CHAPTER 11:

SOURCES OF CAPITAL
DEBT OR EQUITY FINANCING

• Debt financing is a financing method involving an

interest-bearing instrument, usually a loan, the
payment of which is only indirectly related to the
sales and profits of the venture.
• Debt financing (also called asset-based financing)
requires that some asset (such as a car, house,
inventory, plant, machine, or land) be used as
collateral.
• If the financing is short term (less than one year), the
money is usually used to provide working capital to
finance inventory, accounts receivable, or the operation of
the business.
• Long-term debt (lasting more than one year) is
frequently used to purchase some asset such as a piece of
machinery, land, or a building, with part of the value of
the asset (usually from 50 to 80 percent of the total value)
being used as collateral for the long-term loan.
• Using debt as the financing instrument is called
leveraging the firm.
• The higher the amount of leverage (debt/total
assets), the greater the risk in the venture.
• Requires the entrepreneur to pay back the
amount of funds borrowed plus the interest rate.
• Equity financing does not require collateral and offers
the investor some form of ownership position in the
venture.
• The investor shares in the profits of the venture
(dividends), as well as any disposition of its assets on
a pro rata basis based on the percentage of the business
owned.
• Key factors favoring the use of one type of financing
over another are the availability of funds, the assets of
the venture, and the prevailing interest rates.
INTERNAL OR EXTERNAL FUNDS

• Internally generated funds can come from several

sources: profits, sale of assets, reduction in working
capital, extended payment terms, and accounts
receivable.
• Assets, whenever possible, should be on a rental basis
(preferably on a lease with an option to buy), not an
ownership basis, particularly when there is not a high
level of inflation and the rental terms are favorable.
• Short-term, internal funds can also be reducing short-
term assets: inventory, cash, and other working-capital
items and through extended payment terms from
suppliers.
• Alternative sources of external financing need to be
evaluated on three bases:
1. the length of time the funds are available;
2. the costs involved;
3. the amount of company control lost.
SOURCES OF EXTERNAL FUNDS

1. PERSONAL FUNDS
• least expensive funds in terms of cost and control, but
they are absolutely
• essential in attracting outside funding, particularly
from banks, private investors, and venture capitalists.
• it is not the amount of the capital but rather the fact
that all monies available are committed that makes
outside investors feel comfortable with their
commitment level and therefore more willing to invest.
2. FAMILY AND FRIENDS
• most likely to invest due to their relationship with
the entrepreneur
• keep the business arrangements strictly business.
• agree on everything up front and in writing (the
amount of money involved, the terms of the
money, the rights and responsibilities of the
investor, and what happens if the business fails).
3. COMMERCIAL BANKS
• funds provided are in the form of debt financing and
require some tangible guaranty or collateral—some
asset with value.
• collateral can be in the form of business assets (land,
equipment, or the building of the venture), personal
assets (the entrepreneur’s house, car, land, stock, or
bonds), or the assets of the cosigner of the note.
TYPES OF BANK LOANS

• Asset base for loans is usually accounts receivable, inventory,

equipment, or real estate.
1. Accounts Receivable Loans
• a bank may finance up to 80% of the value of their
accounts receivable.
• factoring arrangement whereby the factor (the bank)
actually “buys” the accounts receivable at a value below
the face value of the sale and collects the money directly
from the account.
• The costs of factoring involve:
• the interest charge on the amount of
money advanced until the time the
accounts receivable are collected
• the commission covering the actual
collection
• protection against possible uncollectible
accounts.
2. Inventory Loans
• when the inventory is more liquid and can be easily sold.
• The finished goods inventory can be financed for up to
50% of its value.
• Trust receipts are a unique type of inventory loan used to
finance floor plans of retailers, such as automobile and
appliance dealers.
• In trust receipts, the bank advances a large percentage of
the invoiced price of the goods and then is paid back on a
pro rata basis as the inventory is sold.
3. Equipment Loans-
• financing the purchase of new equipment
• financing used equipment already owned by the company
• sale-leaseback financing
• lease financing
4. Real Estate Loans- usually easily obtained to finance a
company’s land, plant, or another building, often up to 75
percent of its value.
CASH FLOW FINANCING
1. Line of credit- the company pays a “commitment
fee” to ensure that the commercial bank will make
the loan when requested and then pays interest on
any outstanding funds borrowed from the bank.
2. Installment loans- short-term funds (30 to 40
days) used to cover working capital needs for a
period of time, such as when seasonal financing is
needed.
CASH FLOW FINANCING

