A Firm s Sources of Financing

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1 CHAPTER OUTLINE Spotlight: Just Send Cash 1 The Nature of a Firm and Its Financing Sources Describe how the nature of a firm affects its financing sources. A Firm s Economic Potential Potential for high growth and large profits has more sources of financing Company Size and Maturity Direct bearing on types of financing available Larger and older firms as opposed to smaller firms Venture capitalists limit how much they will invest in startup companies Types of Assets Two types considered when evaluating a loan Have students discuss the difference between the two types of assets. Tangible assets Intangible assets Owner Preferences for Debt or Equity Discuss why an owner might choose each type of financing as well as the disadvantages of the two types for the owner. 2 Debt of Equity Financing? Evaluate the choice between debt financing and equity financing. Potential Profitability Rate of return on investment important to owners Return on Assets Return on Equity General rule as long as a firm s rate of return on its assets (operating profits divided by total assets) is greater than the cost of the debt (interest rate), the owners rate of return on equity will increase as the firm uses more debt Financial Risk Debt is risky Equity is less demanding Voting Control Degree of control retained by owners Equity financing means giving up part of the firm s ownership and releasing some control Debt increases risk but allows owner to retain full ownership 3 Sources of Financing Identify the typical sources of financing used at the outset of a new venture. Exhibit 12-3 Sources of Funds Sources Close to Home Personal Savings imperative to have some personal investment in the business Banker unlikely to loan venture funds if the entrepreneur doesn t risk personal money Friends and Family Second likely place to obtain funding 127

2 Accept only if that person will not be hurt financially to any significant extent if the entire amount is lost These people often expect to provide advice when they invest Make agreements in writing to protect personal relationships Credit Cards Requires no justification of the use of the money Must be extremely self-disciplined to avoid becoming overextended Goal should be to use as method of payment not source of credit 4 Bank Financing Discuss the basic process for acquiring and structuring a bank loan. Types of Loans Line of Credit an informal agreement between a borrower and a bank as to the maximum amount of funds the bank will provide at any one time. Revolving credit agreement Term Loans Money loaned for a 5 10-year term, corresponding to the length of time the investment will bring in profits. Mortgages Chattel mortgage a loan for which items of inventory or other movable property serve as collateral. Real estate mortgage a long-term loan with real property held as collateral Understanding a Banker s Perspective Three fundamental concerns Recouping the principal of the loan Determining the amount of income the loan will provide the bank Helping the borrower be successful and then become a larger customer. Five C s of credit Discuss these in terms of how a student might finance a car. How are these relevant to them? Character Capacity Capital Conditions Collateral Effective presentation to bank helpful when requesting money Include three years of firm s historical financial statements, pro forma financial statements including timing and amounts of the debt repayment, personal financial statements showing borrower s net worth Selecting a Banker Location limits range of possible choices of banks; banks interested in home communities Banks lending policies not uniform Negotiating The Loan 128 Interest Rate Prime Rate the interest rate charged by commercial banks on loans to their most creditworthy customers.

3 LIBOR (London InterBank Offered Rate) the interest rate charged by London banks on loans to other London banks. Loan Maturity Date Short-term Long-term Repayment Schedule Balloon payment a very large payment required about halfway through the term over which payments were calculate, repaying the loan balance in full. Loan Covenants bank-imposed restrictions on a borrower that enhance he chance of timely repayment Business may be required to provide financial statements on a monthly or quarterly basis Bank may limit managers salaries an prohibit any personal loans from the business to the owners Bank may put limits on various financial ratios to assure loan payments Borrower will normally be required to personally guarantee the firm s loan Limited liability restriction of an owner s legal financial responsibilities to the amount invested in the business. 5 Business Suppliers and Asset-Based Lenders Explain how business relationships can be used to finance a small firm. Accounts Payable (Trade Credit) Credit extended by suppliers important to a startup Amount available depends on type of business and supplier s confidence in the firm Equipment Loans and Leases Equipment loan an installment loan from a seller of machinery used by a business Leases Asset-Based Lending Asset-based loan a line of credit secured by working capital assets Factoring obtaining cash by selling accounts receivable to another firm Purchase-order financing obtaining cash from a lender who, for a fee, advances the amount of the borrower s cost of goods sold for a specific customer order 6 Private Equity Investors Describe the two types of private equity investors who offer financing to small firms. Business Angels Private individuals who invest in others entrepreneurial venture Informal venture capital funds provided by wealthy private individual to highrisk ventures Investments relatively small (often to companies with fewer than 20 employees) May also contribute know-how to new businesses Often found through contacts with business associates, accountants, and lawyers Guy Kawasaki in The Art of the Start Make sure the investors are accredited Make sure they re sophisticated Don t underestimate them 129

