Introduction
A small business is a business that is independently owned and operated, with a small number of employees (in USA less than 100). It has and relatively low volume of sales. They are generally privately owned corporations, partnerships, or sole proprietorships.
Small business financing is very critical component to its success. Financing should be done in a way that properly balances risk and the profitability of the business. Small business financing (long term and short term) constructs capital structure of the business.
There are several sources of financing available for small business. Main sources of financing are:
1. Boot-strap financing
2. Debt financing
3. Angel Investors
4. Equity Financing
5. Small Business Investment Companies (SBICs)
6. Venture Capital
7. Merger and Partnerships
8. Going public
Each method of financing has its pros and cons. One method which is suitable for some particular business may not be the right choice for some other business. When owner is not willing to dilute equity and it has no means for boot-strap financing, debt financing is the only option left for the business. Debt financing is preferred when owner is sure of the success of its business and he knows that he will be able to arrange the financing required for the business. He is also sure that he will be able to manage the business.
A small business with poor past record or no past record face difficulties in arranging loan from banks. Bankers are conservative in lending. Owner has to present his case strongly and convincingly before the banker to get loan. A good business plan or loan proposal is required to impress the lender.
Other than banks too there are many options for debt financing. One has to choose carefully which option is suitable for his business. A lower interest rate will always improve the cash flow. Tax shield on interest paid is one more reason why businesses prefer debt financing. But business owner should always be aware that with debt financing risk of business increases. With high debt business will find it difficult to arrange further financing and cost of debt will also go high. Also, owner should know what type of loan he needs- Short term loan (to finance working capital) or Long term loan to finance major business expenses such as purchasing real estate and facilities, construction, equipments and machineries, furniture etc.
Where would you suggest Andy look for the financing he needs for Custom Stitches?
Main advantage of debt financing is, lenders do not interfere in the management of the business. Lender is also not entitled for any profit made by the business. Moreover, interest payment is deducted as business expenses and so provides tax shield.
In case of small business, normally owners have unlimited liability. So, debt financing increases the risk. Also, when business is actually needing money, it has to pay interest (outgoing cash flow). If loan is taken from commercial banks, they require the business to pledge property as security of the loan. If business is slowing down and business is unable to pay loan, it has to surrender the security.
Andy’s business is growing fast and showing good profit. His business model has worked and profit made by the business is impressive. I would suggest Andy to look for debt financing as he will not have to share profit with anyone. His business is expected to register impressive growth and profit, so debt financing is preferred over equity financing.
Andy should identify the reasons for debt financing before borrowing money. Purchasing new equipment can improve productivity, increase quality, and lower operating expenses often takes more capital than a growing company can generate internally. Andy should prepare a good business plan/loan proposal to impress the lender to raise fund. By showing good business prospect and healthy cash flow, he can negotiate the interest rate. His business is having impressive track record, so he can impress the lender with his business plan. Custom Stitch is witnessing high growth. As Custom Stitches become more established, Andy can negotiate more favorable borrowing terms compared to their start-up days. Replacing high interest loans with loans carrying lower interest rates can improve cash flow significantly.
There are several sources of debt financing Andy can choose from:
A. Commercial Banks
B. Trade Credit
C. Equipment Suppliers
D. Commercial Financing Company
E. Savings and Loan Associations.
F. Stock Brokers
G. Insurance Companies
H. Small Business Investment Companies
I. Small Business lending Companies
According to the National Federation of Independent Business, 85 percent of loans to operating small businesses come from banks. Most common types of loans given by banks to small businesses are:
· working capital lines of credit,
· credit cards,
· short-term commercial loans (one to three years),
· longer-term commercial loans secured by real estate or other assets,
· equipment leasing and
· letters of credit for international trade
Before choosing the option, Andy should find the reason why he should need the fund. Then he should negotiate the terms of credit and interest rate. Not all banks will prefer to lend the small businesses at favorable terms. He should look for small business friendly banks to arrange financing.
Explain the advantages and disadvantages of using each source of funding you listed in question 1?
