Funding

Equity Capital

Equity capital is a fundamental concept in business finance, acting as the cornerstone for funding operations and growth. It's akin to the foundation of a house, providing the base on which the business stands and grows.

It refers to the money that is invested in a business by its owners or shareholders in exchange for ownership interest. Unlike loans, this money doesn't have to be repaid, but investors expect to gain from the business's profitability, either through dividends or an increase in the value of their shares.

Owners’ Funds

Owners' funds represent the total equity capital in a business. It's essentially the money that owners put into their business, plus any profits retained in the business over time. For a small business or a food truck, owners’ funds could come from personal savings, profits that are reinvested into the business, or funds raised from selling shares in the business.

Types of Owner Shares

Equity Shares

Think of a company like a pie. When someone buys equity shares, they're buying a piece of that pie. The size of their piece depends on how many shares they buy compared to the total number of shares the company has. Owning a piece of the pie means they get to enjoy a portion of the profits (like getting a slice of the profits pie) and have a say in big decisions (like voting on what kind of pie to make next).

For small businesses, including food trucks, the idea is similar. If a food truck owner, let’s say Alex, decides to bring on a partner, Jamie, they might agree that Jamie gives some money to the business (capital) in exchange for a part of the ownership. This is like Alex and Jamie owning pieces of the food truck pie. If the food truck makes money, Jamie gets a share of those profits. Plus, Jamie gets to help make big decisions, like where the truck should park or what items to add to the menu.

Preference Shares

Preference shares are a bit like a VIP ticket at a concert. Holders of these shares get special treatment: they receive their dividends (a share of the profits) before the regular equity shareholders do, and if the company ever shuts down, they get paid out of any remaining money before the regular shareholders. However, just like a VIP ticket might not let you vote on the band’s setlist, preference shares usually don’t come with voting rights.

In the world of small businesses or food trucks, this kind of share might not be as common, but it can be a useful tool. Imagine Alex wants to get some money from another investor, Taylor, without giving up any control over how the food truck is run. Alex could offer Taylor preference shares, meaning Taylor gets a fixed amount of money back before anyone else does if the truck makes a profit, but doesn’t get to make decisions about the truck’s operations.

Retained Earnings

Retained earnings are what you have left when you take the money the business made (revenue), subtract all the costs of making that money (expenses), and then decide not to give all of the leftover money to the owners or shareholders (dividends). It's like if you earned money from a lemonade stand and, after paying back your parents for the lemonade supplies, decided to save some of the money you made instead of spending it all. That saved money can be used to buy more supplies, save for a bigger stand, or even start selling cookies alongside the lemonade.

For a food truck, these saved profits are super important. They let the business grow without having to borrow money or bring in more investors. For example, if Alex’s food truck had a great year and made more money than expected, Alex could decide to use those extra profits to buy a new fridge for the truck, add a new dish to the menu, or even start saving for a second truck. This way, the food truck can expand and improve using the money it's already made, which is often easier and cheaper than finding additional funds from outside sources.

Mini-Case Study

Imagine "Global Grub," a food truck offering international street foods, looking to expand its operations. The owner, Jordan, considers different equity financing options:

1. Equity Shares: Jordan invites a friend to invest in the business, offering a 20% ownership stake. This infusion of equity capital allows Global Grub to purchase a second truck, doubling its operational capacity.
2. Preference Shares: To attract additional investment without diluting control, Jordan offers preference shares to a family member, providing a fixed dividend return but no voting rights. This capital is used to upgrade kitchen equipment across both trucks, improving efficiency and menu variety.
3. Retained Earnings: After a successful year, Global Grub has accumulated profits. Jordan decides to reinvest these funds into the business, developing a branded app that customers can use to place orders ahead of time, enhancing sales and customer experience.

In each scenario, the choice of equity financing impacts Global Grub's ability to grow and adapt to the competitive food truck market.

Financial Markets

Think of financial markets as giant online stores, but instead of buying clothes or games, people buy and sell things like shares of companies or loans. These markets help businesses get the money they need to grow and let investors look for places to potentially make more money from their savings.

Money Market

The Money Market is like a piggy bank for businesses, but it's for short-term saving and borrowing. Imagine a food truck needs to buy a lot of ingredients for a big event next weekend but doesn’t have enough cash on hand. The food truck can "borrow" from this piggy bank to buy what it needs and then pay it back quickly, usually within a year.

