With the changes in the economic condition and ramified financial factors, there are several applied finance issues which have been faced by the organizations while operating its business in market. The business ecosystem all over the world is becoming dynamic day by day due to the influx of business ideas. This phenomenon is not new but the fact that these ideas are allowed to execute is definitely unpreceded. The resources required for the same are being provided with full enthusiasm and the culture of betting the odds on these ideas is ushering. Regardless of the idea, industry or sector, one common and most important resource essential is the funding for the idea. The success of any startup or new enterprises not only depends upon the idea itself but also the way the plan is executed. This evaluation of the quality of execution is often rightly done based on the management of finance. In this research, the main topic which has been selected is financial financial distress in start-ups companies in market. After having said that, one of the major reasons for 80% startup failing to achieve their goals even after great ideas is the melt down of the enterprises in times of financial distress (Geng, Bose, and Chen, 2015). It could be considered that the startups today are driving economies to another regime, and such model can play a significant role in determining the collective performance of these small and fast-growing entities (Altman., et al. 2017).
This research focuses on the analyzing the implied financial distress issues and problems which company could face in its business. It is analyzed that research will help small start-up companies to strengthen its business outcomes and the business outcomes. The financial leverage risk and cost of capital would be analyzed by company to evaluate the financial distress issues and problems which start-up company would face.
Synopsis of the startup funding process
Before developing the probabilistic model, it is indeed very important to understand the process of funding of startups through venture capitalists. As per the perception of Gul, Khedmati, Lim, and Navissi, (2017), it is divulged that the venture capitalist acts as the intermediaries between the startup and the downstream investors who are not interested in directly investing in high risk projects and does not have the competency for the same. Therefore, the investment allocation for the startups is associated with the experts in the venture capitalist companies who are willing and competent to manage them. Venture capitals often invest in a startup company at a stage even when the product has not been developed and therefore keeping the risk in mind the funding from these companies to the startups are done in various steps at various stages in the growth trajectory of the startups. However, incubators and angle investors are the main investors who are ready to invest their capital in the newly started up business. These stages are described as under:
Seed funding: This is the capital provided to the startup for the proof of concept. It may include the product development but does not include product marketing or production
Startup funding: This is the funding used for the initial marketing of the product after the proof of Concept has completed and product development has started
First stage funding: As stated by Delgado-Guay, et al. (2015). It is depicted that it is the stage where the commercial manufacturing and sales would be started for the startup. This funding is executed when the startup has expanded its initial funding in product development and initial marketing.
Second Stage funding: As per the perception of Gul, Khedmati, Lim, and Navissi, (2017), it is revealed that this is the funding process where working capital used by the startup is funded at this stage
Third stage funding: In this stage of funding, funds provided for the major expansion or when the profits are realized
Fourth-stage, mezzanine, or bridge financing: This is the last stage of funding where all the required Capital needed by the startup is arranged when it is about to go public in a year or 6 months. It is ideally done by issue of the shares and debentures in market (Gao, Parsons, and Shen, 2017).
After having understood the cash inflow of the starter, the following assumptions are characterized (Ramsey, et al. (2016).
As stated by (Ramsey, et al. 2016), it is divulged that the startups financial asset is comprised of the study cash flow from the receipt or other financing institutes. For making the calculations less complicated, the assumption is made that the funding is evenly distributed across the various stages described in the previous section and hence at any given time t, considering the amount of funding equal to l dollars, the total funding would be l*t.
However, business promoters needs to first analysis all the internal and external factors before starting up new business as it would allow them to strengthen their business outcomes in efficient manner.
As per the views of Viana, and Rodrigues, (2016), it is divulged that the second assumption is that the outward cash flows are randomly distributed. This assumption old very well as a Startup faces various expenses in a staggered fashion. These expenses can vary from RandD expenses to ordinary operating expenses, capital expenses to litigation expenses. Therefore, At any given time t the value of the cash outflows is symbolized by X(t) dollars. Also, the number of cash outflows over a time interval is taken as a random variable. For a time, interval (0, t), it is symbolized by N(t). The cumulative cash outflow at any given time t is equal to.
