CHAPTER 16 .pptx

Small Business Finance
Ch 16: Relevant Consideration In
Selecting The Finance Package

Relevant Consideration in Selecting the
Finance Package
1. Maturity structure.
2. Type of asset being financed.
Selecting Financial Package

Factors Influencing Decision of Finance
The following factors influence the decision of
finance.
1. Trading on equity.
2. Capital structure mix.
3. Relative cost.
4. Non financial influence on the financial mix.

Non financial influences of the financial mix
• Several information factors come into play in determining the
financing package, the chief ones are ;
a. Debt may be the only source available; to the small firms
regardless of cost.
b. Debt does not disturb the voting position of existing
shareholders.
c. Financial flexibility may not be possible when equity
securities are employed.
• There are times during the life cycle of many firms when
additional equity funds are not available at reasonable costs,
but the same firms may have assets that would serve as
security for either long or short term credit.

Phase I: Individual investment
Phase II: The Gap
Phase III: Public offering
Owner’s personal
Investment
Commercial
Bank
Miscellaneous
Sources
Private Placement
Over the counter market
Regional Exchange
American or New York
Exchange

Long Term Debt As a Source of Financing
There are following sources of a long term financing.
• Commercial Banks
• The Small business administration
• Small business investment corporation
• Venture capital sources
• Insurance companies

Commercial Banks
o Commercial banks are the primary sources of borrowed
funds.
o The funds available through banks are primarily short-term
loans, seasonal operating lines of credit, revolving lines of
credit, term loan, equipment loans, business acquisition
loans, assets based loans and expansion loans.
o Line of credit , seasonal operating and revolving lines and
term loans are “formally” defined as short to intermediate
term in nature: however, they are often times long- term
loans in that they are renewed as the indebtedness
approaches the due date.
o In relying upon the bank as a source of funds, the small
business person should develop a relationship with the
banker prior to the actual need for funds.

Commercial Banks
“Equipment Loans”
o Equipment loans enable small firms to purchase equipment
required in the operation of the firm.
o The length of these loans is tied to the economic life of the assets,
which can run from seven to ten years.
o In the general majority of cases, the asset being financed is used to
secure the loan.
o The interest rate is usually one to two points over prime.
o Equipment financing may also be accomplish through the
companies that manufacture the equipment.
o In nearly every case these companies use installment lending
process rather than relying on the firm’s ability to pay the loan in
one lump sum at the end of, say, ten years.

Commercial Banks
“Industrial development revenue bonds”
Industrial Development Revenue Bonds (IDRB's) are
tax-exempt debt obligations issued by public
corporations to support manufacturing, processing,
and utility type economic development projects.
Using an IDRB to finance projects cuts the financing
costs.
The interest rate is two to three percentage points
lower than the current bank prime lending rate.

Commercial Banks
“Cost of IDRB”
 $2,500 application fee plus an annual fee 0.1% of the
outstanding principal balance of the bonds per year for the
life of the bonds, payable at the time of issuing the bonds.
 Other costs include: bond counsel, underwriting, legal
notice, printing, trustee, and other fees depending on the
financing arrangement.
 The borrower is responsible for the payment of all costs
associated with financing.
 Costs of up to three percent of the face amount of the
bond can be paid from bond proceeds.

Commercial Banks
“Asset Based Loans”
 Asset based lenders have been referred to as lenders of last
resort.
 Asset based lending is not done primarily by banks, rather it is
provided by companies outside the commercial banking
community.
 The lending policies vary among asset-based-lenders.
 While all consider the strength of the assets used as security,
the bank related lenders also consider the cash flow
characteristics of the firm.
 On the other hand, the traditional finance companies tend to
lend solely on the strength of the assets.

