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Financial instrumentsWays to finance your small business
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FinancesOne of the crucial aspect of every business is how to
finance it – either when you start, when you want to grow or when you face business difficulties
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Ways to get financedDebt – various types of borrowing- Friends, Family and Fools, Banks, Leasing, Factoring, OtherEquity – giving up certain portion of your ownership in
the company (by issuing ordinary (common) or preferred stocks or by incorporating partners)
- Business Angels, Venture capitalists, Friends, Family and Fools
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Debt vs. EquityDEBTPROS- Retain ownership in company- Considered cheaper than equity financing- If firm has assets (collateral) it can raise
cheaper long-term loans
CONS- More risky (it becomes your fixed cost!)- Lack of collateral or poor earnings history –
no money or borrowing with high interest rates!
- It has to be returned
EQUITYPROS- no interest to return, no obligation to repay back- Improving credithworthiness- Equity money can be used as collateral- Shareholders may use their personal earnings
history to raise bank loans- Good networking possibilities (especially for
start-ups)
CONS- Giving up piece of the ownership in the company - Have to answer to someone else- Most expensive way of financing (each investor
receives a percentage of total value of the company)
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Rule of the thumb“Whether the price of the money is 2 percent or 20
percent, it should always be lower than the return you expect from spending it. That is to say, don't invest money in any project that won't generate enough profit to more than cover the loan payments, including interest.”
David Worrell, Entrepreneur magazine online edition, 2006
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Types of debt financingFriends, Family, Fools (3F)BanksLeasingFactoringOther
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Friends, family, fools (3F)Perhaps the best way to borrow, with minimum interest rates (or none)Higher level of sympathy and ready to wait for the money to be
returnedAre sometimes eager to interfere in your business and give you advice
whether you want it or notMight ask to become partners or partial owners – rarely, but it
happens!Be sure to clarify things in written agreement, since memories tend to
get fuzzy over time!
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BanksEntrepreneurs are usually high risk clients for banks, unless they
have a solid collateral (e.g. Fixed assets) and a good credit historyBanks will also look closely at your cash flows, liquidity of your
assets and a solid business planShort-term loans – credit card loans, overdrafts (line of credit)–
high interest rates – most commonly use for smaller investments and short-term lack of cash
Long-term loans – lower interest rates, but demand solid collateral
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Credit cardsIt has become increasingly common among entrepreneurs
(almost 50% of entrepreneurs have used it once in their business)
More easily available money than regular bank loan, no justificiations required on how you will spend it, no business plan needed to back up your claim
Beware of the high interest ratesDemands discipline in spending
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Line of credit (overdraft)a flexible loan from a bank or financial institution to an individual or business. a line of credit is a limited/specified amount of money that an individual can
access as needed and then repay immediately or over a pre-specified period of time.
As a loan, a line of credit will charge interest as soon as money is borrowed, and borrowers must be approved by the bank. If you don’t use it, no interest is charged
Useful for shortages of cash, so best to apply for it when sufficient funds are on your bank account
Interest is higher than in regular bank loans
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Long-term loansRequire some kind of collateral – mortgageTwo types of mortgage – chattel (inventory or movable
property serves as collateral and owner cannot sell it without bank’s permission) and real estate (immobile property – house, flat etc.)
Lower interest rates, but it demands solid business plana and purpose of spending is set,
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Before you apply for loan Check yourself – if you have personal track record of late payments, chances of getting a
loan are slim Check your business – have you been blocked, are you paying taxes and other
obligations, how are your cash flows and overall business results What assets do you own – check what do you own, and are you willing to put is a
collateral to secure loan Whom do you know – does your banker know you? Do they know your business?
Personal touch can be of great help in advocating for your loan! How much do you need – are you purchasing equipment or seeking cash cushion. What
would be the ideal? What would be minimum? How will you pay it back - Put together a realistic plan of action for improving the cash
flow in your business and paying back the debt. Identify your marketing strategy and projected sales results over an expected time frame.
Source: O'Berry, D. 2007.„Finding and Keeping Cash in Your Company“, in Small Business Cash Flow: Strategies for Making Your Business a Financial Success, USA: John Wiley and Sons, p.49-50
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LeasingGood way to obtain an asset without necessarily owning
it (used for buying equipment, vehicles etc.)Types: - Operating - Financial (Capital)
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Operating leasingAllows the use of item without getting ownership. Legal and economic owner is leasing agency – takes all risks,
user can return the item after the leasing contract has expiredUsed for short-term leases (e.g. Copy machine, Office
equipment, Computers etc.)Lesee (the person who is leasing) pays monthly instalments
including VAT – calculate it in operating expenses as rental expenses
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Financial (capital) leasingused for long-term leases and for items that not become
technologically obsolete, e.g. machinery. give the lessee the economic ownership and risk, so they
are considered as assets, and they may be depreciated.In general, the items leased are shown in lesees Balance
sheet (Asset/Debt), and depreciation plus cost of interest go to operating costs (in Income statement)
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FactoringShort-term debt, where Factor buys up accounts
receivables and takes % factor feeIn theory, 70-90% of the amount is paid immediately, and
10-30% after the receivables have been collected
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OtherMerchant credit – delayed payment to suppliers (based
on contracts signed, e.g. 30-60 days waiting period)Grants and credits from non-banking institutions (state
and local municipality)
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EquityEntrepreneurs – owners use this option when:- They don’t mind losing part of their control to the others- Cash flows are not sufficient to cover existing debt- Credit history and collateral is not sufficient to raise bank
loans- Bank loans (amounts) do not cover necessary investment
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The usual sources of equity financing
Business angelsVenture capitalists
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Business angels
Succesful entrepreneurs (or entrepreneurial associations) willing to invest money
Work alone or in syndicatesWill invest in start-ups and young companies – will also provide
managerial advice and networking opportunitiesInvest up to 1 mil euros, but in average around 50.000 – 100.000 euros
for period of 2-10 yearsExpect 15-45% return“Patient money”
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Business angels - Methods of workingDifferent from country to countryEither borrow you money (debt) or ask to form new
company where they enter as partnersIssuing of stocks – either as private placement (directly sell
stocks to business angels and do not place them on stock exchange – cheaper and simpler) or going public (Initial public offering – IPO – stocks are offered as stock exchange – expensive and more complex)
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Venture capitalistsInstitutional firms raising a pool of capital from different
sources (including business angels)Used for big investments, 1-30 mil eurosUsually invest in high-growth, more mature companies
(experts do not recommend it for start-ups)Demand good management, solid revenues and cash flows,
good business plan and their own EXIT strategyExpect high returns in 3-5 years
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Methods of workingThey never enter the company without good exit strategy
– will ask for public stock offering (IPO)Will appoint someone to the supervisory board and will in
most cases ask for prefered stocks (it pays dividends and has preference in case of liquidation)