When it comes to sources of financing, firms at any stage of the company’s life cycle have three options from which to choose:
- Internal financing – using retained profits.
- External financing – using funds invested by outside investors and lenders. Investors include the common stockholders, venture capitalists and entrepreneurs.
- Spontaneous financing – such as accounts payable, which increase automatically with increases in sales. Accounts payable, which is also called trade credit, are funds payable to suppliers.
Further, an entrepreneur needs to take into account certain variables when making a decision on optimal sources of financing. Particularly, entrepreneurs need to decide if they are willing to give up part of the voting control which will be inevitable if equity financing is chosen. Entrepreneurs also need to decide if they are willing to take on bigger financial risk which is inevitable when debt financing is selected.
Debt financing increases financial risk because debt must be repaid regardless of whether or not the firm makes a profit. If debt is not repaid according to an agreed upon schedule, creditors may even force the enterprise into bankruptcy. Alternatively, an equity investor is not entitled to more than what is earned by the enterprise.
Personal Sources of Financing
It is most likely that entrepreneurs will have to invest some of his or her “personal” money or money from “personal” sources to ensure that others will even consider investing in the enterprise. The “personal” sources of financing could be personal savings, credit cards, borrowing from friends and relatives or any other way of obtaining money such as selling an asset, such as a car or a summer house, to free up funds for investment in the enterprise.
Personal savings are usually the leading source of “personal” funds. Credit cards are often used but needed to be used with extreme caution as interest rates on outstanding amounts can be incredibly high.
Borrowing from friends and family is also very tricky and should be done with extreme care. If the business fails or does not perform as expected and money is not repaid when agreed than it can destroy or severely damage important relationships. When borrowing from friends and family, it is a good guideline to ensure that it is seen as an investment rather than a gift by the lending side of the transaction. Agreed upon deals should be put in writing since memories are not always reliable. Moreover, the amount borrowed should be repaid as soon as possible.
Bootstrapping is usually a strategy that entrepreneurs follow to survive at the beginning stages of business establishment and growth.A bootstrapping or bootstrap financing refers to a situation when entrepreneur uses his or her initiative to find capital or use capital more efficiently to survive.
It includes minimization of the company’s investments and refers to such situations as leasing instead of buying, adapting just-in-time inventory system, operating business from home, obtaining free publicity instead of paying for advertising and using other people’s resources as much as possible, while paying as little as possible.
Other examples of bootstrap financing include factoring and trade credit. Factoring refers to the situation when the business sells its accounts receivable to a financial institution at a discount rate. Factor refers to the financial institution which business is to purchase accounts receivable from other companies. Trade credit refers to situations when suppliers provide their products and services on credit. Suppliers usually extend interest free credit for 30 days or less commonly for 60 or 90 days interest free credit.
Borrowing from the Bank
When borrowing from the bank, an entrepreneur has a number of options. The following types of loans are generally available:
Lines of credit – this is when the bank agrees to make money available to the business. Agreement is made for up to a certain amount and is not guaranteed but only in place if the bank has sufficient funds available. Such agreement is generally made for a period of 1 year.
Revolving credit agreement – this is similar to the lines of credit but the amount is guaranteed by the bank. A commitment fee of less than 1% of the unused balance is generally charged. Therefore, such an arrangement is generally more expensive for the borrower.
Term loans – such loans are generally used for financing of equipment. The loan generally corresponds to the useful life of the equipment.
Mortgages – such loans are long-term loans and are available for purchase of the property which is used as collateral for the loan.
When banks consider loaning money, they generally will have to consider certain requirements before they will even consider loaning the funds. Such requirements include the request of a business plan to learn whether or not the entrepreneur have their “own skin in the game”.
Other considerations include the entrepreneur’s own net worth which refers to personal assets less personal liabilities. The projected annual income of the entrepreneur is also considered.
If the company is not a start up, the historical financial statements may be requested. Further, pro forma financial statements may be requested which include pro forma income statements, balance sheets and cash flow statements.
It is advisable for the entrepreneur to cultivate a good relationship with the banker since intuitive judgments also play a role when bankers decide whether or not they should lend money to the particular borrower. However, this is only valuable if all other considerations discussed above are attended to.
Banks use different methods to evaluate the appropriateness of the potential borrower. One of such methods, the five C’s method, is discussed below.
Five Cs of credit:
- Capital – businesses position with regards to debt versus equity
- Collateral – whether or not the entrepreneur has assets that can be sold to cover debt
- Character – borrower’s history of meeting obligations
- Capacity – ability to repay the loan. This is judged by such indicators as projected cash flows
- Conditions – conditions surrounding this particular lending opportunity such as market conditions and transaction conditions
In exchange for investment, venture capitalists obtain partial ownership of the business. Convertible preferred stock or convertible debt is usually preferred. This is because venture capital firm would like to have the senior claim on assets in case of liquidation but still have an option to convert it to common stock if the business becomes successful.
Angel Investors, which are also referred to as informal venture capital, are wealthy private individuals who invest in the firms in their individual capacity. Very small percentage of start ups manage to get such funding. Therefore, entrepreneur should have other options available as well.
There are also government supported financing options available which are specific to an entrepreneur’s location.
Other less feasible options exist. One example is to obtain funding from large corporation which is willing to invest in the enterprise.