Commercial Banks "Asset Based Loans”
• As a general rule, asset-based loans are made to all types of
businesses since both current and fixed assets are used as
security.
• Asset based loans are also used in acquisition financing or
leveraged buyouts.
• A leveraged buyout (or LBO, or highly-leveraged transaction
(HLT), or "bootstrap" transaction) occurs when a financial
sponsor gains control of a majority of a target company's equity
through the use of borrowed money or debt.
• This is particular true in cases where divisions are being spun off
(A spin-off is a new organization or entity formed by a split from
a larger one) and sold to persons (either employees or
managers) with in the firm. In these cases, the loans are secured
by the assets purchased, and the payment (interest and
Principal) are obtained from the cash flow of the operations.

Commercial Banks "Asset Based Loans”
• The cost of asset-based-loans tend to be higher than
more conventional types of loans.
• One factor that tends to make this type of loan more
desirable and competitive with other types of
lending is the absence of compensating balances.

Commercial Banks
“Mortgage loans”
 The loan made by banks in which the security is the real
estate owned by the firm is long term in nature.
 It might also be said that this is a type of asset based loan.
 For a long period of time this was the major type of long
term lending that banks provided.
 Most banks will make these types of loans the maturity of
which is based on the size of the real estate involved.
 The cost of the loan tends to be competitive with other
lending institutions that make such loans e.g. life insurance
companies.

Commercial Banks
“Sale & lease back finance”
• Owners of small and middle sized business may use the sale and
lease back technique to raise long term capital.
• This financing strategy allows the firm to “unlock” frozen equity in
real estate assets.
• The sale and lease back permits the firm to sell office buildings,
warehouses, factory building, or other real property and lease them
back under a long term lease.
• This is particularly good technique during periods in which the value
of the assets have increased.
• Sales and lease back are also particularly attractive for institutional
investors such as pension funds and other types of investment
funds.

Small Business Administration
 Established in 1953.
 Purpose is to provide “aid, counsel, assist, protect in as far as
is possible the interest of small business concerns”.
 The SBA provide number of services among which is
assistance in satisfying the needs of small businesses for
intermediate and long term funds.
 If a firm is unable to qualify on an independent basis for
provided commercial financing, the SBA attempts to service
the company’s financial requirements.
 The SBA loan may be “direct” or it may involve “participation”
with a commercial bank.
 Five basic categories of loans exist.

Small Business Administration
• Direct loans not exceeding $ 150,000 may be acquired provided
certain qualification are met and adequate collateral is available.
• Bank participations loans are made in which the SBA supplies up to
but not exceeding $ 150,000.
• Displaced business loans represent financing made to firms
displaced by federally funded programs.
• Economy opportunity loans are available for physically handicapped
persons or minority groups for establishing a small business under
the economic opportunity program.
• Guaranteed loans are available in which the commercial bank
services the loan standard interest rates, with the SBA providing a
90 percent guarantee; the present ceiling is the lesser of 90% or $
500,000. The SBA has recently requested that this be raised to $
750,000.

Small business Investment Corporation
 In 1958, congress passed the Small Business
Investment Act, the purpose of which was to give small
businesses a new sources of long-term funds by
encouraging the certain of private investment
companies that would provide long term capital to
qualified businesses.
 As a result of this legislation the SBIC’s and minority
enterprise SBIC’s are licensed by the SBA and enjoy
certain benefits on that funds are provided or
guaranteed as well as receiving certain tax advantages.

Small business Investment Corporation
There are two types of SBIC’s lending and venture SBIC’s.
– Lending SBIC’s have less than 65% of their equity in
venture equity financing and are permitted by the SBA to
borrow up to three times their equity for financing
ventures.
– Venture capital SBIC’s on the other hand are allowed to
leverage up to four times their equity through the SBA and
invest more than 65 % of their equity into the purchase of
small business equity.
• The venture capital SBIC’s are larger than the lending
SBIC’s and operate more like venture companies in that
they make only a few commitments for year.

