Chapter 14

Sources of Financing

Copyright © 2016 by Nelson Education Ltd.

 LOOKING AHEAD

After studying this chapter, you should be able to

1. Describe how a firm’s characteristics affect its available
financing sources.
2. Evaluate the choice between debt financing and equity
financing.
3. Identify the typical sources of financing used at the outset
of a new venture.
4. Discuss the basic process for acquiring and structuring a
bank loan.
5. Explain how business relationships can be used to finance
a small firm. Copyright © 2016 by Nelson Education Ltd. 14-2
 LOOKING AHEAD cont’d

After studying this chapter, you should be able to

6. Describe the two types of private equity investors who offer
financing to small firms.
7. Distinguish among the different government loan programs
available to small companies.
8. Explain when large companies and public stock offerings can
be sources of financing.
9. Describe how crowdfunding can be used by some small
businesses to raise capital.

Copyright © 2016 by Nelson Education Ltd. 14-3

 BUSINESS NEEDS
• Businesses need cash for three principal
reasons :
1. To purchase assets such as equipment and
inventory
2. To pay for other costs incurred such as payroll,
advertising, taxes, etc.
3. Pre-start-up costs which include R&D and expert
advice

LO 1 Copyright © 2013 by Nelson Education Limited

14-4
 BUSINESS DECISIONS
• Buy or lease the equipment?
– Advantages:
• It requires minimal or no up-front cash, freeing up the firm’s
cash for other purposes.
• Leasing provides a hedge against equipment obsolescence.
– Disadvantages:
• Leasing requires the business to make regular payments.
• May be significant cost or tax implications.
• Acquire new or used equipment?
– Lease-versus-buy calculation program
LO 1 Copyright © 2013 by Nelson Education Limited
14-5
 FIRM CHARACTERISTICS AND
SOURCES OF FINANCING
• Four basic characteristics affect financing:
1. Economic potential
2. Company size and maturity
3. Nature of the assets
4. Personal preferences of owners with respect to
debt versus equity

LO 1 Copyright © 2016 by Nelson Education Ltd. 14-6

 BUSINESS DECISIONS

LO 1 Copyright © 2016 by Nelson Education Ltd. 14-7

 DEBT OR EQUITY FINANCING?

Potential Profitability

• Borrowing increases potential for higher rates of return on

owners’ equity; exposes firm to more financial risk.

Financial Risk

• Investing more owner equity limits potential return on

equity; lowers financial risk for firm.

LO 2 Copyright © 2016 by Nelson Education Ltd. 14-8

 DEBT OR EQUITY FINANCING?

Voting Control

• Raising capital through equity financing requires owners to

share control with external investors.

LO 2 Copyright © 2016 by Nelson Education Ltd. 14-9

 BUSINESS DECISIONS

LO 2 Copyright © 2016 by Nelson Education Ltd. 14-10

 BUSINESS DECISIONS cont’d

LO 2 Copyright © 2016 by Nelson Education Ltd. 14-11

 DEBT OR EQUITY FINANCING?

Total Assets $200,000 Op Inc $28,000

Debt $ 0 Interest Exp 0
Equity $200,000 Net Income $28,000
Total Debt & Equity $200,000
Or
Total Assets $200,000 Op Inc $28,000
Debt (10% interest rate) $100,000 Interest Exp $10,000
Equity $100,000 Net Income $18,000
Total Debt & Equity $200,000

LO 5 Copyright © 2013 by Nelson Education Limited

14-12
 DEBT OR EQUITY FINANCING?

Total Assets $200,000 Net Income $28,000

Debt $ 0
Equity $200,000 ROI = $28,000 / $200,000
Total Debt & Equity $200,000 = 14%
Or
Total Assets $200,000 Net Inc $18,000
Debt (10% interest rate) $100,000
Equity $100,000 ROI = $18,000 / $100,000
Total Debt & Equity $200,000 = 18%

LO 5 Copyright © 2013 by Nelson Education Limited

14-13
 DEBT OR EQUITY FINANCING?

