CQ 2: How can small businesses signal their credit worthiness?
10 important questions on CQ 2: How can small businesses signal their credit worthiness?
What are some advantages of group lending? (2)
- Potentially solves problems for low wealth borrowers
- Reduces moral hazard (trust)
What does succes depend on in group lending? (4)
- Peer selection
- expulsion harmful for the group
- Peer monitoring
- Peer pressure
- Social capital
- community ties
What are 3 points of equity finance?
- Equity is the ownership of a business
- normally in the form of shares
- Equity finance: money is return for part of the ownership
- with a loan you keep the ownership, but you have to repay the loan with interest
- Providers of equity finance are normally referred to as venture capitalists (VC's)
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What are 3 points of venture capital?
- Difference between venture capital and private equity
- venture capital for young business with growth potential (our focus)
- private equity for established firms (not our focus)
- Formal and informal venture capitalists
- VC firms (formal)
- business angels (informal)
- General aim of venture capitalists: purchase shares in growth firm that can be sold later for better price (temporal arbitrage, but uncertainty is large!)
- dividends or other income from the shares less/not important
What are 2 points for 'clearing the market'?
- Valuation very difficult - principally dependent on net present value
- predicting future difficult, particularly for new and small businesses
- X% of the business for price Y
- Presence of exit routes is important for buyer
- trade sales (selling shares to other business)
- initial public offering (IPO)
What are the the 3 components of the structure of VC funds?
- Year 1-3: selecting businesses
- Year 4-8: co-working to let the business grow
- Year 9-10: selling the business
What is the main problem the VC funds faces: Adverse selection?
- Adverse selection
- Picking the wrong business in which to invest (they do not grow after receiving funding)
- Businesses in need of money (and doubt about success) more likely to seek VC funding
- Strategies to tackle adverse selection
- due diligence: spend considerable amount of time to investigate the market and the entrepreneur's track record (VC funds often specialise in particular sectors)
- syndication: syndicate the deal with other so that risk is shared
What is the main problem the VC funds faces: Moral hazard?
- Moral hazard
- the businesses, once they receive the money, feel that they do not need to grow
- Strategies to tackle moral hazards
- monitoring: appoint a non-executive director
- staging: invest funds in stages so that additional funding reflects performance
- legal contract: enumerate managers/entrepreneurs via share options rather than salary (share options only accumulate value over time)
What are 4 advantages of equity finance form the perspective of the entrepreneur?
- No interest payments
- also: money is patient; VC doesn't want to see immediate returns
- Overcoming difficulties in accessing other funding
- because of intangible assets
- Leverage other borrowing
- VC provides support
What are 3 disadvantages of equity finance form the perspective of the entrepreneur?
- Loss of ownership
- Loss of control (economic/ psychological) and 'free rider' problem
- Push towards selling/ IPO
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