Debt Funding In 23 slides 1. Key topics When is debt financing a bad idea for a start- up? What are...

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Debt Funding

In 23 slides

Bygrave & Zacharakis, 2007. Entrepreneurship, New York: Wiley. ©

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Key topics

• When is debt financing a bad idea for a start-up?

• What are alternative sources of debt?• How do bank and non-bank sources of debt

differ and how do they matter?• How should an entrepreneur choose a bank?


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Why use debt?

• Borrowing money allows you to keep equity in your new venture – no co-owners

• Banks don’t care how successful you are – they just want you to make your loan repayments


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Why is it hard to get debt?

• Borrowed money can be hard to acquire, especially if entrepreneur has limited personal resources or track record

• Banks risk losing entire amount of loan with limited upside (principal and interest payments from borrower)

• Most entrepreneurs must be able to show they already have assets (collateral) that can be used – if necessary – to pay off debts


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Why not use debt?

• Most people are in debt for most of their lives (house, car, student loans, charge and credit accounts)

• Interest you pay is generally higher because of the higher risk of starting a new company

• Bank can decide to pull the loan


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The rational lender considers:

• Liquidity: how easy will it be to get the loan repaid?

• Security: collateral and personal commitments from the borrower in case of default

• Cost: time and trouble to handle the loan compared to its return in interest

• Profitability: the value of the interest, goodwill, and “connections” (e.g., convertible stock or warrants) from the loan


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Early debt sources

• Partners: can pledge collateral to back up a bank loan• Suppliers: have a vested interest in what the new

venture produces, but:– Most require payment on delivery in advance to establish

reliability– Can later extend credit to reliable new ventures

• Leasing: lessor retains title to the property, and entrepreneur does not have to buy it up front – obligation does not show up on balance sheet (“off balance sheet financing”)


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Types of loans from commercial banks

• Unsecured loans: bank is confident about ability of individual to repay based on familiarity with bank, wealth, reputation, or accomplishments

• Secured loans: requires entrepreneur to pledge assets as collateral

• Personal guarantee: if loan is to a corporation, limited partnership, or LLC that limits personal liability, person borrowing must personally guarantee repayment – guarantor assumes risk

• SBA guarantee: SBA backs 90% of loan, bank backs other 10%


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“Going concern” bank debt

• What is it? Start-up borrows against its assets - available to start-ups who have established track records

• Types– Seasonal loans: e.g., surfboard manufacturers need

to make boards in February in order for retailers to sell them in March and April – cash will not return to surfboard manufacturers for 120 to 180 days

– Line of credit: borrow against inventory and A/R


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Choosing a bank

• “Go local”– Local bank takes more personal interest, moves

faster, is more flexible, and less likely to have staff transferred to other locations

– Allows entrepreneur to deal directly with top people among bank’s executives

• “Go large”– Larger banks have more resources, connections,

services, information, financial capacity


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What banks loan on going-concern assets*

Asset Borrowable percentage (%) range

Contracts and purchase orders 0 – 100

Accounts receivable (< 60 days) 70 – 90

Raw materials inventory 20 – 50

In-process inventory 0 – 10

Finished goods inventory 20 – 50

General purpose equipment 40 – 70

Special purpose equipment 0 – 30

Commercial real estate 70 – 90

* Businesses with a track record of performance


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Building credit for a loan proposal – what does the banker want?

• Business financial data, such as comparable firms, seasonality, and lease commitments

• Personal financial data, such as your last three years’ tax filings and personal financial statements of all partners

• List of prospective customers (with source of info)• List of competitors by name, what has been happening, and

your competitive advantage(s)• A forecast showing how you will use the money and sources

of repayment• A forecast of cash injection sources and timing, showing who

else may put money into the new venture


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What’s the banker thinking about?

• Is everything the venture wants to borrow for really necessary for the business? (remember, financing provides assets that are used to create revenues)

• Are founders willing to personally guarantee loan? What other debts do they have?

• Who might serve as co-signers?• Will founders be taking out more money personally than

needed?• Will company be extending credit? To whom, and how reliable?• Can some assets be sold and replaced with leased items if

necessary?


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Making bankers confident: Welcome to “C” World

• Character: truthful and keeps promises

• Capacity: has capacity to earn $ to repay

• Capital: other investor $ the borrower has

• Collateral: resalable assets• Coverage: insurance

protection• Conditions: what could

jeopardize borrower’s ability to repay?

• Credit history: applicant has borrowed before and repaid on time

• Cushion: applicant is asking for enough plus some extra to respond to surprises


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Cash conversion cycle

Key Components

The Inventory Cycle

The Accounts Receivable

Cycle

The AccountsPayable Cycle

The unit of measure is days – see next slide

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Cash conversion cycle in English

• A business gets inventory from a supplier so it has something to sell

• When the order is placed, the business gets inventory on its current assets and accounts payable on its current liabilities

• The business tries to turn the inventory into cash before it needs to repay its supplier

• If not, business has a positive cash conversion cycle that will require it to borrow $ for working capital

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Compare Owen to Flo

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Compare Owen to Flo• Owen Banksmore has negotiated repayment of

his credit from suppliers to be an average of 30 days. He is able to sell the inventory he gets from suppliers, on average, about 60 days. He sold his inventory to his customers on credit; his company takes an average of 60 days to turn its accounts receivables into cash.

Conversely, Florence "Flo" B. Chillin has negotiated superior credit repayment terms from her suppliers - 90 days! - and is faster at getting inventory off her store's shelves, averaging 30 days. She gets her customers, who also purchase on credit, to repay their borrowings in 30 days.

As the graphic shows below, Flo's working capital management practices give her a working capital cycle of -30 days, while Owen's practices yield a WC cycle of 90 days. Flo has more cash to fuel growth and does not need to finance her business' growth with other sources of cash.


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More Payables & Less Receivables

Sources of Short-term

Cash

Short-term Bank Loans

Negotiating with

Suppliers

Trade CreditSeasonal Business

Credit Terms

Tightening upAccounts

ReceivableCollections

You can “borrow” money by turning your accounts receivables into cash sooner and taking longer to pay your suppliers – See Flo


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Obtaining Bank Loans through Accounts

Receivables

Obtaining Loans against Inventory

Obtaining Financing from Customer

repayments

Combine the Right Mix of Short-term Financing using these tools

Obtaining SBA-guaranteed Loans

How SBA loans work

• Small Business Administration (SBA) approves lenders for small business loans

• Small businesses go to approved lenders to apply for loans

• Repayment and interest rates of SBA loans are negotiated between a borrower and SBA-approved lender

• Lender receives principal and interest on loan from borrower

• SBA guarantees repayment of 90% of loan if borrower defaults, so lender is more likely to make loan

SBA loans

• SBA’s 7(a) loan is its most common loan program• provides loans to businesses — not individuals —

requirements of eligibility are based on aspects of the business, not the owners

• loan proceeds may be used to establish a new business or to assist in the acquisition, operation, or expansion of an existing business

• specific terms of SBA loans are negotiated between a borrower and an SBA-approved lender

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Summary

• There are several tools you can use besides simply taking out a loan– Line of credit– Negotiations with suppliers– Trade credit– Faster accounts receivable cycle– Faster inventory to sales cycle

• An SBA loan is helpful if your business has a financial track record

Debt Funding In 23 slides 1. Key topics When is debt financing a bad idea for a start- up? What are...

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