EXTERNAL SOURCES OF FUNDS
This page deals in brief form with external sources of finance. In getting to the right source for your particular needs, you will want to check out several of the sources listed. But, besides being equipped with your various financial statements, there are one or two points to bear in mind.
Just as you are in business to make money, so are commercial lenders. Lending organizations which are government sponsored may be in business for slightly different reasons. As a matter of public policy, government lenders may be set up to help the firm which cannot get regular financing, or only on prohibitive terms. Moreover, the location and kind of business are important as many companies are assisted who can be seen to bring significant economic benefit to an area.
Wherever you go for financial help, you must be prepared to learn their language and familiarize yourself with the common terms used in banking and financial practice. At the same time, you should be able to outline your requirements in terms that can be understood by the lender so he/she can translate your needs into the appropriate financial plan.
Two factors are all important you must be able to show that a reasonable portion of your own money is being risked in your own business, and you must demonstrate a feasible repayment plan. This shows confidence and is a guarantee that your full efforts will be devoted to its success. Finally, approach financial agencies after you have explored every avenue of your own business (actual projected) for earnings and savings, and can demonstrate that fact.
EQUITY FINANCING
Equity is money that is put into business other than from outside loans. The most obvious source of equity financing is the individual starting the business. The equity many come from personal savings, securities, relatives, or the sale of real state, but it is put up by the individual or persons who will have ownership of the business.
Many people have the mistaken impression that financial situations, or government agencies, will provide all or most of the basic capital required for a business venture. In fact, the entrepreneur himself must assume the bulk of the risk and does so by committing his fund o the business. The amount of equity investment required varies widely, depending upon the kind of business, experience of the owners, current economic prospect etc.
In most states there are a number of different form of business organizations which influence the way equity is put into business.
The simplest type of business organization is a sole proprietorship. In a sole proprietorship, the owner supplies the money necessary to fund the business. He/she may have to find or more partners willing to put money into the ventures. Obtaining a partner means that the ownership will be shared as well as the liabilities. In a partnership, each partner can be help personally responsible for obligations place on behalf of the business by other partners.
Sometimes the partner is “silent” which means he/she will help supply the capital while you supply the “know how” there should be a word of caution here: you should be careful in choosing business partner. Many partnerships fail because the partner cannot get along. When entering into a partnership, a written agreement should be drawn up between the partners to protect their individual interests.
There is a special legal arrangement whereby a person may contribute financially but cannot be engaged in conducting the affairs of the partnership. This called a “limited partnership”.
A limited partner is normally only liable to the firm or its creditors to the extent of the partnership. To remain a limited partner, a person must take no part in the management of the firm, nor many he/she act on behalf of the company, or he/she becomes a general partner.
The taxation and liability position of a “partners” is complicated. If you are in a position where you have to form a partnership, you should perhaps go on to the next stage, incorporating.
This final form is called a limited company (corporation). In a corporation, ownership is shared, generally in proportion to the amount of money each person invests.
In attempting to attract partners or other equity investors, ewer ad smaller businesses must be able to demonstrate profitability of the venture. Investors can obtain returns exceeding 8% with relatively safe investment in mortgages and bonds. Therefore, in order to invest in your enterprise, which probably carries a greater degree of risk than mortgages, the business must promise better financial returns, investors must be convinced that the payoff will be attractive and the risks minimal. One methods of doing this is with a well documented business plan as given in the chapter of financial planning in this handbook.
Going Public
It is possible to obtain equity financing by offering shared in the business for sale to the general public. The procedure to do so is quite complicated and expensive, and is really not an alternative for the ordinary small entrepreneur. If more information on this method of financing is required, one should contact a lawyer or an established investment dealer.
Venture Capital
There are some firms which will supply money to a fledging business in return for equity participation (part ownership). They are known as venture capital firms. It must be remembered that such firms are hard nosed ad professional, and are interested only if they see an opportunity to make profits for themselves.
DEBT FINANCING
Most of firms borrow money to transact their affairs. There are a number of sources that will lend money to businesses in Manitoba including banks, credit unions and government (see Appendix B, Sources of Business Finance). Entrepreneurs should attempt to familiarize themselves with the lender’s requirements and determine which type of borrowing is most suitable for their business.
