978-0134741086 Chapter 15 Part 1

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SECTION IV. PUTTING THE BUSINESS PLAN TO WORK:

SOURCES OF FUNDS

CHAPTER 15. SOURCES OF FINANCING: EQUITY AND DEBT

Part 1: Learning Objectives

1. Describe the differences between equity capital and debt capital.

2. Discuss the various sources of equity capital available to entrepreneurs.

3. Describe the process of “going public.”

4. Describe the various sources of debt capital.

5. Describe the various loan programs available from the Small Business Administration.

6. Identify the various federal and state loan programs aimed at small businesses.

7. Explain other methods of financing a business.

Part 2: Class Instruction

Introduction

New ventures need money. Raising those funds is one of the initial challenges for

entrepreneurs. As capital markets rise and fall, the search for financing can be an uncertain

journey. Some of the keys to successful financing include these seven steps:

1. Choosing the right sources of capital.

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

3. Raising money takes time and effort.

4. Creativity counts.

5. The Internet puts at entrepreneurs’ fingertips vast resources of information that

can lead to financing. Use it.

6. Put social media to work to locate potential investors.

7. Be thoroughly prepared before approaching potential lenders and investors.

8. Entrepreneurs cannot overestimate the importance of making sure that the

“chemistry” among themselves, their companies, and their funding sources is a

9. Plan an exit strategy.

10. When capital gets tight, remember to bootstrap.

Rather than relying primarily on a single source of funds, entrepreneurs use layered

financing, a technique of raising capital from multiple sources. Capital is any form of

wealth employed to produce more wealth. Entrepreneurs have access to two different

types of capital: equity and debt.

must give up some, or even most, of the ownership. To avoid having to give up control,

entrepreneurs should strive to launch new companies with the least amount of money

possible.

Debt capital represents the financing that entrepreneurs borrow and must repay with

interest. Although borrowed capital allows entrepreneurs to maintain complete

in their companies.

Sources of Equity Financing LO 2

The first place entrepreneurs should look for start-up money is in their own pockets.

They often rely on bootstrapping, which is a process in which entrepreneurs first tap their

personal savings and use creative low-cost start–up methods to launch their businesses.

patient than outside investors and less like to meddle in the operations of the business.

The amounts of money they invest are typically small in comparison to other kinds of

investors. Consider the potential ramifications and consequences on personal relationships

before using this source. Unrealistic expectations or misunderstood risks have destroyed

Chapter 15, Page 239

friendships and relationships with family members. Refer to the Hands On… How To,

Structure Family and Friendship Financing Deals.

Accredited investors are people who have the knowledge and financial ability to assume

the risks that come with investing in a business. They must have a sustained net worth

(excluding their primary residence) of at least $1 million or annual income of at least

$200,000.

Crowdfunding is a method of raising capital that taps the power of social networking and

allows entrepreneurs to post their elevator pitches and proposed investment terms on

specialized Web sites and raise money from ordinary people who invest as little as $100.

implemented, there will be limitations on how much each individual can invest, which will

be based on their income and net worth.

Attracting investors through crowdfunding requires a different approach than attracting

traditional investors. Entrepreneurs should seek advice from financing experts to develop

a long-term financing plan in this circumstance. Refer to Hands On… How To,

proven story and a strong business model that can be pitched for more significant funding.

Angels.

Private investors (angels) are wealthy individuals, often entrepreneurs themselves, who

invest in business start–ups in exchange for equity stakes in the companies. They are

accredited advisors, often with significant industry experience, who fill a specific equity

The major challenge for an entrepreneur is to find angels. Networking is the key through

local friends, attorneys, bankers, stockbrokers, accountants, other business owners, and

consultants. Today there are angel networks and angel capital funds (superangels), many

of which have Web sites. The Angel Capital Association is a professional association

whose members are angels.

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Venture capital companies are private, for profit organizations that purchase equity

positions in young businesses that they believe have high-growth and high-profit potential.

The firms that receive venture capital typically produce annual returns of 300 to 500

percent within five to seven years for the venture capital companies. Refer to Figure 15.3,

Venture Capital Funding.

