Sources of Financing Debt and Equity

Description
Raising the money to launch a new business venture has always been a challenge for entrepreneurs.

462
If you don’t know who the fool
is in a deal, it’s you.
—Michael Wolff
Section IV
Putting the Business
Plan to Work: Sources
of Funds
13 Sources of Financing:
Debt and Equity
On completion of this chapter, you will be able to:
1 Explain the differences among the three types of capital small
businesses require: fixed, working, and growth.
2 Describe the differences between equity capital and debt capital and
the advantages and disadvantages of each.
3 Discuss the various sources of equity capital available to entrepreneurs.
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.
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.
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Raising the money to launch a new business venture has always been a challenge for entre-
preneurs. Capital markets rise and fall with the stock market, overall economic conditions,
and investors’ fortunes. These swells and troughs in the availability of capital make the
search for financing look like a wild roller coaster ride. For instance, during the late 1990s,
founders of dot-com companies were able to attract mountains of cash from private and
professional investors, even if their businesses existed only on paper! Investors flocked to
initial public offerings from practically any dot-com company. The market for capital
became bipolar: easy-money times for dot-coms and tight-money times for “not-coms.”
Even established, profitable companies in “old economy” industries such as manufactur-
ing, distribution, real estate, and brick-and-mortar retail could not raise the capital they
needed to grow. Then, early in 2000, the dot-com bubble burst, and financing an Internet
business also became extremely challenging.
Today, the challenge of attracting capital to start or to expand a business remains. Most
entrepreneurs, especially those in less glamorous industries or those just starting out, face
difficulty finding outside sources of financing. Many banks shy away from making loans to
start-ups, and venture capitalists have become more risk averse, shifting their investments
away from start-up companies to more-established businesses. Private investors have grown
cautious, and making a public stock offering remains a viable option for only a handful of
promising companies with good track records and fast-growth futures. The result has been a
credit crunch for entrepreneurs looking for small to moderate amounts of start-up capital.
Entrepreneurs and business owners needing between $100,000 and $3 million are especially
hard hit because of the vacuum that exists at that level of financing.
In the face of this capital crunch, business’s need for capital has never been greater.
Experts estimate that the small business financing market exceeds $170 billion a year, yet
that still is not enough to satisfy the capital appetites of entrepreneurs and their cash-
hungry businesses.
1
When searching for the capital to launch their companies, entrepre-
neurs must remember the following “secrets” to successful financing:
? Choosing the right sources of capital for a business can be just as important as
choosing the right form of ownership or the right location. It is a decision that will
influence a company for a lifetime, so entrepreneurs must weigh their options care-
fully before committing to a particular funding source. “It is important that compa-
nies in need of capital align themselves with sources that best fit their needs,” says
one financial consultant. “The success of a company often depends on the success
of that relationship.”
2
? The money is out there; the key is knowing where to look. Entrepreneurs must do
their homework before they set out to raise money for their ventures. Understanding
which sources of funding are best suited for the various stages of a company’s growth
and then taking the time to learn how those sources work is essential to success.
? Raising money takes time and effort. Sometimes entrepreneurs are surprised at the
energy and the time required to raise the capital needed to feed their cash-hungry,
growing businesses. The process usually includes lots of promising leads, most of
which turn out to be dead-ends. Meetings with and presentations to lots of potential
investors and lenders can crowd out the time needed to manage a growing company.
Entrepreneurs also discover that raising capital is an ongoing job. “The fund-raising
game is a marathon, not a sprint,” says Jerusha Stewart, founder of iSpiritus Soul
Spa, a store selling personal growth and well-being products.
3
? Creativity counts. Although some traditional sources of funds now play a lesser role in
small business finance than in the past, other sources—from large corporations and cus-
tomers to international venture capitalists and state or local programs—are taking up the
slack. To find the financing their businesses demand, entrepreneurs must use as much
creativity in attracting financing as they did in generating the ideas for their products and
services. For instance, after striking out with traditional sources of funding, EZConserve,
a company that makes software that provides energy management tools for large PC
networks, turned to the nonprofit group Northwest Energy Efficiency Alliance and
received a sizeable grant as well as marketing assistance that fueled its growth.
4
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 463
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? The World Wide Web puts at entrepreneurs’ fingertips vast resources of informa-
tion that can lead to financing; use it. The Web often offers entrepreneurs, espe-
cially those looking for relatively small amounts of money, the opportunity to dis-
cover sources of funds that they otherwise might miss. The Web site created for this
book (http://www.prenhall.com/scarborough) provides links to many useful sites
related to raising both start-up and growth capital. The Web also provides a low-cost,
convenient way for entrepreneurs to get their business plans into potential investors’
hands anywhere in the world. When searching for sources of capital, entrepreneurs
must not overlook this valuable tool.
? Be thoroughly prepared before approaching potential lenders and investors. In the
hunt for capital, tracking down leads is tough enough; don’t blow a potential deal. Be
ready to present your business idea to potential lenders and investors in a clear, concise,
convincing way. That, of course, requires a solid business plan and a well-rehearsed
“elevator pitch”—one or two minutes on the nature of your business and the source of
its competitive edge—capable of winning over potential investors and lenders.
? Entrepreneurs cannot overestimate the importance of making sure that the “chem-
istry” among themselves, their companies, and their funding sources is a good one.
Too many entrepreneurs get into financial deals because they needed the money to
keep their businesses growing, only to discover that their plans do not match those of
their financial partners.
Rather than rely primarily on a single source of funds as they have in the past, entre-
preneurs must piece together capital from multiple sources, a method known as layered
financing. They have discovered that raising capital successfully requires them to cast a
wide net to capture the financing they need to launch their businesses.
464 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
layered financing
the technique of raising capital
from multiple sources.
AgraQuest
Since launching AgraQuest, a company that makes a line of environmentally friendly agri-
cultural biopesticides, Pamela Marrone has raised more than $60 million from a multitude
of sources, providing a perfect illustration of the “patchwork” of start-up financing that
has become so common. Marrone has negotiated eight different rounds of financing with
more than 70 different investors, including friends, family members, major agricultural
corporations, “angels“ (private investors), and venture capital firms. “We’ve gotten
money from everywhere,” says Marrone. “We’ve raised a round of capital every year.
AgraQuest now generates annual sales of more than $10 million and is growing fast,
which provides the impetus for the constant search for cash. “A lot of entrepreneurs get
indignant about the [fund-raising] process,” says Marrone. “But you’ve got to put your
ego aside and get the money in the door.”
5
LEARNING OBJECTIVES
1. Explain the differences among
the three types of capital small
businesses require: fixed, work-
ing, and growth.
This chapter will guide you through the myriad financing options available to entre-
preneurs, focusing on both sources of equity (ownership) and debt (borrowed) financing.
Planning for Capital Needs
Becoming a successful entrepreneur requires one to become a skilled fund-raiser, a job
that usually requires more time and energy than most business founders realize. In start-
up companies, raising capital can easily consume as much as one-half of the entrepre-
neur’s time and can take many months to complete. In addition, many entrepreneurs find
it necessary to raise capital constantly to fuel the hefty capital appetites of their young,
fast-growing companies. Most entrepreneurs seek less than $1 million (indeed, most need
less than $100,000), which may be the toughest money to secure. Where to find this seed
money depends, in part, on the nature of the proposed business and on the amount of
money required. For example, the originator of a computer software firm would have dif-
ferent capital requirements than the founder of a coal mining operation. Although both
entrepreneurs might approach some of the same types of lenders or investors, each would
be more successful targeting specific sources of funds best suited to their particular finan-
cial needs.
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Capital is any form of wealth employed to produce more wealth. It exists in many
forms in a typical business, including cash, inventory, plant, and equipment. Entrepreneurs
need three different types of capital, as follows.
Fixed Capital
Fixed capital is needed to purchase a company’s permanent or fixed assets such as build-
ings, land, computers, and equipment. Money invested in these fixed assets tends to be
frozen because it cannot be used for any other purpose. Typically, large sums of money are
involved in purchasing fixed assets, and credit terms usually are lengthy. Lenders of fixed
capital expect the assets purchased to improve the efficiency and, thus, the profitability of
the business and to create improved cash flow that ensures repayment.
Working Capital
Working capital represents a business’s temporary funds; it is the capital used to support
a company’s normal short-term operations. Accountants define working capital as current
assets minus current liabilities. The need for working capital arises because of the uneven
flow of cash into and out of the business due to normal seasonal fluctuations (refer to
Chapter 12). Credit sales, seasonal sales swings, or unforeseeable changes in demand will
create fluctuations in any small company’s cash flow. Working capital normally is used to
buy inventory, pay bills, finance credit sales, pay wages and salaries, and take care of any
unexpected emergencies. Lenders of working capital expect it to produce higher cash
flows to ensure repayment at the end of the production/sales cycle.
Growth Capital
Growth capital, unlike working capital, is not related to the seasonal fluctuations of a
small business. Instead, growth capital requirements surface when an existing business is
expanding or changing its primary direction. For example, a small manufacturer of silicon
chips for computers saw his business skyrocket in a short time period. With orders for
chips rushing in, the growing business needed a sizable cash infusion to increase plant size,
expand its sales and production workforce, and buy more equipment. During times of such
rapid expansion, a growing company’s capital requirements are similar to those of a busi-
ness start-up. Like lenders of fixed capital, growth capital lenders expect the funds to
improve a company’s profitability and cash flow position, thus ensuring repayment.
Although these three types of capital are interdependent, each has certain sources,
characteristics, and effects on the business and its long-term growth that entrepreneurs
must recognize.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 465
capital
any form of wealth employed to
produce more wealth.
growth capital
capital needed to finance a
company’s growth or its expansion
in a new direction.
working capital
capital needed to support a
business’s short-term operations; it
represents a company’s temporary
funds.
fixed capital
capital needed to purchase a
company’s permanent or fixed
assets such as land, buildings,
computers, and equipment.
© The New Yorker Collection 1977.
Lee Lorenz from cartoonbank.com.
All rights reserved.
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Equity Capital versus Debt Capital
Equity capital represents the personal investment of the owner (or owners) in a business
and is sometimes called risk capital because these investors assume the primary risk of los-
ing their funds if the business fails.
466 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
TeleSym
Karl Denninghoff and Raju Gulabani raised $18 million in venture capital for their
software start-up TeleSym. In exchange for their investment, the venture capital firms
took a controlling interest in the company as well as seats on TeleSym’s board of
directors (which is typical of most venture capital deals). Within three years, the board
voted to fire both Denninghoff and Gulabani from the company they had co-founded.
Fourteen months after their removal, TeleSym went out of business. According to one
former employee, the move to fire the co-founders was “the kiss of death” for the
TeleSym because no one else had as deep an understanding of the company’s products
as they did.
8
debt capital
the financing that a small business
owner has borrowed and must
repay with interest
equity capital
capital that represents the
personal investment of the
owner (or owners) of a
company; sometimes called
risk capital.
LEARNING OBJECTIVES
2. Describe the differences
between equity capital and debt
capital and the advantages and
disadvantages of each.
Govworks.com
Govworks.com, an online provider of government services launched in 1999 by Kaleil
Isaza Tuzman and Thomas Herman, grew quickly and within one year counted more
than 200 employees on its payroll. Even though Tuzman and Herman had raised more
than $60 million in start-up capital, the company had not reached the point at which it
was generating positive cash flow when investors’ affinity for Internet companies dried
up. GovWorks.com, which was the subject of the film Startup.com, declared bank-
ruptcy in late 2000, which meant that the founders and investors, which included pri-
vate equity investors and venture capital firms, lost all of the money they had put into
the company.
6
If a venture succeeds, however, founders and investors share in the benefits, which can
be quite substantial. The founders of and early investors in Yahoo, Sun Microsystems,
Federal Express, Intel, and Microsoft became multimillionaires when the companies went
public and their equity investments finally paid off. One early investor in Google, for
example, put $100,000 into the start-up company that graduate students Sergey Brin and
Larry Page started from their college dorm room; today, his equity investment is worth
$100 million!
7
To entrepreneurs, the primary advantage of equity capital is that it does not
have to be repaid like a loan does. Equity investors are entitled to share in the company’s
earnings (if there are any) and usually to have a voice in the company’s future direction.
The primary disadvantage of equity capital is that the entrepreneur must give up
some—sometimes even most—of the ownership in the business to outsiders. Although 50
percent of something is better than 100 percent of nothing, giving up control of a company
can be disconcerting and dangerous.
Entrepreneurs are most likely to give up significant amounts of equity in their busi-
nesses in the start-up phase than in any other. To avoid having to give up majority control
of their companies early on, entrepreneurs should strive to launch their companies with the
smallest amount of money possible.
Debt capital is the financing that a small business owner has borrowed and must
repay with interest. Very few entrepreneurs have adequate personal savings needed to
finance the complete start-up costs of a small business; many of them must rely on some
form of debt capital to launch their companies. Lenders of capital are more numerous than
investors, although small business loans can be just as difficult (if not more difficult) to
obtain. Although borrowed capital allows entrepreneurs to maintain complete ownership
of their businesses, it must be carried as a liability on the balance sheet as well as be repaid
with interest at some point in the future. In addition, because lenders consider small busi-
nesses to be greater risks than bigger corporate customers, they require higher interest rates
on loans to small companies because of the risk–return tradeoff—the higher the risk, the
greater is the return demanded. Most small firms pay the prime rate—the interest rate
banks charge their most creditworthy customers—plus a few percentage points. Still, the
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cost of debt financing often is lower than that of equity financing. Because of the higher
risks associated with providing equity capital to small companies, investors demand
greater returns than lenders. In addition, unlike equity financing, debt financing does not
require entrepreneurs to dilute their ownership interest in their companies. We now turn
our attention to eight common sources of equity capital.
Sources of Equity Financing
Personal Savings
The first place entrepreneurs should look for start-up money is in their own pockets. It’s
the least expensive source of funds available. “The sooner you take outside money, the
more ownership in your company you’ll have to surrender,” warns one small business
expert.
9
Entrepreneurs apparently see the benefits of self-sufficiency; the most common
source of equity funds used to start a small business is the entrepreneur’s pool of personal
savings.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 467
Kiss My Face
In 1979, when Bob MacLeod and Stephen Byckiewicz launched Kiss My Face, a company
that sold a line of soaps and shampoos, they could not persuade a bank to lend them any
money, so they pooled all they had—just $10,000—and invested it in the business. Sales
were thin in the early years, but they climbed steadily with the help of creative marketing
and the strategic partnerships with larger companies that MacLeod and Byckiewicz
forged. The entrepreneurs financed their company’s growth with retained earnings and
some debt but retained 100 percent ownership. Today, Kiss My Face is debt-free and tal-
lies annual sales of more than $30 million. “We’re very happy to have maintained com-
plete control of our business,” says MacLeod.
10
CMB Sweets
In 2004, Carolina Braunschweig used her own money to launch CMB Sweets, a company
that makes jams and jellies. Sales grew slowly, and the company’s early life was marked by
a series of financial struggles, which Braunschweig managed to work through. Before the
company’s second birthday, Braunschweig’s father offered to invest $15,000 in CMB
Sweets. Braunschweig accepted her father’s offer, but the two agreed to treat the money
as a loan rather than as an equity investment. Until she is able to pay back the loan (with
interest), Braunschweig says she will treat her father as if he were a member of the com-
pany’s board of directors. “I give him regular updates on sales volumes, on who has
reordered, and on what new accounts [the sales] reps have landed,” she says.
11
LEARNING OBJECTIVES
3. Discuss the various sources of
equity capital available to entre-
preneurs.
Lenders and investors expect entrepreneurs to put their own money into a business
start-up. If an entrepreneur is not willing to risk his or her own money, potential investors
are not likely to risk their money in the business either. Furthermore, failing to put up suf-
ficient capital of their own means that entrepreneurs must either borrow an excessive
amount of capital or give up a significant portion of ownership to outsiders to fund the
business properly. Excessive borrowing in the early days of a business puts intense pres-
sure on its cash flow, and becoming a minority shareholder may dampen a founder’s enthu-
siasm for making a business successful. Neither outcome presents a bright future for the
company involved.
Friends and Family Members
Although most entrepreneurs look to their own bank accounts first to finance a business,
few have sufficient resources to launch their businesses alone. After emptying their own
pockets, where should entrepreneurs should turn for capital? The second place most entre-
preneurs look is to friends and family members who might be willing to invest in a busi-
ness venture. Because of their relationships with the founder, these people are most likely
to invest. Often, they are more patient than other outside investors and are less meddle-
some in a business’s affairs than many other types of investors (but not always!).
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Investments from family and friends are an excellent source of seed capital and can get
a start-up far enough along to attract money from private investors or venture capital com-
panies. Inherent dangers lurk in family business investments, however. Unrealistic expecta-
tions or misunderstood risks have destroyed many friendships and have ruined many family
reunions. To avoid such problems, an entrepreneur must honestly present the investment
opportunity and the nature of the risks involved to avoid alienating friends and family mem-
bers if the business fails. Smart entrepreneurs treat family members and friends who invest
in their companies in the same way they would treat business partners. Some investments in
start-up companies return more than friends and family members ever could have imagined.
In 1995, Mike and Jackie Bezos invested $300,000 into their son Jeff’s start-up business,
Amazon.com. Today, Mike and Jackie own six percent of Amazon.com’s stock, and their
shares are worth billions of dollars.
12
The accompanying “Hands on . . . How to” feature
offers suggestions for structuring successful family or friendship financing deals.
468 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
Structure Family and
Friendship Financing Deals
Tapping family members and friends for start-up cap-
ital, whether in the form of equity or debt financing, is a
popular method of financing business ideas. In a typical
year, some 6 million individuals in the United States
invest about $100 billion in entrepreneurial ventures.
Unfortunately, these deals don’t always work to the sat-
isfaction of both parties. For instance, when actor Don
Johnson needed seed capital to launch DJ Racing, a
company that designs and races speedboats, he
approached a wealthy Miami friend who made a
$300,000 interest-free loan on nothing but a hand-
shake. Within a year, a dispute arose over when Johnson
was to pay back the loan. A lawsuit followed, which the
two, now former friends settled out of court. The fol-
lowing suggestions can help entrepreneurs avoid need-
lessly destroying family relationships and friendships:
? Consider the impact of the investment on every-
one involved. Will it work a hardship on anyone?
Is the investor putting up the money because he or
she wants to or because he or she feels obligated to?
Can all parties afford the loan if the business folds?
Lynn McPhee used $250,000 from family members
to launch Xuny, a Web-based clothing store. “Our
basic rule of thumb was, if [the investment is] going
to strap someone, we won’t take it,” she says.
? Keep the arrangement strictly business. The par-
