LongCh1 - Christian Brothers University



11 The Financial Plan, Part 2: Finding Sources of Funds

|— |CHAPTER 11 LECTURE NOTES |

|1 |Describe how the nature of the firm affects its financing sources. | |

|PPT 11-1 |The nature of a firm and its financing sources |

|Chapter 11 |Initially, provide an overview of the chapter by reminding students of the beginning questions that |

|Finding Sources of Funds |must be answered about financing a small company. How much financing will be needed? What type of |

| |financing might be available? |

|PPT 11-2, 3 |Review the three basic types of financing: spontaneous financing, profit retention, and external |

|Looking Ahead |financing. |

| |A firm’s economic potential—high growth and large profits yields more possible sources of financing. |

| |Company maturity—firms with established track record have more financing options than startups (e.g., |

|PPT 11-4/TM 11-4 |bankers loan based on past performance). |

|The Nature of a Firm and |Types of assets—firms with tangible assets have an easier time borrowing money than do those with |

|Its Financing Sources |intangible assets. |

| |Owner preferences for debt or equity—the mix is a matter of preference. |

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|2 |Evaluate the choice between debt financing and equity financing. | |

|PPT 11-5, 6/TM 11-6, 7, 8 |Debt or equity financing? |

|Debt or Equity Financing? |Initially, provide an overview of the chapter by reminding students of the beginning questions that |

|[Acetate 11-6,7] |must be answered about financing a small company. How much financing will be needed? What type of |

| |financing might be available? |

| |Review the three basic types of financing: spontaneous financing, profit retention, and external |

| |financing. |

| |Discuss the tradeoffs in selecting between debt and equity. |

| |Potential profitability—using more debt may increase profitability. |

| |Financial risk—obligations to service debt yields increased firm risk. |

| |Voting control—equity financing requires some loss of owner control. |

|3 |Describe various sources of financing available to small firms. | |

|PPT 11-9/TM 11-9 |Sources of financing |

|Sources of Funds |Point out to students that the funds invested in the business (owners’ equity and creditor capital) are|

|[Acetate 11-9] |represented on the right-hand side of the balance sheet. |

| |Involve students in a discussion of the characteristics and the pros and cons of each of the financing |

|PPT 11-10/TM 11-10 |sources. |

|Startup Financing for Inc. 500 | |

|Companies in 2003 | |

|PPT 11-11 |Sources Close to Home |

|Debt or Equity Financing? |Personal savings—the most frequently used source of equity in startups. |

| |Friends and Family—convenient, but potentially stressful |

|PPT 11-12 |Other individual investors—informal capital, business angels |

|Sources of Personal Capital | |

| |Bank financing |

| |Types of bank loans |

| |Lines of credit—informal agreement as to maximum credit |

|PPT 11-13, 14 |Term loans—specified time horizon to cover specific purchase |

|Financing |Mortgages—long-term, chattel vs. real estate mortgages |

| |Understanding a banker’s perspective |

|PPT 11-15/TM 11-15 |The two concerns of bankers—potential for returns, risk of default |

|The Banker’s Perspective | |

| |The five C’s of credit (character of the borrower, capacity to repay, capital invested by borrower, |

|PPT 11-16/TM 11-16 |condition of the industry/economy, collateral) |

|Questions Lenders Ask |Cultivating a relationship with a banker |

| |Key questions a banker needs answered before making a loan |

| |What are the strengths and qualities of the management team? |

|PPT 11-17 |How has the firm performed financially? |

|The Banker’s Concerns |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? |

| |Does the borrower have qualified support people? |

| |Financial information a banker expects a borrower to provide |

| |Three years of historical financial statements |

| |The firm's pro forma financial statements |

| |Personal financial statements (personal net worth, income) |

|PPT 11-18 |Selecting a banker |

|Financial Information Required for |Negotiating the loan |

|a Bank Loan |Interest rate |

| |Loan maturity date |

| |Repayment schedule—discuss balloon payment |

| |Loan covenants (e.g., timely and complete information, salary limitations, key ratios, personal |

