Financial instruments
Ways to finance your small business
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Finances
 One of the crucial aspect of every business is how to
finance it – either when you start, when you want to grow
or when you face business difficulties
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Ways to get financed
 Debt – various types of borrowing
- Friends, Family and Fools, Banks, Leasing, Factoring, Other
 Equity – giving up certain portion of your ownership in the
company (by issuing ordinary (common) or preferred
stocks or by incorporating partners)
- Business Angels, Venture capitalists, Friends, Family and
Fools
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Debt vs. Equity
EQUITY
DEBT
PROS
PROS
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Retain ownership in company
Considered cheaper than equity financing
If firm has assets (collateral) it can raise
cheaper long-term loans
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CONS
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More risky (it becomes your fixed cost!)
Lack of collateral or poor earnings history –
no money or borrowing with high interest
rates!
It has to be returned
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no interest to return, no obligation to repay
back
Improving credithworthiness
Equity money can be used as collateral
Shareholders may use their personal earnings
history to raise bank loans
Good networking possibilities (especially for
start-ups)
CONS
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Giving up piece of the ownership in the
company
Have to answer to someone else
Most expensive way of financing (each
investor receives a percentage of total value
of the company)
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Rule of the thumb
 “Whether the price of the money is 2 percent or 20
percent, it should always be lower than the return you
expect from spending it. That is to say, don't invest money
in any project that won't generate enough profit to more
than cover the loan payments, including interest.”
David Worrell, Entrepreneur magazine online edition, 2006
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Types of debt financing
 Friends, Family, Fools (3F)
 Banks
 Leasing
 Factoring
 Other
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Friends, family, fools (3F)
 Perhaps the best way to borrow, with minimum interest rates (or
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none)
Higher level of sympathy and ready to wait for the money to be
returned
Are sometimes eager to interfere in your business and give you
advice whether you want it or not
Might ask to become partners or partial owners – rarely, but it
happens!
Be sure to clarify things in written agreement, since memories tend
to get fuzzy over time!
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Banks
 Entrepreneurs are usually high risk clients for banks, unless they
have a solid collateral (e.g. Fixed assets) and a good credit history
 Banks will also look closely at your cash flows, liquidity of your assets
and a solid business plan
 Short-term loans – credit card loans, overdrafts (line of credit)– high
interest rates – most commonly use for smaller investments and
short-term lack of cash
 Long-term loans – lower interest rates, but demand solid collateral
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Credit cards
 It has become increasingly common among entrepreneurs
(almost 50% of entrepreneurs have used it once in their
business)
 More easily available money than regular bank loan, no
justificiations required on how you will spend it, no business
plan needed to back up your claim
 Beware of the high interest rates
 Demands discipline in spending
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Line of credit (overdraft)
 a flexible loan from a bank or financial institution to an individual or
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business.
a line of credit is a limited/specified amount of money that an individual
can access as needed and then repay immediately or over a pre-specified
period of time.
As a loan, a line of credit will charge interest as soon as money is borrowed,
and borrowers must be approved by the bank. If you don’t use it, no
interest is charged
Useful for shortages of cash, so best to apply for it when sufficient funds are
on your bank account
Interest is higher than in regular bank loans
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Long-term loans
 Require some kind of collateral – mortgage
 Two types of mortgage – chattel (inventory or movable
property serves as collateral and owner cannot sell it
without bank’s permission) and real estate (immobile
property – house, flat etc.)
 Lower interest rates, but it demands solid business plana
and purpose of spending is set,
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Before you apply for loan
 Check yourself – if you have personal track record of late payments, chances of
getting a loan are slim
 Check your business – have you been blocked, are you paying taxes and other
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obligations, how are your cash flows and overall business results
What assets do you own – check what do you own, and are you willing to put is a
collateral to secure loan
Whom do you know – does your banker know you? Do they know your business?
Personal touch can be of great help in advocating for your loan!
How much do you need – are you purchasing equipment or seeking cash cushion.
What would be the ideal? What would be minimum?
How will you pay it back - Put together a realistic plan of action for improving the
cash flow in your business and paying back the debt. Identify your marketing
strategy and projected sales results over an expected time frame.
Source: O'Berry, D. 2007.„Finding and Keeping Cash in Your Company“, in Small Business Cash Flow: Strategies for Making Your
Business a Financial Success, USA: John Wiley and Sons, p.49-50
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Leasing
 Good way to obtain an asset without necessarily owning
it (used for buying equipment, vehicles etc.)
 Types:
- Operating
- Financial (Capital)
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Operating leasing
 Allows the use of item without getting ownership.
 Legal and economic owner is leasing agency – takes all risks,
user can return the item after the leasing contract has expired
 Used for short-term leases (e.g. Copy machine, Office
equipment, Computers etc.)
 Lesee (the person who is leasing) pays monthly instalments
including VAT – calculate it in operating expenses as rental
expenses
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Financial (capital) leasing
 used for long-term leases and for items that not become
technologically obsolete, e.g. machinery.
 give the lessee the economic ownership and risk, so they
are considered as assets, and they may be depreciated.
 In general, the items leased are shown in lesees Balance
sheet (Asset/Debt), and depreciation plus cost of interest
go to operating costs (in Income statement)
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Factoring
 Short-term debt, where Factor buys up accounts
receivables and takes % factor fee
 In theory, 70-90% of the amount is paid immediately, and
10-30% after the receivables have been collected
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Other
 Merchant credit – delayed payment to suppliers (based on
contracts signed, e.g. 30-60 days waiting period)
 Grants and credits from non-banking institutions (state
and local municipality)
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Equity
 Entrepreneurs – owners use this option when:
- They don’t mind losing part of their control to the others
- Cash flows are not sufficient to cover existing debt
- Credit history and collateral is not sufficient to raise bank
loans
- Bank loans (amounts) do not cover necessary investment
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The usual sources of equity financing
 Business angels
 Venture capitalists
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Business angels
 Succesful entrepreneurs (or entrepreneurial associations)
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willing to invest money
Work alone or in syndicates
Will invest in start-ups and young companies – will also
provide managerial advice and networking opportunities
Invest up to 1 mil euros, but in average around 50.000 –
100.000 euros for period of 2-10 years
Expect 15-45% return
“Patient money”
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Business angels - Methods of working
 Different from country to country
 Either borrow you money (debt) or ask to form new
company where they enter as partners
 Issuing of stocks – either as private placement (directly
sell stocks to business angels and do not place them on
stock exchange – cheaper and simpler) or going public
(Initial public offering – IPO – stocks are offered as stock
exchange – expensive and more complex)
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Venture capitalists
 Institutional firms raising a pool of capital from different
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sources (including business angels)
Used for big investments, 1-30 mil euros
Usually invest in high-growth, more mature companies
(experts do not recommend it for start-ups)
Demand good management, solid revenues and cash flows,
good business plan and their own EXIT strategy
Expect high returns in 3-5 years
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Methods of working
 They never enter the company without good exit strategy
– will ask for public stock offering (IPO)
 Will appoint someone to the supervisory board and will in
most cases ask for prefered stocks (it pays dividends and
has preference in case of liquidation)
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