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Chapter 13 OTHER FINANCING ALTERNATIVES DISCUSSION QUESTIONS AND ANSWERS 1.

What are business incubators and seed accelerators? How do they differ? A business incubator is an organization that helps startup companies develop by  providing management, operating, and financial services. A seed accelerator is an organization that usually provides both an equity investment and a mentoring and educational fixed­term, cohort program to help startup  companies succeed. Business incubators and seed accelerators generally differ in how they are organized,  the type of funding help they provide to entrepreneurs, and type and length of their  support and educational programs.   While most incubator programs do not make equity investments in their client firms,  they do help entrepreneurs obtain private and public loan funds, and in some cases  help them meet with angel investors. Business incubators are usually formed as  nonprofit organizations that are operated by either private firms or public entities  including government­funded programs, economic development organizations, and  universities. Entrepreneurs must apply for admittance to a business incubation  program by providing their business ideas and business plans. The length of time that  a client (accepted entrepreneur) can stay in an incubator program varies depending on the complexity of the business model and predetermined revenue or other benchmark  targets. Most seed accelerators, also called startup accelerators, make seed investments in  exchange for equity capital in the startups they accept into their programs. Startups in  seed incubators must complete their programs in about 3 months, at which time they  make a pitch to prospective investors. Seed accelerators admit new startups in cohort  groups or classes to encourage peer support and feedback as an important part of the  education mission.

2. What is meant by the terms business crowdsourcing and crowdfunding?

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Business crowdsourcing is the process of obtaining business ideas, development support, and operating services from a large network of nonemployees. Crowdfunding is the process of financing ideas, ventures, and projects by gathering funds from a large network of people. 3.

Describe the two major types of crowdfunding. There are two types of crowdfunding: rewards-based crowdfunding and equity crowdfunding. Rewards-based crowdfunding involves soliciting non-equity funds to finance specific business products and services or requesting donations for a specific purpose. Equity crowdfunding involves soliciting funds from a large number of small investors in exchange for an equity position in the venture requesting the funding.

4.

What are the five C’s of Credit Analysis? The five C’s of credit analysis are capacity, capital, collateral, conditions, and character. See Figure 13.1.

5.

Name three of the common loan restrictions and explain their relation to new venturing financing. What are some additional common loan restrictions? While many different restrictions can be placed on businesses, a few are described here: (1) Limits on total debt are placed on venture firms to limit the amount of leverage the firm has; (2) Dividend restrictions are placed on firms to prevent the firm from paying out the newly issued debt in the form of a dividend; and (3) Maintenance of financial statements may be required to provide the lending institution with a current representation of the company’s financial situation. See Figure 13.2 for some additional common loan restrictions including: (4) restrictions on additional capital expenditures, (5) restrictions on sale of fixed assets, (6) performance standards on financial ratios, and (7) current tax and insurance payments.

6.

What is meant by venture banks? How do they differ from traditional commercial banks? The term “venture banks” refers to a type of debt investor (lender) that will consider lending to early stage ventures that do not have proven cash flows. They typically offer debt to accompany venture equity and will look for compensation in both interest payments and equity positions (including call options) in the venture. Commercial banks typically do not consider this type of very risky lending.

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Why are new ventures at a disadvantage in receiving debt financing? They are at a disadvantage because they usually do not have large amounts of assets to provide as collateral, and the risk associated with the loan is not normally in a riskaverse bank’s goals.

8.

Why is credit card financing attractive to entrepreneurs? What are the risks? It is attractive because it is quite easy to obtain and also provides interest rates lower than prime for the introductory period, but is also risky due to high interest rates charged after the teaser period.

9. What is the EB-5 immigrant visas program? The Immigration and Nationality Act (INA) of 1990 provided an opportunity for foreign nationals to obtain a “green card” through the EB-5 immigrant visas program. A foreign national may seek Lawful Permanent Resident (LPR) status by investing $1 million in the U.S. that will preserve or create at least 10 jobs for U.S. workers. The minimum requirement is reduced to $500,000 if the investment is in a designated rural or high unemployment area. 10.

What is the Small Business Administration (SBA), when was it organized, and what was its purpose? The SBA is the Small Business Administration which was created by Congress in 1953 to provide small businesses help in startup and growth.

