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Financing and Capital


No matter how small the business is, money is necessary to start a small business. The money to start a small business can come from a variety of sources and it generally takes several sources to provide all the money that is needed. Some of the sources that may be available to help you start your small business are listed below:

Personal Resources

Obtaining financing for a start-up enterprise is difficult because there is no track record on which the business can be judged. Personal assets are thus the first source of capital that must be considered. A personal stake in the enterprise shows a commitment to the business and provides lenders with a potential source of collateral to secure a loan. Most banks require at least a 30 percent personal equity investment in a start-up business and 10 percent to 30 percent in a more established business. If an owner does not have access to sufficient personal resources to get through the lean times of the start-up phase, it may be wise to re-evaluate the decision of going into business at this time.

Sources of financing using personal assets:

Home Equity Loans

A second mortgage can be a source of funding for a small business. The feasibility of this source will vary with the amount of equity that has been built up in the home. It can usually be obtained through a bank, a mortgage company, a finance company specializing in secondary funding, or a savings-and-loan (S&L) association. The monthly payment will be a function of the length of the loan and the interest rate. Additionally, there are usually points or fees and closing costs to be considered when assessing the costs of this mode of financing. The proceeds from the second mortgage can either be used as a source of direct financing or as collateral to secure a credit line.

Family and Friends

Family and friends can provide direct investment funds, loans or serve as guarantors on a bank loan if their credit history and resources are strong. Unlike commercial sources, this group is personally acquainted with the entrepreneur, and though they must still be objective in assessing the proposal, intangibles such as personal character are often given more weight by family and friends than by more traditional sources. If an outright loan is not possible, this group can still provide aid in procuring financing through credit enhancement. Credit enhancements are assets of recognized value that can be borrowed to support a loan or other debt obligation. This technique bolsters the asset base so that additional debt financing can be acquired. This can be accomplished through the pledge of personal assets such as a CD, stocks, or bonds as collateral.

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Commercial banks are usually one of the least expensive providers of loan capital.  Banks are most interested in financing firms that can show an ability to repay the loan. This usually means a company must have a strong positive cash flow or assets as collateral that can be easily liquidated. Factors such as the content of the business plan and experience of the management are also considered. 

Payment terms are usually up to seven years for loans from commercial banks. Most debt is secured, although some unsecured lines may be available. Personal guarantees are generally required resulting in exposure of the borrower's personal assets in the event of a business failure. Even if the business is formed as a corporation, the limited liability feature is superseded by a personal guarantee.

The interest rate on a loan is typically expressed as a percentage in excess of the prime rate. Prime is the rate the nation's largest banks charge their best customers. The prime rate itself will vary according to economic conditions; it is primarily dependent on the rate the banks themselves are charged by the Federal Reserve to borrow money. The percentage over prime that a customer is charged is based on the banker's perception of the risk taken by granting the loan.

Lending institutions have different policies towards risk. Some are inclined to follow relatively conservative lending practices; other engage in more creative banking practices. Banks borrow money elsewhere at a lower rate and lend it out at a higher rate; therefore, the commercial bank's primary concern is a borrower's ability to cover principal and interest repayments. Although bankers are interested in all financial aspects of a borrowing firm, hard assets provide their primary insurance if the business fails.

Types of Loans

This category of credit is the most traditional and widely used among businesses.  Listed below are the most common forms of business loans used by small businesses:


These are simply installment loans that are paid back at regular intervals over a specified length of time. These loans are granted for a specific purpose, such as startup costs or working capital. The term of the loan will depend on the use of the funds, but it can range from short term (less than one year) to long term (more than five years).


A demand note is a single-payment loan that is intended for very specific short-term needs. Although the contract will usually call for payment in full within 90 to 180 days, the lender can call for (or demand) repayment of the note at any time. You may be asked to make periodic interest payments during the life of the note.


