Question

1. Describe which of the financing alternatives learned this week you would be most likely to use in a new venture. Be sure to state specific reasons why this would be the best option for your business.

2. Why are new ventures at a disadvantage in receiving debt financing? Why is credit card financing attractive to entrepreneurs in lieu of debt financing? What are the risks?

Answer 1

1. Describe which of the financing alternatives learned this week you would be most likely to use in a new venture. Be sure to state specific reasons why this would be the best option for your business.

Generating enough capital to continue to grow and expand is one challenge many companies face. In addition to reinvesting profits back into the business, companies may need to seek alternative sources of working capital and growth capital to accomplish their goals.

There are many financing options that provide the necessary working capital to grow successfully. We’ve outlined five options below. Some of these may be used alone or in combination, with the objective of providing the right debt and capital structure at an acceptable cost to the business, without overburdening the company. Determine your capital needs for working capital and growth first, and then identify the various sources of capital available.

1. Traditional senior debt may meet all or most of your needs, but there may be limitations on how much is available based on your industry, company profile, and complexities as well as your assets and liabilities, profits, and cash flow. Some growing businesses have difficulty with traditional debt since there is a higher focus on growth versus profits.
2. Asset Based Loans, or ABLs, are a form of secured lending that is based principally on the value, quality, and adequacy of the assets (collateral) pledged. The lender’s interest is secured by the borrower’s assets, which typically consist of inventory, accounts receivable, and other assets. The amount of credit the borrower can access is based on the value of the assets. Generally, the more liquid the assets, the more desirable the collateral becomes, and the higher the advance rate is available on the borrowing base. Advance rates depend on a variety of factors, but can range from 80% to 85% for accounts receivable and from 60% to 70% for inventory. ABLs benefit growing companies with high working capital needs by using strong tangible assets, accounts receivable, and inventory. As sales grow, tangible assets grow, thereby increasing a company’s borrowing base.
3. Mezzanine debt is a layer of financing between the company’s senior debt and equity. It is subordinate to senior debt, but senior to common stock or equity. It usually has embedded equity instruments such as warrants, which can be converted into equity by the holders. Owners still maintain control of the company but may face some dilution of their ownership interest. Mezzanine debt can be structured with flexible payment terms but will incur interest expense over the term of the debt. It can be an attractive way to obtain capital to fund a growing company’s expansion or acquisition needs.
4. Investors or friends and family may be an alternative for additional capital, often in conjunction with bank financing. However, the main disadvantage of bringing in additional investors is that it dilutes existing owners. Plus, the cost of raising equity can be higher than bank facilities and may take a significant amount of time from key stakeholders.
5. Private equity funding can provide a significant amount of capital and active management expertise that a growing company may not have within its existing management team. The key downsides to this alternative are that owners usually lose control of the company, the existing owner’s stake in the business is diluted, and the private equity fund will look to exit the business in a five to seven year timeframe.

Consider the financing options that will put your company in the best position to succeed. When evaluating your options, weigh the risks, price, opportunity cost, flexibility of the structure, and ease of use. There should be a proper balance between price and structure that allows you to meet your growth objectives without being so restrictive that it disrupts the business.

2. Why are new ventures at a disadvantage in receiving debt financing? Why is credit card financing attractive to entrepreneurs in lieu of debt financing? What are the risks?

10 Disadvantages of Debt Financing for Small Businesses

• You will have to pay interest, which is usually carried as a liability on the company’s balance sheet.
• Since you will borrow money to run your business, you may end up committing your business to a large business expense.
• You may be under pressure to repay the loan with cash that you need badly for some other aspects of your business. In such a situation, your business suffers; and it may never recover!
• If you get loans from family or friends and have problems repaying it back or keeping up with the payment terms, this can ruin your relationship with them; temporarily or permanently.
• If you borrow from a bank or commercial lender, you will be required to pledge your property as security for the loan. (If you don’t repay the loan, the lender can take the property and sell it to recoup the money). If you pledge business assets as security for the loan, and you are unable to pay back, you may lose these assets when you need them the most. Worse, if you pledge personal assets, such as your house or stock portfolio, then you risk losing them to pay a business debt.
• Getting a business loan is always very difficult if you don’t have good credit rating and track record, solid financials, and collateral.
• Debt financing can be too expensive for small businesses because of the risk / return tradeoff.
• If you carry too much debt you will be seen as “high risk” by potential investors; which will limit your ability to raise capital by equity financing in the future.
• Debt can make it difficult for a business to grow because of the high cost of repaying the loan (due to compounding interest).
• You are running the risk of bankruptcy. The more debt financing you use, the higher the risk of bankruptcy.

