Amoud university

Faculty of B.P.A
Group Names
1. Abdifatah Mohamed Abdilahi
2. Mohamed Mohamoud Abdi
3. Khadra Ali geele
4. Mohamed Hassan jama
5. Nasteexo fahmi Abdi
6. Amaal Ahmed ismail
 Chapter 9

Small Business Finance

CHAPTER LEARNING OUTCOMES:-

After reading this chapter, you should be able to:

1. Determine the financing needs of your business.

2. Define basic financing terminology.
3. Explain where to look for sources of funding

Small Business Finance:-

Although some entrepreneurs are well versed in determining their need for capital and
knowing where to find it, the failure of many businesses can be traced to undercapitalization,
not having the funds available to get started and carry you through until your
business starts to produce a positive cash flow.

However, every small business owner should understand how to define the amount of funding
required to efficiently operate his business.
Furthermore, the ability to be a proactive manager of the financial aspects
of a business is of paramount importance when the economy takes a downturn.

Initial Capital Requirements:-

The fundamental financial building blocks for an entrepreneur are recognizing:-

1) what assets are required to open the business.

2) what expenses will be required.
3) which expenses cannot be changed and must be paid, called fixed costs.
4) knowing how these costs will be financed.
Defining Required Assets:-

Every business needs a set of short-term and long-term assets in place before the business
ever opens its doors.

Typical short-term assets include cash and inventory but may also
include prepaid expenses (such as rent or insurance paid in advance) and a working capital
(cash) reserve.

The most common long-term assets are buildings and equipment, but these assets
may also include land, leasehold improvements, patents, and a host of other items.

short-term assets:- long-term assets:-

Assets that will be Assets that will not be
converted into cash converted into cash
within one year. within one year.

“Each business must have its assets in place—cash, inventory, patents, equipment,
buildings,whatever it needs to operate—before it ever opens its doors.”

The Five “Cs” of Credit:-

When an entrepreneur decides to seek external financing, she must be able to prove
creditworthiness to potential providers of funds. A traditional guideline used by many
lenders is the five “Cs” of credit, where each “C” represents a critical qualifying element:-

1. Capacity. Capacity refers to the applicant’s ability to repay the loan. It is usually estimated
by examining the amount of cash and marketable securities available, and
both historical and projected cash flows of the business. The amount of debt you already
have will also be considered.

2. Capital. Capital is a function of the applicant’s personal financial strength. The net
worth of a business—the value of its assets minus the value of its liabilities—
determines its capital. The bank wants to know what you own outside of the business
that might be an alternate repayment source.
3. Collateral. Assets owned by the applicant that can be pledged as security for the repayment
of the loan constitute collateral. If the loan is not repaid, the lender can
confiscate the pledged assets. The value of collateral is not based on the assets’ market
value, but rather is discounted to take into account the value that would be received
if the assets had to be liquidated, which is frequently significantly less than
market value .

4. Character. The applicant’s character is considered important in that it indicates his

apparent willingness to repay the loan. Character is judged primarily on the basisof the
applicant’s past repayment patterns, but lenders may consider other factors,
such as marital status, home ownership, and military service when attributing
character to an applicant. The lender’s prior experience with applicant repayment
patterns affects its choice of factors in evaluating the character of a new applicant.

5. Conditions. The general economic climate at the time of the loan application may
affect the applicant’s ability to repay the loan. Lenders are usually more reluctant to
extend credit in times of economic recession or business downturns.

Additional Considerations:-

Potential investors will want to know more about you and your business than just the
“five ‘Cs’.” For start-ups, simply having a good idea will not be enough to convince
many investors to risk their capital in your business. “You will need to show that you are a
competent manager with a track record of prior business success.”

Basic Financial Vocabulary:-

Before an entrepreneur can begin looking for sources of funds, she needs to understand
the terminology associated with the two basic types of funds, debt and equity.

Debt funds :-(also known as liabilities) are borrowed from a creditor and, of course, must be
repaid. Using debt to finance a business creates leverage, which is money you can borrow
against the money you already have .
leverage:-
The goal in using leverage is to:-
put in a little money and get back a lot more. Leverage can enable you to greatly increase
the potential returns expected as you invest your equity in the business. Increased leverage
also increases risk.
Equity funds:- by contrast, are supplied by investors in exchange for an ownership
position in the business.

-Providers of equity funds forgo the opportunity to receive periodic repayments in hopes of later
sharing in the profits of the business.
-As a result, equity financing does not create a constraint on the cash flows of the business.
debt financing :-The use of borrowed funds to finance a business.