Capital Market

The Capital Market is where businesses go when they need more money to grow bigger, like opening more food trucks or expanding to new cities. This market includes places where businesses can get long-term funding (more than a year). Think of it as a place where businesses can find people or other companies willing to invest in them for a longer time.

Primary Market

The Primary Market is a part of the capital market but focuses specifically on issuing new securities (like shares or bonds) for the first time. It's the initial step where businesses get to meet investors. You can think of it as the grand opening of a store, where products are offered to the public for the first time.

Methods of Issue in the Primary Market

1. Initial Public Offering (IPO): This is when a company offers its shares to the public for the first time. It’s like a local bakery deciding to let customers become part-owners by selling them pieces of the business.
2. Rights Issue: Existing shareholders are given the chance to buy more shares at a special price before they are offered to the public. Imagine if, after buying a part of the bakery, you get a chance to buy more of it before anyone else can, and at a cheaper price, because you were already an owner.
3. Private Placement: Selling shares directly to a small group of investors. This is like the bakery owner offering to sell parts of the business directly to a few regular customers rather than to anyone who walks in.

Secondary Market

When a company sells its shares or bonds for the first time, it happens in the Primary Market. After that, these shares or bonds can be bought and sold multiple times between different people, and all these trades happen in the Secondary Market. It's important because it gives investors the flexibility to sell their investments whenever they want, which makes investing less risky and more attractive.

Methods of Trading

In the Secondary Market, there aren't "methods of issue" like in the Primary Market since the securities (stocks and bonds) have already been issued. Instead, there are methods of trading. Here's how it works:

1. Stock Exchanges: These are like big, organized marketplaces for securities. Imagine a vast online platform where people from all over the world come to buy and sell their game items. Stock exchanges, such as the New York Stock Exchange or Nasdaq, operate similarly but for stocks and bonds. Companies don't directly sell new shares here; instead, investors trade shares among themselves.
2. Over-the-Counter (OTC): This is a less formal and more decentralized way of trading securities, not through a central exchange but directly between two parties. Think of it like trading game items directly with a friend or through an online forum, rather than through an official game store.

Stock Exchanges

The Stock Exchange is a specific place where people buy and sell shares of companies, kind of like a farmer’s market but for investments. It helps set the prices for these shares based on how many people want to buy or sell them.

How It Works:

1. Getting Started: To trade (buy or sell shares), you need an account, like starting a new game profile.
2. Making Moves: You decide if you want to buy or sell shares and at what price, like choosing what to buy at a store.
3. Matchmaking: The exchange helps match buyers with sellers. If you want to sell a video game and someone else wants to buy it, the exchange helps you two find each other.
4. Trade Complete: Once you agree on a price and make the trade, the exchange makes sure everything goes smoothly, like making sure you get your game or your money.

Angel Investors

Imagine you have a brilliant idea for a new video game, but you need money to make it happen. You talk to a family friend who believes in your idea and decides to give you the money to develop the game. This family friend is like an Angel Investor.

Features:

• Who They Are: Angel investors are usually wealthy individuals who provide capital to startups or small businesses in exchange for ownership equity or convertible debt. They often are entrepreneurs themselves or retired business executives.
• What They Offer: Beyond money, angel investors can also offer valuable advice, industry connections, and mentorship to help grow the business.

Funding:

• How It Works: Angel investors typically invest in the early stages of a business, often when other investors might consider it too risky. They usually provide one-time funding to help the business get off the ground or ongoing support to carry it through its initial stages.
• Example: For a food truck business, an angel investor might provide the capital needed to purchase a second truck or expand the menu significantly, expecting a piece of the business in return.

Venture Capital

Now, imagine your video game has become popular, and you want to make it even bigger, but you need more money than what one person can provide. You approach a company that invests in young, promising companies like yours. This company is a Venture Capital (VC) firm.

Features:

• Who They Are: Venture capital firms are professional groups that manage funds aimed at investing in companies with high growth potential in exchange for equity.
• What They Offer: VC firms provide significant funding, resources, and expertise but often require a substantial share of the company and sometimes a say in company decisions.

Funding:

• How It Works: Venture capital is suited for businesses that have moved beyond the startup phase and demonstrate high growth potential. VC firms invest in a business with the expectation of a high return on their investment, often through the sale of their shares in the future or the company going public.
• Example: If "Taco Trek" wanted to transform from a regional food truck chain into a national franchise, a venture capital firm might invest millions of dollars to finance this expansion. In exchange, the VC firm would own a part of "Taco Trek" and likely have a seat on the board of directors.