11.

Identify and briefly describe four basic SBA credit programs. Refer to Figure 13.3. The four basic SBA credit programs: 1) 7(a) Loan: can be used for most business purposes including the financing of working capital. 2) 504 Loan: can be used to purchase fixed assets, as well as for other business needs. 3) Microloan: intended for very small businesses with a maximum amount of $35,000 to be used for general purposes. 4) Venture Capital: this credit program works through Small Business Investment Companies (SBICs) which are private for-profit investment firms.

12. Compare the characteristics in terms of loan amounts, lenders, and SBA role in 7(a) loans versus 504 loans. Refer to Figure 13.3.

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7(a) Loan: Lenders include commercial bank, credit union, or financial services firm. Loans are up to $2 million with 7- to 10-year maturities and can be used for most business purposes including the financing of working capital needs. The SBA role approves loan and guarantees up to 85% of loan value. 504 Loan: Lenders include commercial bank jointly with not-for-profit Certified Development Company. Loans are up to $4 million for fixed assets and up to $2 million for other business needs. The SBA role approves and guarantees the development company’s portion of debt. 13. What is a Small Business Investment Company (SBIC)? SBIC stands for Small Business Investment Company and is a private financing company which provides capital of diverse types. 14. What types of advisory services are available from the SBA? The SBA provides advisory services (including technical, financial, and contracting) to many small and disadvantaged businesses. They also provide assistance to exporters and those involved in technology transfer. See section 13.6. 15. What is a debt guarantee and how does the SBA back a small business loan? A debt guarantee is an assurance that a certain portion of the debt principal (and/or interest) will be repaid even in the event of default. The SBA guarantees part of the loan that a local SBA-participating lender makes through an SBA program. 16. In which research areas does the SBA provide supplemental programs? Refer to Section 13.6. The SBA provides technical assistance, financial assistance, contracting assistance, disaster assistance recovery, supports special interests, provides advocacy, laws & regulations assistance, and works to provide civil rights compliance. Technical assistance is provided for entrepreneurial development, management assistance to small business owners, efforts to help small businesses to export, etc. Financial assistance includes loan programs, provides venture capital through Small Business Investment Companies (SBICs), manages surety bond guarantees, etc. Contracting assistance includes working to create an environment for maximum participation by small, disadvantaged, and woman-owned business in federal government contract awards. 17. What are some characteristics of a Community Development Financial Institutions (CDFI) loan? In 1994, Congress created the Treasury Department’s Community Development Financial Institutions (CDFI) Fund. Most CDFIs currently still focus on promoting affordable housing and homeownership. However, CDFIs are increasing their

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financing of small businesses through the making of microloans as well as larger loans. The SVA makes direct loans to CDFIs, which, in turn, make microloans to small businesses. See Figure 13.4 for factors to review when considering a CDFI loan. 18. What are factoring and receivables lending? Factoring is selling receivables to a third party at a discount from their face value in order to have an immediate cash flow instead of a deferred cash flow when the receivable is collected. Receivables lending involves pledging receivables as collateral against a loan. 19.

Describe examples of customer funding used to reduce financing needs. Depending on the type of business venture, funds from customers may be used to  help finance startups. Several models or approaches may be considered by  entrepreneurs.  “Pay­in­advance” is a very common model. For example, many service businesses  require at least a partial payment in advance before the service is provided. Home  remodeling projects usually require partial up­front payments, while tickets for  sporting and entertainment events are usually paid in full prior to the actual event. Subscription models are another way customer funds can be used to help finance  startup ventures. Subscriptions to purchase wine or computer services on a monthly  basis are examples of obtaining financing from customers. 

 

Acting as a matchmaker to bring together buyers and sellers is another way to make  use of customer funding. One example is the matching of the demand for hotel rooms  with the supply of available hotel rooms, for which transaction fees are charged.   Another example is the matching of available short­term apartment or house rentals  with people wanting short­term non­hotel lodging.  20. What is venture leasing? How does it differ from traditional leasing? Venture leasing involves leasing assets to high-growth ventures typically backed by venture investors. The return to the lessor involves lease payments and a portion of the venture’s equity. Traditional leasing targets returns only from the lease payments and the sale of salvaged assets.

