Financing a Small Business
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Financing a Small Business. 4.00 Explain the fundamentals of financing a small business. 4.02 Discuss sources used in financing a small business. How are you going to finance a small business?.

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Financing a Small Business

4.00 Explain the fundamentals of financing a small business.

4.02 Discuss sources used in financing a small business.

How are you going to finance a small business?

1. Equity sources: Money or capital contributed by owners; capital sources that trade cash for some portion of ownership or equity in a business.

  • Equity is sometimes called Risk Capital because the investor puts his/her money at risk.

  • Since the investor acquires ownership in the business, no repayment of money with interest is required.

How are you going to finance a small business?

2. Debt sources: Money or capital that is borrowed and must be paid back with interest.

Equity sources

  • Personal savings

    • Advantages:

      • Owner keeps all the profits

      • Owner’s risk of loss provides motivation to succeed.

    • Disadvantages:

      • Creates chance of loss

      • Causes personal sacrifice

      • Causes loss of return from use of savings

      • Carries unlimited liability

Equity sources

  • Friends and relatives (Love Money)

    • Advantages:

      • Provides quick and easy source of funds.

      • Allows less formal arrangements

      • Imposes fewer restrictions

    • Disadvantages:

      • Creates chance of loss

      • Causes possible loss of return from use of savings

      • Carries unlimited liability

Equity sources

  • Partners with people or with other companies having compatible goods.

    • Advantages:

      • Brings in more cash

      • Shares financial risks and responsibilities

      • Increases borrowing power

    • Disadvantages:

      • Requires giving up a portion of profits

      • Results in the loss of some control and ownership

Equity sources

  • Private investors (Angels): Wealthy individuals functioning as non-professional investors who are willing to invest in local businesses for financial or emotional reasons and who sometimes prefer to remain anonymous.

    • Advantages:

      • Invest in region in which they live

      • Will finance start-up businesses

    • Disadvantages:

      • Not easy to locate

      • Must be chosen carefully and may not always be a reliable source

Equity sources

  • Venture capitalists: Individuals or firms that invest money professionally to make money, expect a large capital gain, and look for high growth potential.

    • Advantages:

      • Provide large amounts of money

      • Allow owner to maintain control and operation of the business

      • Provide for additional assistance

    • Disadvantages:

      • Most businesses do not qualify

      • Entrepreneur must give up part of ownership

      • Small businesses may have trouble attracting venture capitalists.

Equity sources

  • State-sponsored venture capital funds: Funds provided to entrepreneurs by the state in an effort to encourage economic development and creation of jobs.

    • Advantages:

      • Create Jobs

      • Do not focus solely on profits

    • No Disadvantages!

Debt Financing

  • Advantages:

    • Relatively easy and quick to obtain

    • Maintain control and ownership of the business

    • Repay at a more advantageous time

    • Tax deduction for interest and related costs

  • Disadvantages:

    • Higher interest rates

    • Risk of insufficient profit to cover repayment

    • Easy to abuse and overuse

    • Restrictions and limitations imposed by the lender

Debt Financing

  • Sources:

    • Banks

      • Most common source of business financing

      • A line of credit that allows the businesses to borrow a stated amount of money at a stated interest rate to use as the business chooses.

      • Require that money be paid back on a regular basis according to the repayment plan specified.

      • Very conservative and not inclined to lend to businesses that are not well established.

      • Usually require some kind of collateral.

Debt Financing

  • Trade Credit through Venders

    • Short-term financing

    • Credit from within the industry or trade

  • Finance companies

    • Take more risks than banks

    • Are more expensive than banks

    • Will ask for some form of security like the entrepreneur’s home, accounts receivable, or business inventories.

Debt Financing

  • Credit Unions: Cooperatives formed by labor unions or employees for the benefit of the members.

  • Personal loan from a family member or friend:

    • Terms of the repayment may be quite flexible.

    • Interest rate may be low or the loan might be interest free

    • Mixing financial affairs with family/friend relationships may cause problems.

Debt Financing

  • Government agencies: Operated by the government to provide technical assistance, counseling, grants, or other means of financial assistance in the form of low-interest loans.

    • Small Business Administration (SBA)

      • Uses a commercial bank to process and release the money and guarantees up to 90% of the loan if the business fails.

      • Also lends public funds to veterans and handicapped persons who qualify.

Debt Financing

  • Minority Enterprise Small Business Investment Companies (MESBIC’s)

    • Established by the SBA

    • Provide funding to businesses whose ownership is at least 51% minority, female or disabled.

  • Small Business Investment Companies (SBIC’s)

    • Licensed by SBA

    • Provided equity and debt financing to young businesses

    • Invest about twice as often in start-up ventures as do venture capitalists

    • Privately owned

    • Requirements vary

Debt Financing

  • Department of Housing and Urban Development (HUD): Provides grants to cities to lend money to private developers to help improve impoverished areas.

  • The Economic Development Administration (EDA)

    • Division of the U.S. Department of Commerce

    • Lends money to businesses that operate in and benefit economically distressed parts of the country

    • Similar to SBA, but more restricted

Debt Financing

  • State Governments: Most states have economic development agencies and finance authorities that make or guarantee loans to small businesses.

  • Local and municipal governments: Sometimes make small loans of $10,000 or less.

D process for getting a loan
D. Process for getting a loan

  • Steps in getting a loan:

    • Select the bank carefully.

    • Prepare financial statements and a business plan.

    • Make an appointment.

    • Prepare to answer questions.

2. Types of loans available

  • Secured Loans

    • Short-term loans: Must be paid back within one year.

    • Lines of credit: Repayable over a period longer than a year.

    • Lines of credit: Agreement made by the bank to lend money at a stated rate of interest for whenever the owner needs it.

  • Unsecured Loan: a loan that is not guaranteed by collateral.

  • Character: The need to believe in the character of the entrepreneur and the people with whom he or she is associated, including the management team of the business.

    • Responsibility by showing bills paid in the past

    • Good credit rating

    • Good reputation

  • Capacity

    • Evidence of the ability to repay the debt.

    • Legally eligible to enter into contracts.

  • Capital

    • Demonstrated ability and willingness to invest personally in the business venture.

    • Evidence of a good financial plan with little outstanding personal debt.

  • Collateral:

    Something of value that the lender can claim if the debt is not repaid.

  • Conditions:

    The bank will consider all of the environmental conditions such as competition, growth, location, and economic outlook in which the business will operate.

  • Coverage:

    The bank will want to know what kind of insurance coverage the entrepreneur has.

F. Factors to consider when choosing a financial plan

  • Risk

    • There is a greater risk of loss with debt funds since the entrepreneur must repay the loan in accordance with the terms or risk losing the business, collateral, or even personal possessions.

    • There is less risk for the entrepreneur with equity funding since no repayment is required.

  • Control

    • Entrepreneurs often lose control of decision-making power with the use of equity funds.

    • Debt funds do not involve this loss of control.

  • Availability of Funding

    • The entrepreneur’s credit history or earning potential can help or might eliminate him/her from securing a debt loan.

    • Equity sources might not be readily available.