1. PowerPoint Presentation by Charlie Cook The University of West Alabama Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. Part 3 Developing the New Venture Business Plan The Financial Plan, Part 2: Finding Sources of Funds

2. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–2 Looking Ahead After studying this chapter, you should be able to: 1. Describe how the nature of a firm affects its financing sources. 2. Evaluate the choice between debt financing and equity financing. 3. Identify the typical sources of financing used at the outset of a new venture. 4. Discuss the basic process for acquiring and structuring a bank loan. 5. Explain how business relationships can be used to finance a small firm.

3. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–3 Looking Ahead (cont’d.) 6. Describe the two types of private equity investors that offer financing to small firms. 7. Distinguish among the different government loan programs available to small companies. 8. Explain when large companies and public stock offerings can be a source of financing.

4. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–4 The Nature of a Firm and Its Financing Sources Factors That Determine Financing –Firm’s economic potential Growth prospects and long-term profitability –Company size and maturity Life-cycle position in business –Types of assets Tangible or intangible –Owner preferences for debt or equity Tradeoffs required for debt and equity

5. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–5 Debt or Equity Financing? Potential Profitability –Borrowing increases potential for higher rates of return on owners’ equity; exposes firm to more financial risk Return on Assets –Rate of return earned on a firm’s total assets invested, computed as operating income ÷ total assets Return on Equity –Rate of return earned on the owner’s equity investment, computed as net income ÷ owner’s equity investment

6. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–6 Exhibit 11.1 Tradeoffs Between Debt and Equity

7. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–7 Exhibit 11.2 Debt Versus Equity at the Levine Company All Equity: Owners keep all profits in return for accepting the risk of lower returns. Debt is Risky: Lenders have first claim on profits and must be paid even if there are no profits.

8. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–8 Debt or Equity Financing? (cont’d.) Financial Risk –Investing more owner equity limits potential return on equity; lowers financial risk for firm. Voting –Increasing equity through borrowing requires owners to share control with external investors.

9. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–9 Exhibit 11.3 Sources of Funds

10. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–10 Startup Financing for Inc. 500 Companies in 2003 Source: Mike Hofman, “The Big Picture,” Inc., Vol. 25, No. 12 (October 2003), p. 87. Exhibit 11.4

11. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–11 Debt or Equity Financing? (cont’d.) Sources Close to Home –Personal savings Owner equity is expected by other investors. –Family and friends Borrowing puts personal relationships at risk. –Credit cards Provides immediate access to funds and assets; cards should be method of payment and not a source of credit.

12. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–12 Sources of Personal Capital for Small Firms Exhibit 11.5 Source: “Entrepreneurship Monitor 2002,” Wall Street Journal, August 26, 2003, p. B8.

13. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–13 FinancingFinancing Commercial Banks –Line of credit Maximum amount that bank will permit the firm to borrow –Revolving credit agreement The maximum amount a bank is committed to lend a firm on an ongoing basis –Term loans Loans for 5 to 10 years to finance equipment

14. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–14 Financing (cont’d.) Commercial Banks (cont’d.) –Chattel mortgage A loan collateralized by inventory or movable property –Real estate mortgage A long-term loan with real property held as collateral

15. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–15 The Banker’s Perspective Bankers’ Concerns –How much the bank will earn on the loan? –What is the likelihood that the lender will be able to repay the loan? The Five Cs of Credit –Character of the borrower –Capacity of the borrower to repay the loan –Capital invested in the venture by the borrower –Conditions of the industry and economy –Collateral available to secure the loan

16. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–16 Questions Lenders Ask Lender’s Questions –Do the purpose and amount of the loan make sense, both for the bank and for the borrower? –Does the borrower have strong character and reasonable ability? –Does the loan have a certain primary source of repayment? –Does the loan have a certain secondary source of repayment? –Can the loan be priced profitably to the customer and to the bank, and are this loan and the relationship good for both the customer and the bank? –Can the loan be properly structured and documented?

17. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–17 The Banker’s Concerns How much money is needed? What is the venture going to do with the money? When and how will the money be paid back? When will the money be needed?

18. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–18 Financial Information Required for a Bank Loan Three years of the firm’s historical statements –Balance sheets, income statements, and statements of cash flow The firm’s pro forma financial statements –The timing and amounts of the debt repayment included as part of the forecasts Personal financial statements –The borrower’s personal net worth (assets – debts) and estimated annual income

19. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–19 Negotiating a Loan: Interest Rate Prime Rate –The interest rate charged by a commercial bank on loans to its most creditworthy customers LIBOR (London InterBank Offered Rate) –The interest rate charged by London banks on loans to other London banks Fixed Interest Rate –Interest rate remains the same for the term of the loan Floating Interest Rate –Interest rate varies with the changes in the prime rate

20. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–20 Negotiating a Loan: Term of the Loan Loan Maturity Date –Maturity date should match use of funds Repayment Schedule –Equal monthly or annual payments –Decreasing monthly or annual payments Loan Covenants –Bank-imposed restrictions on a borrower that enhance the chances of timely repayment Filing of financial statements, restriction of salaries and personal loans, limits on financial ratios, requiring personal loan guarantees beyond the owner’s limited liability

21. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–21 Business Suppliers and Asset-Based Lenders Trade Credit (Accounts Payable) –Financing provided by a supplier of inventory to a company, which sets up an account payable for the amount Short-duration financing (30 days) Amount of credit available is dependent on type of firm and supplier’s willingness to extend credit

22. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–22 Business Suppliers and Asset-Based Lenders (cont’d.) Equipment Loan and Leases –Installment loan (mortgage on equipment) from the seller of machinery purchased by a business –Equipment leased from a supplier: Frees up cash for other purposes Leaves lines of credit open Provides a hedge against obsolescence

23. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–23 Business Suppliers and Asset-Based Lenders (cont’d.) Asset-Based Loan –A line of credit secured by working-capital assets Factoring –Obtaining cash by selling accounts receivable to another firm Accounts are sold to factor at a discount to invoice value Factor can refuse questionable accounts Factor charges fees for servicing accounts and for amount advanced to firm prior to collection

24. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–24 Private Equity Investors Informal Venture Capital –Funds provided by wealthy private individuals (business angels) to high-risk ventures Formal Venture Capitalists –Individuals who form limited partnerships for the purpose of raising venture capital from large institutional investors The firm’s expected profits in future years The venture capitalist’s required rate of return

25. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–25 Government-Sponsored Programs and Agencies Small Business Administration (SBA) loans –7 (a) Guaranty loan SBA guarantees repayment of loan to lender –The Certified Development Company (CDC) 504 Loan Program –The 7(m) Microloan Program –Small Business Investment Companies (SBICs) –Small Business Innovative Research (SBIR)

26. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–26 Government-Sponsored Programs and Agencies (cont’d.) State and Local Government Assistance –Loan guarantees –Set asides for minority business development Community-Based Financial Institutions –Lenders that provide financing to small businesses in low-income communities for the purpose of encouraging economic development

27. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–27 Where Else to Look Large Corporations –Financing and technical assistance to critical suppliers and technology developers Stock Sales –Private placement The sale of a firm’s capital stock to selected individuals –Initial public offering (IPO) The issuance of stock that is to be traded in public financial markets Places firm under SEC securities regulations

28. Copyright © 2006 Thomson Business & Professional Publishing. All rights reserved. 11–28 Key Terms return on assets return on equity line of credit revolving credit agreement term loan chattel mortgage real estate mortgage prime rate LIBOR (London InterBank Offered Rate) balloon payment loan covenants limited liability accounts payable (trade credit) equipment loan asset-based loan factoring informal venture capital business angels formal venture capitalists 7(a) Loan Guaranty Program Certified Development Company (CDC) 504 Loan Program 7(m) Microloan Program small business investment companies (SBICs) Small Business Innovative Research (SBIR) Program community-based financial institution private placement initial public offering (IPO)