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11SOURCES OF CAPITAL

LEARNING OBJECTIVES

1

To identify the types of financing available

!

To "nde#stand the #ole of co$$e#cial ban%s in financing ne& vent"#es'the types of loans available' and ban% lending decisions

(

To disc"ss S$all )"siness Ad$inist#ative *S)A+ loans

,

To "nde#stand the aspects of #esea#ch and develop$ent li$ited pa#tne#ships

-

To disc"ss gove#n$ent g#ants' pa#tic"la#ly s$all b"siness innovation #esea#ch g#ants

.

To "nde#stand the #ole of p#ivate place$ent as a so"#ce of f"nds

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OPENING PROFILECWalt Disney

I. AN OVERVIEW

A. Different sources of capital are generally used at different times in the life of theventure.

B. Debt or Equity Financing.

1. Debt financinginvolves an interest-bearing instrument, usually a loan, the pay-ment of hich is only indirectly related to sales and profits.

a. Debt financing !also called asset-based financing" re#uires some asset beused as collateral.

b. $he entrepreneur has to pay bac% the amount of funds borroed plus a fee,e&pressed in terms of the interest rate.

c. Shortter! !oneyis used to provide or%ing capital'funds are usually re-paid from resulting sales.

d. Long ter! "ebt!lasting more than a year" is fre#uently used to purchasesome asset, using part of the value of the asset as collateral.

e. Debt lets the entrepreneur retain a large onership position and have greaterreturn on e#uity.

f. (f the debt is too great, payments become difficult to ma%e and groth is in-hibited.

2. Equity financingoffers the investor some form of onership position in the ven-ture.

a. $he investor shares in the profits of the venture.

b. )actors in choosing the type of financing are availability of funds, assets ofthe venture, and prevailing interest rates.

c. *sually a combination of debt and e#uity financing is used.

3. (n a mar%et economy all ventures ill have some e#uity, as all are oned bysome person or institution.

a. $he e#uity may be entirely provided by the oner or may re#uire multipleoners.

b. $his e#uity funding provides the basis for debt financing, hich ma%es upthe capital structure of the venture.

+. Internal or E#ternal Fun"s.

1. $he most often used type of funds is internally generated funds.

a. $hese funds come from sources ithin the company, such as profits, sale ofassets, reduction in or%ing capital, e&tended payment terms, and accountsreceivable.

b. (n the start-up years all the profits are usually ploed bac% into the venture.

c. ometimes little-used assets can be sold or leased.

+hapter 11 25 Entre$reneurshi$

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d. Assets, henever possible, should be on a rental basis, not an onershipbasis.

e. ne short-term internal source of funds is reducing short-term assets, oftenthrough e&tended payments from suppliers.

f. Another method is by collecting accounts receivable more #uic%ly.

2. ther general sources are e#ternalto the venture.

a. Alternative sources should be evaluated by/

!i" 0ength of time the funds are available.

!ii" +osts involved.

!iii" Amount of control lost.

b. $he more fre#uently used sources of start up capital as listed in ntrepreneur-ship magaine are/

!i" savings !14"

!ii" private investor !314"!iii" friends and family !14"

!iv" home e#uity line of credit !164"

!v" ban% loan !14"

!vi" credit cards !174"

!vii" sale of another business !14"

!viii" BA loan !14"

!i&" other sources !24"

II. PERSONAL FUNDS

A. )e ne ventures are started ithout the personal funds of the entrepreneur.

1. 8ersonal funds are the least e&pensive in terms of cost and control9 they are alsoessential in attracting outside funding.

2. $ypical sources include savings, life insurance, or mortgage of a house or car.

B. utside investors ant the entrepreneur to demonstrate financial commitment.

1. $his level of commitment is shon by the percentage of total assets available theentrepreneur has committed.

2. An outside investor ants an entrepreneur to have committed all available assets.

3. (t is not the amount but the fact that all monies available are committed thatma%es outside investors feel comfortable.

III. FAMILY AND FRIENDS

A. After the entrepreneur, family and friends are a common source of capital.

B. )amily and friends provide a small amount of e#uity funding for ne ventures.

(nstructor:s ;anual 255 ection 2/ +hapter

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1. (t is relatively easy to obtain money from family and friends, but the amount ofmoney provided may be small.

