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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
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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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Chapter 15, Page 240
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
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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
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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.
