CHAPTER 8 BUSINESS FINANCING LEARNING OBJECTIVES At the end of this chapter, students will be able to: 1. Understanding the importance of capital in the business. 2. Discuss the differences between the form of debt financing form of equity financing. 3. Identify types and sources of financing in the form of loans provided to entrepreneurs. 4. Discusses the methods to be used to obtain bank loans. 5. Identify sources of financing in the form of equity and the means to obtain it. INTRODUCTION Capital is an important element in biz, be it new or old biz. Studies: obtaining enough capital at the ‘start-up phase’ or at the ‘growth phase’ is the most challenging task for an entrepreneur. WHAT IS CAPITAL? “CAPITAL is the net value of a company that exists in the form of cash, inventories & facilities (machines/equipments/vehicles) to be used to further increase the value of the company” “CAPITAL is cash/facilities that are used to generate income/profit of a biz by way of investment” 3 TYPES OF CAPITAL 1) Fixed Capital – needed to purchase fixedasset(land,building,office, machineries & equipments etc.) This capital is stuck in the biz for a long period of time but it is needed in order for the biz to run efficiently (to create products or services) thus generating cash flow & profit for the biz. 3 TYPES OF CAPITAL 2) Working Capital – short term fund for financing day-to-day operation of the biz. Also known as operation capital. Used to purchase raw materials, pay bills, salaries, to make credit sales & to be used during emergencies. 3) Growth Capital – capital needed to finance the growth of biz (if there is an increase in demand, the biz must increase its production, increase the number of staff & workforce, increase sales; purchase bigger equipments;develop&design new products). All these activities needed more fund in the form of growth capital. QUESTIONS ON CAPITAL. Before an entrepreneur tries to raise the capital for his biz he needs to answer several important questions. How much capital is really needed? What form of financing is suitable for his biz? (loan or equity?) How much ownership/control of his biz to be given away or to let go of? FORMS OF FINANCING THERE ARE 2 FORMS OF FINANCING: 1) DEBT/LOAN FINANCING 2) EQUITY FINANCING 1) DEBT FINANCING Also known as loan financing, it involves an instrument called ‘interest’. The biz has to pay back the ‘principle’ together with the ‘interest’ (it does not matter whether the biz is running at a loss or making profit). TYPES OF DEBT FINANCING There are 2 types of debt financing: Short Termed Loan – duration of payback payment is 12 months or less. (Examples of short term loan: overdrafts, revolving credits, credit card purchase or cash advance. Short Termed Loan is used in daily operations to pay for supplies, buy raw materials, pay bills, salaries & allowances. Long Termed Loans - payback more than 12 months. Used to purchase fixed assets of which can be used as collateral for the said loan. DEBT FINANCING ADVANTAGES Retain ownership & control of the biz; Freedom on financial decision; Creditors do not have any claim on loans after full settlement DISADVANTAGES Payment (payback) must be on-time,regardless of company’s performance; Upon failure to pay: entrepreneur can be penalized with higher interest rate, lower credit rating, creditor might claim payback payment in full; Creditor prefers to give loans to long existing biz with good payback records rather than giving loans to new biz with no track-record. TYPES OF DEBT FINANCING OVERDRAFT Short term facility by a bank to a “current account” holder: allows of withdrawal more than amount available in the account to a pre-agreed limit. Overdraft is usually used to fund working capital for inventories, credit sales or operational expenditures. OVERDRAFT Overdraft can be given by a bank either with collateral or without collateral or with a guarantee. COLLATERAL: in the form of easily liquidated assets such as share certificates, bonds etc. NO COLLATERAL: does not need any form of asset if the client is of high integrity, strong financial support & good biz record GUARANTEE: personal guarantor, corporate guarantor, debentures or lien (right to an asset until someone who take a loan from you pays). REVOLVING CREDIT SHORT TERMED & USED FOR ROLLING CAPITAL Does not need a “current account” with a bank Suitable for a company with good financial status (interest charged is usually lower than other types of financing) Can be continuously used as it is a rolling facility (once payback is completed entrepreneurs can reapply revolving credit again) TERMED LOAN known as fixed loan – a form