Chapter 12

OTHER FINANCING ALTERNATIVES

FOCUS

In this chapter, we consider a variety of government and private sources of new venture
funding. We also consider financing traditionally available only to more mature ventures
including commercial banking loans.

LEARNING OBJECTIVES

1. Identify relevant sources of debt-oriented financing

2. Discuss government loan guarantee and microcredit programs
3. Identify several potential sources of funding for minority-owned enterprises
4. Explain what differentiates venture lending and leasing from traditional lending
and leasing
5. Describe factor financing and compare it to receivables financing through a bank

CHAPTER OUTLINE

12.1 FACILITATORS, CONSULTANTS, AND INTERMEDIARIES

12.2 COMMERCIAL AND VENTURE BANK LENDING
12.3 UNDERSTANDING WHY YOU MAY NOT GET DEBT FINANCING
12.4 CREDIT CARDS
12.5 SMALL BUSINESS ADMINISTRATION PROGRAMS
A. Overview of what the SBA does for Small Businesses
B. Selected SBA Loan and Operating Specifics
12.6 OTHER GOVERNMENT FINANCING PROGRAMS
12.7 RECEIVABLES LENDING AND FACTORING
12.8 DEBT, DEBT SUBSTITUTES, AND DIRECT OFFERINGS
A. Vendor Financing: Accounts Payable and Trade Notes
B. Mortgage Lending
C. Traditional and Venture Leasing
D. Direct Public Offers
SUMMARY

APPENDIX A:
Summary of Colorado Business Financial Assistance Options

DISCUSSION QUESTIONS AND ANSWERS

1. What are the five C’s of Credit Analysis?

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The five C’s of credit analysis are capacity, capital, collateral, conditions, and
character. See Figure 12.1.

2. Name three of the common loan restrictions and explain their relation to new
venturing financing. What are some additional common loan restrictions?

While many different restrictions can be placed on businesses, a few are described
here: (1) Limits on total debt are placed on venture firms to limit the amount of
leverage the firm has; (2) Dividend restrictions are placed on firms to prevent the firm
from paying out the newly issued debt in the form of a dividend; and (3) Maintenance
of financial statements may be required to provide the lending institution with a
current representation of the company’s financial situation.

See Figure 12.2 for some additional common loan restrictions including: (4)
restrictions on additional capital expenditures, (5) restrictions on sale of fixed assets,
(6) performance standards on financial ratios, and (7) current tax and insurance
payments.

3. What is meant by venture banks? How do they differ from traditional commercial
banks?

The term “venture banks” refers to a type of debt investor (lender) that will consider
lending to early stage ventures that do not have proven cash flows. They typically
offer debt to accompany venture equity and will look for compensation in both
interest payments and equity positions (including call options) in the venture.
Commercial banks typically do not consider this type of very risky lending.

4. Why are new ventures at a disadvantage in receiving debt financing?

They are at a disadvantage because they usually do not have large amounts of assets
to provide as collateral, and the risk associated with the loan is not normally in a risk-
averse bank’s goals.

5. Why is credit card financing attractive to entrepreneurs? What are the risks?

It is attractive because it is quite easy to obtain and also provides interest rates lower
than prime for the introductory period, but is also risky due to high interest rates
charged after the teaser period.

6. What is the Small Business Administration (SBA), when was it organized, and
what was its purpose?

The SBA is the Small Business Administration which was created by Congress in
1953 to provide small businesses help in startup and growth.

7. Identify and briefly describe four basic SBA credit programs.

 Chapter 12: Other Financing Alternatives 217

Refer to Figure 12.3. The four basic SBA credit programs:

1) Loan: traditionally has been the SBA’s primary loan program and approached $14
billion in loans in 2006.
2) 504 Loan: this is the SBA’s rapid-growth loan program.
3) Microloan: intended for very small businesses with a maximum amount of
$35,000 to be used for general purposes.
4) Venture Capital: this credit program works through Small Business Investment
Companies (SBICs) which are private for-profit investment firms.

8. Compare the characteristics in terms of loan amounts, lenders, and SBA role in 7(a)
loans versus 504 loans.

Refer to Figure 12.3.

7(a) Loan: Lenders include commercial bank, credit union, or financial services firm.
Loans are up to $2 million with 7- to 10-year maturities and can be used for most
business purposes including the financing of working capital needs. The SBA role
approves loan and guarantees up to 85% of loan value.

504 Loan: Lenders include commercial bank jointly with not-for-profit Certified
Development Company. Loans are up to $4 million for fixed assets and up to $2
million for other business needs. The SBA role approves and guarantees
development company’s portion of debt.