 Policies and Investment Strategies.

Investment and size screening – The average venture capital firm’s investment in a

firms are not passive investors: they may purchase a controlling share of a company,

leaving its founders with a minority share of ownership; may join the boards of

directors of the firm; and even take over the management of the firm.

Stage of investment – Venture capital companies commonly seek out companies in the

early or rapid-growth stage. They often invest over time across several stages of a

investments in specific industries, such as technology, biotechnology, or other

specialty niches. They prefer to invest in firms that have advanced beyond the stage

when angels invest. Refer to Figure 15.5, Angel vs. VC Investments.

 What Venture Capitalists Look For.

Two factors make a deal attractive to venture capitalists: high returns and a convenient

 Intangible factors such based on the venture capitalist’s sense of fit and

potential. For example, a solid sense of direction, strategic planning process,

and the chemistry of the management team.

 Corporate Venture Capital. Large corporations, both U.S. and foreign, finance

and invest in small companies for strategic and financial purposes. Examples

Chapter 15, Page 241

channels, and marketing know-how, and provide introductions to important

customers and suppliers.

Public Stock Sales (“Going Public”) LO 3

One method of raising large capital is to sell shares of stock, known as “going public.” An

initial public offering (IPO) is a method of raising equity capital in which a company sells

shares of its stock to the general public the first time. Refer to Figure 15.6: Initial Public

Investment bankers who underwrite public stock offerings typically look for established

companies with these characteristics:

 Consistently high growth rates

 Scalability

 A strong record of earnings

professionals, including company executives, an accountant, a securities attorney, a

financial printer, and at least one underwriter. The registration process alone is a required,

time-demanding – and potentially expensive – task that involves these steps:

 Choose the underwriter. A managing underwriter (investment banker) is a

financial company that serves two important roles: helping to prepare the

registration statement for an issue and promoting the company’s stock to potential

investors.

 Negotiate a letter of intent. A letter of intent is an agreement between the

underwriter and the company about to go public that outlines the details of the

deal.

 Prepare the registration statement. The registration statement is the document a

company must file with the SEC that describes both the company and its stock

offering and discloses information about the risk of investing.

 File with the SEC. The Division of Corporate Finance can take 30-45 days to

review the application, and can require the company to make revisions.

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 Wait to go effective. While waiting for the SEC’s ruling, the underwriters are

building a syndicate of other underwriters who will market the company’s stock.

During this quite period of time the company must refrain from publicity and

providing information about the potential IPO.

 Road show. A road show is a gathering of potential syndicate members sponsored

by the managing underwriter for the purpose of promoting a company’s IPO.

 Sign underwriting agreement. On the last day before the registration statement

becomes effective, the company signs the formal underwriting agreement. At this

Nonpublic Registrations and Exemptions. The SEC allows several exemptions from this

full-disclosure process for small businesses. Simplified registrations and exemptions enable

smaller companies easier access to capital markets through some recently improved

options for small businesses. A limited private stock offering allows entrepreneurs to sell

stock through a limited private offering to accredited investors, corporations and trust,

SEC.

 Rule 504 is the most popular of the Regulation D exemptions because it is the least

restrictive. It allows a company to sell shares of its stock to an unlimited number

of investors without regard to their experience or level of sophistication. There is

a cap of $1 million in a 12-month period on the amount of capital a company can

35 nonaccredited investors, provide no advertising of the offer, and more has

stringent disclosure requirements.

 Rule 506 imposes no ceiling on the amount that can be raised, but most companies

that make Rule 506 offerings raise between $1 million and $50 million in capital.

Like Rule 505, it limits the issue to no more than 35 nonaccredited investors, and

prohibits advertising the offer. There is no limit on the number of accredited

investors, however.

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Sources of Debt Financing

LO 4

Debt financing involves funds that small business owners borrow and must repay with

interest. Borrowed capital allows entrepreneurs to maintain complete ownership but it

must be carried as a liability on the balance sheet as well as be repaid with interest.

Because small businesses are considered to be greater risks than bigger corporate

and flexibility. Refer to Figure 15.7, Small Business Financing Strategies.