Mini-Case Study

Consider "Eco Eats," a food truck that serves healthy, sustainable meals and has gained a loyal customer base. The owner, Sam, dreams of turning Eco Eats into a national brand.

• Angel Investor Scenario: Sam might pitch Eco Eats to an angel investor interested in sustainable businesses. The angel investor provides $50,000, which Sam uses to buy more trucks and start offering catering services for events, in exchange for a 10% stake in the business.
• Venture Capital Scenario: As Eco Eats grows and proves its concept can work on a larger scale, Sam seeks venture capital to fund national expansion. A VC firm invests $2 million for a 40% stake in Eco Eats, significantly accelerating its growth but also giving up a more considerable portion of ownership and control.

Angel investors and venture capital firms offer powerful funding options for small businesses at different growth stages, providing not just financial resources but also valuable expertise and networks. However, these investments come with the expectation of significant returns and often a say in how the business is run, which owners like Sam need to consider when planning their growth strategies.

Debt Capital

Businesses often need additional cash flow to grow or get through tough times. Food truck businesses are no different. A business loan can help keep the food truck business afloat and even help it get ahead of the competition.

However, the decision to take a loan should never be taken lightly because of the risks. Debt is inherently risky, and loans put a company in debt. An economic downturn can exacerbate this risk for a business. A business's cash flow might take a big hit when the economy is in a recession. This will make it more difficult for the company to repay its loans, thereby exposing the business to the risk of bankruptcy.

That is why it is essential to understand how loans work. Loans are classified as either secured or unsecured.

Secured loans require some form of collateral, often assets owned by the business, to secure them. The company could lose such assets to the lender if it cannot repay the loan.

Unsecured loans do not require collateral, but the business must meet predefined income and credit requirements. Companies with poor incomes or credit histories usually cannot receive unsecured loans. Such loans also have higher interest rates than secured business loans, making individual loan payments more expensive.

Types of Small Business Loans

Several small business loans are available to food truck businesses. Choosing the right type matters for success.

Equipment loans

This is a good option for financing the purchase of new food trucks or equipment for the business. They typically have low-interest rates and flexible repayment terms. However, they often require a down payment, and the lender could repossess the equipment if the business defaults.

Working capital loans

A working capital loan is ideal when a food truck business needs extra cash to cover day-to-day expenses or take advantage of events and new business opportunities. They usually get approved quickly with short and flexible repayment terms. However, the interest rate for this type of loan is higher than others, and the business could be at risk of default if it does not use the borrowed funds wisely.

Business Line of Credit

A business line of credit is a revolving credit line that borrowers can draw from as needed. It works like a credit card but with higher funding amounts. It also has lower interest rates than credit cards and requires interest payment on only the portion of the line of credit used.

Business term loans

This is probably the most popular type of business loan. It is a lump-sum loan repaid with fixed, regular payments over a set time, typically between two to five years. They can be used for various purposes, such as to finance the purchase of new equipment and upgrades or expand the food truck business.

Although the best loan option will depend on the food truck business' funding needs, it is often ideal to go for one with low-interest rates, longer repayment tenures, and higher loan amounts.

In our simulation, the bank offers unsecured, business term loans over five years with debt-to-equity requirements. Before moving to the factors food truck businesses need to consider when taking a loan, it is vital to know when to take it.

When should a business take a loan?

There are a few signs that indicate when to consider taking a loan:

·        Poor cash flow: Whenever the business struggles to pay for inventory and other operating expenses, it is time to think of getting a loan.

·        Insufficient capital for equipment and expansion: Loans can be a lifesaver when the business does not have the cash to buy a new food truck or other equipment outright.

·        Low-interest rates: It might be a good time to get additional capital when the business is doing well, and loan interest rates are low.

Factors to consider when taking a loan

As mentioned earlier, taking a loan for a food truck business is a big decision. Here are the factors you need to keep in mind when taking out a business loan for your food truck:

1. Purpose of the loan

The purpose of the loan has to be known. Whether it is for expansion, upgrades, operating expenses, or an emergency fund in anticipation of unexpected events, it does not matter. Without a clear purpose, abuse is inevitable. A clear purpose will also answer the question of the loan amount required.

2. Loan amount required

The purpose of the loan will determine how much is required. The simulation offers three loan amounts, minimum, average, and maximum, depending on a business' debt-to-equity ratio. It is considered responsible borrowing to borrow just what is needed to achieve the loan's purpose. That is because the company will have to pay more than the original amount borrowed due to interest.

