Abstract
Growth and development are key goals for all small businesses. To achieve this, businesses require ever increasing capital which can at times only be attained from outside sources. This paper reviews the case of Andy Rexford who wants to expand his company but is under financial constraints. An outline of three available sources of capital for Andy will be made. The merits and demerits of these sources will be discussed so as to help propose one source which will be both feasible and most advantageous for Andy.
Introduction
Every business owner appreciates the fact that it takes significant investment in terms of capital for the business to experience impressive growth. While some business owners are able to come up with the necessary capital to finance their business independently, most are not able to raise the required capital without outside sources (Benjamin & Joel, 2005).
This is the case for the entrepreneur Andy Rexford who wishes to expand his custom embroidery company, Custom Stitches. Andy projects that he can double the size of his company within two years if he can get the finances to fuel this growth. The range of financing options open to small businesses is not as expansive as that offered to large well established companies.
This is mostly because of the perceived risk that lenders see in small business. Even so, there are some options that small business owners can explore when looking for additional finances. In this paper, I will offer Andy suggestions on avenues where he can seek financing for Custom Stitches. I will explain the merits and demerits associated with each source of funding and conclude by suggesting what I think would be the most promising financial source for Andy’s capital needs.
Sources of Capital for Andy
One option which Andy could consider for financing his business is commercial banks. Seidman (2005) asserts that commercial banks are the largest financing sources for external business debt. Banks offer loans to successful borrowers for a stated length of time and the loan has a predetermined interest rate attached to it. As a matter of principle, commercial banks are conservative lenders and the borrower must demonstrate a high likelihood of success and present a strong case so as to convince the bank to lend him/her.
Another option open for Andy is Small Business Investment company’s (SBIC) which are private lenders licensed and regulated by the Small Business Administration (Longenecker, 2011). SBIC provide capital to a business and their functioning is similar to venture capital and private equity companies in that they aim to get significant returns from the investment made in the small business.
SBICs help small businesses to acquire funds when they are not able to service a substantial debt repayment from a commercial bank. SBICs are a feasible source of capital for Andy in the event that commercial banks decide that the business does not justify a loan.
Another financing facility that is open to Andy is Trade credit. Trade credit is a significant source of capital for small businesses and Sihle, Richard, and Henry (2004) note that it is the third most important source of capital for private firms. This form of financing is widely used by small businesses to secure capital to run their businesses. Trade credit will be available to Andy since he has been in business for a while and has therefore established contract with his suppliers. His good credit ratings will ensure that he can secure trade credit fairly easily.
Commercial banks
- Merits
One advantage of commercial banks is that they offer a wide variety of loans and it is easy for a borrower to find a product that suits their needs. There are also a wide number of commercial banks and it is fairly easy for someone with a successful business to get a bank that will offer him a loan at a competitive rate. Another advantage of commercial banks is that Andy can try and negotiate the terms of credit and interest rates and therefore obtain the most favorable deal for himself.
- Demerits
A notable disadvantage with commercial banks is that they require security on the loan. Commercial banks require assets that can be used as collateral as well as a visible means of paying off the loan at a reasonable point in the future (Baty & Michael, 2001). This security may be taken over by the bank if the borrower is not able to repay the loan in full or stick to the repayment schedule agreed on.
SBICs
- Merits
The financing offered by SBIC can range from short term to long term therefore suiting the needs of many small businesses. SBICs are also likely to take up starting businesses which do not necessarily have clear evidence that they will be able to produce the cash flow required to meet interest payments. In addition to this, SBICs may provide technical advice to the borrower and this advice can result in further business growth.
- Demerits
A significant demerit of SBICs is that they typically charge high interest rates since their goal is to generate high returns for their investment made in the small business. These sources also require substantial collateral or personal guarantees from the borrower.
SBICs sometimes require the borrower to have assets that can be liquidated if the business fails and they also require the entrepreneur to invest a substantial portion of their net worth and/or postpone salary (Benjamin & Joel, 2005). Another notable demerit is that the SBIC might involve itself in the management of the business so as to safeguard its investment.
Trade Credit
- Merits
Trade credit is especially attractive since it is a spontaneous source of financing which does not have an explicit interest cost attached to it. The interest attached to trade credit is mostly in the form of lost discounts that the buyer would have obtained if they paid in cash (Longenecker, 2011).
This lack of an explicit interest cost is a definite advantage for Andy. This is because lower interest rates will result in reduced expenses for the business and therefore improve the cash flow for Custom Stitches. Additionally, companies such as Andy’s which have low credit risk are likely to receive generous trade credit from their suppliers.
- Demerits
A major demerit of trade credit is that it is a short-term financing source. Moyer, James, and William (2008) document that trade credit extends for a maximum of 90 days which makes it unfeasible as a long term credit facility. Another demerit is that trade credit cannot be used for tasks such as paying for business premises or paying employees.
Most Promising Source for Andy
From the previously outlined sources of financing open to Andy, I would recommend that he makes use of loans offered by commercial banks. As it currently stands, Custom Stitches has experienced a significant growth in a short while and the business prospects are promising.
It is, therefore, likely that a commercial bank will be willing to advance Andy a loan since commercial banks are increasingly focusing on lending to small business that requires huge capital but poses limited risks. With a fixed rate of interest attached to the loan, Andy can predict the cash outflows and, therefore, properly manage the business.
In spite of the costs associated with loans from the commercial bank, the loan will be of great value to the company. Specifically, the loan will provide the additional capital needed to supplement the limited supply of equity that is currently available to Andy’s company. Baty and Michael (2001) observe that banks are known to waive orthodox lending standards and lend substantial amount of money to small businesses on the basis of contracts in hand.
The information provided by Andy indicates that his business is growing fast and is achieving good profits. This suggests that he is using a good business model and the prospects of future growth and increased profitability are high.
It would, therefore, be advisable for Andy to seek a source of financing that will not require him to share his profits. Equity financing will result in Andy giving a percentage of his profits to the SBIC. In addition to this, Andy would like to maintain control of his business as he has in the past. Commercial banks will not interfere with his running of the business as would SBICs.
Conclusion
From this paper, it is clear that there are a number of finance options open for Andy. However, each source comes with its inherent merits and demerits. Analyzing this pros and cons is important for a person to make the most prudent source choice. From the information provided in this paper, commercial banks are the best capital source for Andy to finance his business’ growth.
References
Baty, G.B. & Michael, B. (2001). Entrepreneurship–back to basics. Boston: Beard Books.
Benjamin, G., & Joel, M. (2005). Angel capital: how to raise early-stage private equity financing. Chicago: John Wiley and Sons.
Longenecker, L.G. (2011). Small Business Management: Launching & Growing Entrepreneurial Ventures. NY: Cengage Learning.
Moyer, C.R., James, R.M., & William, J.K. (2008). Contemporary Financial Management. NY: Cengage Learning.
Seidman, K.F. (2005). Economic development finance. NY: Sage.
Sihle, W.W., Richard, C., & Henry, A.D. (2004). Smart financial management: the essential reference for the successful small business. Texas: AMACOM Div American Agmt Assn.