Section IV - Putting the Business Plan to Work

Section IV - Putting the Business Plan to Work

Chapter 12

Sources of Financing: Debt and Equity (PPT 12.1 thru 12.3)

Part One: Learning Objectives

1. Explain the differences in the three types of capital small businesses require: fixed, working, and growth.

2. Describe the differences in equity capital and debt capital and the advantages and disadvantages of each.

3. Describe the various sources of equity capital available to entrepreneurs, including personal savings, friends and relatives, angels, partners, corporations, venture capital, and public stock offerings.

4. Describe the process of "going public," as well as its advantages and disadvantages and the various simplified registrations and exemptions from registration available to small businesses wanting to sell securities to investors.

5. Describe the various sources of debt capital and the advantages and disadvantages of each: banks, asset-based lenders, vendors (trade credit), equipment suppliers, commercial finance companies, savings and loan associations, stock brokers, insurance companies, credit unions, bonds, private placements, Small Business Investment Companies (SBICs), and Small Business Lending Companies (SBLCs).

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

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

8. Discuss valuable methods of financing growth and expansion internally.

Part Two: Lesson Plan

I. Planning for Capital Needs (PPT 12.4)

Rather than relying on a single source of funds, entrepreneurs may need to piece together multiple sources, a method known as layered financing.

Capital is any form of wealth employed to produce more wealth. It exists in many forms in a business, including cash, inventory, plant, and equipment. Small businesses require three types of capital:

A. Fixed Capital - Capital needed to purchase the business's permanent or fixed assets.

B.  Working Capital - Capital used to support the business's day-to-day operations.

C.  Growth Capital - Capital requirements surface when an existing business is expanding or changing its primary direction.

II. Equity Capital vs. Debt Capital (PPT 12.5, 12.6)

Equity Capital represents the personal investment of the owner(s) in a business.

Debt Capital represents the financing that a small business owner has secured and must repay with interest.

III. Sources of Equity Financing (PPT 12.7 thru 12.29)

A. Personal Savings - The most common form of equity funds is the entrepreneur's pool of personal savings. Entrepreneurs should expect to provide between 20% -50% of the required start-up funds.

B. Friends and Family Members

C. Angels - Angels are wealthy individuals, often entrepreneurs themselves, who invest in business start-ups in exchange for an equity stake.

D. Partners - Entrepreneurs can choose to take on a partner(s) to expand their capital.

E. Corporate Venture Capital – Some large corporations, both U.S. and foreign, finance and invest in small companies.

F.  Venture Capital Companies - Venture capital companies are private, for profit

organizations that purchase equity positions in young businesses with high growth and profit potential.

G.  Public Stock Sale - One method of raising large capital is to sell shares of stock,

known as "going public."

YOU BE THE CONSULTANT – Filled With Promise, But Low on Capital

After serving as consultants to some technology companies, Astro Teller and his friends launched BodyMedia, a company built around a device worn on the arm that measures, records and analyzes bodily functions and calorie burn-rates. The partners bounced from market to market due to financial and other constraints and are sorely in need of a second round of financing in order to sustain their operation.

Q1. What role do factors that are beyond entrepreneurs’ control-- such as a faltering economy or a falling stock market-- have on their ability to attract the capital they need?

Q2. Explain why the following funding sources would or would not be appropriate for BodyMedia: family and friends, angel investors, an initial public offering, a traditional bank loan, asset-based borrowing, or one of the many federal or SBA loans.

Q3. Work with a team of your classmates to devise a workable strategy for raising the capital BodyMedia needs to market their product.

A1. The availability of capital and the degree of investor risk is directly affected by the economy, the stock market, interest rates and other factors beyond the entrepreneur’s control.

A2. & A3. Students will offer the trade-offs and advantages and disadvantages of each of the funding sources, and will devise strategies for securing financing.

IV. The Nature of Debt Financing (PPT 12.30 thru 12.39)

Debt financing involves funds that small business owner's borrow and must repay with interest. Borrowed capital does allow entrepreneurs to maintain complete ownership.

