Individual Assignment

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INFLUENCE OF FINANCING SOURCE ON THE SMALL BUSINESS

PERFORMANCE

Mihaela Mikic University of Zagreb, Faculty of Economics and Business, Croatia

[email protected]

Tomislav Novoselec [email protected]

Dinko Primorac University North, Croatia

[email protected]

ABSTRACT

Finding funds for financing entrepreneurial venture often presents most difficult obstacle in

realization of entrepreneurial idea. During this process choosing the source of financing

represent the special challenge. Although in first it may look there is a wide selection of

source of financing as: private equity, business angels, public finance, etc., in practice

entrepreneurs usually depend on their own assets, informal investors and debt financing. This

paper gives detail overview of possible source of financing for new and already existing

entrepreneurs. Based on conducted research and multiple linear regression analysis is

defined influence of individual source of financing and small business performance. As profit

represents the core motive for entrepreneurship, these research findings should be

entrepreneurs’ guidelines in choosing the source of financing their venture.

Keywords: business angels, business performance, private equity, small business, source of

financing

1. INTRODUCTION

Like everywhere in the world, small entrepreneurship in Croatia is the most important

generator of development, it openes new workplaces, encourag sole proprietorships and

inovation, increase production and export, and thus create added value. Role of this

companies is not only in ecenomical spheres of society, but also in social, cultural and historic

spheres. Due to their contribution to employment, creating GDP and export, sole

proprietorships represent a huge part of Croatian economy. Small and middle sized companies

(SMEs) encompass 99.6% of total number of registered businesses in 2012. Out of that,

98.3% are small sized and 1.34% are middle sized businesses. Share of small businesses in

employment in 2012 recorded a growth compared to 2011 and now stands at 67.04% (49%

are small sized and 18.04% are middle sized businesses). At the same time, SMEs constitute

43.06% of total Croatian export, 21% are small busineses, 22.6% are middle sized businesses

(HGK 2014). Small activity in new ventures, small share of growing companies,

administrative barriers, under-developed financial market (too dependent on traditional

instruments) and lack of education focused on honing entrepreneurship knowledge and skills

are main traits of small businesses in Croatia.

Financial resources are needed for realization of every idea and inovation. Financial requests

have a tight bond with business strategy, which in interaction with financial strategy enables

creating added value and raising the level of competitiveness. Without financial resources it is

impossible to realize new good business ideas. When a business is started, financial resources

are ensured from owners own sources. With growth and development of a company,

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requirements grow with them, and so possibility to finance come from many different sources.

Each stage of a company's life cycle has different sources of financing. In earlier phases

personal assets, loans from family/friends and micro loans present key financing resoruces,

while in later phases they can be expended with equity funds, business angels (as informal

investors) and public financing. Small businesses face many barriers in they life cycle and

financing is one of most common to appear and hardest to overcome.

2. POTENTIAL SOURCES OF FINANCING

2.1. Self-financing

When launching a business, every entrepreneur must first turn to his own personal property.

Although entrepreneurs prefer to invest only someone else's capital to reduce their risk, banks

and other investors require capital investment by entrepreneurs as a sign of faith in the

venture. The largest part of their funds is personal savings they've acquired over the years.

The funds presented as savings can be found at the current bank accounts, saving bank

accounts or in the form of effective money. There's a positive correlation between savings and

probabilities, it is a cause - effect relationship characterized by great likelihood that a person

will start a business venture if it has a larger amount of savings, on the one hand, and that

he/she will generate greater amounts of savings if he/she engages in running a business, on the

other (Hurst and Lusardi, 2006). Likewise, savings (wealth) is concentrated by

entrepreneurially active people and entrepreneurship is a powerful factor which affects the

level of aggregate savings (wealth), and thus the aggregate consumption (Gentry and Glenn,

2004). Surveys show that the majority of entrepreneurs in Croatia opted for entrepreneurship

out of necessity (GEM, 2013), so an important source of self-financing is redundancies that

can reach very high amounts. The next type of self-financing is personal debt that can be

result of overdraft on current account or credit card. Among these, personal loans are suitable

for setteling short-term liabilities and are sometimes used in order to achieve tax benefits on

such loans (Grgić, Bilas and Franc, 2011).

