Sources of Funds:
Equity and Debt
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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.
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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.
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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.
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Raising Capital
• Raising capital to
launch or expand a
business is a challenge.
• Many entrepreneurs
are caught in the
“credit crunch.”
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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.
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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.
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Sources of Equity Financing
• Personal savings
• Friends and family members
• Partners
• Corporations
• Venture capital companies
• Public stock sale
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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.
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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.
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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.
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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
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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.
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Asset-Based Borrowing
• Discounting accounts
receivable
 Inventory financing
Accounts
Receivable
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Sources of Debt Capital
•
Commercial banks
 Asset-based
 Vendor
$$
lenders
financing (trade credit)
 Equipment suppliers
 Commercial finance companies
 Saving and loan associations
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Sources of Debt Capital
• Stock brokerage houses
• Insurance companies
• Credit unions
• Bonds
• Small Business Investment Companies
(SBICs)
• Small Business Lending Companies
(SBLCs)
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Internal Methods of Financing
• Factoring - selling accounts receivable
outright
• Leasing - assets rather than buying them
• Credit cards
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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.