CHAPTER VI

FINANCING SMALL BUSINESS

DEVELOPING FINANCIAL PLAN

After the project report is prepared, the entrepreneur takes steps to implement the
project. Project implementation requires bringing together the inputs of land, labor,
machinery, staff etc.

Finance is required to assemble these inputs. Proper financing of business is essential for
success in both small and large enterprises.
Financial planning is the process of formulating policies and strategies relating to the
procurement, investment and administration of funds for an enterprise, while
formulating a financial plan, the entrepreneur has to answer the following questions:
A. How much money is needed?
B. Where the money comes from?
C. When should the money be available?
These three questions are concerned respectively with the estimation of financial needs,
sources of finance, and the time of raising funds.

Characteristics of small business finance

a. High proportion of working funds: due to labor-intensive technology, a large
proportion of total funds are required in the form of liquid assets.
b. High gearing: generally, the ownership funds of the small-scale entrepreneur are
limited. He has to depend on a great extent on borrowed funds.
c. Personal  control: the entrepreneur wants to control the enterprise. Therefore, he
is oversea to the source of funds whereby his control is diluted.
d. Low credit standing: the credit worthiness of a new small entrepreneur is
generally low. He requires credit against the scarcity of his assets.
e. Poor documentation: a small-scale entrepreneur is rarely familiar with legal
formalities involved in financing the business. He cannot afford legal experts.
Therefore, he prefers few and less time consuming formalities.
8.2. SOURCE OF FINANCE
Financing is obtaining money from various sources. The various sources of finance may
be broadly be classified as follows:

Finance

Internal sources External source

(Owner capital or owners equity)
(Borrowed or debt capital)
1. Personal saving 1. Commercial banks
2. Friends and relatives 2. Trade credit
3. Angels (private investors) 3. Equipment suppliers
4. Partners 4. Accounts receivable
Financing
5. Venture capital companies 5. Credit unions
6. Public stock sale (going public) 6. Insurance companies
7. Bonds (debt securities)

A. Internal sources
(Equity capital)
Owner’s capital or owner’s equity represent the personal investment of the
owner or owners in a business, and it is sometimes called risk capital because
these investors assume the primary risk of losing their funds if the business fails.
However, if the venture succeeds, thy also share in the benefits, which can be
quite substantial. It requires no repayment in the form of debt and much safer for
new ventures than debt financing. It also requires sharing the ownership and
profits with the funding sources.

Source of equity capital:

1. Personal savings:
the first place entrepreneurs should take for start up money is in their own
pockets. It is the least expensive source of funds available. The sooner you take
outside money, the more ownership in your company you will have to
surrender: entrepreneurs apparently see the benefits of self sufficiency; the most
common source of equity funds used to start a small business is
the entrepreneurs pool of personal savings.
 As a general rules, entrepreneurs should expect to provide at least half of the
start up funds in the form of equity capital. If the entrepreneur is not willing to
risk his own money potential investors re not likely to risk their money in the
business either furthermore, if an owners contributes any less than half of the
initial capital requirement, he must borrow an excessive amount of capital to
fund the business properly, and the high repayment schedule put intense
pressure on cash flow. In some cases, however, a creative entrepreneur is able to
invest as little as 10 percent of the initial capital requirement. The important
point is that an entrepreneur should not surrender all hopes of going into
business just because he is unable to provide half of the starting funds.

2. Friends and relatives:

After emptying their own pockets, entrepreneurs should turn to
friends and relatives who might be willing to invest in the business venture.
Because of their relationships with the founder, these people are most likely to
invest. But having them invest can lead to controversy if their participation is not
clear to everyone. Inherent dangers lurk in family business investments,
however. Unrealistic expectations or misunderstood risks have destroyed many
friendships and have ruined many family reunions. To avoid such problems, and
entrepreneur must honestly present the investment opportunity and the nature
of risks involved to avoid alienating friends and family members if the business
fails.

3. Angels:
After dipping into their own pockets and convincing friends and relatives to
invest in their business ventures, many entrepreneurs still find themselves short
of the seed capital they need. Frequently, the next step on the road to business
financing is private investors. These private investors (or angels) are wealthy
individuals, often entrepreneurs themselves, who invest in business start ups in
exchange for equity stakes in the companies.

Angles are a primary source of start up capital for companies in the embryonic
stage through the growth stage and their roles in financing small business and
significant. Due to the inherent risks in start up companies, may venture
capitalists have shifted their investment portfolios away form startups toward
more established firms. That is why angle financing is so important. Angles will
often finance the deals that no venture capitalists will consider most angles have
substantial business and financial experience and prefer to invest in companies at
the start up or infant growth stage. Angles also look for businesses they know
 something about and most expect to invest their knowledge, experience and
energy as well as their money in a company. Angles tend to invest in clusters as
well with the right approach and entrepreneur can attract and angle might share
the deal with some of his/her close friends or companions.