When they exhaust their own sources of financing entrepreneurs turn to informal investors,

friends and family. Unlike other investors family members and friends are often more patient

and don't interfere in the way entrepreneurs conduct their business. Also they usually do not

sign formal contracts and the contractor doesn't pay any interest (if they exist they are

insignificant) for the borrowed funds. Information on the return and the potential benefits are

also informal (Skrtic and Mikic, 2011). Repayment period of the borrowed funds is often

flexible and it adapts to the undertakings' capabilities, and the borrowing decision depends on

the personal trust in the entrepreneur as a person. Because of the mutual relations of family

members or friends and business drivers, they will prefer to invest in entrepreneur’s

investment than decide to hold cash or invest in other investments (Scarborough and

Zimmerer, 2009). In this case there may be conflicts between entrepreneurs and family or

friends, and the main causes of disagreement are usually unrealistic expectations or

misunderstood risk by those who have invested in venture project. In order to avoid distortion

of relations, the entrepreneur must honestly and realistically present strengths, weaknesses,

opportunities and threats of the project and the nature of the investing risks.

If we talk about financing of the existing company, then we need to mention another form of

self – financing, which in this case is the most important, financing from business retained

earnings. There are two options that a company can use if it makes profit. One is to reinvest

the acquired funds in the business to help them achieve new value added, and the other option

is to distribute its profits to owners in the form of dividends.

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2.2. Debt financing

The most common form of debt financing is a bank loans. Such financing can be shorterm or

longterm and is marked by giving collateral as insurance of payment by entrepreneurs. It is for

this reason that this type of financing is difficult to apply to businesses that are at the very

beginning of their life cycle. Bank wants proof of successfully conduction of business and real

evidence of stable sales and the ability of products or services to generate adequate cash flows

to ensure the repayment of the loan, and therefore they insist on collateral when financing

entrepreneurial projects in early stage of development. In assessing the requirements for

lending resources, banks focus on the ability of the company to generate cash flows since it

will continue to serve for servicing the loan. Other forms of debt financing include: trade

credits, factoring and leasing. Trade credit is given by the supplier (also called loan of

manufacturer to the customer), and is implemented through the granting of loans under a

contract for the delivery of goods with deferred payment, usually 30 to 90 days. Suppliers

often use this type of financing to attract new customers, and customers or contractors use it

as a way of acquiring the additional working capital. Since these loans are often not linked to

interest payments, entrepreneurs often use it in their daily business. Factoring, as a form of

debt financing, represents a form of shortterm financing on the basis of sales of short, in

general, unsecured assets of enterprises (primarily trade receivables without collateral

payments) to specialized financial organization, which is called a factor. These financial

institutions may also provide other services, such as claims management and underwriting

payment from the debtor. Factoring regularly represents a shortterm rating with a large circle

of regular customers and large annual turnover and is often not an option for small businesses.

Leasing is a form of financing that is based on the idea that it is better to use the object of

leasing than to buy it. It allows the user to obtain any equipment or property for use during

needed time, rather than to buy it. By leasing, SMEs can obtain manufacturing and other

goods without spending their own funds and without taking expensive loans in the financial

market, and allows compensation for the use of subjects on the principle of "pay out of what

you earn." There are two types of leasing: financial and operational. Financial leasing is a

basic contract period of the lease, in which one of the contracting parties can't cancel, it is

designed as a "contract of full amortization," which means that the user, during the duration of

the contract paid the full value of the service (where the costs of maintenance and

obsolescence of subjects bears the recipient). On the other hand, operating leasing represents a

shortterm contract for the lease that can be terminated at any time (under the terms of the

agreement), it lasts less than the economic life of the subject, the fee is smaller than the value

of the object, so the service is depreciated only by a portion of their expenses and assumes the

risk of obsolescence and maintenance costs of leased items. Also after the expiry of the lease

entrepreneur can (if the contract was concluded) redeem the subject of leasing. In operations

of European companies leasing is mostly used for the acquisition of transport equipment and

machinery, and technology (European Commission, 2013). Leasing purchase of equipment

allows small businesses to keep up with technological change and to preserve their

technological competitive advantage.