One cardinal rule of finance should be observed: that is, long term use of funds should be supplied from long term sources of funds. In other words, avoid imbalance in financing. Long term debt financing should not be used for short term working capital and, conversely, working capital should not be used to finance long term fixed assets.
Fixed Assets Financing
It is useful to think of business credit as being divided into two categories, one concerned with medium and long term credit of more than one year, and the other with short-term credit of one year or less. The fixed assets of business, i.e. those having a life of more than one year, are ordinarily financed from equity capital contributed by the owner or by medium or long term loans having a duration related to the expected life of the assets.
One method of obtaining fixed assets financing is to negotiate a “term loan”. A term loan is a business loan which has a maturity of not less than one year and usually does not go beyond 10 years.
The security offered for repayment is normally a form of chattel mortgage against the equipment or other property being financed. The length of the repayment of schedule is generally related to the useful life of the assets. The lender will only give a percentage of the value of the assets being purchased. For example, a bank may lend up to 75% of the value of a truck to be repaired within five years, whereas the same bank may lend up to 80% for a building to be repaid within 10 years. The balance of the money owing for the assets would come from the equity contributed by the owner.
The advantage of a term loan is that the terms, including repayment schedules, can be negotiated between the lender and the borrower. The loan agreement is based upon the ability of the borrower to repay the loan out of earnings generally in installments. As long as the borrower complies with the terms of the loan, he has assurance that no payments other than regular installment will be required prior to the due date of the loan. There is the added advantage that the lender and barrower develop a relationship over a relatively long period of time and that the lender can be of assistance in advising on financial matters and perhaps be able to offer additional financial assistance.
When lending on a medium or long-term basis, credit institutions tend to place emphasis on the earning power of the business over a period of years and on its ability to repay the debt. The business owner must, therefore, convince the lenders that the business owner must, therefore, convince the lenders that the business is sound, preferably by the use of a business plan.
One of the more important indicators used by the lenders to demonstrate the soundness of the business financial position, is the debt equity ratio. For example, if your business owes $4,000 to others and you have only a $2,000 investment in the business, then your debt-to-equity ratio is 2:1. Some lenders interpret this ratio differently, but for new businesses it is unlikely that the lender with go beyond 2:1.
Another key indicator is the current ratio, the ratio of current assets to current debt. This is used as a measure of short-term solvency. For example, this is used as a measure of short-term solvency. For example, if your cash on hand and accounts receivable add up to $6,000 and your account s payable are only $2,000m then your current ratio is 3:1, which is favorable. This demonstrates to lenders that your cash position is sound.
If the loan is given to a small corporation, the lender may require your personal guarantee. In other words, you agree that if the company cannot repay the loan, you will. In fact, most banks require personal guarantees for loans made to small corporations
Conditional sales purchases
In many cases, manufacturers of new equipment will assist in financing the purchase of their equipment will assist in financing the purchase if their equipment through the use of conditional sales purchases. The manufacturer will take the purchaser’s note after a down payment of one quarter to one third of the purchase price. The ownership of the property under such an arrangement is retained by the seller until the buyer made all the required monthly or quarterly payments over the term of the contract.
Leasing
More and more businesses are using leasing as a means to finance the use of equipment without large capital expenditures. A company can acquire the use of equipment by merely committing itself to pay rentals without making substantial cash payment. The lease is usually written on the total costumer selling price and is drawn for a period of three to five years. The total amount to be paid is computed by adding finance charges to the total costumer selling price
Sale-leaseback arrangements have also become increasingly popular in recent years. By this method of financing, a company sells an asset to an insurance company or other institution and then immediately lease back, here again, the lessee obtains working capital and rental payments can, in most cases, be charged as an expense for the tax purposes. The sale leaseback arrangement makes it possible for the seller to borrow more money that he might have been able to if the business owner help encumbered property. Leases are generally medium term and the good credit standing of the lessee is important. For new businesses, leasing can be advantageous in that equity capital can remain intact for operating expenses.
Financing Working Capital
Obtaining sufficient working capital is frequently cited as one of the more difficult problems facing small business. Retail stores can be especially hard pressed in this regard. However, there are a number of methods by which operating money can be obtained through debt financing.