|PPT 11-19 |guarantees) |

|Negotiating a Loan: Interest Rate | |

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|PPT 11-20/TM 11-20 | |

|Negotiating a Loan: Term of the | |

|Loan | |

| |Business suppliers and asset-based lenders |

|PPT 11-21, 22, 23 |Accounts payable (trade credit)—very short-term, most widely used by small firms |

|Business Suppliers and Asset-Based |Equipment loans and leases |

|Lenders |Installment loans on equipment normally run 3-5 years. |

| |The chapter lists three reasons for the rising popularity of leases. |

| |Asset-based lending—credit secured by receivables, inventory, etc. |

| |Private Equity Investors |

| |Business Angels (informal venture capital)—individuals with cash and experience invest in others’ |

| |businesses |

| |Oldest and largest segment of US venture capital industry |

|PPT 11-24 |Usually invest in small businesses (less than 20 employees) |

|Private Equity Investors |Venture Capital Firms—limited partnerships of individuals who raise capital to invest in business |

| |ventures |

| |Government-sponsored programs and agencies |

| |Small Business Administration (SBA) |

|PPT 11-25, 26 |The 7(a) loan guaranty program |

|Government-Sponsored |Primary loan program for small businesses |

|Programs and Agencies |The certified development company 504 loan program |

| |Provides long-term, fixed-rate financing to small businesses |

| |The 7(m) microloan program |

| |Short-term loans up to $35,000 |

| |Small business investment companies (SIBCs) |

| |SBICs are licensed by the SBA |

| |The small business innovative research program |

| |Financing for companies who want to market laboratory research |

| |State and local government assistance |

| |Community-based financial institutions |

| |Lenders that secure low-income communities |

| |Where else to look |

| |Large corporations—investing for future partnerships |

| |Stock sales |

| |Private placement—stock sold to selected individuals |

| |Public sale—stock made available to the general public |

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|PPT 11-27 | |

|Where Else to Look | |

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|( |Using Computerized Business Plan Programs Such as BIZPLANBuilder and Business | |

| |Plan Pro | |

| |As part of laying the foundation for you own business plan, the entrepreneur should answer several |

| |questions regarding the financing of the venture. |

| |What is the total financing required to start the business? |

| |How much money do you plan to invest in the venture? What is the source of this money? |

| |Will you need financing beyond what you personally plan to invest? |

| |If additional financing is needed for the startup, how will you raise it? How will the financing be |

| |structured—debt or equity? What will the terms be for the investors? |

| |According to your pro forma financial statements, will there be a need for additional financing within |

| |the first five years of the firm’s life? If so, where will it come from? |

| |How and when will you arrange for investors to cash out of their investment? |

|— |SOURCES OF AUDIO, VIDEO, AND OTHER INSTRUCTIONAL MATERIALS |

A VHS videotape discussing the role of capital in starting a business is available through Ambrose Video Publishing, 28 W. 44th St., Suite 2100, New York, NY 10036. Their toll-free number is (800) 526-4663. This tape is part of their Growing a Business series.

Inc. Business Resources provides a tape on financing, entitled Raising Capital. The tape contains tips on raising money and on what banks want to know before making a loan. Inc. Business Resources has a toll-free number: (800) 372-0018.

A Venture Capital Proposal Package, which guides the user with a step-by-step outline for structuring a financing proposal, is available through PSI Research/Oasis Press by calling (800) 228-2275.

|— |Answers to end-of-chapter |

| |discussion questions |

1. How does the nature of a business affect its sources of financing?

p. 237-239 Four basic factors determine how a firm is financed. First, the economic potential of the firm has an impact because firms with greater potential for high growth and high profits will have more financing options than those with projected unattractive returns. Second, the maturity of the business plays a role, since finding sources of financing is much more difficult for startups than it is for established firms with a track record of strong performance. Third, the types of assets held by the firm makes a difference in financing options, with those holding tangible asset being able to obtain financing much easier than those whose assets are primarily intangible in nature. Finally, the preferences of the owners figures in heavily as they make decisions when there is no right or wrong answer to the question of mix between debt and equity.