2.3. Equity capital

Venture capital funds are a form of equity financing, and represent funds for medium and

longterm investment in companies that typically are not listed and have high growth potential

(Cvijanovic, Marovic and Sruk, 2008). These funds are known under the name of private

equity funds and by the Investment Funds Act of Republic of Croatia defined as mutal venture

capital funds with a private offering (150/05). Venture capital funds usually invest in

companies that are engaged in hightech service sectors such as Internet, communications,

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information technology, biotechnology, etc.. To attract capital, company must primarily have

potential for rapid growth. The process of obtaining capital is rigorous and requires

entrepreneur to professionally prepare project documentation with longterm business plan.

When a venture capital fund accepts an entrepreneurial project follows an agreement on all

relevant business issues with special emphasis on the management team. Venture capital

funds do not buy more than twenty to forty percent ownership of the company, since the

purchase of a large stake would reduce the enthusiasm of entrepreneurs to manage the

company. The dynamics of investing funds in an entrepreneurial project is not always a one

time investment; instead, if it comes to large amounts, it can be realized in several phases.

Acceptance of this form of financing requires a waiver of part of ownership by the

entrepreneur, and sometimes loss of control over operations. Business angels are individuals

or groups that provide capital for financing new business projects. Most often these are

wealthy individuals who are looking for entrepreneurial ventures (projects) in which they

would invest their own resources in exchange for the acquisition of shares of those companies

(Garaca and Marjanovic, 2010). This is an informal form of investment whose holders are

highly educated business people who invest their funds in start up projects with high potential

of growth. This implies that angels expect a high annual return on investment and a multiple

increase of the initial investment after a few years when they decide to retire from the

business (Figar, 2010). The reason why they are willing to accept such a degree of risk is that

one investment is only a tiny fraction of the total portfolio of personal investments that angels

make (Vasilescu, 2009). On capital market business angels fills the gap between the founders,

family and friends on one side and the venture capital funds on the other, and therefore have a

key role in the financing of SMEs, particularly innovative businesses and businesses with high

growth potential. In some cases, firms choose to raise capital through the public sale of shares

in the capital market, so called going public. By analysing the strengths and weaknesses of

public offering, we can conclude that going public primarily allows the entrepreneur to collect

large amounts of capital, but not without consequences. For some businesses, the

consequences are too big. Most entrepreneurs enter entrepreneurship with the goal of

independence and creating something of their own, so the loss of independence in decision

making and conducting business, shared ownership and a sense of "accountability" are simply

too big sacrifice that most entrepreneurs are not ready to make. For those entrepreneurs who

enjoy the fact that their company outgrew themselves and who want to try some other

challenges, public offering is a good way to achieve that dream. Once an entrepreneur, a small

business owner, weighs all the pros and cons and decides for public offering he will meet with

the formal problems. Today in the world there are only a few specialized stock exchanges for

SMEs, of which the most important for Croatian entrepreneurs is AIM (Alternative

Investments Market) in London. AIM London is the largest and most liquid world market for

growing SMEs, and its biggest advantage over other stock exchanges is that it belongs to the

London Stock Exchange which brings listed companies many advantages and great number of

competitors as well.

3. CHOOSING THE SOURCE OF FUNDING

Raising funds for launching an entrepreneurial project is a big challenge for every

entrepreneur. Constant changes on the market only make the mentioned challenge more

difficult. When selecting sources of financing entrepreneurs need to consider the following

factors (Stokes and Wilson, 2010):

 legal forms of conducting business

 phase of enterprise life cycle

 the nature of funds

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Companies with more complex legal forms of conducting business, such as public limited

companies, will have an increasing number of opportunities related to funding the company,

while those with simpler legal forms (sole traders) will be much more limited in terms of the

diversity of funding sources. Thus, for example, sole traders can't get access to equity capital

because there is no possibility of selling shares of the company.

