Chapter 12
A Firm’s Sources of Financing
CHAPTER OUTLINE
Spotlight: Just Send Cash
1 The Nature of a Firm and Its Financing Sources
Describe how the nature of a firm affects its financing sources.
 A Firm’s Economic Potential
 Potential for high growth and large profits has more sources of financing
 Company Size and Maturity
 Direct bearing on types of financing available
 Larger and older firms as opposed to smaller firms
 Venture capitalists limit how much they will invest in startup companies
 Types of Assets
 Two types considered when evaluating a loan
Have students discuss the difference between the two types of assets.
 Tangible assets
 Intangible assets
 Owner Preferences for Debt or Equity
Discuss why an owner might choose each type of financing as well as the
disadvantages of the two types for the owner.
2 Debt of Equity Financing?
Evaluate the choice between debt financing and equity financing.
 Potential Profitability
 Rate of return on investment important to owners
 Return on Assets
 Return on Equity
 General rule – as long as a firm’s rate of return on its assets (operating profits
divided by total assets) is greater than the cost of the debt (interest rate), the
owners’ rate of return on equity will increase as the firm uses more debt
 Financial Risk
 Debt is risky
 Equity is less demanding
 Voting Control
 Degree of control retained by owners
 Equity financing means giving up part of the firm’s ownership and releasing some
control
 Debt increases risk but allows owner to retain full ownership
3 Sources of Financing
Identify the typical sources of financing used at the outset of a new venture.
 Exhibit 12-3 Sources of Funds
 Sources Close to Home
 Personal Savings – imperative to have some personal investment in the business
 Banker unlikely to loan venture funds if the entrepreneur doesn’t risk personal
money
 Friends and Family
 Second likely place to obtain funding
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A Firm’s Sources of Financing

Accept only if that person will not be hurt financially to any significant extent
if the entire amount is lost
 These people often expect to provide advice when they invest
 Make agreements in writing to protect personal relationships
 Credit Cards
 Requires no justification of the use of the money
 Must be extremely self-disciplined to avoid becoming overextended
 Goal should be to use as method of payment not source of credit
4 Bank Financing
Discuss the basic process for acquiring and structuring a bank loan.
 Types of Loans
 Line of Credit – an informal agreement between a borrower and a bank as to the
maximum amount of funds the bank will provide at any one time.
 Revolving credit agreement
 Term Loans – Money loaned for a 5 – 10-year term, corresponding to the length
of time the investment will bring in profits.
 Mortgages
 Chattel mortgage – a loan for which items of inventory or other movable
property serve as collateral.
 Real estate mortgage – a long-term loan with real property held as collateral
 Understanding a Banker’s Perspective
 Three fundamental concerns
 Recouping the principal of the loan
 Determining the amount of income the loan will provide the bank
 Helping the borrower be successful and then become a larger customer.
 Five C’s of credit
Discuss these in terms of how a student might finance a car. How are these
relevant to them?
 Character
 Capacity
 Capital
 Conditions
 Collateral
 Effective presentation to bank helpful when requesting money
 Include three years of firm’s historical financial statements, pro forma
financial statements including timing and amounts of the debt repayment,
personal financial statements showing borrower’s net worth
 Selecting a Banker
 Location limits range of possible choices of banks; banks interested in home
communities
 Banks’ lending policies not uniform
 Negotiating The Loan
 Interest Rate
 Prime Rate – the interest rate charged by commercial banks on loans to their
most creditworthy customers.
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Chapter 12
A Firm’s Sources of Financing

LIBOR (London InterBank Offered Rate) – the interest rate charged by
London banks on loans to other London banks.
 Loan Maturity Date
 Short-term
 Long-term
 Repayment Schedule
 Balloon payment – a very large payment required about halfway through the term
over which payments were calculate, repaying the loan balance in full.
 Loan Covenants – bank-imposed restrictions on a borrower that enhance he
chance of timely repayment
 Business may be required to provide financial statements on a monthly or
quarterly basis
 Bank may limit managers’ salaries an prohibit any personal loans from the
business to the owners
 Bank may put limits on various financial ratios to assure loan payments
 Borrower will normally be required to personally guarantee the firm’s loan
 Limited liability – restriction of an owner’s legal financial responsibilities to
the amount invested in the business.
5 Business Suppliers and Asset-Based Lenders
Explain how business relationships can be used to finance a small firm.