Venture Capital & Small Business
o Venture capital is generally thought to be equity
capital, but it should be emphasized that venture
capital takes the following forms; equity, debt, and
convertible debt.
o Venture capital investing is also confusing in that
there is no one precise definition for this concept.
o The term simply has different connotations to
different individuals. Venture is defined as “an
undertaking involving chance, risk or danger,
especially a speculative business enterprise”.

A number of definitions could be cited, with four such
explanations being as follows:
• Providing capital for any high-risk financial venture.
• Providing “seed capital” for a stand up situation.
• Investing in a firm that is unable to raise capital from
conventional sources.
• Investing in large publicly traded corporations where the
risk is significant.

The following attributes generally prevail with venture capital
investing.
 The investor is usually “located in” to the firm for some
duration of time, without an opportunity to sell stock quickly
in response to a change in the company’s position, either
favorable or unfavorable.
 The venture capital normally represents the first equity
financing from an “independent” party, as opposed to a friend
or relative.
 Venture capital investors have divergent interests. Hence, an
investment having no appeal to one venture capital group
might be of extreme interest to other venture investors.

Venture capital may be obtained from the following
sources;
• Private and public investments firms.
• Small business investment corporations.
• Institutions.
• Banks.
• Corporation.
• Informal investors.

Insurance Companies
 The executive of the small corporation may find an insurance
company to be a viable source of financing.
 As a financial intermediary, an insurance firm has large sums
of money available for investments.
 Although only a small portion of such funds are available for
the small firm.
 The extension of credit generally comes in the form of
mortgage loan.
 Most insurance firms are interested in making loans in large
amounts; however, loans for as little as $10,000 have been
granted.
 In general, mortgage loans extend over a 10 to 20 year period.

Insurance Companies
 The insurance companies may issue credit on a an
unsecured long term basis to the borrower having
questionable integrity and an excellence credit
rating.
 If such loans are granted, the duration of loan is up
to 10 years.
 The interest rate charged will be 1 to 2 % above the
bank rate.

Insurance Companies
In applying for a loan with an insurance organization, the borrower
should be aware of the relevant regulatory stipulations. Such
requirements would include ;
• The corporate form of doing business by the company.
• A minimum number of years that the borrower has conducted
business.
• Demonstrated historical and present earning records.
• Also information may be required relating to projected cash and
operating budgets, plans indicating the intended application of the
funds being borrowed, sales forecasts by product line on service
line, and background information relating to the corporate
management.

Equity Financing In The Small Business
 The term equity relates to investment of both preferred and
common stockholders in a company.
 The amount of investment of these two categories of
shareholders is reflected in the capital stock, capital surplus,
and retained earnings accounts with in the balance sheet.
 Common equity represents the portion of total equity
identified with the common shareholders.
 The equity segment of the firm may be altered as a result of
one of three factors:
– The sale or purchase of the company’s preferred stock.
– The sale or reacquisition of common stock.
– A change in retained earnings, which are increased by profits and
reduced by any dividends distributed during the period.

Common share
• Authorized, issued capital.
• Par value, premium or discount.
• Voting rights.
• The unique characteristic of common stock relates to the
shareholders being the residual claimants of;
– All corporate earnings after the payments of operating
expenses, financial charges, and taxes.
– All assets upon liquidation after prior claims have been
satisfied.

Advantages of Financing with Common Stock
 Less risky than financing with bonds.
 Dividends paid only on decision by board of directors.
 If a company does not pay a dividend, it may reinvest
the cash.
 No maturity date for repayment of funds.
 Increase the firm borrowing power.

Disadvantages of Financing with Common Stock
Dividends paid are not tax deductible.
Issuing stock dilutes ownership.
High cost due to high risk.

Preferred Stock
o Preferred sock is seldom used as a financing
instrument by small businesses.
o If such a security is employed a conversion feature
generally accompanies the issue.
o The dividend payment represents a fixed charge.
o The dividend payments are not deductible for tax
purposes.
o Cumulative and non cumulative.
o No voting rights.

CHAPTER 16 .pptx

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CHAPTER 16 .pptx