Capital Alternatives
Understanding Money Sources

Internal Sources of Capital. There are three principal sources of internal capital:

Increasing the amount of earnings kept in the business.
Prudent asset management.
Cost control.
Increased Earnings Retention. Many businesses are able to meet all of their capital needs through earnings retention. Each year, shareholders' dividends or partners' draws are restricted so that the largest reasonable share of earnings is retained in the business to finance its growth.

As with other internal capital sources, earnings retention not only reduces any external capital requirement, but also affects the business' ability to secure external capital. Lenders are particularly concerned with the rate of earnings retention. The ability to repay debt obligations normally depends upon the amount of cash generated through operations. If this cash is used excessively to pay dividends or to permit withdrawals by investors, the company's ability to meet its debt obligations will be threatened.

Asset Management. Many businesses have non-productive assets that can be liquidated (sold or collected) to provide capital for short-term needs. A vigorous campaign of collecting outstanding receivables, with particular emphasis on amounts long outstanding, can often produce significant amounts of capital. Similarly, inventories can be analyzed and those goods with relatively slow sales activity or with little hope for future fast movement can be liquidated. The liquidation can occur through sales to customers or through sales to wholesale outlets, as required.

Fixed assets can be sold to free cash immediately. For example, a company auto might be sold and provide cash of $2,000 or $3,000. Owners and employees can be compensated on an actual mileage basis for use of their personal cars on company business. Or if an auto is needed on a full-time basis, a lease can be arranged so that a vehicle will be available.

Other assets such as loans made by the business to officers or employees, investments in non-related businesses, or prepaid expenses should be analyzed closely. If they are non-productive, they can often be liquidated so that cash is available to meet the immediate needs of the business.

Any of the above steps can be taken to alleviate short-term cash shortages. On a long-term basis, the business can minimize its external capital needs by establishing policies and procedures that will reduce the possibility of cash shortages caused by ineffective asset management. These policies could include the establishment of more rigorous credit standards, systematic review of outstanding receivables, periodic analysis of slow-moving inventories, and establishment of profitability criteria so that fixed asset investments are most closely controlled.

Cost Reduction . Careful analysis of costs, both before and after the fact, can improve profitability and therefore the amount of earnings available for retention. At the same time, cost control minimizes the need for cash to meet obligations to trade creditors and others.

Before the fact, a business can establish buying controls that require a written purchase order and competitive bids on all purchases above a specified amount. Decisions to hire extra personnel, lease additional space, or incur other additional costs can be reviewed closely before commitments are made.

After the fact, management should review all actual costs carefully. Expenses can be compared with objectives, experience in previous periods, or with other companies in the industry. Whenever an apparent excess is identified, the cause of the excess should be closely explored and corrective action taken to prevent its recurrence.

TRADE CREDIT
Trade credit is credit extended by suppliers. Ordinarily, it is the first source of extra capital that the small business owner turns to when the need arises.

Informal Extensions. Frequently, this is done with no formal planning by the business. Suppliers' invoices are simply allowed to "ride" for another 30 to 60 days. Unfortunately, this can lead to a number of problems. Suppliers may promptly terminate credit and refuse to deliver until the account is settled, thus denying the business access to sorely needed supplies, materials, or inventory. Or, suppliers might put the business on a C.O.D. basis, requiring that all shipments be fully paid in cash immediately upon receipt. At a time when a business is obviously strapped for cash, this requirement could have the same effect as cutting off deliveries all together.

Planning Advantages. A planned program of trade credit extensions can often help the business secure extra capital that it needs without recourse to lenders or equity investors. This is particularly true whenever the capital need is relatively small or short in duration.

A planned approach should involve the following:

Take full advantage of available payment terms. If no cash discount is offered and payment is due on the 30th day, do not make any payments before the 30th day.
Whenever possible, negotiate extended payment terms with suppliers. For example, if a supplier's normal payment terms are net 30 days from the receipt of goods, these could be extended to net 30 days from the end of the month. This effectively "buys" an average of 15 extra days.
If the business feels that it needs a substantial increase in time, say 60 to 90 days, it should advise suppliers of this need. They will often be willing to accept it, provided that the business is faithful in its adherence to payment at the later date.
Consider the effect of cash discounts and delinquency penalties for late payment. Frequently, the added cost of trade credit may be far more expensive than the cost of alternate financing such as a short-term bank loan.
Consider the possibility of signing a note for each shipment, promising payment at a specific later date. Such a note, which may or may not be interest-bearing, would give the supplier evidence of your intent to pay and increase the supplier's confidence in your business.
Ready Availability. Trade credit is often available to businesses on a relatively informal basis without the requirements for application, negotiation, auditing, and legal assistance often necessary with other capital sources.