A. Sources of Debt Capital

·  Commercial Banks

·  Equipment Suppliers

·  Commercial Finance Companies

·  Savings and Loan Associations

·  Stock Brokerage Houses

·  Insurance Companies

·  Credit Unions

·  Bonds

·  Private Placements

·  Small Business Investment Companies (SBICs)

·  Small Business Lending Companies (SBLCs)

V. Federally Sponsored Programs

·  Economic Development Administration (EDA)

·  Department of Housing and Urban Development (HUD)

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

·  Small Business Innovation Research (SBIR)

·  The Small Business Technology Transfer Program

YOU BE THE CONSULTANT – Two Financing Puzzles

Lissa D’Aquanni, owner of The Chocolate Gecko, has been able to slowly grow her home-based company by raising funds in creative ways such as selling gift certificates and bartering for services. She now faces her biggest fundraising challenge-- the purchase and renovation of a commercial building.

John Acosta, owner of Jolly Technologies, faces the same fundraising challenge as Lissa, as he attempts to raise $100,000 to modify the production and enhance the marketing efforts for his garage door- opening device.

Q1. Describe the advantages and the disadvantages of both equity capital and debt capital for Lissa D’Aquanni and John Acosta.

Q2. Explain why the following funding sources would or would not be appropriate for these entrepreneurs: family and friends, angel investors, an initial public offering, a traditional bank loan, asset-based borrowing, or one of the many federal or SBA loans.

Q3. Work with a team of your classmates to brainstorm ways that Lissa D’Aquanni and John Acosta could attract the capital they need for their businesses. What steps would you recommend they take before they approach the potential sources of funding you have identified?

A1. Students will offer the general advantages and disadvantages of each form of capital, but should realize that neither principle has any equity at this time.

A2. Students will offer perspectives on each form of financing that is relevant to the principle’s situations.

A3. Students should be encouraged to think outside of the box and to generate both traditional and creative ways in which the principles could acquire financing.

VI. Small Business Administration (SBA) (PPT 12.40 thru 12.43)

The SBA has several programs designed to help finance both start-up and existing businesses that do not qualify for traditional loans. Programs include:

§  7(A) Loan Guaranty Program

§  The CAPLine Program

§  The Export Working Capital Program

§  The International Trade Program

§  Section 504 Certified Development Company Program

§  Microloan Program

§  Pre-qualification Loan Program

§  Disaster Loans

VII. State and Local Loan Development Programs (PPT 12.44)

These programs come in a variety of forms. They focus on developing small businesses that create the greatest number of jobs and economic benefits.

VIII. Internal Methods of Financing (PPT 12.45)

Bootstrap financing is a term used for internal methods of financing that include factoring, leasing rather than purchasing equipment, using credit cards, and managing the business frugally.

Part Three: Suggested Answers to Discussion Questions

1. Why is it so difficult for most small business owners to raise the capital needed to start, operate, or expand their ventures?

The financial industry has been through difficult times, resulting in credit crunches. Banks have tightened their lending criteria, venture capitalists have become more conservative, private investors have grown more cautious, and the issuing of public stock remains viable for only select businesses with established track records.

2. What is capital? List and describe the three types of capital a small business needs for its operations.

Capital is any form of wealth employed to produce more wealth. Fixed Capital is used to purchase a company's fixed assets. Working Capital is used to sustain day-to-day operations. Growth Capital is used to expand an existing business or to change its primary direction.

3. Define equity financing. What advantages does it offer over debt financing?

Equity financing represents the personal investment of the owner(s) of the business. The primary advantage of this type of financing is that is does not have to be repaid with interest.

4. What is the most common source of equity funds in a typical small business? If an owner lacks sufficient equity capital to invest in the firm, what options are available for raising it?

The owner's personal savings is the most common source of equity financing. Owners that lack sufficient funds may turn to family and friends, angels, partners, venture capital companies, corporations, and public stock offerings.

5. What guidelines should an entrepreneur follow if friends and relatives choose to invest in her business?

Entrepreneurs should be honest and objective in their presentation of the investment opportunity and risks involved. It is also wise to establish a written agreement that addresses the many what-if questions that may arise.

