the theory of agency costs, pecking order theory, infant industry theory, and trade-off theory are considered with respect to the issues that arise when launching the new companies. These concepts deal with various dimensions of a new startup ranging from the relationships between investors, shareholders, and managers and the issues that could potentially arise as a result of conflict of interests, asymmetrical information issue (The theory of agency cost), selection of sources of financing to achieve positive financial outcomes for each stakeholder (Pecking order theory), the importance of economic protection (Infant industry argument) to the use of debt and equity for efficiency maximization (Trade-off theory). The explanation of the main concepts of the theories can be found below.

9.2 Agency Costs Theory

A key concept of the agency costs theory is that a principal employs an agent to perform the tasks on the behalf of a principal. Agency reflects the relationships between a principal and an agent. Principals incur agency costs after monitoring the behavior of agency based on monitoring of agents’ performance. Agents are accountable to principals who employ these agents (Grigore and Ştefan-Duicu, 2010).

With respect to the problem examined in the current research, agency costs can be associated with the conflicts of interests between senior management of a new company and shareholders of this company. Shareholders require that the management of the company generate returns from investments and maximize shareholder value. Meanwhile, the management of the company may run the company in a way to maximize their power or wealth that may not coincide with the interests of the shareholders. Thus, conflict of interests arises. Agency costs usually comprise of material incentives for principals like stock options or performance bonuses and moral incentives for agents. Thus, the interests of principals and agents can be aligned (Grigore and Ştefan-Duicu, 2010).

Jensen (1986) concerned agency costs theory with regard to funding new businesses. Jensen (1986) stated that debt financing benefits reducing agency costs could be used in financing new start-ups. Also, Jensen (1986) considered the influence of programs of diversification on income and losses from the perspective of the agency costs theory that could be also helpful when starting a new company having limited financial resources. Jensen (1986) touched upon the issue of offering bids and abnormal performance of the companies before takeover.

Bankman and Cole (2001) explain the problem of agency costs when launching new enterprises. Also, Bankman and Cole (2001) concerned the relationships problem between business owners, investors and management of new companies. In addition, Bankman and Cole (2001) stated that venture capital-backed investments cannot bring extraordinary returns, but it may seem that they do. Thus, the use of capital-backed investments should be considered closely when starting-up the new companies.

Grigore and Ştefan-Duicu (2010) aimed to explain a behavioral aspect from the perspective of agent costs theory. Additionally, Grigore and Ştefan-Duicu (2010) considered the optimal capital structure for the new companies based on the perspective of agency costs theory.  As well as Bankman and Cole (2001), Grigore and Ştefan-Duicu (2010) paid much attention to emerging of conflicts between investors and managers. It is necessary to take these issues into account when launching the new companies.

Like Bankman and Cole (2001), Grigore and Ştefan-Duicu (2010), and Jensen (1986), Frank and Goyal (2005) shed light on agency conflicts, bankruptcy and transactions costs. Frank and Goyal (2005) explained the problems arising between agents by use of debt financing. The outcomes of Frank and Goyal (2005) are based on pecking order theory of leverage and the trade-off theory. Also, Frank and Goyal (2005) reviewed the evidence related these theories. The evidence is related different forms of ownership of the companies including private firms, small and large public companies. Typically, small public firms tend to use equity financing. On the contrary to small public firms, large public firms tend to use corporate bonds and retained earnings. Frank and Goyal (2005) considered the impact of transaction and bankruptcy costs on the choice of type of financing.

Institute of Management Accountants (1997) analyzed the process of creating value from managers’ perspective in the global market. This research was inspired by increasing accountability of corporate executives and owners demanding more value from their investments. The study helps broaden awareness of managers and shareholder’s regarding creation of shareholder’s value.

Thus, the various researches and observations carried out under this theory suggest that it is crucial to monitor principal-agent relationships to gain the maximum benefits from the agency contract. It also tries to address the important issues like relationship issues and asymmetrical information issues which generally arises in these relations and could consume an adequate amount of financial and other resources that could be used as funds in startups at different stages.

9.3 Pecking Order Theory

Pecking order theory also called pecking order model, is an approach that helps define the capital structure of the companies. The main goal of this theory is to explain priorities in choosing financial sources. The idea of the theory is that a company tends to follow the course of least resistance by obtaining available sources of financing and then moving to sing the financial sources that are difficult to use. For example, when starting a business, founders can use available internal sources, such as own financial sources and capital borrowed from friends and family. After the primary sources of financing are exhausted, the founders start to seek for investors or lenders. When other options are not available, the new businesses may use equity in the assets held by the business (Frank and Goyal, 2005).

9.4 Infant Industry Argument

An infant industry at the early stage of development cannot compete against mature competitors in the industry. Infant industry argument also called infant industry theory advocates protectionism for new industries fierce competition until maturity. The protection of newly established companies is exercised by governments in the form of tariffs, quotas, import duties or exchange rate control procedures. These measures aim to prevent competitors from beating or matching the price level of the infant industries in the international markets. These protection measures help infant industries stabilize and develop in privileged environment (Krueger and Tuncer, 2003).

Krueger and Tuncer (2003) considered an application of the principle of the infant industry arguments in practice. They developed an empirical test for the validity of the infant industry argument and used that test on Turkish Data. Krueger and Tuncer (2003) concluded that at least in the Turkish case, protection did not draw out the sort of growth in output per unit of input on which infant industry proponents supported their claims for protectionism.

Melitz (2005) emphasized the necessity to protect new companies based on infant industry protection theory. Also, Melitz (2005) considered functioning of new companies on national and international markets. Melitz (2005) compared the efficiency of different tools in choosing an appropriate funding policy.

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9.5 Trade-off Theory

Trade-off theory states that a company can choose the proportions of using debt and equity financing by balancing the benefits and costs. Trade-off theory offsets the cost of debt relatively to its benefits. The theory describes the following concepts of corporate finance: agency costs and cost of financial distress. Also, the theory explains why the new companies are financed partially by debt and partially by equity. Debt financing has certain advantages in the form of tax benefits while debt financing is also associated with higher costs (bankruptcy and non-bankruptcy costs) in comparison to equity financing. The theory states that further increase in debt decreases the marginal benefit of this increase thus raising marginal costs. Thus, a firm should focus on its trade-offs by maximizing the overall value when choosing debt or equity financing (Frank and Goyal, 2005).

Thus, existing theories are what we base our assumptions on for further practical experiments and deductions. With growing competition at domestic levels and increasing globalization at international levels, all these concepts exhibit apt significance even at present times. They address the various factors related to decisions of different forms of resources; mainly economical.

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