3. Loan term

The loan term refers to the total repayment period. Because interest is paid for the duration, shorter repayment lengths mean lower total interest costs. The repayment period for loans in the simulation is set at five years. Repaying the loan earlier than the due date reduces the actual interest paid by the business.

4. Interest rate

The interest rate is the percentage of the loan amount the lender chargers as interest. Getting a loan at the lowest possible interest rate is the first step in succeeding with loans.

Two types of interest rates exist: fixed interest and variable interest. With a fixed-interest loan, the bank sets the interest rate for the duration of the loan. The monthly repayments stay the same even when the Central Bank changes its rates. Variable interest loans have repayments that can go up or down, depending on how the Central Bank's rates fluctuate.

The bank in our simulation offers a fixed-interest rate loan.

How is the interest rate determined?

Commercial banks set their interest rates based on the prevailing rate set by the Central Bank. They then benchmark their rates against what competitors are charging and adjust accordingly.

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The role of the Central Bank

The goal of the Central Bank in every economy is to maintain price and financial stability. They do this by controlling the key or policy interest rates. These rates are offered to commercial banks, which in turn add their margin and offer slightly higher rates to the public.

Relationship between Gross Domestic Product (GDP) and Interest Rate

The Central Bank adjusts its interest rates based on the country's economic health as indicated by its Gross Domestic Product (GDP). When the economy is booming, the Central bank can increase interest rates to make credit more expensive and reward savings. When the economy is in a recession, it can lower the rates to stimulate further investment and demand.

The commercial bank rate will also drop when the Central Bank lowers its interest rates. Hence, businesses often find some of the lowest interest rates during a recession.

Countries usually go through a 10-year cycle of economic booms and recessions. The simulation compresses this 10-year cycle to one in-game year.

Base interest rate

At any given time in the simulation, the bank's base interest rate (offered to companies with almost no debts) can be calculated thus:

Central Bank rate + Bank margin = Base interest rate

Current interest rate

This is based on the bank's perceived risk of loaning money to a specific business at a given time. Depending on the business' income and credit history, the bank may consider the company a medium or high-risk enterprise and offer loans at a higher interest rate than its base rate.

Debt-to-Equity Ratio and Current Interest Rate

In the simulation, the bank uses a company's debt-to-equity ratio to assess its creditworthiness and classify its risk of loaning money to it.

The debt-to-equity ratio indicates how much a company finances its operations with debt instead of equity or retained earnings. It is calculated by dividing total liabilities by total equity.

The bank considers companies with low debt-to-equity ratios as low-risk businesses. Those with a high debt-to-equity ratio are considered high-risk businesses.

The current interest rate for low-risk companies is lower than that for high-risk businesses. Companies classified as very high-risk (highest debt-to-equity ratio) cannot take loans from the bank.

To improve creditworthiness, the company can pay off its loan, increase its profitability, or improve its inventory management.

5. Loan Fees

Aside from the interest rate, businesses will also have to pay other fees when taking out a loan. These fees often add up to a substantial amount, so they are worth mentioning. However, businesses may end up negotiating them with the bank. They include:

Processing Fee: Usually a small, fixed amount; banks charge this fee for processing the loan application. The bank in the simulation charges 5% of the loan principal for this fee. It is the only loan fee the bank charges.

Origination Fee: A fee charged by the bank for providing the loan. It is usually a percentage of the loan the business pays upon receiving it.

Commitment Fee: Banks sometimes charge this as compensation for promising to provide the loan. Usually, a percentage of the loan amount is paid when the loan is approved.

Exit Fees: Banks sometimes include an exit fee when the loan is repaid early. Also called a prepayment penalty, the fee compensates the lender for the interest they would have earned if the borrower had held the loan for the entire term.

6. Default risk

There is always the risk of being unable to pay back a loan as a business. When this happens, the company is considered in default. This has severe consequences for the business and the owners.

In the simulation, companies that default on their loans declare bankruptcy. Budgeting is a wonderful way to minimize default risk. It helps to show the maximum monthly payment a company can afford. Knowing this amount can also contribute to the size of a loan the business can take.

The financial section is handy for budgeting as it contains the business's weekly, monthly, and yearly sales, income, and expenditure records. These records will help business owners create accurate budgets to aid their loan decisions based on the historical performance of their company.