Financing The Small Business

Chapter 6

COMM320 – Fall 2019

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Financing – Overview
 Raising $$$$$$$$ (obtaining financing) has always been a major
challenge in the venture creation process;

 The Business Plan is the key document; and take note…

 It Can Be Done!... with…
 Perseverance, Perseverance, and more…Perseverance!

 Several concepts to be familiar with:

 Angel Investor,
 Capital,
 Debt / Equity considerations,
 Retained Earnings,
 Venture Capital.

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Small Business Financing

 Reasons For Financing of Ongoing

Operations:
 New Products and Services
 Acquisition / Joint Venture
 Expansion
 Capital expenditures
 Working capital needs

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Small Business Financing

 Common management problems affecting

financing:
 underestimating financial requirements.
 lack of knowledge of sources of equity and debt
capital.
 lack of skills in presenting a proposal for financing .
 failure to plan in advance for needs.
 poor financial control of operations.

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Capital and Planning

 Yes, it’s true, CASH is King! or Queen!

 The Importance of Capital and Planning

 How much do you need ?

 When will the funds be used ?

 How long will the money last ?

 Where can the money be raised and what type of

financing (debit versus equity) will be used ?

 Do you need funds immediately ?

 Will I get anything else besides money ?

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Determining the Amount of Funds Needed

 Start-up Costs
 Remember, businesses usually need to purchase some form of
assets, equipment, inventory, etc. $$$$$$

 Ongoing Operating Costs

 Also, there is the need to fund the first 2 – 3 – 6 months of
operating costs, this can vary…

 The Owner’s Net Worth

 This will help to estimate how much the owner can invest, and
will likely be required by outside investors, etc.

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Start-up Costs - Sample

 77

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Ongoing Operating Costs
 Estimates linked to Cash Flow

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The Owner’s Net Worth
 The Owner’s Net Worth, likely required by Investors:

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Financing sources - Business stages

 During the start-up stage it is primarily personal savings, personal

credit cards and the personal loans of the entrepreneur(s) that
account for the start-up financing;

 In Table 6-4 (p. 143-144) you can see the % for Start-Ups:
 66% using Personal Savings
 32% actually using their Credit Cards!
 Note differences between Start-Ups and existing (SME’s).

 External lenders are reluctant to take risk with a start-up;

 At the growth stage, once the concept has been proven and the
business is generating positive cash flow, the primary sources of
expansion financing are commercial loans, commercial lines of credit
and trade credit from suppliers.

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Types of Financing

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Types of Financing

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Sources / Stages
 When the business has “slow growth” potential the following are the
primary methods of financing (Table 6-5, p. 144):

 Early stage (seed capital):

 Used for feasibility study and business plan, the sources are from
personal savings, personal credit cards, family/friends, and
sometimes government grants;

 Early stage (start-up):

 Used to get the business running, again, the sources are
personal savings, personal loans and credit cards and
family/friends, perhaps some trade credit, and government
programs.

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“slow growth” potential

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Sources / Stages

 Expansion / Maintaining Operations:

 First stage:
 Business is striving to become profitable; most like sources
are personal savings, retained earnings, trade credit,
business loans;

 Second stage:
 The business is now beginning to show profit, starting to
grow; financing comes from retained earnings, commercial
lines of credit, trade credit.

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Sources / Stages
 On the other hand, a start-up business with “high growth” potential
(Table6-6, p. 145): is more likely to use equity financing because
investors see the medium-long term potential of more return;

 Early stage Financing:

 Seed capital:
 Besides their own (and family) often feasibility and business plan

are financed by angel investors. The business is not “above the

radar” yet, is not seen by VC;

 Start-up:
 Usually angel investors again because this phase can be within

their capacity.

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“high growth” potential

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Sources / Stages

 Expansion / Development financing:

 Concept is now proven, profits are becoming evident and VC are

now ready to play with large investment for growth.

 An equity stake in the business is now worth more because the

concept is proven;

 It is time for major expansion, rapid sales growth;

 Ultimately, the last stage of growth is the bridge financing phase

where VC puts up funding needed to go public.

