Sources of Funds: Equity and Debt 1 Financing Ventures • How will you finance your business? • Where do you find the money? (Source of Capital) Alternative sources of Financing • Identify the alternative sources of financing a new business? • Discuss their advantages and limitations • A primary reason small business fails is lack of adequate capital • Obtaining those resources in the amounts needed and at the time when they are needed can be difficult for entrepreneurial ventures because they are generally considered more risky than established enterprise. Cont’d… • financing means more than merely obtaining money; it is very much a process of managing assets wisely to use capital efficiently. • The critical issue is to assure sufficient cash flow for operations, as well as to plan financing that coincides with changes in the enterprise •What is capital? ▫ Capital is the amount of cash and other assets owned by a business. ▫ Capital can also represent the accumulated wealth of a business, represented by its assets less liabilities. ▫ Capital can also mean stock or ownership in a company. Three Types of Capital Capital is any form of wealth employed to produce more wealth for a firm. • Fixed - used to purchase the permanent or fixed assets of the business (e.g., buildings, land, equipment, and others). • Working - used to support the small company's normal short-term operations (e.g., buy inventory, pay bills, wages, or salaries, and others). • Growth - used to help the small business expand or change its primary direction. 7 Debt Capital and Equity Capital Equity Capital • Represents the personal investment of the owner(s) in the business. • Is called risk capital because investors assume the risk of losing their money if the business fails. • Does not have to be repaid with interest like a loan does. • If other people are involved, means that an entrepreneur must give up some ownership in the company to outside investors. 9 Debt Capital • Must be repaid with interest. • Is carried as a liability on the company’s balance sheet. • Can be just as difficult to secure as equity financing, even though sources of debt financing are more numerous. • Can be expensive, especially for small companies, because of the risk/return tradeoff. 10 Raising Capital • Raising capital to launch or expand a business is a challenge. • Many entrepreneurs are caught in the “credit crunch.” 11 How will you finance your business? • What Is Financing ? ▫ Means of obtaining the resources to purchase an item, then paying back the loan in a set time period. ▫ Financing is typically categorized into two fundamental types: debt financing and equity financing. How will you finance your business? • Debt financing: ▫ Means borrowing money that is to be repaid over a period of time, usually with interest. ▫ Can be either short-term or long-term ▫ The lender does not gain an ownership interest in your business. In smaller businesses, personal guarantees are likely to be required on most debt instruments How will you finance your business? • Equity financing ▫ Describes an exchange of money for a share of business ownership (without having to repay a specific amount of money at any particular time) ▫ The major disadvantage to equity financing is the dilution of your ownership interests and the possible loss of control that may accompany a sharing of ownership with additional investors. Sources of finance Sources of Finance Internal Sources External Sources (Owner capital or owners equity) (Borrowed or debt capital) Sources Internal Sources Personal saving Friends and relatives Partners Public stock sale (going public) Sources External Sources Commercial banks Trade credit Equipment suppliers Credit unions Insurance companies The “Secrets” to Successful Financing 1. Choosing the right sources of capital is a decision that will influence a company for a lifetime. 2. The money is out there; the key is knowing where to look. 3. Raising money takes time and effort. 4. Creativity counts. Entrepreneurs have to be as creative in their searches for capital as they are in developing their business ideas. 18 The “Secrets” to Successful Financing 5. The World Wide Web puts at entrepreneur’s fingertips vast resources of information that can lead to financing. 6. Be thoroughly prepared before approaching lenders and investors. 7. Entrepreneurs should not underestimate the importance of making sure that the “chemistry” among themselves, their companies, and their funding sources is a good one. 19 Sources of Equity Financing • Personal savings • Friends and family members • Partners • Corporations • Venture capital companies • Public stock sale 20 Personal Savings • The first place an entrepreneur should look for money. • The most common source of equity capital for starting a business. • Outside investors and lenders expect entrepreneurs to put some of their own capital into the business before investing theirs. 