3.2: Venture Financing

Question 1

What is the difference between debt financing in ideal vs. real markets?

Answer 1

1. In the ideal market, there is perfect information, flexibility and competition, all NPV>0 ventures get funded
2. In real life, there is asymmetric information, market imperfections and stochastic outcomes

Question 2

What are the 2 general assumptions about asymmetric information?

Answer 2

1. Entrepreneurs are fully informed about their proposed risky venture
2. Lenders have incomplete information since the ventures are new and have no history, no credit rating agency has rated them and the costs of getting said information is too high

Question 3

What is credit rationing, and describe its two types?

Answer 3

Credit rationing happens if lenders are unwilling to give borrowers additional funds at the market interest rate - it is seen as a limitation in the financial markets
2 types:
Type I - Some or all loan applicants receive a smaller loan than they desire at the quoted interest rate
Type II - Some randomly selected loan applicants are denied a loan altogether (although same terms, same possibilities, virtually identical applicants)

Question 4

What are the causes of Type I credit rationing with regards to banks?

Answer 4

• Single interest rate - banks generally charge the same single interest rate to heterogenous entrepreneurs, irregardless of their risk profiles
• Bankruptcy costs

Question 5

What is redlining?

Answer 5

Redlining is the systematic denial of financial services based on location, rather than the individual’s creditworthiness, because the bank believes it cannot obtain its required return at any interest rate.

Question 6

What do under- and overinvestment refer to? What is a socially efficient venture?

Answer 6

1. Underinvestment occurs when socially efficient ventures are not undertaken
2. Overinvestment happens when socially inefficient ventures are undertaken
3. A socially efficient venture is one whose expected value is >= expected value from employing its resources in the best alternative use

Question 7

What did the Characteristics of Business Owners database say about family finance in 1992?

Answer 7

1. Family finance is the most used form of loan outside of financial institutions, with numbers varying based on ethnic groups
2. Non-minority owned: 26.8% family financed, 65.9% institution financed
3. Korea and China: 41.2% family financed, 37.4% institution financed
4. Developing countries have even more of a reliance on family
5. Family finance correlated with low profitability and high failure rates

Question 8

What are some of the advantages of family finance?

Answer 8

1. For the family over a bank: they have private information on borrowers, easier to monitor investment, and can exert peer pressure on borrowers
2. For borrowers: family loans are usually interest-free

Question 9

What are some characteristics of micro-finance?

Answer 9

1. Small, and often non-profit making, and located in developing countries
2. For individuals that don’t have access to normal financial options (often based on poverty)
3. Directly monitor borrowers, have regular repayment schedules, and often the threat of a lack of refinancing potential is present

Question 10

What are some characteristics of group lending?

Answer 10

1. A form of micro-financing

2. Group members jointly punished if one member defaults, such as credit denial to all members, or shared loan liability

Question 11

Explain the Grameen Bank lending scheme.

Answer 11

1. Loans (average $75) to groups of five people for productive purposes only
2. At first, only two members of the group get loans - paid back weekly in one year - then next two after six weeks
3. Group must meet weekly with other groups as well as a bank representative to discuss financial issues and plans

Question 12

What are some of the advantages of joint liability with regards to incentives, moral hazards problems, and adverse selection?

Answer 12

1. Incentives of both entrepreneurs and lenders are consistent
2. Mitigates moral hazard through monitoring, which is easier through familiarity, as is discipline
3. Mitigates adverse selection, as a group would not select a bad member/would discipline them

Question 13

What are some of the benefits of microfinance schemes?

Answer 13

1. Higher repayment rates means more capital recycled back into the system
2. Benefits for women (97% of Grameen clients are women)
3. Allows for additional social development programs to be carried out

Question 14

What are some criticisms of microfinance?

Answer 14

1. Excessive monitoring by group members
2. Overly cautious investments
3. Potential need for subsidies when programs are unable to break even

Question 15

Explain the concept of credit cooperatives.

Answer 15

They are voluntary groups that obtain funds and allocate credits to members, with the whole being liable for debts of any single member.

Question 16

What are some drawbacks from credit cooperatives?

Answer 16

1. There is a decreased incentive to monitor, as the liability is spread
2. They are more vulnerable to covariant risks - e.g. bad weather leads to a mass default of all

Question 17

Explain the concept of mutual guarantee schemas. Where are they popular?

Answer 17

1. A voluntary grouping of individuals that guarantees a fraction of any loan a member gets from a bank
2. Not popular in US, but is in Europe, with rates in Italy randing from 50-100%, and those in Germany going up to 70%
3. Loans are normally pre-screened, and financial advice is provided and shared among members

Question 18

Explain the concept of trade credits. What are their benefits?

Answer 18

1. Between firm loans that are used to purchase material goods
2. Mitigates credit rationing, as partners possess inside information unavailable to banks

Question 19

Explain the concept of equity finance.

Answer 19

1. The lender is entitled to a stake or share of a firm’s profits
2. Comes from private independent funds, corporate subsidiaries, angel investors, and venture capitalists

Question 20

Explain what a venture capitalist is, and how long do equity investments typically last?

Answer 20

1. Manages several entrepreneurial ventures - being actively involved in their prospects and success
2. Equity investments last for 3-7 years, after which they are sold

Question 21

What are some advantages of venture capital investments, and what do they normally lead to?

Answer 21

Screening, monitoring and mentoring within VC funds leads to faster professionalization, stronger innovation, higher growth, and employment creation within the entire venture.

Question 22

What are some factors affecting the availability of equity finance for entrepreneurs, and what is a main concern for those involved?

Answer 22

1. Fixed costs of issuing shares are problematic, as most enterprises never grow to a size where the costs are warranted
2. Information costs, but also costs from asymmetric information
3. Further, the involvement of outside financiers can cause conflicts of interest, such as entrepreneurs taking benefits that reduce the outside value of the firm

Question 23

What is the preferred method of finance for entrepreneurs, and why? Order them.

Answer 23

1. Entrepreneurs prefer debt financing more, as they need to share less if they succeed.
2. They choose finance based on the degree that they will be interfered: internal - debt - equity
3. Informal financiers - such as angels - are the best option, but are of limited supply

Question 24

What can be done to promote equity finance?

Answer 24

1. Reduce new issue costs and market transaction costs, as well as remove restrictions on the source of investor finance
2. Subsidize agencies that improve information flows between entrepreneurs and VCs
3. A capital gains tax can also be implemented to drive more investment