2. How is debt different from equity?

p. 239 Debt is the money that has been borrowed and must be repaid by some predetermined date. Ownership equity, on the other hand, represents the owners’ investment in the company – money they have personally put into the firm without any specific date for repayment.

3. Explain the three tradeoffs that guide the choice between debt financing and equity financing.

p. 239-242 The three factors are potential profitability, financial risk, and voting control. Borrowing money (debt) rather than issuing common stock (owner’s equity) increases the potential for higher rates of return to the owners. Also, issuing debt allows the owners to retain voting control of the company. But debt exposes the owners to greater financial risk. On the other hand, a company that issues stock rather than increasing debt limits the potential rates of return to the owners and requires them to give up some voting control in order to reduce risk.

4. Assume that you are starting a business for the first time. What do you believe are the greatest personal obstacles to obtaining funds for the new venture? Why?

For younger entrepreneurs, age is most likely the greatest personal obstacle. Also, a lack of previous experience is typically a major obstacle to obtaining funding. A previous business failure may also handicap funding efforts. Some female entrepreneurs may feel their gender is an obstacle. In some situations this may still be true, but conditions are changing rapidly. Having no business plan or a poorly conceived plan is always a barrier to financing.

5. If you were starting a new business, where would you start looking for capital?

p. 243-258 Answers will vary with each student. However, many students will probably mention friends and family as sources because these people are easier to talk with and do represent a good source of funds. Other sources are discussed in the chapter.

Students will not likely change their first choice of family and friends, no matter what type of business is discussed. Their second and subsequent choices may differ depending on the business, however. Banks will probably be mentioned frequently, since students have interaction with these financial institutions almost daily.

6. Explain how trade credit and equipment loans can provide initial capital funding.

p. 253-254 Trade credit is funding extended by suppliers when they sell merchandise on credit. The customary credit period is 30 days. If $100,000 of merchandise is purchased on credit, the supplier has, in effect, provided the purchaser with $100,000 of funds (now in merchandise form). The amount of trade credit available to a new firm depends on the type of business and the suppliers’ confidence in the firm.

Equipment loans are similar to trade credit except that they are for fixed-asset items usually purchased on an installment basis.

7a Describe the different types of loans made by a commercial bank.

p. 247-248 Line of credit is an informal agreement or understanding between the borrower and the bank as to the maximum amount of credit the bank will provide the borrower at any one time. A term loan is money lent on a five- to ten-year term, corresponding to the length of time the investment will bring in profits. A mortgage represents a long-term source of debt capital. Mortgages are of two types: chattel mortgages, for which items of inventory or other moveable property serve as collateral, and real estate mortgages, which are long-term loans with real estate held as collateral.

7b What does a banker need to know in order to decide whether to make a loan?

p. 248-249 In making a loan decision. a banker looks at the proverbial five Cs of credit: the borrower’s character, the borrower’s capacity to repay the loan, the capital being invested in the venture by the borrower, the conditions of the industry and the economy, and the collateral available to secure the loan. Also, there are certain key questions that a banker needs answered before a loan will be made, among them the following:

• What are the strength and quality of the management team?

• How has the firm performed financially?

• What is the borrower going to do with the money?

• How much does the borrower need?

• When and how will the money be paid back?

• When does the borrower need the money?

• Does the borrower have a good accountant and attorney?

• Does the borrower already have a banking relationship?

Finally, a well-prepared plan containing projections of cash flows and profits (and losses) and balance sheets is essential, because only with these projections can the borrower clearly demonstrate the need for the loan and how it can be repaid.

8. Distinguish between informal venture capital and formal venture capital.

p. 254-255 The federal government provides financial assistance primarily through the SBA and SBICs. Among the different types of loans provided by the SBA are direct loans, participation loans, disaster relief loans, and economic opportunity loans. The federal government helps indirectly with initial financing by providing entrepreneurs with information on the subject.

