Essentials_of_Entrepreneurship_and_Small_Business_Management,_Global

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 499

● Put social media to work to locate potential investors. Social media such as Facebook,
Twitter, LinkedIn, and others are useful tools for locating potential investors. For example,
LinkedIn has several groups that help investors and entrepreneurs connect with each other,
such as Angel Investors, Impact Investors, and Angel Investor Group.

● Be thoroughly prepared before approaching potential lenders and investors. In the hunt
for capital, tracking down leads is tough enough; don’t blow a potential deal by failing to
be ready to present your business idea to potential lenders and investors in a clear, concise,
convincing way. That, of course, requires a solid business plan and a well-rehearsed eleva-
tor pitch—one or two minutes on the nature of your business and the source of its competi-
tive edge to win over potential investors and lenders. “Entrepreneurs who come across with
unsubstantiated market assessments, no competitive analysis, and flimsy marketing and
sales plans will be the losers in the race to money,” says venture capitalist John May.6

● Entrepreneurs cannot overestimate the importance of making sure that the “chemistry”
among themselves, their companies, and their funding sources is a good one. Too many
entrepreneurs get into financial deals because they need the money to keep their businesses
growing only to discover that their plans do not match those of their financial partners.

● Plan an exit strategy. Although it may seem peculiar for entrepreneurs to plan an exit
strategy for investors when they are seeking capital to start their businesses, doing so in-
creases their chances of closing a deal. Investors do not put their money into a business
with the intent of leaving it there indefinitely. Their goal is to get their money back—along
with an attractive return on it. Entrepreneurs who fail to define potential exit strategies for
their investors reduce the likelihood of getting the capital their companies need to grow.

● When capital gets tight, remember to bootstrap. Because capital is tighter for small busi-
nesses, don’t forget to use some of the clever ways you employed to get your business go-
ing when you had limited funds. Bootstrapping is not just for start-ups!

Rather than rely primarily on a single source of funds as they have in the past, entrepreneurs layered financing
must piece together capital from multiple sources, a method known as layered financing. They the technique of raising
have discovered that raising capital successfully requires them to cast a wide net to capture the capital from multiple
financing they need to launch their businesses. sources.

ENTREPRENEURIAL PROFILE: John and Patrick Collison: Stripe After launching their
first company and selling it in just ten months, brothers John and Patrick Collison launched
Stripe, an online payments company, with their own money. While working on several projects,
Patrick realized how difficult taking online payments was for merchants and decided that he and
his brother could develop a better method. They tested their simple payment solution with online
shoppers, made the necessary modifications, and landed a spot (and the seed financing that came
with it) in Y Combinator, a prestigious business accelerator in Mountain View, California. Stripe
grew quickly, and the Collisons secured investments from several high profile angel investors, in-
cluding entrepreneurs Elon Musk and Peter Thiel, and eventually venture capital firms. Just four
years after start-up, the Collisons had raised more than $120 million in capital, and Stripe was
worth an estimated $1.75 billion.7 ■

This chapter will guide you through the myriad financing options available to entrepreneurs, capital
focusing on both sources of equity (ownership) and debt (borrowed) financing. Becoming a suc- any form of wealth em-
cessful entrepreneur requires one to become a skilled fund-raiser, a job that usually requires more ployed to produce more
time and energy than most business founders realize. In start-up companies, raising capital can wealth.
easily consume as much as one-half of the entrepreneur’s time and can take many months to com-
plete. In addition, many entrepreneurs find it necessary to raise capital constantly to fuel the hefty
capital appetites of their young, fast-growing companies. Although the amount an entrepreneur
needs to launch a start-up varies significantly by the type of business being launched, the Global
Entrepreneurship Monitor reports that new entrepreneurs need on average about $15,000 to start
their businesses and an additional $16,000 in funding after start-up.8 However, these “small”
amounts of capital can be most difficult to secure.

Capital is any form of wealth employed to produce more wealth. It exists in many forms in
a typical business, including cash, inventory, plant, and equipment. Entrepreneurs have access to
two different types of capital: equity and debt.

500 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

LO1 Equity Capital versus Debt Capital
Describe the differences
between equity capital Equity capital represents the personal investment of the owner (or owners) in a business and
and debt capital. is sometimes called risk capital because these investors assume the primary risk of losing their
equity capital funds if the business fails. If a venture succeeds, however, founders and investors share in the
capital that represents the benefits, which can be quite substantial. The founders of and early investors in Yahoo!, Sun
personal investment of the Microsystems, Federal Express, Intel, and Microsoft became multimillionaires when the com-
owner (or owners) of a panies went public and their equity investments finally paid off. Michael Moritz, a partner in
company; sometimes called the venture capital firm Sequoia Capital, recalls a meeting in 1999 that took place around a
risk capital. ping-pong table that doubled as a conference table for Sergey Brin and Larry Page, the founders
of a start-up company that had developed a search engine called Google. The young company had
debt capital just changed its name from Backrub and had only 12 employees when Moritz agreed to invest
the financing that an $25 million in exchange for 16 percent of the company’s stock. When Google made an initial
entrepreneur borrows and public offering five years later, Moritz’s original investment was worth $3 billion!9
must repay with interest.
To entrepreneurs, the primary advantage of equity capital is that it does not have to be repaid
like a loan does. Equity investors are entitled to share in the company’s earnings (if there are any)
and usually to have a voice in the company’s future direction. The primary disadvantage of equity
capital is that the entrepreneur must give up some—sometimes even most—of the ownership in
the business to outsiders. Although 50 percent of something is better than 100 percent of noth-
ing, giving up control of a company can be disconcerting and dangerous. Entrepreneurs are most
likely to give up significant amounts of equity in their businesses in the start-up phase than in any
other. To avoid having to give up control of their companies early on, entrepreneurs should strive
to launch their companies with the least amount of money possible.

Debt capital is the financing an entrepreneur borrows and must repay with interest. Very
few entrepreneurs have adequate personal savings to finance the total start-up costs of a small
business; many of them must rely on some form of debt capital to launch their companies.
Lenders of capital are more numerous than investors, but small business loans can be just as
difficult (if not more difficult) to obtain. Although borrowed capital allows entrepreneurs to
maintain complete ownership of their businesses, it must be carried as a liability on the balance
sheet, and it must be repaid with interest in the future. In addition, because lenders consider
small businesses to be greater risks than bigger corporate customers, they require higher inter-
est rates on loans to small companies because of the risk–return trade-off: The higher the risk,
the greater the return demanded. Most small firms pay the prime rate—the interest rate banks
charge their most creditworthy customers—plus a few percentage points. Still, the cost of debt
financing often is lower than that of equity financing. Because of the higher risks associated
with providing equity capital to small companies, investors demand greater returns than lend-
ers. In addition, unlike equity financing, debt financing does not require entrepreneurs to dilute
their ownership interest in their companies. We now turn our attention to eight common sources
of equity capital.

LO2 Sources of Equity Financing
Discuss the various sources
of equity capital available Personal Savings
to entrepreneurs.
The first place entrepreneurs should look for start-up money is in their own pockets. It’s the
bootstrapping least expensive source of funds available! A start-up has very little if any financial history, and
a process in which entre- investors view investments in early-stage companies as high risk. Therefore, the earlier in the
preneurs tap their personal life of the company that an entrepreneur must raise capital, the more he or she will likely have to
savings and use creative, give up in ownership to secure that financing. Entrepreneurs apparently see the benefits of self-
low-cost start-up methods sufficiency; tapping their personal savings and using creative, low-cost start-up methods, a tech-
to launch their businesses. nique known as bootstrapping, is one of the most common sources of funds used to start a business.
According to a survey by the Kauffman Foundation and LegalZoom, more than 86 percent of
U.S. entrepreneurs use personal savings and assets as a primary source of financing for their start-
ups.10 However, it is not just small businesses that rely on personal savings. A recent survey of
companies in the Inc. 500 List of America’s Fastest Growing Companies finds that 77 percent of the
entrepreneurs who founded these high-growth ventures also relied on personal savings to help
fund their businesses.11 The Global Entrepreneurship Monitor survey reports that entrepreneurs

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 501

Other FIGURE 13.1
2%
Sources of
Friends Banks Financing for
1% 16% Typical Start-Up
Businesses
Family
8% Source: Donna J. Kelley,
Abdul Ali, Candida Brush,
Personal Savings Andrew C. Corbett, Mahdi
73% Majbouri, and Edward G.
Rogoff, “2012 United States
Report,” Global Entrepre-
neurship Monitor, p. 23.

in the U.S. rely on personal savings for 73 percent of total funding (see Figure 13.1).12 Bootstrap-
pers learn quickly to be frugal and stretch the income-generating power of every dollar, espe-
cially when most or all of those dollars come from their personal savings.

ENTREPRENEURIAL PROFILE: Sandi Bryant: Americare Pharmacy Sandi Bryant,
founder of Americare Pharmacy in Fairview, North Carolina, needed $300,000 to open her
long-term care pharmacy business. To fund the business, Bryant used $100,000 from her retire-
ment savings and took out a personal loan using her home as collateral. Although she and her
husband were anxious about taking the risk, after analyzing how many prescriptions she would
have to fill to break even, they decided that investing their personal savings was worth the risk.
Americare Pharmacy broke even after only eight months, and Bryant is now able draw a good
salary and put money into her retirement account.13 ■

Lenders and investors expect entrepreneurs to put their own money into a business start-up.
If an entrepreneur is not willing to risk his or her own money, potential investors are not likely
to risk their money in the business either. Furthermore, failing to put up sufficient capital of their
own means that entrepreneurs must either borrow an excessive amount of capital or give up a
significant portion of ownership to outsiders to fund the business properly. Excessive borrowing
in the early days of a business puts intense pressure on its cash flow, and becoming a minority
shareholder may dampen a founder’s enthusiasm for making a business successful.

Friends and Family Members

Although most entrepreneurs look to their own bank accounts first to finance a busi-
ness, few have sufficient resources to launch their businesses alone. After emptying
their own pockets, where should entrepreneurs turn for capital? The second place most
entrepreneurs look is to friends and family members who might be willing to invest in
(or lend to) a business venture. Because of their relationships with the founder, these
people are most likely to invest. Often they are more patient than other outside inves-
tors and are less meddlesome in a business’s affairs (but not always!) than many other
types of investors.

ENTREPRENEURIAL PROFILE: Tom Haarlander: ARCiPLEX Tom Haarlander, Tom Haarlander, CEO of ARCiPLEX
President of ARCiPLEX, Nashville, Tennessee, has relied on friends and family for
most of the funding needs of the company he cofounded. Although Haarlander often
has been uncomfortable with the responsibility of using friends’ and family members’
money, he has had to rely on their support to fund the early growth of his business. In
every situation, Haarlander sets up a formal agreement that pays interest every month
to those who lend ARCiPLEX money to show his intention to pay them back. Haarlander
has always been aggressive in using any excess cash flow to pay back the principal on the
loans from friends and family, sometimes to the detriment of the business. By keeping
any funding from friends and family structured as a loan, Haarlander says he has been
able to keep good relationships with all of those who have helped fund his business.14 ■

502 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

accredited investors Investments from family and friends are an important source of capital for entrepreneurs,
investors who have a but the amounts invested typically are small, often no more than just a few thousand dollars. Ac-
sustained net worth cording to the Global Entrepreneurship Monitor, entrepreneurs in the United States receive about
(excluding their primary 9 percent of total funding from friends and family.15
residences) of at least
$1 million or annual income Investments (or loans) from family and friends are an excellent source of seed capital and
of at least $200,000. can get a start-up far enough along to attract money from private investors or venture capital
companies. Inherent dangers lurk in family business investments and loans, however. One study
crowdfunding reports a default rate of 14 percent on business loans from family and friends, compared to a
a method of raising capital default rate of 1 percent for bank loans.16 Unrealistic expectations or misunderstood risks have
that taps the power of so- destroyed many friendships and have ruined many family gatherings. Remember: Thanksgiving
cial networking and allows comes around every year! To avoid problems, an entrepreneur must honestly present the invest-
entrepreneurs to post their ment opportunity and the nature of the risks involved to avoid alienating friends and family
elevator pitches and pro- members if the business fails. Smart entrepreneurs treat family members and friends who invest
posed investment terms on in their companies in the same way they would treat outside investors. Some investments in
specialized Web sites and start-up companies return more than friends and family members ever could have imagined. In
raise money from ordinary 1995, Mike and Jackie Bezos invested $300,000 in their son Jeff’s start-up business, Amazon
people who invest as little .com. Today, Mike and Jackie own 6 percent of Amazon.com’s stock, and their shares are worth
as $100. billions of dollars!17 The accompanying “Hands On . . . How To” feature offers suggestions for
structuring successful family or friendship financing deals.

Crowd Funding

Historically, securities laws limited who can invest in small businesses. Investing in entrepreneur-
ial businesses has been the realm of those with the knowledge and financial ability to assume the
risks that come with such investments. Known as accredited investors, these people must have a
sustained net worth (excluding their primary residence) of at least $1 million or annual income of at
least $200,000. There are between 5 million and 7.2 million accredited investors in the United States;
however, only about 756,000 of these accredited investors have made direct investments in entre-
preneurial businesses.18 A few creative entrepreneurs have used a loophole to raise money from in-
vestors who do not meet the requirements of accredited investors using a funding technique called
crowdfunding. Crowdfunding taps the power of the Internet and social networking and allows
entrepreneurs to post their elevator pitches and proposed investment terms on specialized Web
sites and raise money from ordinary people who invest as little as $100. Crowdfunding primarily
has been used to help raise money to support social causes, help fund aspiring artists, or support
local small business start-ups. The money received from crowdfunding had to be considered a
contribution or a donation, rather than an investment. In most cases, entrepreneurs offer some

Joe Oater/Cartoon Bank

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 503

Hands On . . . How To

Structure Family and Friendship Financing Deals

Tapping family members and friends for start-up capital, whether • Settle the details up front. Before any money changes
in the form of equity or debt financing, is a popular method of fi- hands, both parties must agree on the details of the deal.
nancing business ideas. In a typical year, some 6 million individuals How much money is involved? Is it a loan or an investment?
in the United States invest about $100 billion in entrepreneur- How will the investor cash out? How will the loan be paid
ial ventures. Unfortunately, not all of these deals work to the off? What happens if the business fails?
satisfaction of both parties. The following suggestions can help
entrepreneurs avoid needlessly destroying family relationships and • Create a written contract. Don’t make the mistake of
friendships: closing a financial deal with just a handshake. The prob-
ability of misunderstandings skyrockets! Putting an agree-
• Family should not be your first financing option. Loans ment in writing demonstrates the parties’ commitment to
and investments from family members should never be con- the deal and minimizes the chances of disputes from faulty
sidered the easy option for financing a business. Make sure memories and misunderstandings.
you have done everything you can to bootstrap your business
to minimize the cash you actually will need before turning to • Treat the money as “bridge financing.” Although family
family for help. and friends can help you launch your business, it is unlikely
that they can provide enough capital to sustain it over the
• Choose your financier carefully. One of the first issues long term. Sooner or later, you will need to establish a rela-
to consider is the impact of the investment on everyone tionship with other sources of credit if your company is to
involved. Will it work a hardship on the investor or lender? survive and thrive. Consider money from family and friends
Is the investor putting up the money because he or she as a bridge to take your company to the next level of financ-
wants to or because he or she feels obligated? Can all par- ing, as seen in the Entrepreneurial Profile of Tom Haarlander
ties afford the loan if the business folds? No matter how in this chapter.
much capital you may need, accepting more than fam-
ily members or friends can afford to lose is a recipe for • Develop a payment schedule that suits both the
disaster—and perhaps bankruptcy for the investors. Lynn entrepreneur and the lender or investor. One of the
McPhee used $250,000 from family members to launch primary benefits of financing from family members and
Xuny, a Web-based clothing store. Her basic rule was that if friends is that the repayment or cash-out schedule usually
the investment would cause any financial distress or poten- is flexible. Although lenders and investors may want to get
tial hardship, she would not accept their money. Remember their money back as quickly as possible, a rapid repayment
that relationships often suffer if a business fails and friends or cash-out schedule can jeopardize a fledgling company’s
and family members lose their money. survival. Establish a realistic repayment plan that works for
the parties without putting excessive strain on your young
• Keep the arrangement strictly business. The parties company’s cash flow. Family members are usually more than
should treat all loans and investments in a business-like willing to be patient funders of your business.
manner, no matter how close the friendship or family rela-
tionship, to avoid problems down the line. If the transaction • Have an exit plan. Every deal should define exactly how
is a loan exceeding $10,000, it must carry a rate of interest investors will “cash out” their investments or loans.
at least as high as the IRS minimum rate; otherwise, the
Internal Revenue Service may consider the loan a gift and Sources: Based on Luke Landers, “8 Rules for Borrowing Money from Friends and Fam-
penalize the lender. Treat family investors just like any other ily,” Consumerism Commentary, February 26, 2013, www.consumerismcommentary
early stage investor in the business. .com/rules-borrowing-money-friends-family/; Caron Beesley, “6 Tips for Borrowing
Startup Funds from Friends or Family,” SBA Community, January 3, 2012, http://
• Prepare a business plan. Treat friends and family mem- community.sba.gov/community/blogs/community-blogs/small-business-cents/
bers just as you would angel investors, bankers, venture 6-tips-borrowing-startup-funds-friends-or-family; Rosalind Resnick, “For You, Grad-
capitalists, and other professionals by doing your research uate, Some Start-Up Capital,” Wall Street Journal, June 7, 2011, http://online.wsj.com/
and preparing a business plan. The most important use of article/SB10001424052702304432304576369842747489336.html; Sarah Dougherty,
a business plan is to communicate the business model to “ ‘Love Money’ Seeds Many Budding Ventures,” Financial Post, January 30, 2008,
potential investors, so prepare a thoroughly researched busi- http://www.financialpost.com/small-business/business-solutions/story.html?id=
ness plan and go over it carefully with any potential family 269859; Paulette Thomas, “It’s All Relative,” Wall Street Journal, November 29,
members interested in providing funding for the business. 2004, pp. RR4, R8; Andrea Coombes, “Retirees as Venture Capitalists,” CBS
Be honest and be clear about the worst-case scenario in MarketWatch, November 2, 2003, http://netscape.marketwatch.com/news/story.asp?
your plan. dist=feed&siteid=netscape&guid={1E1267CD-32A4-4558-9F7E-40E4B7892D01};
Paul Kvinta, “Frogskins, Shekels, Bucks, Moolah, Cash, Simoleans, Dough, Dinero:
Everybody Wants It. Your Business Needs It. Here’s How to Get It,” Smart Business,
August 2000, pp. 74–89; Alex Markels, “A Little Help from Their Friends,” Wall
Street Journal, May 22, 1995, p. R10; and Heather Chaplin, “Friends and Family,”
Your Company, September 1999, p. 26.

504 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

nominal benefit in return for financial support. For example, a musician might show appreciation
to contributors by giving them a free download of a new song. Likewise, an owner of a new restau-
rant may offer each contributor a special discount. The contributions are motivated by the desire
to help out the aspiring musician or restaurateur. The most commonly used websites that promote
traditional crowdfunding are Kickstarter, Rock the Post, and IndieGoGo. AngelList is a crowd-
funding site for accredited angel investors looking to make small investments. Kiva and Accion
are crowd lending sites that link small businesses with people willing to provide micro loans.

