Entrepreneurship and Small Business Management This Photo by Unknown Author is licensed under CC BY-SA-NC

FINANCING STRATEGY: DEBT, EQUITY, OR BOTH? This Photo by Unknown Author is licensed under CC BY-SA-NC

Learning Objectives Explore your financing preferences. Identify the types of business financing. Compare the pros and cons of debt and equity financing. Identify sources of capital for your business. Understand stocks and bonds as investment alternatives.

What Is Financing? The act of providing or raising funds (capital) for a purpose. Ways to finance a business: Obtain gifts and grants. Borrow money (finance with debt). Exchange a share of the business for money (finance with equity). More than half of new firms survive 8 or more years.

Which Type Financing is Best? It depends on risk tolerance. Raising capital to grow: Finance with earnings. Finance with equity. Finance with debt.

Gifts Repayment not required but may come with conditions or “strings attached”. Examples: Cash. Free use of facilities and equipment. Unpaid labor by friends and family. Forgiveness or deferral of debts. Tax abatements—legal reductions in taxes. Tax credits—direct reductions of taxes.

Grants No repayment, but may have specific requirements. Primarily provided for research and commercialization efforts. Difficult for start-up or low-technology companies to obtain. Explore crowdfunding opportunities.

% of Small Firms Using Credit

Debt Financing Promissory note—document that is a written promise to pay a specific sum of money on or before a particular date. Principal—the amount of debt or loan before interest and fees are added.

Forms of Debt Financing Commercial loans—business loans typically provided by a bank. Real estate—up to 20 yrs. Equipment and improvements—up to 7 yrs. Working capital—1 year or less. Asset based—depends on type of asset pledged. Accounts receivable factoring—often 30 days.

Forms of Debt Financing (continued) Personal loans—taken out on personal credit and used for the business. Credit cards—”revolving” terms. Home equity loans—variable terms; some are lines of credit. Title loans—short-term fixed repayment. Payday loans—short-term fixed repayment.

Forms of Debt Financing (continued) Leases—debts incurred for the rights to use specific property. Vehicle leases. Equipment leases. Bonds—long-term debt used to raise large sums of money.

Debt Financing: Pros and Cons Advantages Disadvantages Lenders have no say in business management. Payments are predictable. Payments can be set up to coincide with seasonal sales. Lenders have no share in business profits. Lenders can force bankruptcy. Lenders can take owner’s home and possessions. Payments increase fixed costs, lowering profits. Repayment reduces available cash. Lenders expect financial reporting and compliance.

Equity Financing In return for money, an investor receives a percentage of ownership in a company. The investor hopes that the investment will provide a high rate of return.

Equity Financing: Pros and Cons Advantages Disadvantages Giving up too much ownership may lead to loss of business control. Investors may interfere with the business. Investors may want to influence business management and receive higher rate of return. Investors share in profits. If no profit is made, investors are not paid. There are no required regular payments of principal or interest. Investors cannot force bankruptcy. Investors may provide valuable advice and contacts.

Bankers Operate on the Five Cs of Credit Collateral—property or assets that lender can take if loan is not repaid. Character—measured by your ability to borrow and your credit history. Capacity—sufficient business cash flow. Capital—personal resources invested. Conditions—industrial/economic “climate”.

Creditworthiness

Community Development Financial Institutions (CDFIs) Lenders that share a vision of expanding economic opportunity and improving quality of life for low-income communities. Four sectors: Community development banks (CDBs). Community development credit unions (CDCUs). Community development loan funds (CDLFs). Community development venture capital funds (CDVCs).

Venture Capitalists Investors or investment companies seeking equity. Expect 6-10 times their money back over 5 years, or a 45% rate of return. Desire candidates likely to generate at least $50 million in sales within 5 years. Sometimes seek a majority interest.

Angels Wealthy, private individual investors. Usual investment is between $100,000 and $500,000. Typically seek a return of 10 times the investment at the end of 5 years. Best strategy: recruit one angel who finds others.

Other Financing Options Insurance companies provide loans based on the surrender value of a policy. Vendor financing is achieved by extending the “float” time between receiving bills and paying bills. Federally supported investment companies provide loans to minorities, rural enterprises, and small businesses in low-income geographic areas.

Other Financing Options (continued) U.S. Department of Agriculture—provides assistance to rural/agricultural businesses. Bootstrap financing—creative ways of “stretching” existing capital resources. Networking via the Internet can help identify financing options.

Three Categories of Investment Stocks—shares of companies (equity). Bonds—loans (debt) to companies or government entities. Cash—investments easily liquidated (turned into cash) within 24 hours, such as savings accounts and treasury bills. High Risk = High Reward Low Risk = Low Reward

Stocks Shares of stock represent a percentage of ownership in a corporation. Public corporations sell stock to the general public to raise capital. Stock prices reflect investors’ opinions about business performance and value. Investors make money by selling stock at a price higher than the one they paid.

Bonds Interest-bearing certificates that corporations and governments issue to raise capital. Have a lower risk and lower return expected than stocks. A form of debt financing with a specific rate of return to investors. Pay a yearly interest rate semi-annually to bondholders until maturity when they are redeemable at face value.