Entrepreneurship Chapter 8 Financing Strategy Debt or Equity

Financing: The Use and Manipulation of Money used to start a business is called capital. There are 2 ways to obtain capital to finance a business: 1. Borrow money (debt) 2. Sell a share of the business (equity) Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

Sources of Capital n n n Family and friends (equity or debt) Accounts payable (debt) Angels (equity) Banks, credit unions (debt) Minority financing sources (equity or debt) Small Business Investment Companies (SBICS —debt) Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

How Often Do Small Firms Fail? n n n Myth: 4 out of 5 small businesses fail in the first 5 years of operation. Truth: over half of new small firms survive for 8 or more years. (according to Dun & Bradstreet study) A small business is a high risk-high return investment. Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

3 Categories of Financial Investment 1. 2. 3. Stocks—shares of companies (equity) Bonds—loans to companies or government entities (debt) Cash—investments that can be liquidated (turned into cash) within 24 hours (savings accounts, treasury bills) The higher the reward an investment offers, the greater the risk. There is no such thing as a low risk/high return investment!! Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

Compound Interest: Money Making Money A compound rate of return is calculated on not just the original investment but also on interest that has been earned by the investment. n n $100 invested at 10% per year (not compounded) earns $10 per year. In 10 years you’ll have $200. $100 invested at a compound rate of 10% earns $110 the first year ($100 + $10 interest), $121 the second year ($110 + $11 interest), etc. In 10 years you’ll have $259. 37. Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

Future Value of $1 After “N” Periods Marriotti: Entrepreneurship © 2007 Pearson Education. Upper

The Present Value of Money Rule of thumb: You always want your money now. n If you can’t have it now, you want to be compensated with a return. n There are 3 risks to your money when you lend or invest it: 1. 2. 3. Inflation—if prices rise, your money will be worth less when it comes back to you. Risk of loss—if the investment fails, you will lose your money. Opportunity—you might find a better investment. Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

Net Present Value Chart Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ,

How Can You Compensate Investors in Your Business? 1. Debt—Borrow money and promise to pay it back over a set period of time at a set rate of interest. Investor receives interest. 2. Equity—Sell a percentage (share) of ownership in your business for money. Investor receives share of profits. Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

Business Legal Structures 1. Sole Proprietorship n n Owned by one person May offer investors debt or equity 2. Partnership n n Marriotti: Entrepreneurship Owned by 2 or more people May offer investors debt or equity © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

Business Legal Structures (cont. ) 3. Corporation n n Legal “person” composed of equity investors in company. May sell stock (equity) or bonds (debt) 4. Nonprofit Corporation/501 (c) (3) n n Marriotti: Entrepreneurship Financed by donations; may not sell debt or equity Tax exempt © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

Business Legal Structures (cont. ) 5. Cooperative n n Marriotti: Entrepreneurship Owned by customer/members All customer/members own shares of company but each has one vote © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

Debt Financing: Pros and Cons Pros: n Lender has no say in operation of business n Loan payments are predictable n Lenders do not share business profits Cons: n If loan payments are not made, lender can force business into bankruptcy n If business is not incorporated and defaults, lender can take house and other possessions of owner n Loan payments increase fixed costs, lower profit Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

Equity Financing: Pros and Cons Pros: n If business does not make profit, investor does not get paid n Equity investors want business to succeed, will share contacts and advice Cons: n Entrepreneur can lose control of business to equity investors n Equity investor takes more risk, wants higher return n Entrepreneur must share profits with equity investors Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

6 “Cs” of Bank Borrowing 1. 2. 3. 4. 5. 6. Collateral—does entrepreneur own property, cars, etc. that bank can take if loan is not paid? Cash Flow—do projected cash flow statements show business will be able to make loan payments? Credit History—does entrepreneur have good credit? Capacity—what are business’s expense? Can it afford to pay the loan? Commitment—how much of own money has entrepreneur invested? Conditions—general economic climate Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

Establish Good Credit n n n “No credit” is not “good credit. ” Prove you can make regular payments on a debt. Open a charge account, charge some purchases and pay them off on time. Check your credit reports every 6 months to make sure they are accurate. Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

Creative Financing Micro-Loan financing: n $100–$25, 000, supported by federal government n Loan made based not on 6 Cs but on entrepreneur’s character and business plan Line of credit: n Pre-arranged loan business owner can draw on when needed n Short-term (under one year)—must be paid in full during the year Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

More Creative Financing Angel Financing: n Private investors seeking equity n Typically $100, 000–$500, 00 range Minority Financing: n MESBICs: charted by Small Business Administration to support minority business n MBDC: Minority Business Development Centers MBDA. gov Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

More Creative Financing Bootstrap Financing: n Hire as few employees as possible. n Lease rather than buy equipment. n Use personal savings. n Work from home, borrow office space (business incubators). n Put profits back into business. Floating Accounts Payable: n Float—time between a payment is due and cash is received by creditor. n Accounts Payable—money a business owes its suppliers. n Negotiate with suppliers for best possible terms. Try to get more time to pay bills. Marriotti: Entrepreneurship © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.

You Need a Business Plan to Raise Capital Investors will not see an entrepreneur who does not have a business plan. n Business plan should include: n Business idea n Long and short-term goals n Market research n Marketing plan n Start-up and fixed operating costs n Management n Legal structure Marriotti: Entrepreneurship § § § § Time management plan Financing Breakeven analysis Accounting system Projected monthly income statement Projected yearly income statement Financial ratio analysis Balance sheet © 2007 Pearson Education. Upper Saddle River, NJ, 07458. All Rights Reserved.