2. (f it is in the form of e#uity funding, the family member or friend has an oner-ship position in the venture.

3. (f they have direct input into operations of the venture, it may have a negative ef-

fect on employees or profits.+. $o avoid potential future problems, the entrepreneur must present the positive and

negative aspects and the nature of the ris%s of the investment.

1. $o minimie any future problems, the entrepreneur should %eep the business ar-rangements strictly business.

2. Any loan should specify the rate of interest and the proposed repayment scheduleof interest and principal.

3. $he entrepreneur should settle everything up front and in riting.

. A formal agreement specifying details of the funding helps avoid future prob-lems.

D. $he entrepreneur should carefully consider the impact of the investment on the fam-ily member or friend before it is accepted.

IV. COMMERCIAL BANKS

A. %o!!ercial ban&sare the most fre#uently used source of short-term funds hen col-lateral is available.

1. $his is debt financing and re#uires some tangible guaranty or collateral, someasset ith value.

2. $his collateral can be business assets, personal assets, or the assets of the cosign-er of the note.

B. $ypes of Ban% 0oans.

1. $he asset base for loans is usually accounts receivable, inventory, e#uipment, orreal estate.

2. 'ccounts Recei(able Loans.

a. Accounts receivable provide a good basis for a loan, especially if the custom-er base is creditorthy.

b. A ban% may finance up to 74 of the value of the accounts receivable.

c. A )actoring arrange!entcan be developed hereby the factor !ban%" actu-ally buys the accounts and collects the money.

d. (f any of the receivables are not collectible, the factor sustains the loss, notthe business.

e. $he cost of factoring is higher than the cost of securing a loan against the ac-counts receivable.

3. In(entory Loans.


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a. (nventory is often a basis for a loan, particularly hen inventory is li#uid andcan be sold easily.

b. )inished goods inventory can be financed up to 574 of value.

c. $rust receipts are a type of inventory loan used to finance floor plans of re-tailers such as auto dealers.

d. $he ban% advances a large percentage of the invoice price of the goods and ispaid a pro rate basis as the inventory is sold.

. Equi$!ent Loans.

a. #uipment can be used to secure longer term financing up to 3 to 17 years.

b. =hen ne e#uipment is purchased, 57 to 74 of value can be financed.

c. (n saleleasebac& )inancingthe entrepreneur >sells? the e#uipment to a lenderand then leases it bac%.

5. Real estate loansare easily obtained to finance land, plant, or building, usuallyup to 654 of value.

+. +ash )lo )inancing.1. +ash flo financing, or conventional bank loans*include lines of credit, install-

ment loans, straight commercial loans, long-term loans, and character loans.

a. Lines o) cre"itfinancing are the most fre#uently used by entrepreneurs.

b. $he company pays a +co!!it!ent )ee,at the start then pays interest on out-standing borroed funds.

2. Install!ent Loans.

a. Install!ent loanscan be obtained by a going venture ith a trac% record ofsales and profits.

b. $hese funds are used to cover or%ing capital needs, usually for 37 to 7days.

3. Straight %o!!ercial Loans.

a. (n this hybrid of the installment loan, funds are advanced to the company for37 to @7 days.

b. $hese self-li#uidating loans are used for seasonal financing.

. Long-er! Loans.

a. $hese loans are usually only available to strong, mature companies.

b. )unds are available for up to 17 years ith the debt repaid according to afi&ed interest and principle schedule.

5. %haracter Loans.

a. =hen the business does not have assets to support a loan, the entrepreneurmay need a character loan.

b. $hese loans must have assets of an individual pledged as collateral, or havethe loan cosigned by another.

D. Ban% 0ending Decisions.


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1. Ban%s are very cautious in lending money, particularly to ne ventures.

a. +ommercial loan decisions are made only after the loan officer does a carefulrevie of the borroer.

b. Decisions are made based on #uantifiable and subective udgments.