At different company life cycle stages (start up, growth, differentiation, consolidation,

liquidation) company will require increasing amounts of resources for growth and prosperity

of business. The needs for financial resources of a recently founded company and one that has

a long tradition of conducting business are not the same. It is essential that strategy and

structure of the company are changing along with the changes in the life cycle and therefore

business conditions, and indirectly the needs for financial resources will also change. Funding

problems are encountered mostly by entrepreneurs who are at the very beginning of their

entrepreneurial adventures, so at the very beginning, funds come from entrepreneurs, friends,

relatives, business angels. Banks are reluctant to finance new business ideas for entrepreneurs

usually can't provide adequate collateral. On the other hand, the venture capital funds are

usually not interested in these investments because for them the amounts of profit are very

low. In the next stage, the resources are needed for the development of the business idea and

its expansion, so for the entrepreneur, through well developed business plan the possibility of

using others financing resurses is opening up. When a company occupies a certain market

position through quality business it will have a full range of possible sources of funding

available.

In the case of fixed resources, financing is mostly carried out through owner’s equity, and

funding source is most often seen in the proportion of entrepreneur’s ownership (in the form

of shares) in the company or personal loans of entrepreneurs or their partners. This serves to

cover the initial operating expenses or new product development in the stage of development

and expansion. Unlike fixed assets, current assets are covered by shortterm financing and are

used to cover operating costs and often the procurement of rolling stock. Financing assets

carried out through medium and long term financing (3 – 10 years) is used for the acquisition

of plants, machinery, equipment, while making sure that credit conditions correspond to life

expectancy (or shorter) of the underlying assets. In financing sources entrepreneur should pay

attention to the potential problems that are presented by exchange rate fluctuations,

requirements and safety charges.

5. SMALL BUSINESS FINANCING IN CROATIA

5.1. Methodology

Population of this research is all Croatian small businesses. Small business has maximum of

50 employees and size data are available in the register of business entities at Croatian

Chamber of Economy. Research sample consists of 350 small businesses from various

business activities: manufacturing, construction, wholesale and retail sale, repairs of motor

vehicle and motorcycles, and objects for personal consumptions and households,

transportation, storage and communications. Research was conducted via electronic mail, and

rate of return is 11.71%. Regardless relatively small percentage of return, given sample is

sufficient for relevant analysis and impact assessment of choosing financing source on small

business performance. Questionnaire was answered by owners of small business, ie small

entrepreneurs.

Determining financing sources was done by using five-level Likert item scale. Financing

sources include: self-financing by entrepreneur, informal investor (3F), venture capital funds

and business angels. This research was based on acquisition of self-selected, subjective

answers about the financial and non-financial performance of the firm from the entrepreneurs

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of the retained sample companies with an effort to reflect its multi-dimensionality. Business

performance was operationalized accordingly by Gupta and Govindarajan (1984) where the

respondents were asked to rate the extent to which stated financial and non-financial

indicators are important for their business, and subsequently, to assess the extent of

satisfaction with the achieved performance of these indicators. For this purpose three financial

and three non-financial indicators were used; each of the indicators was measured with three

questions using a five point Likert scale. Financial performance represents the key of business

effectivity and it is considered important, but not self-sufficient for defining business

performance (Murphy et al., 1996). We used these indicators of finance performance:

 total profit

 ROA

 ROE. Business performance represents market oriented components and includes indicators of total

revenues and market share. This definition was subject in numerous researches (Koufopoulos

et al., 2010; Postma, Zwart, 2001)

Multiple linear regression method is used for the prediction of the dependent variable on the

basis of the insights that can be obtained from a number of independent variables and for

determining the nature and relationship between these variables and the variables used to

measure the quantitative scale. Standard methods of multiple linear regression is used and all

independent variables entered into the regression equation simultaneously in order to explore

the relationship between the entire set of independent variables and the dependent variable.

For the evaluation of the strength of relations among variables the regression coefficients and

t-test is used.

5.2. Sample characteristics

We gathered responses from 41 small business. The biggest part of questioned business is

from construction 37% and wholesale and retail sale 29% (Figure 1). The majority was

founded in period of 1990 to 2000, average year of foundation is 1996, and the modal year is

1991.

Figure 1: Distribution of the business according the business activity

37%

29%

17%

17%

Construction

Wholesale and retail sale

Transportation, storage and communications

Manufacturing

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As main reason for using self-financing entrepreneurs stated completely ownership over the

resources 24%, no interest rates and monthly payments As main reason for using self-

financing entrepreneurs stated completely ownership over the resources 24%, no interest rates

and monthly payments 23% and independence in disposing resources 22% (Figure 2).