• Debt can be a very powerful tool to boost

your returns – (Termed Leverage – like
losing a lever to increase your financial
strength)
• Debt is a very sharp sword that cuts both
ways. If you aren’t profitable, still on the
hook for the interest payments as well as
principle. Think of US homeowners.
LO 5 Copyright © 2013 by Nelson Education Limited
14-14
 SOURCES OF EARLY FINANCING

LO 3 Copyright © 2016 by Nelson Education Ltd. 14-15

 SOURCES OF FINANCING

LO 3 Copyright © 2016 by Nelson Education Ltd. 14-16

 BANK FINANCING

• Primary Providers:
• Commercial banks
- Typically lend to established firms with a proven track
record.
- Borrower has plenty of assets for collateral.
- Reluctant to finance losses, research and development
expenses, marketing campaigns.
• Credit unions
- Can be more flexible than banks.
- Member owned so more interest in community
development and service to members.
LO 4 Copyright © 2016 by Nelson Education Ltd. 14-17
 TYPES OF LOANS

Line of credit
• Lender to lend up to a maximum agreed amount.

Term loan
• Money loaned for a 5- to 10-year term, corresponding to the
length of time the investment will bring in profits.

Chattel mortgage
• Loan for which equipment or other moveable property serves
as collateral.

LO 4 Copyright © 2016 by Nelson Education Ltd. 14-18

 TYPES OF LOANS cont’d

Real estate mortgage

• Long-term loan with real property held as collateral.

Corporate credit cards

• Offers business a level of convenience in making purchases, not

having to establish trade credit, and still delaying when goods
have to be paid for.

LO 4 Copyright © 2016 by Nelson Education Ltd. 14-19

 UNDERSTANDING A BANKER’S
PERSPECTIVE
• Priorities:
1. Recouping the principal of the loan.
2. Amount of income the loan will provide the bank.
3. Helping the borrower to become a larger customer.
• The Five Cs of Credit:
– Character of the borrower
– Capacity of the borrower to repay the loan
– Capital invested in the venture by the borrower
– Collateral available to secure the loan
– Conditions of the industry and economy
LO 4 Copyright © 2016 by Nelson Education Ltd. 14-20
 UNDERSTANDING
UNDERSTANDING A
A BANKER’S
PERSPECTIVE
LENDER’S cont’d
PERSPECTIVE
• Lender’s Questions:
– How much money is needed?
– What is the venture going to do with the money?
– When is the money needed?
– When and how will the money be paid back?

LO 4 Copyright © 2016 by Nelson Education Ltd. 14-22

 UNDERSTANDING A
FORMULA LENDING
LENDER’S PERSPECTIVE
• Reduces administration of loan.
• Loans under $200,000 assessed using a credit
scoring system of owners.
• Owners present a personal statement of
net worth.
• Independent verification of earnings of
owners.

LO 4 Copyright © 2016 by Nelson Education Ltd. 14-23

 NEGOTIATING THE LOAN

• Interest rate
• Loan maturity date
• Repayment schedule
• Loan covenants

LO 4 Copyright © 2016 by Nelson Education Ltd. 14-24

 BUSINESS SUPPLIERS AND
ASSET-BASED LENDERS
• Trade Credit (Accounts Payable)
• Equipment Loans and Leases
• Asset-Based Lending
• Factoring
• Purchase-Order Financing

LO 5 Copyright © 2016 by Nelson Education Ltd. 14-25

 PRIVATE EQUITY INVESTORS

• Business Angels
– Private individuals who invest in others’
entrepreneurial ventures.
– ‘Saviours’ for entrepreneurs struggling to obtain
start-up capital.
– Provide both capital and advice.
– Act as a mentor.

LO 6 Copyright © 2016 by Nelson Education Ltd. 14-26

 VENTURE CAPITAL COMPANIES

• Venture capitalists look for

– Companies no longer in start-up and entering a
high-growth stage.
– Compound annual growth of 40 percent or more.
– Product or technology-based company rather than
a service business.

LO 6 Copyright © 2016 by Nelson Education Ltd. 14-27

 VENTURE CAPITAL PITFALLS

• Downside of venture capital

• Control – VCs exert control in a number of ways,
such as having a member on the board.
• Forced growth – VCs want a high return, which
comes from high growth.
• Forced-exit strategy – VCs do not stay invested
once growth begins to slow.

LO 6 Copyright © 2016 by Nelson Education Ltd. 14-28

 OTHER SOURCES OF FINANCING

• Large corporations
• Stock sales
• Private placement
• Public sale (IPO)

LO 8 Copyright © 2016 by Nelson Education Ltd. 14-30

 CROWDFUNDING

• The process of raising very small investments

from a large number of investors online.
• Four basic approaches:
1. Donations
2. Rewards
3. Pre-purchases
4. Equity investing

LO 9 Copyright © 2016 by Nelson Education Ltd. 14-31