ENTREPRENEURIAL PROFILE: Erin Anderson and Dan Ellsworth: Daniel Ellsworth &
The Great Lakes Erin Anderson is the manager for an up-and-coming band called Daniel
Ellsworth & The Great Lakes. Anderson and Ellsworth set up a crowdfunding campaign for the
band’s newest release on a crowdfunding site, Pledge Music, which helps them run a pre-order
campaign through the band’s Web site to raise funding and predict initial demand for new
T-shirts, CDs, vinyl albums, and posters. They were able to use the money raised through the
Pledge Music campaign to print the T-shirts and posters and produce CDs and albums. The cam-
paign also helped them predict future demand, which helped them order the right amount of
inventory.19 ■

Courtesy of Daniel Ellsworth The Jumpstart Our Business Startups (JOBS) Act of 2012 significantly expands the use of
crowdfunding as a way to raise equity investment for small businesses. Once this law is fully
enacted, those who provide funding can now become equity investors with ownership in the
business. The JOBS Act opens up funding of start-ups to a much broader group of investors who
do not meet the legal criteria to be considered accredited investors. To be eligible for crowdfund-
ing, a business have less than $1 billion in annual revenue. An eligible business can raise up to
$1 million from a crowdfunding offering each year. The first phase of the JOBS Act opened up
crowdfunding only to accredited investors. Eventually, the JOBS Act will open up equity-based
crowdfunding to any investor. When the law is fully enacted, it will establish a ceiling on an indi-
vidual’s crowdfunding investment that is based on his or her income and net worth. The original
goal of the JOBS Act was to allow anyone to invest some amount in a business start-up. When the
law is finally fully implemented, entrepreneurs no longer will be limited to only seeking funding
from accredited investors.20

Attracting investors through crowdfunding, particularly traditional crowdfunding Web sites,
requires a different approach than an entrepreneur uses when pursuing more sophisticated and
experienced investors. Unlike experienced investors who invest more in people than in their
ideas, crowdfunding investors tend to be attracted to compelling stories and business ideas they
can see themselves using. Crowdfunding works through social media, so the entrepreneur’s exist-
ing network of contacts must be advocates to lend credibility to the business among the broader
network.21 Although the JOBS Act will eventually significantly broaden the pool of people
who can invest in small businesses, it also creates new challenges for entrepreneurs who use
crowdfunding. Crowdfunding may complicate future fundraising if an entrepreneur uses layered
financing, so entrepreneurs should seek advice from financing experts to develop a long-term
financing plan. Crowdfunding creates a large number of owners who all have certain expecta-
tions and may require attention from the entrepreneur. If adding one additional partner increases
the complexity of running a business, imagine what a crowd of partners can do to complicate an
entrepreneur’s life! The accompanying “Hands On . . . How To” feature offers some additional
cautions when using crowdfunding to finance a small business.

accelerator programs Accelerators
programs, often sponsored
by communities and univer- Inexperienced entrepreneurs have difficulty finding early stage seed funding. The first-time en-
sities, that provide a small trepreneur doesn’t have the credibility to attract professional investors and typically doesn’t have
amount of seed capital and the personal wealth required to launch a business. To help bridge this gap in funding, many com-
a wealth of additional sup- munities and universities have established accelerator programs that offer new entrepreneurs a
port for start-up companies. small amount of seed capital and a wealth of additional support. Accelerator programs help move
entrepreneurs from the idea stage to a point when the business has a proven story and a strong
business model that the founder can pitch for more significant funding. Accelerators offer a struc-
tured program that lasts from three months to one year. A select group of entrepreneurs, typically
10 to 20, are invited to participate as a group in an accelerator program. The accelerator provides

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 505

Hands On . . . How To

Crowdfunding

Crowdfunding Web sites, such as Kickstarter, are a popular way Avoiding a Kickstarter Disaster
for small start-ups to get seed funding. There are many success
stories of companies that got the start-up capital they needed for Crowdfunding remains a popular tool for entrepreneurs to use
a successful launch through a crowdfunding campaign. to help get hard-to-find seed capital. When approached care-
fully, crowdfunding can be a highly effective means for rais-
Nathan Resnick, founder of Yes Man Watches, had hoped to ing funding. The following suggestions can help entrepreneurs
raise $15,000 using Kickstarter to launch his online retail watch avoid creating disastrous situations when raising money using
business. Resnick used blogs that write about watches to help crowdfunding:
build buzz about his new business and its Kickstarter campaign.
He asked all of his contacts to post on Twitter and Facebook about • Start with a business plan. Although business plans
Yes Man Watches, sending them pictures of his watches they are not required by crowdfunding Web sites, it is always
could include with their posts. When his campaign went live, he advisable to develop one as part of your preparation.
had strong support the first day and was able to exceed his goal Remember, one of the most important uses of a busi-
by raising more than $32,000. ness plan is to communicate with investors and bankers.
Although Kickstarter backers are not technically investors,
Ilene Ruvinsky, cofounder of a skin care company called Don’t developing a plan that spells out what you will do with the
Call Me Ma’am, developed a video to support her fundraising money and how you will achieve what you promise benefits
campaign on the crowdfunding site Fundable.com. She spent her both investors and the entrepreneur.
own money producing the video in hopes that its quality would
result in even more funding from her crowdfunding campaign. • Have contracts in place. Because crowdfunding usu-
Ruvinsky met her goal of raising $20,000 through Fundable.com, ally involves some sort of a product, make sure you have
and the business is moving toward a launch of its product line. contacts in place with suppliers or outsource manufacturers
to ensure that you can deliver what you promise at the price
The Dark Side of Crowdfunding you have planned for in your projections and budgets.

Not every crowdfunding story has a happy ending, however. • Be honest about the risks. If there are risks and chal-
Seth Quest launched a Kickstarter campaign to raise $10,000 lenges that may prevent you from delivering a product, be
open and honest about all of these risks in the information
in seed money to help launch his iPad stand called Hanfree. He you present at the crowdfunding Web site. Doing so avoids
put a photo of a prototype on his Kickstarter fundraising page. nasty surprises if things do not go as planned.
The description on the Kickstarter page said that for a minimum
pledge of $50, backers could preorder a Hanfree, which would be • Remember that backers view themselves as custom-
made in San Francisco, California, out of sustainably forested alder ers, not investors. When people provide backing for your
wood. He also promised that each one would be hand-numbered project, they are assuming that they have placed a preorder
and signed by the designer. The campaign was a success, raising with you that you will fulfill. They do not view themselves as
more than $35,000 from 440 backers. investors who may or may not get any return for the money
they give you.
However, the excitement over Quest’s fundraising success
quickly faded. Quest had no business experience and had never Sources: Based on Karen E. Klein, “How to Get Funded on Kickstarter,” Bloomberg
manufactured a product before. As a result, he was unable to fill Business Week, April 18, 2014, www.businessweek.com/articles/2014-04-18/how-
the preorders as promised. Some of the backers became angry, to-get-funded-on-kickstarter; Eric Markowitz, “When Kickstarter Investors Want
and soon there were hundreds of negative comments on Hanfree’s Their Money Back,” Inc., January 10, 2013, www.inc.com/eric-markowitz/when-
Kickstarter page. Quest realized that he was not going to be able kickstarter-investors-want-their-money-back.html; James Holloway, “Kickstarter
to fill the orders, so he posted a promise that he planned to refund Disaster: When Crowdfunding Backfires,” Gizmag, July 30, 2013, www.gizmag
the money given by the backers. However, after several weeks with .com/kickstater-disaster/28514/; “Don’t Call Me Ma’am,” Fundable, n.d., www
no refund, some of the backers decided to take action against .fundable.com/dont-call-me-maam; Todd Hixon, “Is Crowdfunding a Boon or a
Quest. One of the backers filed a breach of contract lawsuit against Disaster?” Forbes, April 4, 2012, www.forbes.com/sites/toddhixon/2012/04/04/
Quest, which eventually forced Quest to file for bankruptcy. is-crowdfunding-a-boon-or-a-disaster/.

entrepreneurs with about $15,000 to $25,000 in seed capital, gives them temporary space to work
on their business and their elevator pitch, and connects them with a team of mentors who each
get a small share of equity in the business in return for their guidance. All of this requires the en-
trepreneur to give up 6 to 10 percent of the ownership in the business. At the end of the program,
the accelerator hosts a large pitch event. Local angel investors and venture capitalists are invited
to hear all of the pitches of the accelerator participants. Those investors who are interested can

506 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

join the mentor team as investors in businesses that “graduate” from the accelerator program.
Private accelerators are located in most major cities, and a growing number of universities have
accelerator programs to assist student and alumni entrepreneurs.

Two of the largest accelerator programs are Y Combinator and TechStars. Although accel-
erators do provide small investments, the most important contribution they offer is the coaching
and mentoring from angel investors and experienced entrepreneurs. Angel investors work along-
side the founding entrepreneurs, serving as mentors and advisers. As a result, they help to shape
the business model of the companies in which they invest. The Techstars accelerator program
reports that 70 percent of its participants receive subsequent funding after going through the
program. An amazing 94 percent of businesses launched through the Y Combinator accelerator
program receive additional funding.22

Courtesy of Jake Gish ENTREPRENEURIAL PROFILE: Jake Gish: Beyond Right Now Technologies Jake Gish
has used two different accelerator programs to help his start-up, Beyond Right Now Tech-
private investors nologies. Gish plans to create several products that use the latest technology for resource conserva-
(angels) tion and management, crop health monitoring, endangered species conservation, land mapping,
wealthy individuals, often seed and spore dispersal, and delivery of mitigating solutions. The first accelerator program he
entrepreneurs themselves, participated in was the Next Farm Agriculture Innovation Accelerator based at Northwest Tennessee
who invest in business Entrepreneur Center in Martin, Tennessee, which helped Gish formulate his basic business model.
start-ups in exchange After completing the Next Farm accelerator, he was accepted into the JumpStart Foundry accelera-
for equity stakes in the tor in Nashville, Tennessee. “Accelerator programs helped me decide exactly which product and
companies. customer to focus on,” says Gish. “Going into the programs we had enough ideas for over a dozen
products for even more customers. Accelerators [also] helped us craft a pitch tailored to communi-
cate clearly to possible investors, strategic partners, and customers.”23 In the JumpStart Foundry
accelerator, Gish plans to develop a lead product: Pig Punisher. This product is a drone that helps
hunt feral hogs, which are responsible for billions of dollars in crop losses, property damage, and
degradation of water quality. A growing concern is that feral hogs carry diseases that infect
domestic livestock. The Pig Punisher has an exclusive license for a tool developed at Oak Ridge
National Laboratories that helps identify from an aerial drone feral hogs that are infected.24 ■

Angels

After dipping into their own pockets and convincing friends and relatives to invest in their busi-
ness ventures, many entrepreneurs still find themselves short of the seed capital they need.
Frequently, the next stop on the road to business financing is private investors. These private
investors (angels) are wealthy individuals, often entrepreneurs themselves, who are accredited
investors and choose to invest their own money in business start-ups in exchange for equity
stakes in the companies. Angel investors have provided much-needed capital to entrepreneurs for
many years. In 1938, when World War I flying ace Eddie Rickenbacker needed money to launch
Eastern Airlines, millionaire Laurance Rockefeller provided it.25 Alexander Graham Bell, inven-
tor of the telephone, used angel capital to start Bell Telephone in 1877. More recently, companies
such as Google, Apple, Starbucks, Kinko’s, and the Body Shop relied on angel financing in their
early years to finance growth.

In many cases, angels invest in businesses for more than purely economic reasons—for
example, because they have a personal interest or experience in a particular industry—and they
are willing to put money into companies in the earliest stages, long before venture capital firms
and institutional investors jump in. Angel financing, the fastest-growing segment of the small
business capital market, is ideal for companies that have outgrown the capacity of investments
from friends and family but are still too small to attract the interest of venture capital companies.
Angel financing is vital to the nation’s small business sector because it fills this capital gap in
which small companies need investments ranging from $100,000 or less to perhaps $5 million or
more. For instance, after raising the money to launch Amazon.com from family and friends, Jeff
Bezos turned to angels for capital because venture capital firms were not interested in investing
in a business start-up. Bezos attracted $1.2 million from a dozen angels before landing $8 million
from venture capital firms a year later.26

Angels are a primary source of start-up capital for companies in the start-up stage through the
growth stage, and their role in financing small businesses is significant. Research at the University
of New Hampshire shows that nearly 299,000 angels and angel groups invest $24.8 billion a year

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 507

30.0 80,000 FIGURE 13.2
Amount Invested (in billions) 70,000 Angel Financing
Number of Firms 60,000
50,000 Source: Based on data from
25.0 the Center for Venture Re-
search, Whittemore School
20.0 of Business, University of
Billions of $ Invested New Hampshire, http://
Number of Small Companies paulcollege.unh.edu/
center-venture-research.

15.0 40,000

30,000
10.0

20,000

5.0
10,000

0.0 0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Year

in more than 70,000 small companies, most of them in the start-up phase.27 In short, angels are
one of the largest and most important sources of external equity capital for small businesses. Their
investments in young companies nearly match those of professional venture capitalists, providing
vital capital to 18 times as many small companies (see Figure 13.2).

ENTREPRENEURIAL PROFILE: Carter Cleveland: Artsy Artsy, founded by computer sci-
entist Carter Cleveland, seeks to make all of the world’s art accessible to anyone with an
Internet connection. It is an online platform for discovering, learning about, and collecting art.
Artsy provides one of the largest collections of contemporary art available online by partnering
with galleries to help broaden their target markets. Artsy’s revenues come from the artwork it
sells on behalf of its gallery partners. The business model has proved so effective that the company
has 1,000 additional galleries on a waiting list to join the Artsy network. Artsy has received invest-
ments from more than 20 individual angel investors as well as significant venture capital
funding. After raising more than $1.4 million in angel seed investments, Artsy had a successful
round of venture capital financing of $6 million. The company is currently raising a new round of
up to $18.5 million from venture capital firms.28 ■

Angels fill a significant gap in the seed capital market. They are most likely to finance
start-ups with capital requirements in the $10,000 to $2 million range, well below the $5 million
to $10 million minimum investments most professional venture capitalists prefer. The average
angel investment (including angel funds and networks) in a company is $350,000.29 Because a
$1 million deal requires about as much of a venture capitalist’s time to research and evaluate as
a $20 million deal, venture capitalists tend to focus on big deals where their returns are bigger.
Because angels tend to invest in the earliest stages of a business, they incur the highest levels of
risk. In fact, 52 percent of angels’ investments lose money, returning less than the angels’ original
investment. The potential for investing in big winners exists as well; 7 percent of angels’ invest-
ments produce a return of more than 10 times their original investments.30

Lewis Gersh, an experienced angel investor, says that out of 10 companies that an angel in-
vests in, 5 will fail, 2 will break even, and 2 will return two to three times the original investment.
Just 1 company in 10 will produce a significant return. All of the deals will be high potential, but
with high potential comes high risk. Most angels consider a “home-run” investment to be one
that results in a return of 10 to 30 times the original investment in five to seven years, somewhat
lower than the returns venture capital firms expect.31 Because of the inherent risks in start-up

508 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

companies, many venture capitalists have shifted their investment portfolios away from start-ups
toward more established businesses. That’s why angel financing is so important: Angels often
finance deals that no venture capitalist will consider.

Angels accept between 10 and 15 percent of the deals pitched to them and invest an average
of $50,000 in a company that is at the seed or start-up growth stages.32 Most angels are seasoned
entrepreneurs themselves; on average, angel investors have founded 2.7 companies and have
14.5 years of entrepreneurial experience. They also are well educated; 99 percent have college
degrees. Research also shows that 86 percent of angel investors are men (their average age is
57 years) who have been investing in promising small companies for nine years. The typical
angel invests in one company per year.33 When evaluating a proposal, angels look for a qualified
management team (generally not just an individual entrepreneur) and a business with a clearly
defined niche, market potential, and competitive advantage. They also want to see market re-
search that proves the existence of a sizable customer base and a viable exit strategy, the avenue
by which they get their investments back, ideally with a handsome return. Angels want a path
to a clean exit for their investment, rather than a business that might yield dividends over time.

Entrepreneurs in search of capital quickly learn that the real challenge lies in finding angels.
Most angels have substantial business and financial experience, and many of them are entrepre-
neurs or former entrepreneurs. Because most angels frown on “cold calls” from entrepreneurs they
don’t know, locating them boils down to making the right contacts. Networking is the key. Asking
friends, attorneys, bankers, stockbrokers, accountants, other business owners, and consultants for
suggestions and introductions is a good way to start. Many angel investors use their attorneys and
accountants as gatekeepers for potential deals. Angels almost always invest their money locally,
so entrepreneurs should look close to home for them—typically within a 50- to 100-mile radius.
In fact, 7 out of 10 angels invest in companies that are within 50 miles of their homes or offices.34
Angels also look for businesses they know something about, and most expect to invest their
knowledge, experience, and energy as well as their money in a company. In fact, the advice and
the network of contacts that angels bring to a deal can sometimes be as valuable as their money!

Angel investing has become more organized and professional than it was 20 years ago, with
investors pooling their resources to form angel networks and angel capital funds, dubbed “super-
angels,” that operate like miniature versions of professional venture capital firms and draw on
investors’ skills, experience, and contacts to help the start-ups in which they invest to succeed.
Today more than 300 angel capital networks operate in cities of all sizes across the United States
(up from just 10 in 1996). Angel networks make the task of locating angels much easier for
entrepreneurs in search of capital.

ENTREPRENEURIAL PROFILE: Crista Freeman: Phin & Phebes Ice Cream Crista Freeman,
CEO and cofounder of Phin & Phebes Ice Cream, launched her business with the help of an
investment by angel investor William Hines, who was part of the company’s $150,000 seed fund-
ing round. Phin & Phebes Ice Cream is made with no preservatives, conventional stabilizers, or
syrups of any kind. It is made with milk, cream, sugar, and egg yolks. Phin & Phebes has expanded
into 22 states and more than 260 stores in its first three years in business. Its products are sold in
stores such as Whole Foods, Earth Fare, Central Market, Gourmet Garage, Fresh Direct, and Mor-
ton Williams. In its second round of funding, Phin & Phebes is raising $5 million in capital to fund
its continued growth. The second round of fundraising includes investments by two angel inves-
tors, Brad Feld and Joanne Wilson. Feld is part of Foundry Group, which is a venture capital and
angel investment group in Boulder, Colorado. Wilson is a businesswoman from New York City who
is an active angel investor.35 ■

The Internet has expanded greatly the ability of entrepreneurs in search of capital and angels
in search of businesses to find one another. Dozens of angel networks have set up shop on the
Internet many of which are members of the Angel Capital Association. The association reports
that its average member group has 42 investors and makes investments in four small companies
each year.36 Entrepreneurs can expand the scope of their hunt for financing by including online
angel groups and the Angel Capital Association’s membership list in their searches. AngelList is
another Web site that connects angel investors with high potential deals.

Angels are an excellent source of “patient money,” often willing to wait seven years or longer
to cash out their investments. They earn their returns through the increased value of the business,

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 509

not through dividends and interest. For example, more than 1,000 early investors in Microsoft
Inc. are now multimillionaires. Angels’ return-on-investment targets tend to be lower than those
of professional venture capitalists. Although venture capitalists shoot for 60 to 75 percent returns
annually, angel investors usually settle for 20 to 50 percent (depending on the level of risk in-
volved in the venture). A study by the Kauffman Foundation reports that the average return on
angels’ investments in small companies is 2.6 times the original investment in 3.5 years, which
is the equivalent of a 27 percent internal rate of return.37 Angel investors typically purchase
15 to 30 percent ownership in a small company, leaving the majority ownership to the company
founder(s). They look for the same exit strategies that venture capital firms look for: either an
initial public offering or a buyout by a larger company. The lesson: If an entrepreneur needs rela-
tively small amounts of money to launch or to grow a company, angels are an excellent source.

Venture Capital Companies venture capital
companies
Venture capital companies are private, for-profit organizations that assemble pools of capital private, for-profit orga-
and then use them to purchase equity positions in young businesses they believe have high- nizations that purchase
growth and high-profit potential, producing annual returns of 300 to 500 percent within five to equity positions in young
seven years. More than 400 venture capital firms operate across the United States today, investing businesses that they believe
billions of dollars (see Figure 13.3) in promising small companies in a wide variety of industries. have high-growth and
Companies in the high-tech hubs in California’s Silicon Valley and Boston’s high-tech corridor high-profit potential.
account for nearly half of all venture capital investments, but “secondary” cities, such as Boulder
(Colorado), Salt Lake City (Utah), Ann Arbor (Michigan), Providence (Rhode Island), Norwalk
(Connecticut), and Stamford (Connecticut), offer thriving venture capital sectors that invest sig-
nificant sums of money, especially in local small businesses with high growth potential.38 Venture
capital firms have invested billions of dollars in high-potential small companies over the years,
including such notable businesses as Google, Apple, FedEx, Netscape, Home Depot, Microsoft,
Intel, Starbucks, Whole Foods Market, and Genentech.39

ENTREPRENEURIAL PROFILE: Steven DeGennaro, Patrick Parker, and Dirk Gates:
Xirrus Xirrus, located in Thousand Oaks, California, develops specialized, Wi-Fi hotspots
aimed at high-density and high-performance locations, such as campuses and public areas. Steven
DeGennaro, Patrick Parker, and Dirk Gates, all of who remain active in the company, founded

Amount (in Billions of $)$120 9,000 FIGURE 13.3
Number of DealsAmount (in Billions of $)8,000Venture Capital
Number of Deals 7,000 Funding
6,000
$100 5,000 Source: Price Waterhouse
4,000 Coopers, https://www
$80 3,000 .pwcmoneytree.com/
2,000 MTPublic/ns/nav
$60 1,000 .jsp?page=historical.
0
$40

$20

$0
Year
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013

510 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

Xirrus and successfully raised six rounds of venture capital funding totaling $105.9 million. Venture
capitalists investing in Xirrus are among the most prominent firms, including August Capital, Ca-
naan Partners, InterWest, QuestMark Partners, and U.S. Venture Partners. These firms participated
in more than one of the company’s rounds of venture capital funding.40 ■

POLICIES AND INVESTMENT STRATEGIES Venture capital firms usually establish stringent policies
to implement their overall investment strategies.

Investment Size and Screening The average venture capital firm’s investment in a small company
is $7.4 million.41 Depending on the size of the venture capital company, minimum investments
range from $100,000 to $5 million, but most venture capital firms seek investments in the $5 million
to $25 million range to justify the cost of screening the large number of proposals they receive.

In a typical year, venture capital firms invest in about 4,000 of the nearly 28 million small
businesses in the United States. The venture capital screening process is extremely rigorous.
According to the Global Entrepreneurship Monitor, only about 1 in 1,000 businesses in the United
States receives venture capital during its existence.42 The typical venture capital firm receives
about 1,200 business plans each year (although some receive many more). For every 100 business
plans the average venture capital firm receives, 90 of them are rejected immediately because they
do not match the firm’s investment criteria or requirements. The firm conducts a thorough due
diligence investigation of the remaining 10 companies and typically invests in only 1 of them (see
Figure 13.4). The average time required to close a venture capital deal is 60 to 90 days.

Ownership and Control Most venture capitalists prefer to purchase ownership in a small business
through common stock or convertible preferred stock. Although many venture capital firms
purchase less than 50 percent of a company’s stock, others buy a controlling share of a company,
leaving its founders with a minority share of ownership. Most venture capitalists prefer to let
the founding team of managers employ its skills to operate a business if they are capable of
managing its growth. However, it is quite common for venture capitalists to join the boards of
directors of the companies in which they invest. Sometimes venture investors step in and shake
up the management teams in the companies in which they invest. Janet Effland, a partner in the
venture capital firm Apax Partners, says her fund changes management in the deals they fund

FIGURE 13.4 The Business Plan Funnel

The Business Plan
Funnel

100 business plans come in
100

10 are a good fit and promising
they get a close look
10

Extensive due diligence

1
1 gets funded

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 511

about 40 percent of the time.43 In other words, entrepreneurs should not expect venture capitalists
to be passive investors! Some serve only as financial and managerial advisers, but others take
an active role managing the company—recruiting employees, providing sales leads, choosing
attorneys and advertising agencies, and making daily decisions. The majority of these active
venture capitalists say they are forced to step in because the existing management team lacks the
talent and experience to achieve growth targets.

