SECTION V: FINANCING TECHNIQUES AND VEHICLES Chapter 13 Capital Requirements Capital Requirements and Private Sources of Financing and Private Sources of Financing Many small and medium-sized businesses suffer from undercapitalization and/or poor management of financial resources, often during the first few years of operation. Typically, the entrepreneur either overestimates demand for the product or severely underestimates the need for capital resources and organizational skills. Undercapitalization may also be a result of the entre- preneur’s aversion to equity financing (fear of loss of control over the busi- ness) or the lender’s resistance to provide capital due to the entrepreneur’s lack of credit history and a comprehensive business plan (Gardner, 1994; Hutchinson, 1995). Large corporations have an advantage in raising capital compared with small businesses.
They have greater bargaining strength with lenders, they can issue securities, and they have greater access to capital markets around the world. However, major changes are taking place in small/medium-sized business financing due to three important factors: technology, globalization, and deregulation. Information technology enables the financial world to operate efficiently, to decentralize while improving control. It also provides businesses seeking capital to choose from a vast range of financial instru- ments (Grimaud, 1995).
Globalization allows businesses to turn increasingly to international markets to raise capital. With a touch of a button, businesses will have access to individual or corporate sources of finance around the world. With deregulation, in many countries, competition in financial prod- ucts is allowed across all depository institutions. The distinction between investment and commercial banking is quite blurred, and both sectors now compete in the small business financing market.
It is important to properly evaluate how much capital is needed, in what increments, and over what time period. First are the initial capital needs to Export-Import Theory, Practices, and Procedures, Second Edition 297 298 EXPORT-IMPORT THEORY, PRACTICES, AND PROCEDURES start the export-import business. Start-up costs are not large if the exporter- importer begins as an agent (without buying for resale) and uses his or her own home as an office. Initial capital needs are for office supplies and equipment—telephone, fax, computer—and a part-time assistant.
The busi- ness could also be started on a part-time basis until it provides sufficient revenues to cover expenses, including the owner’s salary. However, when the business is commenced with the intention of establishing an independent company with products purchased for resale (merchant, distributor, etc.), a lot more capital is needed to prepare a business plan, travel, purchase, and distribute the product, and exhibit in major trade shows. Second, capital is needed to finance growth and for expansion of the business. It is thus criti- cal to anticipate capital needs during the time of growth and expansion as well as during abnormal increases in accounts receivable, inventory levels, and changes in the business cycle.
The capital needs and financing alternatives of an export-import business are determined by its stage of evolution, ownership structure, distribution channel choice, and other pertinent factors. A very small sum of money is often needed to start the business as an agent because no payments are made for merchandise, transportation, or distribution of the product. However, ini- tial capital needs are substantial if a person starts the business as a merchant, distributor, or trading company with products available for resale. This en- tails payments for transportation, distribution, advertising and promotion, travel, and other expenses.
Capital needs at the start-up stage may be smaller compared to those needed during the growth and expansion period. However, this depends on the degree of expansion and the capital needed to support additional market- ing efforts, inventories, and accounts receivable. The ownership structure of an export-import firm tends to have an important influence on financing al- ternatives and little or no influence on capital needs. Studies on small busi- ness financing indicate the following salient features: • Incorporated companies are more likely to receive equity (and other nondebt) financing than debt financing because lenders perceive the incorporated entity as having a greater incentive to take on risky ven- tures due to its limited liability (Brewer et al.
• Younger firms are more likely to obtain equity (nondebt) than debt fi- nancing. The probability of receiving debt financing increases with age. This is consistent with standard theories of capital structure, which state that such businesses have little or no track record on which to base financing decisions and are often perceived as risky by lenders. Capital Requirements and Private Sources of Financing 299 • Firms with high growth opportunities, a volatile cash flow, and low liquidation value are more likely to finance their business with equity than debt.
In firms with high growth opportunities, conflicts are likely between management and shareholders over the direction and pace of growth options, and this reduces the chances of debt financing. How- ever, businesses with a good track record and high liquidation value (with assets that can be easily liquidated) have a greater chance of financing their business with debt rather than equity (Williamson, 1988; Stulz, 1990; Schleifer and Vishny, 1992). CAPITAL SOURCES FOR EXPORT-IMPORT BUSINESSES Capital needs to start the business or to finance current operations or ex- pansion can be obtained from different sources. Internal financing should be explored before resorting to external funding sources.
This includes us- ing one’s own resources for initial capital needs and then retaining more profits in the business or reducing accounts receivables and inventories to meet current obligations and finance growth and expansion. Such reduc- tions in receivables or inventories should be applied carefully so as not to lead to a loss of customers or goodwill, both of which are critical to the viability of the business. External financing takes different forms and businesses use one or a combination of the following: • Debt or equity financing: Debt financing occurs when an export-import firm borrows money from a lender with a promise to repay (principal and interest) at some predetermined future date. Equity financing involves raising money from private investors in exchange for a per- centage of ownership (and sometimes participation in management) of the business.