Angles are an excellent source of patient money often willing to wait seven years
or longer to cash out their investments. They earn their returns through the
increased value of the business, not through dividends and interests. For
example, more than 1000 early investors in Microsoft inc. (now a giant in
computer software industry) are now millionaires. Angles return of investment
targets tend to be lower than those of professional venture capitalists. While
venture capitalists shoot for 60 percent to 75 percent returns annually, private
investors usually settle for 35 percent (depending on the level of risk involved in
the venture). Private investors typically take less than 50 percent ownership,
leaving the majority ownership to the company founders.
4. Partners:
an entrepreneur can choose to take on a partner to expand the capital
foundation of the proposed business. Before entering into any partnership
arrangement, however, the owner must consider the impact of giving up some
personal control over operations and of sharing profits with one or more
partners. Whenever an entrepreneur gives up equity in his/her business
(through what ever mechanisms), he/she runs the risk of losing control over it.
As the founder’s ownership is a company becomes increasingly diluted, the
probability of losing control of its future directional and the entire decision
making process increases.

5. Venture capital companies:

venture capital companies are private, for profit organizations that purchases
equity positions in young businesses they believe have high growth and high
profit potential. They provide start up (seed money) capital to new ventures,
development funds to businesses in their early growth stage, and expansion
funds to rapidly growing ventures that have the potential to go public or that
need capital for acquisitions. Small business owners must realize that it is a very
difficult for any small business, especially fledging or struggling firms, to pass
the intense screening process of a venture capital company and quality for an
investment. Two factors make a deal attractive to venture capitalists: high
returns and a convenient (and profitable) exit strategy. When evaluating
potential investments, venture capitalists look for the following features:
a. Competent management: the most important ingredient in the success of
any business is the ability of the manager or the management team, and
venture capitalists recognize this. Venture capitalists are really buying
into the management of your company. If the light is not on at the top, it
is dim all the way down.
b. Competitive edge: investors are searching for some factor that will enable
a small business to set it self-apart form its competitors. This distinctive
competence may range from an innovative product or service to a unique
marketing or research and development approach. It must be something
with the potential to make the business a leader in its field.
c. Growth industry: hot industries attract profits and venture capital. Most
venture capitalists focus their searches for prospects in rapidly expanding
fields because they believe the profit potential is greater in these areas.
d. Intangible factors: some other important factors considered in the
screening process are not easily measured; they are intuitive, intangible
factors the venture capitalists detect by gut feeling. This feeling might be
the result of the small firms solid sense of direction, its strategic planning
process, the chemistry of its management team or a number of other
factors.
In a nut shell, venture capitalists are extremely well informed about the
industries in which they invest, and most have experienced market
research department that provide information vital to the enterprise. As
stockholders, venture capitalists are anxious to help business succeed,
and they provide consultation to assist entrepreneurs in every way
possible. Most venture capitalist maintain frequent contact with their
entrepreneurs, and through their contacts, thy provide access to
prospective customers, suppliers, and professional services.
In many instance they also become mentors/advisors. Venture capitalists
are involves, but they do not try to take over the business. They are
primarily investors and are not interested in managing the business in
which they invest. To do so would mean that venture capitalists would
have to personally assume management responsibilities for a dozen or
more new business every year. Consequently, entrepreneurs are not
likely to lose control of their businesses. To contrary, venture capitalists
invest because they are reasonably convinced that entrepreneurs are
capable.
 6. Public stock sale (going public)
In some cases, entrepreneurs can go public by selling shares of
stock in their corporation to outside investors. This is an effective method of
raising large amounts of capital, but it can be an expensive and time-
consuming process filled with regulatory nightmares.

Going public is not for every business. In fact, most small companies do not meet
the criteria for making a successful public stock offering. It is almost impossible
for a start up company with no track record of success to raise money with a
public offering.