Stage of Investment Most venture capital firms invest in companies that are in either the
early stages of development (called early-stage investing) or in the rapid-growth phase (called
expansion-stage investing). About 96 to 98 percent of all venture capital investments go to
businesses in these stages; very few invest in small companies that are in the start-up phase.44
Most venture capital firms do not make just a single investment in a company. Instead, they invest
in a company over time across several stages, where their investments often total $10 million to
$15 million or more.

Advice and Contacts In addition to the money they invest, more venture capital companies are
providing the small companies in their portfolios with management advice and access to valuable
networks of contacts of suppliers, employees, customers, and other sources of capital than they
did just a few years ago. One of their goals in doing so is to strengthen the companies in which
they have invested, thereby increasing their value.

Investment Preferences Venture capital firms now are larger, more professional, and more speci-
alized than they were 25 years ago. As the industry matures, venture capital funds increasingly are
focusing their investments in niches—everything from information technology to biotechnology.
Some will invest in almost any industry, but most prefer companies in later stages. Traditionally,
fewer companies receiving venture capital financing are in the start-up or seed stage, when
entrepreneurs are forming a company or developing a product or service and when angels are
most likely to invest (see Figure 13.5). Most of the start-up businesses that attract venture capital
are technology companies in “hot” fields such as software, biotechnology, energy, medical
devices, and media and entertainment.45

WHAT VENTURE CAPITALISTS LOOK FOR Entrepreneurs must realize that it is difficult for any
small business, especially fledgling or struggling firms, to pass the intense screening process
of a venture capital company and qualify for an investment. A great elevator pitch and a sound
business plan are essential to convincing venture capital firms to invest in a company. Geeta
Vemuri, a principal in a venture capital firm, says investors want to see proof of concept for deals
they consider investing in.46 Two factors make a deal attractive to venture capitalists: high returns

Percentage of Angel Investments 55% FIGURE 13.5
55% Percentage of Venture Capital Investments
Angel vs VC
50% 43% 43% Investments
45%
Sources: Based on data from
45% Jeffrey Sohl, “The Angel
Investor Market in 2013:
40% A Return to Seed Investing,”
Center for Venture Research,
Percentage of Investments 35% April 30, 2014,http://
paulcollege.unh.edu/sites/
30% paulcollege.unh.edu/files/
2013%20Analysis%20
25% Report%20FINAL.pdf; https://
www.pwcmoneytree.com/
20% MTPublic/ns/moneytree/
filesource/displays/notice-D
15% 12% .html “MoneyTree Report,”
10% PriceWaterhouseCooper and
National Venture Capital
5% Association, April 18, 2014.
2%

0% Early Expansion/Later
Seed/Start-up

Stage of Company

512 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

and a convenient (and profitable) exit strategy. When evaluating potential investments, venture
capitalists look for the following features:

Competent Management The most important ingredient in the success of any business is the
ability of the management team, and venture capitalists understand this. To venture capitalists,
the ideal management team has experience, managerial skills, commitment, and the ability to
expand the team as the business grows.

Competitive Edge Investors are searching for some factor that will enable a small business to set
itself apart from its competitors. This distinctive competence may range from an innovative product
or service that satisfies unmet customer needs to a unique marketing or research-and-development
(R&D) approach. It must be something with the potential to create a sustainable competitive edge,
making the company a leader in its industry. Bill Turner, founder of venture capital firm Signature
Capital, stresses that he looks for transformational business models, such as his investments in an
online music service, a hearing-aid maker, and an HIV-therapy company.47

Growth Industry Hot industries attract profits—and venture capital. Most venture capital funds
focus their searches for prospects in rapidly growing fields because they believe the profit
potential is greater in these areas. Venture capital firms are most interested in young companies
that have enough growth potential to become at least $100 million businesses within three to
five years. Venture capitalists know that most of the businesses they invest in will flop, so their
winners have to be big winners.

ENTREPRENEURIAL PROFILE: Chieh Huang: Boxed Chieh Huang, founder and CEO of
Boxed, is trying to become a giant killer. Huang founded Boxed with the intent of creating
an app to compete with the likes of Amazon, Costco, and Walmart. Boxed is an e-commerce com-
pany (like Amazon) offering discounts on large quantities of bulk items (like Costco). Boxed sells
its products only through a mobile app and ships to customers anywhere in the United States.
Huang raised $6.5 million in an A round of funding that was led by venture capital firms Greycroft
Ventures, First Round Capital, and Signia Venture Partners. Three other venture capital firms also
participated in the company’s first round of funding, which Boxed used to complete the develop-
ment of the app and launch the company. Boxed plans to attract customers in the Millennial
Generation, who typically are not as loyal to companies such as Costco and Sam’s Club, preferring
to shop online.48 ■

Viable Exit Strategy Venture capitalists not only look for promising companies with the ability
to dominate a market but also want to see a plan for a feasible exit strategy, typically to be
executed within three to five years. Venture capital firms realize the return on their investments
when the companies they invest in either make an initial public offering or are acquired by or
merged into another business. As the market for initial public offerings has softened, venture
capitalists have had to be more patient in their exit strategies. Venture-backed companies that go
public now take an average of 5.3 years from the time of their first venture capital investment to
their stock offering, up from an average of less than three years in 1998.49

ENTREPRENEURIAL PROFILE: Reid Hoffman: LinkedIn The venture capital firms that
invested in LinkedIn, the business networking Web site with more than 300 million users in
200 countries, reaped a handsome return on their investments when the company made an initial
public offering in 2011. Founder Reid Hoffman guided LinkedIn through five rounds of venture
financing from firms including Sequoia Capital, Greylock Partners, Bessemer Venture Partners,
and Bain Capital before making an initial public offering. After the initial public offering, the
venture capital firms’ investments of $103 million, which gave them a 41.4 percent ownership in
LinkedIn, were worth $1.76 billion! Hoffman retained 20.1 percent of LinkedIn’s stock, worth
$853 million at the time of the company’s initial public offering.50 ■

Intangible Factors Some other important factors considered in the screening process are not
easily measured; they are the intuitive, intangible factors that the venture capitalist detects by gut
feeling. This feeling might be the result of the small firm’s solid sense of direction, its strategic
planning process, the chemistry of its management team, or other factors. Venture capital firms
want to know that entrepreneurs will use their money wisely—for investments that provide
profitable results and not those that merely feed entrepreneurial egos.

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 513

ENTREPRENEURIAL PROFILE: Mark Montgomery: FLO {thinkery}
and Blue Chair Bay Rum Mark Montgomery, founder of FLO {think-
ery}, CEO of Blue Chair Bay Rum, and angel investor, has sat on both sides of
the table when it comes to equity investments. Montgomery pays close
attention to every detail when assessing an investment in an entrepreneurial
venture, particularly early decisions made by the leadership team. “When I go
into a startup burning $300,000 a month, and they’ve got amazing offices with
expensive furniture, I immediately think the leadership team’s priorities are
wrong,” says Montgomery, an angel investor from Nashville, Tennessee. “On
the other side, I don’t think you should have your people sitting on milk crates
at a ping pong table. Just be practical.”51 ■

Despite its many benefits, venture capital is not suited for every entrepre-
neur. Venture capital investments come with many strings attached and can
limit entrepreneurs’ ability to navigate their companies as they would prefer.

Corporate Venture Capital Courtesy of Mark Montgomery

Large corporations have gotten into the business of financing small companies
and invest in businesses for both strategic and financial reasons. More than
300 large corporations across the globe, including Google, BMW, Comcast,
Amazon, Qualcomm, Intel, General Electric, Dow Chemical, Cisco Systems,
UPS, Wal-Mart, Unilever, and Johnson & Johnson, invest in small companies, usually companies
that are in the later stage of growth and because of their maturity are less risky. Today, more than
17 percent of all venture capital deals involve corporate venture capital. The average investment
that large corporations make in small companies is $4.53 million, which represents 10.6 percent
of total venture capital investments.52 Young companies not only get a boost from the capital injec-
tions large companies give them but also stand to gain many other benefits from the relationship.
The right corporate partner may share technical expertise, distribution channels, and marketing
know-how and provide introductions to important customers and suppliers. Another intangible yet
highly important advantage an investment from a large corporate partner gives a small company
is credibility, often referred to as “market validation.” Doors that otherwise would be closed to a
small company magically open when the right corporation becomes a strategic partner.

ENTREPRENEURIAL PROFILE: Google Ventures and Shoaib Makani: KeepTruckin initial public offering
In 2009, Google launched Google Ventures, the company’s venture capital division, with the (IPO)
goal of investing $200 million a year in small companies with fast-growth potential across all stages a method of raising equity
of development. Since its inception, Google Ventures has invested amounts ranging from $200,000 capital in which a company
to $33 million in promising companies in a variety of industries. Although long-haul trucking is not sells shares of its stock to
an industry that sounds like it would attract an investment from Google, KeepTruckin received a the general public for the
seed round of investment of $2.25 million that was led by Google Ventures. Currently, long-haul first time.
truckers keep and report the logs that track their mileage and hours using pen, paper, and fax
machines. KeepTruckin plans to automate this process using smart phones. According to Keep-
Truckin cofounder and CEO Shoaib Makani, most of the technological solutions applied to long-
haul trucking have focused on solving corporate problems. KeepTruckin, however, is focused on
the 3 million truckers in this industry. Its app automatically tracks time and distance driven, gener-
ates log files, and automatically sends the files to a dispatcher. The app also alerts drivers when
they are over federally mandated driving limits. KeepTruckin plans to move beyond automated
drive logs into fleet and truck management.53 ■

Public Stock Sale (“Going Public”) LO3

In some cases, companies can “go public” by selling shares of stock to outside investors. In an Describe the process of
initial public offering (IPO), a company raises capital by selling shares of its stock to the general “going public.”
public for the first time. An IPO is an effective method of raising large amounts of capital, but
it can be an expensive and time-consuming process filled with regulatory nightmares. Once a
company makes an IPO, nothing will ever be the same again. Managers must consider the impact
of their decisions not only on the company and its employees but also on shareholders and the
value of their stock.

514 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS $ Raised (Billions) 900
$120.0 Number

$100.0 800

700

$80.0 600
Amount Raised (Billions of $)
Number of IPOs$60.0500
400

$40.0 300

$20.0 200
100

$0.0 0
1996 1998 2000 2002 2004 2006 2008 2010 2012

Year

FIGURE 13.6
Initial Public Offerings (IPOs)

Source: Based on data from 2014 IPO Report, WilmerHale, 2014, p. 2.

Going public isn’t for every business. In fact, most small companies do not meet the criteria
for making a successful public stock offering. Since 2001, the average number of companies
that make IPOs each year is 120, and only about 20,000 companies in the United States—less
than 1 percent of the total—are publicly held (see Figure 13.6). The dramatic drop in the num-
ber of IPOs that occurred in the early part of this century was due in large part to the passage
of Sarbanes-Oxley, a law that put significant restrictions and requirements on publicly traded
companies. An outcome of this law was to make IPOs unaffordable for smaller companies. Since
Sarbanes-Oxley became law, few new companies with less than $25 million in annual sales man-
age to go public successfully. Since 2001, 68 percent of the companies that have completed IPOs
have had annual sales of $50 million or more.54 For instance, LinkedIn, the professional network-
ing Web site, was generating sales of $243 million at the time of its IPO. When Zygna, the creator
of popular Facebook games such as Farmville, Cityville, and Words with Friends, filed for its
IPO, the company’s sales were $597 million.55

It is almost impossible for a start-up company with no track record of success to raise money
with an IPO. Instead, the investment bankers who underwrite public stock offerings typically
look for established companies with the following characteristics:

● Consistently high growth rates. In the three years prior to its IPO, LinkedIn’s revenues
grew an impressive 212 percent.56

● Scalability. Underwriters and institutional investors want proof that a company can main-
tain or improve its efficiency as it experiences the strain that rapid growth imposes.

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 515

● A strong record of earnings. Strangely enough, profitability at the time of the IPO is
not essential; from 2001 to 2013, 49 percent of companies making IPOs had negative
earnings.57

● Three to five years of audited financial statements that meet or exceed Securities and
Exchange Commission (SEC) standards. After the Enron and WorldCom scandals, inves-
tors are demanding impeccable financial statements.

● A solid position in a rapidly growing industry. In 2000, the median age of companies
making IPOs was 6 years; today, it is 12 years.58

● A sound management team with experience and a strong board of directors.

ENTREPRENEURIAL PROFILE: Shayan Zadeh: Zoosk Shayan Zadeh, cofounder and
CEO of Zoosk, has taken his business from start-up to IPO in only seven years. During that
time, the online dating company has amassed 26 million members, which includes 650,000 paid
subscribers, from 80  countries. Although the company has yet to make a profit, it has raised
$61.6 million in venture capital and plans to raise another $100 million in its IPO. Merrill Lynch,
Pierce, Fenner & Smith, and Citigroup Global Markets provided underwriting for Zoosk’s IPO.59 ■

THE REGISTRATION PROCESS Taking a company public is a complicated, bureaucratic process
that usually takes several months to complete. Many experts compare the IPO process to running
a corporate marathon, and both the company and its management team must be in shape and
up to the grueling task. The typical entrepreneur cannot take his or her company public alone.
It requires a coordinated effort from a team of professionals, including company executives, an
accountant, a securities attorney, a financial printer, and at least one underwriter. The key steps in
taking a company public are as follows:

● Choose the underwriter. The single most important ingredient in making a successful managing underwriter
IPO is selecting a capable managing underwriter (investment banker). The managing (investment banker)
underwriter serves two primary roles: helping to prepare the registration statement for the a financial company that
issue and promoting the company’s stock to potential investors. The underwriter works serves two important roles:
with company managers as an adviser to prepare the registration statement that must be helping to prepare the
filed with the SEC, promotes the issue, prices the stock, and provides aftermarket support. registration statement for
Once the registration statement is finished, the managing underwriter’s primary job is an issue and promoting
selling the company’s stock through an underwriting syndicate of other investment bankers the company’s stock to
it develops. potential investors.

● Negotiate a letter of intent. To begin an offering, the entrepreneur and the underwriter letter of intent
must negotiate a letter of intent, which outlines the details of the deal. The letter of intent an agreement between the
covers a variety of important issues, including the type of underwriting, its size and price underwriter and the com-
range, the underwriter’s commission, and any warrants and options included. It almost al- pany about to go public
ways states that the underwriter is not bound to the offering until it is executed—usually the that outlines the details of
day before or the day of the offering. However, the letter usually creates a binding obliga- the deal.
tion for the company to pay any direct expenses the underwriter incurs relating to the offer.

● Prepare the registration statement. After a company signs the letter of intent, the next registration statement
task is to prepare the registration statement to be filed with the SEC. This document the document a company
describes both the company and the stock offering and discloses information about the must file with the SEC that
risks of investing. It includes information on the use of the proceeds, the company’s his- describes both the company
tory, its financial position, its capital structure, the risks it faces, its managers’ experience, and its stock offering and
and many other details. The statement is extremely comprehensive and may take months to discloses information about
develop. To prepare the statement, entrepreneurs must rely on their team of professionals. the risk of investing.

● File with the SEC. When the statement is finished (with the exception of pricing the
shares, proceeds, and commissions, which cannot be determined until just before the issue
goes to market), the company officially files the statement with the SEC and awaits the
review of the Division of Corporate Finance, a process that takes 30 to 45 days (or more).
The division sends notice of any deficiencies in the registration statement to the company’s
attorney in a comment letter. The company and its team of professionals must cure all of

516 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

the deficiencies in the statement noted in the comment letter. Finally, the company files
the revised registration statement along with a pricing amendment (giving the price of the
shares, the proceeds, and the commissions).

● Wait to go effective. While waiting for the SEC’s approval, the managers and the underwrit-
ers are busy. The underwriters are building a syndicate of other underwriters who will market
the company’s stock. (No stock sales can be made prior to the effective date of the offering,
however.) The SEC also limits the publicity and information a company may release during
this quiet period (which officially starts when the company reaches a preliminary agreement
with the managing underwriter and ends 25 days after the effective date).

road show ● Road show. Securities laws do permit a road show, a gathering of potential syndicate
a gathering of potential members sponsored by the managing underwriter. Its purpose is to promote interest
syndicate members spon- among potential underwriters in the IPO by featuring the company, its management, and
sored by the managing un- the proposed deal. The managing underwriter and key company officials barnstorm major
derwriter for the purpose of financial centers at a grueling pace.
promoting a company’s IPO.
● Sign underwriting agreement. On the last day before the registration statement becomes
effective, the company signs the formal underwriting agreement. The final settlement, or
closing, takes place a few days after the effective date for the issue. At this meeting the un-
derwriters receive their shares to sell, and the company receives the proceeds of the offer-
ing. Typically, the entire process of going public takes from 120 to 180 days, but it can take
much longer if the issuing company is not properly prepared for the process.

● Meet state requirements. In addition to satisfying the SEC’s requirements, a company also
must meet the securities laws in all states in which the issue is sold. These state laws (or
“blue-sky” laws) vary drastically from one state to another, and the company must comply
with them.

NONPUBLIC REGISTRATIONS AND EXEMPTIONS The IPO process just described, called an S-1
filing, requires maximum disclosure in the initial filing and discourages most small businesses
from using it. Fortunately, the SEC allows several exemptions from this full-disclosure process
for small businesses seeking to sell stock through a limited private stock offering. Entrepreneurs
can sell stock through a limited private offering to accredited investors, corporations and trusts,
and insiders to the business. The SEC has established simplified registration statements and
exemptions from the registration process through what is known as Regulation D (Rule 504, 505,
and 506).

Regulation D rules minimize the expense and time required to raise equity capital for small
businesses by simplifying or eliminating the requirement for registering the offering with the
SEC, which often takes months and costs many thousands of dollars. Under Regulation D, the
whole process typically costs less than half of what a traditional public offering costs. The SEC’s
objective in creating Regulation D was to give small companies the access to equity financing
that large companies have via the stock market while bypassing many of the costs and filing re-
quirements. A Regulation D offering requires only minimal notification to the SEC.

Rule 504 is the most popular of the Regulation D exemptions because it is the least restric-
tive. It allows a company to sell shares of its stock to an unlimited number of investors without
regard to their experience or level of sophistication. A business also can make multiple offerings
under Rule 504 as long as it waits at least six months between them; however, Rule 504 places a
cap of $1 million in a 12-month period on the amount of capital a company can raise.

An offering under Rule 505 has a higher capital ceiling ($5 million in a 12-month period)
than Rule 504 but imposes more restrictions (no more than 35 nonaccredited investors, no adver-
tising of the offer, and more stringent disclosure requirements).

Rule 506 imposes no ceiling on the amount that can be raised, but most companies that
make Rule 506 offerings raise between $1 million and $50 million in capital. Like a Rule 505
offering, it limits the issue to no more than 35 nonaccredited investors and prohibits advertising
the offer to the public. There is no limit on the number of accredited investors, however. Rule
506 also requires detailed disclosure of relevant information, but the extent depends on the size
of the offering.

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 517

Sources of Debt Financing LO4

Debt financing involves the funds that the small business owner borrows and must repay with Describe the various
interest. Debt financing is a popular tool that many entrepreneurs use to acquire capital. In a typi- sources of debt capital.
cal year, small businesses borrow about $1 trillion.60 Lenders of capital are more numerous than
investors, although small business loans can be just as difficult (if not more difficult) to obtain.
According to the National Small Business Association, 35 percent of small business owners say
they are unable to obtain adequate financing for their companies.61

ENTREPRENEURIAL PROFILE: Vicky Vij: Bukhara Grill Vicky Vij, an immigrant from
Delhi, India, built a successful restaurant called Bukhara Grill in downtown New York City.
The restaurant had sales of more than $2.5 million a year, three straight years of profitability, and
excellent credit. However, when Vij decided to buy a catering business to expand the operation,
he had no success getting funding from local banks. Vij turned to an online service, Biz2Credit
.com, which was able to find a bank in Salt Lake City that was willing to give his business an SBA-
guaranteed loan for $3.9 million to purchase a banquet hall and equipment.62 ■

Although borrowed capital allows entrepreneurs to maintain complete ownership of their prime rate
businesses, it must be carried as a liability on the balance sheet as well as be repaid with interest the interest rate that
at some point in the future. In addition, because small businesses are considered to be greater risks banks charge their most
than bigger corporate customers, they must pay higher interest rates because of the risk–return creditworthy customers.
trade-off—the higher the risk, the greater is the return demanded. Most small firms pay well above
the prime rate, the interest rate that banks charge their most creditworthy customers. A study by
David Walker, a professor at Georgetown University, reports that small businesses pay two to
three times the prime rate, primarily because they rely heavily on credit cards and other high-cost
methods of debt financing.63 Still, the cost of debt financing often is lower than that of equity
financing. Because of the higher risks associated with providing equity capital to small compa-
nies, investors demand greater returns than lenders. In addition, unlike equity financing, debt
financing does not require an entrepreneur to dilute his or her ownership interest in the company.

Entrepreneurs seeking debt capital are quickly confronted with an astounding range of credit
options varying greatly in complexity, availability, and flexibility. Not all of these sources of debt
capital are equally favorable, however. By understanding the various sources of debt capital and
their characteristics, entrepreneurs can greatly increase the chances of obtaining a loan.

Figure 13.7 shows the financing strategies that existing small businesses use. We now turn to
the various sources of debt capital.

Financing Strategy Earnings from the Business 17% 35% FIGURE 13.7
Bank Loans 16% 33%
Credit Cards 31% Small Business
Financing
Private Loan (Family or Friends) 30% 35% Strategies
Vendor Financing
Other Source: National Small
Business Association, 2013
Small Business Administration Loan Mid-Year Report, p.11.
Leasing
7%
Asset-based Loans or Factoring 5%
Private Placement of Debt 5%
2%
2%

0 5% 10% 15% 20% 25%
Percentage of Small Businesses

518 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

Commercial Banks

Commercial banks are the very heart of the financial market for small businesses, providing the
greatest number and variety of loans to small companies. Currently, outstanding small business
bank loans total $587.8 billion.64 For small business owners, banks are lenders of first resort. The
average microbusiness bank loan (those less than $100,000) is $6,377, and the average small
business bank loan (those between $100,000 and $1 million) is $240,428.65

Banks tend to be conservative in their lending practices and prefer to make loans to estab-
lished small businesses rather than to high-risk start-ups. Unfortunately for entrepreneurs, turbu-
lence in the financial markets has caused banks to tighten their lending standards, making it more
difficult for small businesses, even established ones, to qualify for loans.