 Accounts Payable (Trade Credit)
 Credit extended by suppliers important to a startup
 Amount available depends on type of business and supplier’s confidence in the
firm
 Equipment Loans and Leases
 Equipment loan – an installment loan from a seller of machinery used by a
business
 Leases
 Asset-Based Lending
 Asset-based loan – a line of credit secured by working capital assets
 Factoring – obtaining cash by selling accounts receivable to another firm
 Purchase-order financing obtaining cash from a lender who, for a fee, advances
the amount of the borrower’s cost of goods sold for a specific customer order
6 Private Equity Investors
Describe the two types of private equity investors who offer financing to small firms.
 Business Angels
 Private individuals who invest in others’ entrepreneurial venture
 Informal venture capital – funds provided by wealthy private individual to highrisk ventures
 Investments relatively small (often to companies with fewer than 20 employees)
 May also contribute know-how to new businesses
 Often found through contacts with business associates, accountants, and lawyers
 Guy Kawasaki in The Art of the Start
 Make sure the investors are accredited
 Make sure they’re sophisticated Don’t underestimate them
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 Understand their motivation
 Enable them to live vicariously
 Make your story comprehensible to the angel’s spouse
 Sign up people the angel has heard of
 Be nice
 Venture Capital Firms
 Formal venture capitalists – individuals who form limited partnerships for the
purpose of raising venture capital from large institutional investors
 Receives the right to own a percentage of the entrepreneur’s business
 Few small companies, especially startups, ever receive this kind of funding
7 The Government
Distinguish among the different government loan programs available to small
companies
 The Small Business Administration (SBA) does not loan money but serves as a
guarantor of loans through five basic programs
 The 7(A) Loan Guaranty Program –a loan program that helps small companies
obtain financial through a guaranty provided by the SBA
 The Certified Development Company (CDC) 504 Loan Program – An SBA loan
program that provides long-term financial for small businesses to acquire real
estate or machinery and equipment
 The 7(M) Microloan Program – An SBA loan program that provides short-term
loans of up to $35,000 to small businesses and not-for-profit child-care centers.
 Small Business Investment Companies (SBICs) – Privately owned banks,
regulated by the SMA, that provide long-term loans and/or equity capital to small
businesses.
 The Small Business Innovative Research (SBIR) Program – An SBA program
that helps to finance companies that plan to transform laboratory research into
marketable products.
 State and Local Government Assistance
 Community-Based Financial Institutions – a lender that uses funds from federal,
state, and private sources to provide financial to small businesses in low-income
communities.
8 Where Else to Look
Explain when large companies and public stock offerings can be sources of financing.
 Large Corporations provide funds when their self-interest is involved
 Stock Sales made to outside individual investors through either private placement or
public sales
 Private placement - the sale of a firm’s capital stock to select individuals
 Public Sale (going public)
 Initial public offering (IPO) – the issuance of stock to be traded in public
financial markets
 Common stock may be sold to underwriters
ANSWERS TO END-OF-CHAPTER DISCUSSION QUESTIONS
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Chapter 12
A Firm’s Sources of Financing
1. How does the nature of a business affect its sources of financing?
Four basic factors determine how a firm is financed. First, the economic potential
of the firm has an impact because firms with greater potential for high growth and
high profits will have more financing options than those with projected unattractive
returns. Second, the maturity of the business plays a role, since finding sources of
financing is much more difficult for startups than it is for established firms with a
track record of strong performance. Third, the types of assets held by the firm
makes a difference in financing options, with those holding tangible asset being
able to obtain financing much easier than those whose assets are primarily
intangible in nature. Finally, the preferences of the owners figures in heavily as
they make decisions when there is no right or wrong answer to the question of mix
between debt and equity.
2. How is debt different from equity?
Debt is the money that has been borrowed and must be repaid by some
predetermined date. Ownership equity, on the other hand, represents the owners’
investment in the company – money they have personally put into the firm without
any specific date for repayment.
3. Explain the three trade-offs that guide the choice between debt financing and
equity financing.
The three factors are potential profitability, financial risk, and voting control.
Borrowing money (debt) rather than issuing common stock (owner’s equity)
increases the potential for higher rates of return to the owners. Also, issuing debt
allows the owners to retain voting control of the company. But debt exposes the
owners to greater financial risk. On the other hand, a company that issues stock
rather than increasing debt limits the potential rates of return to the owners and
requires them to give up some voting control in order to reduce risk.
4. Assume that you are starting a business for the first time. What do you believe
are the greatest personal obstacles to obtaining funds for the new venture? Why?
For younger entrepreneurs, age is most likely the greatest personal obstacle. Also,
a lack of previous experience is typically a major obstacle to obtaining funding. A
previous business failure may also handicap funding efforts. Some female
entrepreneurs may feel their gender is an obstacle. In some situations this may still
be true, but conditions are changing rapidly. Having no business plan or a poorly
conceived plan is always a barrier to financing.