Line of Credits (Demand Loans)
A line of credit is provided by banks to support working capital required by the business. The bank will negotiate to lend up to a certain amount of money, providing certain terms and conditions are met. The bank can cancel the line at anytime it considers necessary (hence the name “demand loan”). However, it will not generally cancel without cause. A line of credit is extremely useful to a business.
The loan will go up and down as the business needs the money and interest is paid only on the amount outstanding. Generally, it is wise to avoid continuous operation at the upper end of the credit line. Bankers appreciate full use of an approved line of credit. They do not welcome either under or over utilization.
Character Loans
Character loans are given to individuals or companies with excellent credit ratings. They are generally unsecured loans made for the short term to be used for general purposes.
Commercial Loans
These are self-liquidating loans made for the short term (30 to 90 days). They are generally used for such things as seasonal financing for inventory purchases.
Accounts Receivable Financing
In accounts receivable financing, lenders make cash advances to borrowers using accounts receivable as security. There are two methods by which this is accomplished. In the first method, the borrower’s customers are asked to remit payment directly to the lender. This arrangement is generally not desirable as it could upset the relationship between the borrower and his costumers. In the second method, the borrower receives payment from his costumers and remits the total payment intact to the lender. The lender will release the borrower’s indebtedness and return any excess payments after deducting finance charges.
With accounts receivable financing, the borrower is able to secure a continuous source of operating cash without entering into long-term financing arrangements. The relationship with the finance company can develop into a continual arrangement whereby up to 80% of the assigned accounts can be financed. It is important to recognize, however, that the borrower is still responsible for collecting the account receivable.
Factoring
Factors are companies involved in purchasing outright the accounts receivable of their clients. It usually means a continuous agreement whereby the factor is responsible for granting credit to the business customers, performing the accounts receivable bookkeeping and collecting the accounts in the other words, the factor assumes all risk in regard to granting credit and collections. Generally cash is made available to the client on the collection date of the goods sold.
To do business with a factor, the volume of business must be sizeable (about $250,000). The prospective client should sell on normal credit terms and the majority of its customers should have good credit ratings.
Factoring companies generally service manufacturers and wholesalers engaged in the production and selling of items for which there is continuing or repeat business. See your yellow pages under “factors”.
Inventory Financing
For some establishment firms, inventory will be financed by banks or commercial finance companies up to 75% of the value both raw materials, work in progress and finished goods. Section 88 of the Bank Act in Canada enables chartered bank operating under the Bank Act to lend against security consisting of products of the mine, forest or stream. However, in most cases of inventory financing, good rapport has been established over a period of time between the lender and the borrower. For new business, inventory financing can be difficult to obtain.
FEDERAL AND PROVINCIAL PROGRAMS
The Federal and the Provincial Governments of most countries offer a number of assistance program, if the business can qualify. Next: Approaching a Lender.
SOURCES OF BUSINESS FINANCE
With particular attention to the needs of small business
| Where you should go | What other have found |
what they will lend your money for |
| They make loans for | ||
| Banks | - they assess management ability and the viability of business - you have to invest some of your own money - Money usually has to be paid back within a specified term - Slightly higher interest rate than for big business - They will want security – either mortgage on property or equipment line, or personal guarantees |
- equipment - real estate - operating capital |
| Leasing Companies | ||
(you can find them in thePhonebook |
- Good for financing building and equipment for varying number of years - At the end of the time the business may |
Main purpose is the finance by leasing buildings or equipment |
| Credit Unions | ||
| - You must be a member of the credit union to get a loan - Short and long-term loans, flexible Terms - Usually require some of your own money invested in the company |
They provide for - real estate - equipment - operating capital |
|
Federal Business Development Bank or similar (FBDB) |
- Covers both establishment as well as new business - Usually lend to business which can’t get financing from chartered banks - will require either a mortgage or pledge on equipment - May taken an equity position - Will package business proposals for a fee - Provide ‘matchmaking’ (investors and Investment opportunities) |
They lend money for - real estate - operating capital - change ownership - equipment |
| Government Business Services | - Program for Export Market Development - Promotes international trade & industry development through the provision of business and trade intelligence -Expands scientific, technological, managerial and production base |
- Support sector competitiveness initiative and provide business information and development services |