Question

SALMA IT Software consultancy and solutions venture raised a 150 thousand pond in 2011 from family and friends, and they become successful companies in terms of IT, data engineering. with anticipating 120% growth since 2015, they going to enter a Large agreement worth 1,000,000 ponds with a famous financial service sector. The firm requires a 250,000 pond working capital in 12 months to be able to fund this expansion. Since the management of the company is price sensitive and do not want to borrow excessive money that could cost them higher. Therefore firms require to create bridge financing depend on the contract to link the shortage of cash flow gap with working capital prior to an equity fund. Founding a profitable business usually looks attractive to investors, we recommend SALMA to choose the Venture Capitalism, Equity-Based Finding and cash line for Financing options base on that please discuss the blow question.

1)Consider and explain the valuation issues associated with the chosen financing option

2)Compare financing option to alternative financial options at the same point in the ventures progressions

Answer 1

1. Issues with venture capitalism

• Forced Management - venture capital funding comes with a few strings attached. First, investors will require a stake in equity. Second, they will want to add management and possibly, remove some key managers currently in place.
  The forced management changes may come under the request of bringing in a more experienced hand. In some cases, the investor may have decades of qualified business experience, which could be beneficial. However, handing over control of your management team is not always ideal. Your management team will often set the stage for your company’s culture. If the team has any dislike, or it seems that the funding is held over your head time and time again, the capital may not have been worth it.
• Loss of Equity - It’s expected, but it’s still a downfall. When looking for venture capital funding, you’re often willing to give away a chunk of your business. Be wary of giving away too large of an equity stake in your company. If you have an investor dedicated to your vision, consider working out a private equity investment.

Issues with Equity Financing

• Cost: Equity investors expect to receive a return on their money. The business owner must be willing to share some of the company's profit with his equity partners. The amount of money paid to the partners could be higher than the interest rates on debt financing.
• Loss of Control: The owner has to give up some control of his company when he takes on additional investors. Equity partners want to have a voice in making the decisions of the business, especially the big decisions.
• Potential for Conflict: All the partners will not always agree when making decisions. These conflicts can erupt from different visions for the company and disagreements on management styles. An owner must be willing to deal with these differences of opinions.
• NO TAX SHIELD
  The dividends distributed to the shareholders are not a tax-deductible expense. On the contrary, the interest expense is an eligible expense for tax benefits. A 12% interest rate with 40% prevailing Tax Rate makes the effective cost of funds to be 7.2% {12% * (1-40%)} in case of debt. This benefit is not available to the equity source of financing and therefore, it is considered as a costly source of financing.

Issues with Cash line

• Cash credit facility is usually offered for a period of 12 months, after which the bank re-evaluates the creditworthiness of the account holder and accordingly sanctions fresh drawing power. The accountholder has to repay the over-drawn amount before the expiry of the repayment period. Thus, short tenure and revaluation of drawing power at regular intervals make cash credit a short-term source of financing. Hence, borrowers should not use cash credit facility to finance capital expenditures, as such expenditures usually take longer time to generate profit.