Commercial Banks.

Commercial Banks provide the greatest number and variety of loans to small companies,

but prefer to lend to established small businesses rather than to high-risk start-ups. Before

making a loan, the bank will scrutinize the firm’s financial reports to project its position in

personally repay the loan. In essence, bankers look for three sources to repay a loan: sales

sufficient to repay, the entrepreneur’s personal guarantee, and collateral that could be sold

to repay the loan. Refer to Hands On… How to for a list of seven common reasons banks

turn down loan requests.

Short-Term Loans.

 Home equity loans

 Commercial loans (or “traditional” bank loans)

 Lines of credit. A line of credit is a short-term bank loan with a preset limit

that provides working capital for day-to-day operations.

 Floor planning

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These types of loans are normally secured by collateral and are extended for one year or

longer. The typical uses include constructing buildings, purchasing real estate and

equipment, expanding a business, and other long-term investments. Installment loans and

term loans are examples.

 Installment loans are used by entrepreneurs to purchase equipment, facilities, real

estate, and other fixed assets. Repayment of the loan is set to coincide with the

length of the equipment’s usable life.

ratios.

Consider using You Be the Consultant: “The Never–Ending Hunt for Financing” at

this point.

The Small Business Administration (SBA) Loan

Guarantee Programs LO 5

the credit risk, lenders are more willing to consider riskier deals. SBA loans often have a

longer term than traditional bank loans, and need less collateral. Refer to Table 15.1, SBA

Loan Program Overview.

SBA programs include:

 7(A) loan guaranty program is an SBA program in which loans made by private

company (CDC). A certified development company is a nonprofit organization

licensed by the SBA and designed to promote growth in local communities by

working with commercial banks and the SBA to make long-term loans to small

businesses.

 Microloan Program. About three-fourths of small businesses need less than

Chapter 15, Page 245

who can borrow amounts of money as small as $100 up to a maximum of $50,000.

This is the single largest source of funding for microenterprises, provided by about

180 authorized lenders that are nonprofit intermediaries. Micro loans do not carry

SBA guarantees, but lenders’ standards are less demanding than on conventional

loans.

Other SBA Loan Programs.

 SBAExpress Program

turnaround times to small companies that are developing or expanding their

export initiatives.

 Export Working Capital (EWC) Program is an SBA loan program that is

designed to provide working capital to small exporters.

 The International Trade Program is an SBA loan program for small businesses

 Asset-Based Lenders. Asset-based lenders allow businesses to borrow money by

pledging collateral, such as accounts receivable and inventory. Asset-based lenders

may be small commercial banks, commercial finance companies, specialty lenders,

or divisions of bank holding companies. The advance rate is the percentage of an

asset’s value that a lender will lend.

 Vendor Financing.

 Equipment Suppliers.

 Commercial Finance Companies.

 Saving-and-Loan Associations.

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 Stockbrokers. Margin loans are loans from a stockbroker that use the stocks and

bonds in the borrower’s portfolio as collateral. A margin (maintenance) call

occurs when the value of a borrower’s portfolio drops and the broker calls the loan

in, requiring the borrower to put up more cash and securities as collateral.

 Credit Unions are a nonprofit financial cooperative that promotes saving and

provides loans to its members.

 Private Placements. This involves selling debt to one or a small number of

investors, usually insurance companies or pension funds. This is a hybrid between

a conventional loan and a bond.

Economic Development Administration (EDA).

The Economic Development Administration (EDA) offers loan guarantees to create new

business and to expand existing businesses in areas with below- average income and high

unemployment.

Department of Housing and Urban Development (HUD).

nonfarm employment opportunities in rural areas that are underserved. Various

programs help fund projects that create or preserve quality jobs and/or promote a

clean rural environment. The Rural Development Rural Business Services (RBS)

does not make direct loans to small businesses, but will guarantee bank loans.

 Small Business Innovation Research Program (SBIR). The federal government

in universities, federally funded R&D centers, and nonprofit research institutions.

 State and Local Loan Development Programs.