Figure 2: Reasons for using self-financing

Most common source of self-financing is savings through the years 34%, and from other

sources inheritance and selling of the personal property (Figure 3) Personal debt financing and

current account overdraw are least represented, which can be interpreted as willingness of

entrepreneurs to stay independent in disposing resources without attachments to interest rates

and terms as in the case of bank loans.

Figure 3: Source of personal property

As for the entrepreneus who used the loans to family/friends to finance busienss equity, 65%

of them stated these reasons for using this form of financing: no detachment deadlines and

high interest rates and the fact that family members/friends will not interfere with their way of

doing business. Interesting is that the 35% of the sample did not use any borrowings from

family/friends to finance equity (Figure 4).

22%

24%

23%

18%

Independence in disposing resources

Completely ownership over the resources

No interest rates and monthly payments

Signaling to investors faith in investment

34%

14%

11%

10%

15%

Savings throug the years

Personal loan

Current account overdraw

Redundancy

Funds from selling property

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Figure 4: Reasons for using funds form family/friends

The other interesting finding is that 44% questiond entrepreneust said that the concept of

venture capital is completely unknown to them. Only 41% of respondents answered that they

have heard of venture funds, but are not familiar with possibility of using their finance

resources (Figure 5).

Figure 5: Familiarity of venture capital funds

Even worse indicators relate to knowledge of the term of business angels and their advantages

and disadvantages. Only 15% of respondents is fully aware of business angels (Figure 6). At

the same time, to 59% of entrepreneurs business angels are completely unknown concept. The

above shows an extremely negative trends of Croatian SMEs, and states the area within is

necessary to conduct additional training of entrepreneurs in order to improve these negative

trends.

18%

17%

15% 15%

35%

Detachment to return deadlines and high interest rates

Family members/friends do not interfere with their way of doing business

Not obligatory to report business performance details

Do not have enought own funds

Did not used this financing source

44%

41%

15%

Do not know

Heard, but do not know the details

Fully understand

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Figure 6: Familiarity of business angels

As conclusion it can be stated that the Croatian small businesses or entrepreneurs show a more

traditional approach to finance business equity. Majority of financing is based on their

personal property and only a small part on the borrowed funds from family/friends or informal

investors.

5.3. Results of multiple linear regression

Regression equation is:

Y = α + β1X1 + β2X2 + β3X3 + ei Y = business performance

X1 = entrepreneur's savings

X2 = funds form family/friends

X3 = bank loans

In the above regression equation venture capital funds and business angels are exempt as

previously mentioned results show that questioned entrepreneurs did not use their funds for

financing their business venture.

The business performance(Y) is the dependent variable and is measured as a weighted average

which is obtained through multiplying the importance and satisfaction for each individual

criterion. Criteria used are: (1), Financial performance: company total profit, profitability of

total assets (ROA) and return on equity (ROE); (2) Business performance: total revenue and

market share. The independent variables in this model represent the types of financing that

take three modalities: personal property of entrepreneur, fund from family/friends and bank

loans.

The outcome of a multiple linear regression using method of least squares (Table 1)

show estimated equation model of the impact of financing source on small business

performance as follows:

Ŷ= 0,14 + 0,67X1 – 0,37X2 + 0,49X3

58% 27%

15%

Do not know

Heard, but do not know the details

Fully understand

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Table 1: The outcomes of the multiple linear regression (financing source/small business

performance)

N=41

Coefficient Standard deviation t(41) p-level

α 0.136546624 0.769284092 0.177498 0.860085165

X1 0.66667436 0.120485453 5.533235 0.0000026921391

X2 -0.369496985 0.251370055 -1.46993 0.150032975

X3 0.489712921 0.128733438 3.804085 0.000516709

Statistics Value

Multiple R 0.698670101

Multiple R 2

0.48813991

Adjusted R 2

0.44663774

F(3,37) 11.76179259

p 0.0000147744

Contribution of financing sources to explanation of business performance is satisfactory

because it explains 48.81% of variance, on the whole population is 44.66%. This data is

significant as a source of financing is one of the most influential factors of business success -

but not the only one. There are many other factors that affect business performance - both on

the internal as well as external level, which in this analysis was not included. Regardless of

the high coefficient of multiple linear determination, the impact of the financing source on

small business performance is highly significant (p <0.01.).