Advantages and disadvantages of going public

1. Advantages of going public

- Size of capital amount: selling securities is one of the fastest ways to raise large
sum of capital in a short period of time.
- Liquidity: the public market provides liquidity for owners since thy can readily
sell their stock.
- Value: the market place puts a value on the company’s stock, which in turn
allows value to be placed on the corporation.
- Image: the image of a publicly traded corporation often is stronger in the eyes of
suppliers, financers and customers.
- Attracting and retaining key employees: public companies often use stock based
compensation plans to attract and retain quality employees. Stock options and
bonuses are excellent methods for winning employees loyalty for installing a
healthy ownership attitude among theme. Employee stock ownership plans
(ESOPs) and stock purchase plans are popular recruiting and motivational tools
in may small corporations, enabling them to hire top-flight talent, they other
wise would not be able to afford.
- Using stock for acquisitions: a company’s whose stock is publicly traded acquire
other businesses by offering its own shares (rather than cash). Acquiring other
companies with shares of stock eliminates the need to incur additional debt.
2.Disadvantage of going public
- Costs: the expenses involved with a public offering are significantly higher than
for other sources of capital. Accounting fees. Legal fees and prospectus printing
and distribution as well as the cost of underwriting the stock can result in high
costs
 - Dilution of founder’s ownership: whenever entrepreneur sells stock to the public,
they automatically dilute their ownership in the business. Most owners retain a
majority interest in the business, but they may still run the risk of unfriendly take
over years later after selling stock.
- Loss of control: if enough shares are sold in the public offering, the founder risks
losing control of the company. If a large block of shares fall in to the hands of
dissident stockholders, thy could vote the existing management team (including
the founder) out
- Disclosure: detailed disclosure of the company’s affairs must be made public
information that was once private must be available for public scrutiny. This
might a variety of information about the company and its operation from
financial data and raw material sources to legal matters and patents to any one,
including competitors.
- Shareholder pressure: management decisions are sometimes short term in nature
in order to maintain a good performance e record for earnings and dividends to
the shareholders. This pressure can lead to a failure to give adequate
consideration to the company’s long-term growth and improvement.

B. External source
(Debt capital)
Borrowed capital or debt capital is the external financing that a small business owner
has borrowed and must repay with interest. Small enterprises have few choices that
large firm for obtaining debt financing. They are excluded from financial sources such as
money rises through the sale of bond inventories or markets that provide few assets for
collateralizing loans.
Although borrowed capital allows entrepreneurs to maintain complete ownership of
their business, it must be carried as a liability on the balance sheet as well as be repaid
with interest at some point in the future or with in the time stipulated in the contract. In
addition, because lenders consider small businesses to be greater risks than bigger
businesses (corporate customers) they require higher interest rates on loans to small
companies
Most small firms pay the prime rate; the interest rate banks charge their most credit
worthy customers plus a few percentage points. Because of the higher risks associated
with providing equity capital to small companies, investors demand greater returns than
lenders. Also unlike equity financing, debt financing does not require an entrepreneur to
dilute his/her ownership interest in the company.
1. Commercial banks:
Commercial banks are by far the most frequently used source of short term by the
entrepreneur. In most cases commercial banks give short-term loan (repayable with in
one year or less) and medium term loan (maturing in above one year but less than fire
years) as a working capital. Long term loans (maturing in more than five years) given by
commercial banks to finance for the purchase of property or equipment or as a project
loan, with the purchased asset or the project itself serving as collaterals for the loan
banks tend to be conservative in their lending practices and prefer to make loans to
established small businesses rather than to high risk start ups. Bankers want to see
evidence of a company’s successful track record before committing to a loan. They are
concerned with a firms operating past and will scrutinize its records to project its
position in the immediate future. They also want proof of the stability if the firms sakes
and about the ability of the product or services to generate adequate cash flows to ensue
repayment of the loan.
A bank commodity is money and this money is obtained mainly from depositors. As a
result, banks are responsible to pay to the depositors on demand. There fore, banks need
to feel extremely confident that collection of loan along with interest will occur as per
the time stipulated in the loan contract. Banks provide
unsecured and secured loans. An unsecured loan is a loan in which collateral is not
requested. That is the loan is granted against personal guarantee or corporate customers
of the bank. Unsecured loans will have high interest charges but this may not be
necessarily applicable by all banks. Secured loans are those with security pledged to the
bank as assurance that the loan will be paid. There are many types of security a bank
will consider, such as a guarantor another credit worthy person or company that agrees
to pay the loan in the event the form of tangible assets pledged as collateral. Hence, if
they do make loans of start up venture, banks like to see sufficient cash flows to repay
the loan ample collateral to secure it. Repayment of the principal is over the term
established and comes chiefly from cash.
To secure a bank loan, an entrepreneur typically will have to answer a number of
question, together with descriptive commentaries
 What do you plan to do with the money (credit facility)? Do not plan on
using the facility for a high-risk venture. Banks seed the most secure
venture possible. The borrowers are required to use the loan only for the
intended purpose or for the purpose stipulated in the contract and
diversion of the loan to other purpose is not only unlawfully but also
creates negative relationship with the bank
 How much do you need? Some entrepreneurs got a bank with no clear
idea of how much money they need. All they know is that they want
 money. The more precisely the entrepreneur can answer this questions
the more likely the loan will be granted
 When do they need it? Never rush to the bank with immediate requests
for money with no plan. Such a strategy shows that the entrepreneur is a
poor planner and most lenders will not want to lend for such
entrepreneur.
 How long will you need it? The shorter the period of time the
entrepreneur needs the money, the more likely he or she is to get the loan.
The time at which the loan will be repaid should correspond to some
important milestone in the business plan.
 How will you repay the loan? This is the most important question. What
if plans go away? Can other income be diverted to pay off the loan? Does
adequate collateral exist? Even if a quantity of fixed assets exists, the bank
may be unimpressed because it knows from experience that assets sold at
a liquidation auction bring only a fraction of their value. But this does not
true always. That is sometimes assets are sold at a remarkable price from
which the proceed is more than enough to cove r the principal loan,
acquired interest and other charges.