2. Ban% lending decisions can be summaried by the )i(e %s'+haracter, +apacity,

+apital, +ollateral, and'+onditions.

a. 8ast financial statements are revieed in terms of %ey ratios and the entre-preneur:s capital invested.

b. )uture proections on mar%et sie, sales, and profitability are evaluated.

c. (ntuitive factors'+haracter and +apacity'are also ta%en into account andbecome more important hen there is little or no trac% record.

3. $he loan application format is generally a >mini? business plan.

a. $his provides the loan officer and loan committee information on the credit-orthiness of the individual and the ability of the venture to repay the loan.

b. 8resenting a positive business image and folloing procedure are importantin obtaining the funds.

. $he entrepreneur should borro the ma&imum amount possible that can be re-paid, as long as the prevailing interest rates and terms are satisfactory.

a. $he venture must ma%e sure that it ill generate enough cash flo to repaythe interest and principal on the loan.

b. $he entrepreneur should evaluate the trac% record and lending policies ofseveral ban%s in the area.

V. ROLE OF SBA IN SMALL BUSINESS FINANCING

A. =hen the entrepreneur is unable to secure a regular commercial ban% loan, an altern-ative is a guarantee from the S!all /usiness '"!inistration 0S/'1.

1. $he BA is primarily a guarantor of loans made by private and other institutions.

2. $he /asis 20a1 Loan Guarantyhelps #ualified small businesses obtain financinghen they cannot obtain loans through regular lending channels.

B. $o get a 6!a" loan, the small business person or entrepreneur must be eligible.

1. +riteria include good character, management capability, collateral, sie, type ofbusiness, use of proceeds, and the availability of funds from other sources.

2. $he BA 6!a" loan program has a ma&imum loan amount of 2 million ith the

BA:s ma&imum e&posure of 1 million.3. $he interest rates on the loan are negotiated beteen the borroer and the lender,

but are subect to BA ma&imums.

+. ;ost of the loans have the same guarantee features.

1. $he BA can guarantee 54 of loans of 157,777 or less and 654 of loansabove 157,777 to a ma&imum of 1 million.

2. S/' E#$ress loanshave a ma&imum guarantee of 574, and e&port or%ing cap-


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ital loans have a ma&imum guarantee of @74.

3. 0enders are charged a guaranty and servicing fee for each approved loan.

D. ther BA 8rograms.

1. $he 345 Loan Progra!provides fi&ed-rate financing to enable small businessesto ac#uire machinery, e#uipment, or real estate.

2. $he loan can include a loan from a %o!!unity De(elo$!ent %o!$any 0%D%1bac%ed by a 1774 BA guaranteed debenture.

. S/' 6icroloanis a 6!m" loan program.

1. $his program provides short-term loans of up to 35,777 to small businesses foror%ing capital or the purchase of assets.

2. $he small business receives the loan from a lender, ith the loan being guaran-teed by the BA.

3. ther loans include7o!e an" Personal Pro$erty Disaster Loans* Physical Disaster /usiness Loses Loans* and6ilitary Reser(ist Econo!ic In8ury Disaster

Loans.

VI. RESEARCH AND DEVELOPMENT LIMITED PARTNERSHIPS

A. $his method of financing provides funds from inventors loo%ing for ta& shelters.

1. A typical CD partnership arrangement is established beteen a sponsoringcompany developing the technology ith funds provided by a limited partnershipof individual investors.

2. Research and development limited partnershipsare particularly good hen theproect involves a high degree of ris% or significant e&pense.

B. ;aor lements.

1. $he three components are the contract, the sponsoring company, and the limitedpartnership.

2. $he contractspecifies the agreement beteen the sponsoring company and thelimited partnership.

a. $he sponsoring company does not guarantee results, but performs or% on abest-effort basis.

b. $he typical contract specifies that the liability for any loss be borne by thelimited partners.

c. $here are some ta& advantages for both the partnership and the company.

3. $he ne&t component is the limited partners.a. $heli!ite" $artnershave limited liability but are not a ta&able entity.

b. Any ta& benefits of the losses are passed directly to the limited partners.

c. =hen the technology is successfully developed, the partners share in theprofits.

