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> Equity Financing
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Online Small Business Workshop

 

 

 

Last Edited
April 14, 2003

 

 

ONLINE SMALL BUSINESS WORKSHOP
> Financing Your Business

Equity
Long Term Debt
Short Term Debt
Leverage
Abusing your Loan Privilege - An Example

To start your business you must purchase licenses, pay for permits, engage professional services (e.g. legal, accounting, insurance etc.), do leasehold improvements, buy furniture, fixtures and equipment etc. You may require initial retail inventory, an opening stock of repair parts, accessories or office supplies such as business cards, letterhead, envelopes, staples etc. Once you start operating, you must replenish these retail or parts stocks and pay the day-to-day wages of your employees (i.e.working capital requirements). There are financial strategies to satisfy these needs and to approach the various sources of this financing (i.e. lenders & investors).

Money that finances business is called capital. Bank loans approved for day-to-day business operations (working capital) have characteristics that make them different from those approved for equipment purchases (long term capital or capital assets). A bank loan officer can often assist you in finding a workable combination of these different types of capital. Using loans approved for purposes other than those for which they were approved is considered an abuse of your loan privilege.

Equity
Equity funds come from personal moneys of the partners (such as savings, inheritance or personal borrowings from financial institutions, friends, relatives and business associates) and from stockholders of the shares in a corporation. These funds are normally unsecured and have no registered claim on any of the assets of the business, freeing those up to be used as collateral for the loans (debt financing). Higher equity creates " increased leverage." Leverage reflects the business
's ability to attract other loans and investment. An equity position of $30,000 may enable the business to obtain debt financing of up to three times that amount, $90,000. A fully-leveraged business has no further ability to borrow money.

Long Term Debt
"Term" refers to the time for which money (a secured loan) is required and the period over which the loan repayment is scheduled. A long term loan is arranged when the scheduled repayment of the loan and the estimated useful life of the assets purchased (e.g. building, land, machinery, computers, equipment, shelving, etc.) is expected to exceed one year.

Short Term Debt
Short Term Loans usually take the form of operating term loans (less than one year) and revolving lines of credit. These finance the day-to-day operations of the business, including wages of employees and purchases of inventory and supplies.

Leverage
This is the relationship of debt financing to equity financing (leverage or debt-to-equity ratio). A proposal which involves $6000 of debt, and is based on an equity contribution of $2000 is said to have a debt/equity ratio of 3:1. Generally, the lender would like to see a new business owner who is just building a reputation have this at 2:1 or even 1:1.

Abusing your Loan Privilege - An Example:
Your business plan tells the banker that your proposed business requires a revolving line of credit of $40,000 to meet its day-to-day expenses over a number of months. The line of credit is approved because the banker believes that amount of money is absolutely necessary to enable you to operate over the specified time period. Shortly after this approval, you approach the bank again, this time with a request for a term loan of $25,000 to purchase new office furnishings. The bank denies you the term loan as it does not feel that, at this stage, the business can service such a large amount of debt. Disappointed by this refusal, you nonetheless decide to buy the new office furniture, taking the required $25,000 out of your operating line of credit account.

What has occurred? The integrity of your business plan has been betrayed! With the depletion of your operating line of credit, you can no longer expect to purchase the inventory deemed necessary to achieve your projections. The business will be less able to generate the sales revenue required to service the existing (plus additional) debt; and your revolving line of credit will have surrendered its ability to revolve. You return to the banker pleading for an extension of your line of credit, but the banker, feeling betrayed, has lost confidence in your management ability and may withdraw the line of credit privilege, insist on more equity, recall the loan in its entirety or force the business into receivership. Furthermore, this performance will remain on file as a black mark against your management ability long after the business is only a hazy memory.

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