Bank lending decision

Due to previous bad loan decisions banks are more cautious in lending money since
they cannot afford to incur more bad loans. Commercial loan decisions are made only
after the loan officer and loan committee do a careful review of the borrower and the
financial track record of the business. For this reason the small business owner needs to
be aware of the criteria bankers use in evaluating the credit worthiness of a loan
application. Most bankers refer to the five Cs of credit in making lending decision. The
five Cs are capital, capacity, collateral, character and conditions
1. Capital: a small business must have a stable capital base before a bank will grant
a loan. Otherwise, the bank would be making in effect a capital investment in the
business. Most banks refuse to make loans that are capital investments because
the potential for return on the investment is limited strictly to the interest on the
loan and the potential loss would probably exceed the reward. In fact, the most
common reasons that bank gives for rejecting small business loan applications
are under capitalization or too much debt. The bank expects the small business to
have an equity base of investment by the owners that will help support the
venture during times of financial strain.
 2. Capacity: A synonym for capacity is cash flow. The bank must be convinced of
the firm’s ability to meet its regular financial obligations and to repay the bank
loan. And that takes cash more small business fail from lack of profit. It is
possible for a company to be showing a profit and still have no cash that is, to be
technically bankrupt. Bankers expect the small business loan applicant to pass
the test of liquidity, especially for short-term loans. The bank studies closely the
small company’s cash flow position to decide whether or not it meets the
capacity required.
3. Collateral: collateral includes any assets the owner pledges to the bank as
security for repayment of the loan. If the company defaults on the loan, the bank
has the right to sell the collateral and use the proceeds to satisfy the loan, bankers
view the owner’s willingness to pledge collateral (Personal or business assets) as
an indication of dedication to making the venture a success. A sound business
plan can improve a banker’s attitude toward a venture.
4. Character: before approving a loan to a small business, the banker must be
satisfied with the owner’s character. The evaluation of character frequently is
based on intangible factors such as honesty, competence, polish determine,
willingness to negotiate with the bank and give a position response for bank
enquiry Judged are abstract, this evaluation plays a critical role in the banker’s
decision. Loan officers know that most small businesses fail because of
incompetent management, and so they try to avoid extending loans to high-risk
managers. The business plan and a polished presentation but the entrepreneur
can go far in convincing the banker of the owner’s capability.
5. Conditions: the conditions surrounding a loan request also affect the owner’s
chance of receiving funds. Banks consider factors relating to the business
operation such as potential growth in the market, competition, location, of
ownership, and loan purpose. Again, the owner should provide this relevant
information in an organized format in the business plan. Another important
condition influencing the banker’s decision is the shape of the overall economy
including interest rate levels, inflation rate, and demand for money. Although
these factors are beyond an entrepreneur’s control, they still are an important
component in a banker’s decision.

The higher a small business scores on these five Cs, the greater its chance will be of
receiving a loan. The wise entrepreneur keeps this in mind when preparing a business
plan and presentation.
Non-Bank source of debt capital Banks are not the only source of debt financing. There
are some reasons that forces entrepreneurs to look beyond the bank:

1. To Acquire More money.

2. To Overcome Bank’s Conservatism
3. To accommodate the diversity of the small business sector.
4. To nourish success.
5. To Forestall failure
6. To Reduce Dependence on advantage.
7. To support innovation
8. To improve networking and community visibility
9. To finance substantive growth.

Let us now turn attention to other sources of debt financing that entrepreneurs can tap
to feed their cash hungry companies.