A line of credit, like a credit card, establishes a credit limit and specific terms for repaying money that is borrowed. Lines of credit are easy to access and offer flexibility in managing the cash flow needs of a small business. Many small business owners establish a line of credit as a precaution, before they have a real need for the money. Lines of credit are usually linked to short-term assets such as accounts receivable, inventory, materials, etc.


There are several loan programs in which the government provides a guarantee of repayment for other small business lenders. Government-assisted small business loans are offered by federal agencies such as the Small Business Administration (SBA), the Economic Development Administration (EDA) and the Rural Economic and Community Development (previously known as the Farmers Home Administration or FHA), as well as by state and local agencies. Government-assisted loans, like bank loans, usually require that the small business owner have their own money invested in the business in order to share the risk with the lender.

How Banks Make Lending Decisions

A lender wants to be assured that your company can and will repay the loan as agreed, and that the loan will not saddle you with too much debt, which could cause financial problems for you. To get this assurance, the lender will evaluate your business plan to learn about you, you’re associates, your objectives, and your plans for the company.

The lender will be looking for the Five Cs of credit:

1.    Capital - How much of your own money do you have invested in the business? How much money do you have in reserve, in case of unexpected needs?

2.    Collateral - What is the fair market value of the security that you are offering to guarantee repayment of the loan? Does it meet the classic criteria for good collateral: (a) ease of transfer of title, (b) low cost/no cost to maintain/service, (c) increasing in value, (d) a ready and liquid market.

3.    Capacity to Repay - How much profits will your company generate? Will your cash flow provide you with enough money on a regular basis to cover the repayment of the loan? Are your projections for sales and profits realistic when compared to other firms in the same industry?

4.    Conditions - What are the economic, demographic, and regulatory trends which impact your business? What terms can be negotiated to allow the bank to evaluate the risk/reward considerations?

5.    Character - What is your track record, personal and professional, in managing finances and paying credit obligations? Who are the key managers in your business; do they have the experience and the ability to run this business successfully?


Lenders have rules and policies to follow in determining the risk and feasibility of your plan and evaluating your loan proposal. In addition to business and financial projections a lender will look for six important factors:

1.    Equity - The lender expects the borrower(s) to have already invested from 10 to 30 percent of the loan amount. If your business has existed for less than three years, plan for 30 percent.

2.    Collateral - Lenders require sufficient collateral to protect the loan. The items pledged to secure the loans are assets which reflect the following liquidity:

3.    Personal guarantees - All parties to the loan request must be willing to pledge guarantees. Personal guarantees state that the borrower(s) truly believe in their venture.

4.    Good credit based on borrower's credit report(s).

5.    Ability to carry debt service - The cash flow projections normally reflects this.

6.    A secondary source of repayment - Important especially in start-up venture (e.g., spouse has a full time position)

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"Angel" Investors

The increasing role of wealthy private investors called "angels" provides an alternative to traditional venture capital. This, however, is a difficult source to locate since there is no directory or central source that identifies these people. Angels are usually passive members of the business community, and there is no extensive association or organization of these individuals. They are most often found through networking with other entrepreneurs or through members of the professional community such as accountants and lawyers.

In attempting to locate angels, the key is to start early. It will take time to locate an angel and considerable time for the potential investor to investigate your company. These individuals tend to invest in ventures close to home and in a business in which they have some expertise. Since angels will likely want to be involved in the business, the search should focus on individuals residing in the immediate vicinity of the company. Although angels will usually want to be active in managerial decisions, such financing generally does not require giving up the sizable ownership position and control that turning to venture capitalists may involve.

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Sale of Stock


Securities Offerings


The issues of equity securities usually must be registered with the Securities and Exchange Commission. Registration documents include detailed disclosure, historical financial statements, and third-party audits. This can be a costly process. A private placement, however, is exempt from federal registration. A private placement under Regulation D of the security code can minimize costs and delays while giving a business access to equity capital.

