In starting a small business in our competitive marketplace, the small business owner needs money to pay rent and utilities; to acquire inventory, equipment, and fixtures; to pay salaries for employees; to make payments for vehicles; to market (advertise) product(s) or service(s); to pay taxes and needed insurance; and most importantly to pay his/her "own salary."  Then there is always the item that bedevils even the most astute small business owner:  unforeseen costs.The overview which follows describes many of the options available for obtaining financing or working capital with which to start a new business or expand an existing one.  Remember that the financing you borrow must be paid back.  What must be paid back will usually carry interest. What must be paid back must first be "earned" in a globally competitive marketplace.  And the financing that is borrowed in the first place must be accompanied by a highly credible business plan that defines exactly what you plan to do and how you want to do it.

SHORT-TERM DEBT FINANCING

Short-term financing/credit sources are usually grouped into two basic categories:  unsecured and secured.

  A.    Unsecured credit is obtained without the borrower's pledge of specific assets to serve as collateral.

1. Personal credit cards, savings, stocks and bonds, and/or cash value of life insurance policies.

2. Funds borrowed from family members and/or friends.

3. A short-term, unsecured transaction loan  -  A direct, single payment financing arrangement with a bank that is evidenced by a promissory note. The maturity on this type of loan is usually between 1 and 6 months, but may extend up to 1 year.

4. A company line of credit  -  A commitment from a bank to its regular, credit worthy business customers to provide a stated maximum amount of short-term financing for a specified time period. The credit line is often granted with a compensating balance requirement, and the floating or variable-rate method of interest payment is used.  

5. Trade credit  -  A credit extended by one firm to another in conjunction with the sale of goods or services that are used in the normal course of business. For the purchasing firm, using trade credit is the equivalent of a consumer charge account at a department store - goods are purchased but payment can be delayed to the extent of the specified credit terms.  

6. Accruals  -  These are services that are provided to a business on a continuing basis but are not paid for at the time the services are rendered.  For example, employees provide services to the business each day they work; however, they are usually not paid until some specified future payroll date.

Characteristics of secured assets:

• The asset is easily liquidated in the event of default.
  
• The resale value of the asset is relatively stable.
• The legal claim to the asset is easily verified in the event of default.
• The lender would have little difficulty maintaining control over the physical whereabouts of the asset.

In order for the lender to legally establish the security interest in the pledged asset, a copy of a security agreement must be filed in a designated public office in the borrower's state.  A security interest is a legal claim to the ownership of a pledged asset in the event of a borrower's default.  Lenders seldom lend 100% of the current worth of an asset as collateral value.

The interest rate charged on secured short-term loans varies depending on the nature of the loan and the quality of the collateral, but secured short-term financing is usually more costly than unsecured short-term borrowing.

In general, to qualify as acceptable collateral an asset should:

• Have a current market value that is at least equal to or greater than the amount of the loan.
• Be in a form that is easy to identify (e.g.., large appliances instead of unprocessed coffee beans).
• Be in a form that makes it easy for the lender to maintain legal/physical control (e.g.. goods in a bonded warehouse as opposed to work-in-process inventory).
• Have a readily accessible, active secondary market making it easy for the lender to liquidate in the event of a borrower's default.

FORMS OF SECURED SHORT-TERM FINANCING

Home Equity Loan (by the business owner)

Accounts Receivable Financing - Pledging and Factoring

1.	Pledging Accounts Receivables
	Accounts receivables represent the money owed to a business from credit sales to customers.  A firm's accounts receivables may be used as collateral for a loan.  The collateral value of a "group" of pledged accounts depends on the credit standing of your firm's customers and your returns and allowances record.  The borrower and lender will usually sign a general lien agreement. The borrower (firm) will remit customer payments, as they are received, to the lender.
2.	Factoring Accounts Receivables
	Factoring involves the actual "sale" of the account receivables and, in contrast to pledging, title and risk pass to the factor.  Factors are financial institutions which specialize in providing short-term financing to small businesses through an accounts receivable financial process known as factoring. Factoring is when a financial institution actually purchases "at a discount" the accounts receivables of a business, assumes the title and risk of those receivables, and in return provides that business with needed funds.  Procedures, conditions, and charges associated with factoring are detailed in the factoring agreement.
3.	Short-term Inventory Financing
	Financing Pledging inventory to secure a loan is another financing method for a firm. For inventory to qualify as collateral, it must be easy for the lender to maintain legal and physical control  over the inventory and to repossess and liquidate the inventory in the event of a borrower's default