N(t) sum of i=1*x(i)
The third assumption is that the initial funding arranged by the founder of the starter is equal to K. In real scenarios, this funding plays the role of mitigating the moral hazard associated with the startup. Thus, many financial institutes require the founders to invest this small amount as a token of mutual confidence (Lemonakis, et al. 2017).
Thus the net asset position of a startup at any given time is, symbolized by ????(???? | ????, ????)
????(???? | ????, ????) =k +tl =N(t) sum of i=1*xt
During the course of operation of the starter at various stages the financial source will evaluate the condition of the finances of the startup to analyze the further decision of funding. If the funding source comes up with the result that the startup is in the financial distress it can seize the further formed which can result in the death of the business. The financial distress issues are those issues which could not only hamper the smooth running of its business but also destruct the business in long run (Meeker, et al. 2017).
As stated by Kao, and Sie, (2016). It is depicted that practically the cash flow from the VC should be designed to enable the startup to meet its short-term liabilities as they accrue. If the starter cannot liquefy is account payable at the time required to prove its liquidity, the startup is considered in the financial distress. For the scope of the analysis in this essay the stage of financial distress is considered at a point where the total asset of the starter, which is consist of the cash inflows from the VC or other sources and the cash outflows for the operational expenses, becomes less than zero. For the terminology used in this essay so far, this can be expressed as following (Kruger, et al. 2015).
As stated by Mangena, Priego, and Manzaneque, (2016), it is depicted that the above equation represents the conditional probability that the business will experience financial distress at given time t given the fixed and the known variables of the started initial equity and the continuous cash flow financing. It is analyzed that rewriting the above equation in the simplified notations.
As per the views of Halteh, Kumar, and Gepp, (2018), it is divulged that the last equation in the preceding section is incomplete because the distribution function governing N(t) is not at specified. Keeping in view the multiplicity of the independent cost associated with each element in the series, the best approach is to assume that the random variable N(t) depends on the continuous time parameter t such that the increment N(t+1)- N(t) are mutually Independent for any finite set of t i.e. t (1) < t (2) <t (3) < t (4) < t (5) <…< t(n) and so on. It is analyzed that there should be proper equilibriums between the cash inflow and outflow from the business if company wants to sustain its business in long run.
As stated by Ul Hassan, Zainuddin, and Nordin, (2017). It is divulged that these above are the assumptions and points which will assist organization to identify the applied financial issues in the financial distress. The main issue arise when company fails to arrange the available resources for its business and faces various problems. The financial leverage risk is also one of the major risks which company face due to high financial distress. The practical application of the equation derived in this essay can help the financial institute to allocate funds to a start-up company based on the random characteristics of cash outflow and the company’s initial equity. The financial risk arises when company has high debt funding in its business. It is considered that if company fails to manage the financial capital in its business and profitability then it may result to firm’s ability to cover up its financial cost. It may destruct the brand image and business sustainbitiy of organization. It is analyzed that if company does not manage its cost of capital in accordance with the profitability then it will result to destruction of the business in long run. It is analyzed that starting up company should be less inclined towards raising its business funds form the debt and borrowing if it wants to sustain its business in long run. It is analyzed that if it is properly done then it will assist organization to lower down the possibility of the financial distress (Alifiah, 2018).
Another use of this equation can be done by the financial institute to affix the requirement of the initial funding by the founders as more the initial funding will be to a level the risk of the total asset going below zero level would be decreased. However, a very large initial funding from the founders would keep the venture capitalist funds. Nonetheless, after assessing the assumptions and certain factors, it could be inferred that these venture capitalist are ready to take high risk only when these investors are offered high amount of return on investment. If in case the return on investment offered to angel investors and other investors are good then it will assist company to attract more investors for the investment purpose (Kumar, 2018).
As per the views of Lohe, and Calabrò, (2017) it is revealed that the start-up industry has a great relevance on the present status of the business and the economy as the whole. When the results of the equations and the concept derived in the above process are applied to a number of start-ups, the results were slightly different from the actual course of financial transactions that occurred during the period of reference.