ties should treat all loans and investments in a
business-like manner, no matter how close the
friendship or family relationship, to avoid problems
down the line. “If the [family member] doesn’t ask
to go through a formal process, the risks for the
business are significantly higher,” says Tom
Davidow, a family business consultant. If the trans-
action is a loan exceeding $10,000, it must carry a
rate of interest at least as high as the market rate;
otherwise the IRS may consider the loan a gift and
penalize the lender.
? Settle the details up front. Before any money
changes hands, both parties must agree on the
details of the deal. How much money is involved?
Is it a loan or an investment? How will the investor
cash out? How will the loan be paid off? What
happens if the business fails?
? Never accept more than investors can afford to
lose. No matter how much capital you may need,
accepting more than family members or friends
can afford to lose is a recipe for disaster—and per-
haps bankruptcy for the investors.
? Create a written contract. Don’t make the mistake
of closing a financial deal with just a handshake.
The probability of misunderstandings skyrockets.
Putting an agreement in writing demonstrates the
parties’ commitment to the deal and minimizes
the chances of disputes from faulty memories and
misunderstandings.
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CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 469
? Treat the money as “bridge financing.” Although
family and friends can help you to launch your
business, it is unlikely that they can provide enough
capital to sustain it over the long term. Sooner or
later, you will need to establish a relationship with
other sources of credit if your company is to sur-
vive and thrive. Consider money from family and
friends as a bridge to take your company to the
next level of financing.
? Develop a payment schedule that suits both the
entrepreneur and the lender or investor. Although
lenders and investors may want to get their money
back as quickly as possible, a rapid repayment or
cashout schedule can jeopardize a fledgling com-
pany’s survival. Establish a realistic repayment
plan that works for the parties without putting
excessive strain on the young company’s cash
flow.
? Have an exit plan. Every deal should define exactly
how investors will “cash out” their investments.
Derek Mercer called his favorite aunt, Delores
Kessler, herself a successful entrepreneur, and asked her
to look over a business plan for a software company he
wanted to launch. Then he asked her to lend him
$50,000 in start-up capital. Impressed by the quality of
Mercer’s business plan, Kessler agreed to lend the
money on one condition: “It will be a business arrange-
ment,” she insisted, “with paperwork, not just a hug
and off you go.” With her business experience, Kessler
convinced Mercer that $50,000 would not be sufficient
start-up capital. Instead, she offered Mercer a $100,000
line of credit that he could draw on as needed in
$10,000 increments at an interest rate tied to the prime
rate. “It was crystal clear,” recalls Mercer. “If I didn’t
make an interest payment, her assistant would call me.”
Mercer launched Recruitmax Software Inc. and
within a few years repaid the entire loan from his aunt.
As the company grew and its capital requirements
increased, Kessler helped her nephew establish contacts
with potential investors and venture capitalists. Using
those contacts, Mercer secured $17.3 million in venture
capital and has built Recruitmax into a successful busi-
ness with 230 employees and annual sales approaching
$40 million. “I am just so proud of him,” says Kessler of
her nephew.
Source: Adapted from Paulette Thomas, “It’s All Relative,” Wall Street
Journal, November 29, 2004, pp. RR4, R8; Andrea Coombes,
“Retirees as Venture Capitalists,” CBS.MarketWatch.com, November 2,
2003, http://netscape.marketwatch.com/news/story.asp?dist=feed&
siteid=netscape&guid=/{E1267CD-32A4-4558-9F7E-40E4B7892D01};
Paul Kvinta, “Frogskins, Shekels, Bucks, Moolah, Cash, Simoleans,
Dough, Dinero: Everybody Wants It. Your Business Needs It. Here’s
How to Get It,” Smart Business, August 2000, pp. 74–89. Alex
Markels, “A Little Help from Their Friends,” Wall Street Journal, May
22, 1995, p. R10; Heather Chaplin, “Friends and Family,” Your
Company, September 1999, p. 26.
”Angels”
After dipping into their own pockets and convincing friends and relatives to invest in their
business ventures, many entrepreneurs still find themselves short of the seed capital they
need. Frequently, the next stop on the road to business financing is private investors. These
private investors (“angels”) are wealthy individuals, often entrepreneurs themselves,
who invest in business start-ups in exchange for equity stakes in the companies. Angel
investors have provided much-needed capital to entrepreneurs for many years. In 1938,
when World War I flying ace Eddie Rickenbacker needed money to launch Eastern
Airlines, millionaire Laurance Rockefeller provided it.
13
Alexander Graham Bell, inventor
of the telephone, used angel capital to start Bell Telephone in 1877. More recently, compa-
nies such as Google, Apple Computer, Starbucks, Kinko’s, and the Body Shop relied on
angel financing in their early years to finance growth. Today, angel capital is the largest
source of external financing for companies in the seed and start-up phases.
In many cases, angels invest in businesses for more than purely economic reasons—
for example, they have a personal interest or experience in a particular industry—and they
are willing to put money into companies in the earliest stages long before venture capital
firms and institutional investors jump in. Angel financing is ideal for companies that have
outgrown the capacity of investments from friends and family but are still too small to
attract the interest of venture capital companies. Angel financing is vital to the nation’s
small business sector because it fills this capital gap in which small companies need invest-
ments ranging from $100,000 or less to perhaps $5 million. For instance, after raising the
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money to launch Amazon.com from family and friends, Jeff Bezos turned to angels for
capital because venture capital firms were not interested in investing in a business start-up.
Bezos attracted $1.2 million from a dozen angels before landing $8 million from venture
capital firms a year later.
14
Angels are a primary source of startup capital for companies in the embryonic stage
through the growth stage, and their role in financing small businesses is significant.
Research at the University of New Hampshire shows that nearly 230,000 angels invest
$23 billion a year in 50,000 small companies, most of them in the start-up phase.
15
Because the angel market is so fragmented and, in many cases, built on anonymity, it is
difficult to get a completely accurate estimate of its investment in business start-ups.
Although they may disagree on the exact amount of angel investments, experts concur on
one fact: angels are the largest single source of external equity capital for small businesses.
Their investments in young companies exceed those of professional venture capitalists,
providing more capital to 17 times as many small companies.
Angels fill a significant gap in the seed capital market. They are most likely to
finance start-ups with capital requirements in the $10,000 to $2,000,000 range, well
below the $3 million to $10 million minimum investments most professional venture cap-
italists prefer. Because a $1 million deal requires about as much of a venture capitalist’s
time to research and evaluate as a $10 million deal, venture capitalists tend to focus on big
deals, where their returns are bigger. Angels also tolerate risk levels that would make ven-
ture capitalists shudder; as much as 80 percent of angel-backed companies fail.
16
One
angel investor, a former executive at Oracle Corporation, says that of the 10 companies he
has invested in, 7 flopped. Three of the start-ups, however, have produced 50-fold
returns!
17
Because of the inherent risks in start-up companies, many venture capitalists
have shifted their investment portfolios away from start-ups toward more-established
firms. That’s why angel financing is so important: Angels often finance deals that no ven-
ture capitalist will consider.
The typical angel invests in companies at the seed or start-up growth stages and
accepts 10 percent of the investment opportunities presented, makes an average of two
investments every three years, and has invested an average of $80,000 of equity in 3.5
firms. Ninety percent say they are satisfied with their investment decisions.
18
When evalu-
ating a proposal, angels look for a qualified management team and a business with a
clearly defined niche, market potential, and competitive advantage. They also want to see
market research that proves the existence of a sizable customer base.
Entrepreneurs in search of capital quickly learn that the real challenge lies in finding
angels. Most angels have substantial business and financial experience, and many of them
are entrepreneurs or former entrepreneurs. Because most angels frown on “cold calls”
from entrepreneurs they don’t know, locating them boils down to making the right con-
tacts. Networking is the key. Asking friends, attorneys, bankers, stockbrokers, accountants,
other business owners, and consultants for suggestions and introductions is a good way to
start. Angels almost always invest their money locally, so entrepreneurs should look close
to home for them—typically within a 50- to 100-mile radius. Angels also look for busi-
nesses they know something about, and most expect to invest their knowledge, experience,
and energy as well as their money in a company. In fact, the advice and the network of con-
tacts that angels bring to a deal can sometimes be as valuable as their money.
470 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
eSigma
When Troy Haaland and three co-workers left their jobs to launch eSigma, a company
that offers Web-based business services, they recognized that although they had ample
technical skill, they lacked managerial skill and business experience. Haaland and his co-
founders approached two angel investors in the Chicago area and asked them not only to
invest in the business, but also to help the entrepreneurs find the management talent they
needed. The two angels invested $200,000 in eSigma and used their network of contacts
to recruit a CEO for the company.
19
Angels tend to invest in clusters as well. With the right approach, an entrepreneur can
attract an angel who might share the deal with some of his or her cronies.
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CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 471
An important trend in angel investing is the formation of angel networks, organized
groups of angels who pool their capital and make investment decisions much like venture
capital companies do. Angel investing “is not what it used to be,” says Bob Greene, co-
founder of the investment company Oncore Capital. “It’s getting more organized and more
professional.”
21
More than 200 angel networks now operate in the United States.
22
Taking
a more sophisticated and formal approach than informal angel clusters, angel networks are
more visible and make the task of locating angels much easier for entrepreneurs in search
of capital.
Band of Angels
In 1995, Hans Severiens, a professional investor, created the Band of Angels, a group of
about 150 angels (mostly Silicon Valley millionaires, many of whom are retired entrepre-
neurs) who meet monthly in Portola Valley, California, to listen to entrepreneurs pitch
their business plans. The Band of Angels reviews about 30 proposals each month before
inviting three entrepreneurs to make 20-minute presentations at their monthly meeting.
Interested members often team up with one another to invest in the businesses they con-
sider most promising. Over the years, the Band of Angels has invested a total of more
than $117 million in promising young companies. The average investment is $700,000,
which usually nets the angels between 15 percent and 25 percent of a company’s stock.
At one meeting, Craig McMullen, CEO of Cardiac Focus, a company that is developing a
disposable vest to help doctors map patients’ cardiac arrythmias without surgery, made a
pitch for $2 million. Cardiac Focus needed the money to complete its management team,
perform clinical trials, and file for approval from the Food and Drug Adminstration. Within
weeks of the presentation, 14 members of the Band of Angels decided to invest, giving
Cardiac Focus the capital it needed to reach the next phase of growth.
20
Intellifit
When Albert Charpentier was looking for capital to
launch Intellifit, a company that makes a booth that uses
radio waves to scan shoppers’ bodies in just 10 seconds
to get the perfect fit in clothing, he approached Robin
Hood Ventures, an angel network based in Philadelphia
that typically invests up to $500,000 in a single round.
Charpentier convinced Robin Hood Ventures to invest
$200,000 in a first round of financing for Intellifit, which
now has its body-scanning booths in more than a dozen
retail clothing locations across the United States and
England.
23
Finding the capital to launch
or expand their businesses is a
struggle for many entrepreneurs.
To finance the start-up of
Intellifit, a company that makes
a booth that uses radio waves
to scan shoppers’ bodies for the
perfect fit in clothing, Albert
Charpentier relied on financing
from private investors (“angels”).
The Internet has expanded greatly the ability of entrepreneurs in search of capital and
angels in search of businesses to find one another. Dozens of angel networks have opened
on the Web, many of which are members of the Angel Capital Association (http://www.
angelcapitalassociation.org). The association reports that its average member group has
50 investors and invests $1.85 million in five small companies each year.
24
Another network,
Active Capital (formerly called ACE-Net, the Access to Capital Electronic Network), is a
Web-based listing service that provides a marketplace for entrepreneurs seeking between
$250,000 and $5 million in capital and angels looking to invest in promising businesses.
Since its inception in 1995, Active Capital has helped entrepreneurs raise more than $100
million.
25
Entrepreneurs pay a maximum of $1,000 a year to list information about their
companies with Active Capital (http://www.activecapital.org), which potential angels can
access at any time. One significant advantage to entrepreneurs who register their equity offer-
ings with Active Capital is that the online registration exempts them from having to register
their offerings separately with regulators in each state (which can cost anywhere from
$10,000 to $50,000 per state). Small companies that raise capital through Active Capital do
so by using one of the simplified registrations—often the Small Company Offering
Registration (SCOR) or Regulation D, Rule 504—that we will cover later in this chapter.
Angels are an excellent source of “patient money,” often willing to wait seven years or
longer to cash out their investments. They earn their returns through the increased value of
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the business, not through dividends and interest. For example, more than 1,000 early
investors in Microsoft Inc. are now multimillionaires. The $200,000 that Sun
Microsystems co-founder Andy Bechtosheim invested in a small start-up named Google
grew to be worth more than $300 million!
26
Angels’ return on investment targets tend to be
lower than those of professional venture capitalists. Although venture capitalists shoot for
60 to 75 percent returns annually, angel investors usually settle for 20 to 50 percent
(depending on the level of risk involved in the venture). Angel investors typically purchase
15 to 30 percent ownership in a small company, leaving the majority ownership to the com-
pany founder(s). They look for the same exit strategies that venture capital firms look for:
either an initial public offering or a buyout by a larger company. The lesson: If an entre-
preneur needs relatively small amounts of money to launch or to grow a company, angels
are an excellent source.
Partners
As we saw in Chapter 4, entrepreneurs can take on partners to expand the capital founda-
tion of a business.
472 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
Rollerblades Inc.
At age 19, Scott Olson started a company that manufactured in-line skates—a company
that he had big dreams for. Rollerblades Inc. grew quickly but soon ran into the problem
that plagues so many fast-growing companies—insufficient cash flow. Through a series of
unfortunate incidents, Olsen began selling shares of ownership in the company for the
money he desperately needed to bring his innovative skate designs to market. Ultimately,
investors ended up with 95 percent of the company, leaving Olson with the remaining
scant 5 percent. Frustrated at not being able to determine the company’s direction, Olson
soon left to start another company. “It’s tough to keep control,” he says. “For every
penny you get in the door, you have to give something up.”
28
CME Conference Video
When Lou Bucelli and Tim Crouse were searching for the money to launch CME
Conference Video, a company that produces and distributes videotapes of educational
conferences for physicians, they found an angel willing to put up $250,000 for 40 percent
of the business. Unfortunately, their investor backed out when some of his real estate
investments went bad, leaving the partners with commitments for several conferences but
no cash to produce and distribute the videos. With little time to spare, Bucelli and Crouse
decided to form a series of limited partnerships with people they knew, one for each video-
tape they would produce. Six limited partnerships produced $400,000 in financing, and
the tapes generated $9.1 million in sales for the year. As the general partners, Bucelli and
Crouse retained 80 percent of each partnership. The limited partners earned returns of up
to 80 percent in just six months. Within two years, their company was so successful that
venture capitalists started calling. To finance their next round of growth, Bucelli and Crouse
sold 35 percent of their company to a venture capital firm for $1.3 million.
27
Before entering into any partnership arrangement, however, entrepreneurs must con-
sider the impact of giving up some personal control over operations and of sharing profits
with others. Whenever entrepreneurs give up equity in their businesses (through whatever
mechanism), they run the risk of losing control over it. As the founder’s ownership in a
company becomes increasingly diluted, the probability of losing control of its future direc-
tion and the entire decision-making process increases.
Corporate Venture Capital
Large corporations have gotten into the business of financing small companies. Today,
about 300 large corporations across the globe, including Motorola, Qualcomm, Intel,
General Electric, Dow Chemical, Cisco Systems, UPS, Wal-Mart, and Johnson & Johnson,
invest in fledgling companies, most often those in the product development and sales
growth stages. Approximately 20 percent of all venture capital invested comes from
corporations.
29
Young companies not only get a boost from the capital injections large
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companies give them, but they also stand to gain many other benefits from the relationship.
The right corporate partner may share technical expertise, distribution channels, and mar-
keting know-how and provide introductions to important customers and suppliers. Another
intangible yet highly important advantage an investment from a large corporate partner
gives a small company is credibility. Doors that otherwise would be closed to a small com-
pany magically open when the right corporation becomes a strategic partner.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 473
Digital Orchid
When Chris Duggan, founder of Digital Orchid, a small company that provides ring tones
and images for customizing cell phones, needed a first round of external capital to
finance his company’s fast growth, he turned to corporate venture capital. Just two years
old, Digital Orchid already had built an impressive list of clients, including NASCAR and
the National Hockey League. Duggan’s first choice was the venture capital arm of wireless
communications giant Qualcomm. “We were looking for something other than money,”
says Duggan. “We wanted someone who could provide a strategic fit. By aligning ourselves
with Qualcomm, we’ll have a better shot at deploying our products around the world.”
30
Foreign corporations such as Nestle S.A., the Swiss food giant, Japanese electronics
companies Hitachi and Nokia, and Orange S.A., one of France’s largest companies, are
also interested in investing in small U.S. businesses. Often, these corporations are seeking
strategic partnerships to gain access to new technology, new products, or access to lucra-
tive U.S. markets. In return, the small companies they invest in benefit from the capital
infusion as well as from their partners’ international experience and connections. In other
cases, small companies are turning to their customers for the resources they need to fuel
their rapid growth. Recognizing how interwoven their success is with that of their suppli-
ers, corporate giants such as AT&T, ChevronTexaco, and Ford now offer financial support
to many of the small businesses they buy from.
RadioFrame Networks
Jeff Brown, CEO of RadioFrame Networks, found not only a customer in France’s wireless
technology giant Orange S.A., but also an investor. RadioFrame’s technology improves the
performance of wireless networks inside buildings, making it a perfect fit with Orange’s
primary business. Through its venture capital division, Orange invested $1.5 million in the
55-person company, giving it enough fuel to feed its growth.
31
Venture Capital Companies
Venture capital companies are private, for-profit organizations that assemble pools of
capital and then use them to purchase equity positions in young businesses they believe
have high-growth and high-profit potential, producing annual returns of 300 to 500 percent
within five to seven years. More than 1,300 venture capital firms operate across the United
States today, investing billions of dollars (see Figure 13.1) in promising small companies
in a wide variety of industries. Pratt’s Guide to Venture Capital Sources, published by
Venture Economics, is a valuable resource for entrepreneurs looking for venture capital.
The guide, available in most libraries, includes contact information as well as investment
preferences for hundreds of venture capital firms.
Colleges and universities have entered the venture capital business; more than 100 col-
leges across the nation now have venture funds designed to invest in promising businesses
started by their students, alumni, and faculty.
32
Even the Central Intelligence Agency
(CIA) has launched a venture capital firm called In-Q-Tel that invests in companies that are
developing new technologies that could benefit it. One of In-Q-Tel’s investments is in a
company that is developing a three-dimensional Web browser that allows users to see
“live” versions of the Web sites they visit.
33
Venture capital firms, which provide about seven percent of all funding for private
companies, have invested billions of dollars in high-potential small companies over the
years, including such notable businesses as Google, Apple Computer, FedEx, Home
Depot, Microsoft, Intel, Starbucks, and Genentech.
34
In many of these deals, several ven-
ture capital companies invested money, experience, and advice across several stages of
venture capital companies
private, for-profit organizations
that purchase equity positions in
young businesses they believe have
high-growth and high-profit
potential.
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474 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
$0
Year
$20
$40
$60
$120
$100
9,000
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
$80
A
m
o
u
n
t