5. If you were starting a new business, where would you start looking for capital?
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Answers will vary with each student. However, many students will probably
mention friends and family as sources because these people are easier to talk with
and do represent a good source of funds. Other sources are discussed in the chapter.
Students will not likely change their first choice of family and friends, no matter
what type of business is discussed. Their second and subsequent choices may differ
depending on the business, however. Banks will probably be mentioned frequently,
since students have interaction with these financial institutions almost daily.
6. Explain how trade credit and equipment loans can provide initial capital funding.
Trade credit is funding extended by suppliers when they sell merchandise on credit.
The customary credit period is 30 days. If $100,000 of merchandise is purchased
on credit, the supplier has, in effect, provided the purchaser with $100,000 of funds
(now in merchandise form). The amount of trade credit available to a new firm
depends on the type of business and the suppliers’ confidence in the firm.
Equipment loans are similar to trade credit except that they are for fixed-asset items
usually purchased on an installment basis.
7a. Describe the different types of loans made by a commercial bank.
Line of credit is an informal agreement or understanding between the borrower and
the bank as to the maximum amount of credit the bank will provide the borrower at
any one time. A term loan is money lent on a five- to ten-year term, corresponding
to the length of time the investment will bring in profits. A mortgage represents a
long-term source of debt capital. Mortgages are of two types: chattel mortgages, for
which items of inventory or other moveable property serve as collateral, and real
estate mortgages, which are long-term loans with real estate held as collateral.
7b. What does a banker need to know in order to decide whether to make a loan?
In making a loan decision, a banker always considers the “five C’s of credit”: (1)
the borrower’s character, (2) the borrower’s capacity to repay the loan, (3) the
capital being invested in the venture by the borrower, (4) the conditions of the
industry and economy, and (5) the collateral available to secure the loan. In an
effort to evaluate the five C’s, the banker specifically wants to know:





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If the loan make sense, both for the bank and for the borrower. In other
words, can the loan be priced profitably to the borrower and to the bank, and
is the relationship good for both the customer and the bank?
If the borrower has strong character and ability.
If the cash flows from operations will be the primary source of repayment.
If a secondary source of repayment is available in case the cash flows from
operations are not adequate to repay the loan.
If the loan be properly structured and documented.
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Chapter 12
A Firm’s Sources of Financing
Obtaining a bank loan requires cultivation of a banker and personal selling.
Although a banker’s review of a loan request certainly includes analysis of
economic and financial considerations, this analysis is best complemented by a
personal relationship between the banker and the entrepreneur. This is not to say
that a banker would allow personal feelings to override the facts provided by a
careful loan analysis. But, after all, a banker’s decision as to whether to make a
loan is driven in part by the banker’s confidence in the entrepreneur as a person
and a professional. Intuition and subjective opinion based on past experience
often play a role here.
When seeking a loan, an entrepreneur will be required to provide certain
information in support of the loan request, including the following:
•
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?
Furthermore, a banker will want, if at all possible, to see the following detailed
financial information:
•
Three years of the firm’s historical financial statements, if available, including
balance sheets, income statements, and cash flow statements
•
The firm’s pro forma financial statements (balance sheets, income statements,
and cash flow statements), in which the timing and amounts of the debt
repayment are included as part of the forecasts
•
Personal financial statements showing the borrower’s net worth (net worth =
assets - debt) and estimated annual income. A banker simply will not make a
loan without knowing the personal financial strength of the borrower. After
all, in the world of small business, the owner is the business.
8. Distinguish between informal venture capital and formal venture capital.
The federal government provides financial assistance primarily through the SBA
and SBICs. Among the different types of loans provided by the SBA are direct
loans, participation loans, disaster relief loans, and economic opportunity loans.
The federal government helps indirectly with initial financing by providing
entrepreneurs with information on the subject.
9. In what ways does the federal government help with initial financing for small
businesses?
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The federal government provides financial assistance primarily through the SBA
and SBICs. Among the different types of loans provided by the SBA are direct
loans, participation loans, disaster relief loans, and economic opportunity loans.
The federal government helps indirectly with initial financing by providing
entrepreneurs with information on the subject.
10. What advice would you give an entrepreneur who was trying to finance a startup?
Answers to this question can vary widely, but those offered should conform to the
issues highlighted in the chapter.
COMMENTS ON CHAPTER “YOU MAKE THE CALL” SITUATIONS
Situation 1
1.