9. In what ways does the federal government help with initial financing for small businesses?

p. 256-257 The federal government provides financial assistance primarily through the SBA and SBICs. Among the different types of loans provided by the SBA are direct loans, participation loans, disaster relief loans, and economic opportunity loans. The federal government helps indirectly with initial financing by providing entrepreneurs with information on the subject.

10. What advice would you give an entrepreneur who was trying to finance a startup?

Answers to this question can vary widely, but those offered should conform to the issues highlighted in the chapter.

|— |COMMENTS ON CHAPTER “YOU MAKE THE CALL” SITUATIONS |

Situation 1

1. What is your impression of Bernstein’s perspective on raising capital “to get to the next level”?

Bernstein gives the impression that he is looking to a wide variety of sources. However, typically, anything that is of interest to one type of investor will not be of interest to another. For example, what a bank would be interested in would not be of interest to a venture capitalist. Bernstein needs to clarify exactly what he needs and then focus on sources that are a good fit for that need.

2. What advice would you offer Bernstein as to both appropriate and inappropriate sources of financing in his situation?

If Bernstein is looking to finance assets that can be used as collateral for a loan, then a bank or an asset lender might have an interest. However, if $2 million in debt would overload the company’s debt position, then he needs to find equity financing. To be an attractive investment for private equity investors, he must demonstrate that the investors have a chance to earn substantial rates of return—70% or more per year—and be able to cash out in five to seven years. If he cannot do that, then he will need to rely on friends and family to help with the financing, or he may just have to limit the expansion to the firm’s ability to finance the growth internally.

Situation 2

1. Compare the two financing options in terms of projected return on the owner’s equity investment. Ignore any effect from income taxes.

Owner’s return on equity investment = Net income ( Owner’s investment

If equity is issued:

Owner’s return on equity investment = ($350,000 × 16%) ( $350,000 = 16%

If debt is issued:

Owner’s return on equity investment = ([$350,000 × 16%] – [$200,000 × 6%]) ( $150,000 = 29%

2. What if Dalton is wrong and the company earns only 4 percent in operating income on total assets?

If equity is issued:

Owner’s return on equity investment = ($350,000 × 4%) ( $350,000 = 4%

If debt is issued:

Owner’s return on equity investment = ([$350,000 × 4%] – [$200,000 × 6%]) ( $150,000 = 1.3%

3. What must Dalton consider in choosing a source of financing?

He has to compare the firm’s expected return on its assets with the interest rate. As a general rule, as long as a firm’s return on its assets is greater than the cost of the debt (interest rate), the owner’s return on equity investment will be increased. Stegemoller hopes to earn 16 percent on its assets but pay only a 6-percent interest rate for debt financing. Using debt therefore increases the owners’ opportunity to enhance the rate of return on their investment.

Situation 3

1. Should Peplin be surprised by the bank’s demand for a personal guarantee? Why or why not?

Paplin should not be surprised that the bank wants him to personally guarantee the loan Rarely do banks make loans to small businesses without the owner personally guarantee the loan, much less when the firm is having financial difficulty.

2. What would you advise Peplin to do?

Accept the need to personally guarantee the loan, and then over deliverer on his promises to be in a better position to have the guarantee removed at some point in the future.

|— |Answers to exploring the web exercises |

For each chapter, the instructor’s manual will include a short summary of suggested results students will have after completing the various Web exercises. Because the Web is a constantly changing medium, the answers may vary, and the links may change as well. Thus, answers are only suggested, and the URL for resources, where required, is provided.

Exercise 1

a. The SBA offers numerous loan programs to assist small businesses. It is important to note, however, that the SBA is primarily a guarantor of loans made by private and other institutions.

• Basic 7(a) Loan Guaranty—Serves as the SBA’s primary business loan program to help qualified small businesses obtain financing when they might not be eligible for business loans through normal lending channels. It is also the agency’s most flexible business loan program, since financing under this program can be guaranteed for a variety of general business purposes.  