4 Understand their motivation Enable them to live vicariously Make your story comprehensible to the angel s spouse Sign up people the angel has heard of Be nice Venture Capital Firms Formal venture capitalists individuals who form limited partnerships for the purpose of raising venture capital from large institutional investors Receives the right to own a percentage of the entrepreneur s business Few small companies, especially startups, ever receive this kind of funding 7 The Government Distinguish among the different government loan programs available to small companies The Small Business Administration (SBA) does not loan money but serves as a guarantor of loans through five basic programs The 7(A) Loan Guaranty Program a loan program that helps small companies obtain financial through a guaranty provided by the SBA The Certified Development Company (CDC) 504 Loan Program An SBA loan program that provides long-term financial for small businesses to acquire real estate or machinery and equipment The 7(M) Microloan Program An SBA loan program that provides short-term loans of up to $35,000 to small businesses and not-for-profit child-care centers. Small Business Investment Companies (SBICs) Privately owned banks, regulated by the SMA, that provide long-term loans and/or equity capital to small businesses. The Small Business Innovative Research (SBIR) Program An SBA program that helps to finance companies that plan to transform laboratory research into marketable products. State and Local Government Assistance Community-Based Financial Institutions a lender that uses funds from federal, state, and private sources to provide financial to small businesses in low-income communities. 8 Where Else to Look Explain when large companies and public stock offerings can be sources of financing. Large Corporations provide funds when their self-interest is involved Stock Sales made to outside individual investors through either private placement or public sales Private placement - the sale of a firm s capital stock to select individuals Public Sale (going public) Initial public offering (IPO) the issuance of stock to be traded in public financial markets Common stock may be sold to underwriters ANSWERS TO END-OF-CHAPTER DISCUSSION QUESTIONS 130

5 1. How does the nature of a business affect its sources of financing? Four basic factors determine how a firm is financed. First, the economic potential of the firm has an impact because firms with greater potential for high growth and high profits will have more financing options than those with projected unattractive returns. Second, the maturity of the business plays a role, since finding sources of financing is much more difficult for startups than it is for established firms with a track record of strong performance. Third, the types of assets held by the firm makes a difference in financing options, with those holding tangible asset being able to obtain financing much easier than those whose assets are primarily intangible in nature. Finally, the preferences of the owners figures in heavily as they make decisions when there is no right or wrong answer to the question of mix between debt and equity. 2. How is debt different from equity? Debt is the money that has been borrowed and must be repaid by some predetermined date. Ownership equity, on the other hand, represents the owners investment in the company money they have personally put into the firm without any specific date for repayment. 3. Explain the three trade-offs that guide the choice between debt financing and equity financing. The three factors are potential profitability, financial risk, and voting control. Borrowing money (debt) rather than issuing common stock (owner s equity) increases the potential for higher rates of return to the owners. Also, issuing debt allows the owners to retain voting control of the company. But debt exposes the owners to greater financial risk. On the other hand, a company that issues stock rather than increasing debt limits the potential rates of return to the owners and requires them to give up some voting control in order to reduce risk. 4. Assume that you are starting a business for the first time. What do you believe are the greatest personal obstacles to obtaining funds for the new venture? Why? For younger entrepreneurs, age is most likely the greatest personal obstacle. Also, a lack of previous experience is typically a major obstacle to obtaining funding. A previous business failure may also handicap funding efforts. Some female entrepreneurs may feel their gender is an obstacle. In some situations this may still be true, but conditions are changing rapidly. Having no business plan or a poorly conceived plan is always a barrier to financing. 5. If you were starting a new business, where would you start looking for capital? 131