. $he s$onsoring co!$anyacts as thegeneral partnerdeveloping the technology.

(nstructor:s ;anual 25@ ection 2/ +hapter

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a. $he sponsoring company usually has the base technology but needs funds forcommercial success.

b. $he company usually retains the rights to use this technology to develop oth-er products.

+. 8rocedure.

1. (n the )un"ing stage, a contract is established and the money invested for the pro-posed CD effort.

2. (n the "e(elo$!ent stage*the sponsoring company performs the actual research,using the funds of the limited partners.

3. (f the technology is successfully developed, thee#it stage begins, ith bothparties reaping the benefits.

a. (n the typical agreement, the sponsoring company and limited partners form ane ointly oned corporation.

b. An alternative e&it strategy is a royalty $artnership in hich a royalty basedon the sale of the products is paid by the company to the limited partnership.

c. $he company and limited partners may form a8oint (entureto manufactureand mar%et the product.

D. Benefits and +osts.

1. /ene)its.

a. CD limited partnerships provide needed funds ith a minimum of e#uitydilution hile reducing the ris%s involved.

b. $he sponsoring company:s financial statements are strengthened through theattraction of outside capital.

2. %osts.

a. +onsiderable time and money are e&pended.

b. An CD limited partnership ta%es a minimum of si& months and 57,777 inprofessional fees.

c. ;ost CD limited partnership are unsuccessful.

d. $he restrictions placed on the technology may be substantial.

e. $he e&it from the partnership may be too comple&.

. &amples.

1. uccessful CD limited partnerships include ynte& +orporation, Eenetech, and$rilogy 0imited.

2. CD limited partnerships offer one alternative to funding technological develop-ment.

VII. GOVERNMENT GRANTS

A. $he mall Business (nnovation Development Actre#uires all federal agencies toaard a portion of the CD funds to small businesses through the Small Business


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Innovation Research (SBIR) grantprogram.

1. $his provides a uniform method of soliciting, evaluating, and selecting researchproposals.

2. $en agencies are involved in the program.

a. mall businesses submit proposals directly to each agency.

b. ach agency evaluates each proposal on a competitive basis and ma%esaards.

B. $he B(C grant program has three phases.

1. Phase I9aards are up to 177,777 for si& months of feasibility-related e&peri-mental or theoretical research.

2. Phase IIis the principal CD effort.

a. 8hase (( aards are up to 657,777 for 2 months of further research and de-velopment.

b. $he money is to be used to develop prototype products.

3. (nPhase IIIfunds from other sources, such as the private sector or regular gov-ernment contracts, are needed to commercialie the developed technologies.

+. 8rocedure.

1. $he agencies publish solicitations describing the areas of research they ill fund.

2. $he second step is submission of the proposal by a company or individual.

3. ach agency screens the proposals it receives, and those passing are evaluated ona technology basis by e&perts.

. Aards are granted to those proects that have the best potential for commercial-iation.

5. Any patent rights, research data, and softare generated are oned by the com-pany, not the government.

D. $he B(C grant program is one alternative for a technically-based entrepreneurialcompany that is independently oned and operated and employs 577 or feer indi-viduals.

. $he S!all /usiness -echnology -rans)er 0S--R1 program as established by themall Business $echnology $ransfer Act of 1@@2.

1. )ederal agencies ith budgets over 1 billion are re#uired to set aside 7.34 forsmall businesses.

2. )ive agencies participate in the $$C program/

a. $he Department of Defense !DD"

b. $he Department of nergy !D""

c. Department of Fealth and Fuman ervices !DFF"

d. $he

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3. B(C and $$C programs differ in to ays/

a. (n the B(C program, the borroer must be employed by the venture9 there isno employment stipulation in the $$C program.

b. $he $$C program re#uires at least 74 of the research be conducted by thesmall business concern and at least 374 conducted by the partnering non-

profit institution.

VIII. PRIVATE PLACEMENT

A. Another source of funds is$ri(ate $lace!entith investors ho may be family andfriends or ealthy individuals.

B. $ype of (nvestors.

1. An investor usually ta%es an e#uity position and can influence the nature of thebusiness to an e&tent.

2. $he investors: degree of involvement is important for the entrepreneur to con-sider.

