Download Financing a Small Business 4.00 Explain the fundamentals of

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 savings
a. Advantages:
1) Owner keeps all the profits
2) Owner’s risk of loss provides
motivation to succeed.
b. Disadvantages:
1) Creates chance of loss
2) Causes personal sacrifice
3) Causes loss of return from use of
savings
4) Carries unlimited liability
2. Friends and relatives (Love Money)
a. Advantages:
1) Provides quick and easy source of funds.
2) Allows less formal arrangements
3) Imposes fewer restrictions
b. Disadvantages:
1) Creates chance of loss
2) Causes possible loss of return from use of savings
3) Carries unlimited liability
3. Partners with people or with other companies
having compatible goods.
a. Advantages:
1) Brings in more cash
2) Shares financial risks and responsibilities
3) Increases borrowing power
b. Disadvantages:
1) Requires giving up a portion of profits
2) 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 live
2) Will finance start-up businesses
b. Disadvantages:
1) Not easy to locate
2) 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 money
2) Allow owner to maintain control and operation of the
business
3) Provide for additional assistance
b. Disadvantages:
1) Most businesses do not qualify
2) Entrepreneur must give up part of ownership
3) 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 Jobs
2) Do not focus solely on profits
b. No Disadvantages!
1.
Advantages:
a.
b.
c.
d.
2.
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:
a.
b.
c.
d.
Higher interest rates
Risk of insufficient profit to cover repayment
Easy to abuse and overuse
Restrictions and limitations imposed by the lender
3.
Sources:
a. Banks
1) Most common source of business financing
2) 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 Venders
1) Short-term financing
2) Credit from within the industry or trade
c. Finance companies
1) Take more risks than banks
2) Are more expensive than banks
3) 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 free
3) 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 SBA
b) Provide funding to businesses whose ownership is at
least 51% minority, female or disabled.
3)
Small Business Investment Companies (SBIC’s)
1) Licensed by SBA
2) Provided equity and debt financing to young
businesses
3) Invest about twice as often in start-up ventures as do
venture capitalists
4) Privately owned
5) 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 Commerce
b) Lends money to businesses that operate in and benefit
economically distressed parts of the country
c) 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 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 Loans
1) 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 past
b. Good credit rating
c. 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. Risk
a. 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. Control
a. 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 Funding
a. 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.