6 Answers will vary with each student. However, many students will probably mention friends and family as sources because these people are easier to talk with and do represent a good source of funds. Other sources are discussed in the chapter. Students will not likely change their first choice of family and friends, no matter what type of business is discussed. Their second and subsequent choices may differ depending on the business, however. Banks will probably be mentioned frequently, since students have interaction with these financial institutions almost daily. 6. Explain how trade credit and equipment loans can provide initial capital funding. Trade credit is funding extended by suppliers when they sell merchandise on credit. The customary credit period is 30 days. If $100,000 of merchandise is purchased on credit, the supplier has, in effect, provided the purchaser with $100,000 of funds (now in merchandise form). The amount of trade credit available to a new firm depends on the type of business and the suppliers confidence in the firm. Equipment loans are similar to trade credit except that they are for fixed-asset items usually purchased on an installment basis. 7a. Describe the different types of loans made by a commercial bank. Line of credit is an informal agreement or understanding between the borrower and the bank as to the maximum amount of credit the bank will provide the borrower at any one time. A term loan is money lent on a five- to ten-year term, corresponding to the length of time the investment will bring in profits. A mortgage represents a long-term source of debt capital. Mortgages are of two types: chattel mortgages, for which items of inventory or other moveable property serve as collateral, and real estate mortgages, which are long-term loans with real estate held as collateral. 7b. What does a banker need to know in order to decide whether to make a loan? In making a loan decision, a banker always considers 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, (4) the conditions of the industry and economy, and (5) the collateral available to secure the loan. In an effort to evaluate the five C s, the banker specifically wants to know: If the loan make sense, both for the bank and for the borrower. In other words, can the loan be priced profitably to the borrower and to the bank, and is the relationship good for both the customer and the bank? If the borrower has strong character and ability. If the cash flows from operations will be the primary source of repayment. If a secondary source of repayment is available in case the cash flows from operations are not adequate to repay the loan. If the loan be properly structured and documented. 132

7 Obtaining a bank loan requires cultivation of a banker and personal selling. Although a banker s review of a loan request certainly includes analysis of economic and financial considerations, this analysis is best complemented by a personal relationship between the banker and the entrepreneur. This is not to say that a banker would allow personal feelings to override the facts provided by a careful loan analysis. But, after all, a banker s decision as to whether to make a loan is driven in part by the banker s confidence in the entrepreneur as a person and a professional. Intuition and subjective opinion based on past experience often play a role here. When seeking a loan, an entrepreneur will be required to provide certain information in support of the loan request, including the following: How much money is needed? What is the venture going to do with the money? When is the money needed? When and how will the money be paid back? Furthermore, a banker will want, if at all possible, to see the following detailed financial information: Three years of the firm s historical financial statements, if available, including balance sheets, income statements, and cash flow statements The firm s pro forma financial statements (balance sheets, income statements, and cash flow statements), in which the timing and amounts of the debt repayment are included as part of the forecasts Personal financial statements showing the borrower s net worth (net worth = assets - debt) and estimated annual income. A banker simply will not make a loan without knowing the personal financial strength of the borrower. After all, in the world of small business, the owner is the business. 8. Distinguish between informal venture capital and formal venture capital. The federal government provides financial assistance primarily through the SBA and SBICs. Among the different types of loans provided by the SBA are direct loans, participation loans, disaster relief loans, and economic opportunity loans. The federal government helps indirectly with initial financing by providing entrepreneurs with information on the subject. 9. In what ways does the federal government help with initial financing for small businesses? 133