• Certified Development Company (CDC), a 504 Loan Program—Provides long-term, fixed-rate financing to small businesses to acquire real estate or machinery or equipment for expansion or modernization

• Microloan, a 7(m) Loan Program—Provides short-term loans of up to $35,000 to small businesses and not-for-profit child-care centers for working capital or the purchase of inventory, supplies, furniture, fixtures, machinery, and/or equipment.

• Loan Prequalification—Allows business applicants to have their loan applications for $250,000 or less analyzed and potentially sanctioned by the SBA before they are taken to lenders for consideration.

b. The SBA offers the following specialty loans followed by their purpose:

• Export Working Capital—The Export Working Capital Program (EWCP) was designed to provide short-term working capital to exporters.

• Export Express—SBA Export Express combines the SBA’s small business lending assistance with its technical assistance programs to help small businesses that have traditionally had difficulty in obtaining adequate export financing.

• International Trade Loans—If a business is preparing to engage in or is already engaged in international trade, or is adversely affected by competition from imports, the International Trade Loan Program is designed for it.

• Delta—SBA's Defense Economic Transition Assistance program is designed to help eligible small business contractors to transition from defense to civilian markets.

• CAIP Program—CAIP is a program established to assist U.S. companies that are doing business in areas of the country that have been negatively affected by NAFTA.

• Employee Trusts—The objective of this program is to provide financial assistance to Employee Stock Ownership Plans.

• Pollution Control—The program is designed to provide financing to eligible small businesses for the planning, design, or installation of a pollution control facility. This facility must prevent, reduce, abate, or control any form of pollution, including recycling.

• CAPLines—CAPLines is the umbrella program under which the SBA helps small businesses meet their short-term and cyclical working-capital needs.

Exercise 2

Below is a list of the most common small business options for equity financing:

• forms of business organization—your organizational form influences how willing others will be to invest in your business

• business combinations—cooperative arrangements with other businesses for sharing costs

• venture capital—money and expertise for hot businesses

• SBICs—the government's venture capital businesses

• angels—private investors who want to make money and also help small businesses

• initial public offerings—going public can mean big gains, but it's not for everyone

• alternatives to going public—limited private offerings of ownership interests

• franchising—a shortcut to getting started, but don't expect to run the whole show

• ESOPs—employee stock ownership plans that allow employees to own a piece of the business; can boost production and provide leverage for additional financing

Exercise 3

Week 1 Conduct organizational meeting.

Week 5 Distribute Securities and Exchange Commission (SEC) registration statement; additional drafting sessions.

Week 6 Distribute second draft of registration statement; additional drafting session.

Week 7 Distribute third draft of registration statement; additional drafting session.

Week 8 File registration statement with the SEC; begin preparation of road-show presentations; begin getting clearances in states where the offering is to be sold.

Week 12 Get comments from SEC on registration statement.

Week 13 File first amendment to registration statement with SEC, addressing comments. Prepare and distribute preliminary prospectus; commence road-show meetings.

Week 15 SEC declares offering effective; company and underwriter agree on final price; prepare, file, and distribute final prospectus.

Week 16 Close and deliver offering proceeds.