Usage. Trade credit must be used judiciously. Its easy availability is particularly welcome in brief periods of limited needs. Used imprudently, however, it can lead to curtailment of relations with key suppliers and jeopardize your ability to locate other, competitive suppliers who are willing to extend credit to your business. Remember, that on the other side of the transaction there is another business that is trying to manage its sources of capital, too!

DEBT - TYPES & AVAILABILITY
Debt capital. Debt is an amount of money borrowed from a creditor. The amount borrowed is usually evidenced by a note, signed by the borrower, agreeing to repay the principal amount borrowed plus interest on some predetermined basis.

Borrowing Term. The terms under which money is borrowed may vary widely. Short-term notes can be issued for periods as brief as 10 days to fill an immediate need. Long-term notes can be issued for a period of several years.

Discounted Notes. In some case, particularly in short-term borrowing, the total amount of interest due over the term of the note is deducted from the principal before the proceeds are issued to the borrower. Such a note is called a discounted note.

Short-term Borrowing. Short-term borrowing usually requires repayment within 60 to 90 days. Notes are often renewed, in whole or in part, on the due date, provided that the borrower has lived up to the obligations of the original agreement and the business continues to be a favorable lending risk.

Credit Lines. When a business has established itself as being worthy of short-term credit, and the amount needed fluctuates from time to time, banks will often establish a line of credit with the business. The line of credit is the maximum amount that the business can borrow at any one time. The exact amount borrowed can vary according to the needs of the business but cannot exceed its established credit line.

These arrangements give the business access to its requirements up to the credit limit or line. However, it pays interest only on the actual amount borrowed, not the entire line of credit available to it.

Long -term Debt. Long-term debt is borrowing for a period greater than one year. This general classification includes "intermediate debt" which is borrowing for periods of one to 10 years.

Repayment Schedules. When the terms of a debt are negotiated, a payment schedule is established for both interest obligations and principal repayment. The dates on which principal and interest payments are due should be scheduled carefully. For example, a manufacturer with heavy sales just before Christmas and receivables collections through January might best be able to schedule repayments in February. If a payment were due in October or November, when inventories were high and receivables were climbing, the payment could be crippling.

Mortgage Loan Repayment Schedules. Principal and interest payments on mortgages usually involve uniform monthly payments that include both principal and interest. Each successive monthly payment reduces the amount of principal outstanding. Therefore, the amount of interest owed decreases and the portion of the monthly payment applicable to principal increases. In the early years of a mortgage, the portion of the monthly payment applied against the principal is relatively small, but grows with each payment.

Term Loan Payment Schedules. For term loans, payment of principal and interest is ordinarily scheduled on an annual, semiannual or quarterly basis.


Availability. Commercial banks are the ordinary source of short-term loans for the small business. For small businesses, borrowed capital for periods greater than 10 years is usually available only on real estate mortgages. Other long-term borrowing usually falls into the "intermediate" classification and is available for periods up to 10 years. Such loans are called "term loans."

Selecting Type and Term. The type and term of the loan should be based on the purpose for which the funds will be used. Your banker or accountant can help you determine what type of loan is best to meet your needs. See if you can "pass the test" and match the loan request with the appropriate borrowing arrangement.


COLLATERAL
Loans may be secured or unsecured. In a secured loan, the borrower pledges certain assets as collateral (security) to protect the lender in case of default on the loan or failure of the business. If the business defaults on the loan through failure to meet interest obligations or principal repayments, the noteholder (lender) assumes ownership of the collateral. If the business fails, the noteholder claims ownership of those specific assets pledged as collateral before the claims of other creditors are settled.

Typical Collateral. In long-term borrowing, fixed assets such as real estate or equipment are usually pledged as collateral. For short-term borrowing, inventories or accounts receivable are the usual collateral.

Inventory Financing. Inventory financing is most commonly used in auto and appliance retailing. As each unit is purchased by the retailer, the manufacturer is paid by the lender. The lender is repaid by the retailer when the unit is sold. Interest is determined separately for each unit, based upon the actual amount originally paid by the lender and the period between the time the money is paid the lender is reimbursed by the retailer.

Accounts Receivable Financing. Basically, accounts receivable financing falls into two categories as follows:

Assignments. The business pledges, or "assigns" its receivables as collateral for a loan
Factoring. The borrower sells its accounts receivable to a lender (factor).
Although these arrangements are not loans, in a pure sense, the effect is the same.

Receivables Assignments. When receivables are assigned, the amount of the loan varies according to the volume of receivables outstanding. Normally the lender will advance some specified percentage of the outstanding accounts receivable up to a specific credit limit.


