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Financing Basics: Debt vs. Equity


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Financing Basics: Debt vs. Equity

  1. 1. The Braunschweig/Wolfenbuettel University of Business and Applied Sciences Texts and Materials for Session 5 Business Simulation Game in English (WS 2006-2007) Financing Basics: Debt vs. Equity A brief overview of the basic types of financing may be helpful to understanding which options might be most attractive and realistically available to your particular business. Typically, financing is categorized into two fundamental types: debt financing and equity financing. Debt financing means borrowing money that is to be repaid over a period of time, usually with interest. Debt financing can be either short-term (full repayment due in less than one year) or long-term (repayment due over more than one year). The lender does not gain an ownership interest in your business and your obligations are limited to repaying the loan. In smaller businesses, personal guarantees are likely to be required on most debt instruments; commercial debt financing thereby becomes synonymous with personal debt financing. Equity financing describes an exchange of money for a share of business ownership. This form of financing allows you to obtain funds without incurring debt; in other words, without having to repay a specific amount of money at any particular time. The major disadvantage to equity financing is the dilution of your ownership interests and the possible loss of control that may accompany a sharing of ownership with additional investors. Equity financing requires that you sell an ownership interest in the business in exchange for capital. The most basic hurdle to equity financing is finding investors who are willing to buy into your business; however, the amount of equity financing that you undertake may depend more upon your willingness to share management control than upon the investor appeal of the business. By selling equity interests in your business, you sacrifice some of your autonomy and management rights. The effect of selling a large percentage of the ownership interest in your business may mean that your own investment will be short-term, unless you retain a majority interest in the business and control over future sale of the business. Of course, many small business operators are not necessarily interested in maintaining their business indefinitely, and your personal motives for pursuing a small business will determine the value you place upon business ownership. Sometimes the bottom line is whether you would rather operate a successful business for several years and then sell your interests for a fair profit, or be repeatedly frustrated in attempts at financing a business that cannot achieve its potential because of insufficient capital. The financing of your business can be further classified as start-up financing, which is usually equity, working capital financing and growth financing. Start-up financing is the financing to get the company to an operational level including the costs of getting the first product(s) to market. This is best done with equity and long term loans or leases. Working capital is required to drive the day to day operation of the business. In most businesses the operational needs vary during the year (seasonality, inventory buildup, etc.) and the working capital tides over the fluctuating expenses involved with doing the base business. Growth capital is not tied to the yearly aspects of fueling the business. Rather, it is needed when the business is expanding or being changed in some significant and costly way that is expected to result in higher and increased cash flow. It is generally longer term than working capital and is paid back over a period of years from the profits of the business. 1
  2. 2. The Braunschweig/Wolfenbuettel University of Business and Applied Sciences Texts and Materials for Session 5 Business Simulation Game in English (WS 2006-2007) Knowing specifically what type of capital your business will be needing will put you in a stronger position when evaluating how and where to seek your financing. Self-funding The vast majority of businesses (close to 90%) are begun with less than $100,000 and close to a third are begun with less than $10,000. This kind of money is usually available to the motivated entrepreneur by taking a close look at the personal resources at his or her disposal well in advance. Several of the most common self-funding methods are described here. Personal Savings and Equity The vast majority of new businesses are started with the main source of funding coming from personal savings or various forms of personal equity of the founder(s). This capital reflects the degree of motivation, commitment and belief of the founder in the enterprise. This type of investment also takes the shape of sweat equity, where individuals either donate their time or provide it at below market value to help the business get established. Many times entrepreneurs use profits from previous endeavors to pour into their new enterprise. Moonlighting Many home-based businesses are begun while the founder is still working a regular job. The income form the job can both help support the owner during negative or low cash flow of the business set up phase an it can provide working capital to augment the business’s cash flow. Usually when the business begins paying as well or better than the regular job, the entrepreneur can jump ship from his job and devote full time to building his new business. Home Equity Loans This may be the fastest growing method of raising money for individuals. Banks generally are willing to lend up to 70% or more of a home’s appraised value, minus any existing mortgage(s). Home equity loans are generally offered through commercial banks or savings and loans associations. Present interest rates for second mortgages are under 12%. In some instances an approved home equity loan can be structured like a bank line of credit at slightly lower interest rates. For tax purposes, you can deduct interest on up to $100,000 of debt on home equity loans, regardless of how you use the money. This makes a home equity loan attractive when looking for your start-up capital. Remember that since this money is secured by your home, the bank could foreclose if you fall behind in your payments. Credit Cards “Pulling out the plastic” for at funding of your business is more viable now than ever before. MasterCard or Visa card holders with a good credit now often receive credit limits of $10,000 and above. By being able to carry more than one credit card, as an entrepreneur you can considerably boost the total amount your can tap into at any one time. Credit card interest rates on cash advances vary considerable, from as high as 21% to 15% or lower. Annual fees can also range from over $50 down to zero. This means it is wise to investigate getting the best deal you can when obtaining your credit cards. It may be advantageous to close out one or more of your high interest cards and transfer the balances to lower cost credit cards. 2