|— |SUGGESTED SOLUTION TO CASE 11: |

| |CALVERT TOYOTA |

1. Explain how the proposed financing for the dealership is to be structured, as represented in the agreement.

|Purchase price for dealership |$ |1,200,000 |

|Cash |$ |600,000 |

|Stock | |600,000 |

| |$ |1,200,000 |

|Purchase of real estate | | |

|Price |$ |3,000,000 |

|Cash |$ |2,200,000 |

|Seller’s note | |800,000 |

| |$ |3,000,000 |

|Source of cash: | | |

|Allied Bank loan |$ |2,000,000 |

|Loan from dealership |$ |200,000 |

|Application of Allied loan to dealership: | | |

|Cash |$ |200,000 |

|Loan to partnership | |200,000 |

|Cash to seller for dealership | |600,000 |

|Total Allied loan to dealership |$ |1,000,000 |

|Application of Allied loan to partnership | | |

|Cash to seller |$ |2,000,000 |

2. Is buying the dealership a good investment for Mr. Calvert? Explain.

Whether or not the dealership is a good deal for Calvert is largely dependent on the fit of the opportunity and the rates of return on the investment. Clearly the opportunity is a good fit for Calvert. All of his experience is in the car business, and he obviously has done well in managing the dealership. As to the rates of return on the investment, let’s assume that a fair salary for Calvert is $120,000 per year. Thus, the projected net income of $548,000 would be reduced to $428,000. This latter amount better represents the earnings from the investment after paying Calvert for his time and effort. (If you didn’t pay Calvert to run the dealership, you would have to pay someone else to manage the business.)

Calvert will also be paying interest on the bank loans and the loan to the seller. While not stated, the “rent and equipment” expense in the income statement is mostly the rent paid to the real estate partnership so that it can in turn have the money to make the note payments. This “rent” is therefore a de facto interest payment. So, if we add back the interest to the loans, we would have a close estimate of the firm’s projected operating income. Assuming a 12 percent interest rate on the $2,800,000 loan ($2 million loan to the partnership from Allied Bank and $800,000 from the seller of the dealership), then interest must be about $336,000 (12% x $2,800,000). Thus, our estimate of operating income would be $764,000 ($428,000 net income after salaries [as computed above] plus the interest of $336,000).

We may then conclude that Calvert expects to earn $764,000 on the firm’s assets. In turn, the company’s assets are the sum of the dealership assets ($3,490,000 as shown on the balance sheet) plus the $3 million in real estate assets, or $6,490,000 in total. If Calvert does earn $764,000 on $6,490,000 of assets, the operating income return on investment (recall Chapter 10 discusses the calculation of OIROI) would be 21.9 percent ($764,000 ( $6,490,000). This return on total assets is reasonably attractive.

When we shift to the rate of return on Calvert’s investment, it becomes clear just how attractive the deal is for Calvert. If he can earn our adjusted $428,000 net income on his $600,000 equity investment in the company, then his rate of return is 71 percent ($428,000 ( $500,000). However, to realize this rate of return, Calvert takes on a great deal of debt, which translates to a significant measure of risk.

3. If you were a banker, would you make the loan? Why or why not?

Possibly, but possibly not. It is not an easy decision for the banker, which was evident from the fact that Calvert had been rejected by several banks prior to getting Allied Bank to take the loan. If for no other reason, a bank would be reluctant to make the loan simply because of the high debt levels the firm would be assuming. Any problem would quickly result in Calvert not being able to make the loan payments.

4. As the banker, how would you want to structure the loan if you made it? (Think about the problems of the loan and how the loan could be structured to compensate for these deficiencies—if there were any.)

To make the loan, the banker required the following terms:

1. Calvert had to personally guarantee the loan.

2. The loan was amortized as equal principal plus interest, reducing the loan balance more quickly.

3. The loan was for 7 years, versus 15 years for the dealership.

4. The loan to the seller was subordinated to the loan to the bank.

5. Calvert was required to take on a partner in the dealership with a large net worth to co-sign the note.

6. The loan from the bank would become due if Calvert’s net worth fell below $600,000.

5. The proformas prepared by Mr. Calvert assume that the note payments to the bank are amortized (equal payments each month). What if the bank requires equal principal payments plus interest? (Assume a 12 percent interest rate.)

The following table shows the difference in payments Calvert would have to make, depending on how the loan repayment is restructured:

| |Equal Monthly |Principal Plus |Difference |

| |Payments |Interest | |

|$2.8 million (15 years, 12%) |$33,605 |$44,092 |$10,487 |

|$1 million (7 years, 12%) |17,653 |22,238 |4,585 |

| |$51, 258 |$66,330 |$15,072 |

| |$51,258 |$66,330 |$15,072 |

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