C. Financing a Small Business 4.00 Explain the fundamentals of financing a small business Discuss sources used in financing a small business.

How are you going to finance a small business? Equity sources: Money or capital contributed by owners; capital sources that trade cash for some portion of ownership or equity in a business.

How are you going to finance your business?  Equity is sometimes called risk capital because the investor puts his/her money at risk.  Since the investor acquires ownership in the business, no repayment of money with interest is required.

How are you going to finance a small business? Debt sources: Money or capital that is borrowed and must be paid back with interest.  Banks  Trade credit through vendors  Finance companies  Credit unions  Government agencies

 Personal savings  Friends and relatives  Partners  Private investors  Venture capitalists  State-sponsored venture capital funds

PERSONAL SAVINGS ADVANTAGES  Owner keeps all the profits  Owner’s risk of loss provides motivation to succeed

PERSONAL SAVINGS DISADVANTAGES  Creates chance of loss  Causes personal sacrifice  Causes loss of return from use of savings  Carries unlimited liability

FAMILY AND FRIENDS ADVANTAGES  Provides quick and easy sources of funds  Allows less formal arrangements  Imposes fewer restrictions

FAMILY AND FRIENDS DISADVANTAGES  Creates chance of loss  Causes possible loss of return from use of savings  Carries unlimited liability

PARTNERS ADVANTAGES  Brings in more cash  Shares financial risks and responsibilities  Increases borrowing power

PARTNERS DISADVANTAGES  Requires giving up a portion of profits  Results in the loss of some control and ownership

PRIVATE INVESTORS (ANGELS) ADVANTAGES  Angels are wealthy individuals functioning as non-professional investors who are willing to invest in local businesses for financial or emotional reasons and who sometimes prefer to remain anonymous.  Invest in region in which they live  Will finance start-up businesses

PRIVATE INVESTORS DISADVANTAGES  Not easy to locate  Must be chosen carefully and may not always be a reliable source

VENTURE CAPITALISTS  Individuals or firms that invest money professionally to make money, expect a large capital gain, and look for high growth potential (30-50% return on investment).  Provide large amounts of money  Allow owner to maintain control and operation of the business  Provide for additional assistance, when available

VENTURE CAPITALISTS DISADVANTAGES  Most businesses do not quality  Entrepreneur must give up part ownership  Small businesses may have trouble attracting venture capitalists

STATE-SPONSORED VENTURE CAPITAL FUNDS  Funds provided to entrepreneurs by the state in an effort to encourage economic development and creation of jobs  The advantages are they create jobs  Do not focus solely on profits  There are no disadvantages

DEBT FINANCING ADVANTAGES  Relatively easy and quick to obtain  Maintain control and ownership of the business  Repay at a more advantageous time  Tax deduction for interest and related costs

DEBT FINANCING DISADVANTAGES  Higher interest rates  Risk of insufficient profit to cover repayment  Easy to abuse and overuse  Restrictions and limitations imposed by the lender

SOURCES OF DEBT FINANCING  Banks are the most common source of business financing  A line of credit allows businesses to borrow a stated amount of money at a stated interest rate to use as the business chooses  Require that money be paid back on a regular basis according to the repayment plan specified

SOURCES OF DEBT FINANCING  Very conservative and not inclined to lend to businesses that are not well established  Usually require some kind of collateral

TRADE CREDIT THROUGH VENDORS  Short-term financing  Credit from within the industry or trade  Example: One may purchase goods on days of credit, interest-free. The business owner then has the use of the money for at least 30 days. Provided customers pay for goods and services on time, the owner can then pay his/her bills on time.

FINANCE COMPANIES  Take more risks than banks  Are more expensive than banks  Will ask for some form of security like the entrepreneur’s home, accounts receivable, or business inventories

CREDIT UNIONS  Credit Unions are cooperatives formed by labor unions or employees for the benefit of the members.

