sources of financing: debt and equity

1Chapter 13: Sources of Funds Copyright 2008 Prentice Hall Publishing Company

Sources of Financing:Debt and

Equity


Raising CapitalRaising Capital

Raising capital to launch or Raising capital to launch or expand a business is a expand a business is a challenge.challenge.

Many entrepreneurs are Many entrepreneurs are caught in the “credit caught in the “credit crunch.”crunch.”

Financing needs in the Financing needs in the $100,000 to $3 million may $100,000 to $3 million may be the toughest to fill.be the toughest to fill.


The “Secrets” to The “Secrets” to Successful FinancingSuccessful Financing

1. Choosing the right sources of capital 1. Choosing the right sources of capital is a decision that will influence a is a decision that will influence a company for a lifetime.company for a lifetime.

2. The money is out there; the key is 2. The money is out there; the key is knowing where to look.knowing where to look.

3. Raising money takes time and effort. 3. Raising money takes time and effort. 4. Creativity counts. Entrepreneurs have 4. Creativity counts. Entrepreneurs have

to be as creative in their searches for to be as creative in their searches for capital as they are in developing their capital as they are in developing their business ideas.business ideas.


The “Secrets” to The “Secrets” to Successful FinancingSuccessful Financing

5. The World Wide Web puts at 5. The World Wide Web puts at entrepreneur’s fingertips vast resources entrepreneur’s fingertips vast resources of information that can lead to financing. of information that can lead to financing.

6. Be thoroughly prepared before 6. Be thoroughly prepared before approaching lenders and investors. approaching lenders and investors.

7. Entrepreneurs should not underestimate 7. Entrepreneurs should not underestimate the importance of making sure that the the importance of making sure that the “chemistry” among themselves, their “chemistry” among themselves, their companies, and their funding sources is a companies, and their funding sources is a good one. good one.


Layered FinancingLayered Financing

Entrepreneurs must cast Entrepreneurs must cast a wide net to capture a wide net to capture the financing they need the financing they need to launch their to launch their businesses.businesses.

Layering – piecing Layering – piecing together capital from together capital from multiple sources. multiple sources.


Three Types of Three Types of CapitalCapital

FixedFixed - used to purchase the permanent - used to purchase the permanent or fixed assets of the business (e.g., or fixed assets of the business (e.g., buildings, land, equipment, and others).buildings, land, equipment, and others).

WorkingWorking - used to support the small - used to support the small company's normal short-term company's normal short-term operations (e.g., buy inventory, pay operations (e.g., buy inventory, pay bills, wages, or salaries, and others).bills, wages, or salaries, and others).

GrowthGrowth - used to help the small - used to help the small business expand or change its primary business expand or change its primary direction.direction.

CapitalCapital is any form of wealth is any form of wealth employed to produce more wealth employed to produce more wealth for a firm.for a firm.


Equity CapitalEquity Capital Represents the personal investment Represents the personal investment

of the owner(s) in the business.of the owner(s) in the business. Is called Is called risk capital risk capital because because

investors assume the risk of losing investors assume the risk of losing their money if the business fails.their money if the business fails.

Does Does notnot have to be repaid with have to be repaid with interest like a loan does.interest like a loan does.

Means that an entrepreneur must Means that an entrepreneur must give up some ownership in the give up some ownership in the company to outside investors.company to outside investors.


Debt CapitalDebt Capital Must be repaid with interest.Must be repaid with interest. Is carried as a liability on the Is carried as a liability on the

company’s balance sheet.company’s balance sheet. Can be just as difficult to Can be just as difficult to

secure as equity financing, secure as equity financing, even though sources of debt even though sources of debt financing are more numerous.financing are more numerous.

Can be expensive, especially Can be expensive, especially for small companies, because for small companies, because of the risk/return tradeoff.of the risk/return tradeoff.


Sources of Equity Sources of Equity FinancingFinancing

Personal savingsPersonal savings Friends and family membersFriends and family members AngelsAngels PartnersPartners CorporationsCorporations Venture capital companiesVenture capital companies Public stock salePublic stock sale Simplified registrations and Simplified registrations and

exemptionsexemptions


Personal Personal SavingsSavings

The The firstfirst place an place an entrepreneur should look for entrepreneur should look for money. money.

The most common source of The most common source of equity capital for starting a equity capital for starting a business.business.