(
i
n

b
i
l
l
i
o
n
s

o
f

$
)
N
u
m
b
e
r

o
f

D
e
a
l
s
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Amount (in billions of $)
Number of Deals
FIGURE 13.1
Venture Capital Funding
Source: Money Tree Survey,
PriceWaterhouseCoopers, 2006.
growth. Table 13.1 offers a humorous look at how venture capitalists decipher the language
of sometimes overly optimistic entrepreneurs.
Policies and Investment Strategies Venture capital firms usually establish stringent
policies to implement their overall investment strategies.
INVESTMENT SIZE AND SCREENING Most venture capital firms seek investments in the
$3 million to $10 million range to justify the cost of investigating the large number of
proposals they receive. The venture capital screening process is extremely rigorous. The
typical venture capital company invests in less than one percent of the applications it
receives. For example, the average venture capital firm screens about 1,200 proposals a
year, but more than 90 percent are rejected immediately because they do not match the
firm’s investment criteria. The remaining 10 percent are investigated more thoroughly at a
cost ranging from $2,000 to $3,000 per proposal. At this time, approximately 10 to
15 proposals will have passed the screening process, and these are subjected to
comprehensive review. The venture capital firm will invest in 3 to 6 of these remaining
proposals.
OWNERSHIP AND CONTROL Most venture capitalists prefer to purchase ownership in a
small business through common stock or convertible preferred stock. Typically, a venture
capital company seeks to purchase 20 to 40 percent of a business, but in some cases, a
venture capitalist may buy 70 percent or more of a company’s stock, leaving its founders
with a minority share of ownership.
Most venture capitalists prefer to let the founding team of managers employ its skills
to operate a business if they are capable of managing its growth. However, it is quite com-
mon for venture capitalists to join the boards of directors of the companies they invest in or
to send in new managers or a new management team to protect their investments.
Jigsaw Data
Corporation
Jim Fowler, founder of Jigsaw Data Corporation, a small company whose online service
allows salespeople to trade business contacts online, discusses operating issues several
times a week with the venture capitalists who invested in his company. El Dorado, the
venture capital firm, has invested $2.5 million in Jigsaw so far. Fowler, a former Navy diver,
has limited managerial experience and welcomes the advice. “Venture capitalists have to
justify their investments, and they spend a lot more time on them [than before],” says
Fowler.
35
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CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 475
TABLE 13.1 Deciphering the Language of the Venture Capital Industry
By nature, entrepreneurs tend to be optimistic. When screening business plans, venture capital-
ists must make an allowance for entrepreneurial enthusiasm. Here’s a dictionary of phrases com-
monly found in business plans and their accompanying venture capital translations.
Exploring an acquisition strategy—Our current products have no market.
We’re on a clear P2P (pathway to profitability)—We’re still years away from earning a profit.
Basically on plan—We’re expecting a revenue shortfall of 25 percent.
Internet business model—Potential bigger fools have been identified.
A challenging year—Competitors are eating our lunch.
Considerably ahead of plan—Hit our plan in one of the last three months.
Company’s underlying strength and resilience—We still lost money, but look how we cut our losses.
Core business—Our product line is obsolete.
Currently revising budget—The financial plan is in total chaos.
Cyclical industry—We posted a huge loss last year.
Entrepreneurial CEO—He is totally uncontrollable, bordering on maniacal.
Facing unprecedented economic, political, and structural shifts—It’s a tough world out there,
but we’re coping the best we can.
Highly leverageable network—No longer works but has friends who do.
Ingredients are there—Given two years, we might find a workable strategy.
Investing heavily in R & D—We’re trying desperately to catch the competition.
Limited downside—Things can’t get much worse.
Long sales cycle—Yet to find a customer who likes the product enough to buy it.
Major opportunity—It’s our last chance.
Niche strategy—A small-time player.
On a manufacturing learning curve—We can’t make the product with positive margins.
Passive investor—She phones once a year to see whether we’re still in business.
Positive results—Our losses was less than last year.
Repositioning the business—We’ve recently written off a multi-million-dollar investment.
Selective investment strategy—The board is spending more time on yachts than on planes.
Solid operating performance in a difficult year—Yes, we lost money and market share, but look
how hard we tried.
Somewhat below plan—We expect a revenue shortfall of 75 percent.
Expenses were unexpectedly high—We grossly overestimated our profit margins.
Strategic investor—One who will pay a preposterous price for an equity share in the business.
Strongest fourth quarter ever—Don’t quibble over the losses in the first three quarters.
Sufficient opportunity to market this product no longer exists—Nobody will buy the thing.
Too early to tell—Results to date have been grim.
A team of skilled, motivated, and dedicated people—We’ve laid off most of our staff, and those
who are left should be glad they still have jobs.
Turnaround opportunity—It’s a lost cause.
Unique—We have no more than six strong competitors.
Volume-sensitive—Our company has massive fixed costs.
Window of opportunity—Without more money fast, this company is dead.
Work closely with the management—We talk to them on the phone once a month.
A year in which we confronted challenges—At least we know the questions even if we haven’t
got the answers.
Sources: Adapted from Suzanne McGee, “A Devil’s Dictionary of Financing,” Wall Street Journal, June
12, 2000, p. C13; John F. Budd Jr., “Cracking the CEO’s Code,” Wall Street Journal, March 27, 1995,
p. A20; “Venture-Speak Defined,” Teleconnect, October 1990, p. 42; Cynthia E. Griffin, “Figuratively
Speaking,” Entrepreneur, August 1999, p. 26.
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Sometimes venture investors step in and shake up the management teams in the com-
panies in which they invest. “We change management in the companies we fund about
40 percent of the time,” says Janet Effland, a partner in the venture capital firm Apax
Partners.
36
In other words, entrepreneurs should not expect venture capitalists to be passive
investors. Some serve only as financial and managerial advisors, but others take an active
role managing the company—recruiting employees, providing sales leads, choosing attor-
neys and advertising agencies, and making daily decisions. The majority of these active
venture capitalists say they are forced to step in because the existing management team
lacks the talent and experience to achieve growth targets.
STAGE OF INVESTMENT Most venture capital firms invest in companies that are either in
the early stages of development (called early-stage investing) or in the rapid-growth phase
(called expansion-stage investing); very few invest in small companies that are in the start-
up phase. Others specialize in acquisitions, providing the financing for managers and
employees of a business to buy it out. About 98 percent of all venture capital goes to
businesses in these stages, although a few venture capital firms are showing more interest
in companies in the start-up phase because of the tremendous returns that are possible by
investing then.
37
Most venture capital firms do not make just a single investment in a
company. Instead, they invest in a company over time across several stages, where their
investments often total $10 to $15 million.
INVESTMENT PREFERENCES The venture capital industry has undergone important
changes over the last decade. Venture capital funds now are larger and more specialized.
As the industry matures, venture capital funds increasingly are focusing their investments
in niches—everything from low-calorie custards to the latest Web technology. Some will
invest in almost any industry but prefer companies in particular stages, from start-up to
expansion. Traditionally, however, only two percent of the companies receiving venture
capital financing are in the start-up or seed stage, when entrepreneurs are forming a
company or developing a product or service. Most of the start-up businesses that attract
venture capital are technology companies—software, biotechnology, medical devices, and
telecommunications.
38
What Venture Capitalists Look For Small business owners must realize that it is very
difficult for any small business, especially fledgling or struggling firms, to pass the intense
screening process of a venture capital company and qualify for an investment. A sound
business plan is essential to convincing venture capital firms to invest in a company.
“Investors want to see proof that a concept works,” says Geeta Vemuri, a principal in a
venture capital firm.
39
Venture capital firms finance only about 3,000 deals in a typical
year. Two factors make a deal attractive to venture capitalists: high returns and a
convenient (and profitable) exit strategy. When evaluating potential investments, venture
capitalists look for the following features.
COMPETENT MANAGEMENT The most important ingredient in the success of any
business is the ability of the management team, and venture capitalists recognize this. To
venture capitalists, the ideal management team has experience, managerial skills,
commitment, and the ability to build teams. “If you don’t have good management [in
place], it’s going to bite you,” says Phil Soran, CEO of Compellent Technologies, a data
storage company that has attracted venture capital successfully.
40
COMPETITIVE EDGE Investors are searching for some factor that will enable a small
business to set itself apart from its competitors. This distinctive competence may range
from an innovative product or service that satisfies unmet customer needs to a unique
marketing or R&D approach. It must be something with the potential to create a
sustainable competitive edge, making the company a leader in its industry.
GROWTH INDUSTRY Hot industries attract profits—and venture capital. Most venture
capital funds focus their searches for prospects in rapidly expanding fields because they
believe the profit potential is greater in these areas. Venture capital firms are most
476 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
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interested in young companies that have enough growth potential to become at least
$100 million businesses within three to five years. Venture capitalists know that most of
the businesses they invest in will flop, so their winners have to be big winners (see
Figure 13.2). One venture capital investor says, “If you want to get really good returns,
your hits generally have to earn 10 times your investment in three to five years.”
41
VIABLE EXIT STRATEGY Venture capitalists not only look for promising companies with
the ability to dominate a market, but they also want to see a plan for a feasible exit strategy,
typically to be executed within three to five years. Venture capital firms realize the return
on their investments when the companies they invest in either make an initial public
offering or are acquired by or merged into another business. As the market for initial public
offerings has softened, venture capitalists have had to be more patient in their exit
strategies. Venture-backed companies that go public now take an average of 5.5 years from
the time of their first venture capital investment to their stock offering, up from an average
of less than three years in 1998.
42
INTANGIBLE FACTORS Some other important factors considered in the screening process
are not easily measured; they are the intuitive, intangible factors the venture capitalist
detects by gut feeling. This feeling might be the result of the small firm’s solid sense of
direction, its strategic planning process, the chemistry of its management team, or a
number of other factors.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 477
5 t o 10 t imes t he init ial
invest ment
9%
10+ t imes t he init ial
invest ment
7%
2 t o 5 t imes t he init ial
invest ment
20%
1 t o 2 t imes t he init ial
invest ment
30%
Part ial loss
23%
Tot al loss
11%
FIGURE 13.2
Average Returns
on Venture Capital
Investments
Source: Paul Keaton, “The Reality
of Venture Capital,” Small Business
Forum, Arkansas Small Business
Development Center, p. 8,
http://asbdc.ualr.edu/bizfacts/501.asp
?print=Y,p.8.
Zula USA LLC
Deborah Manchester, president of Zula USA LLC, a company that provides educational
content for various media, recently raised more than $7 million in venture capital to
finance the production of an educational television series based on a cast of characters
she had created while recovering from foot surgery. Part of the company’s appeal was the
popularity the Zula characters had achieved among its target audience of young children
and the endorsement parents and teachers gave the content. Manchester, who has exten-
sive skills in the fields of child development and animation, used the capital to launch a
television series called The Zula Patrol that airs on PBS.
43
Despite its many benefits, venture capital is not suited for every entrepreneur.
“[Venture capital] money comes at a price,” warns one entrepreneur. “Before boarding a
one-way money train, ask yourself if this is the best route for your business and personal
desires, because investors are like department stores the day after Christmas—they expect
a lot of returns in a short period of time.”
44
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Public Stock Sale (“Going Public”)
In some cases, entrepreneurs can “go public” by selling shares of stock in their corpora-
tions to outside investors. In an initial public offering (IPO), a company raises capital by
selling shares of its stock to the general public for the first time. A public offering is an
effective method of raising large amounts of capital, but it can be an expensive and time-
consuming process filled with regulatory nightmares. Once a company makes an initial
public offering, nothing will ever be the same again. Managers must consider the impact of
their decisions not only on the company and its employees, but also on its shareholders and
the value of their stock.
Going public isn’t for every business. In fact, most small companies do not meet the
criteria for making a successful public stock offering. Over the last 20 years, an average of
440 companies per year have made initial public offerings of their stock, although the
number of IPOs has fallen off significantly since 2000 (see Figure 13.3). Only about
20,000 companies in the United States—less than one percent of the total—are publicly
held. Few companies with less than $20 million in annual sales manage to go public suc-
cessfully. It is extremely difficult for a start-up company with no track record of success to
raise money with a public offering. Instead, the investment bankers who underwrite public
stock offerings typically look for established companies with the following characteristics:
? Consistently high growth rates.
? A strong record of earnings.
? Three to five years of audited financial statements that meet or exceed Securities and
Exchange Commission (SEC) standards. After the Enron and WorldCom scandals,
investors are demanding impeccable financial statements.
? A solid position in a rapidly growing industry. In 2000, the median age of companies
making IPOs was 3 years; today, it is 15 years.
45
? A sound management team with experience and a strong board of directors.
Entrepreneurs who are considering taking their companies public should first consider
carefully the advantages and the disadvantages of an IPO. The advantages include the
following.
Advantages
ABILITY TO RAISE LARGE AMOUNTS OF CAPITAL The biggest benefit of a public
offering is the capital infusion the company receives. After going public, the corporation
478 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
LEARNING OBJECTIVES
4. Describe the process of “going
public” as well as its advantages
and disadvantages and the vari-
ous simplified registrations and
exemptions from registration
available to small businesses
wanting to sell securities to
investors.
initial public offering (IPO)
a method of raising equity capital
in which a company sells shares of
its stock to the general public for
the first time.
$0
Year
$20
$40
$60
$120
$100
1,000
900
800
700
600
500
400
300
200
100
0
$80
A
m
o
u
n
t