PERSONAL LOAN FROM FAMILY MEMBER  Terms of repayment may be quite flexible  Interest rate may be low or the loan might be interest free  Mixing financial affairs with family relationships or friendships can sometimes cause problems

GOVERNMENT AGENCIES  Operated by the government to provide technical assistance, counseling, grants, or other means of financial assistance in the form of low-interest loans.

GOVERNMENT AGENCIES  Small Business Administration: Uses a commercial bank to process and release the money and guarantees up to 90% of the loan if the business fails  Also lends public funds to veterans and handicapped persons who qualify

GOVERNMENT AGENCIES  Minority Enterprise Small Business Investment Companies (MESBIC’s)  Established by SBA  Provide funding to businesses whose ownership is at least 51% minority, female, or disabled

GOVERNMENT AGENCIES  Small Business Investment Companies (SBIC’s)  Licensed by SBA  Provide equity and debt financing to young businesses  Invest about twice as often in start-up ventures as do venture capitalists  Private owned  Requirements vary

GOVERNMENT AGENCIES  Department of Housing and Urban Development (HUD): Provides grants to cities to lend money to private developers to help improve impoverished areas.

GOVERNMENT AGENCIES  The Economic Development Administration (EDA) is a division of the US Department of Commerce  Lends money to businesses that operate in and benefit economically distressed parts of the country  Similar to SBA, but more restricted

GOVERNMENT AGENCIES  State governments: Most states have economic development agencies and finance authorities that make or guarantee loan to small businesses.  Local and municipal governments: Sometimes make small loans of $10,000 or less

Process for getting a loan Select the bank carefully. Prepare financial statements and a business plan. Make an appointment. Prepare to answer questions.

Types of loans available Secured Loans Short-term loans Lines of credit

TYPES OF LOANS AVAILABLE  Secured Loan: A loan that is backed by collateral  Short-term loan: Must be paid back with a year; may be used for the specific purpose of dealing with a cash flow problem

TYPES OF LOANS AVAILABLE  Long-term loan: Repayable over a period longer than one year; may be used to make improvements that will help increase profits.  Lines of credit: Agreements made by a bank to lend money at a stated interest rate whenever the owner needs it. A fee is charged for the privilege whether the money is used or not, and interest is charged on any money that is used.

TYPES OF LOANS AVAILABLE  Unsecured loan: A loan that is not guaranteed by collateral; usually granted to a bank’s most credit-worthy customers for a short period (less than a year) and for a specific purpose

Entrepreneurial characteristics needed to obtain financing  Character  Capacity  Capital  Collateral  Conditions

SIX “C’s” OF CREDIT  Character: The bank needs to believe in the character of the entrepreneur and the people with whom he or she is associated, including the management team of the business.  Responsibility shown by paying bills in the past  Good credit rating  Good reputation

SIX “C’s” OF CREDIT  Capacity is the ability to repay the debt  Legally eligible to enter into contracts

SIX “C’s” OF CREDIT  Capital is the demonstrated ability and willingness to invest personally in the business venture  Evidence of a good financial plan with little outstanding personal debt

SIX “C’s” OF CREDIT  Collateral: Something of value that the lender can claim if the debt is not repaid.

SIX “C’s” OF CREDIT  Conditions: The bank will consider all of the environmental conditions such as competition, growth, location, and economic outlook in which the business will operate.

SIX “C’s” OF CREDIT  Coverage: The bank will want to know what kind of insurance coverage the entrepreneur has.

Factors to consider when choosing a financial plan Risk Control Availability

Factors to consider when choosing a financial plan  Risk: There is a greater risk of loss with debt funds since the entrepreneur must repay the loan in accordance with the terms or risk losing the business, collateral, or even personal possessions.  There is less risk for the entrepreneur with equity funding since no repayment is required.

Factors to consider when choosing a financial plan  Control: Entrepreneurs often lose control of decision-making power with the use of equity funds.  Debt funds do not involve this loss of control.

Factors to consider when choosing a financial plan  Availability of Funding: The entrepreneur’s credit history or earning potential can help or might eliminate him or her from securing a debt loan.  Equity sources might not be readily available.