 Debt Financing Three important parameters associated with debt financing

are the amount of principal to be borrowed, the loan’s interest rate, and the
loan’s length of maturity.
 Together they determine the size and extent of your obligation to the creditor.
 Until the debt is repaid, the creditor has a legal claim on a portion of the
business’s cash flows

Principal :-An amount of money borrowed from a lender.

 The principal of the loan is the original amount of money to be
borrowed.
 Minimizing the size of the loan will reduce your leverage and your
financial risk.

interest rate :-

The amount of money paid for the use of borrowed funds.

The interest rate of the loan determines the “price” of the borrowed funds. In most
cases it will be based on the current prime rate of interest. In the past, the prime rate was
defined as the rate of interest banks charge their “best” customers—those with the lowest
risk.

-Interest rates for small business loans are normally the prime rate plus some
additional percentage points.
For example:- if the prime rate is 8.5 percent, a bank might
offer small business loans at “prime plus four,” or 12.5 percent. Additional factors, such
as default risk and maturity, will also affect the cost of a loan.

-The actual rate of interest the borrower will pay on a loan is called the effective rate
of interest.
 the lender may require a compensating balance, meaning that the borrower is required to keep a
minimum dollar balance (often as much as 10 percent of the principal) on deposit with

-This requirement reduces the amount of funds accessible to the borrower and
increases the actual rate of interest because over the life of the loan, the borrower pays
the same amount of interest dollars but has fewer funds available.
-Compounding refers to the intervals at which you pay interest. Lenders may compound
interest annually, semiannually, quarterly, monthly, weekly, daily, or even continuously.

Whether a loan has a fixed rate or a variable rate of interest affects its ultimate cost.
 fixed-rate loan :-A loan whose interest rate remains constant.
 variable-rate loan:- A loan whose interest rate changes over the life of the loan.
Maturity:-The length of time in which a loan must be repaid.
 A short-term loan must be repaid within one year.
 an intermediate-term loan must be repaid within one to ten years.
 long-term loan must be repaid within ten or more years.

Equity financing: - The sale of common stock or the use of retained earnings to provide long-
term financing.
-Equity Financing As stated earlier, equity financing does not have to be repaid. There
are no payments to constrain the cash flow of the business. There is no interest to be
paid on the funds. Providers of equity capital wind up owning a portion of the business
and are generally interested in:-
(1) getting dividends,
(2) benefiting from the increased value of the business (and thus their investment in it), and
(3) having a voice in the management of the business.

Dividends:- Payments based on the net profits of the business and made to the providers of
equity capital.
- Dividends are payments based on the net profits of the business and made to the
providers of equity capital. These payments often are made on either a quarterly, a semiannual,
or an annual basis.

Other Loan Terminology

Two additional sets of terms that you will often encounter while searching for financing
relate to loan security and loan restrictions. These terms can be of great importance and
should be thoroughly understood.
loan security:- Assurance to a lender that a loan will be repaid.
 Loan Security Loan security refers to the borrower’s assurance to lenders that loans will
be repaid.
-If the entrepreneur’s signature on a loan is not considered sufficient security by
a lender, the lender will require another signature to guarantee the loan. Other individuals
whose signatures appear on the loan are known as endorsers. Endorsers are contingently
liable for the notes they sign. Two types of endorsers are comakers and guarantors.
Comakers create a joint liability with the borrower. The lender can collect from either
the maker (original borrower) or the comaker. Guarantors ensure the repayment of a note
by signing a guarantee commitment. Both private and government lenders often require
guarantees from officers of corporations to ensure continuity of effective management.
Loan Restrictions:- Sometimes called covenants, loan restrictions spell out what the
borrower
cannot do (negative covenants) or what she must do (positive covenants). These
restrictions are built into each loan agreement and are generally negotiable—as long as you are
aware of them.

How Can You Find Capital?

Once you determine how much capital is needed for the start-up or expansion, you are
ready to begin looking for capital sources. To prepare for this search, you need to be
aware of what these sources will want to know about you and your business before
they are willing to entrust their funds to you. You also need to understand the characteristics
of each capital source and the process for obtaining funds from it.

So further more you can get a capital for two main reason:-
1. Loan Application Process.
2. Sources of Debt Financing. The wide array of credit options available confuses many
entrepreneurs. A thorough understanding of the nature and characteristics of these debt
sources will help ensure that you are successful in obtaining financing from the most
favorable source for you.
Sources of debt financing include:-
 Commercial Banks:- these kind of banks provides two types of loan.
A. Short term loans (unsecured loans )
Most short-term loans are unsecured loans, meaning that the bank does not require any collateral as long as the
entrepreneur has a good credit standing. These loans are often self-liquidating,
which means that the loan will be repaid directly with the revenuesgenerated from the original purpose of the loan. -
-Types of short-term loans include lines of credit, demand notes, and floor planning.
B. Long-term loans .