Outside investors and lenders Outside investors and lenders expect entrepreneurs to put expect entrepreneurs to put some of their own capital into some of their own capital into the business the business beforebefore investing investing theirs.theirs.


Friends and Family Friends and Family MembersMembers

After emptying their own After emptying their own pockets, entrepreneurs pockets, entrepreneurs should turn to those most should turn to those most likely to invest in the likely to invest in the business: friends and family business: friends and family members.members.

Careful!!! Inherent dangers Careful!!! Inherent dangers lurk in family/friendly lurk in family/friendly business deals, business deals, especiallyespecially those that flop.those that flop.


Friends and Family Friends and Family MembersMembers

Guidelines for family and friendship Guidelines for family and friendship financing:financing: Consider the impact of the investment on Consider the impact of the investment on

everyone involved.everyone involved. Keep the arrangement “strictly business.”Keep the arrangement “strictly business.” Settle the details up front.Settle the details up front. Never accept more than investors can afford to Never accept more than investors can afford to

lose. lose. Create a written contract.Create a written contract. Treat the money as “bridge financing.” Treat the money as “bridge financing.” Develop a payment schedule that suits both Develop a payment schedule that suits both

parties. parties. Have an exit plan. Have an exit plan.


AngelsAngels

Private investors who invest in Private investors who invest in emerging entrepreneurial companies.emerging entrepreneurial companies.

Fastest growing segment of the small Fastest growing segment of the small business capital market. business capital market.

An excellent source of “patient An excellent source of “patient money” for investors needing money” for investors needing relatively small amounts of capital relatively small amounts of capital ranging from $100,000 (sometimes ranging from $100,000 (sometimes less) to as much as $5 million.less) to as much as $5 million.


AngelsAngels

An estimated 230,000 angels An estimated 230,000 angels across the U.S. invest $23 billion across the U.S. invest $23 billion a year in 50,000 small a year in 50,000 small companies. companies.

Their investments exceed those Their investments exceed those of venture capital firms, of venture capital firms, providing more capital to 17 providing more capital to 17 times as many small companies.times as many small companies.


AngelsAngelsThe typical angel:The typical angel:

Invests in companies at the seed or startup Invests in companies at the seed or startup stages.stages.

Accepts 10 percent of the proposals presented Accepts 10 percent of the proposals presented to him.to him.

Makes an average of two investments every Makes an average of two investments every three years.three years.

Has invested an average of $80,000 in 3.5 Has invested an average of $80,000 in 3.5 businesses. businesses.

90 percent are satisfied with their 90 percent are satisfied with their investments. investments.

Key: finding them! Key: finding them! Network!Network! Look nearby, a 50- to 100-mile radius.Look nearby, a 50- to 100-mile radius. Informal angel “clusters” and networksInformal angel “clusters” and networks


Corporate Venture Corporate Venture CapitalCapital

20 percent of all venture capital 20 percent of all venture capital investments come from corporations.investments come from corporations.

About 300 large corporations across About 300 large corporations across the globe invest in start-up the globe invest in start-up companies.companies.

Capital infusions are just one benefit; Capital infusions are just one benefit; corporate partners may share corporate partners may share marketing and technical expertise. marketing and technical expertise.


Venture Capital Venture Capital CompaniesCompanies

More than 1,300 venture capital More than 1,300 venture capital firms operate across the U.S. firms operate across the U.S.

Most venture capitalists seek Most venture capitalists seek investments in the $3,000,000 to investments in the $3,000,000 to $10,00,000 range in companies $10,00,000 range in companies with high-growth and high-profit with high-growth and high-profit potential. potential.

Business plans are subjected to Business plans are subjected to an an extremelyextremely rigorous review - rigorous review - less than 1 percent accepted.less than 1 percent accepted.

Venture Capital Funding

$-

$20.000

$40.000

$60.000

$80.000

$100.000

$120.000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005Year

Am

ount

(in

Bill

ions

of $

)

-1,0002,0003,0004,0005,0006,0007,0008,0009,000

Num

ber o

f Dea

ls

Amount (in Billions of $) Number of Deals

Source: “MoneyTree Report,” PriceWaterhouseCoopers, http://www.pwcmoneytree.com/moneytree/nav.jsp?page=historical

http://www.pwcmoneytree.com/moneytree/nav.jsp?page=historical



Most venture capitalists take an Most venture capitalists take an active role in managing the active role in managing the companies in which they invest.companies in which they invest.