R
a
i
s
e
d

(
i
n

b
i
l
l
i
o
n
s

o
f

$
)
N
u
m
b
e
r

o
f

I
P
O
s
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005
Amount Raised (in billions of $)
Number of IPOs
FIGURE 13.3
Initial Public Offerings
(IPOs)
Source: Thomson Financial
Securities Data.
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has the cash to fund R&D projects, expand plant and facilities, repay debt, or boost
working capital balances without incurring the interest expense and the obligation to repay
associated with debt financing. For instance, clothing retailer J. Crew recently made an
IPO that raised $200 million, and Under Armour, the maker of high-performance athletic
gear, raised $200 million in an S-1 filing. In one of the most publicized IPOs in recent
history, Google sold 19.6 million shares at $85 per share, raising nearly $1.7 billion
(before expenses) to fuel the company’s growth.
IMPROVED CORPORATE IMAGE All of the media attention a company receives during
the registration process makes it more visible. In addition, becoming a public company in
some industries improves its prestige and enhances its competitive position, one of the
most widely recognized intangible benefits of going public.
IMPROVED ACCESS TO FUTURE FINANCING Going public boosts a company’s net
worth and broadens its equity base. Its improved stature and financial strength make it
easier for the firm to attract more capital—both debt and equity—and to grow.
ABILITY TO ATTRACT AND RETAIN KEY EMPLOYEES Public companies often use stock-
based compensation plans to attract and retain quality employees. Stock options and
bonuses are excellent methods for winning employees’ loyalty and for instilling a healthy
ownership attitude among them if the company’s stock performs well in the market.
Employee stock ownership plans (ESOPs) and stock purchase plans are popular recruiting
and motivational tools in many small corporations, enabling them to hire top-flight talent
they otherwise would not be able to afford.
USE OF STOCK FOR ACQUISITIONS A company whose stock is publicly traded can
acquire other businesses by offering its own shares rather than cash. Acquiring other
companies with shares of stock eliminates the need to incur additional debt.
LISTING ON A STOCK EXCHANGE Being listed on an organized stock exchange, even a
small regional one, improves the marketability of a company’s shares and enhances its
image. Most publicly held companies’ stocks do not qualify for listing on the nation’s
largest exchanges—the New York Stock Exchange (NYSE) and the American Stock
Exchange (AMEX). However, the AMEX now has a market for small-company stocks,
The Emerging Company Marketplace. Most small companies’ stocks are traded on either
the National Association of Securities Dealers Automated Quotation (NASDAQ) system’s
National Market System (NMS) and its emerging small-capitalization exchange or one of
the nation’s regional stock exchanges.
Despite these advantages, many factors can spoil a company’s attempted IPO. In fact,
only five percent of the companies that attempt to go public ever complete the process.
46
The disadvantages of going public include the following.
Disadvantages
DILUTION OF FOUNDER’S OWNERSHIP Whenever entrepreneurs sell stock to the public,
they automatically dilute their ownership in their businesses. Most owners retain a
majority interest in the business, but they may still run the risk of unfriendly takeovers
years later after selling more stock.
LOSS OF CONTROL If enough shares are sold in a public offering, a founder risks losing
control of the company. If a large block of shares falls into the hands of dissident
stockholders, they could vote the existing management team (including the founder)
out.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 479
Stax’s
George Stathakis, owner of the highly successful chain of Stax’s restaurants in Greenville,
South Carolina, recalls investment bankers approaching him about taking his company
public to fund its growth, but he refused them all. “The one thing you don’t have when
you go public is control,” he says, “and that’s something my partners and I just couldn’t
handle.”
47
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LOSS OF PRIVACY Taking their companies public can be a big ego boost for owners, but
they must realize that their companies are no longer solely theirs. Information that was
once private must be available for public scrutiny. The initial prospectus and the
continuous reports filed with the SEC disclose a variety of information about the company
and its operations—from financial data and raw material sources to legal matters and
patents—to anyone, including competitors. Loss of privacy and loss of control are the most
commonly cited as the reasons that CEOs choose not to attempt IPOs.
48
REPORTING TO THE SEC Operating as a publicly held company is expensive, especially
since Congress passed the Sarbanes-Oxley Act in 2002. The SEC traditionally has required
publicly held companies to file periodic reports with it, which often requires a more
powerful accounting system, a larger accounting staff, and greater use of attorneys and
other professionals. Created in response to ethical fiascoes such as Enron and WorldCom,
Sarbanes-Oxley was designed to improve the degree of internal control and the level of
financial reporting by publicly held companies. Although many executives agree with the
intent of the law, they contend that the cost of complying with it is overbearing. A study by
Financial Executives International reports that the cost to public companies with $25 million
to $99 million in annual revenues of complying with the most significant section of
Sarbanes-Oxley averages $740,000 per year. The high cost of regulatory compliance
dissuades many potential companies from going public.
480 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
Earth Fare
The owners of Earth Fare, a chain of organic supermarkets based in Asheville, North
Carolina, recently hit $100 million in annual revenues and were considering making an
IPO to finance the opening of a wave of new stores. However, after considering the cost
of complying with Sarbanes-Oxley, they decided against the IPO. “The requirements to
comply with [Sarbanes-Oxley] are so expensive, there’s no way Earth Fare could have
afforded it,” says John Warner, chairman of the company’s board of directors.
49
Since Sarbanes-Oxley was passed, record numbers of public companies have decided
to leave the public spotlight and “go private,” reversing the initial public offering process
and selling out to private investors. Kerzner International, a hotel group that went public in
2004, recently announced that a group of private investors was taking the company, which
owns the Atlantis Resort in the Bahamas, private in a deal valued at $3.6 billion.
50
FILING EXPENSES A public stock offering usually is an expensive way to generate funds
for start-up or expansion. For the typical small company, the cost of a public offering is
about 15 percent of the capital raised. On small offerings, costs can eat up as much as
40 percent of the capital raised, whereas on larger offerings, those above $25 million, only
10 to 12 percent will go to cover expenses. Once an offering exceeds $15 million, its
relative issuing costs drop. The largest cost is the underwriter’s commission, which is
typically 7 percent of the proceeds on offerings less than $10 million and 13 percent on
those over that amount.
ACCOUNTABILITY TO SHAREHOLDERS The capital that entrepreneurs manages is no
longer just their own. Managers of publicly held firms are accountable to their companies’
shareholders. Indeed, the law requires that they recognize and abide by a relationship built
on trust. Profit and return on investment become the primary concerns for investors. If the
stock price of a newly public company falls, shareholder lawsuits are inevitable. Investors
whose shares decline in value often sue the company’s managers for fraud and the failure
to disclose the potential risks to which their investments expose them.
PRESSURE FOR SHORT-TERM PERFORMANCE In privately held companies, entrepreneurs
are free to follow their strategies for success, even if those strategies take years to produce
results. When a company goes public, however, entrepreneurs quickly learn that
shareholders are impatient and expect results immediately. Founders are under constant
pressure to produce growth in profits and in market share, which requires them to maintain
a delicate balance between short-term results and long-term strategy.
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DEMANDS ON TIME AND TIMING As impatient as they can be, entrepreneurs often
find the time demands of an initial public offering frustrating and distracting. Managing
the IPO takes time away from managing the company. Working on an IPO can consume
as much as 75 percent of top managers’ time. “You want to make sure you’re not
becoming a chief ‘going public’ officer as opposed to a chief executive officer,” advises
an investment banker.
51
When one company that produced sports entertainment software
decided to go public, managers spent so much time focusing on the demands of the IPO
that the company failed to get a new product to market in time for the Christmas season.
Because it missed this crucial deadline, the company never recovered and went out of
business.
52
During this time, a company also runs the risk that the overall market for IPOs or for a
particular industry may go sour. Factors beyond managers’ control, such as declines in the
stock market and potential investors’ jitters, can quickly slam shut a company’s “window
of opportunity” for an IPO. For instance, when Nanosys, a pioneering company in nan-
otechnology, withdrew its initial public offering after receiving a lukewarm reception from
potential investment bankers, several other nanotechnology companies postponed their
planned IPOs.
53
The Registration Process Taking a company public is a complicated, bureaucratic
process that usually takes several months to complete. Many experts compare the IPO
process to running a corporate marathon, and both the company and its management team
must be in shape and up to the grueling task. The typical entrepreneur cannot take his or
her company public alone. It requires a coordinated effort from a team of professionals,
including company executives, an accountant, a securities attorney, a financial printer, and
at least one underwriter. Table 13.2 shows a typical timetable for an IPO. The key steps in
taking a company public include the following.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 481
TABLE 13.2 Timetable for An Initial Public Offering
Time Action
Week 1 Conduct organizational meeting with IPO team, including underwriter, attor-
neys, accountants, and others. Begin drafting registration statement.
Week 5 Distribute first draft of registration statement to IPO team and make revisions.
Week 6 Distribute second draft of registration statement and make revisions.
Week 7 Distribute third draft of registration statement and make revisions.
Week 8 File registration statement with the SEC. Begin preparing presentations for
road show to attract other investment bankers to the syndicate. Comply with
“blue sky” laws in states where offering will be sold.
Week 12 Receive comment letter on registration statement from SEC. Amend registra-
tion statement to satisfy SEC comments.
Week 13 File amended registration statement with SEC. Prepare and distribute prelimi-
nary offering prospectus (called a “red herring”) to members of underwriting
syndicate. Begin road show meetings.
Week 15 Receive approval for offering from SEC (unless further amendments are
required). Issuing company and lead underwriter agree on final offering price.
Prepare, file, and distribute final offering prospectus.
Week 16 Company and underwriter sign the final agreement. Underwriter issues stock,
collects the proceeds from the sale, and delivers proceeds (less commission)
to company.
Sources: Adapted from “Initial Public Offering,” Entrepreneur, June 14, 2002,
http://www.entrepreneur.com/article/0/4621,300892,00,html; PriceWaterhouseCoopers, “Going Public
Timetable,”http://www.pwcglobal.com/Extweb/industry.nsf/docid/
2C9CA8A7F060404A85256AC5007A86B8#.
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CHOOSE THE UNDERWRITER The most important ingredient in making a successful IPO
is selecting a capable underwriter (or investment banker). The underwriter serves two
primary roles: helping to prepare the registration statement for the issue and promoting the
company’s stock to potential investors. The underwriter works with company managers as
an advisor to prepare the registration statement that must be filed with the SEC, promotes
the issue, prices the stock, and provides after-market support. Once the registration
statement is finished, the underwriter’s primary job is selling the company’s stock through
an underwriting syndicate of other investment bankers it develops. According to a study by
Notre Dame professors Shane Corwin and Paul Schultz, the larger the syndicate that
supports an IPO, the more likely it is that the company will obtain more favorable pricing
and overall results from the offering.
54
NEGOTIATE A LETTER OF INTENT To begin an offering, the entrepreneur and the
underwriter must negotiate a letter of intent, which outlines the details of the deal. The
letter of intent covers a variety of important issues, including the type of underwriting, its
size and price range, the underwriter’s commission, and any warrants and options
included. It almost always states that the underwriter is not bound to the offering until it is
executed—usually the day before or the day of the offering. However, the letter usually
creates a binding obligation for the company to pay any direct expenses the underwriter
incurs relating to the offer.
PREPARE THE REGISTRATION STATEMENT After a company signs the letter of intent,
the next task is to prepare the registration statement to be filed with the SEC. This
document describes both the company and the stock offering and discloses information
about the risks of investing. It includes information on the use of the proceeds, the
company’s history, its financial position, its capital structure, the risks it faces, its
managers’ experience, and many other details. The statement is extremely comprehensive
and may take months to develop. To prepare the statement, entrepreneurs must rely on their
team of professionals.
FILE WITH THE SEC When the statement is finished (with the exception of pricing the
shares, proceeds, and commissions, which cannot be determined until just before the issue
goes to market), the company officially files the statement with the SEC and awaits the
review of the Division of Corporate Finance, a process that takes 30 to 45 days (or more).
The Division sends notice of any deficiencies in the registration statement to the
company’s attorney in a comment letter. The company and its team of professionals must
cure all of the deficiencies in the statement noted in the comment letter. Finally, the
company files the revised registration statement, along with a pricing amendment (giving
the price of the shares, the proceeds, and the commissions).
WAIT TO GO EFFECTIVE While waiting for the SEC’s approval, the managers and the
underwriters are busy. The underwriters are building a syndicate of other underwriters who
will market the company’s stock. (No stock sales can be made prior to the effective date of
the offering, however.) The SEC also limits the publicity and information a company may
release during this quiet period (which officially starts when the company reaches a
preliminary agreement with the managing underwriter and ends 90 days after the effective
date).
Securities laws do permit a road show, a gathering of potential syndicate members
sponsored by the managing underwriter. Its purpose is to promote interest among potential
underwriters in the IPO by featuring the company, its management, and the proposed deal.
The managing underwriter and key company officials barnstorm major financial centers at
a grueling pace.
482 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
road show
a gathering of potential syndicate
members sponsored by the
managing underwriter for the
purpose of promoting a company’s
initial public offering.
Ometric Corporation
During the road show for Ometric Corporation, a South Carolina-based company that has
developed the technology to provide real-time spectroscopy in a variety of industrial appli-
cations, CEO Walter Allessandrini made 140 presentations to potential syndicate mem-
bers in both Europe and the United States in just two and a half weeks!
underwriter (or investment
banker)
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.
letter of intent
an agreement between the
underwriter and the company
about to go public that outlines
the details of the deal.
registration statement
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.
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On the last day before the registration statement becomes effective, the company signs
the formal underwriting agreement. The final settlement, or closing, takes place a few days
after the effective date for the issue. At this meeting the underwriters receive their shares to
sell and the company receives the proceeds of the offering.
Typically, the entire process of going public takes from 60 to 180 days, but it can take
much longer if the issuing company is not properly prepared for the process.
MEET STATE REQUIREMENTS In addition to satisfying the SEC’s requirements, a
company also must meet the securities laws in all states in which the issue is sold. These
state laws (or “blue-sky” laws) vary drastically from one state to another, and the company
must comply with them.
Simplified Registrations and Exemptions
The IPO process just described (called an S-1 filing) requires maximum disclosure in the
initial filing and discourages most small businesses from using it. Fortunately, the SEC
allows several exemptions from this full-disclosure process for small businesses. Many
small businesses that go public choose one of these simplified options the SEC has
designed for small companies. The SEC has established the following simplified registra-
tion statements and exemptions from the registration process.
Regulation S-B Regulation S-B is a simplified registration process for small companies
seeking to make initial or subsequent public offerings. Not only does this regulation
simplify the initial filing requirements with the SEC, but it also reduces the ongoing
disclosure and filings required of companies. Its primary goals are to open the doors to
capital markets to smaller companies by cutting the paperwork and the costs of raising
capital. Companies using the simplified registration process have two options: Form SB-1,
a “transitional” registration statement for companies issuing less than $10 million worth of
securities over a 12-month period, and Form SB-2, reserved for small companies seeking
more than $10 million in a 12-month period.
To be eligible for the simplified registration process under Regulation S-B, a company
must meet the following criteria:
? Be based in the United States or Canada.
? Have revenues of less than $25 million.
? Have outstanding publicly held stock worth no more than $25 million.
? Must not be an investment company.
? Must provide audited financial statements for two fiscal years.
The goal of Regulation S-B’s simplified registration requirements is to enable smaller
companies to go public without incurring the expense of a full-blown registration. Total
costs for a Regulation S-B are approximately $35,000.
Regulation D (Rule 504): Small Company Offering Registration Created in the
late 1980s, the Small Company Offering Registration (SCOR; also known as the Uniform
Limited Offering Registration, ULOR) now is available in all 50 states and the District of
Columbia. A little-known tool, SCOR is designed to make it easier and less expensive for
small companies to sell their stock to the public by eliminating the requirement for
registering the offering with the SEC. The whole process typically costs less than half of
what a traditional public offering costs. Entrepreneurs using SCOR need an attorney and
an accountant to help them with the issue, but many can get by without a securities lawyer,
which can save tens of thousands of dollars. Some entrepreneurs even choose to market
their companies’ securities themselves (for example, to customers), saving the expense of
hiring a broker. However, selling an issue is both time and energy consuming, and most
SCOR experts recommend hiring a professional securities or brokerage firm to sell the
company’s shares. The SEC’s objective in creating SCOR was to give small companies the
same access to equity financing that large companies have via the stock market while
bypassing many of the same costs and filing requirements.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 483
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The capital ceiling on a SCOR issue is $1 million (except in Texas, where there is no
limit), and the price of each share must be at least $5. That means that a company can
sell no more than 200,000 shares (making the stock less attractive to stock manipula-
tors). A SCOR offering requires only minimal notification to the SEC. The company
must file a standardized disclosure statement, the U-7, which consists of 50 fill-in-the-
blank questions. The form, which asks for information such as how much money the
company needs, what the money will be used for, what investors receive, how investors
can sell their investments, and other pertinent questions, closely resembles a business
plan, but also serves as a state securities offering registration, a disclosure document,
and a prospectus. Entrepreneurs using SCOR may advertise their companies’ offerings
and can sell them directly to any investor, with no restrictions and no minimums. An
entrepreneur can sell practically any kind of security through a SCOR, including com-
mon stock, preferred stock, convertible preferred stock, stock options, stock warrants,
and others.
484 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
CorpHQ
Steve Crane and Art Aviles, Jr., co-founders of CorpHQ, a Web-portal that links small and
home-based business owners in an online community, decided to bypass venture capital
and relied on a SCOR offering to attract their first round of outside capital. The entrepre-
neurs believed that taking their company public not only would save them money, but
also would create greater opportunities for future financing efforts, both of which have
proved to be true. Early on, Crane and Aviles recognized the need to promote their newly
public company, whose shares trade on the OTC Bulletin Board, in the investment com-
munity. “Our success as a public company depends not only on how well we do finan-
cially but also how well we market our company and our story to the financial markets,”
says Crane.
55
A SCOR offering offers entrepreneurs needing equity financing several advantages:
? Access to a sizable pool of equity funds without the expense of full registration with
the SEC. Companies often can complete a SCOR offering for less than $25,000.
? Few restrictions on the securities to be sold and on the investors to whom they can be
sold.
? The ability to market the offering through advertisements to the public.
? New or start-up companies can qualify.
? No requirement of audited financial statements for offerings less than $500,000.
? Faster approval of the issue from regulatory agencies.
? The ability to make the offering in several states at once.
There are, of course, some disadvantages to using SCOR to raise needed funds:
? Partnerships cannot make SCOR offerings.
? A company can raise no more than $1 million in a 12-month period.
? An entrepreneur must register the offering in every state in which shares of stock will
be sold to comply with their “blue sky” laws, although current regulations allow
simultaneous registration in multiple states.
? The process can be time consuming, distracting an entrepreneur from the daily rou-
tine of running the company. A limited secondary market for the securities may limit
investors’ interest. Currently, SCOR shares must be traded through brokerage firms
that make small markets in specific stocks. However, the Pacific Stock Exchange and
the NASDAQ’s electronic bulletin board recently began listing SCOR stocks, so the
secondary market for them has broadened.
Regulation D (Rules 505 and 506): Private Placements Rules 505 and 506 of
Regulation D, also known as the Private Placement Memorandum, are exemptions from
federal registration requirements that give emerging companies the opportunity to sell
stock through private placements without actually going public. In a private placement, a
company sells its shares directly to private investors without having to register them with
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the SEC or incur the expenses of an IPO. Instead, a knowledgeable attorney simply draws
up an investment agreement that meets state and federal requirements between the
company and its private investors. Most companies offer private investors “book deals,”
proposals with terms the company determines made on a take-it-or-leave-it basis.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 485
BioE
When Mike Haider, CEO of BioE, a biotech company in St. Paul, Minnesota, realized that
his company needed growth capital, he turned once again to private placements because
he had already raised more than $14 million for BioE from more than 200 individual
investors in several small private placements. It took one year, hundreds of hours, and
more than 100 presentations to potential investors, but Haider’s persistence and patience
paid off; he raised $8.5 million from 240 investors, mostly professional and business peo-
