CHAPTER-11

SOURCES OF CAPITAL
LEARNING OBJECTIVES

1: To identify the types of financing available.

2: To understand the role of commercial banks in financing new ventures, the types of loans available,
and bank lending decisions.

3: Role of Government Agencies in Small-Business Financing.

I.AN OVERVIEW
A. For an entrepreneur, available financing needs to be considered from the perspective
of debt versus equity, using internal versus external funds.
B. Debt or Equity Financing
1. Debt financing involves an interest-bearing instrument, usually a loan, the
payment of which is only indirectly related to sales and profits.
a. Debt financing (also called asset-based financing) requires some asset be used
as collateral.
b. The entrepreneur has to pay back the amount of funds borrowed plus a fee,
expressed in terms of the interest rate.
c. Short-term financing is used to provide working capital—funds are usually
repaid from resulting sales and profits.
d. Long term debt (lasting more than a year) is frequently used to purchase some asset,
using part of the value of the asset as
collateral.
e. When interest rates are low, debt financing lets the entrepreneur retain a large
ownership position and have greater return on equity.
f. If the debt is too great, payments become difficult to make, growth will be
inhibited, and possibly end in bankruptcy.
2. Equity financing does not require collateral and offers the investor some form of
ownership position in the venture.
a. The investor shares in the profits of the venture.
b. Factors in choosing the desirable type of financing are availability of funds,
assets of the venture, and prevailing interest rates.
c. Usually a combination of debt and equity financing is used.
 3. In a market economy all ventures will have some equity, as all are owned by some
person or institution.
a. The equity may be entirely provided by the owner or may require multiple
owners.
b. This equity funding provides the basis for debt financing, which makes up the
capital structure of the venture.
C. Internal or External Funds
1. The most frequently employed type of funds are internally generated funds.
a. These funds come from sources within the company, such as profits, sale of
assets, reduction in working capital, extended payment terms, and accounts
receivable.
b. In the start-up years all the profits are usually plowed back into the venture.
c. Sometimes little-used assets can be sold or leased.
d. Assets, whenever possible, should be on a rental basis, not an ownership basis.
e. One short-term internal source of funds is reducing short-term assets, often
through extended payments from suppliers.
f. Another method is by collecting accounts receivable more quickly.
2. Other general sources are external to the venture.
a. Alternative sources should be evaluated by:
i. Length of time the funds are available.
ii. Costs involved.
iii. Amount of control lost.
b. Whenever an entrepreneur deals with items external to the firm, some ethical
dilemmas can occur.
II.PERSONAL FUNDS
A. Few new ventures are started without the personal funds of the entrepreneur.
1. Personal funds are the least expensive in terms of cost and control; they are also
essential in attracting outside funding.
2. Often referred to as blood equity, typical sources of personal funds include
savings, life insurance, or mortgage of a house or car.
B. Outside investors want the entrepreneur to demonstrate financial commitment.
1. This level of commitment is reflected in the percentage of total assets the
entrepreneur has available, that are committed to the venture.
2. An outside investor wants an entrepreneur to have committed all available assets.
 3. It is not the amount but the fact that all monies available are committed that makes
outside investors feel comfortable.

III.FAMILY AND FRIENDS

A. After the entrepreneur, family and friends are a common source of capital.
B. Family and friends provide a small amount of equity funding for new ventures.
1. It is relatively easy to obtain money from family and friends, but the amount of
money provided may be small.
2. If it is in the form of equity funding, the family member or friend has an
ownership position in the venture.
3. If they have direct input into operations of the venture, it may have a negative
effect on employees or profits.
4. They are not problem investors and are more patient than other investors in
desiring a return on their investment.
C. To avoid potential future problems, the entrepreneur must present the positive and
negative aspects and the nature of the risks of the investment.
1. To minimize any future problems, the entrepreneur should keep the business
arrangements strictly business.
2. Any loan should specify the rate of interest and the proposed repayment schedule
of interest and principal.
3. The entrepreneur should settle everything up front and in writing.
4. A formal agreement specifying details of the funding helps avoid future problems.
D. The entrepreneur should carefully consider the impact of the investment on the family
member or friend before it is accepted.
E. They should regularly receive income statements showing results every quarter
or at least every six months.

IV.COMMERCIAL BANKS
A. Commercial banks are the most frequently used source of short-term funds when
collateral is available.
1. This is debt financing and requires some tangible guaranty or collateral, some
asset with value.
2. This collateral can be business assets, personal assets, or the assets of the cosigner
of the note.
B. Types of Bank Loans
1. The asset base for loans is usually accounts receivable, inventory, equipment, or
real estate.
2. Accounts Receivable Loans
a. Accounts receivable provide a good basis for a loan, especially if the customer
base is creditworthy.
b. A bank may finance up to 80 percent of the value of the accounts receivable
for creditworthy customers.
c. A factoring arrangement can be developed whereby the factor (bank) actually
buys the accounts receivable at a value below the face value of the sale and
collects the money directly from the account.
d. If any of the receivables are not collectible, the factor sustains the loss, not the
business.
e. The cost of factoring is higher than the cost of securing a loan against the
accounts receivable.
f. The costs of factoring involve the interest charge on the amount of money advanced
until the time the accounts receivable are collected, the commission covering the
actual collection, and protection against possible uncollectible accounts.