Many venture capitalists focus their Many venture capitalists focus their investments in specific industries investments in specific industries with which they are familiar.with which they are familiar.

Venture capitalists typically Venture capitalists typically purchase between 20 percent and purchase between 20 percent and 40 percent of a company but in 40 percent of a company but in some cases will buy 70 percent or some cases will buy 70 percent or more. more.



Most often, venture capitalists Most often, venture capitalists invest in a company across several invest in a company across several stages.stages.

On average, 98 percent of venture On average, 98 percent of venture capital goes to:capital goes to: Early stage investments (companies in Early stage investments (companies in

the early stages of development).the early stages of development). Expansion stage investments Expansion stage investments

(companies in the rapid growth phase).(companies in the rapid growth phase). Only 2 percent of venture capital Only 2 percent of venture capital

goes to businesses in the startup or goes to businesses in the startup or seed phase. seed phase.


What Do Venture What Do Venture CapitalCapital

Companies Look For?Companies Look For? Competent Competent

managementmanagement Competitive edgeCompetitive edge Growth industryGrowth industry Viable exit strategyViable exit strategy Intangibles factorsIntangibles factors

Average Returns on Venture Capital Investments

Total loss11%

Partial loss23%

1 to 2 times the initial investment

30%

2 to 5 time the initial investment

20%

5 to 10 times the initial investment

9%

10+ times the initial invesment

7%

Source: Paul Keaton, "The Reality of Venture Capital," Small Business Forum, Arkansas Small Business Development Center, http://asbdc.ualr.edu/bizfacts/501.asp?print=Y, p. 8.


Going PublicGoing Public Initial public offering (IPO) - when Initial public offering (IPO) - when

a company raises capital by selling a company raises capital by selling shares of its stock to the public for shares of its stock to the public for the first time. the first time.

Typical year: about 410 companies Typical year: about 410 companies make IPOs.make IPOs.

Few companies with sales below Few companies with sales below $20 million in annual sales make $20 million in annual sales make IPOs. IPOs.

Initial Public Offerings (IPOs)

$0.0

$20.0

$40.0

$60.0

$80.0

$100.0

$120.0

Year

Amou

nt R

aise

d (B

illio

ns o

f $)

01002003004005006007008009001000

Num

br o

f IPO

s

$ Raised (Billions)

Number


Successful IPO Successful IPO CandidatesCandidates

Consistently high growth ratesConsistently high growth rates Strong record of earningsStrong record of earnings 3 to 5 years of audited financial 3 to 5 years of audited financial

statements that meet or exceed SEC statements that meet or exceed SEC standardsstandards

Solid position in a rapidly growing Solid position in a rapidly growing industryindustry

Sound management team with experience Sound management team with experience and a strong board of directorsand a strong board of directors


Advantages of “Going Advantages of “Going Public”Public”

Ability to raise large amounts Ability to raise large amounts of capitalof capital

Improved corporate imageImproved corporate image Improved access to future Improved access to future

financingfinancing Attracting and retaining key Attracting and retaining key

employeesemployees Using stock for acquisitionsUsing stock for acquisitions Listing on a stock exchangeListing on a stock exchange


Disadvantages of “Going Disadvantages of “Going Public”Public”

Dilution of founder’s Dilution of founder’s ownershipownership

Loss of controlLoss of control Loss of privacyLoss of privacy Reporting to the SECReporting to the SEC Filing expensesFiling expenses Accountability to shareholdersAccountability to shareholders Pressure for short-term Pressure for short-term

performanceperformance TimingTiming


The Registration The Registration ProcessProcess

Choose the underwriterChoose the underwriter Negotiate a letter of intentNegotiate a letter of intent Prepare the registration Prepare the registration

statementstatement File with the SECFile with the SEC Wait to “go effective” and road Wait to “go effective” and road

showshow Meet state requirementsMeet state requirements

TimeTime ActionActionWeek Week 11

Conduct organizational meeting with IPO team, including Conduct organizational meeting with IPO team, including underwriter, attorneys, accountants, and others. Begin drafting underwriter, attorneys, accountants, and others. Begin drafting registration statement.registration statement.