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Sources / Stages

 Acquisitions / Leveraged buy-out financing:

 Acquiring other companies (direct purchase);

 Leveraged buy-outs (buy-out enough existing owners for control);
 Go private (Purchase all stock of a company);

 Venture capital and bank financing are the two primary forms of
financing at this stage.

 The three “risk-capital markets” are informal (Angels), VC, and also
public-equity market (launching an IPO).

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Equity or Debt Financing?
 Equity represents ownership in the business, raising funding this
way means “giving up” a portion of your ownership:

 It does dilute ownership;

 It may (differing issues / levels) result in a loss of control.

 Remember, debt is borrowing money (usually in the form of a

loan) that has to be repaid:

 It does not dilute ownership;

 It does not result in a loss of control;

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Advantages of Equity Financing

 1. There is no obligation to pay dividends or

interest. This flexibility allows the firm to invest
earnings back into the business in its early years,
when these funds are usually needed most.

 2. Often the original owner benefits from the

expertise the investor brings to the business in
addition to the financial assistance.

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Advantages of Equity Financing
(cont.)
 3. Equity capital expands the borrowing power of
the business. Most lenders require a certain
percentage of equity investment by the owners
before they will provide debt financing. Thus, the
more equity a business has, the greater is its ability
to obtain debt financing.

 4. Equity financing spreads the risk of failure of the

business to others.

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Disadvantages of Equity Financing

 1. Equity financing dilutes the ownership interest of the

original owner and leads to decreased independence.
Because of this drawback, many owner-managers are
hesitant to follow this route in obtaining capital.

 2. With others sharing the ownership interest, the

possibility of disagreement and lack of coordination in
the operations of the business increases.

 3. A legal cost may be associated with issuance of the

ownership interest.

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Equity or Debt Financing?
 Equity based financing implies that the investor/partner will take risk
along with the entrepreneur so there is no monthly cash outlay
which allows the company to conserve cash;

 However, the investor has some form of ownership in the business.

 Debt requires a monthly payment, including interest (a pressure on

cash flow in the early, fragile stage when the best practice is to
conserve cash);

 Debt also requires some form of collateral;

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Equity or Debt Financing?
 Equity financing does not require the pledge of any asset. If the
business fails the investor/partner has no “collateral” to seize;

 Debt financing is usually “asset based” which means that a business

or personal asset has to be pledged as collateral;

 Equity financing is done on a “variable” basis where the investor has

a large return if the business realizes its upside potential;

 Debt financing is done on a “fixed” expense basis which means the

payment is fixed no matter how well the company does;

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Equity or Debt Financing?

 A lot in the decision depends on the entrepreneur. Some are not

comfortable with giving up any equity (control);

 A lot also depends on the start-up scope. A “mom-and-pop” shop will

not attract equity financing;

 Canadian start-ups use less equity financing perhaps because they

like to retain control but more likely because the scope of Canadian
ventures is more “safe” without the high upside potential to attract
investors who are willing to take big risks.

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Other Considerations
 Conserving cash is critical at start-up, debt requires cash re-payments
based on some schedule, equity requires no cash outlay in the short term;

 Remember, many start-ups overestimate sales and underestimate costs to

make the business plan more attractive;

 Equity based financing may bring expertise that is invaluable at the start-up
through the contacts and management expertise of the investor;

 Debt financing can be more attractive when interest rates are low,
particularly for investing in fixed assets;

 A start-up is usually done “on a shoestring” with bootstrapping techniques to

conserve cash and be self-financing until the concept is proven.