9. What is a Small Business Investment Company (SBIC)?

SBIC stands for Small Business Investment Company and is a private financing
company which provides capital of diverse types.

10. What types of advisory services are available from the SBA?

The SBA provides advisory services to many of the same niches (e.g. small and
disadvantaged businesses) listed in the answer to question 7 above. They also
provide assistance to exporters and those involved in technology transfer.

11. What is a debt guarantee and how does the SBA back a small business loan?

A debt guarantee is an assurance that a certain portion of the debt principal (and/or
interest) will be repaid even in the event of default. The SBA guarantees part of the
loan that a local SBA-participating lender makes through an SBA program.

12. In which research areas does the SBA provide supplemental programs?

Refer to Section 12.5. The SBA provides technical assistance, financial assistance,
contracting assistance, disaster assistance recovery, supports special interests,
provides advocacy, laws & regulations assistance, and works to provide civil rights
218 Chapter 12: Other Financing Alternatives

compliance. Technical assistance is provided for entrepreneurial development,

management assistance to small business owners, efforts to help small businesses to
export, etc. Financial assistance includes loan programs, provides venture capital
through Small Business Investment Companies (SBICs), manages surety bond
guarantees, etc. Contracting assistance includes working to create an environment for
maximum participation by small, disadvantaged, and woman-owned business in
federal government contract awards.

13. What are some characteristics of a Community Development Financial Institutions

(CDFI) loan?

In 1994, Congress created the Treasury Department’s Community Development

Financial Institutions (CDFI) Fund. Most CDFIs currently still focus on promoting
affordable housing and homeownership. However, CDFIs are increasing their
financing of small businesses through the making of microloans as well as larger
loans. The SVA makes direct loans to CDFIs, which, in turn, make microloans to
small businesses. See Figure 12.4 for factors to review when considering a CDFI
loan.

14. What is factoring? What is receivables lending?

Factoring is selling receivables to a third party at a discount from their face value in
order to have an immediate cash flow instead of a deferred cash flow when the
receivable is collected.

Receivables lending involves pledging receivables as collateral against a loan.

15. What is venture leasing? How does it differ from traditional leasing?

Venture leasing involves leasing assets to high-growth ventures typically backed by

venture investors. The return to the lessor involves lease payments and a portion of
the venture’s equity.

Traditional leasing targets returns only from the lease payments and the sale of
salvaged assets.

16. What is a direct public offering?

A direct public offering is a security offering made directly to a large number of

investors. It is often done over the internet but the success rate is still debatable.

17. From the Headlines – Solix: Describe the alternative financing Solix arranged for the
launch of its biofuels production facility. Comment on your impressions of what
attracted the investors.
 Chapter 12: Other Financing Alternatives 219

Answers will vary: Solix’s technology and development were initially subsidized by
Colorado State University and government grants. Then, to produce its large-scale
algal oil production facility, it partnered with the Southern Ute Alternative Energy
fund for a plant location and contributed capital. It also secured funding from
private investors and government-funded entities. Among other things, the attraction
to investors appears to have been a combination of affinity for the new technology
and its promise, public policy and funding for related initiatives, and the possibility
of investment returns.

INTERNET ACTIVITIES

1. Locate your state’s small business credit facilitation web page. Describe the
resources you state makes available in broad categories.

Web-researched results will vary due to constant updating of the related web sites.

2. Find the web solicitation for a direct public offering. (You might start at
http://www.vipo.com or other similar facilitation sites.) Describe the venture and
its prospects.

Web-researched results will vary due to constant updating of the related web sites.

EXERCISES/PROBLEMS AND ANSWERS

1. [Bank Loan Considerations] Assume you started a new business last year with
$50,000 of your own money that was used to purchase equipment. Now you are
seeking a $25,000 loan to finance the inventory needed to reach this year’s sales
target. You have agreed to pledge your venture’s delivery truck and your personal
automobile as support for the loan. Your sister also has agreed to cosign the loan.
During your initial year of operation, you paid your suppliers in a timely fashion.

A. Analyze the loan request from the viewpoint of a lender who uses the “five Cs” of
credit analysis as an aid in deciding whether to make loans.

Capacity to pay: depend on the venture’s ability to generate profits and cash flow
from the business activities

Capital: $50,000 personal capital has been invested in the venture.

Collateral: The delivery truck and the entrepreneur’s personal automobile have
been pledged as collateral. A sister has agreed to cosign the loan.

Conditions: The loan is to finance the inventory. Consequently the conditions

would relate to this inventory use.
 220 Chapter 12: Other Financing Alternatives

Character: The venture has a history of paying creditors in a timely fashion.

B. Assume you are currently carrying an accounts receivable balance of $10,000. How
might you use accounts receivables to obtain an additional bank loan?