In many industries, accounts receivable financing is considered a sign of weakness. However, it is quite common in others. This is particularly true in the garment industry and in personal finance companies. When accounts receivable are assigned, the borrower is still responsible for collection. Upon collection of any receivable, the amount borrowed should be repaid. Interest is based upon the amount borrowed and the time between receipt of proceeds by the borrower and repayment.

Factoring Accounts Receivable. When accounts receivable are factored, they are sold to the factor and the borrower has no responsibility for collection. The borrower pays the factor a service charge based upon the amount of each receivable sold. In addition, the borrower pays interest for the period between the sale of the receivable and the date the customer pays the factor

Since the factor is responsible for collection, it will only purchase those receivables for which is has approved credit. When customers must pay invoices directly to a factor, it may create doubts about the company's financial stability and, therefore, its ability to deliver. However, factoring is also common in some industries. For example, high tech companies often factor receivables to finance growth and research and development and consider this a way to outsource part of their accounting activities.

Unsecured Debt. The secured creditor's risk is reduced by the claim against specific assets of the business. In default or liquidation, the secured creditor can take possession of these assets to recover any unpaid amounts due from the business. Holders of unsecured notes do not enjoy the same protection. If the company defaults on a payment, the unsecured creditor, under normal circumstances, can only re-negotiate the amount due, perhaps by seeking collateral, or force the company to liquidate. In liquidation, the holder of an unsecured note would normally have no rights that are superior to those of any other creditors.

Restriction On business. When accepting an unsecured note, the lender will often place certain restrictions on the business. A typical restriction might be to prevent the company from incurring any debt with a prior claim on the assets of the business in the event of default or failure. For example, a term note agreement might prevent a company from financing its receivables or inventories since this would result in a prior claim against the assets of the business in liquidation. Such restrictions may have no effect on the business' ability to operate. However, in other cases, such restrictions could be severe. For example, a business may have a chance to sell to a major new customer. The new customer may insist upon 60 day credit terms which will require the business to seek additional external financing. Normally, this financing might be readily available on realistic terms from a factor. However, the restriction of the unsecured note could prevent the business from taking advantage of this significant opportunity for sales and profit improvement.

Personal Guarantees. The liability of a corporation's shareholders is generally limited to the assets of the business. Creditors have no normal claim against the personal assets of the stockholders if the business should fail. Therefore, many lenders, when issuing credit to small corporations, seek the added protection of a personal guarantee by the owner (or owners). This protects the creditors if the business fails, since they retain a claim against the personal assets of the owners to fulfill the debt obligation.

Interest Rates. The interest rates at which small businesses borrow are often relatively high. Banks and other commercial lending institutions normally reserve their lowest available interest rate, the so-called prime rate, for those low risk situations such as short-term loans for major corporations and public agencies where the chances of default are slim and the costs for collection, credit search, and other administrative tasks are minimal. Because of the higher risks involved in loaning to small businesses, lenders often seek greater collateral while charging higher interest rates to offset their added costs of credit search and loan administration.

EQUITY CAPITAL
Unlike debt, equity capital is permanently invested in the business. The business has no legal obligation for repayment of the amount invested or for payment of interest for the use of the funds.

Share of Ownership. The equity investor shares in the ownership of the business and is entitled to participate in any distribution of earnings through dividends, in the case of corporations or drawings in the case of partnerships. The extent of the equity investor's participation in the distribution of earnings of a corporation depends upon the number of shares held. In a partnership, the equity investor's participation will depend upon the ownership percentage specified in the partnership agreement.

Voting Rights. The equity investor's ownership interest also carries the right to participate in certain decisions affecting the business.

Legal liability. The personal liability of equity investors for debts of the business depends upon the legal form of the organization. Basically, the investor who acquires equity in a partnership could be personally liable for debts of the business if the business should fail. In a corporation, the liability of equity investors (shareholders) is limited to the amount of their investment. In other words, if a partnership should fail, creditors could have a claim against the personal assets of the individual partners. If a corporation should fail, the only claims of creditors would be against any remaining assets of the corporation, not against any personal assets of the shareholders.

Equity Investor's compensation . The purchaser of an equity interest in a business expects to be compensated for the investment in any of the three following ways:

Income from earnings distribution of the business, either as dividends paid to corporate shareholders or as drawings in a partnership.
Capital gain realized upon sale of the business.
Capital gain realized from selling his or her interest to other partners.
Capital Gains . Capital gain is the term used to describe any excess of the selling price of an investment over the initial purchase price. For example, if you purchased an equity interest in a business for $5,000 and later sold it for $8,000, you would realize a capital gain of $3,000 ($8,000 - $5,000).