ENTREPRENEURIAL PROFILE: Jeff Goldstein: AcuPOLL Research Even though Jeff
Goldstein had a successful track record as a corporate brand manager and consultant, he
had a difficult time finding a bank that would lend him the money to buy an existing market re-
search company called AcuPOLL Research. Ten banks turned him down, even though he was seek-
ing a loan with a 75% guarantee from the U.S. Small Business Administration. Eventually, Goldstein
was able to find a bank that would fund his purchase of AcuPOLL Research.66 ■

Because start-up companies are so risky, bankers prefer to make loans to existing businesses
with successful track records. They are concerned with a firm’s operating past and will scrutinize
its financial reports to project its position in the future. They also want proof of the stability of the
company’s sales and its ability to generate adequate cash flow to repay the loan. If they do make
loans to a start-up venture, banks like to see sufficient cash flow to repay the loan, ample collat-
eral to secure it, or an SBA guarantee to insure it. Small banks are more likely than large banks
to extend loans to small businesses. Small banks also tend to be “small business friendly” and are
more likely than their larger counterparts to customize the terms of their loans to the particular
needs of small businesses, offering, for example, flexible payment terms to match the seasonal
pattern of a company’s cash flow or interest-only payments until a piece of equipment begins
generating revenue. Small and midsize banks approve 45 percent of small business loan requests,
but large banks approve only 10 percent of loan requests from small companies.67

When evaluating a loan application, especially for a business start-up, banks focus on a com-
pany’s capacity to create positive cash flow because they know that is where the money to repay
their loans will come from. The ability of the business to comfortably repay the loan, both inter-
est and principal, is the first source of payment bankers want to see. The first question in most
bankers’ minds when reviewing an entrepreneur’s business plan is, “Can this business generate
sufficient cash to repay the loan?”

Bankers look to business owners as the second source of repayment if a company is not able
to repay a small business loan. Banks and other lenders also require entrepreneurs to sign personal
guarantees for any loan they make to small businesses. By making a personal loan guarantee, an
entrepreneur is pledging that he or she will be liable personally for repaying the loan in the event
that the business itself cannot repay the loan. Recall from Chapter 6 that in the eyes of the law,
a sole proprietor or a general partner and the business are one and the same; therefore, for them,
personal loan guarantees are redundant. However, because the owners of S corporations, corpora-
tions, and LLCs are separate from their businesses, they are not automatically responsible for the
company’s debts. Once the owners of these businesses sign a personal loan guarantee, however,
they become liable for their companies’ loans. It is as if these individuals have “cosigned” the
loan with the business, not unlike many parents must cosign loans for their young adult children.

Even though bankers rely on collateral to secure their loans, the last thing banks want is for
a borrower to default, forcing them to sell the collateral (often at “fire-sale” prices) and use the
proceeds to pay off the loan. Therefore, collateral is actually the third source of repayment bank-
ers look to for repayment of a small business loan. That’s why bankers stress cash flow when
analyzing a loan request and demand personal guarantees from the entrepreneurs.

Short-Term Loans

Short-term loans, extended for less than one year, are the most common type of commercial loan
banks make to small companies. These funds typically are used to replenish the working capital
account to finance the purchase of inventory, boost output, finance credit sales to customers, or

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 519

take advantage of cash discounts. As a result, an entrepreneur repays the loan after converting
inventory and receivables into cash. There are several types of short-term loans.

HOME EQUITY LOANS Many entrepreneurs use the equity that they have built in their homes to
finance their business start-ups. Entrepreneurs borrow from themselves by pledging their homes
as collateral for the loans they receive. However, declining real estate values in most parts of
the country have reduced or wiped out the equity in many people’s homes, making securing
home equity loans for their businesses much more difficult. Brother and sister Russell and Julia
Lundstrom funded their start-up Simple Smart Science, which produces cognitive and memory
nutritional products, with a $125,000 home equity loan from a community bank.68

COMMERCIAL LOANS (OR “TRADITIONAL BANK LOANS”) A basic short-term loan is the commercial
bank’s specialty. Business owners typically repay the loan, which often is unsecured because
secured loans are much more expensive to administer and maintain, as a lump sum within three to
six months. In other words, the bank grants a loan to a business owner without requiring him or
her to pledge any specific collateral to support the loan in case of default. The owner repays the
total amount of the loan at maturity. Sometimes the interest due on the loan is prepaid—deducted
from the total amount borrowed. Until business owners can prove their companies’ creditworthiness
to the bank’s satisfaction, they are not likely to qualify for unsecured commercial loans.

LINES OF CREDIT One of the most common requests entrepreneurs make of banks and commercial line of credit
finance companies is to establish a commercial line of credit, a short-term loan with a preset a short-term bank loan
limit that provides much-needed cash flow for day-to-day operations. A line of credit is ideal for with a preset limit that
helping business owners smooth out the uneven flow of cash that results from seasonal sales, funding provides working capital
inventory purchases, extending trade credit, and smoothing out fluctuations in a business’s working for day-to-day operations.
capital. With a commercial line of credit, a business owner can borrow up to the predetermined
ceiling at any time during the year by quickly and conveniently drawing down on the line of
credit. Bankers often require a company to rest its line of credit during the year, maintaining a zero
balance, as proof that the line of credit is not a perpetual crutch. Like commercial loans, lines of
credit can be secured or unsecured but normally require a personal guarantee. In a recent NFIB
survey, 54 percent of small business owners who applied for a new line of credit received one.69

ENTREPRENEURIAL PROFILE: Jordan Drake When Jordan Drake was approved to open
a State Farm Insurance agency in Hendersonville, Tennessee, he knew that he would need
additional financing to supplement the personal savings he was using to start his new business.
Drake was able to get a $25,000 line of credit through his local bank by securing the loan with his
personal pickup truck. State Farm provided an additional $25,000 unsecured line of credit. Fortu-
nately, through careful negotiation of his lease and prudent cash management, Drake was able to
open the business without drawing on either line of credit. However, he says he sleeps easier know-
ing he has access to additional funding if his start-up hits any bumps in the road.70 ■

FLOOR PLANNING Floor planning is a form of financing frequently employed by retailers of
“big-ticket items” that are easily distinguishable from one another (usually by serial number),
such as automobiles, boats, and major appliances. For example, a commercial bank finances
Auto City’s purchase of its inventory of automobiles and maintains a security interest in each
car in the order by holding its title as collateral. Auto City pays interest on the loan monthly
and repays the principal as it sells the cars. The longer a floor-planned item sits in inventory,
the more it costs the business owner in interest expense. Banks and other floor planners often
discourage retailers from using their money without authorization by performing spot checks to
verify prompt repayment of the principal as items are sold.

Intermediate- and Long-Term Loans

Banks are primarily lenders of short-term capital to small businesses, although they will make
intermediate- and long-term loans. Intermediate- and long-term loans, which are normally se-
cured by collateral, are extended for one year or longer. Commercial banks grant these loans for
constructing buildings, purchasing real estate and equipment, expanding a business, and other
long-term investments. Matching the amount and the purpose of a loan to the appropriate type
and length of loan is important. Loan repayments are normally made monthly or quarterly.

520 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

INSTALLMENT LOANS One of the most common types of intermediate-term loans is an installment
loan, which banks make to small firms for purchasing equipment, facilities, real estate, and other
fixed assets. When financing equipment, a bank usually lends the small business from 60 to
80 percent of the equipment’s value in return for a security interest in the equipment. The loan’s
amortization schedule, which is based on a set number of monthly payments, typically coincides
with the length of the equipment’s usable life. In financing real estate (commercial mortgages),
banks typically lend up to 75 to 80 percent of the property’s value and allow a lengthier repayment
schedule of 10 to 30 years.

Hands On . . . How To

Get a Bank to Say “Yes” to Your Loan Application

Landing a loan to start or expand a small business is much more try to find a neutral location that gets the banker out of his or
difficult today than in the past because of stodgy credit markets her office. Make sure you have your “elevator pitch” honed,
and upheaval in the banking and financial industries. Entrepre- as it creates the first impression of you and your business. You
neurs often complain that bankers don’t understand the financial should be able to describe your business—what it does, sells,
needs they face when starting and operating their businesses. In or makes and its competitive edge—in just one or two minutes.
many instances, however, business owners fail to help themselves Your business plan should address why there is an opportunity
when they apply for bank loans. Following are the seven most in the market, your company’s major competition, what it will
common reasons bankers reject small business loan applications— take to succeed in the market, and how your business will
and how you can avoid them. gain a competitive advantage in the market. Keep your plan
focused and concise. Do not fill it up with operational details.
Reason 1. “Our bank doesn’t make small business In addition, be prepared to supply multiple scenarios of your
loans.” financial projections, business credit references, and a personal
credit history.
Cure: Select the right bank. Before applying for a bank loan,
research banks to find out which ones actively seek the type Reason 3. “You haven’t told me why you need the
of loan you need. Some banks don’t make loans of less than money.”
$500,000, whereas others focus almost exclusively on small
company loans. The SBA’s reports Micro-Business-Friendly Cure: A solid business plan with clear financial forecasts and
Banks in the United States and Small Business Lending in the budgets will explain how much money you need and how
United States are valuable resources for locating the banks in you plan to use it. Make sure your request is specific; avoid
your area that are most likely to make small business loans. requests for loans “for working capital.” Don’t make the
Small, local banks tend to be more receptive to small business mistake of answering the question “How much money do
loan requests than many large banks, which often rely on you need?” with “How much will you lend me?” Also, don’t
formulas and templates to make lending decisions. Other just throw out a rough number without any rationale or
factors that influence the types of loans that banks make justification. If a banker thinks you are just guessing on your
include the industry in which the company competes, the financing needs, the conversation will be over immediately.
company’s geographic location, and the length of time it has Instead, know how much money you need and be able to
been in business. Establishing a relationship with a bank before explain how the money will benefit your business and get
you need a loan also increases the probability that your loan it profitable enough to easily repay the loan. Remember
request will be successful. Once you find the right bank for your that bankers want to make loans (after all, that’s how they
business, open an account there, seek a small line of credit, and generate a profit), but they want to make loans only to
repay it consistently. those people they believe will repay them. Their primary
responsibility is to protect the money that all of us entrust with
Reason 2. “I don’t know enough about you or them in our checking and savings accounts.
your business.”
Reason 4. “Your numbers don’t support your loan
Cure: Although a business plan that explains what your request.”
company does (or will do) is a good first step, develop a
personal relationship with the banker so he or she gets to Cure: Include a cash flow forecast in your business plan. Bankers
know you better and hears about your business from your analyze a company’s balance sheet and income statement to
perspective. If you already have a physical location for your judge the quality of its assets and its profitability, but they lend
business, try to get the banker to meet with you there. If not, primarily on the basis of cash flow. “Can you repay the loan

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 521

Hands On . . . How To (continued)

balance?” is the question that most concerns bankers, and that protection by personally guaranteeing the loan. Another
they know that repaying a loan requires adequate cash flow. way to lower the risk of a bank extending a loan to a small
Collateral that backs up the loan is their last form of repayment, company is to secure a loan guarantee through one of the
so do not stress collateral in your presentation—stress cash flow! SBA’s programs.
If your business does not generate adequate cash flow, don’t
expect to get a loan. Prove to the banker that you understand Reason 7: “You don’t have enough ‘skin’ in
your company’s cash flow and how to manage it properly. the game.”

As a measure of a company’s ability to repay a loan, bank- Cure: Increase the amount of money you have invested in the
ers calculate the company’s cash coverage ratio, which is its net
income plus its noncash expenses (such as depreciation and project. A few years ago, entrepreneurs were able to get loans
amortization) divided by the annual payments on the proposed for projects by investing as little as 5 to 10 percent of the total
loan. They want to see a cash coverage ratio of at least 1.5:1 amount. Today, depending on the project, bankers expect
before granting a loan. In other words, to support $100,000 of entrepreneurs to put up at least 20 to 25 percent of the project’s
loan payments, a company should have net cash flow of at least cost—and sometimes much more. Be prepared to use your
$150,000. company’s retained earnings to pay for a significant portion of
the cost of a project.
Reason 5. “You don’t have enough collateral.”
David Pitts, owner of Classic Graphics, a printing company
Cure: Be prepared to pledge your company’s assets—and your in Charlotte, North Carolina, knows firsthand how the small busi-
personal assets—as collateral for the loan. If a company’s cash ness lending environment has changed. In the company’s 30-year
flow declines to the point that it cannot make loan payments, history, Pitts has relied on many bank loans to finance the com-
banks look for other ways to get their money back. To protect pany’s growth. Recently, however, securing bank loans has been
themselves in a worst-case scenario (a business that is unable much more difficult despite Classic Graphics’ rapid growth (from
to repay a loan), bankers want the security of collateral before $39 million in sales to $50 million in sales in just one year) and
they make a loan. They will look to your personal assets first strong financial performance. Securing several loans that ranged
through your personal guarantee. They also expect more than from $200,000 to more than $1 million became much more dif-
$1 in collateral for every $1 of money they lend a business. Banks ficult than in the past, says Pitts. Although Pitts took realistic
typically lend 50 to 90 percent of the value of real estate, 50 to financial projections and a strong business plan to banks, several
80 percent of the value of accounts receivable, and just 10 to bankers rejected his loan requests for Classic Graphics.
50 percent of the value of inventory and equipment pledged as
collateral. There’s no magic to getting a bank to approve your loan re-
quest. The secret is proper preparation and building a solid busi-
Reason 6. “Your business does not support the ness plan that helps explain your business model and builds your
loan on its own.” credibility with the banker as a reliable business owner.

Cure: Be prepared to provide a personal guarantee on the Sources: Based on “Five Tips to Increase Your Chances of Getting a Small Business
loan. This is a given for most small business loans until the Bank Loan,” American Bankers Association, March 25, 2013, www.aba.com/press/
company has a history of strong financial performance. By pages/032513TipsForSmallBankLoan.aspx; Marla Tabaka, “4 Tips for Getting a
giving a personal guarantee, you’re telling the banker that if Business Loan,” Inc., January 21. 2013, www.inc.com/marla-tabaka/4-ways-to-get-
your business cannot repay the loan, you will. Many bankers see a-business-loan.html; Kirsten Valle Pittman, “Small Businesses Ready for Recovery,
their small business clients and their companies as one and the Lenders Aren’t,” MCT/Joplin Globe, July 18, 2011, http://www.joplinglobe.com/
same. Even if you choose a form of ownership that provides you dailybusiness/x357284366/Small businesses-ready-for-recovery-but-their-lenders-
with limited personal liability, bankers will ask you to override aren-t; Emily Maltby, “How to Land a Bank Loan, CNNMoney, September 17, 2008,
http://money.cnn.com/2008/09/16/smallbusiness/land_a_bank_loan.smb/index.htm;
Jim Melloan, “Do Not Say ‘I Just Want the Money,’” Inc., July 2005, p. 96; Crystal
Detamore-Rodman, “Raising Money: Loan Packaging Help,” Entrepreneur, October
2008, p. 56; and Kate Lister, “The Numbers That Matter,” Entrepreneur, November
2010, pp. 98–99.

TERM LOANS Another common type of loan banks make to small businesses is a term loan. term loan
Typically unsecured, banks grant these loans to businesses whose past operating history suggests a bank loan that imposes
a high probability of repayment. Some banks make only secured term loans, however. Term restrictions (covenants)
loans impose restrictions (called covenants) on the business decisions an entrepreneur makes on the business decisions
concerning the company’s operations. For instance, a term loan may set limits on owners’ an entrepreneur makes
salaries, prohibit further borrowing without the bank’s approval, or require maintaining certain concerning the company’s
financial ratios (recall the discussion of ratio analysis in Chapter 11). operations.

The accompanying “Hands On . . . How To” feature describes the seven most common rea-
sons bankers reject small business loan applications and how to avoid them.

522 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

LO5 The Small Business Administration (SBA)
Describe the various Loan Guarantee Programs
loan programs available
from the Small Business The SBA works with local lenders (both bank and nonbank) to offer many other loan programs
Administration. that are designed to help entrepreneurs who cannot get capital from traditional sources gain ac-
cess to the financing they need to launch and grow their businesses. When they were just small
7(a) loan guaranty companies, Callaway Golf, Outback Steakhouse, and Intel Corporation borrowed through the
program SBA’s loan programs. The SBA has several programs designed to help finance both start-up and
an SBA program in which existing small companies that cannot qualify for traditional loans because of their thin asset base
loans made by private and their higher risk of failure. The SBA guarantees more than 52,000 small business loans total-
lenders to small businesses ing more than $19 billion each year, which enable many entrepreneurs to get the financing they
are guaranteed up to a need for start-up or for growth. In the wake of the upheaval in the financial markets, banks have
ceiling by the SBA. tightened their lending standards, and many small businesses cannot qualify for loans.

SBA loan programs are aimed at entrepreneurs who do not meet lending standards at
conventional lending institutions. About 30 percent of SBA-backed loans go to start-up
companies.71 The SBA does not actually lend money to entrepreneurs directly; instead, en-
trepreneurs borrow money from a traditional lender, and the SBA guarantees repayment of
a percentage of the loan (at least 50 percent and sometimes as much as 85 percent) in case the
borrower defaults. The loan application process can take from three days to several months, de-
pending on how well prepared the entrepreneur is and which bank or lender is involved.

Qualifying for an SBA loan guarantee requires cooperation among the entrepreneur, the
participating lender, and the SBA. The participating lender determines the loan’s terms and sets
the interest rate within SBA limits. Contrary to popular belief, SBA-guaranteed loans do not
carry special deals on interest rates. The average interest rate on SBA-guaranteed loans is prime-
plus-2 percent (compared to prime-plus-1 percent on conventional bank loans).

The average duration of an SBA loan is 12 years—far longer than the average commercial
small business loan. In fact, longer loan terms are a distinct advantage of SBA loans. At least half
of all bank business loans are for less than one year. By contrast, SBA real estate loans can extend
for up to 25 years (compared to just 10 to 15 years for a conventional loan), and working capital
loans have maturities of seven years (compared with two to five years at most banks). These
longer terms translate into lower loan payments, which are better suited for young, fast-growing,
cash-strapped companies.

Because SBA-guaranteed loans are riskier, their default rate is higher than that of standard
bank loans. Because the SBA assumes most of the credit risk, lenders are more willing to con-
sider riskier deals that they normally would refuse. With the SBA’s guarantee, borrowers also
have to come up with less collateral than with a traditional bank loan.

The SBA offers several loan programs, which are summarized in the following sections.
Table 13.1 displays a summary of the most popular SBA loan programs.

7(A) LOAN GUARANTY PROGRAM The 7(a) loan guaranty program is the SBA’s flagship loan
program (see Figure 13.8 on page 525). More than 3,500 private lenders in the United States
make SBA loans to small businesses, but the SBA guarantees them (85 percent of loans up to
$150,000 and 75 percent of loans that range from $150,001 up to the loan cap of $3.75 million for
7(a) loans). The average 7(a) loan is $344,520.72 A 7(a) loan is a term loan that business owners
can use for expansion, renovation, new construction, purchasing land or buildings, purchasing
equipment, working capital, a seasonal line of credit, inventory, or starting a business.

ENTREPRENEURIAL PROFILE: Dennis Clem: Clem’s Service Station Dennis Clem
learned about the business of running a service station from his father, and Clem is teach-
ing his own son what he will need to know to run the family business some day. In 2010, Clem
decided he would buy out his siblings who also had inherited a share in the business to allow him
to pass the business on to his son when he was ready to retire. All of the siblings agreed because
Dennis was the only family member who worked in the service station. The Clem family had never
used credit to fund the growth of the business. Each new expansion was funded by the company’s
retained earnings. However, buying out his siblings would require more cash than the business
could generate. Clem was able to secure an SBA guaranteed loan through the 7(a) loan program
from his local bank.73 ■

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 523

You Be the Consultant

The Never-Ending Hunt for Financing

The Automobile Film Club of America were very effective. However, she knew that American consumers
were used to sucking on breath mints. She decided that she would
Ralph Lucci, owner of The Automobile Film Club of America in package the gel cap with a breath mint, so consumers could suck
Stapleton, New York, operated a true niche market business. on the mint after swallowing the gel cap. She would market her
Lucci’s business rented vintage and specialty cars for use in mov- product as Eatwhatever.
ies and television shows filmed in the New York City area. The
Automobile Film Club of America had been operating since 1993. Rosshandler outsourced product formulation and production
Although the business suffered in the aftermath of 9/11, it survived to a contract manufacturer. She hired a packaging designer to cre-
that setback, and Lucci was able to rebuild the company as film ate a package that displayed the product in a clear and attractive
and television production returned to New York. way. Eatwhatever is marketed as “2 Steps to Kissable Breath.”