What is your impression of Bernstein’s perspective on raising capital “to get to
the next level”?
Bernstein gives the impression that he is looking to a wide variety of sources.
However, typically, anything that is of interest to one type of investor will not be
of interest to another. For example, what a bank would be interested in would not
be of interest to a venture capitalist. Bernstein needs to clarify exactly what he
needs and then focus on sources that are a good fit for that need.
2. What advice would you offer Bernstein as to both appropriate and inappropriate
sources of financing in his situation?
If Bernstein is looking to finance assets that can be used as collateral for a loan,
then a bank or an asset lender might have an interest. However, if $2 million in
debt would overload the company’s debt position, then he needs to find equity
financing. To be an attractive investment for private equity investors, he must
demonstrate that the investors have a chance to earn substantial rates of return—
70% or more per year—and be able to cash out in five to seven years. If he cannot
do that, then he will need to rely on friends and family to help with the financing,
or he may just have to limit the expansion to the firm’s ability to finance the growth
internally.
Situation 2
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Chapter 12
A Firm’s Sources of Financing
1. Compare the two financing options in terms of projected return on the owner’s
equity investment. Ignore any effect from income taxes.
Owner’s return on equity investment = Net income  Owner’s investment
If equity is issued:
Owner’s return on equity investment = ($350,000 × 16%)  $350,000 = 16%
If debt is issued:
Owner’s return on equity investment = ([$350,000 × 16%] – [$200,000 × 6%])
 $150,000 = 29%
2. What if Dalton is wrong and the company earns only 4 percent in operating
income on total assets?
If equity is issued:
Owner’s return on equity investment = ($350,000 × 4%)  $350,000 = 4%
If debt is issued:
Owner’s return on equity investment = ([$350,000 × 4%] – [$200,000 × 6%])
 $150,000 = 1.3%
3. What must Dalton consider in choosing a source of financing?
He has to compare the firm’s expected return on its assets with the interest rate. As
a general rule, as long as a firm’s return on its assets is greater than the cost of the
debt (interest rate), the owner’s return on equity investment will be increased.
Dalton hopes to earn 16 percent on its assets but pay only a 6-percent interest rate
for debt financing. Using debt therefore increases the owners’ opportunity to
enhance the rate of return on the investment.
Situation 3
1. What guidance will you give Smith in negotiating with the bank?
This is a very tough situation and , as it stands, things look very bleak for Smith.
Smith’s only chance might be to re-negotiate the terms and conditions of his loan.
Or, he may see if he can refinance the loan or he may ask for a moratorium on his
loan- allowing him some time to get caught up on his payments.
2. Why might you advise him not to go into a meeting with bank officers with a plan
already in mind?
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He may want to see what the banks have to offer. The bank doesn’t want him to
default on his loan- the bank is motivated to help him succeed. It’s quite likely that
the bank will require that Smith bring in a management team hired by the bank to
oversee the operations of the business and to help turn the company around.
SUGGESTED SOLUTION TO CASE 12: MOONWORKS
1. Describe what a line of credit involves, and explain the legal obligation of a bank to
provide capital with a line of credit.
A line of credit is an informal agreement or understanidng between a borrower and a
bank as to the maximum amount of credit the bank will provide the borrrower at any one
time. The bank has no legal obligation to provide the capital unlike revolving lines of
credit, which do legally commit both sides. Entrepreneurs should arrange for a line of
credit in advance of any actual need as banks are reluctant to spontaneously extend credit.
2. On what three priorities might BankRI representative Matt Weiner have based the
decision to extend Moon Associates’ line of credit or offer additional financing? What
are the “five C’s of credit”?
The five C's of credit are: 1) the borrower's character, 2) the borrower's capacity to
repay the loan, 3) the capital being invested in the venture by the borrower, 4) the
conditions of the industry and economy, and 5) the collateral available to secure the
loan.
3. Even as the remodeling market weakened and taking on extra financing became risky,
what are some things that Moon Associates’ president and CEO Jim Moon did to sustain
the company’s long-term profitability?
They explored other means of generating operating cash. Moon Associates struck a deal
to be the sole southern New England partner – Renewal by Anderson. This partnership,
Moon Associates was positioned to serve its existing customer base with Andersen’s
stylish, energy efficient windows. Moon Associates also called sought out the help of
their banker, BankRI. This long-term relationship stood them well as they were able to
increase their credit line which eased their cash flow situation. Lastly, the company
wisely diversified its product line to include general exterior home replacement products
like roofing and siding as well as insulations and hot water heaters. Moon Associates
changes its name to Moonworks - branding itself as a more comprehensive supplier of
home building materials.