Personal assets of entrepreneur has a positive impact on business performance (β1 = 0.67, p

<0.01 - significant at 1%). The above result was expected because when investing their own

funds entrepreneurs are acting and making decisions more prudently. As an entrepreneur

invests his savings accumulated for years, thereby risking the financial stability of your

family, it is logical that he will be managing it more responsibly while avoiding investment in

high-risk activities. In this case, we can say that the entrepreneur takes reasonable assumption

of risk when making business decisions.

And financing through bank loans has a positive impact on business performance (β3 = 0.49,

p <0.05 - significant at 5%). The reason for this can be found in the complex procedure of

loan approval which credit institutions protect against bad loans. When applying for funds,

entrepreneurs are responsible for providing high quality and systematically developed a

business plan which covers all areas of the business in order to reduce potential operational

risks to a minimum. By doing so, companies are obliged to comply with the plan. At the same

time, the bank will only approve funding for promising projects that have a certain economic

potential. In this way the bank invests only in ventures that promise a return, so it is logical

that between bank loans - as a form of business financing - and the business performance we

have a positive link.

Interesting results showed that analysis of the impact of funds from family/friends on small

business performance. Results of the analysis indicate a negative relationship (β2 = -0.37, p =

15 - significant at 15%). This is explained with very informal relationship that exists between

entrepreneurs and investors mentioned. As the landing of the funds is usually based on

acquaintance and relationship with the entrepreneur, or trust, all the information about the

entrepreneurial venture and the potential returns are usually verbal. The lack of formal

developed business plan that will provide an objective picture of the business venture

potential may lead to worse malpractice risk management operations, thereby to achieving

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poorer financial results. Also, entrepreneurs are often turning to family and friends when they

exhausted all their own available funds or personal property and at the time when they can no

longer get any bank loans. The most common reason is high-risk from non-viability of a

business project or already high indebtedness of entrepreneur.

The research results bring answers to many questions related to the Croatian small businesses

and ways to finance it, but also many questions remain open for further research. Additional

limitation is the scarcity of data on business performance in the Republic of Croatia so the

quality of doing business is still incomplete. A small sample represents a kind of restriction

regarding the use of inferential statistics and advanced statistical models for more detailed and

better analyses.

5. CONCLUSION

Finding and selecting sources of financing is a significant problem in implementation of

Croatian entrepreneurs' ideas. Although they have available many sources of financing, as

shown in this paper, they usually use only three types: personal property of entrepreneur (self-

financing), informal investors (family and friends) and bank loan. The reason for this lies in

the lack of knowledge of other forms of financing that are at their disposal, such as venture

capital funds and business angels. Also, stated unwillingness of investors to finance

entrepreneurial ventures in the initial phase of the life cycle or to finance such "small" amount

does not help. The limiting factor in finding funding represents a legal form of business,

which entrepreneur is not usually aware of when starting a business.

The empirical research has shown that there is a positive relationship between self-financing

of the entrepreneurial venture or investment of his personal property, and small business

performance, and above is explained by the fact that such firms conduct much more sensibly

risk management. Entrepreneurs are investing savings gathered through the years and

inherited assets, the reason is completely ownership over the resources, no interest rates and

monthly payments and independence in disposing resources The reverse situation is present

when borrowings from family/friends. Results of multiple linear regression show a negative

correlation between this form of financing and business performance. The main reason for

borrowing from family/friends is detachment to high interest rates. The fact that family

members/friends do not interfere in doing business, is the second most common reason for

using this type of financing. Financing through bank loans positively affects the achievement

of successful business results, and one of the reasons is systematically and holistically

developed a business plan that is needed for obtaining bank funds. Croatian small businesses

show a more traditional approach to funding equity, the majority of funding is based on the

personal assets of the entrepreneur (in 2012 the average proportion of self-financing was

80.14%), and only a small part is based on the borrowed funds from family/friends and bank

loans. Precisely for this reason, the Croatian entrepreneurs should through education for

entrepreneurship, improvement of technical and technological knowledge and skills, and

international entrepreneurial practices adopt the best European (global) trends in

entrepreneurship so their work and business efforts could result with a long term national and

international competitiveness.

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