C.   Primary Sources of Secured Short-term Financing

1. Commercial Banks
2. Commercial Finance Companies
3. Factors 
4. U.S. Small Business Administration (SBA) "guaranteed" loan obtained through private lenders.  The SBA rarely makes a "direct" loan to an individual or company. The SBA is primarily a guarantor of loans made by private and other institutions and does not offer loans to small businesses. Some of the various types of SBA loans programs include: 

Snapshot  -	Serves as the SBA's primary business loan program to help qualified small businesses obtain financing when they might not be eligible for business loans through normal lending channels.  Provides long-term, fixed-rate financing to small businesses to acquire real estate or machinery or equipment for expansion or modernization.
Basic 7(a) -    Loan Program	7(a) loans are the most basic and most used type loan of SBA's business loan programs. Its name comes from section 7(a) of the Small Business Act, which authorizes the Agency to provide business loans to American small businesses
Pre-qualification -  Program	The Prequalification Loan program uses intermediary organizations to assist prospective borrowers in developing viable loan application packages and securing loans. This program targets low income borrowers, disabled business owners, new and emerging businesses, veterans, exporters, rural and specialized industries.
CDC/504 -   Program	The CDC/504 loan program is a long-term financing tool for economic development within a community. The 504 Program provides growing businesses with long-term, fixed-rate financing for major fixed assets, such as land and buildings. A Certified Development Company is a nonprofit corporation set up to contribute to the economic development of its community.
Micro-Loans -	Provides very small loans to start-up, newly established, or growing small business concerns. Under this program, SBA makes funds available to nonprofit community based lenders (intermediaries) which, in turn, make loans to eligible borrowers in amounts up to a maximum of $35,000. The average loan size is about $13,000. Applications are submitted to the local intermediary and all credit decisions are made on the local level.
Disaster -  Recovery	If you are in a declared disaster area and are the victim of a disaster, you may be eligible for financial assistance from the U.S. Small Business Administration - even if you don't own a business. As a homeowner, renter and/or personal-property owner, you may apply to the SBA for a loan to help you recover from a disaster.

                                                 

EXTENDED-TERM FINANCING

Extended-term financing refers to multi-year debt obligations that are repaid in periodic installments. The required collateral for extended-term financing usually consists of the asset(s) purchased with the proceeds of the financing, other available business assets, and/or your own personal assets. Interest rates on extended-term financing vary with your risk characteristics and with changes in market rates of interest. Interest paid on the loan is a tax-deductible business expense.  The lender usually imposes restrictive or protective covenants that protect the lender's claim on your firm's assets and liquidity position in the loan agreement.

Examples of common provisions found in small businesses, extended-term financing agreements include requirements that the firm:

• Limit the use of the loan proceeds to the purpose(s) specified in the agreement
• Maintain a minimum working capital position
• Purchase life insurance on its owner(s)/principal(s) naming the lender as beneficiary
• Maintain adequate accounting records and furnish the lender financial statements and specified reports
• Prohibit the owner(s) from creating additional liens on existing assets or the taking of any other actions that would weaken the lender's claim on the firm's asset base
• Prohibit the selling of any of its fixed assets without the lender's approval
• Limit dividend payments (owner's withdrawals) to amounts specified in the agreement
• Limit salaries, bonuses, and other compensation for the firm's officers and directors to the amounts specified in the agreement

A.  Forms of Extended-term Financing

1. Asset-based Loans - Equipment that is owned free of any liens and in good operating order may serve as collateral for extended-term financing.  The financing arrangement used is in the form of a term loan with a maturity tied to the remaining service life of the asset.  In some cases, receivables or inventory may be accepted as collateral for asset-based loans.

