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.

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

b. 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.

1. Personal savingsa. Advantages:

1) Owner keeps all the profits2) Owner’s risk of loss provides

motivation to succeed.b. Disadvantages:

1) Creates chance of loss2) Causes personal sacrifice3) Causes loss of return from use of

savings4) Carries unlimited liability

2. Friends and relatives (Love Money)a. Advantages:

1) Provides quick and easy source of funds.2) Allows less formal arrangements3) Imposes fewer restrictions

b. Disadvantages:1) Creates chance of loss2) Causes possible loss of return from use of savings3) Carries unlimited liability

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

a. Advantages:1) Brings in more cash2) Shares financial risks and responsibilities3) Increases borrowing power

b. Disadvantages:1) Requires giving up a portion of profits2) Results in the loss of some control and

ownership

4. 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.

a. Advantages: 1) Invest in region in which they live2) Will finance start-up businesses

b. Disadvantages:1) Not easy to locate2) Must be chosen carefully and may not always be a

reliable source

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

a. Advantages:1) Provide large amounts of money2) Allow owner to maintain control and operation of the

business3) Provide for additional assistance

b. Disadvantages:1) Most businesses do not qualify2) Entrepreneur must give up part of ownership3) Small businesses may have trouble attracting venture

capitalists.

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

a. Advantages:1) Create Jobs2) Do not focus solely on profits

b. No Disadvantages!

1. Advantages:a. Relatively easy and quick to obtainb. Maintain control and ownership of the businessc. Repay at a more advantageous timed. Tax deduction for interest and related costs

2. Disadvantages:a. Higher interest ratesb. Risk of insufficient profit to cover repaymentc. Easy to abuse and overused. Restrictions and limitations imposed by the lender

3. Sources:a. Banks

1) Most common source of business financing2) 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.

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

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

5) Usually require some kind of collateral.

b. Trade Credit through Venders1) Short-term financing2) Credit from within the industry or trade

c. Finance companies1) Take more risks than banks2) Are more expensive than banks3) Will ask for some form of security like the

entrepreneur’s home, accounts receivable, or business inventories.

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

e. Personal loan from a family member or friend:1) Terms of the repayment may be quite flexible.2) Interest rate may be low or the loan might be

interest free3) Mixing financial affairs with family/friend

relationships may cause problems.

f. 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.

1) Small Business Administration (SBA)a) Uses a commercial bank to process and release

the money and guarantees up to 90% of the loan if the business fails.

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

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

a) Established by the SBAb) Provide funding to businesses whose ownership is at

least 51% minority, female or disabled.3) Small Business Investment Companies

(SBIC’s)1) Licensed by SBA2) Provided equity and debt financing to young

businesses3) Invest about twice as often in start-up ventures as do

venture capitalists4) Privately owned5) Requirements vary

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

5) The Economic Development Administration (EDA)

a) Division of the U.S. Department of Commerceb) Lends money to businesses that operate in and benefit

economically distressed parts of the countryc) Similar to SBA, but more restricted

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

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

D. Process for getting a loanD. Process for getting a loan

1. Steps in getting a loan:a) Select the bank carefully.

b) Prepare financial statements and a business plan.

c) Make an appointment.

d) Prepare to answer questions.

2. Types of loans available

a. Secured Loans1) Short-term loans: Must be paid back

within one year. 2) Lines of credit: Repayable over a period

longer than a year.3) Lines of credit: Agreement made by the

bank to lend money at a stated rate of interest for whenever the owner needs it.

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

E. Entrepreneurial characteristics needed to obtain financing

(6 C’s of Credit)

1. 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.a. Responsibility by showing bills paid in the pastb. Good credit ratingc. Good reputation

2. Capacity

a. Evidence of the ability to repay the debt.

b. Legally eligible to enter into contracts.

3. Capital

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

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

4. Collateral:

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

5. Conditions:

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

6. Coverage:

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

F. Factors to consider when choosing a financial plan

1. Riska. 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.

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

2. Controla. Entrepreneurs often lose control of

decision-making power with the use of equity funds.

b. Debt funds do not involve this loss of control.

3. Availability of Fundinga. The entrepreneur’s credit history or

earning potential can help or might eliminate him/her from securing a debt loan.

b. Equity sources might not be readily available.