You could approach a bank with the receivables and your track record of
collections and ask if they could be collateral for a loan. You could also contact a
factor and see if you could “sell” the receivables for cash.

C. Assume at the end of next year, you will have an accounts receivable balance of
$15,000 and an inventories balance of $30,000. If a bank normally lends an amount
equal to 80 percent of accounts receivable and 50 percent of inventories pledged as
collateral, what would be the amount of a bank loan a year from now?

$15,000  .80 = $12,000

$30,000  .50 = $15,000
Total = $27,000

2. [Factor Financing] Assume the operation of your business resulted in sales of $730,000
last year. Year-end receivables are $100,000. You are considering factoring the
receivables to raise cash to help finance your venture’s growth. The factor imposes a 7
percent discount and charges an additional 1 percent for each expected ten-day average
collection period over thirty 30 days.

A. Estimate the dollar amount you would receive from the factor for your receivables if
the collection period was thirty 30 days or less.

If the collection period is 30 days or less, the factor will pay .93 x $100,000 =
$93,000.

B. Estimate the dollar amount you would receive from the factor for your receivables if the
average collection period was sixty days.

If the collection period is 60 days, the factor will pay 90% of the value (i.e., .07 for 30
days plus an additional .01 for 31-40 days, plus an additional .01 for 41-50 days, and
an additional .01 for 51-60 days. Thus, the dollar amount paid would be: .90 x
$100,000 = $90,000.

C. Show how your answer in Part B would change if the factor charges an 8 percent
discount and charges an additional .5 percent for each expected fifteen-day average
collection period over thirty days.

.08 + .005 +.005 = .09

1.00  .09 = .91
.91  $100,000 = $91,000
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Or, (1(.08 + (.005  2)))  $100,000 = $91,000

D. If the $730,000 in sales last year were evenly distributed throughout the year, an
average $100,000 in receivables outstanding would imply what average collection
period? Given the original terms stated in the problem, what dollar amount would you
expect to receive for your receivables?

Recall from Chapter 5 that the average collection period is also referred to as the days
of sales outstanding and even the “sale-to-cash conversion period.”
$100,000 / ($730,000 / 365) = $100,000/$2,000 = 50.0 days average collection period
Original terms: for 50 days, the discount would be .07 + .01 +.01 = .09
1.00  .09 = .91
.91  $100,000 = $91,000
Or, (1(.07 + (.01  2)))  100,000 = 91,000

MINI CASE: JEN AND LARRY’S FROZEN YOGURT COMPANY (Revisited)

In 2010, Jennifer (Jen) Liu and Larry Mestas founded Jen and Larry’s Frozen Yogurt
Company, which was based on the idea of applying the microbrew or microbatch strategy
to the production and sale of frozen yogurt. Jen and Larry began producing small
quantities of unique flavors and blends in limited editions. Revenues were $600,000 in
2010 and were estimated at $1.2 million in 2011.
Since Jen and Larry were selling premium frozen yogurt containing premium
ingredients, each small cup of yogurt sold for $3. The cost of producing the frozen yogurt
averaged $1.50 per cup. Administrative expenses, including Jen and Larry’s salary and
expenses for an accountant and two other administrative staff, were estimated at
$180,000 in 2011. Marketing expenses, largely in the form of behind-the-counter
workers, in-store posters, and advertising in local newspapers, were projected to be
$200,000 in 2011.
An investment in bricks and mortar was necessary to make and sell the yogurt. Initial
specialty equipment and the renovation of an old warehouse building in lower downtown
(known as LoDo) of $450,000 occurred at the beginning of 2010 along with $50,000
being invested in inventories. An additional equipment investment of $100,000 was
estimated to be needed at the beginning of 2011 to make the amount of yogurt forecasted
to be sold in 2011. Depreciation expenses were expected to be $50,000 in 2011 and
interest expenses were estimated at $15,000. The tax rate was expected to be 25 percent
of taxable income.

A. How much net profit, before any financing costs, is the venture expected to earn in
2011? What would be the net profit if sales reach $1.5 million? What would be the
net profit if next year’s sales are only $800,000?

Note: Cost of goods sold is: $1.50/$3.00 per unit = 50% of sales.
222 Chapter 12: Other Financing Alternatives

Scenario 1 Scenario 2 Scenario 3

Net Sales $1,200,000 $1,500,000 $800,000
Cost of Goods Sold -600,000 -750,000 -400,000
Gross Profit 600,000 750,000 400,000
General and Admin. -180,000 -180,000 -180,000
Marketing -200,000 -200,000 -200,000
Depreciation -50,000 -50,000 -50,000
EBIT 170,000 320,000 -30,000
Interest -15,000 -15,000
-15,000
Earnings before Taxes 155,000 $305,000 -$45,000
Taxes (@ 25% rate) 38,750 -76,250 0
Net Profit $116,250 $228,750 -$45,000

Note: a venture’s profits can be measured in a number of different ways: before interest
and taxes (EBIT); net profit (or income) after financing and taxes; or net operating profit
after taxes (NOPAT) calculated as EBIT times (1 – tax rate).