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21. What is a direct public offering? A direct public offering is a security offering made directly to a large number of investors. It is often done over the internet but the success rate is still debatable. 22.

From the Headlines – Solix: Describe the alternative financing Solix arranged for the launch of its biofuels production facility. Comment on your impressions of what attracted the investors. Answers will vary: Solix’s technology and development were initially subsidized by Colorado State University and government grants. Then, to produce its large-scale algal oil production facility, it partnered with the Southern Ute Alternative Energy fund for a plant location and contributed capital. It also secured funding from private investors and government-funded entities. Among other things, the attraction to investors appears to have been a combination of affinity for the new technology and its promise, public policy and funding for related initiatives, and the possibility of investment returns.

EXERCISES/PROBLEMS AND ANSWERS 1. [Bank Loan Considerations] Assume you started a new business last year with $50,000 of your own money that was used to purchase equipment. Now you are seeking a $25,000 loan to finance the inventory needed to reach this year’s sales target. You have agreed to pledge your venture’s delivery truck and your personal automobile as support for the loan. Your sister also has agreed to cosign the loan. During your initial year of operation, you paid your suppliers in a timely fashion. A. Analyze the loan request from the viewpoint of a lender who uses the “five Cs” of credit analysis as an aid in deciding whether to make loans. Capacity to pay: depend on the venture’s ability to generate profits and cash flow from the business activities Capital: $50,000 personal capital has been invested in the venture. Collateral: The delivery truck and the entrepreneur’s personal automobile have been pledged as collateral. A sister has agreed to cosign the loan. Conditions: The loan is to finance the inventory. Consequently the conditions would relate to this inventory use. Character: The venture has a history of paying creditors in a timely fashion.

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B. Assume you are currently carrying an accounts receivable balance of $10,000. How might you use accounts receivables to obtain an additional bank loan? You could approach a bank with the receivables and your track record of collections and ask if they could be collateral for a loan. You could also contact a factor and see if you could “sell” the receivables for cash. C. Assume at the end of next year, you will have an accounts receivable balance of $15,000 and an inventories balance of $30,000. If a bank normally lends an amount equal to 80 percent of accounts receivable and 50 percent of inventories pledged as collateral, what would be the amount of a bank loan a year from now? $15,000  .80 = $12,000 $30,000  .50 = $15,000 Total = $27,000 2. [Factor Financing] Assume the operation of your business resulted in sales of $730,000 last year. Year-end receivables are $100,000. You are considering factoring the receivables to raise cash to help finance your venture’s growth. The factor imposes a 7 percent discount and charges an additional 1 percent for each expected ten-day average collection period over thirty 30 days. A. Estimate the dollar amount you would receive from the factor for your receivables if the collection period was thirty 30 days or less. If the collection period is 30 days or less, the factor will pay .93 x $100,000 = $93,000. B. Estimate the dollar amount you would receive from the factor for your receivables if the average collection period was sixty days. If the collection period is 60 days, the factor will pay 90% of the value (i.e., .07 for 30 days plus an additional .01 for 31-40 days, plus an additional .01 for 41-50 days, and an additional .01 for 51-60 days. Thus, the dollar amount paid would be: .90 x $100,000 = $90,000. C. Show how your answer in Part B would change if the factor charges an 8 percent discount and charges an additional .5 percent for each expected fifteen-day average collection period over thirty days. .08 + .005 +.005 = .09 1.00  .09 = .91 .91  $100,000 = $91,000 Or, (1(.08 + (.005  2)))  $100,000 = $91,000

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D. If the $730,000 in sales last year were evenly distributed throughout the year, an average $100,000 in receivables outstanding would imply what average collection period? Given the original terms stated in the problem, what dollar amount would you expect to receive for your receivables? Recall from Chapter 5 that the average collection period is also referred to as the days of sales outstanding; and in Chapter 6, the “sale-to-cash conversion period.” $100,000 / ($730,000 / 365) = $100,000/$2,000 = 50.0 days average collection period Original terms: for 50 days, the discount would be .07 + .01 +.01 = .09 1.00  .09 = .91 .91  $100,000 = $91,000 Or, (1(.07 + (.01  2)))  100,000 = 91,000