 A line of credit is an agreement between a bank and a business that specifies the
amount of unsecured short-term funds the bank will make available to a business.
 demand note A short-term loan that must be repaid (both principal and interest) in a
lump sum at maturity.
 installment loans A loan made to a business for the purchase of fixed assets such as
equipment and real estate.
 balloon notes A loan that requires the borrower to make small monthly payments
(usually enough to cover the interest), with the balance of the loan due at maturity.
 unsecured term loans A loan made to an established business that has demonstrated
a strong overall credit profile.
 Commercial Finance Companies:- Commercial finance companies extend
short- and intermediate-term credit to firms that cannot easily obtain credit
elsewhere. Because these companies are willing to take a bigger risk than
commercial banks, their interest rates are often considerably higher.
 Among the most common types of loans provided by commercial finance companies are
floor planning, leasing, and factoring accounts receivable.
floor planning:- A type of business loan generally made for “bigticket” items. The business
holds the item in inventory and pays interest, but it is actually owned by the lender until the item
is sold.
 Floor planning:- is a special type of loan used particularly for financing high-
priced inventory items, such as new automobiles, trucks, recreational vehicles,
and boats.
Secured loan :- A loan that requires collateral as security for the lender.
Factoring :-The practice of raising funds for a business through the sale of accounts
receivable.

Insurance Companies:- For some entrepreneurs, life insurance companies have become
a principal source of debt financing.
policy loans:- A loan made to a business by an insurance company, using the business’s
insurance policy as collateral.

Federal Loan Programs:- Government lending programs exist to stimulate economic

activity.
SBA loan :-A loan made to a small business through a commercial bank, of which a portion is
guaranteed by the Small Business Administration.
 SBA loan programs include the 7(a) loan guaranty program, the Microloan
Program, the Small Business Investment Company program, and the 504 loan
program.
certified development company :- A nonprofit organization sponsored either by private
interests or by state or local governments.
SBA Express program:- A relatively new loan program available through the SBA that
simplifies the paperwork that has historically been required.

State and Local Government Lenders:- Many state and local governments lend money
to entrepreneurs through various programs.

Trade Credit The last major source of debt financing covered here is the use of trade
credit, or accounts payable.
 trade credit The purchase of goods from suppliers that do not demand payment
immediately.

What if a Lender Says “No”?

Not every deal gets approved. Not every loan package is accepted. When rejection happens
to you, get past the blow to your ego and try to learn what you did wrong.
When a lender says, “no,” do the following:

 Thank the lender for the time spent reviewing your package. Do not show
resentment.
Lenders almost always consider applications in a highly professional, objective
manner. If you remain professional yourself, you will improve the odds of
favorably impressing the lender when you return for future loans. Maintain the
relationship.
 Ask what specific information, or lack thereof, counted against you. Federal
regulations
require a lender to prepare a detailed explanation for its loan rejection. Talk
about the points cited, but don’t argue—you are trying to learn as much as you
possibly can. If you can make the changes suggested, ask when you can reapply.
 Ask the lender for specific, personal recommendations. Straight out ask for any
personal advice the lender may have.
 Give the bank a reason to make the loan. Make sure you know exactly what you
are asking for and the reason behind the request. Be prepared to tell your story
effectively.17
 Understand that business loans are generally turned down for one (or more) of
four main reasons: a poor credit score, lack of collateral, uncertainty of cash flow,
and/or a poorly written business plan.
Ask whether the bank can rework your application so that it meets the lending
criteria This effort may require substantial changes in your business structure or adding
personal collateral.

Sources of Equity Financing:-

From our discussion of debt financing, you know that lenders will expect entrepreneurs to
provide their own funds—equity funds—in the amount of at least 20 percent, and possibly
50 percent or more, before approving a loan. The higher the risk assumed by the lender,
the more of your own money you must put into the business. The most common sources
of equity financing are personal funds, family and friends, partners, venture capital firms,
small business investment companies.

Personal Funds:- Most new businesses are originally financed with their creators’ funds.
The Department of Commerce estimates that nearly two-thirds of all start-ups are begun
without borrowed funds. (SBICs), angels, and various forms of stock offerings.

-The first place most entrepreneurs find equity capital is in their personal assets.

Family and Friends:- The National Federation of Independent Business reported a 2010
survey that stated that more than one-third of new businesses are at least partially
funded by the family and friends of the entrepreneurs.
Partners:- Acquiring one or more partners is another way to secure equity capital
(seeChapter2).
“Partners may play an active role in the venture’s operation or may choose to be ‘silent,’
providing funds only in exchange for an equity position.”