2. Mortgage Loans - This is financing provided by a security interest in real property: land and buildings. The rate of interest charged depends on the secured property.  Loan payments are usually quarterly rather than monthly.

3. Sale-and-Leaseback Financing - This involves the sale of a lien-free, business asset to the lender (lessor) while simultaneously creating a long-term lease agreement through which the selling business (lessee) leases the property back from the lender.  The assets are usually limited to factory building, land, office buildings, warehouses, or other real property. 

4. Lease Financing - The usual procedure is for the lessor, often a financial institution specializing in industrial leasing, to buy the asset required, including specialized plant or equipment, by your firm and lease its services according to the terms of a binding agreement. 

The lessor remains the legal owner of the asset and is entitled to the depreciation tax benefits.  If the lease agreement meets IRS guidelines, the lessee is able to deduct the entire payment from taxable income.

TYPES OF LEASE FINANCING

1. Financial Lease - A financial lease, also called a capital lease, is used to finance land, buildings, and equipment of any kind.  The financial lease may be a net lease or a service lease. Under a net lease, the business (lessee) is responsible for all service, maintenance, taxes, and insurance on the asset.  Under a service lease, the lessor provides financing as well as the required service and maintenance on the asset.
   
   
2. Operating Lease - This is a short-term lease that can be canceled, with a penalty payment, at any time during the term of the agreement.  This form of leasing is commonly used for equipment with relatively short service or technological lives, such as computers and automobiles.

The advantages of lease financing by businesses include:

• No down payment requirement with lease financing
• Businesses with marginal credit ratings may obtain the services of an asset that cannot be acquired by borrowing
• Avoid the restrictive covenants in a loan agreement
• Lease payments are tax deductible
• The term of the lease often extends beyond the maturity period on a comparable loan
• The lessor often provides both the asset and the financing
• A lease agreement is structured more quickly than a loan contract and is often less difficult to administer.

The disadvantages of lease financing are the higher annual effective cost than that of a term loan of comparable maturity and no build up of equity in the asset.

     5.    Industrial Development Financing - State and local governments have established economic development agencies to promote business and economic growth in  their area.  Incentives offered by these agencies to qualifying businesses take a variety of forms, including financing assistance at attractive rates. Some agencies may offer leases on land, buildings, or other plant assets on attractive terms.  Most of the financing plans are:  industrial revenue bonds (IRB) or packaged loans. An IRB is commonly referred to as a long-term bond issue sold to the public by a state or municipal economic development agency.  The purpose of the bond issue is to raise funds on behalf of, and that will be spent by, the target business.  The recipient business assumes liability for the interest and principal payment on the bond.  The interest payments received by the bondholder are free from federal income tax. 

An economic development agency may make a direct packaged loan to a business at interest cost lower than the prevailing market rate.  Loan funds are obtained by the agency from a combination of governmental and private sources. 

    6.    Venture Capital Financing - Venture capital is the financing made available for investment in promising firms but with a risk exposure greater than what is acceptable to traditional institutional lenders.  Financing is provided by sophisticated investors who seek investments that hold the prospects for large capital gains. Such  investors are referred to as venture capitalists.

Venture capitalists may be (a) privately owned firm(s) licensed and regulated by the U.S. Small Business Administration or (b) non-regulated firms.  The former group is known as Small Business Investment Companies (SBICs).  SBICs provide financing in the form of equity capital, debt financing with an equity sweetener, and in some cases, straight long-term loans.  The non-regulated firms, which specialize in equity financing, are referred to as Venture Capital Companies (VCCs).

    7.     Angel Investors -  Angel Investors are high net worth individual investors who seek high returns through private investments in start-up companies. Private investors generally are a diverse and dispersed population who made their wealth through a variety of sources.  But the typical business angels are often former entrepreneurs or executives who cashed out and retired early from ventures that they started and grew into successful businesses.  They typically seek companies with high growth potentials, strong management teams,  and solid business plans.  They typically invest in ventures involved in industries or technologies in which they are personally familiar.  Angel Investors often co-invest with trusted friends and business associates. In these situation there usually is one lead investor ("Archangel") whose judgment is trusted by the entire group of angels or investors.

