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Small Business Management, 11th editionLongenecker, Moore, and Petty© 2000South-Western College Publishing

Chapter 11

Finding Sources of Finding Sources of FinancingFinancing

In the Spotlight:The Potomac Group Inc.www.medifax.com

In the Spotlight:The Potomac Group Inc.www.medifax.com

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Learning Objectives: Chapter 11

1. Evaluate the choice between debt financing and equity financing.

2. Describe various sources of financing available to small firms.

3. Explain how the Internet is being used to find sources of financing.

4. Discuss the most important factors in the process of obtaining startup financing.

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• Spontaneous financing, which comes from sources that automatically increase with increases in sales.

• Profit retention, which requires owners to forgo taking cash out of the business, letting it remain within the firm to finance growth.

• External financing, which comes from outside investors.

Three Basic Types of Financing

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Tradeoffs in Selecting Between Debt and Equity

Financial RiskDebt is risky. Use of debt financing not only increases potential returns when a firm is performing well; it also increases the possibility of lower, even negative, returns if the firm doesn’t attain its goals in a given year.

Voting ControlDebt increases risk, but it also permits the existing owners to retain all the stock and full ownership.

Potential ProfitabilityAs a general rule, as long as a firm’s return on its assets (operating income total assets) is greater than the cost of the debt (interest rate), the owner’s return on equity investment will be increased as the firm uses more debt.

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Sources of Funds

Equity

Personal Savings

Debt

Friends and Relatives

Other Individual Investors

Business Suppliers

Asset-Based Lenders

Commercial Banks

Government-Sponsored Programs

Community-Based Financial Institutions

Large Corporations

Venture Capital Firms

Sale of Stock

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Individuals as Sources of Funds

Personal Savings• This is the most frequently used source of equity financing for starting a new company.• In a new business, equity is needed to allow for a margin of error.• A banker will not loan a company money if the entrepreneur does not have his or her own

money at risk.

Friends and Relatives• This source of financing is based more on personal relationships than on extensive

financial analysis.• To minimize the chance of damaging important personal relationships, the entrepreneur

should plan for repayment of such loans as soon as possible.

Other Individual Investors• These individuals provide informal capital; no established marketplace exists in which

they regularly invest.• These investors have acquired the label of business angels.• The traditional path to informal investors is through contacts with business associates,

accountants, and lawyers.

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Business Suppliers and Asset-Based Lenders as Sources of Funds

Trade Credit• Credit extended by suppliers is very important to a startup.• It is of short duration -- 30 days is the customary credit period.• The amount of trade credit available to a new firm depends on the type of business and the

supplier’s confidence in the firm.Equipment Loans and Leases• For an equipment loan, a down payment of 25 to 35 percent is usually required, and the

contract period normally runs from three to five years.• Leases typically run for 36 to 60 months and cover 100 percent of the cost of the asset

being leased, with a fixed rate of interest included in the lease payments.• The advantages of leasing are (1) the firm’s cash remains free for other purposes, (2) lines

of credit can be used for other purposes, (3) leasing provides a hedge against equipment obsolescence.Asset-Based Lending• Asset-based lending is financing secured by working-capital assets (accounts receivable,

inventory).• Factoring is the most frequently used asset-based loan, making cash available to a business

before accounts receivable payments are received from customers.

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Commercial Banks as Sources of Funds

Lines of Credit• An informal agreement or understanding is established between the borrower and the bank

as to the maximum amount of credit the bank will provide the borrower at any one time.• Under this type of agreement, the bank has no legal obligation to provide the stated capital.

Term Loans• Under certain circumstances, a bank will loan money on a five- to ten-year term.• Term loans are generally used to finance equipment with an economically useful life that

corresponds with the loan’s term.

Mortgages• A chattel mortgage is a loan for which certain items of inventory or other moveable

property serve as collateral.• A real estate mortgage is a loan for which real property, such as land or a building,

provides the collateral.

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The Five C’s of Credit

1. The borrower’s character

2. The borrower’s capacity to repay the loan

3. The capital being invested in the venture by the borrower

4. The conditions of the industry and economy

5. The collateral available to secure the loan

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Financial Information Required for a Bank Loan

• Three years of the firm’s historical statements, if available, including balance sheets, income statements, and statements of cash flow

• The firm’s pro forma financial statements, in which the timing and amounts of the debt repayment are included as part of the forecasts

• Personal financial statements, showing the borrower’s personal net worth and estimated annual income

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Government-Sponsored Agencies as Sources of Funds

Federal Assistance to Small Business

• Small Business Administration (SBA) loans

• Small business investment centers (SBICs)

• Small Business Innovative Research (SBIR) program

State and Local Government Assistance to Small Business

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Other Sources of Financing

• Community-based financial institutions• Large corporations• Venture capital firms• Stock sales

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Internet Services That Match Entrepreneurs and Investors

• Wit Capital Corporation: www.witcapital.com• Quicken Business CashFinder:

www.cashfinder.com• ACE-Net:

http://ace.org/gils/SBA1998Mar05.101626.html• PriCap: www.pricap.com• NVST: www.nvst.com• America’s Business Funding Directory:

www.businessfinance.com

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Amar Bhide’s Recommendations for Startup Businesses

• Get operational. At some point, it is time to stop planning and just make things happen.

• Go for quick break-even and high cash-flow generating projects whenever possible.

• Fit growth goals to available personal resources.

• Have a preference for high-ticket, high-profit-margin products and services that can sustain direct personal selling.

• Start up with only a single product that satisfies a clear need.

• Forget about needing a crack management team with textbook credentials.

• Focus on cash, rather than profits, market share, or anything else.

• Cultivate the banker.

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BizPlanExpress on Microlenders (p. 130)

In the 1990s, microloans have become popularin areas where ready access to business funding has traditionally been limited. Microlenderprograms tend to be revolving funds offering afew hundred dollars to $25,000 loans. This moneyis usually provided at high market-rate interestand is often coupled with training and technical assistance to the qualifying entrepreneur.

In the 1990s, microloans have become popularin areas where ready access to business funding has traditionally been limited. Microlenderprograms tend to be revolving funds offering afew hundred dollars to $25,000 loans. This moneyis usually provided at high market-rate interestand is often coupled with training and technical assistance to the qualifying entrepreneur.

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BizPlanExpress on “Boutiques” (p. 131)

A variation on investment banking firms is investment“boutiques.” The “boutiques” operate on a smaller scale,aiming at local or regional companies who need capitalin the $1 to $10 million range. They raise funding forventures through private individuals, banks, financecompanies, and investing their own capital.

A variation on investment banking firms is investment“boutiques.” The “boutiques” operate on a smaller scale,aiming at local or regional companies who need capitalin the $1 to $10 million range. They raise funding forventures through private individuals, banks, financecompanies, and investing their own capital.

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