Week Week 55

Distribute first draft of registration statement to IPO team and Distribute first draft of registration statement to IPO team and make revisions. make revisions.

Week Week 66

Distribute second draft of registration statement and make Distribute second draft of registration statement and make revisions. revisions.

Week Week 77

Distribute third draft of registration statement and make revisions. Distribute third draft of registration statement and make revisions.

Week Week 88

File registration statement with the SEC. Begin preparing File registration statement with the SEC. Begin preparing presentations for road show to attract other investment bankers to presentations for road show to attract other investment bankers to the syndicate. Comply with Blue Sky laws in states where offering the syndicate. Comply with Blue Sky laws in states where offering will be sold. will be sold.

Week Week 1212

Receive comment letter on registration statement from SEC. Receive comment letter on registration statement from SEC. Amend registration statement to satisfy SEC comments. Amend registration statement to satisfy SEC comments.

Week Week 1313

File amended registration statement with SEC. Prepare and File amended registration statement with SEC. Prepare and distribute preliminary offering prospectus (called a “red herring”) distribute preliminary offering prospectus (called a “red herring”) to members of underwriting syndicate. Begin road show meetings.to members of underwriting syndicate. Begin road show meetings.

Week Week 1515

Receive approval for offering from SEC (unless further Receive approval for offering from SEC (unless further amendments are required). Issuing company and lead underwriter amendments are required). Issuing company and lead underwriter agree on final offering price. Prepare, file, and distribute final agree on final offering price. Prepare, file, and distribute final offering prospectus.offering prospectus.

Week Week 1616

Company and underwriter sign the final agreement. Underwriter Company and underwriter sign the final agreement. Underwriter issues stock, collects the proceeds from the sale, and delivers issues stock, collects the proceeds from the sale, and delivers proceeds (less commission) to company.proceeds (less commission) to company.

Timetable for an IPOTimetable for an IPO


Simplified RegistrationsSimplified Registrationsand Exemptionsand Exemptions

GoalGoal: To give small companies easy : To give small companies easy access to capital markets with access to capital markets with simplified registration requirements.simplified registration requirements.

Regulation S-BRegulation S-B Regulation D: Rule 504 - Small Regulation D: Rule 504 - Small

Company Offering Registration Company Offering Registration (SCOR)(SCOR)

Regulation D: Rule 505 and 506Regulation D: Rule 505 and 506


Simplified Simplified RegistrationsRegistrations

and Exemptionsand Exemptions Section 4 (6) Private Section 4 (6) Private

PlacementsPlacements Rule 147 (Intrastate Rule 147 (Intrastate

offerings)offerings) Regulation ARegulation A Direct Stock Offering on Direct Stock Offering on

the World Wide Web the World Wide Web (WWW)(WWW)


Sources of Debt Sources of Debt CapitalCapital

Commercial banksCommercial banks


Commercial Commercial BanksBanks

Short-term loansShort-term loans Commercial loansCommercial loans Lines of creditLines of credit Floor planningFloor planning

Intermediate and long-Intermediate and long-term loansterm loans Installment loans and Installment loans and

contractscontracts

...the heart of the financial market for small ...the heart of the financial market for small businesses!businesses!


Six Most Common Reasons Six Most Common Reasons Bankers Reject Small Bankers Reject Small

Business LoansBusiness Loans1.1. ““Our bank doesn’t make small Our bank doesn’t make small

business loans.” business loans.” CureCure: Before applying for a loan, : Before applying for a loan, research banks to find out which research banks to find out which ones seek the type of loan you need. ones seek the type of loan you need.

2.2. ““I don’t know enough about you or I don’t know enough about you or your business.”your business.”CureCure: Develop a detailed business : Develop a detailed business plan to present to the banker. plan to present to the banker.



Business LoansBusiness Loans

3.3. “You haven’t told me why you need the “You haven’t told me why you need the money.” money.” CureCure: Your business plan should : Your business plan should explain how much money you need and explain how much money you need and how you plan to use it. how you plan to use it.

4.4. “Your numbers don’t support your loan “Your numbers don’t support your loan request.”request.”CureCure: Include a cash flow forecast in : Include a cash flow forecast in your business plan. your business plan.

(continued)(continued)



Business LoansBusiness Loans5.5. “You don’t have enough collateral.” “You don’t have enough collateral.”

