Week 6 Discussion - Equity and Debt
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cf_katz_ESB_6e_chap014_PPT.pptxChapter Fourteen Small Business Finance: Using Equity, Debt, and Gifts
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Sources of Financing for Small Businesses
The number one source is from the owners themselves.
Other major sources include family and friends, credit cards, trade credit, banks, and other commercial lenders.
Less used sources include grants, angel investors, government programs, community financiers, stock sales, and venture capital.
Sources of financing are either debt, equity, or gifts.
Debt can take many forms of debt equity, such as borrow money from banks, agencies, governments, or individuals.
When you sell part of your business, the money received is equity capital.
Assets or money donated without obligation to repay is a gift resulting in gift equity.
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Financing with Equity
Personal equity.
The amount you contribute depends on your personal worth.
Not all personal wealth is easily available.
You need to know the amount and type of wealth you have.
Outside equity.
Outside equity is money from selling part of your business to people not involved in the business, called outside equity investors.
This is only possible if the business is organized as a partnership, a corporation, or a limited liability company (LLC).
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Financing with Debt
Debt is a claim on the value of a business’s asset but unlike equity, debts are legally enforceable to pay back.
Secured debt provides a lender with the right to seize specific assets if the loan is not paid.
Unsecured debt does not give the lender the right to seize any specific asset.
Lenders must use court action to collect unpaid unsecured debt.
Though debt is easier to obtain than equity, avoid it if possible.
There are repayment obligations.
Lenders can enforce payment regardless of your ability to pay.
The amount of debt financing you can raise is limited by your personal wealth, your business’ wealth, and your debt history.
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Financing with Gifts
Few are able to obtain gift funding for a start-up.
Available to a few established businesses with several years of successful operations.
Even then, a small business will get a grant if, and only if, the business operations meet some desirable societal goal.
Virtually all gift financing comes either from governments or private foundations.
Few foundations exist to support small business and none exist to specifically provide start-up or working capital funding.
Remember that gifts come with strings attached – even grants require periodic reports detailing how the grant is being used and its impact.
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Financing with Equity: Getting Others to Invest in Your Business
Small businesses get started because the owners want to make money.
Investors want to make money, too.
Lenders expect a return on their money by collecting interest on their investment.
People expect to receive a gain on investment, or a dividend.
Even governments expect a return in the economic development of an area.
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Financing with Equity: Equity Capital from the Investors’ View
How do investors decide which business to invest in?
They want to know how likely the business is to produce a gain, they want to know the business’s risk.
Investors know some investments will fail, so they diversify.
They will invest only if your business is organized to limit the liability of outside owners.
To estimate an expected gain, investors will evaluate your growth potential, a primary concern.
The time required to receive gains can be a deal killer.
Business angels want to know your plan to pay investor’s profits, called the harvest or exit.
A hybrid form of investing, called royalty financing is rarely used.
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Financing with Equity: Methods to Obtain Equity Capital
Using your own capital and funds generated by the start-up is called bootstrapping.
Minimize overhead costs.
Cloud computing, virtual storefronts, incubators, office co-ops, or co-working spaces.
Maximize returns from employee expense.
Student interns, overtime, contractors.
Minimize operating costs.
Outsource, subcontract, rent space or equipment, work from home.
Maximize the results of marketing.
Word of mouth and publicity.
Crowdfunding is a new way to gather investors.
IPOs are limited to a few start-ups.
Under the JOBS Act, investors must be a sophisticated investor or an accredited investor.
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Financing with Equity: Angel Investors
A number of high-wealth individuals invest in first- and second-stage funding – called angel investors.
It is probable that few really good business ideas go undeveloped, and a large percentage of “good ideas” prove not to be in the long run.
Individual angel.
Hard to find, proximity is critical, informal involvement, unplanned exit.
Angel network.
Easy to find, proximity preferred, informal involvement, cash-out exit.
Angel fund.
Easy to find, proximity preferred, formal involvement, cash-out exit.
More formal reporting requirements, but offers the highest funding.
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Financing with Equity: Equity Capital from the Owner’s View
Financing with equity is expensive and guaranteed to create problems of control and decision making.
If you sell half your business, you sell half of all future profits, future growth, and future wealth.
You will have to provide regular reports to investors and they have the right to inspect the accounting records any time they choose.
If investors disagree with your running of the company, they can challenge you, sue you, or even replace you as manager.
There are three primary reasons to use outside equity in your business.
You will reduce your own exposure to financial loss.
Your business will not have increased costs in the form of interest.
Outside investors can reenergize an existing business by providing new ideas, procedures, and processes.
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Financing with Debt: Getting a Loan for Your Business
Done in three ways: (1) direct cash loans, (2) guaranteed loans, and (3) reduced taxes by deducting interest.
Established firms have valuable assets to borrow against.
Small businesses look to banks, but there are options if turned down.
