Chapter 8

1. Chapter 8 C H A P T E R 8 Obtaining Funding

2. Chapter Objectives • Describe where money comes from. • Compare various short-term borrowing strategies. • Understand how to use personal funds and private financing as a source of capital. • Understand how government-backed borrowing can spur economic growth. • Understand how to use existing resources to leverage the financial position of a business. • Distinguish between leasing and other financial vehicles.

3. Where Money Comes From • Example: funding a golf course • A significant amount of up-front capital is needed to purchase the land and develop the course. • A National Golf Foundation report concluded that financing for the average golf course loan requires 40 to 50% equity. • To build a $5 million course, then, developers need to raise approximately $2 to $2.5 million from other sources such as • own money, limited partnerships, corporate investments, syndications, pension funds, or possibly real estate investment trusts (REITs) in order to obtain a bank loan; • public coffers; • general budget allocations; • selling of bonds; and • establishing a public development corporation. (continued)

4. Where Money Comes From (continued) • Example: funding a golf course • Investors have been extremely cautious about funding golf courses in recent years. • Prior to 2001, more than 1,100 of the nation’s 15,827 golf courses were built; after 9/11, 2001, there was a severe drop in leisure and business travel that included rounds of golf. • Lenders will examine the cost of running a business to make sure it is viable. • Average cost percentages for club maintenance are as follows: • Salaries and wages 63% • Chemicals 14% • Repairs and maintenance 9% • Other 14% • Lenders examine the projected budget and calculate if the costs are similar to what other clubs in the industry face. (continued)

5. Where Money Comes From (continued) • If a project is a public facility, the following financing techniques could be used: • Loans • General obligation bonds • Project revenue bonds • Tax revenue bonds • Certificates of participation • Tax incremental financing • Tax exemptions • Tax rebates (continued)

6. Where Money Comes From (continued) • There are three primary categories of sources of capital: • Equity investors • Investors purchase a portion of the business (e.g., in the form of stock) with the hope of future returns through capital gains or dividend payments. • Long-term debt obligations (i.e., bonds) • Bondholder is interested in receiving an appropriate rate of return on the investment with the lowest possible risk. • Short-term loans • Suppliers of merchandise or raw goods are often the source of loans of this type. • They sell goods on the basis that the buyer will pay within 30 days, for example. (continued)

7. Where Money Comes From (continued) • Small Business Administration (SBA) • SBA was developed by the government in the 1950s to “aid, counsel, and protect the interest of the nation’s small business community.” • Microloans range from $100 to $50,000; the average loan is around $13,000; loans need to be paid back in six years at 8 to 13% interest. (continued)

8. Where Money Comes From (continued) • Small Business Administration (SBA) • SBA lends money to people starting a business if they have • excellent credit, including no collection letters in the past 3 years; • no bankruptcies in the past 10 years; • a business plan; • some type of collateral, such as a home; • up to one-third of the required capital to put into the business; • 24 months’ experience in the same field as its current business; • at least 12 months of training or special certification required for the business; • an explanation of hardship that caused any blemishes to personal credit; and • a personal expense plan because a lender will want to make sure of a prospective borrower’s ability to meet his or her own living expenses. (continued)

9. Where Money Comes From (continued) • Self-Funding • Utilizing depreciation allowances and profits not paid out as dividends as a way of fueling further expansion • Retaining profits • Investing liquid assets in a bank, in commercial paper, or in Treasury bills for a short period and then withdrawing them for any fiscal needs • Raising ticket or membership prices • Selling sponsorships, naming rights, television rights • Selling assets

10. Short-Term Funding • Accounts Payable • This represents amounts owed to vendors and suppliers for services that have been rendered or products that have been delivered. • For example, purchasing items on a corporate credit card or buying office supplies and inventory with a bill at the end of every month; usually needs to be repaid within 30 days of receiving the bill • The problem with accounts payable is the often slow turnaround time for repayment. • Might need funds sooner rather than later • Possibility of never getting paid (continued)

11. Short-Term Funding (continued) • Bank Financing • Most economical and flexible means of short-term financing • Term loan: Longer-period loan, such as three to five years. • Often entails regular periodic payments and one balloon payment. • Collateral: Utilized to secure a loan. • Businesses may use physical property such as land, buildings, inventory, or equipment; accounts receivable; or the rights to an invention or patent as collateral. • If a business defaults on the loan, the bank can seize anything that was used to secure the loan. (continued)