ple from Minneapolis and St. Paul. The private placement cost BioE $600,000 in fees and
expenses, far below what an IPO would have cost. Thanks to the capital infusion, BioE is
on track to earn its first profit, and Haider could not be more pleased. “My full-time job is
to ensure capital for this company,” he says. “Just when you’ve finished raising money,
it’s time to start another round.”
56
A Rule 505 offering has a higher capital ceiling than a SCOR offering ($5 million) in
a 12-month period but imposes more restrictions (no more than 35 nonaccredited investors,
no advertising of the offer, and more-stringent disclosure requirements).
Rule 506 imposes no ceiling on the amount that can be raised, but, like a Rule 505
offering, it limits the issue to 35 “nonaccredited” investors and prohibits advertising the
offer to the public. There is no limit on the number of accredited investors, however. Rule
506 also requires detailed disclosure of relative information, but the extent depends on the
dollar size of the offering.
These Regulation D rules minimize the expense and the time required to raise equity
capital for small businesses. Fees for private placements typically range from 1 to 5 per-
cent rather than the 7 to 13 percent underwriters normally charge for managing a public
offering. Offerings made under Regulation D do impose limitations and demand certain
disclosures, but they only require a company to file a simple form (Form D) with the SEC
within 15 days of the first sale of stock. One drawback of private placements is that the
SEC does not allow a company to advertise its stock offering, which means that entrepre-
neurs must develop a network of wealthy contacts if the placement is to succeed.
Section 4(6) Section 4(6) covers private placements and is similar to Regulation D,
Rules 505 and 506. It does not require registration on offers up to $5 million if they are
made only to accredited investors.
Intrastate Offerings (Rule 147) Rule 147 governs intrastate offerings, those sold only
to investors in a single state by a company doing business in that state. To qualify, a company
must be incorporated in the state, maintain its executive offices there, have 80 percent of its
assets there, derive 80 percent of its revenues from the state, and use 80 percent of the
offering proceeds for business in the state. There is no ceiling on the amount of the offering,
but only residents of the state in which the issuing company operates can invest.
Ben & Jerry’s
Homemade
Years ago, Ben Cohen and Jerry Greenfield founded a small ice cream manufacturing
business named after themselves that struck a chord with customers. Ben & Jerry’s
Homemade grew rapidly, and the founders needed $600,000 to build a new manufactur-
ing plant in Vermont, where the company was based. They decided to “give the opportu-
nity to our neighbors to grow with our company” by making an intrastate offering under
Rule 147. Cohen and Greenfield registered their offering of 73,500 shares of stock with
the Vermont Division of Banking and Insurance. Ben & Jerry’s Homemade sold the entire
offering (mostly to loyal customers) by placing ads in newspapers and stickers on ice
cream containers that touted “Get a Scoop of the Action.”
57
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Regulation A Regulation A, although currently not used often, allows an exemption for
offerings up to $5 million over a 12-month period. Regulation A imposes few restrictions,
but it is more costly than the other types of exempted offerings, usually running between
$80,000 and $120,000. The primary difference between a SCOR offering and a Regulation
A offering is that a company must register its SCOR offering only in the states where it will
sell its stock; in a Regulation A offering, the company also must file an offering statement
with the SEC. Like a SCOR offering, a Regulation A offering requires only a simplified
question-and-answer SEC filing and allows a company to sell its shares directly to investors.
Direct Stock Offerings Many of the simplified registrations and exemptions just
discussed give entrepreneurs the power to sidestep investment bankers and sell their
companies’ stock offerings directly to investors and, in the process, save themselves thousands
of dollars in underwriting fees. By cutting out the underwriter’s commission and many legal
and most registration fees, entrepreneurs willing to handle the paperwork requirements and to
market their own shares typically can make direct public offerings (DPOs) for 6 to 10 percent
of the total amount of the issue, compared with 15 percent for a traditional stock offering.
486 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
Real Goods Trading
Company
Real Goods Trading Company, a retailer of environmentally friendly products, was a pio-
neer of direct public offerings over the Web. In 1991, the company engineered a success-
ful DPO that raised $1 million and followed with two more DPOs in later years that gen-
erated $3.6 million each. More than 5,000 of the company’s loyal customers became
investors. In fact, managers discovered that once customers became shareholders, they
purchased nearly twice as much merchandise as customers who were not shareholders.
Managers at Real Goods found that using the Web to reach potential investors was not
only one of the best bargains, but also one of the most effective methods for selling its
stock to the public.
58
When 23-year-old Ross McDowell decided to open a
retail store specializing in running shoes, he was quite
comfortable making decisions about the kinds of shoes
he would stock in the store’s inventory, the décor of the
retail space, and how to reach his potential customers.
A competitive runner since the sixth grade, McDowell
knew which shoes would sell best to his target audi-
ence, and he knew that he needed to round out his
merchandise mix with hats, shirts, energy drinks and
snacks, and other accessories. What he wasn’t so sure
about, however, was how to find the financing for his
business. “I came from a middle class family and didn’t
have the money myself,” he explains.
Gaining access to adequate capital is a challenge for
many entrepreneurs but can be an especially vexing
problem for those in the start-up phase, where risks are
highest. Launching a business with too little capital is a
recipe for failure, as many entrepreneurs have learned.
According to the SBA’s Office of Advocacy, in one-third
of small business bankruptcies, entrepreneurs cite finan-
cial problems as the cause of their companies’ failure.
Most entrepreneurs dig deep into their own pockets
first before turning to friends and family members for
the capital to launch their businesses. In many cases,
however, these sources cannot provide sufficient capital
to cover start-up costs. After emptying their own pock-
ets and those of their friends and family members,
where do entrepreneurs turn for the capital they need?
Before approaching any potential lender or investor,
McDowell knew that he needed to put together a busi-
ness plan that spelled out just how much money he
would need to launch his store and how he planned to
use it. “The most common pitfall is that everyone thinks
sales will be bigger than they are and costs will be less
than they are,” says John Hammersley, director of loan
Running on Empty
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CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 487
LEARNING OBJECTIVES
5. Describe the various sources
of debt capital and the advan-
tages and disadvantages of each.
prime rate
the interest rate banks charge their
most credit-worthy customers.
programs for the SBA. McDowell researched the fixed
expenses he could expect, including rent, utilities, and a
salary for himself so he could pay his living expenses.
Then he estimated how much it would take to equip
the store, including items such as shelving, storage
racks, cash registers, signs, and couches for customers
to sit on. To make sure that he did not underestimate
these costs, McDowell assumed that he would pay retail
prices for everything. He also included wages for a part-
time employee and advertising costs and came up with
a total of $22,000.
With plans for the store’s fixtures in place, McDowell
needed to stock it with inventory. He decided to carry
six different brands and, after meeting with sales repre-
sentatives from all six companies, selected 25 popular
styles of running shoes. Adding in the costs of the
accessories such as shirts, shorts, hats, and other items
brought the total cost estimate to $50,000.
McDowell estimated that his monthly operating
expenses would be $6,500, but his business plan
included strategies for reducing them by generating
publicity for the new store and promoting it at running
events and local schools. “You’ve got to be resourceful,”
he explains. McDowell’s plan called for raising enough
start-up capital for his shoe store to survive for three
months without any revenue at all. McDowell managed
to come up with 10 percent of the $72,000 start-up
cost he estimates he will need to open the store. The
question he faces now is where the remaining 90 per-
cent will come from.
1. Describe the advantages and the disadvantages
of both equity capital and debt capital for Ross
McDowell.
2. Explain why the following funding sources would
or would not be appropriate for McDowell: family
and friends, angel investors, an initial public offer-
ing, a traditional bank loan, asset-based borrow-
ing, or one of the many federal or SBA loans.
3. Work with a team of your classmates to brainstorm
ways that Ross McDowell could attract the capital
he needs for his businesses. What steps would you
recommend he take before approaching the poten-
tial sources of funding you have identified?
Sources: Adapted from Gwendolyn Bounds, “The Great Money Hunt,”
Wall Street Journal, November 29, 2004, pp. R1, R4.
The World Wide Web is an easy-to-use avenue for direct public offerings and is one
the fastest-growing sources of capital for small businesses. Much of the Web’s appeal as a
fund-raising tool stems from its ability to reach large numbers of prospective investors
very quickly and at a low cost. “This is the only form of instantaneous international contact
with an enormous population,” says one Web expert. “You can put your prospectus out to
the world.”
59
Companies making direct stock offerings on the Web most often make them
under either Regulation A or Regulation D. Direct public offerings work best for compa-
nies that have a single product or related product lines and a base of customers who are
loyal to the company. In fact, the first company to make a successful DPO over the Internet
was Spring Street Brewing, a microbrewery founded by Andy Klein. Klein raised $1.6 mil-
lion in a Regulation A offering in 1996. Companies that make successful direct public
offerings of their stock over the Web must meet the same standards that companies making
stock offerings using more traditional methods. Experts caution Web-based fund seekers to
make sure their electronic prospectuses meet SEC and state requirements.
Table 13.3 provides a summary of the major types of exemptions and simplified offer-
ings. Of these, the limited offerings and private placements are most commonly used.
The Nature of Debt Financing
Debt financing involves the funds that the small business owner borrows and must repay
with interest. Lenders of capital are more numerous than investors, although small busi-
ness loans can be just as difficult (if not more difficult) to obtain. Although borrowed cap-
ital allows entrepreneurs to maintain complete ownership of their businesses, it must be
carried as a liability on the balance sheet as well as be repaid with interest at some point in
the future. In addition, because small businesses are considered to be greater risks than big-
ger corporate customers, they must pay higher interest rates because of the risk–return
tradeoff—the higher the risk, the greater is the return demanded. Most small firms pay the
prime rate, the interest rate banks charge their most creditworthy customers, plus two to
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three percentage points. Still, the cost of debt financing often is lower than that of equity
financing. Because of the higher risks associated with providing equity capital to small
companies, investors demand greater returns than lenders. In addition, unlike equity
financing, debt financing does not require an entrepreneur to dilute his or her ownership
interest in the company.
Entrepreneurs seeking debt capital are quickly confronted with an astounding range of
credit options varying greatly in complexity, availability, and flexibility. Not all of these
sources of debt capital are equally favorable, however. By understanding the various
sources of capital—both commercial and government lenders—and their characteristics,
entrepreneurs can greatly increase the chances of obtaining a loan.
We now turn to the various sources of debt capital.
Commercial Banks
Commercial banks are the very heart of the financial market for small businesses, provid-
ing the greatest number and variety of loans to small companies. One study by the Small
Business Administration found that commercial banks provide 64 percent of the credit
available to small businesses, compared to 12.3 percent supplied by commercial finance
companies, the next-most-prominent source of small business lending. The study also
revealed that 67 percent of all small businesses that borrow from traditional sources get
financing from banks.
60
For small business owners, banks are lenders of first resort. Most
small business bank loans are for less than $100,000.
61
Banks tend to be conservative in their lending practices and prefer to make loans to
established small businesses rather than to high-risk start-ups. One expert estimates that only
five to eight percent of business start-ups get bank financing.
62
Bankers want to see evidence
of a company’s successful track record before committing to a loan. They are concerned with
a firm’s operating past and will scrutinize its financial reports to project its position in the
future. They are also want proof of the stability of the company’s sales and about the ability
of the product or service to generate adequate cash flows to ensure repayment of the loan. If
they do make loans to a start-up venture, banks like to see sufficient cash flows to repay the
loan, ample collateral to secure it, or a Small Business Administration (SBA) guarantee to
insure it. Studies suggest that small community banks (those with less than $300 million in
assets) are most likely to lend money to small businesses.
63
These small banks, which make
up 90 percent of U.S. banking institutions, also are more likely than their larger counterparts
to customize the terms of their loans to the particular needs of small businesses, offering, for
example, flexible payment terms to match the seasonal pattern of a company’s cash flow or
interest-only payments until a piece of equipment begins generating revenue.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 489
Mega Rentals
When Megan Decker, owner of Mega Rentals, a company that provides traffic control
equipment for highway construction projects, had the opportunity to purchase a larger
competitor, she went to her banker to discuss financing. Because her business is highly
seasonal, incurring large cash outlays each spring and with major cash inflows not coming
in until the fall (and virtually nonexistent in the Wisconsin winters), Decker requested loan
repayment terms that matched her irregular cash flow patterns, and the bank agreed.
“[The bank] tailored my revolving loans so that I’m paying the larger principal payments in
November, when I actually have the money,” says Decker. “It’s a tremendous advantage
for me as far as my cash flow is concerned.”
64
When evaluating a loan application, especially for a business start-up, banks focus on
a company’s capacity to create positive cash flow because they know that that’s where the
money to repay their loans will come from. The first question in most bankers’ minds
when reviewing an entrepreneur’s business plan is “Can this business generate sufficient
cash to repay the loan?” Even though they rely on collateral to secure their loans, the last
thing banks want is for a borrower to default, forcing them to sell the collateral (often at
“fire sale” prices) and use the proceeds to pay off the loan. That’s why bankers stress cash
flow when analyzing a loan request, especially for a business start-up. “Cash is more
important than your mother,” jokes one experienced borrower.
65
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Short-Term Loans Short-term loans, extended for less than one year, are the most
common type of commercial loan banks make to small companies. These funds typically
are used to replenish the working capital account to finance the purchase of more
inventory, boost output, finance credit sales to customers, or take advantage of cash
discounts. As a result, an entrepreneur repays the loan after converting inventory and
receivables into cash. There are several types of short-term loans.
COMMERCIAL LOANS (OR “TRADITIONAL BANK LOANS”) A basic short-term loan is
the commercial bank’s specialty. Business owners use commercial loans for a specific
expenditure—to buy a particular piece of equipment or to make a specific purchase, and
terms usually require repayment as a lump sum within three to six months. Two types of
commercial loans exist: secured and unsecured. A secured loan is one in which the
borrower’s promise to repay is secured by giving the bank an interest in some asset
(collateral). Although secured loans give banks a safety cushion in case the borrower
defaults on the loan, they are much more expensive to administer and maintain. With an
unsecured loan, the bank grants a loan to a business owner without requiring him or her to
pledge any specific collateral to support the loan in case of default. Until a small business
is able to prove its financial strength to the bank’s satisfaction, it will probably not qualify
for an unsecured commercial loan. For both secured and unsecured commercial loans, an
entrepreneur is expected to repay the total amount of the loan at maturity. Sometimes the
interest due on the loan is prepaid—deducted from the total amount borrowed.
LINES OF CREDIT One of the most common requests entrepreneurs make of banks and
commercial finance companies is to establish a commercial line of credit, a short-term
loan with a pre-set limit that provides much-needed cash flow for day-to-day operations.
With a commercial (or revolving) line of credit, a business owner can borrow up to the
predetermined ceiling at any time during the year quickly and conveniently by writing
himself or herself a loan. Banks set up lines of credit that are renewable for anywhere from
90 days to several years, and they usually limit the open line of credit to 40 to 50 percent of
a firm’s present working capital, although they will lend more for highly seasonal
businesses. Bankers may require a company to rest its line of credit during the year,
maintaining a zero balance, as proof that the line of credit is not a perpetual crutch. Like
commercial loans, lines of credit can be secured or unsecured. A business typically pays a
small handling fee (one to two percent of the maximum amount of credit) plus interest on
the amount borrowed—usually prime plus three points or more.
The accompanying “Hands on . . . How to” feature describes the six most common
reasons bankers reject small business loan applications and how to avoid them.
490 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
line of credit
a short-term bank loan with a pre-
set limit that provides working
capital for day-to-day operations.
Get a Bank to Say “Yes” to
Your Loan Application
Entrepreneurs often complain that bankers don’t
understand the financial needs they face when starting
and operating their businesses. In many instances, how-
ever, business owners fail to help themselves when they
apply for bank loans. Following are the six most com-
mon reasons bankers reject small business loan applica-
tions (and how you can avoid them).
Reason 1. “Our bank doesn’t make small business
loans.” Cure: Before applying for a bank loan,
research banks to find out which ones actively
seek the type of loan you need. Some banks
don’t emphasize loans under $500,000, whereas
others focus almost exclusively on small company
loans. The Small Business Administration’s reports
Micro-Business-Friendly Banks in the United
States and Small Business Lending in the United
States are valuable resources for locating the
banks in your area that are most likely to make
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CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 491
small business loans. Small local banks tend to be
the ones that are most receptive to small business
loan requests.
Reason 2. “I don’t know enough about you or your
business.” Cure: Develop a detailed business plan
that explains what your company does (or will do)
and describes how you will gain a competitive
edge over your rivals. The plan should address your
company’s major competition, what it will take to
succeed in the market, and how your business will
gain a competitive advantage in the market. Also
be prepared to supply business credit references
and a personal credit history. Finally, make sure you
have your “elevator pitch” honed; you should be
able to describe your business, what it does, sells,
or makes, and the source of its competitive edge
in just one or two minutes.
Reason 3. “You haven’t told me why you need the
money.” Cure: A solid business plan will explain
how much money you need and how you plan to
use it. Make sure your request is specific; avoid
requests for loans “for working capital.” Don’t
make the mistake of answering the question,
“How much money do you need?” with “How
much will you lend me?” A sound business plan
always includes realistic financial forecasts that
support your loan request. Remember: bankers
want to make loans (after all, that’s how they gen-
erate a profit), but they want to make loans only
to those people they believe will repay them. Make
sure your plan clearly shows how your company
will be able to repay the bank loan.
Reason 4. “Your numbers don’t support your loan
request.” Cure: Include a cash flow forecast in your
business plan. Bankers analyze a company’s bal-
ance sheet and income statement to judge the
quality of its assets and its profitability, but they
lend primarily on the basis of cash flow. They know
that that’s how you’ll repay the loan. If adequate
cash flow isn’t available, don’t expect a loan. Prove
to the banker that you know what your company’s
cash flow is and how to manage it.
Reason 5. “You don’t have enough collateral.” Cure:
Be prepared to pledge your company’s assets—
and perhaps your personal assets—as collateral for
the loan. Bankers like to have the security of collat-
eral before they make a loan. They also expect
more than $1 in collateral for every $1 of money
they lend. Banks typically lend 80 to 90 percent
of the value of real estate, 70 to 80 percent of
the value of accounts receivable, and just 10 to
50 percent of the value of inventory pledged
as collateral.
Reason 6. “Your business does not support the loan
on its own.” Cure: Be prepared to provide a per-
sonal guarantee on the loan. By doing so, you’re
telling the banker that if your business cannot
repay the loan, you will. Many bankers see their
small business clients and their companies as one
and the same. Even if you choose a form of own-
ership that provides you with limited personal lia-
bility, most bankers will ask you to override that
protection by personally guaranteeing the loan.
Ronald Reed launched Benchmark Mobility Inc., a
home health-care equipment company, with just
$1,800 of his own money. The business’s rapid growth
over the next few years outstripped Reed’s ability to
fund the company internally, and he had to turn to
external sources of funding. “I was sitting on a couple
hundred thousand dollars of business I couldn’t do any-
thing with because I had outgrown my personal credit,”
he says. Over the course of two years, Reed applied for
business loans at 21 large banks but was turned down
by all of them. “There were times when I wasn’t sure I
was going to meet payroll,” he recalls. Frustrated by his
lack of success, Reed turned to the Central Indiana
Small Business Development Center, where a counselor
referred him to a small local bank that ultimately
approved a $250,000 line of credit. “That’s a bank I
never would have considered,” says Reed. The lesson
Reed learned? Shop around until you find just the right
bank, one that fits your company’s needs.
There’s no magic to getting a bank to approve
your loan request. The secret is preparing properly and
building a solid business plan that enhances your
credibility as a business owner with your banker. Use
your plan to prove that you have what it takes to sur-
vive and thrive.
Sources: Adapted from Jim Melloan, “Do Not Say ‘I Just Want the
Money,’” Inc., July 2005, p. 96; Anne Field, “Getting the Bank to
Yes,” Success, May 1999, pp. 67–71; J. Tol Broome, Jr., “How to
Get A ‘Yes’ from Your Banker,” Nation’s Business, April 1996,
p. 37; “Five Red Flags to Avoid When Applying for a Bank Loan,”
National Federation of Independent Businesses, June 18, 2002,
http://www.nfib.com/object/3387621; “How a Start-up Small Business
Can Maximize Chances for a Bank Loan,” December 9, 2004,
National Federation of Independent Businesses, http://www.nfib.com/
object/IO_19179; Crystal Detamore-Rodman, “Just Your Size,”
Entrepreneur, April 2005, pp. 59–61.
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FLOOR PLANNING Floor planning is a form of financing frequently employed by
retailers of “big ticket items” that are easily distinguishable from one another (usually by
serial number), such as automobiles, boats, and major appliances. For example, a
