Section 4

From the Business Plan

to Funding the Venture

Chapter 11
Sources of Capital

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 Debt or Equity Financing
Evaluate financing from perspective of debt versus equity, and
then whether to use internal or external funds.
• Debt financing involves an interest-bearing loan, with payment
indirectly related to sales and profits – requires collateral.
• Short-term financing provides working capital and long-term debt may be
used to purchase an asset, using the asset as collateral.
• Called leveraging the firm – more leverage equals more risk.
• Equity financing requires no collateral and offers investors some form
of ownership – the investor shares in the profits.

Key factors in choosing include availability of funds, assets of the

venture, and interest rates.
• Usually a combination of financing is used.

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 Internal or External Funds
Internally generated funds are the most frequently used.
• In the startup years, profits are plowed back into the venture.
• Assets, whenever possible, should be rented, not owned.
• Extended payments from suppliers is one short-term source of funds.
• Another is collecting accounts receivable quicker.

Evaluate external fund sources by:

• The length of time the funds are available.
• Costs involved.
• The terms of the contract.

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 Self (Personal Funds)
Few new ventures begin without personal funds.
• Least expensive in terms of cost and control.
• They are essential in attracting outside funding.
• Often referred to as blood equity, sources include savings, life
insurance, or mortgage on a house or car.

Outside investors want financial commitment.

• The percentage of available total assets committed to the venture
demonstrates commitment level.
• Outside investors want all available assets committed.

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 Family and Friends
Family and friends provide a small amount of equity funding.
• The amount may be small but it is relatively easy to obtain.
• It is a form of equity funding and there is now an ownership position.

To avoid problems, present the positive and negative aspects and

nature of the risks of the investment.
• Keep arrangements strictly business – put it in writing.
• Any loan should specify interest rate and payment schedule.
• Family members and friends investing in the venture should receive
regular financial statements.

Carefully consider the impact before accepting funds.

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 Commercial Banks
When collateral is available, banks can provide short-term funds.
• Collateral can be business assets, personal assets or cosigner’s assets.

The asset base for loans is usually accounts receivable, inventory,

equipment, or real estate.
• A bank can finance up to 80% of the value of accounts receivable or
use a factoring agreement.
• Finished goods inventory can be financed up to 50% of its value and
some retailers, such as auto dealers, use trust receipts.
• Equipment loans are for 3-5 years for the purchase of new or used
equipment, sale-leaseback financing, or lease financing.
• Real estate loans are easily obtained for up to 75% of its value.

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 Cash Flow Financing
Cash flow financing, or conventional bank loans, include:
• Lines of credit are popular and ventures pay a commitment fee to
ensure the bank will make the loan when requested.
• Installment loans are possible with previous sales and profits.
• Straight commercial loans are advanced for 30-90 days – used for
seasonal financing.
• Long-term loans (up to 10 years) are for strong, mature companies.
• Where there are no business assets, a character loan is an option.

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 Bank Lending Decisions
Banks are very cautious in lending money to new ventures.
• Loan officers and loan committees review the borrower and the
venture.
• Decisions are both quantifiable and subjective.

Lending decisions are made according to the five C’s of lending.

• Character, capacity, capital, collateral, and conditions.

The loan application format is generally a “mini” business plan.

• This provides information on how the venture will repay the loan.

With satisfactory interest rates and terms, borrow the maximum

that can be repaid.
• Evaluate several banks to find the most favorable terms.

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 Role of the SBA in Small Business Financing
When unable to secure a commercial bank loan, an alternative is
a guaranty loan from the Small Business Administration (SBA).
• The Basic 7(a) Loan Guaranty is the SBA’s primary program.
• Repayment ability from cash flow is essential to obtain this loan.

The SBA guarantees 85% of loans up to$150,000, and 75% of

loans above that.
• SBA Express loans have a maximum guarantee of 50% and export
working capital loans guarantee 90%.
• The 504 loan program provides funds to buy machinery, equipment, or
real estate.
• The SBA Microloan provides short-term loans up to $50,000.
• Other loan types are available through the SBA.