The major disadvantage with equity financing is the owner’s potential loss of control over the business. • Short-term, intermediate, or long-term financing: Short-term financing involves a credit period of less than one year, while intermediate financ- ing is credit extended for a period of one to five years. In long-term financing, the credit period ranges between five and twenty years. • Investment, inventory, or working capital financing: Investment financ- ing is money used to start the business (computer, fax machine, tele- phone, etc.
Inventory capital is money raised to purchase products for resale. Working capital supports current operations such as rent, advertising, supplies, wages, and so on. All three could be financed by debt or equity. 300 EXPORT-IMPORT THEORY, PRACTICES, AND PROCEDURES Several sources of funding are available to existing export-import busi- nesses that have established track records.
However, financing is quite lim- ited for initial capital needs, and the entrepreneur has to use his or her own resources or borrow from family or friends. It is also important to evaluate funding sources not just in terms of availability (willingness to provide fund- ing) but also in regard to the capital’s cost and its effect on business profits, as well as any restrictions imposed by lenders on the operations of the busi- ness. Certain loan agreements, for example, prevent the sale of accounts re- ceivable or equipment, or require the representation of lenders in the firm’s management. The following is an overview of possible sources of capital for export/import businesses.
Internal Sources This is the best source of financing for initial capital needs or expansion because there is no interest to be paid back or equity in the business to be surrendered. Start-up businesses have limited chances of obtaining loans so self-funding becomes the only alternative. Internal sources include the following: • Money in saving accounts, certificates of deposit, and other personal accounts • Money in stocks, bonds, and money market funds External Sources Family and Friends This is the second-best option for raising capital for an export-import business. The money should be borrowed with a promissory note indicating the date of payment and the amount of principal and interest to be paid.
As long as the business pays a market interest rate, it is entitled to a tax deduc- tion and the lender gets the interest income. In the event of failure by the business to repay the loan, the lender may be able to deduct the amount as a short-term capital loss. Such an arrangement protects the lender and also prevents the latter from acquiring equity in the business. Banks and Other Commercial Lenders The largest challenge to successful lending is the turnover rate of small businesses.
In general, fewer than half of all small businesses survive be- yond the third-year mark. However, the survival rate for export-import busi- nesses is generally higher than that of other businesses. Due to the level of Capital Requirements and Private Sources of Financing 301 risk, banks and other commercial lenders tend to avoid start-up financing without collateral. A 1994 IBM consulting group survey of small businesses revealed that bank credit was the most popular primary source of capital in the United States, followed by internally generated funds.
Credit cards were not a significant source of financing. Of the businesses, 58 percent main- tained a working capital line of credit, followed by term loans (42 percent). Only 3 percent of the businesses used Small Business Administration (SBA) loans (Anonymous, 1995). Banks remain the cheapest source of borrowed capital for export-import firms as well as other small businesses.
To persuade a bank to provide a loan, it is essential to prepare a business plan that sets clear financial goals, in- cluding how the loan will be repaid. Banks always review the ability of the borrower to service the debt, whether sufficient cash is invested in the busi- ness, as well as the nature of the collateral that is to be provided as a guarantee for the loan. Bankers always investigate the five Cs in making lending deci- sions: character (trustworthiness, reliability), capacity (ability and track record in meeting financial obligations), capital (significant equity in the business), collateral (security for the loan), and condition (the effect of over- all economic conditions) (Lorenz-Fife, 1997). Even though it is often diffi- cult to obtain a commercial loan for start-up capital, a good business plan and a strong, experienced management team may entice lenders to make a decision in favor of providing the loan.
The following are different types of financing. Asset-based financing. Banks and other commercial lenders provide loans secured by fixed assets, such as land, buildings, and machinery. For example, they will lend up to 80 percent of the value of one’s home minus the first mortgage.
These are often long-term loans payable over a ten-year period. Business assets, such as accounts receivable, inventories, and personal as- sets (savings accounts, cars, jewelry, etc.), can be used as collateral for busi- ness loans. With accounts receivable and inventories, commercial lenders usually lend up to 50 percent and 80 percent of their respective values. Use of saving accounts as collateral could reduce interest payment on a loan.
Suppose the interest on the savings account is 4 percent and the business loan is financed at 12 percent. The actual interest rate that is to be paid is reduced to 8 percent. Lines of credit. These are short-term loans (for a period of one year) in- tended for purchases of inventory and payment of operating costs.
They may sometimes be secured by collateral such as accounts receivable based on the creditworthiness and reputation of the borrower. A certain amount of money (line of credit) is made available, and interest is often charged on the amount 302 EXPORT-IMPORT THEORY, PRACTICES, AND PROCEDURES used. Certain lenders do not allow use of such lines of credit until the busi- ness’s checking account is depleted. Personal and commercial loans.