3. Straight Commercial Loans- self-liquidating loans,

funds are advanced to the company for 30 to 90 days,
used for seasonal financing and for building up
inventories.
4. Long-Term Loans- usually available only to strong,
mature companies), can make funds available for up to
10 years, debt incurred is usually repaid according to a
fixed interest and principal schedule.
CASH FLOW FINANCING

5. Character Loans- personal loans that must have

the assets of the entrepreneur or other individual
pledged as collateral or the loan cosigned by another
individual.
• Assets that are frequently pledged include cars,
homes, land, securities, and certificate of deposit.
BANK LENDING DECISIONS

Five Cs of lending or credit:

1. Character
2. Capacity
3. Capital
4. Collateral
5. Conditions
SBA IN SMALL-BUSINESS FINANCING
• helps qualified small businesses obtain financing
when they cannot obtain business loans through
regular lending channels
• used for a variety of business purposes, such as
working capital; machinery and equipment;
furniture and fixtures; land and building; leasehold
improvements; and even, under some conditions,
debt refinancing.
RESEARCH AND DEVELOPMENT LIMITED
PARTNERSHIPS
• source of funds for entrepreneurs in high-technology areas.
• provides funds from investors looking for tax shelters.
• involves a sponsoring company developing the technology
with funds being provided by a limited partnership of
individual investor(s).
• three major components are the contract, the sponsoring
company, and the limited partnership.
R&D LIMITED PARTNERSHIPS

1. Contract specifies the agreement between the

sponsoring company and the limited partnership,
whereby the sponsoring company agrees to use the
funds provided to conduct the proposed research and
development
• the liability for any loss incurred is borne by the
limited partners.
• there are some tax advantages to both the limited
partnership and the sponsoring company
2. Limited partners have limited liability and are
not a total taxable entity, share in the profits.
3. Sponsoring company acts as the general
partner developing the technology, usually has the
base technology but needs funds to further
develop and modify it for commercial success.
R&D LIMITED PARTNERSHIP PROCEDURE

1. The funding stage- a contract is established

between the sponsoring company and limited
partners, and the money is invested for the
proposed R&D effort.
• All the terms and conditions of ownership, as
well as the scope of the research, are carefully
documented.
2. The development stage- the sponsoring
company performs the actual research, using the
funds from the limited partners.
3. The exit stage- the sponsoring company and the
limited partners commercially reap the benefits of
the effort. This can be done through:
• equity partnerships
• royalty partnerships
• joint ventures.
• Equity partnership arrangement- the sponsoring
company and the limited partners form a new,
jointly owned corporation.
• Royalty partnership- based on the sale of the
products developed from the technology is paid by
the sponsoring company to the R&D limited
partnership.
• royalty rates typically range from 6 to 10 percent
of gross sales
• Joint venture- the sponsoring company and the
partners form a joint venture to manufacture and
market the products developed from the
technology.
• The agreement allows the company to buy
out the partnership interest in the joint
venture at a specified time or when a
specified volume of sales and profit has been
reached.
GOVERNMENT GRANTS

• provides an opportunity for small businesses

to obtain research and development money
• offers a uniform method by which each
participating agency solicits, evaluates, and
selects the research proposals for funding
1. Each agency develops topics and publishes
solicitations describing the R&D topic it will fund.
2. Small businesses submit proposals directly to
each agency using the required format, which is
somewhat standardized, regardless of the agency.
3. Each government agency, using its established
evaluation criteria, evaluates each proposal on a
competitive basis and makes awards through a
contract, grant, or cooperative agreement.
PRIVATE FINANCING
• Private offering- A formalized approach for
obtaining funds from private investors
• Regulation D contains (1) broad provisions designed
to simplify private offerings, (2) general definitions
of what constitutes a private offering, and (3) specific
operating rules.
BOOTSTRAP FINANCING

• Involves using any possible method for conserving cash.

1. Take as long as possible to pay without incurring
interest or late payment fees or being cut off from
any future items from the supplier
2. Ask about discounts for volume, frequent customer
discounts, promotional discounts for featuring the
vendor’s product, and even “obsolescence money,”
which allows for upgrading to an enhanced product
at no additional cost.
3. Ask for bulk packaging instead of paying more for
individually wrapped items.
4. Use co-op advertising with a channel member so that the
cost of the advertisement is shared.
5. Consignment financing allow entrepreneurs to place a
standing order for the entire amount of goods to be used
over a period of time but take shipment and make payment
only as needed, therefore securing the lower price of a larger
order without having to carry the cost of the inventory.
6. Outsourcing anything possible reduces the capital needed.