12. Short-Term Funding (continued) • Bank Financing • Here are the five Cs of credit used by banks when deciding whether or not to loan someone money: • Character: The applicant’s credit history and the applicant’s truthfulness. • Capacity: Does the potential business have the right management team and philosophy to become a profitable enterprise to be able to pay back the loan? • Collateral: Anything of value that can be pledged to guarantee final repayment of the loan. • Capital: Equity that the applicant will put into own business. • Condition: Sell the lender on the value of the business (is industry growing? What or who are the competitors? Proper channels with which to sell the product or service? (continued)

13. Short-Term Funding (continued) • Commercial Paper • Promissory note that might mature in one to nine months • Common among some large manufacturers and sales finance companies • Private Placement • Process of obtaining funds from private parties such as investors, venture capital investors, or other companies interested in investing in a business • Investments can take the form of debt instruments, equity interest, or a blend of the two (continued)

14. Short-Term Funding (continued) • Private Companies • Small business investment companies (SBICs) can provide either debt financing by issuing long-term loans or equity financing by acquiring an ownership interest in a company. • Private Investment Group • Money is pooled from a variety of sources including individuals, endowments, pension funds, private investors, and institutional investors. (continued)

15. Short-Term Funding (continued) • Factoring • This method entails selling assets (e.g., inventories or accounts receivable). • It is more expensive than bank borrowing because the factor charges a higher interest rate based on the potential risk factors. • Installment Sales • This method is common in the auto sales industry. • The person makes a down payment and makes monthly payments of principal and interest for a specified number of months or years. (continued)

16. Short-Term Funding (continued) • Supplier Financing • An example is loaning equipment to a business to reduce purchase prices or extending credit or creating longer repayment terms (continued)

17. Short-Term Funding (continued) • Leasing • Advantages • Funds that would normally be used to purchase assets could be used for working capital and other needs. • No external financing is required, or the amount of such funds would be minimal. • The corporation’s financial picture is strengthened—investments in fixed assets are reduced and debt service is not increased. • Entire lease payment is deducted from taxable income. • Technological obsolescence due to the rapid increase in technology can be avoided when one is able to rapidly replace older leased equipment. • Leasing equipment can eliminate numerous repair and upkeep expenses that could be covered by the lease agreement. (continued)

18. Short-Term Funding (continued) • Leasing • Disadvantages • Gross lease costs are traditionally higher than financing costs if extended over the life of the asset. • After the point at which an asset would have been paid for if purchased, the lessee is still making regular lease payments throughout the lease period rather than the life of the asset. • A lessee loses the benefits associated with inflation, increased values, or increased salvage values because the asset is turned over after the lease period ends, and the lessor gains these benefits. • A long lease obligation may force a company to keep using older equipment covered by the lease in order to avoid paying any penalties for breaching the lease. • A lessor can always confiscate the equipment upon default, leaving the company without machinery.

19. Long-Term Funding • Most traditional forms of long-term funding are stocks and bonds (usually used by large businesses). • Mortgages or long-term loans exist for medium-sized businesses. • Mezzanine Financing • Financing is available to established companies that show growth potential but that are not yet ready for a capital stock offering. • Raise between $1 million and $20 million through a combination of borrowing money from and selling stocks to the same investor. • Rule of thumb for mezzanine lending is that a company can • leverage two to three times its cash flow in senior secured debt. It can raise total debt four to five times cash flow with a mezzanine deal. So if the company is doing $2 million in cash flow, it can probably raise $4 million to $6 million in senior debt and $4 million to $5 million more in mezzanine financing, for a total debt of $10 million or five times cash flow. (continued)

20. Long-Term Funding (continued) • Venture Capital • Opportunity for people with marketable ideas or products to raise funds from private investors willing to take a risk in owning part of the company in exchange for their investment. • Ultimate goal for any VC investment is that the company will go public, and through a public offering the VC company can make many times over their investment.

21. Questions for Class Discussion • If you have ever applied for a credit card, what were you required to show to obtain credit? • If you have ever borrowed money to buy a car, what was involved in that process? • If you have ever borrowed money for college, what steps were involved in that process? • What would you want from a friend (e.g., collateral, a contract) if you loaned the person $1,000? • If a friend asked you for a $1,000 loan to start a business, what information would you want to obtain to help you make your decision? (continued)

22. Questions for Class Discussion (continued) • Is there value in “sweat equity,” or the owner’s involvement in a company to help fund a business? • Have you ever defaulted on a loan? What were the ramifications? • If you had the money, would you lend it to someone to help start a business if you knew that the business had a 75% chance of failing? • If you had to develop a strategy to fund building a sports facility based exclusively on borrowing funds, what sources would you pursue? What do you think your chances of success would be? What criteria could help or hurt your chances of obtaining funds?