Sources of Funds How much start-up funds are neededHow much start-up funds are needed Sources of financingSources of financing

How Much Money? More, more, more!More, more, more! –Insufficient capital an important factor in business failure Reasons for insufficient capitalReasons for insufficient capital –Shoestring financing –Underestimation of costs –Failure to consider initial operating losses Need to know amount to request financingNeed to know amount to request financing

Elements of Start-up Cost Furniture, Fixtures and EquipmentFurniture, Fixtures and Equipment –Useful to obtain price quotes and contact vendors well in advance –Used equipment will often be available –Include additional amounts for cost overrunscost overruns unforeseen equipment needsunforeseen equipment needs Rent deposit months advanceRent deposit months advance

Start-up Costs Advertising and promotionAdvertising and promotion –Initial advertising will be critical to the success of the business –Yellow pages and similar ads are expensive –Quality web site can be expensive to set up and maintain

Start-up Costs - Inventory Initial inventory stock constitutes one of the major initial outlays of the business Amount depends on product lines, turnoverAmount depends on product lines, turnover Some may be financed by supplierSome may be financed by supplier Estimating Requirements: 1. Annual COS/Inv. Turnover or monthly COS x months sales or monthly COS x months sales in inventory in inventory 2. Estimate based on similar firms (note potential for seasonal fluctuations) (note potential for seasonal fluctuations)

Estimating Inventory Example: Estimate annual sales $100,000 Estimated annual COS 60,000 Estimated turnover  4 Estimated required inv. 15,000 (60,000 / 4) Or Monthly COS (60,000/12) 5,000 Number of months in inv. (12/4) x 3 Estimate required inv. 15,000

Start-up Costs - Accounts Receivable Accounts receivable is another asset which must be financed. –Applies if business sells on credit –Initial sales won’t become a cash inflow until collected –Current accounts receivable generally makes very good collateral for bank loans

Start-up Costs - Working Capital Business will need an additional 1-3 months operating costBusiness will need an additional 1-3 months operating cost –Cushions against losses and unforeseen expenses ContingencyContingency –Additional reserve for unexpected costs

Cost Amount Source EquipmentRemodeling Rent deposit Utility deposits Legal, etc. AdvertisingInventory Accts. Rec. Work. cap Contingency Total Total

Sources of Funds Many businesses start with relatively modest investmentsMany businesses start with relatively modest investments –Once established, it is easier to borrow You will be a primary source of fundsYou will be a primary source of funds –Allows you to maintain complete control over business –Difficult to borrow –Lenders expect to see some of your money on the line

Family and Friends May be the only source availableMay be the only source available –Relatively easy to obtain Structuring the arrangementStructuring the arrangement –Debt preferred No loss of controlNo loss of control Interest deductibleInterest deductible –Equity Need to find a way toNeed to find a way to provide compensation provide compensation

Venture Capital and Angels Unless your venture is sufficiently large, and promising, venture capital not likely to be interestedUnless your venture is sufficiently large, and promising, venture capital not likely to be interested Some individual investors (“angels”) may be interestedSome individual investors (“angels”) may be interested –For either type of financing, a formal business plan, with well- developed projections, will be necessary

Bank Financing In general, the bank won’t be a significant source of start-up financingIn general, the bank won’t be a significant source of start-up financing –May finance portion of receivables and inventory –Necessary to first seek bank financing for SBA loans

Working Capital Financing Line-of-creditLine-of-credit –Most businesses will want to establish a credit arrangement for seasonal needs –Will normally finance 70-80% of current accounts receivable Factoring - Sale of accounts receivableFactoring - Sale of accounts receivable –Common in clothing industry –Factor may provide credit function –May be with or without recourse (your responsible if not paid) Suppliers for inventorySuppliers for inventory

Debt Versus Equity If return on assets exceeds cost of debt, owner return on equity will increase as the firm uses more debt (p. 238 of text) (p. 238 of text) Debt is also preferred because it does not involve loss of ownership controlDebt is also preferred because it does not involve loss of ownership control Debt is risky - it also increases downside riskDebt is risky - it also increases downside risk

Debt vs. Equity Example Equity Debt Equity Debt Operating income $28,000 $28,000 Interest ($100,000 x 10%) 0 10,000 Net income 28,000 18,000 ROI (NI/Equity) 14% 18% (28k/200k) (18/100k) (28k/200k) (18/100k) Original owner’s share 19,600 18,000 of income (70%) (100%) of income (70%) (100%)

Preparing for Financing How much do you need?How much do you need? Cash flow projectionsCash flow projections –Adequate to meet debt service Evidence of a marketEvidence of a market Don’t hide the negativesDon’t hide the negatives

The Five C’s of Credit 1. The borrower’s character 2. The borrower’s capacity to repay the loan 3. The capital being invested in the venture by the borrower by the borrower 4. The conditions of the industry and economy 5. The collateral available to secure the loan

Walker Machine Works Prop 1 Prop 2 Prop 3 Prop 1 Prop 2 Prop 3 Person Williams Thomas Davis Relation None Friend Prof Father Father Background Hydraulics Real est. Mktg. Involvement Active Advice Advice Equity split Financing 9,000 9,000+ 9,000+