commercial bank finances Auto City’s purchase of its inventory of automobiles and
maintains a security interest in each car in the order by holding its title as collateral. Auto
City pays interest on the loan monthly and repays the principal as it sells the cars. The
longer a floor-planned item sits in inventory, the more it costs the business owner in
interest expense. Banks and other floor-planners often discourage retailers from using their
money without authorization by performing spot checks to verify prompt repayment of the
principal as items are sold.
Intermediate- and Long-Term Loans Banks primarily are lenders of short-term
capital to small businesses, although they will make certain intermediate and long-term
loans. Intermediate and long-term loans, which are normally secured by collateral, are
extended for one year or longer and are normally used to increase fixed- and growth-
capital balances. Small companies often face a greater challenge qualifying for
intermediate- and long-term loans because of the increased risk to which they expose the
bank. Commercial banks grant these loans for constructing a plant, purchasing real estate
and equipment, expanding a business, and other long-term investments. Loan repayments
are normally made monthly or quarterly. One of the most common types of intermediate-
term loans is an installment loan, which banks make to small firms for purchasing
equipment, facilities, real estate, and other fixed assets. When financing equipment, a bank
usually lends the small business from 60 to 80 percent of the equipment’s value in return
for a security interest in the equipment. The loan’s amortization schedule, which is based
on a set number of monthly payments, typically coincides with the length of the
equipment’s usable life. In financing real estate (commercial mortgages), banks typically
will lend up to 75 to 80 percent of the property’s value and will allow a lengthier
repayment schedule of 10 to 30 years.
Another common type of loan banks make to small businesses is a term loan.
Typically unsecured, banks grant these loans to businesses whose past operating history
suggests a high probability of repayment. Some banks make only secured term loans, how-
ever. Term loans impose restrictions (called covenants) on the business decisions an entre-
preneur makes concerning the company’s operations. For instance, a term loan may set lim-
its on owners’ salaries, prohibit further borrowing without the bank’s approval, or maintain
certain financial ratios (recall the discussion of ratio analysis in Chapter 11). Entrepreneurs
must understand all of the terms attached to term loans before accepting them.
Matching the amount and the purpose of a loan to the appropriate type and length of
loan is important.
492 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
term loan
a bank loan that imposes
restrictions (covenants) on the
business decisions an entrepreneur
makes concerning the company’s
operations.
Keystone Protection
Industries
When John Lawlor had the opportunity to acquire other businesses and fold them into
Keystone Protection Industries, his $9 million commercial and industrial fire-protection
company, he borrowed $900,000 on the company’s revolving line of credit. When busi-
ness slowed, however, Lawlor found it difficult to handle the interest rate on the line of
credit and transferred the debt to a traditional fixed-rate long-term loan that was more
suitable for handling the cost of the acquisitions, and the move improved his company’s
cash flow.
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Non-Bank Sources of Debt Capital
Although they are usually the first stop for entrepreneurs in search of debt capital, banks
are not the only lending game in town. We now turn our attention to other sources of debt
capital that entrepreneurs can tap to feed their cash-hungry companies.
Asset-Based Lenders Asset-based lenders, which are usually smaller commercial banks,
commercial finance companies, or specialty lenders, allow small businesses to borrow money
by pledging otherwise idle assets such as accounts receivable, inventory, or purchase orders as
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collateral. This form of financing works especially well for manufacturers, wholesalers,
distributors, and other companies with significant stocks of inventory or accounts receivable.
Even unprofitable companies whose financial statements could not convince loan officers to
make traditional loans can get asset-based loans. These cash-poor but asset-rich companies
can use normally unproductive assets—accounts receivable, inventory, fixtures, and purchase
orders—to finance rapid growth and the cash crises that often accompany it.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 493
Borneo Fitness
International
Katalin Posztos, founder of Borneo Fitness International,
a company that sells sporty, stylish activewear, faced a
dilemma that confronts many entrepreneurs: Orders
were pouring into her company, but she lacked the capi-
tal and the cash flow to fill them. Posztos tried to land a
bank loan to finance the growth, but the four-year-old
company’s track record was not strong enough to con-
vince bankers to lend any money. “We had a bunch of
big orders and nowhere to go,” recalls Posztos. That’s
when she turned to an asset-based lender, Capstone
Business Credit. Using customer orders as collateral,
Posztos borrowed enough capital to pay fabric suppliers and manufacturers to produce the
garments she had designed. When she sold the clothing, Posztos took the accounts receiv-
able that they generated and used them as collateral to borrow the money to launch a new
upscale clothing line to complement the existing mass market line. Posztos’s asset-based
borrowing, which to date has cost $100,000 in interest and fees, has been “invaluable”
she says; Borneo’s sales have increased threefold to more than $8 million annually.
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Katalin Postzos and Shawn
Boyer, co-founders of Borneo
Fitness International (BFI)
faced a dilemma: Orders for
their company’s stylish active
wear were pouring in, but they
lacked the capital to fill them.
The entrepreneurs used asset-
based financing to get the
capital they needed, and BFI’s
sales increased three-fold.
Like banks, asset-based lenders consider in a company’s cash flow, but they are more
interested in the quality of the assets pledged as collateral. The amount a small business
can borrow through asset-based lending depends on the advance rate, the percentage of an
asset’s value that a lender will lend. For example, a company pledging $100,000 of
accounts receivable might negotiate a 70 percent advance rate and qualify for a $70,000 asset-
based loan. Advance rates can vary dramatically depending on the quality of the assets
pledged and the lender. Because inventory is an illiquid asset (i.e., hard to sell), the
advance rate on inventory-based loans is quite low, usually 10 to 50 percent. A business
pledging high-quality accounts receivable as collateral, however, may be able to negotiate
up to an 85 percent advance rate. The most common types of asset-based financing are dis-
counting accounts receivable and inventory financing.
DISCOUNTING ACCOUNTS RECEIVABLE The most common form of secured credit is
accounts receivable financing. Under this arrangement, a small business pledges its
accounts receivable as collateral; in return, the lender advances a loan against the value of
approved accounts receivable. The amount of the loan tendered is not equal to the face
value of the accounts receivable, however. Even though the bank screens the firm’s
accounts and accepts only qualified receivables, it makes an allowance for the risk
involved because some will be written off as uncollectible. A small business usually can
borrow an amount equal to 55 to 80 percent of its receivables, depending on their quality.
Generally, lenders will not accept receivables that are past due.
INVENTORY FINANCING Here, a small business loan is secured by its inventory of raw
materials, work in process, and finished goods. If an owner defaults on the loan, the lender
can claim the pledged inventory, sell it, and use the proceeds to satisfy the loan (assuming
the bank’s claim is superior to the claims of other creditors). Because inventory usually is
not a highly liquid asset and its value can be difficult to determine, lenders are willing to
lend only a portion of its worth, usually no more than 50 percent of the inventory’s value.
Most asset-based lenders avoid inventory-only deals; they prefer to make loans backed by
inventory and more secure accounts receivable. The key to qualifying for inventory
financing is proving that a company has a plan or a process in place to ensure that the
inventory securing the loan sells quickly.
advance rate
the percentage of an asset’s value
that a lender will lend.
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Asset-based financing is a powerful tool, particularly for small companies that have
significant sales opportunities but lack the track record to qualify for traditional bank
loans. A small business that could obtain a $1 million line of credit with a bank would be
able to borrow as much as $3 million by using accounts receivable as collateral. Asset-
based borrowing is also an efficient method of borrowing because a small business owner
has the money he or she needs when it is needed. In other words, the business pays only for
the capital it actually needs and uses.
To ensure the quality of the assets supporting the loans they make, lenders must mon-
itor borrowers’ assets, making paperwork requirements on these loans intimidating, espe-
cially to first-time borrowers. In addition, asset-based loans are more expensive than tradi-
tional bank loans because of the cost of originating and maintaining them and the higher
risk involved. Rates usually run from two to seven percentage points above the prime rate.
Because of this rate differential, small business owners should not use asset-based loans
for long-term financing; their goal should be to establish their credit through asset-based
financing and then to move up to a line of credit.
Vendor Financing Many small companies borrow money from their vendors and
suppliers in the form of trade credit. Because of its ready availability, trade credit is an
extremely important source of financing to most entrepreneurs. When banks refuse to lend
money to a start-up business because they see it as a high credit risk, an entrepreneur may
be able to turn to trade credit for capital. Getting vendors to extend credit in the form of
delayed payments (e.g., “net 30” credit terms) usually is much easier for small businesses
than obtaining bank financing. Essentially, a company receiving trade credit from a
supplier is getting a short-term, interest-free loan for the amount of the goods purchased.
It is no surprise that businesses receive three dollars of credit from suppliers for every
two dollars they receive from banks as loans.
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Vendors and suppliers often are willing to
finance a small business’s purchases of goods from 30 to 60 days (sometimes longer),
interest-free.
494 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
National Direct
David Johnson, president of National Direct, a Toronto, Canada–based sports collectible
business, needed $400,000 to finance a collection of pins licensed by World Wrestling
Entertainment, but banks were not convinced that National Direct would turn over the
inventory quickly. Johnson found the financing he needed through the Inventory Capital
Group, a specialty inventory lender. After selling out the pin collection, Johnson then bor-
rowed $1.2 million from Inventory Capital Group to introduce a commemorative pin col-
lection aimed at Boston Red Sox fans. With the help of the inventory financing, National
Direct’s sales have more than doubled. “It has allowed us to make a large footprint in the
market that a traditional bank would not have given us,” says Johnson.
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FrogPad
Linda Marroquin, CEO of FrogPad, a company that pro-
duces unique one-handed computer keyboards and
other accessories, relied on vendor financing, negotiat-
ing payment terms that deferred more than $1 million in
costs during the crucial start-up and product launch
period. “With sales increasing 25 percent per month,
vendor contributions have allowed us to sell product
before we pay for it,” says Marroquin. FrogPad’s sales
have surpassed $1 million annually and continue to grow
rapidly.
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Linda Marroquin, founder
of FrogPad, a company that
produces specialized computer
keyboards and accessories,
used vendor financing during
the start-up phase of her
company.
The key to maintaining trade credit as a source of funds is establishing a consistent
and reliable payment history with every vendor.
Equipment Suppliers Most equipment vendors encourage business owners to
purchase their equipment by offering to finance the purchase. This method of financing is
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similar to trade credit but with slightly different terms. Usually, equipment vendors offer
reasonable credit terms with only a modest down payment, with the balance financed over
the life of the equipment (often several years). In some cases, the vendor will repurchase
equipment for salvage value at the end of its useful life and offer the business owner
another credit agreement on new equipment. Some companies get equipment loans to lease
rather than to purchase fixed assets. Start-up companies often use trade credit from
equipment suppliers to purchase equipment and fixtures such as counters, display cases,
refrigeration units, machinery, and the like. It pays to scrutinize vendors’ credit terms,
however; they may be less attractive than those of other lenders.
Commercial Finance Companies When denied bank loans, small business owners
often look to commercial finance companies for the same types of loans. Commercial
finance companies are second only to banks in making loans to small businesses, and,
unlike their conservative counterparts, they are willing to tolerate more risk in their loan
portfolios. Of course, their primary consideration is collecting their loans, but finance
companies tend to rely more on obtaining a security interest in some type of collateral,
given the higher-risk loans that make up their portfolios. Because commercial finance
companies depend on collateral to recover most of their losses, they are able to make loans
to small companies with very irregular cash flows or to those that are not yet profitable.
Approximately 150 large commercial finance companies, such as AT&T Small
Business Lending, GE Capital Small Business Finance, and others, make a variety of loans
to small companies, ranging from asset-based loans and business leases to construction
and Small Business Administration loans. Dubbed “the Wal-Marts of finance,” commer-
cial finance companies usually offer many of the same credit options as commercial banks
do. Because their loans are subject to more risks, finance companies charge a higher inter-
est rate than commercial banks (usually prime plus at least two percent). Their most com-
mon methods of providing credit to small businesses are asset-based—accounts receivable
financing and inventory loans. Rates on these loans vary but can be as high as 15 to 30 per-
cent (including fees), depending on the risk a particular business presents and the quality
of the assets involved. Because many of the loans they make are secured by collateral (usu-
ally the business equipment, vehicle, real estate, or inventory purchased with the loan),
finance companies often impose more onerous reporting requirements, sometimes requir-
ing weekly (or even daily) information on a small company’s inventory levels or accounts
receivable balances.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 495
Princeton Laundry
When Kevin Garlasco decided to move Princeton Laundry, his family’s third-generation
commercial laundry business, out of Manhattan to the Bronx to reduce operating costs,
he knew he needed an infusion of working capital to stabilize the company. Even though
Princeton Laundry had been serving the laundry needs of New York City hotels since
1918, its recent financial challenges caused every bank the Garlascos approached to
refuse their loan applications. “We were falling [deeper] into a hole,” recalls Kevin. Then
the Garlascos turned to Business Alliance Capital, a commercial finance company, for
help, and Business Alliance provided Princeton Laundry with a $600,000 revolving line of
credit secured by accounts receivable. The line of credit has helped to turn Princeton
Laundry around; its annual sales have grown 30 percent, climbing to more than $7 mil-
lion. In addition, the reporting requirements that Business Alliance requires of Princeton
Laundry have imposed a degree of discipline on the family members who manage the
company. “Now we’re running our business much more efficiently,” says Kevin. Because
Princeton Laundry’s line of credit is secured by accounts receivable, making sure cus-
tomers pay their bills on time is paramount. “I really have to keep control of my customers
and keep them paying [on time],” he says.
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Savings and Loan Associations Savings and loan associations (S&Ls) specialize in
loans for real property. In addition to their traditional role of providing mortgages for
personal residences, savings and loan associations offer financing on commercial and
industrial property. In the typical commercial or industrial loan, the S&L will lend up to
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80 percent of the property’s value with a repayment schedule of up to 30 years. Most S&Ls
hesitate to lend money for buildings specially designed for a particular customer’s needs.
S&Ls expect the mortgage to be repaid from the company’s future profits.
Stock Brokerage Houses Stockbrokers also make loans, and many of the loans they
make to their customers carry lower interest rates than those from banks. These margin
loans carry lower rates because the collateral supporting them—the stocks and bonds in
the customer’s portfolio—is of high quality and is highly liquid. Moreover, brokerage
firms make it easy to borrow. Usually, brokers set up a line of credit for their customers
when they open a brokerage account. To tap that line of credit, the customer simply writes
a check or uses a debit card. Typically, there is no fixed repayment schedule for a margin
loan; the debt can remain outstanding indefinitely as long as the market value of the
borrower’s portfolio of collateral meets minimum requirements. Aspiring entrepreneurs
can borrow up to 50 percent of the value of their stock portfolios, up to 70 percent of their
bond portfolios, and up to 90 percent of the value of their government securities. For
example, one woman borrowed $60,000 to buy equipment for her New York health club,
and a St. Louis doctor borrowed $1 million against his brokerage account to help finance a
medical clinic.
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There is risk involved in using stocks and bonds as collateral on a loan. Brokers typi-
cally require a 30 percent cushion on margin loans. If the value of the borrower’s portfolio
drops, the broker can make a margin (maintenance) call—that is, the broker can call the
loan in and require the borrower to provide more cash and securities as collateral. Recent
swings in the stock market have translated into margin calls for many entrepreneurs,
requiring them to repay a significant portion of their loan balances within a matter of
days—or hours. If an account lacks adequate collateral, the broker can sell off the cus-
tomer’s portfolio to pay off the loan.
Over the last two decades, stockbrokers have been adding traditional loans to their line
of small business financial services, but start-up companies rarely meet their stringent
standards. For established companies, however, these loans can be an important source of
funds.
496 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
margin loans
loans from a stockbroker that use
the the stocks and bonds in the
borrower’s portfolio as collateral.
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.
Vertex Systems Inc.
Kevin Nikkhoo, founder of Vertex Systems Inc., a $10 million-a-year technology consult-
ing firm, negotiated a small business loan from Morgan Stanley to finance the company’s
rapid growth. After negotiating with banks and other potential sources of funds, Nikkhoo
decided to go with Morgan Stanley because they offered better terms and the potential
to provide more funding as Vertex grew.
73
Insurance Companies For many small businesses, life insurance companies can be an
important source of business capital. Insurance companies offer two basic types of loans:
policy loans and mortgage loans. Policy loans are extended on the basis of the amount of
money paid through premiums into the insurance policy. It usually takes about two years
for an insurance policy to accumulate enough cash surrender value to justify a loan against
it. Once he or she accumulates cash value in a policy, an entrepreneur may borrow up to
95 percent of that value for any length of time. Interest is levied annually, but borrowers
can defer repayment indefinitely. However, the amount of insurance coverage is reduced
by the amount of the loan. Policy loans typically offer very favorable interest rates, often at
or below prevailing loan rates at banks and other lending institutions. Only insurance
policies that build cash value—that is, combine a savings plan with insurance coverage—
offer the option of borrowing. These include whole life (permanent insurance), variable
life, universal life, and many corporate-owned life insurance policies. Term life insurance,
which offers only pure insurance coverage, has no borrowing capacity.
Insurance companies make mortgage loans on a long-term basis on real property
worth a minimum of $500,000. They are based primarily on the value of the real property
being purchased. The insurance company will extend a loan of up to 75 or 80 percent of the
real estate’s value and will allow a lengthy repayment schedule over 25 or 30 years so that
payments do not strain the firm’s cash flows excessively.
policy loan
a loan insurance companies make
on the basis of the amount of
money a customer has paid into a
policy in the form of premiums.
mortgage loan
a loan insurance companies make
on a long-term basis for real
property worth at least $500,000.
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Credit Unions Credit unions, nonprofit financial cooperatives that promote saving and
provide loans to their members, are best known for making consumer and car loans.
However, many are also willing to lend money to their members to launch businesses.
More than 10,000 state- and federally-chartered credit unions with some 88 million
members operate in the United States, and they make loans to their members totaling more
than $172 billion a year, many of them for the purpose of starting a business.
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Credit unions don’t make loans to just anyone; to qualify for a loan, an entrepreneur
must be a member. Lending practices at credit unions are very much like those at banks, but
they usually are willing to make smaller loans. Entrepreneurs around the globe are turning
to credit unions to finance their businesses, sometimes borrowing tiny amounts of money.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 497
credit union
a nonprofit financial cooperative
that promotes saving and provides
loans to its members.
Joseph Ogwal
When Joseph Ogwal, a refugee of war-torn Sudan, arrived in South Africa, he had
nothing—literally. Ogwal, who has a degree in electronics engineering, wanted to start
his own business to earn enough money to bring his family to South Africa, so he turned
to the Cape Metropole South African Credit Co-operative (SACCO) for a small loan. With
his $115 loan, Ogwal launched a consumer electronics repair business that already is
earning a profit. With another loan from the credit union, he plans to expand his busi-
ness, launching a training center for repair technicians.
75
Bonds Bonds, which are corporate IOUs, have always been a popular source of debt
financing for large companies. Few small business owners realize that they can also tap
this valuable source of capital. Although the smallest businesses are not viable candidates
for issuing bonds, a growing number of small companies are finding the funding they
need through bonds when banks and other lenders say no. Because of the costs involved,
issuing bonds usually is best suited for companies generating sales between $5 million
and $30 million and have capital requirements between $1.5 million and $10 million.
Although they can help small companies raise much-needed capital, bonds have certain
disadvantages. The issuing company must follow the same regulations that govern
businesses selling stock to public investors. Even if the bond issue is private, the company
must register the offering and file periodic reports with the SEC.
Small manufacturers needing money for fixed assets have access to an attractive, rela-
tively inexpensive source of funds in industrial development bonds (IDBs), which were
created to give manufacturers access to capital at rates lower than they could get from tra-
ditional lenders. In 1999, Congress created the mini-bond program, which allows small
companies to issue bonds through a streamlined application process and lower fees.
Typically, the amount of money small companies issuing IDBs seek to raise is at least $1
million, but some small manufacturers have raised as little as $500,000 using IDBs. Even