of long termed loan on a fixed duration of which the maturity is more than a year Finance fixed asset purchase or to finance a project Can be dispensed off in full amount Also can be dispensed off progressively (usually for construction projects by the progress of its completion) Also TERMED LOAN Payback by installment – 3 or 6 months or annually Termed Loan is given depending on reason of loan, payback capability & duration of payback Termed loan is normally given to clients that will receive a sum of money in the future e.g. after securing a government contract HIRE PURCHASE Offered by financial institution to purchase tools, facilities, machineries & vehicles via installments payment Minimun 10% deposit on product cost, remaining balance to be borne by the bank Installment to the bank till the end of duration agreed Ownership is with the bank till full settlement (then only title of ownership is shifted to the clients) MORTGAGE A contract of which the bank buy the fixed asset & rent it to the client Client will pay the rent for a certain period of time. Client has full right to use the asset during the term (but ownership of the asset is of the bank) Advantageous: 1)Usage of asset without purchasing. 2)Increased of cash flow without spending money on asset. 3)Tax deductible on rental of equipment/asset. TYPES OF MORTGAGE 1) Operational Mortgage BANK will provide asset to the client & maintenance of asset. CLIENT agrees on a rental rate & the duration of the renting. Upon the duration of mortgage is completed, asset will be returned to the bank & mortgaged to another party, or to the same client or sold of as a used asset. E.g: computers & photocopy machines TYPES OF MORTGAGE 2) Financial Mortgage Clients determine what is needed & apply to bank to buy it. Maintenance & insurance of asset to be borne by client. Mortgage contract is for the duration of economic lifespan of asset & cannot be ended before the term of mortgage expired. Upon mortgage completion, asset can be returned to the bank, bought at market price or sold off as a used asset to another party. TYPES OF DEBT FINANCING Factoring A type of financing to a biz which offers 30 120 days credit sales to customers. Bank buys over invoice/debts & manage the collection (biz got cash through invoice sales to the bank) Helps cash flow & reduce difficulties & expenses in managing credit sales account. 1) Recourse Factoring – client must also do the collection. 2) Non-Recourse Factoring – client sell off rights to debt & uncollected accounts. Client has no obligation to the bank should the collection fail. FORM OF ISLAMIC SHARIAH BASED FUNDING Al Mudharabah an agreement between a financier and entrepreneur Financier as investors agreed to fully fund the business, while the entrepreneur as a businessman working on it. Distributed profits while losses borne by the financier Al Musyarakah partnership agreement in an arbitration of two or more parties to undertake a business project. financiers with entrepreneurs to jointly contribute to capital funding. Gains and losses in accordance with the agreed ratio. Al Murabahah certain goods sale and purchase agreement between the owner of goods to the buyer. entrepreneurs will first identify a product Financier will buy the goods and then sell it to entrepreneurs with a higher price FORM OF ISLAMIC SHARIAH BASED FUNDING Bai' Bithaman Ajil more or less the same concept mentioned but entrepreneurs as customers defer payments on purchases of goods from the financier. Bai' Al Dayn form of debt financing the provision of financial resources needed for production, business and services through commercial paper and document short term to maturity not exceeding one year. AI Ijarah the concept of lease financing in accordance with sharia. financiers will purchase the first property required by the entrepreneur, and then leased assets Al Wakalah Under the agreement, a person will appoint an institution or organization as its agent, and is authorized to perform a task or job on his behalf. FORM OF ISLAMIC SHARIAH BASED FUNDING ArRahn agreement in which a property or valuable asset is placed in the custody of a person or institution as security for a loan at au debt Al Kafalah the loan guarantee agreement or the performance of work provided by a person to another. Parties will be responsible for providing security to a third party Al Qardhul Hasan credit welfare state that one party agrees to lend to a certain sum for a specified period. The borrower is only required to repay only the amount borrowed APPLYING FOR A LOAN Questions before applying for a loan. Is the capital really needed? Can the biz