The SBA guarantees loans through community development organizations, microlenders, or an SBIC.
You may have access to incubators or accelerators in your area.
Lenders want to see the Four Cs of Borrowing.
Character of the managers of the business.
Capacity to repay both principal and interest on time.
Conditions of the industry and economy in which the firm operates.
Collateral used to secure the loan.
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Financing with Debt: The Four Cs of Borrowing
Owner character is largely judged by the owner’s personal credit rating.
Find your rating at one of four credit reporting agencies (CRAs).
The Fair Credit Reporting Act (FCRA) requires all information reported to CRAs be accurate.
The capacity of your business is measured by profitability and cash flows from operations.
The most important single factor for borrowing money.
Condition of the industry/economy includes factors such as technology, competition, and economic growth.
Cell phones have made pay phones obsolete.
Collateral value is an estimated market value of tangible assets.
Intangible assets, though valuable, cannot be transferred to the lender to satisfy debt.
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Financing with Debt: Customer Funding of Your Business
This is debt because the customer gives you the money and you owe them the product or service.
It provides cash inflows before the necessary outflows occur.
Matchmaker models – Airbnb.
Pay-in-advance models – Threadless.com.
Subscriptions models – Netflix.
Scarcity-based models – Groupon or Gilt.
Service-to-product models – BaseCamp or SaaS like Office 365.
These business models work and there are numerous common examples of each.
The advantage is there is no interest to pay and it provides cash flow from the start.
In addition, these sales are a validation of your business idea.
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Financing with Gifts: Winning Grants for Your Business
Gift financing has a special allure – like getting something for nothing.
Remember that anything that seems too good to be true usually is.
Gift capital is anything but free – it costs time and money to obtain and then report on the use of the money.
There are two general sources of gift financing:
One is institutional, from government agencies and foundations.
The other is personal, from family or occasionally from friends.
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Financing with Gifts: Institutional Gifts
The most common form of institutional gift financing is in the form or reduced taxes, either a tax abatement or a credit against taxes payable.
Tax abatements are provided by state and local governments.
Tax credits are provided by the U.S. government and some states.
Grants are available from the federal and state governments, and semi-private and private economic development agencies.
Grants from foundations are rarely made to for-profit businesses.
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Financing with Gifts: Personal Gifts
Forms include: cash, picking up the tab, accelerated cash-outs, free use, free work or unpaid labor, overpayment, favored status or sweetheart deals, forgiveness, deferrals, or piggybacking.
Accepting money from family members and friends entails some risks.
Put your agreement into writing.
If it is a gift, have the agreement specifically say so.
If it is a loan, have the agreement specify the exact interest and payment terms.
If it is an equity investment, consider non-voting stock.
Gifts from crowdfunding have two models: nonequity and equity.
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What Type of Financing Is Right for Your Business?
The cost of equity is much greater than the cost of debt.
With a capital mix of 70% equity and 30% debt, the weighted average cost of capital is approximately 16%.
At a 50-50 mix, the weighted average cost of capital (WAC) is 13% and 10% at a 30-70 mix.
As debt increases as a percentage of total investment (called financial leverage) returns on equity increase at a decreasing rate up to some limit where more debt causes returns to decline.
This mix of debt and equity is the optimum capital structure.
Financial risk is the probability of financial loss and borrowing money increased financial risk.
Selling equity provides neither the opportunity to repurchase nor the obligation to make payments to owners.
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Figure 14.4: Interaction among Profitability, Control, and Risk
Borrowing enhances the potential for higher rates of return for the owners and allows the owners to keep a greater level of control.
Borrowing increases potential profits by lowering the WAC of capital and provides funds allowing the firm to consider opportunities.
Borrowing allows more control but even lenders impose restrictions, called loan covenants.
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Tools for Financial Management
You must have something to compare with your position and results.
Compare with your planned position and results, with prior years’ position and results, and with the position and results of other firms.
Most financial comparisons are made using ratios.
There are four broad categories of financial ratios: activity ratios, profitability ratios, liquidity ratios, and leverage ratios.
The three most common are ROI, current ratio, and debt-to-equity ratio.
The ratios considered important change as the firm matures.
As the firm reaches breakeven, profits become a reality and profitability ratios become important.
Leverage ratios also become more important as they look at the longer-term success of the firm.
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Financial Management for the Life of Your Business
Financial management for start-up.
Use the financial management techniques for bootstrapping.
Financial management for growth.
Focus is on obtaining cash inflows to pay for added inventory, productive assets, and employees needed to meet growth levels.
Financial management for operations.
Emphasis is on building owner wealth, to conserve assets, to match cash inflows to outflows, and to maximize return on capital assets.
Financial management for exit.
Goals of financial management depend on the nature of the exit.
Exit can be a transfer to heirs, selling to outsiders or employees, or through bankruptcy, a “work-out,” or closing and selling the assets.
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