There are 9 sources stated in question-1 where Andy can try to get loan from. Advantages and disadvantages of getting loan from all these sources are as follows:
Commercial Bank- Commercial banks offer the greatest variety of loan. But they are conservative lenders. Typical short term bank loans in commercial loans. Other forms are Line of credit, discounting accounts receivable, inventory financing, and floor planning. A commercial bank will review the loan proposal thoroughly. So Andy has to prepare a good loan proposal. Commercial banks will be looking for healthy cash flow. Disadvantage is, commercial banks typically want property to be pledged as security of loan. If business does not generate good return and loan is nor repaid, business will lose its valuable assets pledged as security.
Trade Credit- This used extensively by the small business as a source of financing. Vendors and suppliers commonly finance sales to business for 30 to 90 days. Advantage is, trade credit loan comes cheaper. They are short term loans and can not be used to finance long term needs such as such as purchasing real estate and facilities, construction, equipments and machineries, furniture etc.
Equipment Suppliers- They offer small business financing similar to trade credit, but with slightly different forms. This is also a short term loan and can not be used to finance long term needs. Also, this form of credit can not take care of all fund requirements of the business.
Commercial Finance companies- They offer many of the same types of loans that bank does, but they are more risk oriented in their lending practices. Advantage is, getting loan from commercial finance companies is easier than getting loan from commercial banks. Disadvantage is, they charge higher interest.
Savings and Loan- They specialize in loans to purchase real property. It is good option to fund long term financing. Disadvantage is, not suitable for short term financing.
Stock Brokerage- They offer loans to prospective entrepreneurs at lower interest rates than bank because they have stocks and bonds in borrower’s portfolio. Disadvantage of getting loan from stock brokerage is, business has to pledge financial securities to get loan.
Insurance Companies- Provide financing through policy loans and mortgages loans. Here too, loan can be obtained against insurance policy and mortgage only.
Small Business Investment Companies- SBIC are privately owned companies licensed and regulated by the SBA that qualify to be invested in or loaned to small business. For small businesses, SBIC is a good option to raise fund from. They charge slightly higher interest.
Small Business Lending Companies- They makes only intermediate and long term loans guaranteed by the SBA. Disadvantage is, short term financing is not available.
Which sources of financing do you think would be most promising for Andy’s capital needs?
There is not a single source which can qualify for all needs. To fund long term debt requirements to purchase equipments and machineries, Equipment suppliers would be the most promising for Andy. Most equipment vendors encouraged business owners to purchase their equipment by offering to finance the purchase. Equipment vendors offer reasonable credit terms with only a modest down payment with the balance financed over the life of the equipment. Some cases the vendors will repurchase. To finance other long term debt requirements, Andy can approach commercial banks. Commercial banks offer loans at comparatively cheaper rate.
To finance short term debt requirements, first of all Andy should look for Trade credit as it comes at cheaper rate. If his company is having bonds, shares and other financial securities, Andy can approach stock brokers for loan. Any remaining fund requirement can be met by borrowing from commercial banks.
Conclusion
There are several sources available to finance small businesses. Business owner should be aware of the pros and cons of all sources. First he should decide whether he wants equity financing or debt financing. Usually, small businesses do not find many lenders (or if they find, it comes at higher interest rate) and so they opt for equity financing. Any business with good past record and future growth opportunity would like to opt for debt financing. There are several sources of debt financing available in the market. The business owner should explore all the options available and cost of debt from each source. Businesses can not always finance all its needs from single source. Different sources finance different types of requirements of the business. The business owner should first know for what kind of requirements he needs fund and then approach respective sources.
A short term debt requirement should be funded by trade credit, equipment supplier credit and from stock brokers against pledging financial security. They lend at cheaper rate. For long term debt requirements, owner should approach various bankers and negotiate the terms and conditions. If business is risky and no commercial banks are willing to lend, commercial finance companies can be approached who are willing to take more risk.
Reference:
1. http://www.economywatch.com/finance/small-business-finance.html http://www.smallbusinessnotes.com/financing.html http://www.forbes.com/2007/01/05/equity-debt-smallbusiness-ent-fin-cx_nl_0105nolofinancing.html
2. http://ezinearticles.com/?A-Plan-For-Financing-Your-Small-Business-With-Minimal-Debt&id=2099244