2. Trade credit: it is credit given by suppliers who sell goods on account. This credit is
reflected on the entrepreneur’s balance sheet as account payable and in most cases it
must be paid in 30 to 90 or more days interest free because of its ready availability, trade
credit is an extremely important source of financing to most entrepreneurs. When banks
refuse to lend money to a start up business because they see it as a bad credit risk, the
owner usually is able to turn to trade credit as a viable source of capital. Getting
suppliers to extend credit in the form of delayed payments usually is much easier for a
small business than obtaining bank financing.

3.Equipment suppliers: Most equipment vendors encourage business owners to

purchase their equipment by offering to finance the purchase. This method of financing
is similar to trade credit but with slightly different terms. Usually, equipment renders
offer reasonable credit terms with only a modest down payment with the balance
financed over the life of the equipment (usually several years). In some cases, the
vendors will repurchase equipment for salvage value at the end of its useful life and
offer the business owner another credit agreement on new equipment.

4. Commercial finance companies: when denied a bank loan, small business owner
often looks to a commercial finance company for the same type of loan. Unlike their
conservative counterparts, commercial finance companies are usually will to tolerate
more risk in their loan portfolio. Because commercial finance companies depend on
collateral (receivables, inventory and equipment) to recover most of their losses, they do
not require the complete financial projections of future operations that most banks do
However, this does not mean that they do not carefully evaluate a company’s financial
position before making a loan.

Their most common methods of providing credit to small businesses are account
receivable financing and inventory loans, and they operate exactly as commercial banks
do. In fact, commercial finance companies usually offer many of the same credit options
as commercial banks do. However, because their loans are subject to more risks, finance
companies charge a higher interest rate than commercial banks. In addition to short-
term financing for small businesses, commercial finance companies also extend
intermediate and long-term loans for real estate and fixed assets.

5. Accounts receivable financing: is short term financing that involves either the
pledge of receivables as collateral for a loan or the sale of receivables (factoring).
Accounts receivable loans are made by commercial banks, where as factoring is done
primary by commercial financing companies and factoring concerns.

Account receivable bank loans are made on a discounted value of the receivables
pledged. A bank may make receivable loans on a notification or non-notification plan.
Under the notification plan, purchasers of goods are informed that their accounts have
been assigned to the bank. They make payments directly to the bank, which credits
them to the borrower’s account. Under the non-notification plan, borrowers collect their
accounts as usual and then pay off the bank loan.

6. Credit Unions:
Credit unions are non-profit financial cooperatives that promote savings and provide
credit to their members, are best known for extending loans. But credit unions do not
make loans to just anyone; to quality for a loan an entrepreneur must be a member.
Lending practices at credit unions are very much like those at banks, but they usually
are willing to make smaller loans.

7. Insurance Companies:
For many small businesses, life insurance companies can be an important source of
business capital. Insurance companies offer two basic types of loan: policy loans and
mortgage loans.

Policy loans are extended on the basis of the amount of money paid through premiums
into the insurance policy. It usually takes about two years for an insurance policy to
accumulate enough cash surrender value to justify a loan against it. Once cash value is
accumulated in a policy, an entrepreneur may borrow up to95 percent of that value for
any length of time. Interest is levied annually, but repayment may be deferred
indefinitely. However, the amount of insurance coverage is reduced by the amount of
the loan. Only insurance policies that build cash value, that is, combine a savings plan
with insurance coverage offer the option of borrowing. This includes whole life
(permanent insurance), variable life, universal life, and many corporate owned life
insurance and many corporate owned life insurance policies. Term life insurance, which
offers only pure insurance coverage, has no borrowing capacity.

Insurance companies make mortgage loans on a long-term basis on real property. They
are based primarily on the value of the real property being purchased. The insurance
company will extend a loan of up to 75 to 80 percent of the real estates value and will
allow a lengthy repayment schedule over 25 to 30 years so the payments do not strain
the firm’s cash flow excessively.

8. Bonds:
A bond is long-term contract in which the issuer, who is the borrower, agrees to make
principal and interest payments on specific dates to the holder of the bond. Bonds have
always been a popular source of debt financing for large companies. Few small business
owners realize that they can also tap this valuable source of capital. Although, the
smallest businesses are not viable candidates for issuing bonds, a growing number of
small companies are finding the funding they need
through bonds when banks and other lenders say no.
Although they can help small companies raise much needed capital, bonds have certain
disadvantages. The issuing company must follow the same regulations that govern
business-selling stock to public investor.

Advantages
- No relinquishment of ownership is required
- More borrowing allows for potentially greater return on equity
- During periods of low interest rates, the opportunity cost of borrowing is low.
Disadvantage
- Regular (monthly) interest payments are required
- Continual cash flow problems can be intensified because of pay back
responsibility.
- Heavy use of debt can inhibit growth and development.