  3. 3. The Braunschweig/Wolfenbuettel University of Business and Applied Sciences Texts and Materials for Session 5 Business Simulation Game in English (WS 2006-2007) Remember that obtaining funds through credit cards costs much more than bank loans. If you do use your credit cards for business funding, pay them off as quickly as you can. Paying only the minimum payments can extend interest for years without making much progress toward paying off the principle. Also, if your enterprise should not pan out, the credit card payments you will be stuck with may place you in a personal financial squeeze. Investment from Friends and Family Next to personal savings, the second most popular source for start-up capital is friends and family. Often, they may not be as worried about quick returns as other outside investors would be. There have been many success stories form investments of friends and family. There is also a high incidence of problems associated with this source. To illustrate this point, suppose that from the start of your business you had access to only the best and most sophisticated investors. Through this process both the investors and you would develop an understanding of the risks involved with investing in your business. It woule be in both your and the investor’s best interest for your to disclose fully in writing the risks associated with the investment. Because this process of due diligence is often not carried out with family and friends, problems sometimes ensue. Thus, receiving capital from such a consenting, informed investor is often better than from a rich, unsophisticated relative or friend. Your relative or friend may not investigate your deal carefully and, should problems occur with the business and investment, your relationship with them my suffer. A wise policy is to provide the same disclosure to a friend or relative that you would provide to most sophisticated investors. Resist the temptation to keep things loose and undocumented. Draw up the terms, conditions and payment schedule in writing for their signature and yours. Even if you receive “friendship loan” at no or low interest, provide documentation in return. This is the smart, professional business approach that minimizes the potential down side of unstated assumptions and their implications. As a result of formalizing your deal, your relationship with your friends and family will have a much better chance of remaining intact. We will consider two further sources of investment money: venture capital companies and private investors/business angels. I. Venture Capital Firms Venture capital ("VC") firms supply funding from private sources for investing in select companies that have a high, rapid growth potential and a need for large amounts of capital. VC firms speculate on certain high-risk businesses producing a very high rate of return in a very short time. The firms typically invest for periods of three to seven years and expect at least a 20 percent to 40 percent annual return on their investment. When dealing with venture capital firms, keep in mind that mthey are under great pressure to identify and exploit fast growth opportunities before more conventional financing alternatives become available to the target companies. Venture capital firms have a reputation for negotiating tough financing terms and setting high demands on target companies. Three bottom-line suggestions: Make sure to read the fine print. 3
  4. 4. The Braunschweig/Wolfenbuettel University of Business and Applied Sciences Texts and Materials for Session 5 Business Simulation Game in English (WS 2006-2007) Watch for delay maneuvers (they may be waiting for your financial position to weaken further). Guard your trade secrets and other proprietary information zealously. VCs research target companies and markets more vigorously than conventional lenders, although the ultimate investment decision is often influenced by the market speculations of the particular venture capitalists. Due to the amount of money that venture capital firms spend in examining and researching businesses before they invest, they will usually want to invest at least a quarter of a million dollars to justify their costs. Be wary of "shopping" innovative ideas to multiple venture capitalists or private investors. Use caution in revealing any information you consider proprietary. Even if you already have intellectual property protection (e.g., a patent, trademark, or copyright), you don't want to be forced to police your rights. Do your best to limit the details of your particular innovation and seek confidentiality arrangements for additional protection of any preexisting legal rights you may have. The price of financing through venture capital firms is high. Ownership demands for an equity interest in 30 percent to 50 percent of the company are not uncommon even for established businesses, and a startup or higher risk venture could easily require transfer of a greater interest. Although the investing company will not typically get involved in the ongoing management of the company, it will usually want at least one seat on the target company's board of directors and involvement, for better or worse, in the major decisions affecting the direction of the company. The ownership interest of the VC firm is usually a straight equity interest or an ownership option in the target company through either a convertible debt (where the debt holder has the option to convert the loan instrument into stock of the borrower) or a debt with warrants to a straight equity investment (where the warrant holder has the right to buy shares of common stock at a fixed price within a specified time period). An arrangement that eventually