1. The Financial Plan, Part 2: Finding Sources of Funds
Part 3 Developing the New Venture Business Plan

2. 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 basic process for acquiring and structuring a bank loan.
Explain how business relationships can be used to finance a small firm.
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3. Looking Ahead (cont’d.)
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.
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4. The Nature of a Firm and Its Financing Sources
Factors That Determine Financing
Firm’s economic potential
Growth prospects and long-term profitability
Company size and maturity
Life-cycle position in business
Types of assets
Tangible or intangible
Owner preferences for debt or equity
Tradeoffs required for debt and equity
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5. Debt or Equity Financing?
Potential Profitability
Borrowing increases potential for higher rates of return on owners’ equity; exposes firm to more financial risk
Return on Assets
Rate of return earned on a firm’s total assets invested, computed as operating income ÷ total assets
Return on Equity
Rate of return earned on the owner’s equity investment, computed as net income ÷ owner’s equity investment
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6. Tradeoffs Between Debt and Equity
Exhibit 11.1
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7. Debt Versus Equity at the Levine Company
All Equity: Owners keep all profits in return for accepting the risk of lower returns.
Debt is Risky: Lenders have first claim on profits and must be paid even if there are no profits.
Exhibit 11.2
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8. Debt or Equity Financing? (cont’d.)
Financial Risk
Investing more owner equity limits potential return on equity; lowers financial risk for firm.
Voting
Increasing equity through borrowing requires owners to share control with external investors.
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9. Sources of Funds Exhibit 11.3
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10. Startup Financing for Inc. 500 Companies in 2003
Exhibit 11.4
Source: Mike Hofman, “The Big Picture,” Inc., Vol. 25, No. 12 (October 2003), p. 87.
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11. Debt or Equity Financing? (cont’d.)
Sources Close to Home
Personal savings
Owner equity is expected by other investors.
Family and friends
Borrowing puts personal relationships at risk.
Credit cards
Provides immediate access to funds and assets; cards should be method of payment and not a source of credit.
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12. Sources of Personal Capital for Small Firms
Source: “Entrepreneurship Monitor 2002,” Wall Street Journal, August 26, 2003, p. B8.
Exhibit 11.5
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13. Financing Commercial Banks Line of credit Revolving credit agreement
Maximum amount that bank will permit the firm to borrow
Revolving credit agreement
The maximum amount a bank is committed to lend a firm on an ongoing basis
Term loans
Loans for 5 to 10 years to finance equipment
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14. Financing (cont’d.) Commercial Banks (cont’d.) Chattel mortgage
A loan collateralized by inventory or movable property
Real estate mortgage
A long-term loan with real property held as collateral
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15. The Banker’s Perspective
Bankers’ Concerns
How much the bank will earn on the loan?
What is the likelihood that the lender will be able to repay the loan?
The Five Cs of Credit
Character of the borrower
Capacity of the borrower to repay the loan
Capital invested in the venture by the borrower
Conditions of the industry and economy
Collateral available to secure the loan
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16. Questions Lenders Ask Lender’s Questions
Do the purpose and amount of the loan make sense, both for the bank and for the borrower?
Does the borrower have strong character and reasonable ability?
Does the loan have a certain primary source of repayment?
Does the loan have a certain secondary source of repayment?
Can the loan be priced profitably to the customer and to the bank, and are this loan and the relationship good for both the customer and the bank?
Can the loan be properly structured and documented?
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17. The Banker’s Concerns What is the venture going to do with the money?
How much money is needed?
What is the venture going to do with the money?
When and how will the money be paid back?
When will the money be needed?
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18. Financial Information Required for a Bank Loan
Three years of the firm’s historical statements
Balance sheets, income statements, and statements of cash flow
The firm’s pro forma financial statements
The timing and amounts of the debt repayment included as part of the forecasts
Personal financial statements
The borrower’s personal net worth (assets – debts) and estimated annual income
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19. Negotiating a Loan: Interest Rate
Prime Rate
The interest rate charged by a commercial bank on loans to its most creditworthy customers
LIBOR (London InterBank Offered Rate)
The interest rate charged by London banks on loans to other London banks
Fixed Interest Rate
Interest rate remains the same for the term of the loan
Floating Interest Rate
Interest rate varies with the changes in the prime rate
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20. Negotiating a Loan: Term of the Loan
Loan Maturity Date
Maturity date should match use of funds
Repayment Schedule
Equal monthly or annual payments
Decreasing monthly or annual payments
Loan Covenants
Bank-imposed restrictions on a borrower that enhance the chances of timely repayment
Filing of financial statements, restriction of salaries and personal loans, limits on financial ratios, requiring personal loan guarantees beyond the owner’s limited liability
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21. Business Suppliers and Asset-Based Lenders
Trade Credit (Accounts Payable)
Financing provided by a supplier of inventory to a company, which sets up an account payable for the amount
Short-duration financing (30 days)
Amount of credit available is dependent on type of firm and supplier’s willingness to extend credit
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22. Business Suppliers and Asset-Based Lenders (cont’d.)
Equipment Loan and Leases
Installment loan (mortgage on equipment) from the seller of machinery purchased by a business
Equipment leased from a supplier:
Frees up cash for other purposes
Leaves lines of credit open
Provides a hedge against obsolescence
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23. Business Suppliers and Asset-Based Lenders (cont’d.)
Asset-Based Loan
A line of credit secured by working-capital assets
Factoring
Obtaining cash by selling accounts receivable to another firm
Accounts are sold to factor at a discount to invoice value
Factor can refuse questionable accounts
Factor charges fees for servicing accounts and for amount advanced to firm prior to collection
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24. Private Equity Investors
Informal Venture Capital
Funds provided by wealthy private individuals (business angels) to high-risk ventures
Formal Venture Capitalists
Individuals who form limited partnerships for the purpose of raising venture capital from large institutional investors
The firm’s expected profits in future years
The venture capitalist’s required rate of return
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25. Government-Sponsored Programs and Agencies
Small Business Administration (SBA) loans
7 (a) Guaranty loan
SBA guarantees repayment of loan to lender
The Certified Development Company (CDC) 504 Loan Program
The 7(m) Microloan Program
Small Business Investment Companies (SBICs)
Small Business Innovative Research (SBIR)
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26. Government-Sponsored Programs and Agencies (cont’d.)
State and Local Government Assistance
Loan guarantees
Set asides for minority business development
Community-Based Financial Institutions
Lenders that provide financing to small businesses in low-income communities for the purpose of encouraging economic development
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27. Where Else to Look Large Corporations Stock Sales
Financing and technical assistance to critical suppliers and technology developers
Stock Sales
Private placement
The sale of a firm’s capital stock to selected individuals
Initial public offering (IPO)
The issuance of stock that is to be traded in public financial markets
Places firm under SEC securities regulations
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28. 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)
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