Profit Measures:
EBIT $170,000 $320,000 -$30,000

Net Profit $116,250 $228,750 -$45,000

NOPAT $127,500 $240,000 -$30,000

= (EBIT)(1 – tr)

Note: the tax rate is considered to be zero under Scenario 3 which indicates a negative
EBIT or loss.

B. If inventories are expected to turn over ten times a year (based on cost of goods
sold), what will be the venture’s average inventories balance next year if sales are
$1.2 million? How much might the venture be able to borrow if a lender typically
lends an amount equal to 50 percent of the average inventories balance? If the
borrowing rate is 12 percent, how much dollar amount of interest would have to be
paid on the loan?

Recall from Chapter 5 the discussion of the “inventory-to-sale conversion period”

which shows the average number of days to turnover inventories. By dividing the
inventory-to-sale conversion period into a 365 day year we have the inventories
turnover. Thus, if we know the turnover, 365/10 gives the inventory-to-sale
conversion period of 36.5 days.

Cost of goods sold = 50% ($1.50/$3.00) of sales. At sales of $1,200,000, cost of

goods sold would be $600,000 ($1,200,000 x .5).
($600,000) / 10 = $60,000 average inventory balance
$30,000 = 50% of average inventory balance (i.e., $60,000 x .50)
 Chapter 12: Other Financing Alternatives 223

.12 x $30,000 = $3,600

Note: the $3,600 interest expense estimated here is substantially less than the
$15,000 estimated in Part A. Jen and Larry might also borrow against its receivables
and fixed assets. At interest of $15,000 and a 12% borrowing rate, total borrowing
would be $125,000 (i.e., $15,000/.12)

C. How might the venture acquire and finance the new equipment that is needed?

Leasing and secured equipment lending are possibilities.

D. Identify potential government credit resources for the venture.

As co-owner, Jen may qualify for SBA and other special financing. Given the
venture’s location, there also could be incentives related to downtown business
restoration.

E. Prepare a summary of the benefits and risks of Jen and Larry’s continued use of
credit card financing.

While credit cards may appear inexpensive and readily available, managing teaser
rate periods, transferring balances and avoiding penalties and paying high initial
catch-up interest charges if full balances are not paid impose large time costs and
potentially high financing costs. Therefore credit cards are not a recommended long
term source of capital.

F. Prepare a summary of how the venture might benefit from receivables financing if
commercial customers are extended credit for thirty days on their purchases.

Jen and Larry are operating a retail business and are not likely to have receivables
from their day-to-day customer flow. If, however, Jen and Larry begin a larger scale
catering operation dealing with corporate customers and purchase orders, they may
easily find themselves involved in the extension of trade credit to those corporate
customers. If this aspect of Jen and Larry’s business model was to become
sufficiently large, they might benefit from seeking receivables financing.

G. Discuss the impact of potential loan restrictions should the venture seek commercial
loan financing.

It is likely that Jen and Larry will have to maintain and provide (to the lender)
accurate and complete financial statements. They will also probably have to agree to
restrictions on other financing that they may obtain and on the use of the proceeds.
Their ability to withdraw money or assets from the venture will also be limited.

H. Comment on how the venture might be evaluated in terms of the five C’s of credit
analysis.
224 Chapter 12: Other Financing Alternatives

Capacity to pay: Jen and Larry have past revenues and a demonstrated ability to
produce profits. Their capacity to pay appears to be reasonable. Depending on
their continued ability to produce profits and their expansion plans, their ability to
pay may vary.

Capital: Jen and Larry’s personal investment in the business is not known (here)
but they do have some reputational capital in the business from previous
successful operations.

Collateral: Jen and Larry’s collateral possibilities are not known but inventory and
machinery could provide some form of collateral. They will probably have to
personally guarantee the loan and that guarantee may involve personal assets.

Conditions: Jen and Larry will probably have to support working capital
investments from the proceeds of the loan which will most likely have to be paid
off as revenues are realized. It is also likely that their loan will be seasonal, have
some requirement that it be “cleaned up” to a zero balance at least once a year.

Character: Jen and Larry’s character is not indicated but they do appear to have
some business reputation and may also have some reputation with their
employees that could provide insights more generally.