BA350

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Chapter Fourteen
Small Business Finance:
Using Equity, Debt, and Gifts
Copyright 2021 © McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill
Education.

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Sources of Financing for Small Businesses
The number one source is from the owners themselves.
• Other major sources include family and friends, credit cards, trade
credit, banks, and other commercial lenders.
• Less used sources include grants, angel investors, government
programs, community financiers, stock sales, and venture capital.
Sources of financing are either debt, equity, or gifts.
• Debt can take many forms of debt equity, such as borrow money
from banks, agencies, governments, or individuals.
• When you sell part of your business, the money received is equity
capital.
• Assets or money donated without obligation to repay is a gift resulting
in gift equity.

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Financing with Equity
Personal equity.
• The amount you contribute depends on your personal worth.
• Not all personal wealth is easily available.
• You need to know the amount and type of wealth you have.
Outside equity.
• Outside equity is money from selling part of your business to people
not involved in the business, called outside equity investors.
• This is only possible if the business is organized as a partnership, a
corporation, or a limited liability company (LLC).

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Financing with Debt
Debt is a claim on the value of a business’s asset but unlike equity, debts
are legally enforceable to pay back.
• Secured debt provides a lender with the right
to seize specific assets if the loan is not paid.
• Unsecured debt does not give the lender the
right to seize any specific asset.
• Lenders must use court action to collect
unpaid unsecured debt.
Though debt is easier to obtain than equity, avoid
it if possible.
• There are repayment obligations.
• Lenders can enforce payment regardless of
your ability to pay.
The amount of debt
financing you can
raise is limited by
your personal
wealth, your
business’ wealth,
and your debt
history.

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Financing with Gifts
Few are able to obtain gift funding for a start-up.
• Available to a few established businesses with several years of
successful operations.
• Even then, a small business will get a grant if, and only if, the business
operations meet some desirable societal goal.
• Virtually all gift financing comes either from governments or private
foundations.
• Few foundations exist to support small business and none exist to
specifically provide start-up or working capital funding.
• Remember that gifts come with strings attached – even grants require
periodic reports detailing how the grant is being used and its impact.

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Financing with Equity:
Getting Others to Invest in Your Business
Small businesses get started because the owners want to make money.
Investors want to make money, too.
• Lenders expect a return on their money by
collecting interest on their investment.
• People expect to receive a gain on
investment, or a dividend.
Even governments
expect a return in
the economic
development of an
area.

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Financing with Equity:
Equity Capital from the Investors’ View
How do investors decide which business to invest in?
• They want to know how likely the business is to produce a gain, they
want to know the business’s risk.
• Investors know some investments will fail, so they diversify.
• They will invest only if your business is organized to limit the liability of
outside owners.
• To estimate an expected gain, investors will evaluate your growth
potential, a primary concern.
• The time required to receive gains can be a deal killer.
• Business angels want to know your plan to pay investor’s profits,
called the harvest or exit.
• A hybrid form of investing, called royalty financing is rarely used.

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Financing with Equity:
Methods to Obtain Equity Capital
Using your own capital and funds generated by the start-up is called
bootstrapping.
Minimize overhead costs.
• Cloud computing, virtual storefronts, incubators,
office co-ops, or co-working spaces.
Maximize returns from employee expense.
• Student interns, overtime, contractors.
Minimize operating costs.
• Outsource, subcontract, rent space or
equipment, work from home.
Maximize the results of marketing.
• Word of mouth and publicity.
Crowdfunding is a
new way to gather
investors.
IPOs are limited to
a few start-ups.
Under the JOBS
Act, investors must
be a sophisticated
investor or an
accredited
investor.

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Financing with Equity:
Angel Investors
A number of high-wealth individuals invest in first- and second-stage
funding – called angel investors.
• It is probable that few really good business ideas go undeveloped, and
a large percentage of “good ideas” prove not to be in the long run.
Individual angel.
• Hard to find, proximity is critical, informal involvement, unplanned exit.
Angel network.
• Easy to find, proximity preferred, informal involvement, cash-out exit.
Angel fund.
• Easy to find, proximity preferred, formal involvement, cash-out exit.
• More formal reporting requirements, but offers the highest funding.

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Financing with Equity:
Equity Capital from the Owner’s View
Financing with equity is expensive and guaranteed to create problems of
control and decision making.
• If you sell half your business, you sell half of all future profits, future
growth, and future wealth.
• You will have to provide regular reports to investors and they have the
right to inspect the accounting records any time they choose.
• If investors disagree with your running of the company, they can
challenge you, sue you, or even replace you as manager.
There are three primary reasons to use outside equity in your business.
• You will reduce your own exposure to financial loss.
• Your business will not have increased costs in the form of interest.
• Outside investors can reenergize an existing business by providing
new ideas, procedures, and processes.