Sources of Michigan based Angel Investors:

• Ann Arbor Angels

• Grand Angels West Michigan Investments

• Great Lakes Angels

Businesses with the following investment characteristics are attractive candidates for financing by VCCs:

• Large potential. 
• The business has the opportunity and is capable of exploiting a clearly defined market niche, or has the advantage over its competitors

The products/services should:

Other characteristics should include:

• Low cost -  the business should have a product/service with low production cost.
• Large margins - the product/service should have a large profit margin.
• Competent management - the business should have an experienced and capable management team.
• The VCC should be able to easily withdraw at a given future date from a business and liquidate its investment. 

Sources of venture capital financing are:

·         Michigan Venture Capital Firms

·         U.S. Venture Capital Firms

      8.     Financing Through A Public Offering - For some small businesses, the public sale of its securities is the only acceptable means of obtaining the financing needed to accommodate accelerated growth.

A public offering is the selling of the securities of a privately held corporation to the public in order to raise needed cash.  The securities to be sold may be common stock, or convertible bonds.  Common stock is usually sold.

General standards required for a public offering:

• A product or service with a favorable public image, an identifiable edge over the competition, and the potential for solid growth
• An established earnings record as evidenced by the amount, stability, and expected growth trend of net income and cash flow
• Good management
• The business and the common stock offering must be sufficiently large enough in both monetary value and the  number of shares to justify the underwriting cost. 

For small common stock offerings, the underwriting and registration costs can reach as much as 25% of the amount of the funds raised.  An initial public offering or an IPO by a business is a 3-4 month process and will require the assistance of a number of different sources and entities.  An investment banker or underwriter along with other professionals are needed to complete an IPO. Some of the other professionals involved will include; lawyers, accountants, insurers and a investment relations firm. All of these entities are critical in coordinating a successful IPO with the NASDAQ or any of the other U.S. stock markets.  The following is a general and brief description of the key participants and their role in an initial public offering or an IPO;

The investment banker or underwriter will perform the following tasks related to the new common stock issue:

• review with the firm the steps, procedures, and cost estimates of the public offering
• review with the firm the Securities and Exchange Commission (SEC)  and  state rules and regulations for the public offering              
• prepare the underwriting agreement or purchase contract
• meet with outside accountant and underwriter's accountants to decide the financial data requirements for the registration statement
• prepare the registration statement and the prospectus
• obtain an indemnity insurance policy
• file the registration statement with the SEC
• hire a registrar and transfer agent for the issue
• file the 'red herring' or preliminary written offers list with the SEC
• send copies of the final prospectus to syndicate members, dealers, and financial services
• direct and supervise the effort for the issue
• preparation of road show slide presentation to potential investors
• get the issue quoted in the newspapers and listed in stock guides
• meet with the National Association of Security Dealers representatives to make arrangement for listing the stock for over-the-counter trading and advise the company on its responsibilities after the offering
• post-offering responsibilities may include:  monitoring the company's performance as a listed company and by making suggestions on possible improvements, market intelligence, and act as the company's financial advisor on acquisitions and disposals or the viability and need for any secondary fundraising.

The Investment Relations Firm will perform the following tasks or responsibilities;

• serve as a bridge between management and the financial community

• offer guidance and counsel

• provide market intelligence

• provide support for new issuers story

• to establish a strong and accurate messaging platform that can be sustained after the IPO

• organizing media outreach in conjunction with other pricing day activities at the NASDAQ Market Site, which can also create more visibility for a new IPO in a crowded market

• help the company put in place a practical, workable internal investment relations infrastructure  to manage post IPO investor relations procedures and to ensure compliance with SEC regulations and NASDAQ listing rules

The Investment Relations Firm will perform the following tasks or responsibilities;

• serve as a bridge between management and the financial community

• offer guidance and counsel

• provide market intelligence

• support with administrative tasks

• provide support for new issuers story

• to establish a strong and accurate messaging platform that can be sustained after the IPO

• organizing media outreach in conjunction with other pricing day activities at the NASDAQ Market Site, which can also create more visibility for a new IPO in a crowded market