At its peak, the business grew to 14 full-time employees who Although customers loved her product, she had a difficult
helped support the more than 300 cars the company rented for time getting contracts with large retailers. She had success selling
film and television productions. However, over the next few years online and in specialty shops, but it was not enough to fund the
the business faced more challenges. The company lost the lease growth of the company. Cash was tight. In fact, cash was so tight
on the lot it used to store the cars, and Lucci could not find a lot that she did not have enough to pay for marketing or for a new
large enough to keep his entire inventory, forcing him to sell off production run.
many of the cars. Revenues declined, and soon the business could
support only him and his wife on the payroll. When hurricane Rosshandler met Arthur T. Shorin, an angel investor and
Irene hit in 2011, the company took another financial hit due to former CEO in the candy industry. Shorin liked the product and
damage to its property and lost business. offered to invest $250,000, connect Rosshandler with people he
knew in the industry, and give her a salary on top of the invest-
However, the worst was yet to come. ment in the company. In return, he would take 75 percent owner-
When hurricane Sandy hit in October 2012, the storm surge ship in the business. Rosshandler could earn back 15 percent of
flooded his car lot and garage, completely submerging almost all the company if revenues met certain targets. Although her friends
of his cars in salt water. The cars and much of his equipment were urged her not to accept his terms, she was concerned that her
a total loss. The building he used for offices and car maintenance business would not succeed unless it got the cash and connec-
also was severely damaged by the flooding. He estimated that the tions Shorin offered her.
total loss was more than $400,000. The only insurance he carried
on the business was for liability, so there was no coverage for his 1. Which of the funding sources described in this chapter do
lost property. you recommend that Ralph Lucci and Jacqui Rosshandler
Lucci, who is 60 years old, must decide whether he is willing consider for financing their businesses? Which sources do
to use his personal assets, including his home, as collateral and you recommend they not use? Why?
attempt to secure a business loan to restart his company.
2. What can entrepreneurs do to increase the probability that
Eatwhatever bankers will approve their loan requests?

Jacqui Rosshandler, an Australian ex-pat working for an interior 3. Work with a team of your classmates to brainstorm ways
design company in New York City, wanted to start a business these entrepreneurs could attract the capital they need for
and leave her corporate career. She had noticed that a popular their businesses. What steps do you recommend they take
breath-freshening product sold in Australia was not available in before they approach the potential sources of funding you
the United States. The product was a gel cap made from meat have identified?
byproducts, but Rosshandler decided to make her product from
organic peppermint oil and parsley seed oil. Much of the source Sources: Based on Suzanne Sataline, “Wiped Out by Sandy, and Owner Sizes Up
of bad breath is in the stomach, not the mouth, so the gel caps the Risk in Starting Over,” New York Times, February 7, 2013, p. B6; “What is
Eatwhatever?,” Eatwhatever, n.d., www.eatwhatever.com/what/what-is-eatwhatever/;
John Grossman, “Help for a Startup, but at a High Price,” New York Times, January 3,
2103, p. B8.

SECTION 504 CERTIFIED DEVELOPMENT COMPANY PROGRAM The second most popular SBA
loan program is the Section 504 program, which is designed to encourage small businesses to
purchase fixed assets, expand their facilities, and create jobs. Section 504 loans provide long-
term, fixed-asset financing to small companies to purchase land, buildings, or equipment—
“brick-and-mortar” loans. Three lenders play a role in every 504 loan: a bank, the SBA, and a

524 TABLE 13.1 SBA Loan Program Overview

Program Maximum Loan Amount Guaranty Percentage Use of Proceeds Loan Maturity Maximum Interest Rates
Standard 7(a) $5 million 85% on loans up to Term Loan. Expansion/renovation; new Depends on ability Loans less than 7 years:
$150,000; 75 percent construction, purchase land or buildings; to repay. Generally, $0–$25,000 Prime + 4.25%;
SBAExpress $350,000 on loans greater than purchase equipment, fixtures, lease-hold working capital, $25,001–$50,000 Prime + 3.25%;
$151,000 (up to improvements; working capital; refinance machinery & more than $50,000 Prime +2.25%.
Export Express $500,000 $3.75 million maximum) debt for compelling reasons; seasonal line of equipment is Loans 7 years or longer:
credit, inventory or starting a business 5–10 years; real 0–$25,000 Prime + 4.75%;
CAPLines $5 million 50% estate is 25 years. $25,001 - $50,000 P + 3.75%;
$5 million Revolving line of credit or term loan more than $50,000 Prime +2.75%
International $250,000 90% on loans of [same as 7(a)] Up to 7 years for Loans of $50,000 or less: prime
Trade $5 million $350,000 or less; 75% revolving line of + 6.5%; Loans of $50,001 to
Community $5 to $5.5 million, on loans greater than Same as SBAExpress plus standby credit; otherwise, $350,000: prime + 4.5%
Advantage depending on type of $350,000 letter of credit same as 7(a)
Export Working business Same as 7(a) Same as SBAExpress Same as SBAExpress
Capital Seasonal and short-term working capital needs
Section 504 $50,000 90% including advances for inventory and accounts Up to 10 years except Same as 7(a)
through receivables Builders CAPLine,
Community Same as 7(a) Term loan for working capital, equipment, which is 5 years Same as 7(a)
Development 90% facilities, land and buildings and debt refinance Up to 25 years
Corporation related to international trade Prime + 6%
(CDC) CDC: up to 40% Same as 7(a) Same as 7(a)
Microloan Lender: 50% No cap
Equity: 10% Short-term working capital for exporting Generally 1 year or
less, may go up to Fixed rate depends on when SBA’s
N/A Long-term, fixed asset projects such as 3 years maximum) debenture-backed loan is sold
constructing new buildings, purchasing and Equipment—up to
renovating existing buildings, and purchasing 10 years; real estate— 7.75 or 8% above intermediary
equipment and machinery up to cost of funds
20 years
Purchase machinery and equipment, fixtures,
leasehold improvements, financing receivables, Shortest term possible
or working capital. Cannot be used to repay up to 6 years
existing debt.

Source: “Loan Program Quick Reference Guide,” U.S. Small Business Administration, Washington, DC, http://www.sba.gov/sites/default/files/files/Loan%20Chart%20Baltimore%20March%202014_20140414.pdf.

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 525

Billions of $ $20.0 FIGURE 13.8
$18.0 SBA 7(A)
$16.0 Guaranteed Loans
$14.0
$12.0 Source: SBA Guaranteed
$10.0 Loans, U.S. Small Business
Administration, http://www
$80 .sba.gov/7a-loan-program.
$6.0
$4.0
$2.0
$0.0

1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012

certified development company (CDC), which is a nonprofit organization licensed by the SBA certified development
and designed to promote economic growth in local communities. Some 270 CDCs operate across company (CDC)
the United States and make about 8,000 loans in a typical year. The entrepreneur is required to a nonprofit organization
make a down payment of just 10 percent of the total project cost rather than the typical 20 to licensed by the SBA and
30 percent traditional bank loans require. The CDC provides 40 percent at a long-term fixed rate, designed to promote
supported by an SBA loan guarantee in case the entrepreneur defaults. The bank provides long- growth in local communi-
term financing for the remaining 50 percent, also supported by an SBA guarantee. The major ties by working with com-
advantages of Section 504 loans are their fixed rates and terms, their 10- and 20-year maturities, mercial banks and the SBA
and the low down payment required. The maximum loan amount that the SBA will guarantee is to make long-term loans to
$5 million, and the average Section 504 loan is $714,000.74 small businesses.

ENTREPRENEURIAL PROFILE: Joe and Joyce Spatafore: Cubby’s Child Care Center
Due to its success in attracting an ever-expanding group of families, Cubby’s Child Care
Center, located in Bridgeport, West Virginia, needed a larger building. Joe and Joyce Spatafore,
Cubby’s owners, were able to find a location to construct a new 18,000 square foot building to
house their growing business. The Spatafores used the SBA’s 504 Certified Development Company
loan program to help finance the project through their local bank. The new space allowed Cubby’s
to double its enrollment from 150 to 300 children. With the added capacity, Cubby’s also increased
employment by adding 15 new jobs.75 ■

MICROLOAN PROGRAM About three-fourths of all entrepreneurs need less than $100,000 to launch microloans
their businesses. Indeed, most entrepreneurs require less than $50,000 to start their companies. loans made through an SBA
Unfortunately, loans of that amount can be the most difficult to get. Lending these relatively small program aimed at entre-
amounts to entrepreneurs starting businesses is the purpose of the SBA’s Microloan Program. preneurs who can borrow
Called microloans because they range from just $100 to as much as $50,000, these loans have amounts of money as small
helped thousands of people take their first steps toward entrepreneurship. Banks typically shun as $100 up to a maximum
loans in such small amounts because they consider them to be risky and unprofitable. In an attempt of $50,000.
to fill the void in small loans to start-up companies, the SBA launched the microloan program
in 1992, and it has gone on to become the single largest source of funding for microenterprises.
Today, nearly 180 authorized lenders make SBA-backed microloans. The average size of
a microloan is $13,000, with a maturity of three years (the maximum term is six years) and
maximum interest rates that typically are between 8 and 13 percent. Microloans do not carry SBA
guarantees, but lenders’ standards are less demanding than those on conventional loans. In fact,
37 percent of all microloans go to business start-ups, and more than half of all microloans go to
women- and minority-owned businesses.76 A recent survey found that 54 percent of all start-up
microbusiness owners rely on another job as their main source of income.77 All microloans are
made through nonprofit intermediaries that are approved by the SBA. Entrepreneurs can find a
listing of microloan intermediaries at the SBA’s Web site.

526 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

ENTREPRENEURIAL PROFILE: Cary and Meryl Gabeler: Anjolie Ayurveda Cary
Gabeler and her daughter Meryl had learned the holistic aromatherapy practice, called
Ayurvedic, when visiting India. The mother and daughter partners opened their business, Anjolie
Ayurveda, in Hastings-On-Hudson, New York, to bring Ayurvedic therapy to the United States by
importing handmade skincare products from a women-owned and -operated facility in India. The
Gabelers participated in a 60-hour entrepreneurship education program sponsored by the Women’s
Enterprise Development Center in White Plains, New York. After completing the program, they
received an $18,000 SBA microloan to launch a new line of Ayurvedic perfumes made in the United
States to expand their inventory and increase their product line.78 ■

Other SBA Loan Programs

SBAEXPRESS PROGRAM To reduce the paperwork requirements and processing time involved in
its loans, the SBA offers its SBAExpress program that gives entrepreneurs responses to their loan
applications within 36 hours. In the SBAExpress Program, participating lenders use their own
loan procedures and applications to make loans of up to $350,000 to small businesses. Because
the SBA guarantees 50 percent of the loan, banks often are willing to make smaller loans to
entrepreneurs who might otherwise have difficulty meeting lenders’ standards. Entrepreneurs can
use these flexible term loans for a variety of business purposes, such as purchasing equipment,
fixtures, land, or buildings; renovating existing structures or building new ones; buying inventory;
and obtaining a seasonal line of credit. Loan maturities on SBAExpress loans typically are between
5 and 10 years, but loan maturities for fixed assets can be up to 25 years.

SMALL LOAN ADVANTAGE AND COMMUNITY ADVANTAGE LOAN PROGRAMS In 2011, the SBA
introduced two new loan programs, the Small Loan Advantage and the Community Advantage
programs. The Small Loan Advantage program is designed to encourage existing, experienced
SBA lenders, known as preferred lenders, to make smaller loans, which are most likely to benefit
disadvantaged borrowers. The Community Advantage Loan program encourages new lenders
that operate in economically challenged communities that have had little or no access to SBA
loans to enter the SBA’s 7(a) loan program. Both programs include SBA guarantees of 85 percent
on loans up to $150,000 and 75 percent on loans between $150,001 and the ceiling of $250,000
and use a streamlined application process.

CAPLine Program THE CAPLINE PROGRAM In addition to its basic 7(a) loan guarantee program (through which
an SBA program that makes the SBA makes about 75 percent of its loans), the SBA provides guarantees on small business
short-term capital loans to loans for start-up, real estate, machinery and equipment, fixtures, working capital, exporting,
growing companies seeking and restructuring debt through several other methods. About two-thirds of all of the SBA’s loan
to finance seasonal build- guarantees are for machinery and equipment or working capital. The CAPLine Program offers
ups in inventory or accounts short-term capital to growing companies seeking to finance seasonal buildups in inventory or
receivable. accounts receivable under five separate programs, each with maturities up to five years: seasonal
line of credit (provides advances against inventory and accounts receivable to help businesses
Export Express weather seasonal sales fluctuations), contract line of credit (finances the cost of direct labor
Program and materials costs associated with performing contracts), builder’s line of credit (helps small
an SBA loan program that contractors and builders finance labor and materials costs), standard asset-based line of credit (an
offers quick turnaround asset-based revolving line of credit for financing short-term needs), and small asset-based line of
times to small companies credit. CAPLine helps cash-hungry small businesses by giving them a credit line to draw on when
that are developing or they need it. A line of credit is what many small companies need most because they are flexible,
expanding their export efficient, and, unfortunately, quite difficult for small businesses to get from traditional lenders.
initiatives.
LOANS INVOLVING INTERNATIONAL TRADE For small businesses going global, the SBA has
Export Working the Export Express Program, which, like its other express programs, offers quick turnaround
Capital (EWC) Program times on applications for guarantees of 75 to 90 percent on loans up to $500,000 to help small
an SBA loan program that companies develop or expand their export initiatives. Loan maturities range from 5 to 25 years.
is designed to provide
working capital to small The SBA also offers the Export Working Capital (EWC) Program, which is designed
exporters. to provide working capital to small exporters. The SBA works in conjunction with the Export-
Import Bank to administer this loan guarantee program. Applicants file a one-page loan applica-
tion, and the response time normally is 10 days or less. The maximum loan is $5 million with a
90 percent guarantee, and proceeds must be used to finance small business exports.

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 527

ENTREPRENEURIAL PROFILE: Brenda Marrero Brenda Marrero launched her staffing
business after being laid off by a large, multinational corporation. She grew Brenda
Marrero & Associates into a leader in its industry. Marrero had started the business in Puerto Rico,
but soon saw opportunity to expand the executive staffing business into other markets. The first
new markets were the Dominican Republic and Peru. When Marrero wanted to expand into Costa
Rica, Panama, Jamaica, Trinidad & Tobago, and Canada, she needed additional financing. Marrero
was able to secure an Export Express SBA loan through her local bank in Puerto Rico.79 ■

The International Trade Program is for small businesses that are engaging in international International Trade
trade or are adversely affected by competition from imports. The SBA allows global entrepre- Program
neurs to combine loans from the Export Working Capital Program with those from International an SBA loan program for
Trade Program for up to $5 million with a maximum guarantee of $4.5 million. Loan maturities small businesses that are
range from 1 to 25 years. engaging in international
trade or are adversely
DISASTER LOANS As their name implies, disaster loans are made to small businesses devastated affected by competition
by some kind of financial or physical losses from hurricanes, floods, earthquakes, tornadoes, and from imports.
other natural disasters. The maximum disaster loan usually is $2 million, but Congress often raises
that ceiling when circumstances warrant. Disaster loans carry below-market interest rates as low disaster loans
as 4 percent and terms as long as 30 years. Loans for physical damage above $14,000 require an SBA loan program
an entrepreneur to pledge some kind of collateral, usually a lien on the business property. In the that makes loans to small
aftermath of hurricane-force Santa Ana winds in California that damaged or destroyed many businesses devastated by
small businesses, the SBA approved disaster loans at just 4 percent interest to help entrepreneurs some kind of financial or
get their companies back up and running.80 physical loss.

Nonbank Sources of Debt Capital

Although they usually are the first stop for entrepreneurs in search of debt capital, banks are not
the only lending game in town. We now turn our attention to other sources of debt capital that
entrepreneurs can tap to feed their cash-hungry companies.

ASSET-BASED LENDERS Across the United States, nearly 3,400 asset-based lenders, which are advance rate
usually smaller commercial banks, commercial finance companies, specialty lenders, or divisions the percentage of an
of bank holding companies that allow small businesses to borrow money by pledging otherwise asset’s value that a lender
idle assets, such as accounts receivable, inventory, or purchase orders, as collateral. This method will lend.
of financing works especially well for manufacturers, wholesalers, distributors, and other
companies that have significant stocks of inventory or accounts receivable. Asset-based borrowing
is an efficient method of borrowing because business owners borrow only the money they need
when they need it. Even unprofitable companies whose financial statements cannot convince loan
officers to make traditional loans often can get asset-based loans. These cash-poor but asset-rich
companies can use normally unproductive assets—accounts receivable, inventory, and purchase
orders—to finance rapid growth and the cash crises that often accompany it.

Like banks, asset-based lenders consider a company’s cash flow, but they are more interested
in the quality of the assets pledged as collateral. The amount a small business can borrow through
asset-based lending depends on the advance rate, the percentage of an asset’s value that a lender
will lend. For example, a company pledging $100,000 of accounts receivable might negotiate a
70 percent advance rate and qualify for a $70,000 asset-based loan. Advance rates can vary dra-
matically depending on the quality of the assets pledged and the lender. Because inventory is an
illiquid asset (i.e., hard to sell), the advance rate on inventory-based loans is quite low, usually
10 to 50 percent. A business pledging high-quality accounts receivable as collateral, however,
may be able to negotiate up to an 85 percent advance rate. The most common types of asset-based
financing are discounting accounts receivable, inventory financing, and purchase order financing.

Discounting Accounts Receivable The most common form of secured credit is accounts-receivable
financing. Under this arrangement, a small business pledges its accounts receivable as collateral; in
return, the lender advances a loan against the value of approved accounts receivable. The amount
of the loan tendered is not equal to the face value of the accounts receivable, however. Even
though the lender screens the firm’s accounts and accepts only qualified receivables, it makes an
allowance for the risk involved because it will have to write off some of them as uncollectible.

528 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

A small business usually can borrow an amount equal to 55 to 85 percent of its  receivables,
depending on their quality. Generally, lenders do not accept receivables that are past due.

Inventory Financing With inventory financing, a small business loan is secured by its inventory
of raw materials, work in process, and finished goods. If an owner defaults on the loan, the lender
can claim the pledged inventory, sell it, and use the proceeds to satisfy the loan (assuming that
the bank’s claim is superior to the claims of other creditors). Because inventory usually is not
a highly liquid asset and its value can be difficult to determine, lenders are willing to lend only
a portion of its worth, usually no more than 50 percent of the inventory’s value. Most asset-
based lenders avoid inventory-only deals; they prefer to make loans backed by inventory and
more secure accounts receivable. The key to qualifying for inventory financing is proving that
a company has a plan or a process in place to ensure that the inventory securing the loan sells
quickly. To ensure the quality of the assets supporting the loans they make, lenders must monitor
borrowers’ assets, a task that increases the paperwork requirements on these loans.

Purchase Order Financing Small companies that receive orders from large customers can use
those purchase orders as collateral for loans. The customer places an order with a small business,
which needs financing to fill the order. The small company pledges the future payment from
the customer as security for the loan, and the lender verifies the credit rating of the customer
(not the small business) before granting the short-term loan, which often carries interest rates of
40 percent or more. Borrowers usually repay the loan within 60 days.

Asset-based loans are more expensive than traditional bank loans because of the cost of
originating and maintaining them and the higher risk they involve. Rates usually run from 2 to
7 percent (or more) above the prime rate. Because of this rate differential, small business owners
should not use asset-based loans for long-term financing; their goal should be to establish their
credit through asset-based financing and then to move up to a line of credit.

VENDOR FINANCING Many small companies borrow money from their vendors and suppliers in
the form of trade credit. Because of its ready availability, trade credit is an extremely important
source of financing to most entrepreneurs. When banks refuse to lend money to a start-up business
because they see it as a high credit risk, an entrepreneur may be able to turn to trade credit for
capital. Getting vendors to extend credit in the form of delayed payments (e.g., “net 30” credit
terms) usually is much easier for small businesses than obtaining bank financing. Essentially,
a company receiving trade credit from a supplier is getting a short-term, interest-free loan for
the amount of the goods purchased. Vendors and suppliers often are willing to finance a small
business’s purchases of goods from 30 to 60 days (sometimes longer), interest free.

EQUIPMENT SUPPLIERS Most equipment vendors encourage business owners to purchase their
equipment by offering to finance the purchase. This method of financing is similar to trade credit
but with slightly different terms. Equipment vendors offer reasonable credit terms with only a
modest down payment, with the balance financed over the life of the equipment (often several
years). In some cases, the vendor will repurchase equipment for salvage value at the end of its
useful life and offer the business owner another credit agreement on new equipment. Start-up
companies often use trade credit from equipment suppliers to purchase equipment and fixtures
such as display cases, refrigeration units, and machinery. It pays to scrutinize vendors’ credit
terms, however, because they may be less attractive than those of other lenders.

COMMERCIAL FINANCE COMPANIES When denied bank loans, small business owners often look
to commercial finance companies for the same types of loans. Commercial finance companies
are second only to banks in making loans to small businesses, and, unlike their conservative
counterparts, they are willing to tolerate more risk in their loan portfolios. Of course, their
primary consideration is collecting their loans, but finance companies tend to rely more on
obtaining a security interest in some type of collateral, given the higher-risk loans that make up
their portfolios. Because commercial finance companies depend on collateral to recover most of
their losses, they are able to make loans to small companies with irregular cash flows or to those
that are not yet profitable.

Approximately 150 large commercial finance companies, such as AT&T Small Business Lend-
ing, GE Capital Small Business Finance, and others, make a variety of loans to small companies,
ranging from asset-based loans and business leases to construction and SBA loans. Dubbed “the

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 529

Wal-Marts of finance,” commercial finance companies usually offer many of the same credit options
as commercial banks do. Because their loans are subject to more risks, finance companies charge
a higher interest rate than commercial banks. Their most common methods of providing credit to
small businesses are asset based—accounts-receivable financing and inventory loans. Rates on these
loans vary but can be as high as 15 to 30 percent (including fees), depending on the risk a particular
business presents and the quality of the assets involved. Because many of the loans they make are
secured by collateral (if not accounts receivable or inventory, then the business equipment, vehicles,
real estate, or inventory purchased with the loan), finance companies often impose more onerous
reporting requirements, sometimes requiring weekly (or even daily) information on a small com-
pany’s inventory levels or accounts-receivable balances. However, entrepreneurs who cannot secure
financing from traditional lenders because of their short track records, less-than-perfect credit rat-
ings, or fluctuating earnings often find the loans they need at commercial finance companies.

SAVINGS-AND-LOAN ASSOCIATIONS Savings-and-loan associations specialize in loans for real
property. In addition to their traditional role of providing mortgages for personal residences,
savings-and-loan associations offer financing on commercial and industrial property. In the
typical commercial or industrial loan, the savings-and-loan association will lend up to 80 percent
of the property’s value with a repayment schedule of up to 30 years. Most savings-and-loan
associations hesitate to lend money for buildings specially designed for a particular customer’s
needs. They expect the mortgage to be repaid from the company’s future earnings.