21 Friends and Family Members • After emptying their own pockets, entrepreneurs should turn to those most likely to invest in the business: friends and family members. • Careful!!! Inherent dangers lurk in family/friendly business deals, especially those that flop. 22 Friends and Family Members • Guidelines for family and friendship financing: ▫ Consider the impact of the investment on everyone involved. ▫ Keep the arrangement “strictly business.” ▫ Settle the details up front. ▫ Never accept more than investors can afford to lose. ▫ Create a written contract. ▫ Treat the money as “bridge financing.” ▫ Develop a payment schedule that suits both parties. ▫ Have an exit plan. 23 Commercial Banks ...the heart of the financial market for small businesses! • Short-term loans ▫ Commercial loans ▫ Lines of credit • Intermediate and long-term loans ▫ Installment loans and contracts 24 Commercial Bank • Banks provide unsecured and secured loans. But to secure a bank loan, an entrepreneur typically will have to answer a number of question What do you plan to do with the money (credit facility)? How much do you need? When do you pay back? After how long will you need it? How will you repay the loan? Commercial Bank • Due to different reasons banks are more cautious in lending money since they cannot afford to incur more bad loans. • Most bankers refer to the five Cs ( Criteria) of credit in making lending decision. Five Cs Capita l Collatral Capacity Character Condition Where Do You Find the Money?( Source of Finance) • Capital: is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. In some cases, it may need to be at least 25% of the total amount needed to start your business • the frequent reasons that banks give for rejecting small business loan applications capitalization or to match debt. are under Where Do You Find the Money?( Source of Finance) • Capacity: The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. • More small business fails from lack of cash than from lack of profit. It is technically bankrupt. • Bankers expect the small business loan applicant to pass the test of liquidity, especially for short term loans. • It studies closely the small company's cash flow position to decide whether or not it meets the capacity required. Where Do You Find the Money?( Source of Finance) • Conditions: Will the money be used for working capital, additional equipment, or inventory? • Banks consider factors relating to the business operation such as potential growth in the market, competition, location, form of ownership, and loan purpose. • The shape of the overall economy including interest rate levels, inflation rate, and demand for money. Where Do You Find the Money?( Source of Finance) • Character is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. • The evaluation of character frequently is based on intangible factors such as honesty, competency, determination, intelligence and ability. • Although the qualities jugged are abstract, this evaluation plays a critical role in banker's decision. Where Do You Find the Money?( Source of Finance) • Collateral: Collateral includes any assets the owner pledges to the bank as security to the repayment of the loan. or "guarantees" are additional forms of security you can provide the lender. ▫ If for some reason, the business cannot repay its bank loan, the bank wants to know there is a second source of repayment. ▫ Assets such as equipment, buildings, accounts receivable and in some cases inventory Asset-Based Borrowing • Businesses can borrow money by pledging as collateral otherwise idle assets – accounts receivable, inventory, and others • Advance rate – the percentage of an asset’s value that a lender will lend. 33 Asset-Based Borrowing • Discounting accounts receivable Inventory financing Accounts Receivable 34 Sources of Debt Capital • Commercial banks Asset-based Vendor $$ lenders financing (trade credit) Equipment suppliers Commercial finance companies Saving and loan associations 35 Sources of Debt Capital • Stock brokerage houses • Insurance companies • Credit unions • Bonds • Small Business Investment Companies (SBICs) • Small Business Lending Companies (SBLCs) 36 Internal Methods of Financing • Factoring - selling accounts receivable outright • Leasing - assets rather than buying them • Credit cards 37 How much… • There are many ways to reduce expenses: for instance, by initially working out of one's home rather than leasing an office or leasing office equipment rather than buying it. • NOTE: all entrepreneurs need to estimate how much cash they need to cover expenses until the business begins to make a profit. For this task, the best financial tools are the income statement and cash flow statement. Sources of Financing 1. Equity Capital Personal savings Friends and family Credit cards Venture investors Government Programs • Equity Capital: Represents the personal investment of the owner (owners) in a business. Also called risk capital. ▫ Forces to lose some ownership • Debt capital: is the financing that a business owner has borrowed and must repay with interest. ▫ debt financing doesn’t require an entrepreneur to dilute his/her ownership. Debt financing Financial institutions Non-bank sources 1. Commercial banks 1. Trade credit 2. Micro finance 2. Equipment suppliers 3.Accounts receivable financing: 4. Credit unions: 5. Insurance companies 6. Bonds (also known as debt securities 5Cs, Banks’ evaluation criteria • • • • • Capital Capacity Collateral Character, and conditions. There are some reasons that forces entrepreneurs to look beyond the bank: • To acquire more money • To overcome banks' conservatism • To nourish success • To prevent failure • To reduce dependence on leverage • To support innovation • To improve networking and community visibility • To finance substantive growth. Debt financing • Advantages No relinquishment of ownership is required More borrowing allows for potentially greater return on equity During periods of low interest rates, the opportunity cost of borrowing is low. • Disadvantages Regular (monthly) interest payments are required Continual cash flow problems can be intensified because of pay back responsibility. Heavy use of debt can inhibit growth and development.