As per the views of Said, (2018), it is divulged that the general trend from this application was that the equation calculates the financial distress much after the actual distress the start-up is facing. As stated by Tseng, Cheng, and Hou, (2017) it is divulged that the reason for this observation can be justified because start-ups often operate with the negative asset if we count only financial and physical assets as the value of the idea is not considered in the derived equation. For example, companies such as Amazon hand operated in a negative cash flow for about fourteen years after its inception. Even though no profits were generated in these times, the value of the idea was estimated to be high enough to counter the negative magnitude of the cash flows. The general issues arise when company fails to determine the right amount of budget in its business activities. It will not only hamper the financial position of company but also result to high cost of capital and financial distress. As stated by Liao, Tang, and Chi, (2017) it is analyzed that at the time of preparing the budget; investors should keep the project escalation amount in its business. It will not only assist in determining the right flow of capital but also assist in strengthening the financial performance of company.
As stated by Sundarrajan, and Young, (2015), it is started that it has been traditionally difficult to quantify the value of an idea the start-up is based on. Therefore the attempt of the equation to evaluate the state of being in financial distress could not be underestimated. It gives a snapshot of these scenarios and the possible cash outflows which can, in future, the state of financial distress.
As per the views of Cohen, Samuelson, and Katz, (2017), it could be depicted that the equation derived in this report can be more applicable to an asset intensive start-up as the quantification in such cases are often simpler than the starters that lay heavily on the services. However, it can also not be ignored that the majority of start-ups in the contemporary business world are service focused and are providing technological solutions to the problems faced by the customers and hence appropriate modification has to be done into the derived mathematical equations to account for search start-ups. The last but not the least consideration is the rate of growth. Generally, for a company which has recently started its operation and find a large customer base in the market which is still to be acquired the cash flows generated from the operations are distributed in such a way that as the time to progresses, the frequency of inward cash flow also increases
There are primary and secondary research methods have been used to gather the imperative information on the applied financial issues. The observation, meeting and seminars have been conducted to collect the required information to identify the financial distress of the starting up firms. In addition to this, journal articles, books and official gazettes have been used as secondary sources to identify the opportunity and issues in the applied financial program of Start-up Company (Navas-Alemán, Pietrobelli, and Kamiya, 2015).
The function satisfying the above condition is represented by the poison process with parameters 0 < t < 1. The poison equation can be defined as (Smith, Nicolla, and Zafar, 2014).
The poison process can be applied to calculate the total probability of financial distress for an arbitrary time as under (Smith, Nicolla, and Zafar, 2014)
The conditional probability integrand in the above equation can be conditioned again on the magnitude of the first cash outflow namely X(1)
The stochastic process ????(????) renews itself because after time ???? the net asset position appearing on the start-up’s financial statement is ???? + ???????? − ????, given that ???? = ????(n) and ???? = ????(N) and the stochastic process renews itself with the identical functional form.75 The defining characteristic expression of a renewal process allows us to write (Kristanti, Rahayu, and Huda, 2016)
Combining the above equations to arrive at an integral equation would render the final equation for three probabilistic calculation of the financial distress that the start-up can be:
To conclude, in this report, the basic concepts of cash flow has been related to the ascent cycle of the start-up industry to evaluate the future or present financial distress that can lead to the death of the company. Despite of the shortcomings of the equation that has been discussed in the previous section this equation provides a clear picture of the interpretation of the cash flow from the standpoint of the venture capitalist. The value of the idea would depend on the individual carrying out the evaluation but a holistic value to compare the probability could be of use which is derived from the equation.
Conclusion
The report also throws light on the various steps or stages of the funding which in general becomes the pivot at which the decision of further financing is taken by the financial source of the start-up. Understanding of the various stages also outlines the growth or progression trajectory that the starter in any industry would take from the standpoint of the venture capitalist. The report also brings about the concepts of doing probability to derive the mathematical equation and discusses over the shortcoming of these mathematical model in evaluating the dynamic and fast-growing journey of a Start-up regardless of the industry they are operating in. Given that the start-up ecosystem has the potential to bring about significant changes in the economy of the countries, such applications of applied finance in evaluation of parameters defining the success of start-ups becomes more and more crucial.
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