Venture Capital Firms:- Venture capital firms are groups of individuals or companies
that invest significant amount of dollars in new or expanding firms.
Most venture capital firms have investment policies that outline their preferences relative
to industry, geographic location, investment size, and investment maturity.

Small Business Investment Companies:- Small business investment companies (SBICs)

are venture capital firms licensed by the SBA to invest in small businesses.
In 1969, the SBA, in cooperation with the Department of Commerce, created minority enterprise
small business investment companies (MESBICs) to provide equity financing to
minority entrepreneurs.
 Angel:- A lender, usually a successful entrepreneur, who loans money to help new
businesses.
 Angel:-An angel is a wealthy, experienced individual who has a desire to assist start-up
or emerging businesses, frequently in companies in their communities.

“Since most angels are entrepreneurs themselves, they have ‘been there’ and can spot
someone who doesn’t know their business inside and out.”

-Finding an angel investor is not easy. The best ways for an entrepreneur to locate
one are to maintain business contacts with tax attorneys, bankers, and accountants in
the closest metropolitan area and to ask for an introduction. Networking can be key.

Mergers and Acquisitions (M&A):- Merging with a company flush with cash can
provide a viable source of capital. Such transactions may trigger many legal, structural, and tax
issues, however, that you must then work out with your accountant and lawyer.

Stock Offerings:- Selling company stock is another route for obtaining equity financing.
The entrepreneur must consider this decision very carefully, however.

Private Placements:- A private placement involves the sale of stock to a selected group of
individuals. This stock cannot be purchased by the general public.

Public Offerings:- A public offering involves the sale of stock to the general public. These
sales always are governed by Securities and Exchange Commission regulations.
 The first time a company offers its stock to the general public is called an initial
public offering (IPO).
-To be a viable candidate for an IPO, a company must be in good financial health and be able to
attract an underwriter (typically a stock brokerage firm or investment banker) to help sell the
stock offering.
There are three main reasons companies choose public offerings:

1. When market conditions are favorable, more funds can be raised through public offerings
than through other venture capital methods, without imposing the repayment burdens of debt.
2. Having an established public price for the company’s stock enhances its image.
3. The owner’s wealth can be magnified greatly when owner-held shares are subsequently
sold in the market.

# One critical caution about public stock offerings is that they require companies to
make financial disclosures to the public. If a company fails to live up to its self-reported
expectations, shareholders can sue the company, charging that the company withheld or
misrepresented important information.

Choosing a Lender or Investor

A key decision facing entrepreneurs is determining which sources of financing to pursue.
Your choice will often be limited by the degree to which you meet the requirements of
each lending or investing source.

Usually the foremost criterion will be finding the lowest cost or interest
rate available. However other important lender-selection considerations are:

1. Size. The lender should be small enough to consider the entrepreneur an important
customer, but large enough to service the entrepreneur’s future needs.
2. Desire. The lender should exhibit a desire to work with start-up and emerging businesses,
rather than considering them too risky.
3. Approach to problems. The lender should be supportive of small businesses facing
problems, offering constructive advice and financing alternatives.
4. Industry experience. The lender should have experience in the entrepreneur’s industry,
especially with start-up or emerging ventures.

“Although the use of funds obtained from family members, friends, or partners is perhaps
conceivable, none of these sources may be acceptable or feasible for personal reasons.”
Entrepreneurial guru Jeffry A. Timmons offers a few more cautions when choosing
an investor. Each of the following “sand traps,” he says, imposes a responsibility on the
entrepreneur:

1. Strategic circumference. A fundraising decision can affect future financing choices.

Raising equity capital may reduce your freedom to choose additional financing
sources in the future, due to the partial loss of ownership control that accompanies
equity financing.
2. Legal circumference. Financing deals can place unwanted limitations and constraints
on the unwary entrepreneur. It is imperative to read and understand the details of
each financing document. Competent legal representation is recommended.
3. Opportunity cost. Entrepreneurs often overlook the time, effort, and creative energy
required to locate and secure financing. A long search can exhaust the entrepreneur’s
personal funds before the business ever gets off the ground.
4. Attraction to status and size. Many entrepreneurs seek financing from the most
prestigious and high-profile firms. Often a better fit is found with lesser-known firms
that have firsthand experience with the type of business the entrepreneur is starting.
5. Being too anxious. If the entrepreneur has a sound business plan, more than one
venture capital firm may be interested in investing in it. By accepting the first offer,
the entrepreneur could overlook a better deal from another source.

“Although the use of funds obtained from family members, friends, or partners is perhaps
conceivable, none of these sources may be acceptable or feasible for personal reasons.”

 Clearly, choosing a lender or investor takes time and patience. The process is similar
to finding a spouse.

The end