Tax Advantages . Long-term capital gains are those realized on investments held for a period longer than six months. These gains are subject to federal income tax at a lower tax rate than on ordinary income. Therefore, income tax advantages are often a major reason for the investor's desire to acquire an equity interest.

Earnings Distribution. The equity investor in a partnership is entitled to a share of all drawings paid out to partners at a percentage established when the interest was purchased (and defined in the partnership agreement). For example, assume an investor acquired a 20% interest in a partnership. The distribution of earnings to all partners in a given year is $20,000. The holder of the 20% interest would receive $4,000 ($20,000 X 0.20).

Sale (or Liquidation) of business. If a business is sold or liquidated, the equity investor shares in the distribution of the proceeds. As with an earnings distribution, the share of the proceeds in a corporation sale depends upon the number of shares held. In a partnership, each partner's share of the proceeds is based upon the percentages specified in the partnership agreement. If the proceeds received by the equity investor exceed the original purchase price, this excess is considered a capital gain and taxed accordingly at effective rates more favorable than those for ordinary income. If the business were liquidated, the assets would be sold and the proceeds would first be used to discharge any outstanding obligations to creditors. The balance of the proceeds, after these obligations had been fulfilled, would be distributed to the equity investors in accordance with their shareholdings or percentages of interest.

Sale of equity Interest. As a business prospers and grows, the value of an equity interest grows with it. Therefore, the equity investor may be able to sell his or her interest at a price higher than the initial acquisition cost. For example, an equity investor in a corporation may have purchased his or her interest at $10.00 per share. As the business grows, he or she is able to sell the shares at $15.00 per share, realizing a capital gain of $5.00 (15.00 - $10.00) on each share sold.

Capital Gains vs Dividends. In many cases, the equity investor in a small business is primarily interested in capital gains. Aside from the tax advantages described earlier, the equity investor usually realizes that the earnings of the small business are better retained in the business than distributed as dividends or drawings. Retention of earnings permits the business to grow so that the value of the equity interest increases. The investor can realize a return on the investment through a capital gain derived from selling his or her shares or upon sale of the business.

Public Stock Offerings. When businesses are first organized, equity capital is usually secured from a combination of sources such as the original owners' personal savings and through solicitations from friends, relatives, or other persons known to have financial capability for such investments. As the need for equity capital becomes greater, say $50,000 to $200,000, it is customary to seek capital through the services of professional finders, who receive a fee for securing the capital needed. These professionals normally have access to wealthy individuals, capital management companies, estates, trusts, and others with sufficient capital to make such an investment.

As higher levels of capital need, shares are sold through public offerings. The public offering seeks to attract a large number of investors to purchase stock, in large or small amounts. A market is then created for the stock. Shares purchased by the public, as well as the shares held by the original owners and any subsequent equity investors, can also be sold at the going market price. These transactions do not have a direct effect on the business' capital position since it does not receive the proceeds from the sale. The equity investor can realize a capital gain by selling shares at prices higher than the original purchase price.

Risks of Equity Investment. The equity investor assumes substantial risk. Unlike the secured creditor, the equity investor has no specific claim against any assets of the business. In liquidation, all claims of all creditors must be satisfied before any remaining assets become available for distribution to the owners. Even then, the equity investor's participation in the proceeds is restricted to a share that is proportionate to the number of shares held or the partnership interest. Since the risks of equity investment are so substantial, particularly in the case of small businesses, equity investors expect a considerably higher return than the lender. >

A lender might be willing to loan money to a business at an interest rate of 10% or 12% since it has certain legal protections in the event of default or liquidation. The investor of equity capital in the same business might seek a far higher return, perhaps 20%, 50% or even more in order to compensate for the added risk of equity investment.

SUMMARY OF KEY POINTS
Note the following key points:

There are various sources of capital available to the small business owner. Terms, collateral, cost (interest rate and control) vary for each alternative.
The need for additional capital occurs frequently in many small businesses.
The ability of the owners to anticipate the need and to match the type of capital with that need will help them secure capital on the most favorable terms.
Those businesses that are alert to opportunities for internal capital generation will often find that this effort not only minimizes the need for external capital, but also opens the doors of the outside money market to them.
You can minimize your need for external financing through proper asset management, cost control and retention of earnings.
Trade credit can be utilized to maintain favorable supplier relations while taking full advantage of the credit that is available to you from this vital and convenient source.
Various types of loan arrangements were also explored, considering both short- and long-term needs as well as typical requirements for security through pledging of specific assets or the owners' personal guarantees.
Finally, the equity capital market was included so that you understand what the equity investor expects in return for a commitment of capital and the effect that the equity investor's interest can have on your business.
With this information you should now understand the advantages and disadvantages of various capital sources. This will help you select the source or combination of sources that is most appropriate for your needs.

 

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