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Determining Types of Financing

 Equity (Ownership) Financing

 Private Investors
 Corporate Investors
 Government
 Business Development bank of Canada (BDC)
 Canada Development Corporation (CDC)
 Provincial Programs

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Determining Types of Financing

 Equity Financing
 Personal Funds
 Family and Friends
 Crowd-Funding
 Informal Risk
 (Angels)
 Corporate Investors
 Government

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Determining Types of Financing

 Equity Financing
 Personal Funds and Retained Earnings
 Few, if any, new ventures are started without the
personal funds of the entrepreneur
 73 percent of start-ups use personal savings, and three
out of the four most common financing strategies involve
personal guarantees

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Personal Funds
 All other investors and lenders will want to see the entrepreneur
taking risk (they may want to see a statement of personal net worth)
because:

 They want to see that the entrepreneur has to succeed not just
“hopes” to succeed;

 They want to see “commitment” on the part of the entrepreneur;

 They want to see that the entrepreneur has “burned the bridges” so
there is no retreat – the entrepreneur must go forward and make the
business happen;

 If the entrepreneur is not ready to “bet the ranch” then why should
they? They don’t want to just risk their own money.

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Determining Types of Financing

 Equity Financing (cont.)

 Family and Friends
 Family and friends are a common source of capital for a
new venture
 Most likely to invest due to their relationship with the
entrepreneur

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Family & Friends
 The reality is that in many cases a young entrepreneur will have
to turn to family and friends:

 Considerations:
 Relatively easy method to raise some capital;
 If family members take an equity position, they may feel like they
deserve to have a say in how the business is operated;
 The investment of a family member should be treated in the same
way as with any other investor and have a detailed agreement
outlining payment terms, dividends, responsibilities, etc.
 Lastly, the entrepreneur should be conscious about the impact on
the family member (good and bad).

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Determining Types of Financing

 Equity Financing (cont.)

 Crowd-Funding
 A new and emerging trend in equity investment for
business is crowd-funding
 Crowd-funding occurs when an entrepreneur solicits
small donations from the public to fund the start-up or
growth of their company or social enterprise
 Crowd-funding websites such as Kickstarter
(www.kickstarter.com) and Indiegogo
(www.indiegogo.com) have grown in popularity

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Determining Types of Financing

 Equity Financing (cont.)

 Informal Risk-Capital Market (Angels)
 Virtually invisible group of wealthy investors, often called
business angels, who are looking for equity-type
investment opportunities in a wide variety of
entrepreneurial ventures
 Typically investing anywhere from $10,000 to $500,000
 Provide the funds needed in all stages of financing, but
particularly in start-up

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Determining Types of Financing

 Equity Financing (cont.)

 Finding and Soliciting Angels
 Estimated that there are approximately 200,000
Canadian angels who are willing to invest thousands of
dollars in entrepreneurial start-ups

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Angels

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Determining Types of Financing

 Equity Financing (cont.)

 Preparing to Meet an Angel
 1. Prepare in advance
 2. Ask for referrals
 3. Screen potential angel investors
 4. Prepare for the first contact
 5. Pitch the idea
 6. Prepare for a response

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Determining Types of Financing

 Equity Financing (cont.)

 Angel Organizations
 A new trend that has emerged in angel investing over
the last decade is the formation of angel clubs or
associations
 Angels use these clubs to network with other angels,
share investment opportunities, and pool money to
invest in start-up ventures

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Determining Types of Financing

 Equity Financing (cont.)

 Corporate Investors
 Many companies are interested in investing in a small
business in the hope that the value of their investment
will increase over time
 Often they then sell their ownership interest back to the
original owners

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Angel Financing
 Meeting with Angels:

 Find them through accountants, bankers, BDC, angel networks;

 Find one in the relevant industry;
 Prepare in advance (Biz plan, executive summary, elevator
presentation);
 Have references ready (bank, letters of interest, etc.
 Sell the concept (let them buy-in by suggesting implementation
strategies);
 Draw up agreement –have a legal advisor look at it.

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Angels

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Angel Organizations
 As noted in Table 6-8 (p. 158), there are several Angel Investment
Groups best known in Canada.

 Another good source are the business plan competitions across

universities in the U.S. and Canada.

 Students can win good prize $$$ on the tour (e.g. $5,000 for
Queen’s University competition) but the real value is that Angels and
VC are usually judges and may throw money at projects after the
competition is over.