8 The federal government provides financial assistance primarily through the SBA and SBICs. Among the different types of loans provided by the SBA are direct loans, participation loans, disaster relief loans, and economic opportunity loans. The federal government helps indirectly with initial financing by providing entrepreneurs with information on the subject. 10. What advice would you give an entrepreneur who was trying to finance a startup? Answers to this question can vary widely, but those offered should conform to the issues highlighted in the chapter. COMMENTS ON CHAPTER YOU MAKE THE CALL SITUATIONS Situation 1 1. What is your impression of Bernstein s perspective on raising capital to get to the next level? Bernstein gives the impression that he is looking to a wide variety of sources. However, typically, anything that is of interest to one type of investor will not be of interest to another. For example, what a bank would be interested in would not be of interest to a venture capitalist. Bernstein needs to clarify exactly what he needs and then focus on sources that are a good fit for that need. 2. What advice would you offer Bernstein as to both appropriate and inappropriate sources of financing in his situation? If Bernstein is looking to finance assets that can be used as collateral for a loan, then a bank or an asset lender might have an interest. However, if $2 million in debt would overload the company s debt position, then he needs to find equity financing. To be an attractive investment for private equity investors, he must demonstrate that the investors have a chance to earn substantial rates of return 70% or more per year and be able to cash out in five to seven years. If he cannot do that, then he will need to rely on friends and family to help with the financing, or he may just have to limit the expansion to the firm s ability to finance the growth internally. Situation 2 134

9 1. Compare the two financing options in terms of projected return on the owner s equity investment. Ignore any effect from income taxes. Owner s return on equity investment = Net income Owner s investment If equity is issued: Owner s return on equity investment = ($350,000 16%) $350,000 = 16% If debt is issued: Owner s return on equity investment = ([$350,000 16%] [$200,000 6%]) $150,000 = 29% 2. What if Dalton is wrong and the company earns only 4 percent in operating income on total assets? If equity is issued: Owner s return on equity investment = ($350,000 4%) $350,000 = 4% If debt is issued: Owner s return on equity investment = ([$350,000 4%] [$200,000 6%]) $150,000 = 1.3% 3. What must Dalton consider in choosing a source of financing? He has to compare the firm s expected return on its assets with the interest rate. As a general rule, as long as a firm s return on its assets is greater than the cost of the debt (interest rate), the owner s return on equity investment will be increased. Dalton hopes to earn 16 percent on its assets but pay only a 6-percent interest rate for debt financing. Using debt therefore increases the owners opportunity to enhance the rate of return on the investment. Situation 3 1. What guidance will you give Smith in negotiating with the bank? This is a very tough situation and, as it stands, things look very bleak for Smith. Smith s only chance might be to re-negotiate the terms and conditions of his loan. Or, he may see if he can refinance the loan or he may ask for a moratorium on his loan- allowing him some time to get caught up on his payments. 2. Why might you advise him not to go into a meeting with bank officers with a plan already in mind? 135

10 He may want to see what the banks have to offer. The bank doesn t want him to default on his loan- the bank is motivated to help him succeed. It s quite likely that the bank will require that Smith bring in a management team hired by the bank to oversee the operations of the business and to help turn the company around. SUGGESTED SOLUTION TO CASE 12: MOONWORKS 1. Describe what a line of credit involves, and explain the legal obligation of a bank to provide capital with a line of credit. A line of credit is an informal agreement or understanidng between a borrower and a bank as to the maximum amount of credit the bank will provide the borrrower at any one time. The bank has no legal obligation to provide the capital unlike revolving lines of credit, which do legally commit both sides. Entrepreneurs should arrange for a line of credit in advance of any actual need as banks are reluctant to spontaneously extend credit. 2. On what three priorities might BankRI representative Matt Weiner have based the decision to extend Moon Associates line of credit or offer additional financing? What are the five C s of credit? The five C's of credit are: 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, 4) the conditions of the industry and economy, and 5) the collateral available to secure the loan. 3. Even as the remodeling market weakened and taking on extra financing became risky, what are some things that Moon Associates president and CEO Jim Moon did to sustain the company s long-term profitability? They explored other means of generating operating cash. Moon Associates struck a deal to be the sole southern New England partner Renewal by Anderson. This partnership, Moon Associates was positioned to serve its existing customer base with Andersen s stylish, energy efficient windows. Moon Associates also called sought out the help of their banker, BankRI. This long-term relationship stood them well as they were able to increase their credit line which eased their cash flow situation. Lastly, the company wisely diversified its product line to include general exterior home replacement products like roofing and siding as well as insulations and hot water heaters. Moon Associates changes its name to Moonworks - branding itself as a more comprehensive supplier of home building materials. 4. Could Moon Associates have obtained the needed capital to not only keep the company running but expand its Renewal by Andersen line through a mortgage loan? If so, for how long could such a loan be financed? 136