calls for an initial public offering is also possible. Despite the high costs of financing through venture capital companies, they do offer tremendous potential for obtaining a very large amount of equity financing and they usually provide qualified business advice in addition to capital. II. Business Angels Another possible source for external equity financing is through private investors, called "angels," who are seeking new business investments for a variety of economic and personal reasons. Angels can be a very good source of money if you are looking for outside investors but you are not interested in, or not a likely target for, a venture capital firm. Although angels tend to be less demanding in their financing terms than venture capital firms, you should still exercise great caution in ensuring that your "angel" financier doesn't turn out to be a devil in disguise. What Do Angels Look Like? No standard "angel" profile exists, but these investors are often individuals or groups of either local professionals or businesspersons who are interested in assisting new businesses that will enhance the immediate community. They are not typically interested in controlling the business, although they usually want an advisory role. In addition, they may make financing contingent upon the business's adherence to certain goals or practices. 4
  5. 5. The Braunschweig/Wolfenbuettel University of Business and Applied Sciences Texts and Materials for Session 5 Business Simulation Game in English (WS 2006-2007) Most entrepreneurs already recognize that potential "angel" investors for their business might be just about anywhere. Networking within your community and your business circles can often provide a good starting point. Potential financing contacts can arise through your business associates, affiliations with relevant trade associations, inquiries through your local banker, accountant or attorney, local chambers of commerce, and through other small business entrepreneurs. Work Smart When looking for "angel" investors, do your best to shop for "smart money"; in other words, try to get more from an angel than just financing. Many angels will serve as advisors, or on a board of advisors, to offer the value of their experience and strategic advice on operating the enterprise. In addition, the angels will frequently use their own connections to assist the business in finding additional financing growth opportunities, favorable suppliers, new customers, etc. The terms of angel financing depend entirely on what you can negotiate with a particular investor, but almost any type of debt or equity financing is a possibility. Some angels may offer loans at very low interest rates simply to help a new business or the community; others may expect specific rates of return on an equity investment. Some deals involve a debt instrument that allows the investor an option to convert the debt into an equity investment at either a specified time or if certain conditions are met. The investor can thereby protect himself or herself by retaining a debt claim if the business does not do well or can profit by converting the interest into equity ownership if the business succeeds. Most commonly, however, angels will want an equity interest in the business and some guaranteed "exit" provisions, such as a mandatory buyout, a "put" option requiring the business to repurchase the stock at the investor's option, or a public offering of stock. In a five-year period, angels might expect a return on investment of three to five times their initial investment, while a venture capital firm might want a return of five to 10 times its original investment. 5
  6. 6. The Braunschweig/Wolfenbuettel University of Business and Applied Sciences Texts and Materials for Session 5 Business Simulation Game in English (WS 2006-2007) INITIAL CASH REQUIREMENTS FOR THE NEW BUSINESS (all the money you will need to make the first day of business possible) START UP DOLLARS NEEDED Amount Detailed description of what belongs in this line. Advertising Promotion for opening the business Building construction The amount per contractor bid, land Cash Requirements for daily business Interior decorating and Collect bids and estimate the approximate cost to get your modeling headquarters into shape furniture and equipment Use actual bid for furniture and equipment Installing furniture and equipment Use actual bids Professional fees Include CPA, attorney, engineer, Rent Amount to be paid before opening Services Cleaning, accounting, etc. Signs, corporate design The amount per contractor bid and other Transportation and travel Car, private jet and all mobility related expenses Supplies Office supplies Unanticipated expenses these are the unexpected contingencies Miscellaneous All other TOTAL START-UP DOLLARS Total amount of costs before opening 6
  7. 7. The Braunschweig/Wolfenbuettel University of Business and Applied Sciences Texts and Materials for Session 5 Business Simulation Game in English (WS 2006-2007) REPEATING MONTHLY EXPENSES Living expenses Total cost of living expenses per month Advertising Salary of owners or managers Credit card fees How much you pay per month for your credit cards Dues and subscriptions Internet connection, journals, etc. Business related insurance Including liability, disability, key person, fire, theft, car, worker’s compensation, credit, business interruption Lease payments In case you leased equipment Office expense Miscellaneous Payroll other than owner or manager As soon as you have employees Professional fees Did you hire any consultants? Rent The cost of using the premises Repairs and maintenance Employment tax (10%) Includes federal income tax, Social Security tax and Federal unemployment tax Sales tax (15%) Income tax (40%) Bank service charges Supplies Telephone/Internet Utilities Includes water, gas and electricity transportation TOTAL REPEATING EXPENSES TOTAL CASH NEEDED AT STARTUP Initial Cash Requirements for Your New Business 1.Rent for company headquarters 2.Office equipment 3.Interior decorating and modeling 7
  8. 8. The Braunschweig/Wolfenbuettel University of Business and Applied Sciences Texts and Materials for Session 5 Business Simulation Game in English (WS 2006-2007) 4.Professional and consultant fees 5.Initial advertising costs 6.Living expenses for you and your partners 7.Travel and transportation expenses 8.Miscellaneous and Unanticipated expenses 8