Raising equity in the early stages remains a challenge for many new ventures, especially in cases where the product/ service is yet to be developed or the business model is unproven. This task is particularly difficult for small firms who either do not have an established reputation or are not widely known. Three commonly used avenues to raise finances are borrowing from banks or from other financial institutions, venture capital investments and selling equity/ownership in exchange for a stake in ownership (see Bartlett, 1995 for an excellent discussion of related institutional details). Bank financing becomes less forth-coming when there is uncertainty about the proposed product and its demand. Also, new ventures are likely to mainly have intangible assets (e.g. patents, intellectual property) which might be less acceptable as collateral than tangible assets.
Bartlett (1995), Gompers and Lerner (2001) and others have provided general discussions of the financing of new ventures. The paper attempts to provide some formal insights into financing of new ventures in cases where other avenues of financing such as venture capital investments and direct borrowings are not feasible or are unattractive. Such instances might be common for small firms trying to raise finance based on an underdeveloped product or an unproven business model. Borrowing from established economic theory and using a simple model of contract auctions, the behaviour of new firms trying to raise capital by negotiating with potential investors is examined.
The start-ups seek to maximize revenues from selling a given (minority) stake in ownership by auctioning an incentive contract. The outcome of the venture is uncertain at the time of contract and true project costs are revealed only at project completion/launch. This uncertainty limits the ability of the firm to use a straight auction to raise finances.
The effects of a change in investor competition on contractual design and project size is examined. The results show that greater number of investors vying for the same venture will result in, under certain conditions, optimal contracts being close to fixed-price contracts and larger projects being undertaken. In particular, these results are driven by the slope of the marginal bid function.
A special case with a linear bid function shows that the nature of bidder interaction is a crucial determinant of contractual design. In particular, bidder competition moves the contract towards a fixed-price contract, while bidder collusion results in a cost-plus contract. However, project size is unresponsive to a change in the number of bidders in this instance.
An important public policy implication is that promotion of competition among investors will promote research spending/inflate project scale. Reduced competition will result in less ambitious projects being undertaken. Thus while pre-qualification of investors might serve some useful purposes, it has the potential of reducing project size in cases where some investors are disqualified.
The paper can be seen as part of initial steps to formally model and understand the contractual arrangements in early financing of new ventures. The findings can prove useful in cases involving uncertainty about product invention, development or regulation. Some directions for future research include incorporating research competition among
Firms and looking Atmore sophisticated contractual arrangements (Admati and fleiderer, 1994). Reputation effects might also have important bearings on contractual arrangements (Banerjee and Duflo, 2000). As relevant data become available empirical tests of bidding patterns can be conducted.
Goel R, Hasan I. Funding new ventures: some strategies for raising early finance. Applied Financial Economics [serial online]. July 2004;14(11):773-778. Available from: Business Source Premier, Ipswich, MA
About the Author:
Dr.Hisham M Safadi (Hisham Safadi ) BDS & MSc Leadership and Management in Health Care Practice the University of Salford where his Master dissertation was in the effect of Emotional Intelligence on improving Dentistry care in Middle East. He was born and raised in the Emirates of Ras Al Khaimah, United Arab Emirates. Dr.Safadi had start his professional career as a dentist then turn to the field of managing medical facilities and investment management. His main interest is business start-up, leadership and mentoring. Currently he is leading several projects in Manchester that is related to enhance patient experience and improving leadership style through education.
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