 Sign up for our own at Concordia - Dobson Practicum – at:

 http://www.dobsonpracticum.com/

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Venture Capital
 By nature, willing to take on more risk;
 But, VC’s want some control and high returns;

 VC’s may place controls on entrepreneurs:

 Approval of large capital expenditures;

 Remuneration of senior management;
 Approval of long term lease arrangements;
 Approval of disposal of assets;
 Payment of dividends;
 Major borrowing or other financial decisions.

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Venture Capital
 VC essentially manage a fund:

 They want business opportunities that cost a nickel, sell for a buck and are
habit forming with global potential;
 Typically in industries like software development, biotech, environmental
(alternative sources of energy, or recycling), etc.
 These businesses also tend to have government money available dedicated
to support R&D type activities;
 They invest in chunks of $500,000 and up. They sell a portion of their equity
at the “go public” phase, recover their investment and have equity left for
large returns;
 Usually they get in when all other sources of financing have been used to
the maximum and the business is poised to make a mega leap forward and
needs significant funding.
 They bring the $$$ and also may bring in the professional management to
run the operation.

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Venture Capital Criteria
 The Entrepreneur or team:
 Must have a solid strong and highly committed management
team;
 Team must be highly flexible;
 Interesting, the team should be backed with family support.

 The product and/or market opportunity must be something unique

in a “hot” industry, with exclusive rights, patent, or some other
barrier.

 The opportunity must be high growth and one where going public
would trigger a stampede, meaning very large returns for the VC.

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Dealing with VC

 Angels, bankers and others know them – often they will find you
(e.g. Biz plan competitions), remember some sensible guidelines:
 It is a good idea to approach through an intermediary but it is
important that the entrepreneur lead the discussion;
 Develop a brief, succinct presentation;
 Disclose any “problems, or negatives” to develop trust, use the word
“challenges;”
 Avoid, Avoid, Avoid “glib statements” see bullet in Table 6-10, p.
160, (3rd from bottom) – Avoid!
 Avoid too high salaries, or even talking too much about
compensation.

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VC

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JMSB – Entrepreneur – Financing

What about this guy?

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Determining Types of Financing

 Equity Financing (cont.)

 Government
 Programs have been developed in recent years that
permit government funding and incentives for venture-
capital firms or allow for direct equity investment by
government in the business
 Example: BDC

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Bootstrap Financing

 Bootstrapping essentially means using any possible

method for conserving cash, this can come from the
following techniques:
 Profits (re-invest all, no matter how small);
 Sale of assets that are not used, or leasing rather than buying at
start-up and buying used instead of new;
 Reduce working capital by deferring salary and also by using family
who will also defer salary;
 Reduce working capital by using JIT inventory;
 Reduce working capital through trade credit when possible (the
best, no interest loan);
 Minimal accounts receivable or, get a down payment that covers
your cost portion of the sale.

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Bootstrap / Concepts
 “Bootstrapping” is very common in the start-up phase, generally meaning
using any method possible to conserve cash, it is often a reality most
business have to deal with:

 Methods:
 Offer to pay in cash as a negotiating tool for discounts;
 Haggle and barter;
 Used or leased equipment if possible;
 Negotiate the best terms possible from suppliers;
 Reduce waste in every way possible, supplies, travel, etc.

 General approach:
 Collect as early as possible from the people who owe money to you, and
delay for as long as possible paying the people you owe.

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Bootstrap / Benefits
 “Bootstrapping” is a reality most business have to deal with, it can be seen
as an approach to managing cash, with some outcomes that can be seen as
beneficial:

 Positive outcomes:

 Moves the venture from idea to implementation without delay;

 Pressures the venture to generate positive cash flow and break even soon,
and maintain any advantage;
 Avoids premature growth;
 Keeps the attention on cash flow;
 Helps to establish relationship with key stakeholders;
 Avoids the build up of a big team of “pros” being too fast.