3. Inventory Loans
a. Inventory is often a basis for a loan, particularly when inventory is liquid and
can be sold easily.
b. Finished goods inventory can be financed up to 50% of its value.
c. Trust receipts are a type of inventory loan used to finance floor plans of
retailers such as auto dealers.
d. In trust receipts, the bank advances a large percentage of the invoice price of
the goods and is paid a pro rata basis as the inventory is sold.
4. Equipment Loans
a. Equipment can be used to secure longer term financing up to 3 to 10 years.
b. Equipment financing can fall into any of several categories:
i. Financing the purchase of new equipment,
ii. Financing used equipment already owned by the company,
iii. Sale-leaseback financing,
iv. Lease financing.
c. When new equipment is purchased, or presently owned equipment is used as
collateral, usually 50 to 80% of the value can be financed.
d. In sale-leaseback financing the entrepreneur “sells” the equipment to a lender
and then leases it back for the life of the equipment to ensure its continued
use.
 e. In lease financing, the company acquires the use of the equipment through a
small down payment and a guarantee to make a specified number of payments
over a period of time.
5. Real estate loans are easily obtained to finance land, plant, or building, usually up
to 75% of its value.
C. Cash Flow Financing
1. Cash flow financing, or conventional bank loans, include lines of credit,
installment loans, straight commercial loans, long-term loans, and character loans.
a. Lines of credit financing are most frequently used by entrepreneurs.
b. The company pays a “commitment fee” to ensure that the commercial bank will
make the loan when requested and then pays interest on any outstanding funds
borrowed from the bank.
2. Installment Loans
a. Installment loans can be obtained by a venture with a track record of sales and
profits.
b. These short-term funds are used to cover working capital needs, when
seasonal financing is needed, usually for 30 to 40 days.
3. Straight Commercial Loans
a. In this hybrid of the installment loan, funds are advanced to the company for
30 to 90 days.
b. These self-liquidating loans are used for seasonal financing and for building
up inventories.
4. Long-Term Loans
a. These loans are usually available only to strong, mature companies.
b. Funds are available for up to 10 years with the debt repaid according to a
fixed interest and principle schedule.
5. Character Loans
a. When the business does not have assets to support a loan, the entrepreneur
may need a character (personal) loan.
b. These loans must have assets of an individual pledged as collateral, or have
the loan cosigned by another.
c. In extremely rare instances, the entrepreneur, with a high credit rating, can
obtain money on an unsecured basis for a short time.
D. Bank Lending Decisions
1. Banks are very cautious in lending money, particularly to new ventures.
 a. Commercial loan decisions are made only after the loan officer and the loan
committee does a careful review of the borrower and the financial track record
of the business.
b. Decisions are made based on quantifiable and subjective judgments.
2. Bank lending decisions are made according to the five C’s of lending—Character,
Capacity, Capital, Collateral, and Conditions.
a. Past financial statements are reviewed in terms of key profitability and credit
ratios and the entrepreneur’s capital invested.
b. Future projections on market size, sales, and profitability are evaluated.
c. Intuitive factors—Character and Capacity—are also taken into account and
become more important when there is little or no track record.
3. The loan application format is generally a “mini” business plan.
a. This provides the loan officer and loan committee information on the
creditworthiness of the individual and the ability of the venture to repay the
loan.
b. Presenting a positive business image and following the established protocol
are important in obtaining the funds.
4. The entrepreneur should borrow the maximum amount possible that can be
repaid, as long as the prevailing interest rates and terms are satisfactory.
a. The venture must make sure that it will generate enough cash flow to repay
the interest and principal on the loan.
b. The entrepreneur should evaluate the track record and lending policies of several
banks to secure the money needed on the most favorable terms available.

V.Role of Government Agencies in Small-Business Financing

A. Government’s financial assistant to starts-ups (especially to MSMEs) in India is much more

complex than in the US. Unlike in the US, where all the schemes are organized under one agency
(SBA), start-up assistant in India may come from different ministries and departments, depending
on the nature of the start-up. Two major sources of such assistant are the ministry of MSME ( for
small, medium, micro enterprises) and the department of Science and Technology (for technology
start-up) tables 11.2 and 11.3 provide a list of schemes under which non-technical and technical
starts-up may obtain financial and other types of assistant from the Government of India.