CureCure: Be prepared to pledge your : Be prepared to pledge your company’s assets – and perhaps your company’s assets – and perhaps your personal assets – as collateral for the personal assets – as collateral for the loan. loan.

6.6. “Your business does not support the “Your business does not support the loan on its own.”loan on its own.”CureCure: Be prepared to provide a : Be prepared to provide a personal guarantee on the loan. personal guarantee on the loan.

(continued)(continued)



Commercial banksCommercial banks Asset-basedAsset-based lenders lenders


Asset-Based Asset-Based BorrowingBorrowing

Businesses can borrow money Businesses can borrow money by pledging as collateral by pledging as collateral otherwise idle assets – accounts otherwise idle assets – accounts receivable, inventory, and receivable, inventory, and othersothers

Advance rateAdvance rate – the percentage of – the percentage of an asset’s value that a lender an asset’s value that a lender will lend. will lend.


Asset-Based Asset-Based BorrowingBorrowing

Discounting accounts Discounting accounts receivablereceivable

AccountsReceivable

Inventory financingInventory financing



Commercial banksCommercial banks

Vendor financing (trade credit)Vendor financing (trade credit) Equipment suppliersEquipment suppliers Commercial finance companiesCommercial finance companies Saving and loan associationsSaving and loan associations

Asset-based lendersAsset-based lenders

$$



Stock brokerage housesStock brokerage houses Insurance companiesInsurance companies Credit unionsCredit unions BondsBonds Private placementsPrivate placements Small Business Investment Small Business Investment

Companies (SBICs)Companies (SBICs) Small Business Lending Small Business Lending

Companies (SBLCs)Companies (SBLCs)

(Continued)(Continued)



Economic Development Administration Economic Development Administration (EDA)(EDA)

Department of Housing and Urban Department of Housing and Urban Development (HUD)Development (HUD)

U.S. Department of Agriculture’s Rural U.S. Department of Agriculture’s Rural Business-Cooperative ServiceBusiness-Cooperative Service

Small Business Innovation Research (SBIR) Small Business Innovation Research (SBIR) Small Business Technology Transfer Small Business Technology Transfer

programsprograms Small Business Administration (SBA)Small Business Administration (SBA)

(Continued)(Continued)

Federally Sponsored Programs:Federally Sponsored Programs:


Small Business Small Business Administration Loan Administration Loan

ProgramsPrograms Low Doc Loan ProgramLow Doc Loan Program SBASBAExpressExpress Program Program 7(A) Loan Guaranty Program – 7(A) Loan Guaranty Program –

the most popular SBA loan the most popular SBA loan programprogram

$0.0

$2.0

$4.0

$6.0

$8.0

$10.0

$12.0

$14.0

$16.0

$18.0

Bill

ions

of $

1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006

SBA 7(A) Guaranteed Loans


Small Business Small Business Administration Loan Administration Loan

ProgramsPrograms Low Doc Loan ProgramLow Doc Loan Program SBASBAExpressExpress Program Program 7(A) Loan Guaranty Program – the 7(A) Loan Guaranty Program – the

most popular SBA loan programmost popular SBA loan program CAPLine ProgramCAPLine Program International Trade ProgramsInternational Trade Programs

Export Working Capital ProgramExport Working Capital Program International Trade ProgramInternational Trade Program


SBA Loan ProgramsSBA Loan Programs

Section 504 Certified Section 504 Certified Development Company Development Company ProgramProgram

Microloan ProgramMicroloan Program Prequalification Loan ProgramPrequalification Loan Program Disaster LoansDisaster Loans


State and Local Loan State and Local Loan ProgramsPrograms

Capital Access Programs (CAPs)Capital Access Programs (CAPs) – designed to encourage lenders – designed to encourage lenders to make loans to businesses that to make loans to businesses that do not qualify for traditional do not qualify for traditional financing. financing.

Revolving Loan Fund (RLFs)Revolving Loan Fund (RLFs) – – combine private and public funds combine private and public funds to make small business loans. to make small business loans.


Internal Methods of Internal Methods of FinancingFinancing

Factoring - selling accounts Factoring - selling accounts receivable outrightreceivable outright

Leasing - assets rather than Leasing - assets rather than buying thembuying them

Credit cardsCredit cards

sources of financing: debt and equity

Documents