4. Could Moon Associates have obtained the needed capital to not only keep the
company running but expand its Renewal by Andersen line through a
mortgage loan? If so, for how long could such a loan be financed?
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Chapter 12
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It’s possible but this might have been trickier. They already had a line of
credit so convincing the banks to increase this line was an easier task then
seeking out an new (additional) mortgage loan. Also, banks had severely
tightened their lending on these types of loans so the likelihood of Moon
Associates obtaining this type of loan was slim. The duration of these loans
also varies- 10 – 15 years or so on commercial loans.
ACTIVITIES
Purpose: The purpose of the first activity is to give students the opportunity to
interview an entrepreneur within the context of the case material. By investigating
other entrepreneurs’ decisions, students will become aware of their own
entrepreneurial feelings and tendency. The second and third activities help students
streamline the message they deliver when looking for business opportunities or
funding.
Setting it up: Each activity can be done individually, but you can also opt to send
students out to conduct interviews in pairs. The second activity can be used as the
basis of short class presentations. The third activity requires some Internet research,
which you can assign before the next class session and then have students share their
results with the class or in small groups.
1. Arrange for an interview with the owner of a start-up business in your community.
Ask the following questions and share your results with the class.





How did you decide to start [business name], and how did you get funding to get
it off the ground?
How does [business name] make money, and where do you see your growth
coming from in the future?
What do you think is the most important thing you've learned in the course of
developing [business name]?
What advice would you give other entrepreneurs looking to start their own
company?
Ask the business owner to respond to the following quote: If you focus on success,
you won't get there. If you focus on contribution and customer value, then you can
win. --John Doerr, venture capitalist
2. Imagine you’ve just stepped into the elevator of the hotel that is hosting a seminar
you’re attending, “Funding for Continued Growth: Investors Meet One-on-One
with Entrepreneurs.” The venture capitalist you really, really wanted to talk to
about your business venture gets in at the same time. You have about 20 seconds to
make a good impression. “Thank goodness for Jay,” you think. Jay is a friend who
runs an animal training center. Jay always begins business introductions by saying,
“Hi, I’m Jay Doe. I help pet-owners raise likeable pets. I work with people who
want to avoid letting bad behaviors come between them and their friends, but don’t
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know where to start. As a result of working with me, my clients say they enjoy their
pets so much more.” Jay encouraged you to plan out your elevator speech, a 15second introduction of yourself and your company, before coming to the event.
You take a semi-deep breath and start with, “Hello, my name is…”
Use the example above and the three steps below to write a creative elevator speech
to share with the class. A template is provided to get you started.
a) Get someone’s attention. Say who you are and what you can do for others (not
what you do). Get the person to think, “How do you do that?”
b) Tell them about your deliverables. Explain what your product (or service)
provides.
c) Explain your benefits.
“I’m the [occupation/line of work you’re in] that [grab their attention-think up a
“hook” for your line of work]. I specialize in [action verb followed by your
deliverables] for the [target market]. I help [audience types] [benefits].”
3. Jay also encouraged you to have a business plan ready (yours is 30 pages). The
venture capitalist you just met in the elevator gave you her business card, but she
asked you to send over only your executive summary. She’s going to review it and
then call to arrange a time to meet and discuss how she can help you grow your
business. Good thing you have an executive summary that is clear, concise, and
compelling; you really want to make a good first impression and “sell” your
business idea.
Search the Internet for two examples of executive summaries (use the key words
“example executive summary” to get started). Print them out and then compare the
executive summaries you found to the components of an excellent executive
summary listed below. Rate each executive summary from 1 to 5, using a template
like the one below, with 1 indicating that the summary does not incorporate the key
components and 5 for a stellar example of one of the key components. Where
applicable, label the portion of the executive summary with the corresponding letter
of the component it meets.
The executive summary for [business name]:
__a) leads with a compelling statement about why it is qualified to offer a unique
solution to a big problem/opportunity
__b) makes it clear that the problem or opportunity exists and how it plans to solve
it/exploit it
__c) clarifies what it has/what it does to solve/exploit the problem/opportunity
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Chapter 12
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__d) describes its market: how many people/companies, how many dollars, how fast
the growth, what is driving its market segment
__e) states its competitive advantage (unique benefits and advantages)
__f) specifies what levels it will reach in three to five years (how it generates
revenues; how it will be evaluated—customers, units, margin, etc.)
__g) presents a uniquely qualified and winning team or management
__h) outlines a believable summary financial projection
__i) states the amount of funding expected
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