3. ome investors ant to be actively involved in the business, and others are morepassive.

+. 8rivate fferings.

1. 8ublic offerings involve much time and e&pense.

2. Cegistering the securities ith the ecurities and &change +ommission !+"re#uires a number of reporting procedures once the firm has gone public.

3. $his public process as established to protect unsophisticated investors.

. Aprivate offeringis faster and less costly than other funding.

5. $hese sophisticated investors still need access to material information about the

company.

D. Cegulation D.

1. Regulation Dcontains/

a. Broad provisions designed to simplify private offerings.

b. Eeneral definitions of hat constitutes a private offering.

c. pecific operating rulesCCule 57, Cule 575, and Cule 57.

2. Cegulation D re#uires the issuer of a private offering to file five copies of )ormD ith the + on a strict timetable.

3. $he entrepreneur carries the burden of proving that the e&emptions granted have

been met.

a. ach offering memorandum needs to be numbered and contain instructionsthat the document should not be disclosed.

b. $he date that the investor revies the company:s information and dates ofany discussions beteen the company and entrepreneur should be recorded.

c. $he boo% documenting all specifics of the offering should be placed in the


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firm:s permanent file.

3. *nderRule 345a company can sell up to 577,777 of securities to any numberof investors in any 12-month period.

. Rule 343permits the sale of 5 million of unregistered securities in the privateoffering in any 12-month period.

a. $hese can be sold to any 35 investors, and an unlimited number of accreditedinvestors.

b. +'ccre"ite" in(estors,include/

!i" (nstitutional investors.

!ii" (nvestors ho purchase over 157,777 of the issuer:s securities.

!iii" (nvestors hose net orth is 1 million or more.

!iv" (nvestors ith incomes in e&cess of 277,777 in the last to years.

!v" Directors, officers, and general partners of the issuing company.

c. Cule 575 permits no general advertising or solicitation through public media.d. =hen only accredited investors are involved, no disclosure is re#uired under

Cule 575.

e. $o-year financial statements must be available.

f. All companies selling private-placement securities must/

!i" )urnish appropriate company information to both accredited and unac-credited investors

!ii" Allo any #uestions to be as%ed prior to the sale.

5. Rule 34:allos an issuing company to sell an unlimited amount of securities to

35 investors and an unlimited number of accredited investors.. (n securing outside funding, the entrepreneur must accurately disclose all informa-

tion.

1. (f the business turns sour, both investors and regulators scrutinie the company:sdisclosures.

2. =hen a violation of security la is discovered, management and sometimes theprincipal e#uity holders can be held liable.

3. 0asuits under securities la by damaged investors have almost no statute of lim-itations.

. $he entrepreneur needs to be careful to ma%e sure all disclosures are accurate.

5. $he + can also ta%e administrative, civil, or criminal action, ithout any indi-vidual lasuit involved.

IX. BOOTSTRAP FINANCING

A. /ootstra$ )inancingis particularly important at start-up and early years of the ven-ture hen capital from debt financing or e#uity financing is more e&pensive.


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B. utside capital has many costs.

1. (t ta%es three to si& months to raise outside capital hen the company can leastafford the time.

2. utside capital often decreases a firm:s drive for sales and profits.

3. $he availability of capital increases the impulse to spend.

. utside capital can decrease the company:s fle&ibility and hamper the creativityof the entrepreneur.

5. utside capital may cause more disruption and problems in the venture thanithout it.

+. /ootstra$ )inancinginvolves using any possible method for conserving cash.

1. $his can involve delaying payment !ith caution" to suppliers.

2. Also possible/ discounts for volume, fre#uent customer discounts, promotionaldiscounts, >obsolescence money,? and bul% pac%aging.

3. %onsign!ent )inancinginvolves placing a standing order for the entire amount of

goods but ta%ing shipment and ma%ing payment only as needed.D. (n spite of these potential problems, an entrepreneur at times needs e#uity funding.

1. utside capital should only be sought after all possible internal sources of fundshave been e&plored.