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Financing with Debt:
Getting a Loan for Your Business
Done in three ways: (1) direct cash loans, (2)
guaranteed loans, and (3) reduced taxes by
deducting interest.
• Established firms have valuable assets to
borrow against.
Small businesses look to banks, but there are
options if turned down.
• The SBA guarantees loans through
community development organizations,
microlenders, or an SBIC.
• You may have access to incubators or
accelerators in your area.
Lenders want to see the
Four Cs of Borrowing.
1. Character of the
managers of the
business.
2. Capacity to repay
both principal and
interest on time.
3. Conditions of the
industry and
economy in which
the firm operates.
4. Collateral used to
secure the loan.

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Financing with Debt:
The Four Cs of Borrowing
Owner character is largely judged by the owner’s personal credit rating.
• Find your rating at one of four credit reporting agencies (CRAs).
• The Fair Credit Reporting Act (FCRA) requires all information
reported to CRAs be accurate.
The capacity of your business is measured by profitability and cash
flows from operations.
• The most important single factor for borrowing money.
Condition of the industry/economy includes factors such as technology,
competition, and economic growth.
• Cell phones have made pay phones obsolete.
Collateral value is an estimated market value of tangible assets.
• Intangible assets, though valuable, cannot be transferred to the lender
to satisfy debt.

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Financing with Debt:
Customer Funding of Your Business
This is debt because the customer gives you the money and you owe
them the product or service.
• It provides cash inflows before the necessary outflows occur.
• Matchmaker models – Airbnb.
• Pay-in-advance models – Threadless.com.
• Subscriptions models – Netflix.
• Scarcity-based models – Groupon or Gilt.
• Service-to-product models – BaseCamp or
SaaS like Office 365.
These business models work and there are
numerous common examples of each.
The advantage is
there is no interest
to pay and it
provides cash flow
from the start.
In addition, these
sales are a
validation of your
business idea.

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Financing with Gifts:
Winning Grants for Your Business
Gift financing has a special allure – like getting something for
nothing.
Remember that anything that seems too good to be true usually is.
Gift capital is anything but free – it costs time and money to obtain
and then report on the use of the money.
There are two general sources of gift financing:
One is institutional, from government agencies and foundations.
The other is personal, from family or occasionally from friends.

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Financing with Gifts:
Institutional Gifts
The most common form of institutional gift financing is in the form or
reduced taxes, either a tax abatement or a credit against taxes payable.
• Tax abatements are provided by state and local governments.
• Tax credits are provided by the U.S. government and some states.
• Grants are available from the federal and state governments, and
semi-private and private economic development agencies.
• Grants from foundations are rarely made to for-profit businesses.

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Financing with Gifts:
Personal Gifts
Forms include: cash, picking up the tab, accelerated cash-outs, free use,
free work or unpaid labor, overpayment, favored status or sweetheart
deals, forgiveness, deferrals, or piggybacking.
Accepting money from family members and friends entails some risks.
• Put your agreement into writing.
• If it is a gift, have the agreement specifically say so.
• If it is a loan, have the agreement specify the exact interest and
payment terms.
• If it is an equity investment, consider non-voting stock.
Gifts from crowdfunding have two models: nonequity and equity.

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What Type of Financing Is Right for Your Business?
The cost of equity is much greater than the cost of debt.
• With a capital mix of 70% equity and 30% debt, the weighted average
cost of capital is approximately 16%.
• At a 50-50 mix, the weighted average cost of capital (WAC) is 13%
and 10% at a 30-70 mix.
• As debt increases as a percentage of total investment (called
financial leverage) returns on equity increase at a decreasing rate up
to some limit where more debt causes returns to decline.
• This mix of debt and equity is the optimum capital structure.
• Financial risk is the probability of financial loss and borrowing money
increased financial risk.
• Selling equity provides neither the opportunity to repurchase nor the
obligation to make payments to owners.

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Figure 14.4: Interaction among Profitability, Control, and Risk
Borrowing enhances the
potential for higher rates of
return for the owners and
allows the owners to keep a
greater level of control.
Borrowing increases
potential profits by lowering
the WAC of capital and
provides funds allowing the
firm to consider
opportunities.
Borrowing allows more
control but even lenders
impose restrictions, called
loan covenants.

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Tools for Financial Management
You must have something to compare with your position and results.
• Compare with your planned position and results, with prior years’
position and results, and with the position and results of other firms.
• Most financial comparisons are made using ratios.
• There are four broad categories of financial ratios: activity ratios,
profitability ratios, liquidity ratios, and leverage ratios.
• The three most common are ROI, current ratio, and debt-to-equity ratio.
• The ratios considered important change as the firm matures.
• As the firm reaches breakeven, profits become a reality and profitability
ratios become important.
• Leverage ratios also become more important as they look at the
longer-term success of the firm.

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Financial Management for the Life of Your Business
Financial management for start-up.
• Use the financial management techniques for bootstrapping.
Financial management for growth.
• Focus is on obtaining cash inflows to pay for added inventory,
productive assets, and employees needed to meet growth levels.
Financial management for operations.
• Emphasis is on building owner wealth, to conserve assets, to match
cash inflows to outflows, and to maximize return on capital assets.
Financial management for exit.
• Goals of financial management depend on the nature of the exit.
• Exit can be a transfer to heirs, selling to outsiders or employees, or
through bankruptcy, a “work-out,” or closing and selling the assets.

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