6. What is an “angel”? Assemble a brief profile of the typical private investor. How can entrepreneurs locate potential angels to invest in their businesses?

Angels are wealthy investors, often entrepreneurs themselves, who invest in business start-ups in exchange for an equity stake in the company. The typical angel is a 47-year-old white male with a college education earning $100,000 per year with a net worth of $1 million (excluding homes). Most have financial or business experience, and most are drawn to companies at the start-up or early growth stage. The typical angel invests in local companies. The primary way to locate angels is by networking through friends, attorneys, investment institutions, business associations, and other business owners.

7. What advice would you offer an entrepreneur about to strike a deal with a private investor to avoid problems?

Entrepreneurs should be honest with private investors about their needs and expectations. They should realize that private investors are usually not looking for a quick return on investment. Entrepreneurs should keep in mind that angels typically expect a 35%-50% return on investment depending on risk. Private investors normally invest during the start-up or early growth stages. Eighty-two percent of angel investments are for $500,000 or less.

8. What types of businesses are most likely to attract venture capital? What investment criteria do venture capitalists use when screening potential businesses? How do these compare to the typical angel’s criteria?

Venture capital companies typically invest in high-tech industries such as computer software, medical care, biotechnology, and communications-- any company with extraordinary growth potential. Many venture capitalists seek to purchase 30%-40% of a business through common stock or convertible preferred stock. Although venture capitalists usually prefer to allow the founding team of managers to employ their skills to operate the business, they may join the boards of directors and/or send in some new management to protect their investment. Many are choosing to focus their investments in niche markets, rely heavily on their gut instincts and look for businesses that have competent management, a competitive edge, and presence in a growth industry.

9. How do venture capital firms operate? Describe their procedure for screening investment proposals.

Venture capital companies are for-profit organizations that purchase equity positions in young businesses with high-growth and-profit potential, producing annual returns of 300-500 percent over five to seven year periods. The screening process of venture capital firms is extremely stringent and revolves around ownership, control, and investment preferences.

10. Summarize the major exemptions and simplified registrations available to small companies wanting to make public offerings of their stock.

The SEC has established simplified registration statements and exemptions from the registration process: Regulation S-B, Regulation D (Rules 504,505,506), Private Placements, Interstate Offerings (Rule 147), Regulation A and Direct Stock Offerings (DPO).

11. What role do commercial banks play in providing debt financing to small businesses? Outline and briefly describe the major types of short-term, intermediate, and long-term loans commercial banks offer.

Commercial banks provide the greatest number and variety of loans (almost 50%) to small businesses, offering commercial loans, lines of credit and floor planning.

12. What is trade credit? How important is it as a source of debt financing to small firms?

Trade credit focuses on extending credit in the form of delayed payments, usually 30, 60, or 90 days interest free. It is an extremely important source of small business financing, especially when small businesses are seen as a bad risk by commercial banks.

13. What functions do SBICs serve? How does an SBIC operate? What methods of financing do SBICs rely on most heavily?

SBICs are privately owned financial institutions that are licensed and regulated by the SBA. They use a combination of private and public funds to provide long-term capital to small businesses. The most common forms of SBIC financing are: loans with the option to buy stock, convertible debentures, straight loans and preferred stock.

14. Briefly describe the loan programs offered by the following:

a. the Economic Development Administration

b. the Department of Housing and Urban Development

c. the Department of Agriculture’s Rural Business-Cooperative

d. local development companies

(a) 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.

(b) The Department of Housing and Urban Development (HUD) sponsors several loan programs to assist qualified entrepreneurs in raising capital. The Urban Development Action Grants are extended to cities and towns that, in turn, lend or grant money to entrepreneurs to start small businesses that will strengthen the local economy.

(c) The Department of Agriculture’s Rural Business-Cooperative Service loan program is open to all businesses and is designed to create non-farm employment opportunities in rural areas--those with population below 50,000 and not adjacent to a city where densities exceed 100 persons per square mile. The RBS does not make direct loans to small businesses, but it will guarantee as much as 90 percent of a bank's loan up to $25 million.