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 R&D Limited Partnerships
A typical R&D partnership is between a company developing the
technology and funded by a limited partnership of investors.
• Research and development limited partnerships are good when the
project involves a high degree of risk and significant expense.

Three major components are the contract, the sponsoring

company, and the limited partnership.
• The contract specifies the agreement.
• The limited partners have limited liability and any tax benefits of losses
in the early stages are passed on to the partners.
• The sponsoring company acts as the general partner.

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 R&D Limited Partnership Procedure
In the funding stage, a contract is established and money invested.

The actual research is performed in the development stage.

If the technology is successfully developed, the exit stage begins.

• In a typical equity partnership, the sponsoring company and limited
partners form a new jointly owned corporation.
• An alternative is to incorporate the R&D partnership itself and either
merge it into the sponsoring company or continue as a new entity.
• A third exit strategy is a royalty partnership where a royalty based on the
sale of the products is paid by the company to the limited partners.
• The company and limited partners may form a joint venture to
manufacture and market the product.

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 Benefits and Costs of a R&D Limited Partnership
Benefits.
• Provides needed funds, minimum equity dilution and reduced risks.
• Strengthens financial statements of sponsoring company through
attraction of outside capital.

Costs.
• Requires considerable time and money – a minimum of six months and
$50,000 in professional fees.
• Most R&D limited partnerships are unsuccessful.
• Restrictions placed on the technology may be substantial.
• Exit from the partnership may be too complex and involve too much
fiduciary responsibility.

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 Government Grants
The Small Business Innovation Research (SBIR) grants program is
funded by the twelve federal agencies with a R&D budget.
• Each agency solicits for a topic and small businesses make proposals.

The SBIR grant program has three phases.

• Phase 1 awards up to $10,000 for 6-months of theoretical research.
• Phase 2 awards up to $750,000 for 24 months of further R&D.
• Phase 3 provides funds from the private sector or government
contracts to commercialize the developed technology.

Any patent rights or research data is owned by the company.

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 The Small Business Technology Transfer Program
The STTR program was established by the Small Business
Technology Transfer Act of 1992.
• Five federal agencies with budgets of $1 billion set aside 0.3% for small
businesses – DOD, DOE, DHHS, NASA, NSF.

The SBIR and the STTR programs differ in regulations.

• In the SBIR, the principal investigator must be employed by the
company, the STTR program has no such stipulation.
• The SBIR has a maximum of 33% in Phase 1 and 50% in Phase 2 in
consulting costs.

There are many other grants available at the federal, state, and
local levels across the country.

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 Private Financing
Private investors, also called angels, may be family and friends or
wealthy individuals.

Investors usually take an equity position and their degree of

involvement is an important consideration.

Public offerings involve time and expense, but a private offering

is faster and less costly with a limited number of investors.

These sophisticated investors still need access to material

information about the company.

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 Regulation D

Regulation D contains: Rule 504 –sell up to $500,000 to

• Provisions simplifying private unlimited investors in one year.
offerings.
• Definitions of what Rule 505 – sell $5 million of
constitutes a private offering. unregistered securities in a year.
• Specific operating rules. • May sell to 35 investors and
• Rule 504, 505, and 506. unlimited accredited investors.
• No public media advertising
Five copies of Form D must be allowed and no disclosure.
filed with the SEC.
Rule 506 – sell unlimited
The entrepreneur must prove securities to 35 investors and
they met requirements. unlimited accredited investors.

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 Bootstrap Financing
Outside capital has many costs.
• It takes time when a company can least afford it.
• It decreases the drive for profit and increases impulse to spend.
• It can decrease the company’s flexibility and hamper creativity.
• Emphasis on short-term can be at the expense of long-term success.

Bootstrap financing involves using any possible method for

obtaining and conserving cash.
• Can involve: delayed supplier payments; volume, promotional, or
customer discounts; “obsolescence money,” and bulk packaging.
• The only possible limitation of bootstrap financing is the imagination
of the entrepreneur.

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