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 • 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.
Entrepreneurial characteristics needed to obtain financing • (6 C’s of Credit) • 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.