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Debt Financing

 Debt Financing
 Advantages
 Obtain higher ROI by using leverage debt
 Interest costs are tax deductible; dividends from equity
are not
 No loss of ownership control and greater flexibility with
debt financing
 Easier to obtain than equity capital

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Debt Financing

 Debt Financing
 Disadvantages
 Interest must be paid on borrowed money
 Increased paperwork requirements and lender
monitoring
 Total risk on part of the owner

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Debt Financing

 Debt Financing
 Sources of Debt Financing
 Private lenders
 Shareholder loans
 Corporate lenders
 Regular Private Lending Institutions
 Chartered banks, Trust companies, Credit unions, Finance
companies
 Government Lenders
 Canadian Small Business Finance Program

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Debt Financing

 Types
 Short term (demand), medium term, long term

 Sources
 banks, private sources, factors, confirming
houses; term lenders, leasing companies, foreign
banks; trust companies

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Chartered Banks
 Banks are not risk takers by nature. They want their interest rate no
matter how well (or poorly) the business goes.
 They also want no risk on default and they know a start-up has high risk
so they may want personal assets pledged;

 Common forms of financing:

 Accounts Receivables Loans (ABL), sometimes referred to as “factoring;”
 Inventory loans;
 Equipment (commercial pledge);
 Term loans, usually for a major fixed asset (building).

 Cash Flow Financing:

 Lines of Credit;
 Short term working capital;
 Long Term (unusual for a new business);
 Character Loans.

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Dealing with Banks
 Inventory loans are possible but due to factors such as obsolescence and
liquidation value banks will normally only offer 50% of the value;

 Equipment loans are similar because the equipment immediately

depreciates, is usually a specialty item and they have to liquidate it, they will
only offer 60% of your cost and require independent assessment;

 Line of credit and overdraft protection to allow for short term shortfalls

 In any dealing with the bank, view the application process as a “mini”
business plan, provide good, well researched information.

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Dealing with Banks
(and other lenders)

 Everyone wants to now how (and when) they will get their money
out – be clear on that;
 Show that you are taking risk in the venture as well;
 Be realistic with revenue projections (conservative);
 Cover expected objections (risk assessments);
 Talk their language (ratios, returns, margins, etc.);
 Get enough the first time – consider all costs until break even and
build in a contingency cushion – no one likes to do “rescue
financing”
 Indicate you are willing to forego a pay check to make your
payment;
 Show that you are conserving cash (don’t expect them to finance
your lifestyle).

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The Role of Government

 Governments have a wide variety of programs to

assist entrepreneurs;
 Usually come in a variety of terms, including loan
guarantees;

 In Canada, major programs:

 BDC – Business Development Canada;

 Futurpreneur (used to be CYBF)
 EDC - Export Development Centre.

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Government Sources

 Government tends to run programs with specific objectives, it is best

to research them:
 Contributions (actual grant) are sometimes available, especially for
youth, disadvantaged groups;
 Other government sponsored programs subsidize consulting and/or
support for new start-ups. These also provide excellent
opportunities for networking (YES);
 The BDC will take more risk than an “A” bank and the loan can be a
small business loan up to $250,000;
 They also have access to VC and Angels (They have a “matching”
service in the newsletter);
 If you have an opportunity that has export potential the EDC can
support trade show booths, and international travel to trade shows.

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Matching Financing

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Preparing A Proposal to Obtain Financing

 Criteria Used in the Loan Decision

 1. The Applicant’s Management Ability
 How much the applicant knows about the business
 How much care was taken in preparing the proposal
(business plan)
 2. The Proposal
 Level of working capital
 Current ratio
 Quick ratio
 Debt-to-equity ratio
 Collateral

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Preparing A Proposal to Obtain Financing

 Criteria Used in the Loan Decision (cont.)

 3. Applicant’s background and creditworthiness
 Personal information
 Present debt and past lending history
 Amount of equity the applicant has invested
 Will the applicant bank with the lender?

 Lender Relations
 Always maintain a close working relationship…

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Business Plan Guidelines
 We will keep the Financing Plan simple, the statements will be
projected out three years.

 The amount of equity available for development should be

reasonable with respect to the equity position and size of the
existing business, and / or the financial resources of the
entrepreneur;

 It is important match any commercial financing with an

appropriate use.

 There should be some costs associated with the start-up /

growth / expansion of your business, therefore the source of
funds needs to be described in the business plan.

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