STOCKBROKERS Stockbrokers also make loans, and many of the loans they make to their cus- margin loans
tomers carry lower interest rates than those from banks. These margin loans carry lower rates loans from a stockbroker
because the collateral supporting them—the stocks and bonds in the customer’s portfolio—is that use the stocks and
of high quality and is highly liquid. Moreover, brokerage firms make it easy to borrow. Brokers bonds in the borrower’s
often set up a line of credit for their customers when they open a brokerage account. To tap that portfolio as collateral.
line of credit, the customer simply writes a check or uses a debit card. Typically, there is no fixed
repayment schedule for a margin loan; the debt can remain outstanding indefinitely as long as margin (maintenance)
the market value of the borrower’s portfolio of collateral meets minimum requirements. Aspiring call
entrepreneurs can borrow up to 50 percent of the value of their stock portfolios, up to 70 percent occurs when the value of a
of their bond portfolios, and up to 90 percent of the value of their government securities. borrower’s portfolio drops
and the broker calls the
There is risk involved in using stocks and bonds as collateral on a loan. Brokers typically loan in, requiring the bor-
require a 30 percent cushion on margin loans. If the value of the borrower’s portfolio drops, the rower to put up more cash
broker can make a margin (maintenance) call; that is, the broker can call the loan and require and securities as collateral.
the borrower to provide more cash and securities as collateral. Recent swings in the stock market credit unions
have translated into margin calls for many entrepreneurs, requiring them to repay a significant a nonprofit financial
portion of their loan balances within a matter of days—or hours. If an account lacks adequate cooperative that promotes
collateral, the broker can sell off the customer’s portfolio to pay off the loan. saving and provides loans
to its members.
CREDIT UNIONS Credit unions, nonprofit financial cooperatives that promote saving and provide
loans to their members, are best known for making consumer and car loans. However, many are also
willing to lend money to their members to launch and operate businesses. More than 6,500 state-and
federally-chartered credit unions with 99 million members operate in the United States, and they
make loans to their members totaling more than $684 billion per year.81 Credit unions make nearly
$38 billion in small business loans to their members each year, and at 43.6 percent, the approval rates
at credit unions for small business loan requests are higher than those at large banks (18.6 percent) but
lower than those at small banks (51.6 percent).82 Not every credit union makes business loans (about
30 percent of credit unions do), and credit unions don’t make loans to just anyone. To qualify for a
loan, an entrepreneur must be a member. Lending practices at credit unions are very much like those
at banks, but credit unions usually are willing to make smaller loans. Federal law currently limits a
credit union’s loans to businesses to 12.25 percent of the credit union’s assets. The SBA also recently
opened its 7(a) loan program to credit unions, providing yet another avenue for entrepreneurs in
search of financing. Because banks have tightened their lending requirements, many entrepreneurs
are turning to credit unions for start-up and operating business loans.

ENTREPRENEURIAL PROFILE: Muhammad Abdullah: Legacy Business Group After
his company experienced a sales decline during a recent recession, Muhammad Abdullah,
owner of Legacy Business Group, a safety and medical supply company in Des Moines, Iowa,

530 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

landed several large orders from customers and needed a line of credit to support the company’s

cash flow while he filled them. After several banks refused his loan requests, Abdullah turned to

Veridian Credit Union, which provided Legacy Business Group with a $25,000 line of credit that
allows him to take orders that otherwise he would have to refuse.83 ■

Entrepreneurs in search of a credit union near them can use the online database at the Credit
Union National Association’s Web site.

PRIVATE PLACEMENTS Private placements are also available for both equity and debt instruments.
A private placement involves selling debt to one or a small number of investors, usually insurance
companies or pension funds. Private placement debt is a hybrid between a conventional loan and
a bond. At its heart, it is a bond, but its terms are tailored to the borrower’s individual needs as a
loan would be.

In addition to making equity investments in small companies, venture capital firms also provide
venture debt financing, often in private placements. Interest rates on venture debt typically vary
from prime-plus-1-percent to prime-plus-5-percent, and the loan terms range from 24 to 48 months.
Venture debt deals often include warrants, which give the venture capital firm the right to purchase
shares of stock in a company at a fixed price. Venture debt financing is a hybrid between a loan and
venture capital. Most venture loans also come with covenants, requirements that a company must
meet or incur a penalty, such as paying a higher interest rate or giving up more stock.

Small Business SMALL BUSINESS INVESTMENT COMPANIES Small Business Investment Companies (SBICs),
Investment created in 1958 when Congress passed the Small Business Investment Act, are privately owned
Companies (SBICs) financial institutions that are licensed and regulated by the SBA. The 292 SBICs operating in
privately owned finan- the United States use a combination of private capital and federally guaranteed debt to provide
cial institutions that are growing small businesses with long-term venture capital. Like their venture capital counterparts,
licensed by the SBA and most SBICs prefer later-round financing over funding start-ups; about 20 percent of SBIC
use a combination of pri- investments go to start-up businesses.84 Funding from SBICs helped launch companies such as
vate capital and federally Costco, Apple, Intel, Gymboree, Cutter and Buck, Build-a-Bear Workshop, Federal Express,
guaranteed debt to provide Staples, Sun Microsystems, and Callaway Golf.
long-term venture capital to
small businesses. Since 1958, SBICs have provided more than $60 billion in long-term debt and equity fi-
nancing to some 107,000 small businesses, adding hundreds of thousands of jobs to the U.S.
economy.85 SBICs must be capitalized privately with a minimum of $5 million, at which point
they qualify for up to $3 (but most often $2) in long-term SBA loans for every $1 of private capi-
tal invested in small businesses up to a maximum of $150 million. As a general rule, SBICs may
provide financial assistance only to small businesses with a net worth of less than $18 million
and average after-tax earnings of $6 million during their last two years. However, employment
and total annual sales standards vary from industry to industry. SBICs are limited to a maximum
investment or loan amount of 20 percent of their private capital to a single client.

SBICs provide both debt and equity financing to small businesses. Most SBIC financing is
in the much-needed range of $250,000 to $5 million, and the average investment is $1.55 million,
far below the average investment by venture capital firms of $7.4 million.86 When they make
equity investments, SBICs are prohibited from obtaining a controlling interest in the companies
in which they invest (no more than 49 percent ownership).

ENTREPRENEURIAL PROFILE: Rand Capital SBIC: Gemcor II, LLC Tom Speller, founder
of Gemcor II, LLC, developed the automated riveting machine used worldwide by aircraft
manufacturers during World War II. For decades, the company was a major player in the aircraft
industry, but when the aircraft manufacturing industry went through a prolonged slump in the
early 2000s, Gemcor received an investment from Rand Capital SBIC, Inc., to help reengineer its sup-
ply chain and implement a variable cost supply model. After Rand Capital SBIC’s investment and the
changes it helped fund, Gemcor’s revenues grew from $8 million to $19 million seven years later.
During that same period, the number of employees at Gemcor for doubled from 31 to 61.87 ■

LO6 Other Federal and State Programs

Identify the various federal Federally sponsored lending programs have experienced budget fluctuations over the last several
and state loan programs years, but some entrepreneurs have been able to acquire financing from the following programs.
aimed at small businesses.

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 531

Economic Development Administration

The Economic Development Administration (EDA), a branch of the Commerce Department, offers
loan guarantees to create new businesses and to expand existing businesses in areas with below-
average incomes and high unemployment rates. Focusing on economically distressed communi-
ties, the EDA often works with local governments to finance long-term investment projects needed
to stimulate economic growth and to create jobs by making loan guarantees. The EDA guarantees
loans up to 80 percent of business loans between $750,000 and $10 million. Entrepreneurs apply
for loans through private lenders, for whom an EDA loan guarantee significantly reduces the risk
of lending. Start-ups and existing businesses must make equity investments of at least 15 percent
of the guaranteed amount. Small businesses can use the loan proceeds in a variety of ways, from
supplementing working capital and purchasing equipment to buying land and renovating buildings.

EDA business loans are designed to help revitalize economically distressed areas by creat-
ing or expanding small businesses that provide employment opportunities in local communities.
To qualify for a loan, a business must be located in a disadvantaged area, and its presence must
directly benefit local residents. Some communities experiencing high unemployment or suffering
from the effects of devastating natural disasters have received EDA Revolving Loan Fund Grants
to create loan pools for local small businesses.

ENTREPRENEURIAL PROFILE: John and Colleen Pfeifer: VoWac Publishing With the
help of a revolving credit loan from the EDA-funded Northeast Council of Governments Devel-
opment Corporation in Aberdeen, South Dakota, John and Colleen Pfeifer purchased VoWac Publish-
ing Company, which publishes phonics and spelling curriculum for public, private, and home schools.
VoWac, based in Faulkton, South Dakota, serves more than 2,000 schools in 35 states as well as schools
in Asia and Africa. The company has grown enough to employ four full-time employees.88 ■

Department of Housing and Urban Development

Although the Department of Housing and Urban Development (HUD) does not extend loans or
grants directly to entrepreneurs for launching businesses, it does sponsor several programs that
can help qualified entrepreneurs to raise the capital they need. Community Development Block
Grants (CDBGs) are extended to cities and counties that, in turn, lend or grant money to entre-
preneurs to start or expand small businesses, thereby strengthening the local economy. Grants are
aimed at cities and towns that need revitalization and economic stimulation. Some grants are used
to construct buildings and factories to be leased to entrepreneurs, sometimes with an option to
buy. Others are earmarked for revitalizing a crime-ridden area or making start-up loans to entre-
preneurs or expansion loans to existing business owners. No ceilings or geographic limitations are
placed on CDBG loans and grants, but projects must benefit low- and moderate-income families.

ENTREPRENEURIAL PROFILE: Cheryl and Stephen Kraus: Upcountry Provisions
Bakery & Bistro When Cheryl and Stephen Kraus were renovating a building in down-
town Traveler’s Rest, South Carolina, to house their retail bakery, the copreneurs received a $5,750
Façade Improvement Grant from a grant funded by HUD’s CDBG program. The 1,664-square-foot
building on Main Street that serves as the home for the Upcountry Provisions Bakery & Bistro once
housed a drugstore but had stood vacant for 20 years. The Kraus’s wanted a location with more
foot traffic, which this grant allowed them to secure with the Main Street location.89 ■

HUD also makes loan guarantees through its Section 108 provision of the CBDG program.
These loan guarantees allow a community to transform a portion of CDBG funds into federally
guaranteed loans large enough to pursue economic revitalization projects that can lead to the
renewal of entire towns.

U.S. Department of Agriculture’s Business Programs and Loans

The U.S. Department of Agriculture provides financial assistance to certain small businesses
through partnerships with the private sector and the community-based organizations. The
various programs fund projects that create or preserve quality jobs and/or promote a clean ru-
ral environment in underserved rural communities. For example, through its Business and
Industry Guaranteed Loan Program, the Rural Development Rural Business Services (RBS) will
guarantee as much as 80 percent of a commercial lender’s loan up to $5 million, 70 percent for

532 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

loans between $5 million and $10 million, and 60 percent for loans in excess of $10 million.
Entrepreneurs apply for loans through private lenders, who view applicants with loan guaran-
tees much more favorably than those without guarantees. The guarantee reduces a lender’s risk
dramatically because the guarantee means that the government agency would pay off the loan
balance (up to the ceiling) if the entrepreneur defaults on the loan.

ENTREPRENEURIAL PROFILE: La Rinascente Pasta La Rinascente Pasta, a small maker
of pasta, was founded shortly after World War II in the Bronx, New York, but in 2003, a
group of investors purchased the company with plans to relocate it to North Dakota. Working
with the Hope Development Corporation and the Griggs-Steele Empowerment Zone in Hope,
North Dakota, La Rinascente Pasta received a guarantee on a $1.2 million loan from the U.S.
Department of Agriculture’s Business and Industry Guaranteed Loan Program that allowed the
company to purchase the machinery and equipment for its new pasta manufacturing plant.90 ■

Small Business Innovation Research Program

Started as a pilot program by the National Science Foundation in the 1970s, the Small Business
Innovation Research (SBIR) program has expanded to 11 federal agencies, ranging from NASA
to the Department of Defense. The total SBIR budget across all 11 agencies is more than $2 billion
annually. These agencies award cash grants or long-term contracts to small companies that want
to initiate or to expand their R&D efforts. SBIR grants give innovative small companies the op-
portunity to attract early-stage capital investments without having to give up significant equity
stakes or taking on burdensome levels of debt.

The SBIR process involves three phases. Phase I (“proof of concept”) grants, which determine
the feasibility and commercial potential of a technology or product, last for up to six months and
have a ceiling of $150,000. Phase II (“prototype development”) grants, designed to develop the
concept into a specific technology or product, run for up to 24 months and have a ceiling of $1 mil-
lion. Approximately one-third of all Phase II applicants receive funding. Phase III is the commer-
cialization phase, in which the company pursues commercial applications of the R&D conducted in
Phase I and Phase II and must use private or non-SBIR federal funding to bring a product to market.

Competition for SBIR funding is intense; only 17 percent of the small companies that apply
for Phase I grants receive funding. So far, more than 135,000 SBIR awards totaling more than
$34 billion (72 percent in Phase I and 28 percent in Phase II) have gone to small companies,
which traditionally have had difficulty competing with big corporations for federal R&D dollars.
The average grant, including Phase I and Phase II, is $342,000.91 The government’s dollars have
been well invested. Nearly 45 percent of small businesses receiving Phase II SBIR awards have
achieved commercial success with their products.92

Small Business Technology Transfer Program

The Small Business Technology Transfer Program (STTR) complements the SBIR program.
Whereas the SBIR focuses on commercially promising ideas that originate in small businesses,
the STTR helps companies to use the vast reservoir of commercially promising ideas that originate
in universities, federally funded R&D centers, and nonprofit research institutions. Researchers
at these institutions can join forces with small businesses and can spin off commercially promis-
ing ideas while remaining employed at their research institutions. Five federal agencies award
grants of up to $750,000 in three phases to these research partnerships.

State and Local Loan Development Programs

Many states have created their own loan and economic development programs to provide funds
for business start-ups and expansions. They have decided that their funds are better spent en-
couraging small business growth rather than “chasing smokestacks”—trying to entice large busi-
nesses to locate within their boundaries. These programs come in many forms, but they all tend
to focus on developing small businesses that create the greatest number of jobs and economic
benefits. Entrepreneurs who apply for state and local funding must have patience and be willing
to slog through some paperwork, however.

Although each state’s approach to economic development is somewhat special, one common
element is some kind of small business financing program: loans, loan guarantees, development

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 533

grants, venture capital pools, and others. One approach many states have had success with is Capital Access
Capital Access Programs (CAPs). First introduced in Michigan in 1986, many states now offer Programs (CAPs)
CAPs that are designed to encourage lending institutions to make loans to businesses that do not a state lending program
qualify for traditional financing because of their higher risk. Under a CAP, a bank and a borrower that encourages lending
each pay an upfront fee (a portion of the loan amount) into a loan-loss reserve fund at the partici- institutions to make loans
pating bank, and the state matches this amount. The reserve fund, which normally ranges from to businesses that do
6 to 14 percent of the loan amount, acts as an insurance policy against the potential loss a bank not qualify for traditional
might experience on a loan and frees the bank to make loans that it otherwise might refuse. One financing because of their
study of CAPs found that 55 percent of the entrepreneurs who received loans under a CAP would higher risk.
not have been granted loans without the backing of the program.93
revolving loan funds
Even cities and small towns have joined in the effort to develop small businesses and help a program offered by
them grow. Many communities across the United States operate revolving loan funds that com- communities that combine
bine private and public funds to make loans to small businesses, often at favorable interest rates, private and public funds
for the purpose of starting or expanding businesses that create jobs and contribute to economic to make loans to small
development. As money is repaid into the funds, it is loaned back out to other entrepreneurs. businesses, often at below-
market interest rates.
ENTREPRENEURIAL PROFILE: Oregon Business Development Fund: Krauss Craft,
Inc. Krauss Craft, Inc., located in Merlin, Oregon, manufactures commercial playground
equipment under the trademark Playcraft Systems and sells its products nationwide to cities,
school districts, and park districts. Krauss Craft secured a $500,000 loan through the Oregon Busi-
ness Development Fund (OBDF) to build a 30 ,000-square-foot building and to purchase two ro-
tational molding machines and related equipment. Krauss Craft added 40 new jobs as a result of
the expansion project.94 ■

In addition to revolving loan funds, nearly 1,000 communities across the United States have community
created community development financial institutions (CDFIs) that designate at least some of development financial
their loan portfolios to supporting entrepreneurs and small businesses. CDFIs operate through a va- institutions (CDFIs)
riety of institutions, including microenterprise loan funds, community development loan funds, and community-based financial
others to provide capital and credit to otherwise “unbankable” business owners and aspiring entre- institutions that designate
preneurs in low-income communities across the United States. Because the loans that they make are at least a portion of their
higher risk, the interest rates that CDFIs charge are higher than those charged by traditional lenders. loan portfolios to other-
wise “unbankable” busi-
ENTREPRENEURIAL PROFILE: Tina Ferguson-Riffe: Smoke Berkeley Tina Ferguson- ness owners and aspiring
Riffe had been unemployed for three years before she started her restaurant, Smoke entrepreneurs.
Berkeley, in Berkeley, California. Ferguson-Riffe needed to buy new equipment to support the
growth of her business. Unable to secure a traditional business loan, a program called the Oppor-
tunity Fund offered Tina a $20,000 EasyPay loan. Instead of making a fixed monthly payment,
Smoke Berkeley repays its loan based on daily credit and debit card sales. Ferguson-Riffe says be-
ing able to pay the loan back based on sales helps when seasonal slowdowns occur during the
rainy season.95 ■

Other Methods of Financing LO7

Small business owners do not have to rely solely on financial institutions and government agen- Explain other methods of
cies for capital; their businesses have the capacity to generate capital. Other common methods of financing a business.
financing, including factoring, leasing rather than purchasing equipment, and using credit cards,
are available to almost every small business.

Factoring Accounts Receivable factor
a financial institution that
Instead of carrying credit sales on its own books (some of which may never be collected), a small buys business’s accounts
business can sell outright its accounts receivable to a factor. A factor buys a company’s accounts receivable at a discount.
receivable and pays for them in two parts. The first payment, which the factor makes immedi-
ately, is for 50 to 80 percent of the accounts’ agreed-on (and usually discounted) value. The fac-
tor makes the second payment of 15 to 18 percent, which makes up the balance less the factor’s
service fees, when the original customer pays the invoice. High interest rates (often 36 percent or
more) make factoring a more expensive type of financing than loans from either banks or com-
mercial finance companies, but for businesses that cannot qualify for those loans, it may be the
only choice. Factoring volume totals more than $101 billion per year.96

534 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

Factoring deals are either with recourse or without recourse. Under deals arranged with
recourse, a small business owner retains the responsibility for customers who fail to pay their
accounts. The business owner must take back these uncollectible invoices. Under deals arranged
without recourse, however, the owner is relieved of the responsibility for collecting them. If cus-
tomers fail to pay their accounts, the factor bears the loss. Nearly 70 percent of factoring deals
are without recourse.97 Because the factor assumes the risk of collecting the accounts, it screens
a company’s credit customers, accepts those judged to be creditworthy, and advances the small
business owner a portion of the value of the accounts receivable. Factors discount anywhere from
2 to 40 percent of the face value of a company’s accounts receivable, depending on the following
factors related to a small company:

● Customers’ financial strength and credit ratings

● The industry and its customers’ industries because some industries have a reputation for
slow payments

● History and financial strength, especially in deals arranged with recourse

● Credit policies98

The discount rate on deals without recourse usually is higher than on those with recourse because
of the higher level of risk they carry for the factor.

Although factoring is more expensive than traditional bank loans (a 2 percent discount from
the face value of an invoice due in 30 days amounts to an annual interest rate of 24.8 percent), it
is a source of quick cash and is ideally suited for fast-growing companies, especially start-ups that
cannot qualify for bank loans. Small companies that sell to government agencies and large corpo-
rations, both famous for stretching out their payments for 60 to 90 days or more, also find factor-
ing attractive because they collect the money from the sale (less the factor’s discount) much faster.

Rollovers as Business Leasing
Startups (ROBS)
a method of financing that Leasing is another common bootstrap financing technique. Today, small businesses can lease vir-
allows entrepreneurs to tually any kind of asset, including office space, telephones, computers, and heavy equipment. By
use their retirement savings leasing expensive assets, the small business owner is able to use them without locking in valuable
to fund their business capital for an extended period of time. In other words, entrepreneurs can reduce the long-term
start-ups. capital requirements of their businesses by leasing equipment and facilities and are not investing
their capital in depreciating assets. In addition, because no down payment is required and because
the cost of the asset is spread over a longer time (lowering monthly payments), a company’s cash
flow improves.

ROBS

Thousands of aspiring entrepreneurs, particularly Baby Boomers, are tapping into their retire-
ment accounts to fund business start-ups or acquisitions of existing small businesses. Many of
them are turning to Rollovers as Business Startups (ROBS) as a means of using their retire-
ment savings to fund their businesses. By using a 401(k) rollover, entrepreneurs are able to move

existing retirement funds into a start-up. The tax laws governing ROBS
are complex, and if not set up properly, this form of funding can lead to
significant penalties by the IRS. Recent IRS cases show increased scru-
tiny of these funding plans, so entrepreneurs should exercise extreme
care when using a retirement account rollover to fund a business. Once
established, ROBS require entrepreneurs to meet certain reporting and
fiduciary responsibilities.99

Courtesy of Bohnne Jones ENTREPRENEURIAL PROFILE: Bohnne Jones: Decorating
Dens Interiors Bohnne Jones used $260,000 of the $340,000 she
had in her retirement savings to purchase a Decorating Den franchise in
Nashville, Tennessee. After several lean years caused by the recession, her
business is now thriving. Jones says the paperwork to fund her business
with a ROBS was quite complicated, and she has to be vigilant with ongo-
ing reporting requirements. She is required to make monthly payments

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 535

into her 401(k) to repay the loan from her retirement account. If Jones is ever late with a payment,
which is due within seven days of each payroll, the IRS imposes a penalty.100 ■

Merchant Cash Advance merchant cash
advance
A merchant cash advance is used by small businesses to help finance working capital needs. a method of financing in
The provider of the merchant cash advance prepurchases credit and debit card receivables at a which a provider pre-
discount. Each time a sale is made, a percentage of the card receivable is forwarded to the cash purchases credit and
advance provider or purchaser until all of the purchased receivables are paid off. Merchant cash debit card receivables at
advances are most often used for the purchase of new equipment, purchasing inventory, expan- a discount.
sion or remodeling, payoff of debt, and emergency funding. Like factoring accounts receivable,
merchant cash advances are an expensive source of funding.