11 It s possible but this might have been trickier. They already had a line of credit so convincing the banks to increase this line was an easier task then seeking out an new (additional) mortgage loan. Also, banks had severely tightened their lending on these types of loans so the likelihood of Moon Associates obtaining this type of loan was slim. The duration of these loans also varies years or so on commercial loans. ACTIVITIES Purpose: The purpose of the first activity is to give students the opportunity to interview an entrepreneur within the context of the case material. By investigating other entrepreneurs decisions, students will become aware of their own entrepreneurial feelings and tendency. The second and third activities help students streamline the message they deliver when looking for business opportunities or funding. Setting it up: Each activity can be done individually, but you can also opt to send students out to conduct interviews in pairs. The second activity can be used as the basis of short class presentations. The third activity requires some Internet research, which you can assign before the next class session and then have students share their results with the class or in small groups. 1. Arrange for an interview with the owner of a start-up business in your community. Ask the following questions and share your results with the class. How did you decide to start [business name], and how did you get funding to get it off the ground? How does [business name] make money, and where do you see your growth coming from in the future? What do you think is the most important thing you've learned in the course of developing [business name]? What advice would you give other entrepreneurs looking to start their own company? Ask the business owner to respond to the following quote: If you focus on success, you won't get there. If you focus on contribution and customer value, then you can win. --John Doerr, venture capitalist 2. Imagine you ve just stepped into the elevator of the hotel that is hosting a seminar you re attending, Funding for Continued Growth: Investors Meet One-on-One with Entrepreneurs. The venture capitalist you really, really wanted to talk to about your business venture gets in at the same time. You have about 20 seconds to make a good impression. Thank goodness for Jay, you think. Jay is a friend who runs an animal training center. Jay always begins business introductions by saying, Hi, I m Jay Doe. I help pet-owners raise likeable pets. I work with people who want to avoid letting bad behaviors come between them and their friends, but don t 137

12 know where to start. As a result of working with me, my clients say they enjoy their pets so much more. Jay encouraged you to plan out your elevator speech, a 15- second introduction of yourself and your company, before coming to the event. You take a semi-deep breath and start with, Hello, my name is Use the example above and the three steps below to write a creative elevator speech to share with the class. A template is provided to get you started. a) Get someone s attention. Say who you are and what you can do for others (not what you do). Get the person to think, How do you do that? b) Tell them about your deliverables. Explain what your product (or service) provides. c) Explain your benefits. I m the [occupation/line of work you re in] that [grab their attention-think up a hook for your line of work]. I specialize in [action verb followed by your deliverables] for the [target market]. I help [audience types] [benefits]. 3. Jay also encouraged you to have a business plan ready (yours is 30 pages). The venture capitalist you just met in the elevator gave you her business card, but she asked you to send over only your executive summary. She s going to review it and then call to arrange a time to meet and discuss how she can help you grow your business. Good thing you have an executive summary that is clear, concise, and compelling; you really want to make a good first impression and sell your business idea. Search the Internet for two examples of executive summaries (use the key words example executive summary to get started). Print them out and then compare the executive summaries you found to the components of an excellent executive summary listed below. Rate each executive summary from 1 to 5, using a template like the one below, with 1 indicating that the summary does not incorporate the key components and 5 for a stellar example of one of the key components. Where applicable, label the portion of the executive summary with the corresponding letter of the component it meets. The executive summary for [business name]: a) leads with a compelling statement about why it is qualified to offer a unique solution to a big problem/opportunity b) makes it clear that the problem or opportunity exists and how it plans to solve it/exploit it c) clarifies what it has/what it does to solve/exploit the problem/opportunity 138

13 d) describes its market: how many people/companies, how many dollars, how fast the growth, what is driving its market segment e) states its competitive advantage (unique benefits and advantages) f) specifies what levels it will reach in three to five years (how it generates revenues; how it will be evaluated customers, units, margin, etc.) g) presents a uniquely qualified and winning team or management h) outlines a believable summary financial projection i) states the amount of funding expected 139