though the paperwork and legal costs associated with making an IDB issue can run up to
two to three percent of the financing amount, IDBs remain a relative bargain for borrowing
long-term money at a fixed interest rate.
Golterman & Sabo
After using bank loans for many years to finance his company’s capital needs, Ned
Golterman, co-owner of Golterman & Sabo, a small building materials company, decided
to issue mini-bonds. Not only was Golterman able to avoid much of the complicated
paperwork associated with a typical bond issue, but he also managed to get long-term
financing for his company at a rate two percentage points below the best bank loan rate
he could find and favorable repayment terms.
76
Private Placements Earlier in this chapter, we saw how companies can raise capital by
making private placements of their stock (equity). Private placements are also available for
debt instruments. A private placement involves selling debt to one or a small number of
investors, usually insurance companies or pension funds. Private placement debt is a
hybrid between a conventional loan and a bond. At its heart, it is a bond, but its terms are
tailored to the borrower’s individual needs, as a loan would be.
Privately placed securities offer several advantages over standard bank loans. First,
they usually carry fixed interest rates rather than the variable rates banks often charge.
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Second, the maturity of private placements is longer than most bank loans: 15 years rather
than 5. Private placements do not require hiring expensive investment bankers. Finally,
because private investors can afford to take greater risks than banks, they are willing to
finance deals for fledgling small companies.
Small Business Investment Companies Small business investment companies
(SBICs), created in 1958 when Congress passed the Small Business Investment Act, are
privately owned financial institutions that are licensed and regulated by the SBA. The 418
SBICs operating in the United States use a combination of private capital and federally
guaranteed debt to provide long-term capital to small businesses. Most SBICs prefer later-
round financing over funding raw start-ups. Because of changes in their financial structure
made a few years ago, however, SBICs now are better equipped to invest in start-up
companies. In fact, about 43 percent of SBIC investments go to companies that are no
more than three years old.
77
Funding from SBICs helped launch companies such as Apple
Computer, JetBlue Airways, Build-a-Bear Workshop, Federal Express, Staples, Sun
Microsystems, and Callaway Golf.
Since 1958, SBICs have provided more than $46 billion in long-term debt and equity
financing to some 100,000 small businesses, adding many thousands of jobs to the
American economy.
78
SBICs must be capitalized privately with a minimum of $5 million,
at which point they qualify for up to three dollars in long-term SBA loans for every dollar
of private capital invested in small businesses. As a general rule, SBICs may provide finan-
cial assistance only to small businesses with a net worth of less than $18 million and aver-
age after-tax earnings of $6 million during its last two years. However, employment and
total annual sales standards vary from industry to industry. SBICs are limited to a maxi-
mum investment or loan amount of 20 percent of their private capital to a single client.
SBICs provide both debt and equity financing to small businesses. Because of SBA
regulations affecting the financing arrangements an SBIC can offer, most SBICs extend
their investments as loans with an option to convert the debt instrument into an equity
interest later. Most SBIC loans are in the much-needed range of $100,000 to $5 million,
and the loan term is longer than most banks allow. The average SBIC loan is $664,200.
79
When they make equity investments, SBICs are prohibited from obtaining a controlling
interest in the companies in which they invest (no more than 49 percent ownership). The
average SBIC equity investment is $1.13 million, far below the average equity investment
by venture capital firms of $12 million.
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The most common forms of SBIC financing (in
order of their frequency) are a loan with an option to buy stock, a convertible debenture, a
straight loan, and preferred stock.
498 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
Outback Steakhouse
Outback Steakhouse, a highly successful restaurant chain based on an Australian theme,
received early financing from an SBIC, Kitty Hawk Capital I, which allowed it to grow. In
1990, Outback had been in business less than three years when the SBIC decided to
invest $151,000 to boost the company’s working capital balance. That capital infusion
gave Outback the financing it needed to get to the next level. The company made an ini-
tial public offering in 1991 and today generates sales of more than $2.5 billion a year.
81
Outback Steakhouse, which now has locations around the globe, truly is a success
story for the SBIC industry. Due to budget pressure at the federal level, however, the SBIC
program now is fighting for survival.
Small Business Lending Companies Small business lending companies (SBLCs)
make only intermediate- and long-term SBA-guaranteed loans. They specialize in loans
that many banks would not consider and operate on a nationwide basis. Most SBLC loans
have terms extending for at least 10 years. The maximum interest rate for loans of seven
years or longer is 2.75 percent above the prime rate; for shorter-term loans, the ceiling is
2.25 percent above prime. Another feature of SBLC loans is the expertise the SBLC offers
borrowing companies in critical areas. Corporations own most of the nation’s SBLCs,
giving them a solid capital base.
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Federally Sponsored Programs
Federally sponsored lending programs have suffered from budget reductions in the last sev-
eral years. Current trends suggest that the federal government is reducing its involvement in
the lending business, but many programs are still quite active and some are actually growing.
Economic Development Administration
The Economic Development Administration (EDA), a branch of the Commerce
Department, offers loan guarantees to create new business and to expand existing businesses
in areas with below-average income and high unemployment. Focusing on economically
distressed communities, the EDA often works with local governments to finance long-term
investment projects needed to stimulate economic growth and to create jobs by making loan
guarantees. The EDA guarantees loans up to 80 percent of business loans between $750,000
and $10 million. Entrepreneurs apply for loans through private lenders, for whom an EDA
loan guarantee significantly reduces the risk of lending. Start-up companies must supply 15
percent of the guaranteed amount in the form of equity, and established businesses must
make equity investments of at least 15 percent of the guaranteed amount. Small businesses
can use the loan proceeds for a variety of ways, from supplementing working capital and
purchasing equipment to buying land and renovating buildings.
EDA business loans are designed to help replenish economically distressed areas by cre-
ating or expanding small businesses that provide employment opportunities in local communi-
ties. To qualify for a loan, a business must be located in a disadvantaged area, and its presence
must directly benefit local residents. Some communities experiencing high unemployment or
suffering from the effects of devastating natural disasters have received EDA Revolving Loan
Fund Grants to create loan pools for local small businesses. For instance, the city of San Diego
recently used matching funds from the EDA to make a $300,000 loan to Otay Auto Body Parts,
a promising start-up company that sells after-market auto parts to both wholesalers and retail-
ers. The small company used the loan to hire employees and to purchase inventory.
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Department of Housing and Urban Development
The Department of Housing and Urban Development (HUD) sponsors several loan pro-
grams to assist qualified entrepreneurs in raising needed capital. Community Development
Block Grants (CDBGs) are extended to cities and counties that, in turn, lend or grant
money to entrepreneurs to start small businesses that will strengthen the local economy.
Grants are aimed at cities and towns in need of revitalization and economic stimulation.
Some grants are used to construct buildings and plants to be leased to entrepreneurs, some-
times with an option to buy. Others are earmarked for revitalizing a crime-ridden area or
making start-up loans to entrepreneurs or expansion loans to existing business owners. No
ceilings or geographic limitations are placed on CDBG loans and grants, but projects must
benefit low- and moderate-income families.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 499
Clean Advantage
When Linda Black, who co-founded with her husband Clean Advantage, a company that
makes a variety of cleaning products, began landing accounts with many of the nation’s
largest companies, she saw the need to expand her business. Black found the ideal location
for her growing company in tiny Greer, South Carolina. The 55,000-square-foot building,
formerly a toothpaste manufacturing operation, “was just perfect for us,” says Black, who
turned to an SBLC operated by non-bank lender CIT to finance the project. “We were able
to offer Linda 90 percent financing with terms she could afford,” says CIT loan office Mark
Moreno. “We also [integrated] her working capital requirements into the same loan to give
her a cushion to help with moving costs, setup, and other expenses,” says Moreno.
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LEARNING OBJECTIVES
6. Identify the various federal
loan programs aimed at small
businesses.
Cessna Aircraft Company
and Wichita, Kansas
The city of Wichita, Kansas, and Cessna Aircraft Company used the loan guarantee provi-
sion of the CDBG program to purchase a large tract in a troubled neighborhood and to
renovate it. They built the Cessna Learning Work Complex, which included a light assem-
bly factory and a training/day care center for Cessna trainees from the local area. The ren-
ovation stimulated investments in the community, including a new bank, a library, a senior
citizens center, and a housing complex.
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HUD also makes loan guarantees up to $5 million through its Section 108 provision of
the Community Block Development Grant program. The agency has funded more than
1,200 projects since its inception in 1978. These loan guarantees allow a community to
transform a portion of CDBG funds into federally guaranteed loans large enough to pursue
economic revitalization projects that can lead to the renewal of entire town.
U.S. Department of Agriculture’s Rural Business-Cooperative Service
The U.S. Department of Agriculture (USDA) provides financial assistance to certain small
businesses through its Rural Business-Cooperative Service (RBS). The RBS program is
open to all types of businesses (not just farms) and is designed to create nonfarm employ-
ment opportunities in rural areas—those with populations below 50,000 and not adjacent
to a city where densities exceed 100 people per square mile. Entrepreneurs in many small
towns, especially those with populations below 25,000, are eligible to apply for loans
through the RBS program, which makes almost $900 million in loan guarantees each year.
The RBS does make a limited number of direct loans to small businesses, but the major-
ity of its activity is in loan guarantees. Through its Business and Industry Guaranteed Loan
Program, the RBS will guarantee as much as 80 percent of a commercial lender’s loan up to
$25 million (although actual guarantee amounts are almost always far less) for qualified appli-
cants. Entrepreneurs apply for loans through private lenders, who view applicants with loan
guarantees much more favorably than those without such guarantees. The RBS guarantee
reduces a lender’s risk dramatically because the guarantee means that the government agency
would pay off the loan balance (up to the ceiling) if the entrepreneur defaults on the loan.
To make a loan guarantee, the RBS requires much of the same documentation as most
banks and most other loan guarantee programs. Because of its emphasis on developing
employment in rural areas, the RBS requires an environmental-impact statement describ-
ing the jobs created and the effect the business has on the area. The Rural-Business
Cooperative Service also makes grants available to businesses and communities for the
purpose of encouraging small business development and growth.
Small Business Innovation Research Program
Started as a pilot program by the National Science Foundation in the 1970s, the Small
Business Innovation Research Program (SBIR) program has expanded to 11 federal agen-
cies, ranging from NASA to the Department of Defense. These agencies award cash grants
or long-term contracts to small companies wanting to initiate or to expand their research
and development efforts. SBIR grants give innovative small companies the opportunity to
attract early-stage capital investments without having to give up significant equity stakes or
taking on burdensome levels of debt. The SBIR process involves three phases. Phase I
grants, which determine the feasibility and commercial potential of a technology or prod-
uct, last for up to 6 months and have a ceiling of $100,000. Phase II grants, designed to
develop the concept into a specific technology or product, run for up to 24 months and
have a ceiling of $750,000. Approximately 40 percent of all Phase II applicants receive
funding. Phase III is the commercialization phase, in which the company pursues commer-
cial applications of the research and development conducted in phases I and II and must
use private or non-SBIR federal funding to bring a product to market.
Competition for SBIR funding is intense; only 12 percent of the small companies that
apply receive funding. So far, more than 36,000 SBIR awards totaling in excess of $10 bil-
lion have gone to small companies, who traditionally have had difficulty competing with
big corporations for federal R&D dollars. The government’s dollars have been well
invested. Nearly 40 percent of small businesses receiving second-phase SBIR awards have
achieved commercial success with their products.
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500 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
PediSedate
Geoffrey Hart, a physician at Albert Einstein Memorial Center in Philadelphia, knew there
had to be a better way to administer anesthesia to the frightened, injured children whom
he treated in the emergency room. Many children panicked when members of the medical
team approached them with the full-sized anesthesiology masks that covered their entire
faces. Working with engineer David Chastain, Hart created the PediSedate, a child-sized
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The Small Business Technology Transfer Program
The Small Business Technology Transfer Program (STTR) program complements the
Small Business Innovation Research Program. Whereas the SBIR focuses on commer-
cially promising ideas that originate in small businesses, the STTR uses companies to
exploit the vast reservoir of commercially promising ideas that originate in universities,
federally funded R&D centers, and nonprofit research institutions. Researchers at these
institutions can join forces with small businesses and can spin off commercially promising
ideas while remaining employed at their research institutions. Five federal agencies award
grants of up to $500,000 in three phases to these research partnerships.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 501
headset with a swiveling snorkel that delivers the sedating medication and monitors the
child’s respiration. The earpieces connect to either a portable CD player or to a Nintendo
Game Boy unit while simultaneously monitoring the oxygenation of the blood. To finance
the cost of developing the PediSedate and bringing it to market, Hart and Chastain applied
for and received both Phase I and a Phase II SBIR grants through the National Institutes of
Health. “These grants made everything possible,” says Chastain. “They enabled all of the
product development and the clinical trial work [to receive approval from the FDA].”
86
Always On Wireless
In 1988, when Rudy Prince launched his first business,
JetFax, a software company that allowed users to send
faxes over the Internet, he convinced several angel
investors to put up $500,000 in start-up capital even
though the company was little more than an idea on
paper. Today Prince is looking for $1 million for his latest
business venture, Always On Wireless, a company that
markets the WiFlyer, a device that lets dial-up Internet
subscribers connect to the Web wirelessly. This time,
however, Prince and his partners have invested
$200,000 of their own money in Always On and have a
fully-developed product ready to go to market,
Prince has approached potential angel investors, but
this time he is getting a different response: skepticism.
“[Angels] are no longer relying as much on leaps of faith
when it comes to investing,” says Prince. He knows that
angel investors typically expect to purchase 25 percent
to 35 percent of a company’s stock and to receive
returns of 5 to 10 times their original investments.
Tympany Inc.
Chris Wasden, founder of Tympany, a Houston-based
hearing diagnostics device company, worked for invest-
ment banker J.P. Morgan for nine years, and he knows
how the fund-raising business works. With his company
up and running, Wasden is looking for $4.5 million to
fuel Tympany’s growth. Wasden’s business plan projects
third-year revenues of $6 million—if he can find the
financing he needs. Wasden has spent nearly a year
making more than 90 presentations to potential
investors in the Houston area, but none of them have
decided to invest in Tympany. Frustrated, Wasden won-
ders where to turn next.
Marian Heath Greeting Cards
Aaron Kushner, an entrepreneur whose family had been
in the greeting card business for several years, has the
opportunity to buy another company in the industry,
Marian Heath Greeting Cards, from the daughter of the
company’s founder. Kushner and his business partner,
Dan Steever, have a profitable business that is growing
at a steady five percent a year, but they lack the $4 mil-
lion they need to purchase Marian Heath. “We put
together a small portion of the price with our own and
friends’ money, but we are going to need an equity
partner,” says Kushner. He admits, however, that it is
extremely difficult to find “a good equity partner who
isn’t interested in controlling the entire company or flip-
ping [selling] it in a short period of time.”
Money Hunt
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Small Business Administration
The Small Business Administration (SBA) has several programs designed to help finance
both start-up and existing small companies that cannot qualify for traditional loans because of
their thin asset base and their high risk of failure. In its more than 50 years of operation, the
SBA has helped nearly 20 million small businesses through a multitude of programs, enabling
many of them to get the financing they need for start-up or for growth. The SBA’s $45 billion
loan portfolio makes it the single financial backer of small businesses in the nation.
87
To be
eligible for SBA funds, a business must meet the SBA’s criteria that define a small business.
In addition, some types of businesses, such as those engaged in gambling, pyramid sales
schemes, or real estate investment, among others, are ineligible for SBA loans.
The loan application process can take from three days to several months, depending
on how well prepared the entrepreneur is and which bank is involved. To speed up pro-
cessing times, the SBA has established a Certified Lender Program (CLP) and a Preferred
Lender Program (PLP). Both are designed to encourage banks to become frequent SBA
lenders. When a bank makes enough good loans to qualify as a certified lender, the SBA
promises a fast turnaround time for the loan decision—typically 3 to 10 business days.
About 850 lenders across the country are SBA certified lenders. When a bank becomes a
preferred lender, it makes the final lending decision itself, subject to SBA review. In
essence, the SBA delegates the application process, the lending decision, and other details
to the preferred lender. The SBA guarantees up to 75 percent of PLP loans in case the bor-
rower fails and defaults on the loan. The minimum PLP loan guarantee is $100,000, and
the maximum is $500,000. About 500 lenders across the United States meet the SBA’s pre-
ferred lender standards. Using certified or preferred lenders can reduce the processing time
for an SBA loan considerably.
To further reduce the paperwork requirements involved in its loans, the SBA created
the Low Doc Loan Program (“low documentation”), which allows small businesses to
use a simple one-page application for all loan applications. Before the Low Doc Loan
Program, a typical SBA loan application required an entrepreneur to complete at least 10
forms, and the SBA often took 45 to 90 days to make a decision about an application.
Under the Low Doc Loan Program, response time is just three days.
To qualify for a Low Doc loan, a company must have average sales below $5 million
during the previous three years and employ fewer than 100 people. Businesses can use
Low Doc loans for working capital, machinery, equipment, and real estate. The SBA guar-
antees 85 percent of loans up to $100,000 and 75 percent of loans over that amount up to
the loan ceiling of $150,000. Borrowers must be willing to provide a personal guarantee
for repayment of the loan principal. Interest rates are prime plus 2.75 percent on loans of
seven years or longer and prime plus 2.25 percent on loans of less than seven years. The
average Low Doc loan is $79,500.
502 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
1. Explain why the following funding sources would
or would not be appropriate for Rudy Prince, John
Acosta, and Aaron Kushner: family and friends,
angel investors, venture capital, an initial public
offering, a traditional bank loan, asset-based bor-
rowing, or one of the many federal or SBA loans.
2. Rudy Prince knows that potential private investors
in his company are looking to “cash out” their
investments in five to seven years. Discuss the exit
strategies that are available to Prince and his
investors. What are the advantages and disadvan-
tages of each one?
3. Work with a team of your classmates to brain-
storm ways that Rudy Prince, John Acosta, and
Aaron Kushner 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?
Source: Adapted from Paola Singer, “Capital Ideas,” Wall Street
Journal, May 8, 2006, pp. RR6, R12; David Worrell, “Common
Cents,” Entrepreneur, November 2004, pp. 72–74; Darren Dahl,
“Earning Your Wings,” Inc., January 2005, pp. 40–42.
LEARNING OBJECTIVES
7. Describe the various loan pro-
grams available from the Small
Business Administration.
Low Doc Loan Program
a program initiated by the SBA in
an attempt to simplify and
streamline the application process
for small business loans.
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Another program designed to streamline the application process for SBA loan guar-
antees is the SBAExpress Program, in which participating lenders use their own loan
procedures and applications to make loans of up to $350,000 to small businesses. Because
the SBA guarantees up to 50 percent of the loan, banks are often more willing to make
smaller loans to entrepreneurs who might otherwise have difficulty meeting lenders’ stan-
dards. Loan maturities on SBAExpress loans typically are between five and ten years, but
loan maturities for fixed assets can be up to 25 years. Currently, the SBA is planning to
replace the Low Doc Program with the SBAExpress Program. In fact, several SBA loan
programs face potential elimination as Congress and the White House struggle with the
federal budget.
SBA Loan Programs
7(A) Loan Guaranty Program The SBA works with local lenders (both bank and non-
bank) to offer a variety of loan programs all designed to help entrepreneurs who cannot get
capital from traditional sources gain access to the financing they need to launch and grow
their businesses. By far, the most popular SBA loan program is the 7(A) loan guaranty
program (see Figure 13.4). Private lenders extend these loans to small businesses, but the
SBA guarantees them (85 percent of loans up to $150,000; 75 percent of loans above
$150,000 up to the loan guarantee ceiling of $750,000). In other words, the SBA does not
actually lend any money; it merely acts as an insurer, guaranteeing the lender this much
repayment in case the small business borrower defaults on the loan. When they were just
small companies, Callaway Golf, Outback Steakhouse, and Intel Corporation borrowed
through the SBA’s 7(A) loan program.
CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 503
SBAExpress Program
an SBA program that allows
participating lenders to use their
own loan procedures to make
SBA-guaranteed loans.
7(A) loan guaranty program
an SBA loan program in which
loans made by private lenders to
small businesses are guaranteed
up to a ceiling by the SBA.
Richard Smith
Richard Smith, owner of a whitewater rafting business, needed money to expand his 20-
year-old company and to buy new equipment. Smith, however, was hesitant to approach
the SBA because he wanted to avoid “myriads of paperwork.” At his banker’s urging,
Smith decided to try the Low Doc Program, and within days of submitting his application,
he received a $100,000 loan.
88
$0
Year
$2
$4
$6
$18
$16
$14
$12
$10
$8
B
i
l
l
i
o
n
s