ENTREPRENEURIAL PROFILE: Ivan and Mayra Rincon: Orchid Boutique Ivan and
Mayra Rincon, founders of the online swimwear shop Orchid Boutique, needed help funding
the highly seasonal nature of their business. Although the business had solid profit margins on its
$3 million in annual sales, the Rincons were always scrambling to find cash to fund the next season’s
inventory purchases. After several banks rejected their loan requests, they were able to secure a
merchant cash advance of $200,000. The company had to pay $55,000 for the advance, however,
which meant that the Rincons paid 15 percent of sales to the provider until they paid off the $255,000.
The funding cost the company an effective annual interest rate of more than 50 percent!101 ■

Peer-to-peer Lending peer-to-peer loans
Web-based platforms that
New online funding options are emerging to help small businesses with credit. Peer-to-peer create an online community
loans are Web-based vetting platforms, such as Lending Club, Prosper, and Fundation, that create of lenders who provide
an online community of lenders who provide funding to creditworthy small businesses. Lending funding to creditworthy
Club reports that it is making more than $120 million in loans to small businesses each month! small businesses.
Interest rates can range from less than 7 percent to more than 25 percent. Lending Club has a
maximum loan limit of $35,000. Lydia Aguinaldo, owner of Pines Home Health Care Services,
in Broward County, Florida, secured a $250,000 loan from Fundation at a 19 percent interest rate
payable over three years.102

Loan Brokers loan brokers
businesses that specialize
Loan brokers specialize in helping small businesses find loans by tapping into a wide network of in helping small companies
lenders that include SBA lenders, working capital financing, real estate loans, bridge financing, find loans by tapping into a
franchise financing, merchant cash advances, and asset-based lending. Most loan brokers do not wide network of lenders.
charge a fee for the initial evaluation and consulting on financing options for a small business.
Loan brokers take a small percentage of the total loan amount, usually 1 to 2.5 percent, once the
business is successfully financed. MultiFunding, Biz2Credit, and Loan Finder are a few of the
larger companies offering these services to small business clients.

ENTREPRENEURIAL PROFILE: Patricia and Jim McGrath: Branches Atelier Patricia
and Jim McGrath, owners of Branches Atelier, a preschool in Santa Monica, California,
wanted to find a larger location to house their growing business. They found a perfect location
to buy. The mortgage would cost them no more each month than their current rent, so they were
confident that getting a loan would not be difficult. However, when they went to their bank—
where they had done business for 20 years—to apply for a loan to buy the building, they were
turned down for their loan request. They were shocked because they had enough cash for a
down payment and a long waiting list for new students. The McGraths went to a loan brokerage
firm, Multifunding, which was able to find a bank willing to give them the loan they needed to
buy the building.103 ■

Credit Cards

Unable to find financing elsewhere, many entrepreneurs launch their companies using the fast-
est and most convenient source of debt capital available: credit cards. A study by the Kauffman
Foundation reports that 7 percent of the capital for start-up companies comes from credit cards.
The study also shows that 58 percent of new businesses rely on credit cards to finance operations
in their first year of business.104 Putting business start-up costs on credit cards charging 20 percent

536 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

or more in annual interest is expensive, risky, and can lead to severe financial woes. A study by
Robert Scott of Monmouth University and the Kauffman Foundation reports that taking on credit
card debt reduces the likelihood that a start-up company will survive its first three years of opera-
tion. Every $1,000 increase in credit card debt results in a 2.2 percent increase in the probability
that a company will fail.105 Putting business start-up costs on credit cards is expensive and risky,
especially if sales fail to materialize as quickly as planned, but some entrepreneurs have no other
choice. Prudent entrepreneurs rely on credit cards only for making monthly purchases that they
are certain can be paid off when the credit card bill comes due.

Chapter Summary by Learning Objective

1. Describe the differences between equity 3. Describe the process of “going public.”
capital and debt capital.
● Going public involves (1) choosing the underwriter,
Capital is any form of wealth employed to produce (2) negotiating a letter of intent, (3) preparing the
more wealth. Entrepreneurs have access to two differ- registration statement, (4) filing with the SEC, and
ent types of capital: (5) meeting state requirements.

● Equity financing represents the personal investment 4. Describe the various sources of debt capital.
of the owner (or owners), and it offers the advantage
of not having to be repaid with interest. ● Commercial banks offer the greatest variety of
loans, although they are conservative lenders. Typi-
● Debt capital is the financing a small business owner cal short-term bank loans include commercial loans,
has borrowed and must repay with interest. It does lines of credit, discounting accounts receivable, in-
not require entrepreneurs to give up ownership in ventory financing, and floor planning.
their companies.
● Trade credit is used extensively by small businesses
2. Discuss the various sources of equity capital as a source of financing. Vendors and suppliers
available to entrepreneurs. commonly finance sales to businesses for 30, 60, or
even 90 days.
● The most common source of financing a business is
the owner’s personal savings. After emptying their ● Equipment suppliers offer small businesses
own pockets, the next place entrepreneurs turn for financing similar to trade credit but with slightly
capital is family members and friends. Crowdfund- different terms.
ing taps the power of social networking and allows
entrepreneurs to post their elevator pitches and pro- ● Commercial finance companies offer many of
posed investment terms on crowd-funding Web sites the same types of loans that banks do, but they
and raise money to fund their ventures from ordi- are more risk oriented in their lending practices.
nary people who invest as little as $100. Angels are They emphasize accounts-receivable financing and
private investors who not only invest their money in inventory loans.
small companies but also offer valuable advice and
counsel to them. Some business owners have suc- ● Savings-and-loan associations specialize in loans to
cess financing their companies by taking on limited purchase real property—commercial and industrial
partners as investors or by forming an alliance with mortgages—for up to 30 years.
a corporation, often a customer or a supplier. Ven-
ture capital companies are for-profit, professional ● Stock brokerage houses offer loans to prospective
investors looking for fast-growing companies in entrepreneurs at lower interest rates than banks
“hot” industries. When screening prospects, venture because they have high-quality, liquid collateral—
capital firms look for competent management, a stocks and bonds in the borrower’s portfolio.
competitive edge, a growth industry, and important
intangibles that will make a business successful. ● Small Business Investment Companies are privately
Some owners choose to attract capital by taking owned companies licensed and regulated by the
their companies public, which requires registering SBA that qualify for SBA loans to be invested in or
the public offering with the SEC. loaned to small businesses.

● Small Business Lending Companies make only
intermediate- and long-term loans that are guaran-
teed by the SBA.

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 537

5. Describe the various loan programs available create nonfarm employment opportunities in rural
from the Small Business Administration. areas through loans and loan guarantees.

● Almost all SBA loan activity is in the form of loan ● The Small Business Innovation Research Program
guarantees rather than direct loans. Popular SBA involves 11 federal agencies that award cash grants
programs include: the SBA Express program, the or long-term contracts to small companies wanting
Patriot Express program, the 7(a) loan guaranty to initiate or to expand their R&D efforts.
program, the Section 504 Certified Development
Company program, the Microloan program, the ● The Small Business Technology Transfer Program
CAPLine program, the Export Working Capital pro- allows researchers at universities, federally funded
gram, and the Disaster Loan program. R&D centers, and nonprofit research institutions to
join forces with small businesses and develop com-
6. Identify the various federal and state loan mercially promising ideas.
programs aimed at small businesses.
● Many state and local loan and development pro-
● The Economic Development Administration, a grams, such as capital access programs, revolving
branch of the Commerce Department, makes loan loan funds, and community development financial
guarantees to create and expand small businesses in institutions, complement those sponsored by federal
economically depressed areas. agencies.

● The Department of Housing and Urban Develop- 7. Explain other methods of financing a business.
ment extends grants (such as Community Develop-
ment Block Grants) to cities that, in turn, lend and ● Business owners can get the capital they need by
grant money to small businesses in an attempt to factoring accounts receivable, leasing equipment
strengthen the local economy. instead of buying it, borrowing against their retire-
ment accounts, borrowing against future credit card
● The Department of Agriculture’s Rural Business sales, borrowing from peers, using a loan broker, or
Cooperative Service loan program is designed to even using credit cards.

Discussion Questions

13-1. Capital is a form of wealth used to produce more wealth. 13-15. How do venture capital firms operate?
Identify the two types of capital available for an 13-16. Describe a venture capitalist procedure for screening
entrepreneur.
investment proposals.
13-2. What is capital? 13-17. Summarize the major exemptions and simplified
13-3. Define equity financing.
13-4. What advantage does equity financing offer over registrations available to small companies wanting
to make public offerings of their stock.
debt financing? 13-18. Debt financing involves the funds that the small
13-5. What is the most common source of equity funds in business owner borrows and must repay with inter-
est. Describe the various sources of debt capital
a typical small business? available for a small business owner.
13-6. If an owner lacks sufficient equity capital to invest 13-19. Commercial banks are not the only source of debt
financing available to an entrepreneur. Identify the
in the firm, what options are available for raising it? non-bank sources of debt capital that entrepreneurs
13-7. Identify the major difference between equity capital can tap to feed their cash-hungry companies.
13-20. Explain other methods of financing available to a
and debt capital. small business owner.
13-8. What does “going public” mean? 13-21. How important is trade credit as a source of debt
13-9. What are the various types of loan programs avail- financing to small firms?
13-22. What function do SBICs serve?
able from the SBA? 13-23. How does an SBIC operate?
13-10. How can entrepreneurs locate potential angels to 13-24. What methods of financing do SBICs rely on most
heavily?
invest in their businesses? 13-25. Explain the advantages and disadvantages of using
13-11. What advice would you offer an entrepreneur about to crowdfunding.

strike a deal with a private investor to avoid problems?
13-12. What is meant by private placement?
13-13. What investment criteria do venture capitalists use

when screening potential businesses?
13-14. How do venture capitalist criteria for investing com-

pare to the typical angel’s criteria?

538 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

13-26. Briefly describe the loan programs offered by the 13-33. Why would an entrepreneur choose a leasing arrange-
Economic Development Administration. ment, especially when it involves expensive assets?

13-27. Briefly describe the loan programs offered by 13-34. How do merchant cash advances work as a source of
the Department of Housing and Urban financing a small business?
Development.
13-35. What is the difference between peer-to-peer lending
13-28. Briefly describe the loan programs offered by the and lending from loan brokers?
Department of Agriculture.
13-36. Why is extreme caution necessary when using a retire-
13-29. Explain the purpose and the methods of operation of ment account rollover to fund a business?
the Small Business Innovation Research Program and
the Small Business Technology Transfer Program. 13-37. What role do credit cards play in financing small
businesses?
13-30. What is a factor?
13-31. How does the typical factor operate? 13-38. What is the fastest and most convenient source of
13-32. Explain the advantages and the disadvantages of debt capital available to new entrepreneurs?

using factors as a source of funding.

Beyond the Classroom . . .

13-39. Interview several local business owners about how 13-53. Ask the venture capitalist about the screening crite-
they financed their businesses. ria used by his or her firm.

13-40. Where did the initial capital come from for the 13-54. Ask the venture capitalist about how the deals are
small business owners you interviewed? typically structured when his or her firm invests in
an entrepreneurial venture.
13-41. Ask the small business owners how much money
they needed to launch their businesses. 13-55. Why are bankers so cautious when making business
loans?
13-42. Ask the small business owners how much of their
own money they used to start their businesses. 13-56. What are the consequences when banks make too
many bad business loans?
13-43. Ask the small business owners how they raised
the additional capital they needed to start their 13-57. How does the cautious attitude of bankers affect en-
businesses. trepreneurs’ access to bank financing?

13-44. Ask the small business owners what percentage 13-58. Contact a local banker who works with small busi-
of the money they raised to start their businesses nesses and ask him or her how the small business
was debt capital and what percentage was equity lending market has changed over the last five years.
capital.
13-59. What steps can entrepreneurs take to increase
13-45. Ask the small business owners about which of the likelihood that a bank will approve their loan
the sources of funds described in this chapter requests?
they used.
13-60. Interview the administrator of a financial institution
13-46. Ask the small business owners about any advice program offering a method of financing with which
they might offer others seeking capital? you are unfamiliar and prepare a short report on its
method of operation.
13-47. Contact a local private investor and ask him or her
to address your class. 13-61. Contact your state’s economic development board
and prepare a report on the financial assistance
13-48. Ask the investor about the kinds of businesses he or programs it offers small businesses.
she prefers to invest in.
13-62. Go to the “IPO Home” section of the Web site
13-49. Ask the investor about the screening criteria he or for Renaissance Capital, explore the details of a
she uses to select investments. company that is involved in making an initial pub-
lic offering, and view some of the documents the
13-50. Ask the investor about how the deals in which he or company has filed with the SEC, especially the
she invests are typically structured. IPO filing.

13-51. Contact a local venture capitalist and ask him or her 13-63. Prepare a brief report on the company you reviewed
to address your class. at the “IPO Home” section of the Web site for
Renaissance Capital, addressing the type of
13-52. Ask the venture capitalist about the kinds of busi-
nesses his or her company invests in.

CHAPTER 13 • SOURCES OF FINANCING: EQUITY AND DEBT 539

business, its competitors, growth in its industry, risk 13-65. With a team of classmates, develop a detailed
factors, the money it plans to raise in its IPO, its plan for a Kickstarter campaign for a new busi-
anticipated stock price, and the number of shares it ness that one of the group members is interested in
intends to sell. launching.

13-64. Explain why you would or would not invest in the
company you reviewed at the “IPO Home” section
of the Web site for Renaissance Capital.

Endnotes

Scan for Endnotes or go to www.pearsonglobaleditions.com/Scarborough

14 Choosing the Right
Location and Layout

John Lund/Marc Romanelli/Blend Images/Corbis

Learning Objectives near competitors, shared spaces, inside large
retail stores, nontraditional locations, at home,
On completion of this chapter, you will be able to: and on the road.

1. Explain the stages in the location decision: 4. Explain the site selection process for
choosing the region, the state, the city, and the manufacturers.
specific site.
5. Describe the criteria used to analyze the layout
2. Describe the location criteria for retail and service and design considerations of a building,
businesses. including the Americans with Disabilities Act.

3. Outline the location options for retail and 6. Explain the principles of effective layouts for
service businesses: central business districts, retailers, service businesses, and manufacturers.
neighborhoods, shopping centers and malls,

540

CHAPTER 14 • CHOOSING THE RIGHT LOCATION AND LAYOUT 541

Location: A Source of Competitive Advantage LO1

Much like choosing a form of ownership and selecting particular sources of financing, the location Explain the stages in the
decision has far-reaching and often long-lasting effects on a small company’s future. Entrepreneurs location decision: choosing
who choose their locations wisely—with their customers’ preferences and their companies’ needs the region, the state, the
in mind—establish an important competitive advantage over rivals who choose their locations hap- city, and the specific site.
hazardly. Because the availability of qualified workers, tax rates, quality of infrastructure, traffic
patterns, quality of life, and many other factors vary from one site to another, the location decision
is an important one that can influence the growth rate and ultimate success of a company. Thanks
to widespread digital connectivity, mobile computing, extensive cellular coverage, and affordable
air travel, entrepreneurs have more flexibility when choosing a business location than ever before.

Every gardener knows that for a particular plant to thrive and grow, it must be in the right
location to suit its needs. Too much shade (or sun), the wrong type of soil, or too much (or too
little) water will cause the plants to wither. Similarly, a particular business must have the right lo-
cation to suit its needs if it is to thrive. Like plants, the conditions that a business requires depend
on the type of business involved, but the location decision is important for every business because
of its influence on the company’s sales. Myriad variables influence an entrepreneur’s choice of
a location, often making for a difficult decision. However, by conducting research and gathering
and analyzing information about potential sites, entrepreneurs can find locations that are ideally
suited for their businesses. When screening sites for both Disneyland and Disney World, Walt and
Roy Disney hired site selection pioneer Buzz Price to conduct exhaustive studies that included a
demographic analysis, population growth projections, future highway construction, accessibility,
weather patterns, and other relevant factors. The location analysis successfully pinpointed ideal
locations for both Disney theme parks; today the two parks host more than 33 million guests each
year. “Buzz nailed both of those locations dead center,” says Chip Cleary, head of the Interna-
tional Association of Amusement Parks and Attractions.1

The location decision process resembles an inverted pyramid. The first level of the decision
is the broadest, requiring an entrepreneur to select a particular region of the country. (We will
address locating a business in a foreign country in Chapter 15.) Then an entrepreneur must
choose the right state, the right city, and, finally, the right site within the city. The key to selecting
the ideal location lies in knowing the factors that are most important to a company’s success and
then finding a location that satisfies as many of them as possible, particularly those that are most
critical. For instance, one of the most important location factors for high-tech companies is the
availability of a skilled labor force, and their choice of location reflects this. If physically locating
near customers is vital to a company’s success, an entrepreneur’s goal is to find a site that makes
it most convenient for his or her target customers to do business with the company.

ENTREPRENEURIAL PROFILE: Tony and John Calamunci: Johnny’s Lunch Tony and
John Calamunci sell franchises of the family-owned diner that their grandparents, Johnny
and Minnie Colera, started in Brooklyn Square in Jamestown, New York, in 1936 (and that their
parents still operate). In launching the franchise operation, they realized that opening outlets in
areas in which large concentrations of their target customers lived was essential to their success.
They hired an experienced franchise veteran, George Goulson, and worked with Pitney-Bowes
Software’s MapInfo, using geospatial technology to determine the ideal locations for their restau-
rants, which sell budget-priced meals such as hot dogs, hamburgers, onion rings, and milkshakes.
The Calamuncis started by defining their target customers, which they discovered include people
in the lower-middle- to upper-middle-income bracket who fall between the ages of 16 and 24 or
over 60. Using the software, they identified 72 types of neighborhoods that best match the demo-
graphic and psychographic profile of Johnny’s Lunch customers. The next step was to find loca-
tions that matched the 72 prototype neighborhoods. Managers identified 4,500 areas across the
United States that held large concentrations of potential Johnny’s Lunch customers (most of
whom lived within one mile of the proposed location) and would be good locations for restau-
rants. “These models increase our ability to pick ‘home-run’ locations and avoid the site mistakes
that can cripple a budding franchise,” says Goulson. Johnny’s Lunch is launching its franchising
effort in and around Toledo, Ohio, which Goulson says is a microcosm of the United States. “Small
restaurant owners like us can use location intelligence to prevent mistakes that could cripple fran-
chising plans from the start. We can’t afford not to invest in location intelligence.”2 ■

542 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

Frank Cotham/The New Yorker Collection/Conde Nast

The characteristics that make for an ideal location vary dramatically from one company to
another because of the nature of their business. In the early twentieth century, companies looked
for ready supplies of water, raw materials, or access to railroads; today, they are more likely to
look for sites that are close to universities and offer high-speed Internet access and accessible
airports. In fact, one study concluded that the factors that make an area most suitable for starting
and growing small companies included access to dynamic universities, an ample supply of skilled
workers, a nearby airport, a temperate climate, and a high quality of life.3 The key to finding a
suitable location is identifying the characteristics that can give a company a competitive edge and
then searching out potential sites that meet those criteria.
Choosing the Region
The first step in selecting the best location is to focus on selecting the right region. This requires
entrepreneurs to look at the location decision from the “30,000-foot level,” as if he or she were in
an airplane looking down. In fact, in the early days of their companies, Sam Walton, founder of
retail giant Wal-Mart, and Ray Kroc, who built McDonald’s into a fast-food giant, actually used
private planes to survey the countryside for prime locations for their stores.

ENTREPRENEURIAL PROFILE: Walt Disney: Disney World In 1963, Walt Disney flew
over central Florida in a private plane (which is now on display at Disney World) to look at
a tract of nondescript swampland as a potential site for Disney World. Disney lacked sufficient
space to expand Disneyland in California and, with the help of site selection expert Buzz Price and
a group of top managers, established several criteria for the company’s second theme park, in-
cluding a place with good weather throughout most of the year, plenty of land at bargain prices,
a location near a major city, and access to major highways and infrastructure for the company’s
second theme park (dubbed “Project X”). When Disney flew over the intersection of Interstate 4
and Route 192 near Orlando, he knew he had found the ideal location for Disney World, which
now encompasses 30,000 acres, an area that is about the size of San Francisco!4 ■

Which region of the country has the characteristics necessary for a new business to succeed?
Above all, entrepreneurs must place their customers first when considering a location. As the
experience of Johnny’s Lunch suggests, facts and statistics, not speculation, lead entrepreneurs
to the best locations for their businesses. Common requirements may include rapid growth in the

CHAPTER 14 • CHOOSING THE RIGHT LOCATION AND LAYOUT 543

population of a certain age-group, rising disposable incomes, the existence of necessary infra-
structure, an available workforce, and low operating costs. At the broadest level of the location
decision, entrepreneurs prefer to locate in regions of the country that are experiencing substantial
growth. Every year, many popular business publications prepare reports on the various regions
of the nation—which ones are growing, which are stagnant, and which are declining. Studying
overall trends in population and business growth gives entrepreneurs an idea of where the action
is—and isn’t. Questions to consider include the following: How large is the population? How fast
is it growing? What is the makeup of overall population? Which segments are growing fastest?
Slowest? What is the trend in the population’s income? Are other businesses moving into the
region? If so, what kind of businesses? Generally, entrepreneurs want to avoid declining regions;
they simply cannot support a broad base of potential customers.