2. =hen outside funds are obtained, the entrepreneur should not forget the basics ofthe business.

X. IN REVIEW: SUMMARY.

ee Lear!" O#$e%&!'e( Re'!(!&e)*belo.


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LEARNING OBJECTIVES REVISITED

earning !b"ective #$ %o identify the types of financing available$

G Debt )inancinginvolves an interest-bearing instrument, usually a loan, the payment ofhich is only indirectly related to sales and profits.

H hort-term money is used to provide or%ing capital.

H 0ong term debt !lasting more than a year" is fre#uently used to purchase some as-set, ith part of the value of the asset being used as collateral.

G Equity )inancingoffers the investor some form of onership position.

G $he most often used type of funds is internally generate" )un"s, from sources ithin thecompany, such as profits, sale of assets, reduction in or%ing capital, e&tended payment terms, and ac-counts receivable.

G E#ternal )inancingis obtained from sources outside the venture.

H (n terms of cost and control, personal funds are the least e&pensive.

H )amily and friends can provide a small amount of e#uity funding.

earning !b"ective &$ %o understand the role of commercial banks in financing ne' ventures the

types of loans available and bank lending decisions$

G +ommercial ban%s are the most fre#uently used source of short-term funds hen collater-al is available.

G $ypes of ban% loans include accounts receivable loans, inventory loans, e#uipment loans,and real estate loans.

G +onventional ban% loans include lines of credit, installment loans, straight commercialloans, long-term loans, and character loans.

G Ban% lending decisions can be summaried by the five +:sC

+haracter, +apacity, +apital,+ollateral, and +onditions.

earning !b"ective $ %o discuss Small Business *dministrative (SB*) loans$

G $he BA is primarily a guarantor of loans made by private and other institutions.

G $he /asis 20a1 Loan Guarantyhelps #ualified small businesses obtain financing henthey cannot obtain loans through regular lending channels.

G S/' E#$ress loanshave a ma&imum guarantee of 57 percent.

G $he 345 Loan Progra!provides fi&ed-rate financing to enable small businesses to ac-#uire machinery, e#uipment, or real estate.

G $he S/' 6icroloan $rogra!provides short-term loans of up to 35,777 to small busi-nesses for or%ing capital or the purchase of assets.

G ther loans include/

H Fome and 8ersonal 8roperty Disaster 0oans

H 8hysical Disaster Business 0oses 0oans

H ;ilitary Ceservist conomic (nury Disaster 0oans.


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earning !b"ective +$ %o understand the aspects of research and development limited partnerships$

G A research an" "e(elo$!ent $artnershi$arrangement is established beteen a sponsor-ing company developing the technology ith funds being provided by a limited partnership.

G $he three components are the contract, the sponsoring company, and the limited partner -ship.

G $he procedure includes/

H $he )un"ing stage, in hich a contract is established and the money invested forthe proposed CD effort.

H $he "e(elo$!ent stage*in hich the company performs the actual research, us-ing the funds of the limited partners.

H $hee#it stage* in hich both parties reap the benefits.

G $here are benefits and costs'most CD limited partnerships are unsuccessful.

earning !b"ective ,$ %o discuss government grants particularly small business innovation research

grants$

G $he S!all /usiness Inno(ation Research 0S/IR1grant program re#uires all federal agen-

cies to share a portion of the CD funds ith small businesses.

G $he B(C program provides a uniform method of soliciting, evaluating, and selecting re-search proposals.

G $his grant program is one alternative for a technically-based entrepreneurial companythat is independently oned and operated and employs 577 or feer individuals.

G *nder the S!all /usiness -echnology -rans)er 0S--R1program federal agencies ithbudgets over 1 billion are re#uired to set aside 7.34 for small businesses.

earning !b"ective -$ %o understand the role of private placement as a source of funds$

G Another source of funds is private investors ho may be family and friends or ealthy

individuals.G An investor usually ta%es an e#uity position and can influence the nature of the business

to an e&tent.

G A private offering is faster and less costly than other funding.

G Cegulation D contains a number of broad provisions designed to simplify private offer-ings and specific operating rules.


chap011 edit

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