manage the existing cash flow effectively? What is the loan for? How soon is the loan needed? Does he has a good personal credit record? Is the biz capable to pay back? Does the biz has a positive net returns? Does the biz has any outstanding loans or debts? Does the entrepreneur has enough personal capital injection? Does the entrepreneur has any collateral? Is the entrepreneur willing to give personal guarantee to the loan? Does the biz has a good mgt team? APPLYING FOR A LOAN Having answered those questions, (knowing what to do with the needed money, how much is needed etc.), entrepreneur is ready to apply his loan to any financial institutions or banks. He has to prepare a written “ Loan Proposal” to be given to bank officer for evaluation. LOAN PROPOSAL MUST INCLUDE THE FOLLOWING ELEMENTS:1) Summary It should be clear, compact & accurate. Explain briefly how loan will be utilized, how it will be repaid & how the loan will benefit the company. Also includes the interesting & unique characteristics of the products of the biz. ELEMENTS IN LOAN PROPOSAL 2) Management Profile Who plays the vital role in the management? Should include background of the top management team of the company (important to list down their academic qualifications, special skills & experience) ELEMENTS IN LOAN PROPOSAL 3) Business detail (Company) Explain line of business. Includes summary of history; past & current activities. Show clearly that the entrepreneur fully understand the nature of biz, its market trend, risks & its environment. Explain briefly about the product offered. ELEMENTS IN LOAN PROPOSAL 4) Forecast Show a 3-year revenue (sales) & cash flow forecast. The forecast has to be clear & realistic. Contingencies must be included IF the assumptions made are not met. ELEMENTS IN LOAN PROPOSAL 5) Financial Statement Includes biz & personal financial statement.(forecast of P&L, Cash flow & Balance sheet.) Ensure that the entrepreneur fully understand the implications of what was being presented in the financial statement. ELEMENTS IN LOAN PROPOSAL 6) Loan Motive/purpose Prepare a detail statement on how the loan will be used. Make sure the entrepreneur understand the type of loan applied for. Include loan payback method (amount & time of repayment including interest rates) in the forecasted cash flow & income statement. ELEMENTS IN LOAN PROPOSAL 7) Amount of Loan Explain how much loan is needed & how much is the personal capital input. Amount needed is based on the usage of loan & the entrepreneurs capacity to payback/repay. ELEMENTS IN LOAN PROPOSAL 8) Payback Plan Should highlight entrepreneur’s capacity & capability to payback. Explain how the payback will be made; installments by monthly, quarterly, half yearly or annually. WHAT BANKERS LOOK FOR IN AN ENTREPRENEUR When an entrepreneur presents his “Loan Proposal” , bankers will use 5Cs to evaluate the loan application: CHARACTER (PERSONALITY) is often related to ethics such as honesty, integrity, trustworthy & accepted morality in a society. CAPACITY (CAPABILITY) is the entrepreneur’s & his business capacity or ability to payback the loan given. WHAT BANKERS LOOK FOR IN AN ENTREPRENEUR CAPITAL is the financial strength of an entrepreneur. Financial capacity is determined by the entrepreneur’s equity share in the biz (how much he has injected money into his biz) COLLATERAL is used as a security or insurance should entrepreneur fails in loan repayment (house,land,building etc.) WHAT BANKERS LOOK FOR IN AN ENTREPRENEUR CONDITION refers to the environment of the biz. Environment includes all factors that affect capability of entrepreneur to repay the loan which sometimes cannot be controlled by both banker & entrepreneur. (external & internal environments; eg. economic conditions) * EQUITY FINANCING Apart from loan(debt) financing, entrepreneurs can also raise the capital needed through Equity Financing. EQUITY FINANCING (EF) Through EF, entrepreneur offers an investor a form of ownership in his biz (Selling his percentage of his stake, usually 20 to 40% equity). In return equity financers get yearly bonus & dividend. Through EF, entrepreneur is not required to payback any form of funds forwarded by the equity investors. To recover their money, Equity Investor will leave/exit from entrepreneur’s biz through selling off their shares in the future (usually stay in entrepreneur’s co. for a period of 5-10 years) EQUITY FINANCING ADVANTAGES Entrepreneur does not have to repay the money invested/injected into the co. Any biz capable of attracting outside investors shows that the biz itself has a good growth potential & profitable future Investors (equity financers) are more dedicated to the success of the co. They are a good source of consultation, advisory & networking to the biz. EQUITY FINANCING DISADVANTAGES Entrepreneur does not have total control of the co. It might be more difficult to manage (decision-making: has to consult & discuss with other shareholders/owners). Equity Investors do not always agree to the plans of the biz. (sometimes their views might be against the views of the ownerentrepreneur/founder) Arranging equity financing is much more complex & sometimes requires a third party (that could include lawyers & accountants). SOURCES OF EQUITY FINANCING 1) Owner’s Capital: The most common source of fund for new businesses. The fund could either be from a personal saving or sale of personal asset. SOURCES OF EQUITY FINANCING 2) Family & Friends are also considered an important source of equity financing. Normally a source for financing new biz & easily available for small time entrepreneurs. SOURCES OF EQUITY FINANCING 3) Informal Investor also known as “angels” financially strong individuals or rich individuals who invest their money for newly start-up projects or new biz ventures. SOURCES OF EQUITY FINANCING 4) Venture Capital : Funds by companies or professional bodies to invest with new growing business. Example of Venture Capital Companies in Malaysia (Malaysia Venture Capital Management Bhd, PUNB Ventures Bhd, MSC Venture Corporation Sdn Bhd, OSK Venture International Bhd. (BNM – there are more than 20 VC Companies in Malaysia) WHAT KIND OF BUSINESS WILL ATTRACT VENTURE CAPITALIST? High Returns: Venture capitalist takes high risk in investing in a new biz, thus they require a high return to compensate the risks involved; (usually 30%-40% rate of return). WHAT KIND OF BUSINESS WILL ATTRACT VENTURE CAPITALIST? Ease of Exit: Venture Capitalist will only invest in projects/businesses that enables them to leave easily through profitable sale of their share or equity in the future. STAGES OF EQUITY FINANCING 1) Seed financing Financing for a “biz concept” as well as for cost of R&D of a product. Normally, a small fund is needed for research to prove the viability of the concept/idea. Hard to get seed-financing as biz must prove that the product has great market potential or a highly demanded product. STAGES OF EQUITY FINANCING 2) Start-up financing Funds for companies to develop & market the product. Usually given to co. which is at the start-up phase in the midst of organizing its opening, very new & did not make any form of sales yet. Hard to obtain start-up funds. STAGES OF EQUITY FINANCING 3) Development/Growth Financing Funds for development & growth of co. with previous track records. Venture capitalist plays most important role at this stage which can be divided into: First Stage: Funds needed to increase production capacity Second Stage: Funds needed to increase marketing capability (bigger promotion drives) STAGES OF EQUITY FINANCING 4) Mezzanine financing Funds needed for public offering (IPO). The co. is already making profits but needed extra money to increase production capacity; size of factory. Fund is also needed to help financing the cost to attract the general public to invest in the company (from private limited co. to public limited co.) STAGES OF EQUITY FINANCING 5) Management Buy Out Comes in forms of loan or equity investment that enables an existing management to buy over an existing business or part of it from an existing owner. Majlis Amanah Rakyat (MARA) (www.mara.gov.my) Tabung Ekonomi Usaha Niaga (TEKUN) (www.tekun.gov.my) Bank Pembangunan Malaysia Berhad (BPMB) (www.bpmb.com.my) SME Bank (www.smebank.eom.my) Perbadanan Jaminan Kredit (CGC) (www.iguarantee.com.my) Bank Pertanian Malaysia/Agrobank (www.agrobank.eom.my) Kementerian Sains, Teknologi dan Inovasi (MOSTI) (www.mosti.gov.my) Kementerian Belia dan Sukan (KBS) (www.kbs.gov.my) Perbadanan Pembangunan Industri Kecil dan Sederhana (SMIDEC) (www.smidec.gov.my) Multimedia Development Corporation Sdn. Bhd. (MDeC) (www.mdec.com.my) MIMOS Bhd. (www.mimos.com.my) Amanah Ikhtiar Malaysia (AIM) (www.aim.gov.my) Perbadanan Usahawan Nasional Berhad (PUNB) (www.punb.com.my) Bank Negara Malaysia (BNM) (www.bnm.gov.my) CONCLUSION An entrepreneur must understand the form, type and sources for business financing. He/she must understand the evaluation criteria to get a fund. Loan Financing Equity Financing Criteria seached for by a venture capitalist is a strong management team, product uniqueness, market opportunity and growth potential. Stages to Equity Financing starts with seed, start-up, development, mezzanine and management buy out.