One of the first stops entrepreneurs should make when conducting a regional evaluation is
the U.S. Census Bureau (http://www.census.gov/). There entrepreneurs can access for specific lo-
cations vital demographic information such as age, income, educational level, employment level,
occupation, ancestry, commuting times, housing data (house value, number of rooms, mortgage
or rent status, number of vehicles owned, and so on), and many other characteristics. With a little
practice, entrepreneurs can prepare customized reports on the potential sites they are considering.
These Web-based resources give entrepreneurs instant access to important site-location informa-
tion that only a few years ago would have taken many hours of intense research to compile. In
2012, the Census Bureau ceased publication of the U.S. Statistical Abstract (published annually
since 1878), which contained about 1,400 useful data sets about the United States, ranging from
basic population characteristics and leisure activity expenditures to poverty rates and energy con-
sumption. However, ProQuest, an information gateway company founded in 1943, now publishes
in both print and online formats the ProQuest Statistical Abstract of the United States (http://
cisupa.proquest.com/ws_display.asp?filter=Statistical%20Abstract), which closely resembles the
discontinued Census Bureau publication.

The Census Bureau’s American FactFinder site (http://factfinder.census.gov) provides easily
accessible demographic fact sheets and maps on nearly every community in the United States,
including small towns. The Census Bureau’s American Community Survey provides annual up-
dates on the demographic and economic characteristics of areas with populations of at least
65,000, three-year updates on areas with populations between 20,000 and 65,000, and five-year
updates on areas with populations of less than 20,000. Both the American FactFinder and the
American Community Survey allow entrepreneurs to produce easy-to-read, customizable maps
of the information they generate in their searches.

Entrepreneurs also can use nongovernment sources to research potential locations. Zoom-
Prospector (www.zoomprospector.com) is a useful Web site that allows entrepreneurs to search
for the ideal location using a multitude of factors, including population size, job growth rate,
number of patents issued, venture capital invested, education level, household incomes, and prox-
imity to interstate highways, railroads, and airports. Once entrepreneurs locate a city that matches
their customer profiles, they can find other cities across the United States that have similar pro-
files with a single mouse click. Entrepreneurs who are considering a particular region can display
“heat maps” that visually display the areas that have the highest concentrations of people who
have a particular characteristic, such as a bachelor’s degree or the highest household incomes.

ENTREPRENEURIAL PROFILE: Steve Sarowitz: Paylocity Steve Sarowitz, CEO of Pay-
locity, a provider of human resources and payroll services to small and medium-size busi-
nesses, uses ZoomProspector to find the best locations across the United States for the rapidly
expanding company’s new offices. Sarowitz says ZoomProspector helps his company answer the
important question, Would this be a good market for us? “What’s great about ZoomProspector is
that we can get so much information about each individual market we are considering—market
demographics, which industries are strongest, education levels, and more, “says Sarowitz. Founded
in 1997, Paylocity, which is based in Arlington Heights, Illinois, and has appeared on Inc.’s list of
the 5,000 fastest-growing companies seven times, now has 14 locations and, with ZoomProspector’s
help, is looking to add more.5 ■

Zipskinny (www.zipskinny.com) is a Web site that provides quick census data profiles of
various ZIP codes across the United States and allows users to compare the demographic profiles
of the people who live in different ZIP codes. The Population Reference Bureau (www.prb.org)

544 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

provides a detailed breakdown of the most relevant data collected from the most recent census
reports. The Population Reference Bureau’s DataFinder is a database that includes 244 variables
for the United States and 132 variables for 210 other nations. The site includes easy-to-generate
maps and charts and helpful articles that discuss the implications of the changing demographic
and economic profile of the nation’s (and the world’s) population, such as the impact of aging
baby boomers on business and the composition of the U.S. workforce.

Other helpful resources merit mention as well. Lifestyle Market Analyst, a four-part annual
publication, matches population demographics with lifestyle interests. Section 1 provides demo-
graphics and lifestyle information for 210 “Designated Market Areas” across the United States.
Section 2 gives demographic and geographic profiles of 77 lifestyle interests that range from avid
readers and dieters to wine aficionados and pet owners. Section 3 describes the dominant lifestyle
interests for each of the 210 market areas. Section 4 provides comparisons of other activities that
correspond with each lifestyle interest. Entrepreneurs can use Lifestyle Market Analyst to deter-
mine, for example, how likely members of a particular market segment are to own a dog, collect
antiques, play golf, own a vacation home, engage in extreme sports, invest in stocks or bonds, or
participate in a host of other activities.

Other sources of demographic data include Nielsen Marketplace, Editor and Publisher
Market Guide, The American Marketplace: Demographics and Spending Patterns, and Zip Code
Atlas and Market Planner. Nielsen Marketplace provides a comprehensive tool for market
analysis, allowing customers to generate customized reports and maps that show basic demo-
graphics, lifestyle patterns, and purchasing behavior for almost any market in the United States.
The site also includes several unique statistics. Effective buying income (EBI) is a measure of
disposable income, and the buying power index (BPI) is a unique measure of spending power
that takes population, EBI, and retail sales into account to determine a market’s ability to buy
goods and services.

The Editor and Publisher Market Guide includes detailed economic and demographic infor-
mation, ranging from population and income statistics to information on climate and transporta-
tion networks for all 3,096 counties in the United States and more than 1,600 key cities in both
the United States and Canada.

The American Marketplace: Demographics and Spending Patterns provides useful demo-
graphic information in eight areas: education, health, income, labor force, living arrangements,
population, race and ethnicity, and spending and wealth. Most of the tables in the book are
derived from government statistics, but The American Marketplace also includes a discussion of
the data in each table as well as a forecast of future trends. Many users say the primary advantage
of The American Marketplace is its ease of use.

The U.S. Census Bureau also offers the Zip Code Tabulation Areas (ZCTA) Web site (http://
www.census.gov/geo/ZCTA/zcta.html) that organizes the wealth of census data by Zip code. The
database of 33,120 ZCTAs across the United States allows users to create tables and plot maps
of census data by Zip code.

Site Selection magazine (www.siteselection.com) is another useful resource that helps entre-
preneurs determine the ideal location for their companies. Issues contain articles that summarize
the incentive programs that states offer, profiles of each region of the country, and the benefits of
locating in different states.

States now provide geographic information systems (GIS) files online that allow entrepre-
neurs to identify sites that match the criteria they establish for the ideal location. GIS packages
allow users to search through virtually any database containing a wealth of information and
plot the results on a map of the country, an individual state, a specific city, or even a single city
block. The visual display highlights what otherwise would be indiscernible business trends. For
instance, using GIS programs, entrepreneurs can plot their existing customer base on a map
with various colors representing the different population densities. Then they can zoom in on
those areas with the greatest concentration of customers, mapping a detailed view of Zip code
borders or even city streets. GIS street files originate in the U.S. Census Department’s TIGER
(Topographically Integrated Geographic Encoding Referencing) file, which contains map infor-
mation broken down for every square foot of Metropolitan Statistical Areas (MSAs). TIGER files
contain the name and location of every street in the country and detailed block statistics for the
345 largest urban areas. In essence, TIGER is a massive database of geographic features such as

CHAPTER 14 • CHOOSING THE RIGHT LOCATION AND LAYOUT 545

roads, railways, and political boundaries across the United States that, when linked with mapping
programs and demographic databases, gives entrepreneurs incredible power to pinpoint existing
and potential customers on easy-to-read digital maps.

The Small Business Administration’s Small Business Development Center (SBDC) program
also offers location analysis assistance to entrepreneurs. These centers, numbering more than
900 nationwide, provide training, counseling, research, and other specialized assistance to en-
trepreneurs and existing business owners on a wide variety of subjects, all at no charge. They are
an important resource, especially for those entrepreneurs who may not have access to a computer.
(To locate the SBDC nearest you, contact the SBA office in your state or go to the SBA’s Small
Business Development Center locator page at http://www.sba.gov/local-assistance.)

For entrepreneurs interested in demographic and statistical profiles of international cities,
Euromonitor International (http://www.euromonitor.com/) and the Organization for Economic
Development and Cooperation (http://www.oecd.org) are excellent resources. Plant Location
International publishes a report, The World’s Most Competitive Cities, that analyzes 100 top cities
around the world on their suitability as locations for various types of businesses.

Once an entrepreneur has identified the best region of the country, the next step is to evaluate
the individual states in that region.

Choosing the State

Every state has an economic development office working to recruit new businesses. Even though
the publications produced by these offices will be biased in favor of locating in that state, they
still are an excellent source of information and can help entrepreneurs assess the business climate
in each state. Some of the key issues to explore include the laws, regulations, and taxes that
govern businesses, costs of operation, workforce availability, and incentives or investment credits
the state may offer to businesses that locate there.

ENTREPRENEURIAL PROFILE: Terry Douglas: ProNova Solutions After investing a
year looking at potential sites for a new $52 million manufacturing plant, ProNova Solu-
tions, a company that is developing next-generation proton therapy cancer treatment technology,
selected a location in Pellissippi Place, a technology research and development park in Maryville,
Tennessee. The area, dubbed Innovation Valley because of its proximity to the University of
Tennessee and the Oak Ridge National Research Laboratory (ORNL), which is conducting research
in the field, is ideally suited for ProNova’s needs. Tennessee’s pro-business culture and the area’s
talented workforce and existing infrastructure, including the Pellissippi Parkway, a highway that
connects the R&D park with ORNL, sold ProNova’s CEO Terry Douglas on the location. Because of
ORNL, workers in the area already are familiar with the technology that ProNova uses, including
linear accelerators and cyclotrons.6 ■

Factors that entrepreneurs often consider when choosing a location include proximity to
markets, proximity to raw materials, wage rates, quantity and quality of the labor supply, general
business climate, tax rates, Internet access, and total operating costs.

PROXIMITY TO MARKETS Locating close to markets they plan to serve is extremely critical for
manufacturers, especially when the cost of transporting finished goods is high relative to their
value. Locating near customers is necessary to remain competitive. Service firms also often find
that proximity to their clients is essential. If a business is involved in repairing equipment used in
a specific industry, it should be located where that industry is concentrated. The more specialized
a business or the greater the relative cost of transporting the product to the customer, the more
likely it is that proximity to the market will be of critical importance in the location decision.

The ability to get finished products to customers quickly is an important location consider-
ation for many companies.

ENTREPRENEURIAL PROFILE: Alan Yu: Lollicup USA Alan Yu, founder and CEO of
Lollicup USA, a manufacturer of premium beverage and disposable food service products
such as napkins, cups, and utensils, recently relocated to Chino, a city in California’s San Bernardino
Valley, to be closer to its customers, many of whom are quick-service restaurants. Yu notes that in
Southern California, the company’s customer base has grown exponentially, and the ability to get
its products to a large number of customers quickly was a critical factor in Lollicup’s location

546 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

decision. Access to a qualified workforce and lower taxes than those in the company’s former Los
Angeles location added to the area’s attractiveness.7 ■

Splash News/Newscom PROXIMITY TO ESSENTIAL SERVICES AND RAW MATERIALS For some entrepreneurs, locations
near suppliers of essential services are vital. Fashion designer Trina Turk, whose company
produces 11 distinct collections each year, located her business in Alhambra, California, a suburb
of Los Angeles, rather than in the bustling city center for several reasons, including safety (she
employs a significant number of young women who sometimes work after normal business hours)
and low rental rates. However, the location’s main draw is its proximity to Los Angeles’s garment
district, where many of the company’s sewing contractors are based. Although Turk says her
company’s neighborhood is not glamorous or known as a fashion center, the location does give
her company a competitive advantage.8

If a business uses raw materials that are difficult or expensive to transport, it may require a
location near the source of those raw materials. Transporting heavy, low-value raw material over
long distances is impractical—and unprofitable. For products in which bulk or weight is not a
factor, locating manufacturing operations in close proximity to suppliers facilitates quick deliver-
ies and reduces inventory holding costs. Chobani, a maker of Greek yogurt founded by Hamdi
Ulukaya in 2005, recently opened its second factory in the United States in Twin Falls, Idaho.
The main reason that Ulukaya chose Idaho as the location for the factory, which, at 1 million
square feet, is the largest yogurt production facility in the world, is that Idaho is the third larg-
est milk-producing state in the United States. Chobani, the leading maker of Greek yogurt in
the United States, requires 4 to 5 million pounds of milk each day to produce 3 million cases of
Greek yogurt each week. Other factors that led to the decision to locate the factory in Twin Falls
included easier and faster access to markets on the West coast (the company’s other U.S. factory
is in central New York), a skilled labor force with a strong work ethic, and low operating costs.9
The value of products and materials, their cost of transportation, and their unique functions inter-
act to determine how close a business should be to its suppliers.

WAGE RATES Existing and anticipated wage rates provide another measure for comparison among
states. Wages can sometimes vary from one state or region to another, significantly affecting a
company’s cost of doing business. For instance, according to the Bureau of Labor Statistics,
the average hourly compensation for workers (including wages and benefits) ranges from a low
of $27.14 in the South to a high of $34.79 in the Northeast.10 Wage rate differentials within
geographic regions can be even more drastic. When reviewing wage rates, entrepreneurs must
be sure to measure the wage rates for jobs that relate to their particular industries or companies.
In addition to surveys by the Bureau of Labor Statistics (www.bls.gov), local newspaper ads can
give entrepreneurs an idea of the pay scale in an area. Entrepreneurs also can obtain the latest
wage and salary surveys with an e-mail or telephone call to the local chambers of commerce for
cities in the region under consideration. Entrepreneurs should study not only prevailing wage
rates but also trends in rates. How does the rate of increase in wage rates compare to those in
other states? Another factor influencing wage rates is the level of union activity in a state. How
much union organizing activity has the state seen within the last two years? Which industries
have unions targeted in the recent past?

ENTREPRENEURIAL PROFILE: Bombardier Inc. Bombardier Inc., based in Montreal,
Canada, recently built a manufacturing plant in what was once dry cactus fields in
Querétaro, Mexico, to produce the Learjet 85, the company’s newest corporate jet. Bombardier
was attracted by lower wage rates, a pool of trained aeronautics engineers from the local
National Aeronautics University of Querétaro, and proximity to customers in both North and
South America. The availability of a trained labor force and wage rates that are 25 to 30 percent
lower than those in the United States were driving factors in the company’s location decision.11 ■

SIZEANDQUALITYOFLABORFORCE Formanybusinesses,especiallytechnology-drivencompanies,
two of the most important characteristics of a potential location are the size and composition of
the local workforce. The number of workers available in an area and their levels of education,
training, and experience determine a company’s ability to fill jobs with qualified workers at
reasonable wages. For example, Provo, Utah, home to Brigham Young University (BYU), hosts

CHAPTER 14 • CHOOSING THE RIGHT LOCATION AND LAYOUT 547

a large concentration of technology and software companies, second only to California’s Silicon
Valley but without the high costs. One reason that software companies find Provo attractive is the
city’s high concentration of college graduates; nearly 39 percent of its residents have a bachelor’s
degree or higher (compared to 28.5 percent in the United States as a whole).12 Another feature that
attracts technology companies to Provo is access to Google Fiber, the super high-speed Internet
connection currently available in just a handful of cities.

ENTREPRENEURIAL PROFILE: Scott and Ryan Smith and Stuart Orgill: Qualtrics
Scott and Ryan Smith and Stuart Orgill launched Qualtrics, a market research software
company, from their Provo, Utah, basement in 2002. “We had 20 people working in the basement
at one time,” recalls Orgill, “so we moved to another building and continued to hire.” Qualtrics
soon outgrew that space and now has 350 employees and more than 5,000 clients worldwide. The
company benefits from the steady supply of college graduates from nearby BYU and the Univer-
sity of Utah to meet its needs for well-educated employees, 95 percent of whom are locals. “This
market is filled with a lot of very educated people and is home to a very strong work ethic,”
says Orgill. The area also boasts a high quality of life, offering outdoor activities such as mountain
biking, skiing, snowboarding, hiking, and fishing, hobbies that appeal to the young people
Qualtrics hires.13 ■

Before selecting a location, entrepreneurs should know how many qualified people are avail-
able in the area to perform the work required in their businesses. Some states have attempted to
attract industry with the promise of cheap labor. Unfortunately, businesses locating in those states
find unskilled, low-wage workers who are ill suited for performing the work the companies need
and are difficult to train.

Knowing the exact nature of the workforce needed and preparing job descriptions and job
specifications in advance help business owners to determine whether there is a good match
between their companies’ needs and the available labor pool. Reviewing the major industries
already operating in an area provides clues about the characteristics of the local workforce as
well. Checking educational statistics to determine the number of graduates in relevant fields of
study tells entrepreneurs about the available supply of qualified workers.

BUSINESS CLIMATE What is the state’s overall attitude toward your kind of business? Has it passed
laws that impose restrictions on the way a company can operate? Do “blue laws” prohibit certain
business activity on Sundays? Does the state offer small business support programs or financial
assistance to entrepreneurs?

ENTREPRENEURIAL PROFILE: Eclipse Aerospace Eclipse Aerospace, maker of “the
world’s most efficient very light jet,” selected Albuquerque, New Mexico, as the location
for its new 215,000-square-foot manufacturing facility because of the state’s business-friendly
environment. The state legislature passed legislation that eliminated the sales tax on aircraft
parts, services, and finished aircraft. Because the base price of Eclipse Aerospace’s newest jet is
$2.9 million, the exemption saves the company hundreds of thousands of dollars annually. The
company’s factory is conveniently located next to Albuquerque’s International Sunport Airport,
which boasts one of the longest runways in the United States, and access to a railroad spur and to
two major interstate highways. In addition, as one CEO points out, Albuquerque treats entrepre-
neurs like rock stars.14 ■

Some states and cities create policies that are more small business friendly than others.
Texas is the birthplace of many business start-ups, especially technology firms, because it offers
entrepreneurs ready access to venture capital; quality colleges and universities; a young, well-
educated workforce; and a variety of programs designed to encourage entrepreneurship. Texas
was an early participant in the Startup America program, which is designed to encourage start-up
companies and to help them succeed. Austin, Texas, is home to Indeed.com, the world’s leading
job search site. Launched in 2004 by Paul Forster and Rony Kahan, the company attracts more
than 140 million unique visitors to its Web site each month. Forster and Kahan mainly boot-
strapped Indeed.com but landed $5 million in venture capital and grew the company to more than
800 employees before selling it to Tokyo-based human resources services company Recruit Co.
Ltd. for a reported $1 billion.15

548 SECTION IV • PUTTING THE BUSINESS PLAN TO WORK: SOURCES OF FUNDS

TABLE 14.1 Most and Least Small-Business-Friendly States

States Most Friendly to Small Businesses 6. Washington
1. South Dakota 7. Alabama
2. Nevada 8. Indiana
3. Texas 9. Ohio
4. Wyoming 10. Utah
5. Florida
46. Hawaii
States Least Friendly to Small Businesses 47. New York
41. Connecticut 48. Vermont
42. Oregon 49. New Jersey
43. Iowa 50. California
44. Maine
45. Minnesota

Source: Raymond J. Keating, Small Business Policy Index 2013, Small Business & Entrepreneurship Council,
18th Annual Edition, December 2013, p. 2.

The Small Business & Entrepreneurship Council publishes an annual “small-business-
friendly” ranking of the states and the District of Columbia that includes a composite measure
of 47 factors, ranging from a variety of taxes and regulations to crime rates and energy costs (see
Table 14.1).

TAX RATES Another important factor that entrepreneurs must consider when screening states for
potential locations is the tax burden they impose on businesses and individuals. Does the state
impose a corporate income tax? How heavy are the state’s property, income, and sales taxes?
Income taxes may be the most obvious tax that states impose on both business and individuals,
but entrepreneurs also must evaluate the impact of payroll taxes, sales taxes, property taxes,
and specialized taxes on the cost of their operations. Figure 14.1 shows how each state’s overall
tax burden measured by 100 variables ranks. Currently, seven states impose no state individual
income tax (two others do not tax wage income), and three states have no corporate income tax,
but state governments always impose taxes of some sort on businesses and individuals.16 In some
cases, states offer special tax credits or are willing to negotiate fees in lieu of taxes (FILOTs) for
companies that create jobs and stimulate the local economy. The Outdoor Group LLC, a maker of
high-end archery equipment, received $900,000 in tax credits from New York by building a new
manufacturing facility in the Rochester suburb of Henrietta.17

ENTREPRENEURIAL PROFILE: Clint Greenleaf: Greenleaf Book Group Clint Greenleaf,
founder of Greenleaf Book Group, a book publisher dedicated to independent
authors and small presses, moved his company from Ohio to Texas to escape the high tax burden
Ohio imposed and to capitalize on the highly educated workforce in Texas. Since making the
move, Greenleaf Book Group’s annual revenue has grown by a factor of 10.18 ■

HIGH-SPEED INTERNET ACCESS Speedy, reliable Internet access is an increasingly important
factor in the location decision (See Figure 14.2). In fact, 95 percent of small businesses that
have computers have broadband Internet access.19 Fast Internet access is essential for high-tech
companies, those that rely on cloud computing, and those that engage in e-commerce; however,
even companies that may not sell to customers over the Internet find high-speed Internet to be a
valuable business tool. Companies that fall behind in high-speed Internet access find themselves
at a severe competitive disadvantage. According to a recent study, 48 percent of small business
owners in rural areas and 37 percent of business owners in metropolitan areas say they are not
satisfied with their Internet speed.20 Google Fiber, a high-speed fiber network from Google that
runs 100 times faster (1 gigabyte per second) than current broadband, is already in place in
Kansas City (Kansas and Missouri), Austin, Texas, and Provo, Utah, and is proving to be an