The Financial Plan, Part: Finding Sources of Funds Part 3 Developing the New Venture Business Plan

Looking Ahead After studying this chapter, you should be able to: Describe how the nature of a firm affects its financing sources. Evaluate the choice between debt financing and equity financing. Identify the typical sources of financing used at the outset of a new venture. Discuss the process for acquiring and structuring a bank loan. Explain how business relationships can be used to finance a small firm. Describe the two types of private equity investors that offer financing to small firms. Distinguish among the different government loan programs available to small companies. Explain when large companies and public stock offerings can be a source of financing. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Factors Affecting Financing There are four basic factors that determine how a firm is financed: (1) the firm’s economic potential (2) the size and maturity of the company (3) the nature of the firm’s assets (4) the personal preference of the owners as they consider the tradeoffs between debt and equity An entrepreneurial firm that has high growth potential has many more possible sources of financing than does a firm that provides a good lifestyle for the owner but nothing in the way of attractive returns to investors. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Factors Affecting Financing (cont’d.) The size and maturity of a company have a direct bearing on the types of financing that are available. Tangible assets serve as great collateral when a business is requesting a bank loan; intangible assets have little value as collateral. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Debt and Equity Financing Choosing between debt and equity financing involves tradeoffs with regard to potential profitability, financial risk, and voting control. Borrowing money rather than issuing common stock (ownership equity) creates the potential for higher rates of return to the owners and allows the owners to retain voting control of the company, but it also exposes the owners to greater financial risk. Issuing common stock rather than borrowing money results in lower potential rates of return to the owners and the loss of some voting control, but it does reduce their financial risk. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Sources of Financing The aspiring entrepreneur basically has three sources of early financing: (1) personal savings (2) friends and family (3) credit cards Personal savings is the primary source of equity financing used in starting a new business; a banker or other lender is unlikely to loan a venture money if the entrepreneur does not have his or her own money at risk. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Sources of Financing (cont’d.) Loans from friends and family may be the only available source of financing and are often easy and fast to obtain, though such borrowing can place important personal relationships in jeopardy. Credit card financing provides easily accessible financing, but with high interest costs that may become overwhelming at times. Only if these sources are inadequate will the entrepreneur turn to more formal channels of financing, such as banks and outside investors. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Bank Loans Bankers primarily make business loans in one of three forms: lines of credit, term loans, and mortgages. In making a loan decision, a banker always considers the “five Cs 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 Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Bank Loans (cont’d.) Obtaining a bank loan requires cultivation of a banker and personal selling, including a presentation that addresses: (1) how much money is needed (2) what the venture is going to do with the money (3) when the money is needed (4) when and how the money will be paid back Other detailed financial information might be requested, including three years of the firm’s historical financial statements, the firm’s pro forma financial statements, and personal financial statements showing the borrower’s net worth and estimated annual income. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Bank Loans (cont’d.) An entrepreneur should carefully evaluate available banks before choosing one, basing the decision on factors such as the bank’s location, the extent of services provided, and the bank’s lending policies. In negotiating a bank loan, the owner must consider the accompanying terms, which typically include the interest rate, the loan maturity date, the repayment schedule, and the loan covenants. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Business Relationship Financing Business suppliers can offer trade credit (accounts payable), which is the source of short-term funds most widely used by small firms. Suppliers also offer equipment loans and leases, which allow small businesses to use equipment purchased on an installment basis. Asset-based lending is financing secured by working-capital assets, such as accounts receivable and inventory. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Private Equity Financing Business angels are private individuals, generally having moderate to significant business experience, who invest in others’ entrepreneurial ventures. Formal venture capitalists are groups of individuals who form limited partnerships for the purpose of raising capital from large institutional investors, such as pension plans and university endowments. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Government Loan Programs The federal government helps new businesses get started through the programs and agencies of the Small Business Administration (SBA), which include: the 7(a) Loan Guaranty Program, the Certified Development Company (CDC) 504 Loan Program the 7(m) Microloan Program small business investment companies (SBICs) the Small Business Innovative Research (SBIR) Program State and local governments finance new businesses in varying manners, though programs are generally geared to augmenting other sources of funding. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Government Loan Programs (cont’d.) Community-based financial institutions are lenders that use funds from federal, state, and private sources to serve low-income communities and small companies that otherwise would have little or no access to startup funding. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Other Sources of Financing Large companies may finance smaller businesses when it is in their self-interest to have a close relationship with the smaller company. Stock sales, in the form of either private placements or public sales, may provide a few high-potential ventures with equity capital. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.

Key Terms return on assets return on equity line of credit revolving credit agreement term loan chattel mortgage real estate mortgage prime rate LIBOR (London InterBank Offered Rate) balloon payment loan covenants limited liability accounts payable (trade credit) equipment loan asset-based loan factoring informal venture capital business angels formal venture capitalists 7(a) Loan Guaranty Program Certified Development Company (CDC) 504 Loan Program 7(m) Microloan Program small business investment companies (SBICs) Small Business Innovative Research (SBIR) Program community-based financial institution private placement initial public offering (IPO) Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved.