1. part 4 PowerPoint Presentation by Charlie Cook Copyright © 2003 South-Western College Publishing. All rights reserved. All rights reserved. Finding Sources of Financing 13 The New Venture Business Plan 12e

2. Copyright © by South-Western College Publishing. All rights reserved. 13–2 Looking Ahead After studying this chapter, you should be able to: 1. Describe how the nature of a firm affects its financing sources. 2. Evaluate the choice between debt financing and equity financing. 3. Describe various sources of financing available to small firms.

3. Copyright © by South-Western College Publishing. All rights reserved. 13–3 The Nature of a Firm and Its Financing Sources Factors That Determine Financing –Firm’s economic potential  Growth prospects and long-term profitability –Maturity of the company  Life-cycle position in business –Nature of its assets  Tangible or intangible –Owners’ preferences for debt or equity  Tradeoffs required for debt and equity

4. Copyright © by South-Western College Publishing. All rights reserved. 13–4 Debt or Equity Financing? Potential Profitability –Borrowing increases potential for higher rates of return on owners’ equity; exposes firm to more financial risk. 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.

5. Copyright © by South-Western College Publishing. All rights reserved. 13–5 Fig. 13.1 Equity financing Debt financing HIGH LOW HIGH Equity Financing Debt Financing Potential Profitability Financial Risk/Control Tradeoffs Among Potential Profitability, Financial Risk, and Voting

6. Copyright © by South-Western College Publishing. All rights reserved. 13–6 $28,000 income on total assets of $200,000 14% return on assets ($28,000÷ $200,000) 14% return on $200,000 ($28,000÷ $200,000) No debt equals $200,000 equity With no debt and all equity: Fig. 13.2a Debt Versus Equity at the Levine Company Equity: Owners get to keep all of the profits in return for accepting the risk of lower returns

7. Copyright © by South-Western College Publishing. All rights reserved. 13–7 $28,000 income on total assets of $200,000 14% return on assets ($28,000÷ $200,000) 18% return on $100,000 ($18,000÷ $100,000) $100,000 debt (10% cost) equals $100,000 equity With $100,000 debt and $100,000 equity: Fig. 13.2b Debt Versus Equity at the Levine Company Debt is Risky: Lenders have first claim on profits and must be paid even if there are no profits.

8. Copyright © by South-Western College Publishing. All rights reserved. 13–8 Sources of Financing 01020304050607080 Personal Savings Family Members Partners Personal Charge Cards Friends Bank Loans Private Investors Mortgaged Property Venture Capital Other Percentage of Entrepreneurs Using Source of Financing Sources of Financing

9. Copyright © by South-Western College Publishing. All rights reserved. 13–9 Fig. 13.3 Sources of Funds

10. Copyright © by South-Western College Publishing. All rights reserved. 13–10 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

11. Copyright © by South-Western College Publishing. All rights reserved. 13–11 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

12. Copyright © by South-Western College Publishing. All rights reserved. 13–12 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

13. Copyright © by South-Western College Publishing. All rights reserved. 13–13 Business Suppliers and Asset-Based Lenders (cont’d) Commercial Banks –Line of credit  Maximum amount that bank will permit firm to borrow. –Revolving credit agreement  Maximum amount bank is committed to lend a firm on an ongoing basis.

14. Copyright © by South-Western College Publishing. All rights reserved. 13–14 Business Suppliers and Asset-Based Lenders (cont’d) Commercial Banks (cont’d) –Term loans  Loans for 5 to 10 years to finance equipment –Chattel mortgage  Loan collateralized by inventory or moveable property –Real estate mortgage  Long-term loan with real property held as collateral

15. Copyright © by South-Western College Publishing. All rights reserved. 13–15 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 C’s 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

16. Copyright © by South-Western College Publishing. All rights reserved. 13–16 Questions Lenders Ask Lender’s Questions –What are the strengths and qualities of the management team? –How has the firm performed financially? –How much money is needed? –What is the venture going to do with the money? –When is the money needed? –When and how will the money be paid back? –Does the borrower have qualified support people, such as a good public accountant and attorney?

17. Copyright © by South-Western College Publishing. All rights reserved. 13–17 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

18. Copyright © by South-Western College Publishing. All rights reserved. 13–18 Negotiating a Loan Terms of Loans –Interest rate  Fixed or floating rates –Loan maturity date –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 financial statements, restricting salaries and personal loans, requiring personal loan guarantees

19. Copyright © by South-Western College Publishing. All rights reserved. 13–19 Government-Sponsored Programs and Agencies Small Business Administration (SBA) loans –Guaranty loan  SBA guarantees repayment of loan to lender –Direct loan  SBA loans money directly to small firm/borrower Small business investment centers (SBICs) Small Business Innovative Research (SBIR) State and Local Government Assistance

20. Copyright © by South-Western College Publishing. All rights reserved. 13–20 Other Sources of Financing Venture Capital Firms –An investor or investment group that commits money to new business ventures Community-based financial institutions –Lenders that provide financing to small businesses in low-income communities for the purpose of encouraging economic development Large corporations –Financing and technical assistance to critical suppliers and technology developers

21. Copyright © by South-Western College Publishing. All rights reserved. 13–21 Other Sources of Financing (cont’d) 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