o
f

$
1976 1978 1980 1982 1984 1986 1988 1990 1992 2007*
* project ed
1994 1996 1998 2000 2002 2004 2006
FIGURE 13.4
SBA 7(A) Guaranteed Loans
Source: U.S. Small Business Administration.
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504 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
CAPLine Program
an SBA program that makes short-
term capital loans to growing
companies needing to finance
seasonal buildups in inventory or
accounts receivable.
Because the SBA assumes most of the credit risk, lenders are more willing to consider
riskier deals that they normally would refuse. Because of the SBA’s guarantee, borrowers
also have to come up with less collateral than with a traditional bank loan.
Qualifying for an SBA loan guarantee requires cooperation among the entrepreneur,
the participating lender, and the SBA. The participating lender determines the loan’s terms
and sets the interest rate within SBA limits. Contrary to popular belief, SBA-guaranteed
loans do not carry special deals on interest rates. Typically, rates are negotiated with the par-
ticipating lender, with a ceiling of prime plus 2.25 percent on loans of less than 7 years and
prime plus 2.75 percent on loans of 7 to 25 years. Interest rates on loans of less than $25,000
can run up to prime plus 4.75 percent. The average interest rate on SBA-guaranteed loans is
prime plus 2 percent (compared to prime plus 1 percent on conventional bank loans). The
SBA also assesses a one-time guaranty fee of up to 3.75 percent for all loan guarantees.
The maximum loan available through the 7(A) guaranty program is $2,000,000, but
the average loan amount is $154,000. The average duration of an SBA loan is 12 years—far
longer than the average commercial small business loan. In fact, longer loan terms are a
distinct advantage of SBA loans. At least half of all bank business loans are for less than
one year. By contrast, SBA real estate loans can extend for up to 25 years (compared to just
10 to 15 years for a conventional loan), and working capital loans have maturities of seven
years (compared with two to five years at most banks). These longer terms translate into
lower payments, which are better suited for young, fast-growing, cash-strapped compa-
nies. In fact, the SBA’s 7(A) loan program accounts for 40 percent of all long-term loans to
the nation’s 25 million small businesses. For instance, Craig Lindgren, owner of Boulder
Exhibits, a company that designs and builds trade-show exhibits, recently borrowed
$820,000 to purchase a 23,000-square-foot office and warehouse that he financed for 25
years with the help of the 7(A) program.
90
The CAPLine Program In addition to its basic 7(A) loan guarantee program (through
which the SBA makes about 84 percent of its loans), the SBA provides guarantees on small
business loans for start-up, real estate, machinery and equipment, fixtures, working capital,
exporting, and restructuring debt through several other methods. About two-thirds of all
SBA’s loan guarantees are for machinery and equipment or working capital. The CAPLine
Program offers short-term capital to growing companies needing to finance seasonal
build-ups in inventory or accounts receivable under five separate programs, each with
maturities up to five years: seasonal line of credit (provides advances against inventory and
accounts receivable to help businesses weather seasonal sales fluctuations), contract line of
credit (finances the cost of direct labor and materials costs associated with performing
contracts), builder’s line of credit (helps small contractors and builders finance labor and
materials costs), standard asset-based line of credit (an asset-based revolving line of credit
for financing short-term needs), and small asset-based line of credit (an asset-based
revolving line of credit up to $200,000). CAPLine is aimed at helping cash-hungry small
businesses by giving them a credit line to draw on when they need it. These loans built
Lupita’s Bakery and
Fiesta Mexicana Family
Restaurant
After working in the bakery business for 16 years, Abel Diaz used an SBA-guaranteed
loan to open Lupita’s Bakery in South Central Los Angeles. Given Diaz’s modest collateral
and the history of the area in which his bakery would operate (it had been the site of riots,
violence, and other problems in the past), the SBA loan guarantee was essential for Diaz
to qualify for a bank loan. Diaz’s bakery was a success, and he soon opened bakeries in
two more locations. Always on the lookout for business opportunities, Diaz saw the need
for a restaurant and banquet facility in his community and once again applied for an SBA
loan guarantee through a local bank, Banco Popular. Diaz now operates the highly suc-
cessful Fiesta Mexicana Family Restaurant, and its adjoining banquet hall is booked almost
every night of the week. “Abel Diaz has succeeded in both the bakery and the catering
businesses and has created new jobs in a historically underserved area,” says the SBA’s Los
Angeles District Director.
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CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 505
certified development
company (CDC)
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.
around lines of credit are what small companies need most because they are so flexible,
efficient, and, unfortunately, so hard for small businesses to get from traditional lenders.
Loans Involving International Trade For small businesses going global, the SBA
has the Export Working Capital (EWC) Program, which is designed to provide working
capital to small exporters. The SBA works in conjunction with the Export-Import Bank to
administer this loan guarantee program. Applicants file a one-page loan application, and
the response time normally is 10 days or less. The maximum loan is $2,000,000, and
proceeds must be used to finance small business exports.
Export Working Capital
(EWC) Program
an SBA loan program that is
designed to provide working
capital to small exporters.
International Trade Program
an SBA loan program for small
businesses that are engaging in
international trade or are
adversely affected by competition
from imports.
PowerUp Inc.
Paul Wilhelm landed a significant contract to export to Pakistan the diesel engine kits that
his small company, PowerUp Inc., assembles. The only problem was that the start-up com-
pany lacked the working capital to fill the order, and because it had not yet established a
track record, it did not qualify for a traditional loan. With the guidance of the Small Business
Development Center at the University of Georgia, Wilhelm applied for a $125,000 SBA-
guaranteed Export Working Capital loan and received approval within a week. “This export
loan fit our business perfectly,” says Wilhelm. “[It] was essential to the growth of our com-
pany, and we plan to use more of them in the future.” After making the sale in Pakistan,
PowerUp repaid the loan and shortly thereafter received approval on another Export
Working Capital loan—this one for $1 million—to export engine parts to Pakistan.
91
The International Trade Program is for small businesses that are engaging in inter-
national trade or are adversely affected by competition from imports. The SBA allows
global entrepreneurs to combine loans from the Export Working Capital Program with
those from International Trade Program for a maximum guarantee of $1,750,000. Loan
maturities range from 1 to 25 years.
Section 504 Certified Development Company Program The SBA’s Section 504
program is designed to encourage small businesses to expand their facilities and to create
jobs. Section 504 loans provide long-term, fixed-asset financing to small companies to
purchase land, buildings, or equipment. Three lenders play a role in every 504 loan: a
bank, the SBA, and a certified development company (CDC). A CDC is a nonprofit
organization licensed by the SBA and designed to promote economic growth in local
communities. Some 270 CDCs operate across the United States. An entrepreneur generally
is required to make a down payment of just 10 percent of the total project cost. The CDC
puts up 40 percent at a long-term fixed rate, supported by an SBA loan guarantee in case
the entrepreneur defaults. The bank provides long-term financing for the remaining 50
percent, also supported by an SBA guarantee. The major advantages of Section 504 loans
are their fixed rates and terms, their 10- and 20-year maturities, and the low down payment
required. The maximum loan amount is $1.5 million.
Metalcraft Industries
When he learned that Metalcraft Industries, a company that manufactures sheet metal
and machine precision parts for the aerospace industry, was about to shut down and put
out of work many residents of Cedar City, Utah, entrepreneur David Grant decided to
take action. With the help of Mountain West Small Business Finance, a certified develop-
ment company licensed by the SBA, Grant put together a financing package that allowed
him and the company’s management team to purchase the company and save it from the
scrapheap. Today, Metalcraft Industries employs hundreds of people and has become one
of Utah’s most successful small businesses.
92
As attractive as they are, 504 loans are not for every business owner. The SBA
imposes several restrictions on 504 loans:
? For every $35,000 the CDC loans, the project must create at least one new job or
achieve a public policy goal such as rural development, expansion of exports, minor-
ity business development, and others.
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506 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
? Machinery and equipment financed must have a useful life of at least 10 years.
? The borrower must occupy at least two-thirds of a building constructed with the loan,
or the borrower must occupy at least half of a building purchased or remodeled with
the loan.
? The borrower must qualify as a small business under the SBA’s definition and must
not have a tangible net worth in excess of $7 million and not have an average net
income in excess of $2.5 million after taxes for the preceding two years.
Because of strict equity requirements, existing small businesses usually find it easier to
qualify for 504 loans than do startups.
Microloan Program About three-fourths of all entrepreneurs need less than $100,000
to launch their businesses. Indeed, most entrepreneurs require less than $50,000 to start
their companies. Unfortunately, loans of that amount can be the most difficult to get.
Lending these relatively small amounts to entrepreneurs starting businesses is the purpose
of the SBA’s Microloan Program. Called microloans because they range from just $100
to as much as $35,000, these loans have helped thousands of people take their first steps
toward entrepreneurship. Banks typically shun loans in such small amounts because they
consider them to be risky and unprofitable. In an attempt to fill the void in small loans to
start-up companies, the SBA launched the microloan program in 1992. Since then
entrepreneurs have borrowed more than $286 million, making the microloan program the
largest source of funding for microenterprises. Today, more than 150 authorized lenders
make SBA-backed microloans. The average size of a microloan is $13,000, with a maturity
of three years (the maximum term is six years), and lenders’ standards are less demanding
than those on conventional loans. Nearly 40 percent of all microloans go to business start-
ups.
93
All microloans are made through nonprofit intermediaries approved by the SBA.
Microloan Program
an SBA program that makes small
loans, some as small as $100, to
entrepreneurs.
Kimberly Arrington
Kimberly Arrington was a single mother of three struggling to make ends meet with the
help of public assistance, but she had a dream of opening her own hair salon. With no
capital of her own and a credit score no bank would consider, Arrington turned to the
South Bronx Overall Economic Development Corporation (SoBRO) for help. Not only did
SoBRO approve a microloan for Arrington, but the lender also helped her to hone her
business skills with a management class. After just one year in business, Arrington’s salon
was profitable and had three employees.
94
Although many consider the microloan program to be successful, political powers in
Washington have earmarked it for elimination on several occasions.
Prequalification Loan Program The Prequalification Loan Program is designed to
help disadvantaged entrepreneurs such as those in rural areas, minorities, women, the
disabled, those with low incomes, veterans, and others to prepare loan applications and
“prequalify” for SBA loan guarantees before approaching banks and lending institutions
for business loans. Because lenders are much more likely to approve loans that the SBA
has prequalified, these entrepreneurs have greater access to the capital they need. The
maximum loan under this program is $250,000, and loan maturities range from 7 to 25
years. A local Small Business Development Center usually helps entrepreneurs prepare
their loan applications at no charge.
Disaster Loans As their name implies, disaster loans are made to small businesses
devastated by some kind of financial or physical loss. The maximum disaster loan usually
is $1.5 million, but Congress often raises that ceiling when circumstances warrant.
Disaster loans carry below-market interest rates, as low as four percent, and terms as long
as 30 years. Loans for physical damage above $10,000 and financial damage of more than
$5,000 require an entrepreneur to pledge some kind of collateral, usually a lien on the
business property. The SBA has helped entrepreneurs whose businesses have been
Prequalification Loan
Program
an SBA program designed to help
disadvantaged entrepreneurs
“prequalify” for SBA loan
guarantees before approaching
commercial lenders.
disaster loans
an SBA loan program that makes
loans to small businesses
devastated by some kind of
financial or physical loss.
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CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 507
disrupted by a variety of disasters, ranging from hurricanes on the Southeastern coast and
earthquakes on the West coast to floods and to tornadoes in the Midwest and the terrorist
attacks of September 11, 2001.
In Louisiana alone, Hurricane Katrina shuttered more than 81,000 businesses, and
many of them were unable to recover.
Tommy’s Cuisine
Tommy Andrade, owner of Tommy’s Cuisine, an Italian-Creole restaurant in the
Warehouse District in New Orleans, evacuated the day before Hurricane Katrina hit, hop-
ing to return and reopen within a few days. Three months later, Andrade returned to a
building and equipment that were almost completely destroyed. “My spirit was so dam-
aged,” he says. “Thinking of the employees and providing jobs to them is what gave me
the strength to put things together and continue.” With the help of a $350,000 SBA dis-
aster loan, Andrade was able to rebuild his restaurant and reopen. He also took out
another loan to repair a damaged apartment building he owned that provided housing
for his employees. Customers soon returned, and the restaurant came to life again.
95
State and Local Loan Development Programs
Many states have created their own loan and economic development programs to provide
funds for business start-ups and expansions. They have decided that their funds are better
spent encouraging small business growth rather than “chasing smokestacks”—trying to
entice large businesses to locate within their boundaries. These programs come in a wide
variety of forms, but they all tend to focus on developing small businesses that create the
greatest number of jobs and economic benefits. Although each state’s approach to eco-
nomic development is somewhat special, one common element is some kind of small busi-
ness financing program: loans, loan guarantees, development grants, venture capital pools,
and others. One approach many states have had success with is the use of capital access
programs (CAPs). First introduced in Michigan in 1986, many states now offer CAPs that
are designed to encourage lending institutions to make loans to businesses that do not qual-
ify for traditional financing because of their higher risk. Under a CAP, a bank and a borrower
each pay an upfront fee (a portion of the loan amount) into a loan-loss reserve fund at the par-
ticipating bank, and the state matches this amount. The reserve fund, which normally ranges
from 6 to 14 percent of the loan amount, acts as an insurance policy against the potential loss
a bank might experience on a loan and frees the bank to make loans that it otherwise might
refuse. One study of CAPs found that 55 percent of the entrepreneurs who received loans
under a CAP would not have been granted loans without the backing of the program.
96
Even cities and small towns have joined in the effort to develop small businesses and
help them grow. More than 7,500 communities across the United States operate revolving
loan funds (RLFs) that combine private and public funds to make loans to small businesses,
often at below-market interest rates. As money is repaid into the funds, it is loaned back out
to other entrepreneurs. A study by the Corporation for Enterprise Development of RLFs in
seven states found that the median RLF loan was $40,000 with a maturity of five years.
97
capital access programs
(CAPs)
a state lending program that
encourages lending institutions to
make loans to businesses that do
not qualify for traditional financing
because of their higher risk.
revolving loan fund (RLF)
a program offered by communities
that combine private and public
funds to make loans to small
businesses, often at below-market
interest rates.
bootstrap financing
internal methods of financing a
company’s need for capital.
J.B. Motorsports and
Salvage
Brian Hale transformed his passion for snowmobiles, dirt bikes, and ATVs into a thriving
business with the help of a loan from the Central Vermont Revolving Loan Fund. Hale’s
company, J.B. Motorsports and Salvage, repairs as well as refurbishes and sells these vehi-
cles to customers looking for bargains. He used his loan to purchase an inventory of parts
and to purchase a computer system to help him run the business more efficiently.
98
Internal Methods of Financing
Small business owners do not have to rely solely on financial institutions and government
agencies for capital; their businesses have the capacity to generate capital. This type of
financing, called bootstrap financing, is available to virtually every small business and
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508 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
encompasses factoring, leasing rather than purchasing equipment, using credit cards, and
managing the business frugally.
Factoring Accounts Receivable
Instead of carrying credit sales on its own books (some of which may never be collected), a
small business can sell outright its accounts receivable to a factor. A factor buys a company’s
accounts receivable and pays for them in two parts. The first payment, which the factor makes
immediately, is for 50 to 80 percent of the accounts’ agreed-on (and usually discounted)
value. The factor makes the second payment of 15 to 18 percent, which makes up the balance
less the factor’s service fees, when the original customer pays the invoice. Factoring is a more
expensive type of financing than loans from either banks or commercial finance companies,
but for businesses that cannot qualify for those loans, it may be the only choice.
Factoring deals are either with recourse or without recourse. Under deals arranged
with recourse, a small business owner retains the responsibility for customers who fail to
pay their accounts. The business owner must take back these uncollectible invoices. Under
deals arranged without recourse, however, the owner is relieved of the responsibility for
collecting them. If customers fail to pay their accounts, the factor bears the loss. Because
the factoring company assumes the risk of collecting the accounts, it normally screens the
firm’s credit customers, accepts those judged to be creditworthy, and advances the small
business owner a portion of the value of the accounts receivable. Factors discount any-
where from two to 40 percent of the face value of a company’s accounts receivable,
depending on a small company’s:
? Customers’ financial strength and credit ratings.
? Industry and its customers’ industries because some industries have a reputation for
slow payments.
? History and financial strength, especially in deals arranged with recourse.
? Credit policies.
99
The discount rate on deals without recourse usually is higher than on those with recourse
because of the higher level of risk they carry for the factor.
Although factoring is more expensive than traditional bank loans (a 2 percent discount
from the face value of an invoice due in 30 days amounts to an annual interest rate of 24.5
percent), it is a source of quick cash and is ideally suited for fast-growing companies, espe-
cially start-ups that cannot qualify for bank loans. Small companies that sell to government
agencies and large corporations, both famous for stretching out their payments for 60 to 90
days or more, also find factoring attractive because they collect the money from the sale
(less the factor’s discount) much faster.
Leasing
Leasing is another common bootstrap financing technique. Today, small businesses can
lease virtually any kind of asset, from office space and telephones to computers and heavy
equipment. By leasing expensive assets, the small business owner is able to use them with-
out locking in valuable capital for an extended period of time. In other words, the manager
can reduce the long-term capital requirements of the business by leasing equipment and
facilities, and he or she is not investing his or her capital in depreciating assets. In addition,
because no down payment is required and because the cost of the asset is spread over a
longer time (lowering monthly payments), a company’s cash flow improves.
Credit Cards
Unable to find financing elsewhere, many entrepreneurs launch their companies using the
fastest and most convenient source of debt capital available: credit cards. A study by the
Small Business Administration reports that other than personal savings, the most commonly
used source of financing for startup ventures is credit cards (see Figure 13.5).
100
Putting busi-
ness start-up costs on credit cards charging 21 percent or more in annual interest is expensive
and risky, especially if sales fail to materialize as quickly as planned, but some entrepreneurs
have no other choice.
factor
a financial institution that buys
business’s accounts receivable at a
discount.
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CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 509
Tech Images Ltd.
Mike and Susan Nikolich launched Tech Image Ltd., a technology public relations firm in
Buffalo Grove, Illinois, with credit cards when they could not qualify for a bank loan. The
10 credit cards they used gave them access to $100,000 in credit; fortunately, they had to
use only $10,000 of it before they convinced a commercial bank to grant the company a
line of credit after three months of operation. “Those credit cards bailed me out at a time
when banks wouldn’t consider loaning me the money,” says Nikolich. I’d do it again, and
I’d do it the same way.”
101
0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0%
Percent of Ent repreneurs Seeking Financing from t his Source
Second mort gage on home
Vent ure capit al firm
Small Business Administ rat ion
Bank loan
Family or friends
Spouse
Credit cards
Personal savings
Where St art ups Seek Financing
S
o
u
r
c
e
93.0%
31.1%
18.0%
13.7%
8.0%
3.4%
2.6%
2.1%
FIGURE 13.5
Where Do Small
Businesses Get Their
Financing? Percentage
of Business Owners
Who Used the Given
Sources of Capital
within the Last Year
Source: Expected Costs of Startup
Ventures, Blade Consulting Group,
Office of Advocacy, U.S. Small
Business Administration,
November 2003, pp. 23–24.
Chapter Summary by Learning Objectives
1. Explain the differences among the three types
of capital small businesses require: fixed, working,
and growth.
Capital is any form of wealth employed to produce more
wealth. Three forms of capital are commonly identified:
fixed capital, working capital, and growth capital.
Fixed capital is used to purchase a company’s perma-
nent or fixed assets; working capital represents the busi-
ness’s temporary funds and is used to support the business’s
normal short-term operations; growth capital requirements
surface when an existing business is expanding or changing
its primary direction.
2. Describe the differences between equity capital
and debt capital and the advantages and
disadvantages of each.
Equity financing represents the personal investment of the
owner (or owners), and it offers the advantage of not having
to be repaid with interest.
Debt capital is the financing that a small business owner
has borrowed and must repay with interest. It does not require
entrepreneurs to give up ownership in their companies.
3. Describe the various sources of equity capital
available to entrepreneurs.
The most common source of financing a business is the
owner’s personal savings. After emptying their own pock-
ets, the next place entrepreneurs turn for capital is family
members and friends. Angels are private investors who not
only invest their money in small companies, but they also
offer valuable advice and counsel to them. Some business
owners have success financing their companies by taking
on limited partners as investors or by forming an alliance
with a corporation, often a customer or a supplier. Venture
capital companies are for-profit, professional investors
looking for fast-growing companies in “hot” industries.
When screening prospects, venture capital firms look for
competent management, a competitive edge, a growth
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510 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
industry, and important intangibles that will make a busi-
ness successful. Some owners choose to attract capital by
taking their companies public, which requires registering
the public offering with the SEC.
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.
Going public involves (1) choosing the underwriter, (2)
negotiating a letter of intent, (3) preparing the registration
statement, (4) filing file with the SEC, and (5) meeting state
requirements.
Going public offers the advantages of raising large
amounts of capital, improving access to future financing,
improving corporate image, and gaining listing on a stock
exchange. The disadvantages include dilution of the
founder’s ownership, loss of privacy, need to report to the
SEC, filing expenses, and accountability to shareholders.
Rather than go through the complete registration
process, some companies use one of the simplified registra-
tion options and exemptions available to small companies:
Regulation S-B, Regulation D (Rule 504) Small Company
Offering Registration (SCOR), Regulation D (Rule 505 and
Rule 506) Private Placements, Section 4(6), Rule 147,
Regulation A, direct stock offerings, and foreign stock mar-
kets.
5. Describe the various sources of debt capital and
the advantages and disadvantages of each.
Commercial banks offer the greatest variety of loans,
although they are conservative lenders. Typical short-term
bank loans include commercial loans, lines of credit, dis-
counting accounts receivable, inventory financing, and
floor planning.
Trade credit is used extensively by small businesses as
a source of financing. Vendors and suppliers commonly
finance sales to businesses for 30, 60, or even 90 days.
Equipment suppliers offer small businesses financing
similar to trade credit but with slightly different terms.
Commercial finance companies offer many of the same
types of loans that banks do, but they are more risk oriented
in their lending practices. They emphasize accounts receiv-
able financing and inventory loans.
Savings and loan associations specialize in loans to
purchase real property—commercial and industrial
mortgages—for up to 30 years.
Stock-brokerage houses offer loans to prospective
entrepreneurs at lower interest rates than banks because
they have high-quality, liquid collateral—stocks and bonds
in the borrower’s portfolio.
Insurance companies provide financing through policy
loans and mortgage loans. Policy loans are extended to the
owner against the cash surrender value of insurance policies.
Mortgage loans are made for large amounts and are based
on the value of the land being purchased.
Small business investment companies are privately
owned companies licensed and regulated by the SBA that
qualify for SBA loans to be invested in or loaned to small
businesses.
Small business lending companies make only inter-
mediate and long-term loans that are guaranteed by the
SBA.
6. Identify the various federal loan programs aimed
at small businesses.
The Economic Development Administration, a branch of
the Commerce Department, makes loan guarantees to cre-
ate and expand small businesses in economically depressed
areas.
The Department of Housing and Urban Development
extends grants (such as Community Development Block
Grants) to cities that, in turn, lend and grant money to
small businesses in an attempt to strengthen the local
economy.
The Department of Agriculture’s Rural Business-
Cooperative Service loan program is designed to create
nonfarm employment opportunities in rural areas through
loans and loan guarantees.
The Small Business Innovation Research Program
involves 11 federal agencies that award cash grants or long-
term contracts to small companies wanting to initiate or to
expand their research and development efforts.
The Small Business Technology Transfer Program
allows researchers at universities, federally funded research
and development centers, and nonprofit research institu-
tions to join forces with small businesses and develop com-
mercially promising ideas.
7. Describe the various loan programs available
from the Small Business Administration.
Almost all SBA loan activity is in the form of loan guaran-
tees rather than direct loans. Popular SBA programs include
the Low Doc Program, the SBA Express Program, the 7(A)
loan guaranty program, the CAPLine Program, the Export
Working Capital Program, the Section 504 Certified
Development Company Program, the Microloan Program,
the Prequalification Loan Program, the Disaster Loan
Program, and the 8(a) program.
Many state and local loan and development programs
such as capital access programs and revolving loan funds
complement those sponsored by federal agencies.
8. Discuss valuable methods of financing growth
and expansion internally.
Small business owners may also look inside their firms for
capital. By factoring accounts receivable, leasing equip-
ment instead of buying it, and minimizing costs, owners can
stretch their supplies of capital.
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CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 511
Discussion Questions
1. Why is it so difficult for most small business own-
ers to raise the capital needed to start, operate, or
expand their ventures?
2. What is capital? List and describe the three types of
capital a small business needs for its operations.
3. Define equity financing. What advantage does it
offer over debt financing?
4. What is the most common source of equity funds in
a typical small business? If an owner lacks suffi-
cient equity capital to invest in the firm, what
options are available for raising it?
5. What guidelines should an entrepreneur follow if
friends and relatives choose to invest in his or her
business?
6. What is an “angel?” Assemble a brief profile of
the typical private investor. How can entrepre-
neurs locate potential angels to invest in their
businesses?
7. What advice would you offer an entrepreneur about
to strike a deal with a private investor to avoid
problems?
8. What types of businesses are most likely to attract
venture capital? What investment criteria do ven-
ture capitalists use when screening potential busi-
nesses? How do these compare to the typical
angel’s criteria?
9. How do venture capital firms operate? Describe
their procedure for screening investment proposals.
10. Summarize the major exemptions and simplified
registrations available to small companies wanting
to make public offerings of their stock.
11. What role do commercial banks play in providing
debt financing to small businesses? Outline and
briefly describe the major types of short-, interme-
diate-, and long-term loans commercial banks offer.
12. What is trade credit? How important is it as a
source of debt financing to small firms?
13. What function do SBICs serve? How does an SBIC
operate? What methods of financing do SBICs rely
on most heavily?
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.
D. Local development companies.
15. Explain the purpose and the methods of operation
of the Small Business Innovation Research
Program and the Small Business Technology
Transfer Program.
16. How can a firm employ bootstrap financing to
stretch its current capital supply?
17. What is a factor? How does the typical factor oper-
ate? Explain the advantages and the disadvantages
of using factors as a source of funding.
Business Plan Pro
One of the most common reasons
for creating a business plan is to
secure funding. Your business
plan can be an excellent communication tool for convincing
lenders of the stability of your company and convey its
potential earning power to investors. Think about the finan-
cial needs of your company. Do you need start-up funding
to purchase equipment or for other reasons? Is your busi-
ness going to need working capital based on your cash flow
projections and needs? Does your business need additional
financing for growth? If you have the need to raise capital
for any purpose, your business plan can help you to clarify
those needs and formulate a strategy for raising capital.
Business Plan Exercises
On the Web
If you need start-up or growth capital for your venture, visit
http://www.prenhall.com/scarborough for Chapter 13 and
review these financing options. Determine whether these
sources may be of use as you explore financing opportuni-
ties. You will also find additional information regarding
bootstrap and nontraditional funding.
Sample Plans
Review some sample plans and note the financial needs
they expressed in the financial section of their plans. If you
are creating a start-up plan, you may want to review the fol-
lowing sample plans:
? Elsewares Promotional
? Westbury Storage, Inc.
? Southeast Health Plans
If you are going to be searching for financing for an ongo-
ing business, these plans may be of interest:
? Coach House Bed & Breakfast
? The Daily Perk
? Bioring SA (second-round financing)
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512 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS
These diverse plans present financial information in ways
that may give you ideas on how to best communicate your
financial needs. Use approaches that fit your plan as you
consider what your audience will find enticing. Your lender
will want to confirm that you are going to be able to make
your payments on time, and investors will want to learn
more about the growth and earning potential of your busi-
ness. Leverage each aspect of the financial section—the
break-even analysis, projected profit and loss, projected
cash flow, projected balance sheet and business ratios—that
you deem valuable for your financial audience.
In the Software
Open your business plan in Business Plan Pro and go to the
Financial Plan section. You may want to begin this section
by providing an overview of your financial situation and
needs. You will then state your assumptions about your
financial environment. Your assumptions will help to iden-
tify general facts on which you are basing your plan, such
as anticipated economic conditions, current short-term and
long-term interest rates, expected tax rates, personnel
expenses, cash expenses, sales on credit, or any areas that
you hope to develop and confirm through further research.
Let the software lead you through this section.
You will then assess the type and amount of funding
that you will need. Will this be short-term or long-term
financing? Determine whether you are going to bring in
capital through a loan or by taking on an investor. If you are
adding investors, what percentage ownership will they now
have? How does this effect your ownership position? What
kind of control or influence will the investors have in the
business? These questions will be important to address in
this section of your business plan. Continue through the
finance section, and discuss and review your numbers for
your break-even point, projected profit and loss statement,
and cash flow situation and make comments about your
resulting balance sheet. This section will also enable you to
review industry ratios as they compare to your anticipated
business performance. Make certain this section clearly
tells your financial story. Providing relevant information
that will be meaningful to others who will review your plan
for investment or loan purposes is critical.
Building Your Business Plan
One of the most valuable aspects of developing the finan-
cial section of your business plan is to assess the amount of
financing needed, describe the use of these funds, and
make certain that you can live with the financial conse-
quences of these decisions. Keep in mind that potential
lenders and investors will also be assessing the qualifica-
tions of your management team, the growth within your
industry, your proposed exit strategy, and other factors as
they assess the financial stability and potential of your ven-
ture. Your business plan can be an effective way to help
you consider financing options and lead you through what
you determine to be the most attractive options to pursue.
This “financial road map” may allow you to analyze your
funding options. Test each alternative against your plan to
better assess its viability and fit with your venture’s finan-
cial needs.
Beyond the Classroom . . .
1. Interview several local business owners about
how they financed their businesses. Where did
their initial capital come from? Ask the following
questions:
A. How did you raise your starting capital? What
percentage did you supply on your own?
B. What percentage was debt capital and what per-
centage was equity capital?
C. Which of the sources of funds described in this
chapter do you use? Are they used to finance
fixed, working, or growth capital needs?
D. How much money did you need to launch your
businesses? Where did subsequent capital come
from? What advice do you offer others seeking
capital?
2. Contact a local private investor and ask him or her
to address your class. (You may have to search to
locate one!) What kinds of businesses does this
angel prefer to invest in? What screening criteria
does he or she use? How are the deals typically
structured?
3. Contact a local venture capitalist and ask him or
her to address your class. What kinds of businesses
does his or her company invest in? What screening
criteria does the company use? How are deals typi-
cally structured?
4. Invite an investment banker or a financing expert
from a local accounting firm to address your class
about the process of taking a company public. What
do they look for in a potential IPO candidate? What
is the process, and how long does it usually take?
5. After a personal visit, prepare a short report on a
nearby factor’s operation. How is the value of the
accounts receivable purchased determined? Who
bears the loss on uncollected accounts?
6. Interview the administrator of a financial institution
program offering a method of financing with which
you are unfamiliar, and prepare a short report on its
method of operation.
7. Contact your state’s economic development board
and prepare a report on the financial assistance pro-
grams it offers small businesses.
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CHAPTER 13 • SOURCES OF FINANCING: DEBT AND EQUITY 513
8. Go to the IPO section of the Web site for Hoover’s
(http://www.hoovers.com) and explore the details
of a company that is involved in making an initial
public offering. View some of the documents the
company has filed with the SEC, especially the ini-
tial public offering filing. Prepare a brief report on
the company. What is its business? Who are its
major competitors? How fast is the industry grow-
ing? What risk factors has the company identified?
How much money does it plan to raise in the IPO?
What is the anticipated IPO stock price? How
many shares of stock will the company sell in the
IPO? Would you buy this company’s stock?
Explain your rationale.
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