• help the company put in place a practical, workable internal investment relations infrastructure  to manage post IPO investor relations procedures and to ensure compliance with SEC regulations and NASDAQ listing rules

The role of the Law Firm includes the following;

• ensuring compliance with U.S. federal and state securities laws;

• applying to list on NASDAQ and confirming that the issuer meets the related qualitative and quantitative listing requirements

• ensuring that the issuer is prepared to meet its obligations as a U.S. listed public issuer following the offering, including public issuer reporting requirements and the requirements of the Sarbanes-Oxley Act of 2002 (SOX) (see glossary) and related U.S. Securities and NASDAQ operating rules.

The role of the insurer includes the following;

• providing reliable financial protections for board members and their personal assets in the form of directors and officers insurance policies

• providing coverage of litigation and regulatory actions in fragmented securities claims and settlements

• providing protection from Securities and Exchange Commission claims

• reimbursement of directors and officers in the event of insolvency or bankruptcy

B.  Sources of Extended-term Financing

1. Commercial Banks
2. Credit Unions
3. Commercial Finance Companies (Equipment purchases by small firms may be financed through installment loans.)
4. Equipment Manufacturers (Some manufacturers of equipment make financing available to their customer either directly or through a captive financing subsidiary.)
5. Independent Leasing Companies
6. Life Insurance Companies (Life insurance companies that make financing available to small businesses usually engage in industrial leasing, make fixed-rate term and mortgage loans, and buy long-term bonds.)
7. U.S. Small Business Administration (SBA) "guaranteed" loan obtained through private lenders.  The SBA rarely makes a "direct" loan to an individual or company.
8. Michigan Venture Capital Firms  U.S. Venture Capital Firms
9. Financing Through A Public Offering: A detailed loan request should be incorporated into a written formal business plan covering the "same" time frame as the expected financing.
10. Surety Bonds is a three-party instrument between a surety, the contractor and the project owner.  Surety Bonds are typically geared toward contractors bidding for construction projects.  The agreement binds the contactor to comply with the terms and conditions of a contract.  If the contractor is unable to successfully perform the contract, the surety assumes the contractor's responsibilities and ensures that the project is completed. The SBA guarantees four types of surety bonds which are: (1) bid, which guarantees that the bidder on a contract will enter into the contract and furnish the required payment and performance bonds; (2) Payment Bond, which guarantees payment from the contractor of money to persons who furnish labor, materials, equipment and /or supplies for use in the performance of the contract; (3) Performance Bond, which guarantees that the contractor will perform the contract in accordance with its terms; and (4) Ancillary Bond, which are incidental and essential to the performance of the contract. Businesses in the construction and service industries can meet SBA's size eligibility standards if their annual receipts, including those of their affiliates, for the last three fiscal years do not exceed $6 million.

FACTORS INFLUENCING A BANKER'S LOANS AND INVESTMENTS

• The type of deposits held by the bank
• The expectations of bank examiners
• The risk/return perspective of its officers

HOW A LOAN REQUEST IS ANALYZED BY A LENDER

• What is the specific purpose(s) of the loan?
• Exactly how much is required?
• What is the "exact source" of repayment for the loan?
• What evidence is available to substantiate the assumptions that the expected source of repayment is reliable?
• What business or personal assets, or both, are available to collateralize the loan? 
• What evidence is available to substantiate the competence, and ability of a business' management?
• What is the borrower's debt paying record to suppliers, banks, home mortgage holders, and other creditors? 
• What is the ratio of the borrower's debt to net worth?
• What are the past earnings of the company?
• What is the value and condition of the collateral which the borrower offers for security?
• Does the borrower have good management ability?
• What is the borrower's character?
• What are the future prospects of the borrower's business?
• What is the physical condition of the facilities and equipment?
• What is the firm's insurance coverage?
• Are all taxes currently being paid?
• How much do the largest accounts owe and what percentage of the total accounts does this amount represent?

FACTORS THAT MAY CAUSE A LOAN APPLICATION TO BE TURNED DOWN:

• Prior business bankruptcy.
• A bad debt record.
• Low company earnings.
• Low value of secured collateral.