Increasing numbers of entrepreneurs have turned to credit cards to finance their business ventures in recent years. Often, these credit cards were originally secured for personal use, but credit card issuers are targeting business owners for corporate cards as well. Credit cards are one resource available to small businesses with few other options to obtain start-up capital. It is by no means a desirable means of financing a start-up. Most credit cards charge extremely high interest rates making this form of financing very expensive. In terms of using a credit card as a primary means of paying bills monthly, a credit card offers small businesses the administrative benefit of providing detailed records of all charges that may be easily transferred to an accounting process.

Studies indicate that use of credit cards for small business purposes has surged dramatically in recent years. An online article published by About, Inc., part of The New York Times Company, states that two-thirds of small businesses use a credit card for expenses. Of these, 40 percent use business credit cards exclusively and the remaining 60 percent use a personal card for at least part of their credit card purchasing transactions. This represents a growing trend and one that has not been overlooked by credit card issuing companies.

Credit-card issuers are beginning to aggressively pursue small business owners in the hopes of selling them on corporate credit cards. According to Visa USA in a brief article in Cardline, commercial payment volume on Visa cards grew 20.4 percent in the year ending in the middle of 2004. Visa USA expects that these rates of growth are likely to continue through 2010 and they are launching a variety of marketing efforts to try and capture more of this growing commercial business. From the credit card companies' perspective, commercial accounts have several advantages over personal accounts. They include the standard use of annual fees with commercial credit card accounts, the opportunity to establish long-term relationships with commercial customers, and the proceeds they are able to make from extra fees for multiple cards on a single commercial account.

The reasons for the increase in credit card financing vary. Surely the single biggest factor is the explosion in overall credit card use throughout the United States during the 1990s, when overall economic expansion surged. But there are other reasons for the growing use of plastic by entrepreneurs. For one thing, many entrepreneurs contend that large banks habitually steer businesses that are looking for less than $10,000 to consumer loan departments. In addition, entrepreneurs commonly blame their use of credit cards on the reluctance of banks to provide loans. Moreover, using personal or corporate credit cards allows small business owners to skirt the bureaucratic paperwork associated with obtaining loans from banks or the Small Business Administration (SBA). Also, stories of entrepreneurial success that started with the use of credit card financing were common in the late 1990s, providing further encouragement to business owners weighing whether or not to take the plunge. Finally, small business owners who use credit cards to pay off business expenses can also use them to stretch their payment periods or earn significant points in frequent-flyer programs.

Nonetheless, using credit cards is a riskier-than-usual way to finance a company. Every month there is a huge bill instead of several smaller ones that can be juggled. Once a credit line is spent, one can not pay bills and it is a very short trip from cash flow trouble to general weakness to bankruptcy. Entrepreneurs who have parlayed their credit cards into business success caution fellow business owners to pursue other financing options before turning to credit card financing. If credit card financing is the only or best alternative for getting the necessary money to start a business, there are ways in which to minimize the potential downside of this sort of expensive financing. The following six credit card management techniques were presented in the About, Inc. article.

1. Apply with Those You Know: Always consider applying for a small business credit card at the financial institution you already use. Your banking relationship may aid with the approval process. When you need an extension of credit you will have a relationship established with your lender helping with credit applications over $100,000 not using automated scoring systems.
2. Limit Card Hopping: Signing up for multiple cards in an attempt to take advantage of deals can have a negative impact on your credit rating. It is also more difficult to manage many cards well.
3. Use Grace Periods: The majority of small business credit cards offers a 21-day grace period before you have to make payment on your purchases. Improve your cash flow using a credit card instead of checks.
4. Pay Online: When possible save time and extra costs by paying your small business credit card online versus paying by teller at a branch or mailing in your payment.
5. No Cash Advance: Reduce credit card fees and interest costs by not using the cash advance feature on your card. Cash advances incur more fees and costs. Use your business account debit when you need immediate funds.
6. Avoid Late Payments: Late fees and high interest rates quickly erode the merits of using your small business credit card. Be responsible by paying off as much of your balance as possible each month.