Rule 504 is the most commonly used Regulation D exemption. Under Rule 504, the SEC exempts companies that are raising up to $1 million from most of the SEC registration and reporting rules that govern larger stock sales. The only restriction is that the company must not raise more than $1 million over a 12-month period before or after the offering. Somewhat more restrictive requirements for Regulation D exemptions are outlined under Rules 505 and 506 for larger offerings that include non-accredited investors. Rule 504 itself has no prescribed disclosure requirements, no limit on the number of purchasers, and no investor sophistication standards. If the company adheres to the above limits, it can advertise and sell to any number of people. Some states require additional filings and impose further restrictions. Examine regulations on a state-by-state basis where you anticipate the securities will be sold. It is important to remember that the exemptions from registration provided by Regulation D do not include exemptions from the anti-fraud or civil liability provisions of any of the federal or state securities laws.

Although the 504 offering seems tailor-made for entrepreneurs, even simplified stock offerings carry a cost. These offerings are designed to be conducted without the use of an investment banker, but there still are costs associated with marketing the stock offering. The company must either sell the security offering itself or engage the assistance of a licensed brokerage firm. Handling the administration for the first time may lead to unanticipated delays in putting out the issue. Additionally, this method is not for all small companies considering stock offerings. If the company is growing quickly, it may be able to raise more capital by waiting for a traditional IPO.

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Other Financing Methods to Consider


Trade Credits

Trade Credit - also called Accounts Payable - is the single largest category of short-term credit and is especially crucial for small businesses. Trade credit is a customary part of doing business in most industries. It can be a contractual arrangement or an informal agreement that permits a business to pay its supplier over a given time period rather than upon delivery of the goods. A firm that does not qualify for credit from a financial institution may receive trade credit because an existing relationship has familiarized the seller with the creditworthiness of the customer. Since a large part of the supplier's ability to accept delayed payments could be your credit worthiness (which is evidenced by your history of prompt payment), it is vital to pay debts in a timely manner. If you know you will be late on a payment, communicating this to your suppliers, along with a reasonable explanation and new date of payments, will help your favorable relationship continue.

The effect of trade credit can best be seen by example. Assume a firm makes average purchases of $2,000 a day on payment terms of net 30 days. On average, it will owe 30 times $2,000 - or $60,000 - to its suppliers. If its sales (and consequently its purchases) double, accounts payable will also double to $120,000. The firm will have automatically generated an additional $60,000 of financing through trade credit. Similarly, if the firm can negotiate extended terms of credit from 30 days to 40 days, accounts payable will expand from $60,000 to $80,000, which lengthens the average payment period and generates additional financing.


Finance companies assist businesses that are expanding and experiencing a cash shortage by purchasing the business's accounts receivables. In factoring, the receivable is purchased at a discounted rate and the finance company pays the business immediately. There are two types of accounts receivable sales: recourse and non-recourse factoring. In a recourse transaction, the business retains part of the risk of customer default and is ultimately responsible for any short fall. In a non-recourse situation, the finance company takes on all the rights and obligations of the receivable, including the risk of default by the customer.

Finance companies charge a fee that is usually 2 to 6 percent of the receivable. The calculation of this fee depends on the following variables: volume, size, and number of invoices; customers' credit; location of the customers; and length of time of payment. some companies charge an additional fee if the customer is late on payment, while others have one flat fee. Upon payment by the customer, the remaining value (10 to 30 percent), minus the fee, is sent to the business.

There are two methods of factoring, called traditional and spot. With traditional factoring, the finance company obtains the rights to an entire stream of receivables. This is best for companies with at least $1 million in annual sales. Spot factoring is the buying and selling of a single order or account. Businesses that only use factoring for a limited time or purpose, such as seasonal employees, often prefer the spot factoring method.

It is important to keep in mind that, unlike banking, there are not regulatory agencies overseeing the business practices of factoring companies. Most factors will provide prospective clients with a list of former and current clients as well as references from local lending institutions.

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Tips for Getting and Using Small Business Credit


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