Financing Your Business Part 2: Debt

DEAR INVESTOR JUAN

Perhaps the most important reason why you, as a business owner, would want to (partly) finance a venture with debt is that you want to maintain majority or sole ownership and control of the business, which may be significantly diluted if you instead use additional equity financing, as was discussed in Part 1. Also, as I already mentioned in that post, while the business entity would have to be formed first (and in many cases, be in operation for a number of years) before a business loan gets approved, the entrepreneur can always use personal debt to supplement the initial equity raised.

Having said that, here are the most common sources of debt financing for budding entrepreneurs.

1. Credit card debt. Yes, I'm not joking: you can use your credit card to finance some of your business's capital needs. Not only that, it can be your cheapest source of financing if you play your cards right. Remember, you only get charged if you don't pay the entire balance on or before the due date; so the key is to use your credit card to buy some of your business needs, like say, your monthly inventory if you're running a sari-sari store, and pay the entire balance on the due date. Doing this is like getting a one-month loan at zero interest rate every month; as a deal, nothing can be sweeter.

Of course, paying beyond the due date comes at a terribly high price: credit card financial charges in the Philippines run at around 3.5% per month, or 42% per year (annual percentage rate or APR). So don't even bother using your card if you know you won't be able to wipe out the balance every month.

2. Cooperative/payday loans. If you're currently working, ask your more seasoned officemates the going rate for payday loans or for loans offered by your office credit cooperative, and you'll hear that it's anywhere from 1 to 5% per month (by the way, this is add-on interest, which is applied differently than the monthly compounded interest rate of credit cards); while not as high as the infamous "five-six" rates offered by loan sharks, 5% per month is still quite expensive. Still, you might find these loans useful because they are readily available and the application is usually hassle-free.

3. Loans from government offices (SSS, GSIS, Pag-ibig). Not a lot of people know this, but you can actually use all of those deductions you see on your paychecks to your benefit as early as two years after the start of your employment. For example, you can get a two-year, 24,000 peso loan from SSS at only 10% per year. Also, apart from housing loans (best rates in town if you're going to borrow 1 million pesos or less, by the way), Pag-ibig also offers multi-purpose loans and calamity loans to its members. Far from being worthless, these government agencies can boost your debt capacity and strengthen the capital base of your business.

4. Bank loan (personal). Sometimes banks offer really low interest rates for personal loans, like less than 1% per month, add-on, with borrowed amounts that can range from 10,000 to 500,000 pesos. The problem is, the application period may take some time, and there's no certainty that your application will get approved (I know a couple of people who have already been turned down even if they're capable of paying back the loans).

5. Bank loan (business). If your business is already up and running, and you need additional financing for expansion purposes, for example, you can get either a line of credit or a business loan from a bank. With a line of credit, an amount you apply for will be made available to you for a specified period of time; when you need the money, you can borrow or draw funds from this line at a predetermined interest rate, and you don't have to submit an application every time you borrow. SME business loans, like the ones offered by BPI and DBP, generally requires collateral.

In getting a bank loan for your business, it would help immensely if you already have a long and meaningful relationship with the bank, even just by maintaining a considerable deposit balance. With this kind of relationship with your bank, there's a higher chance of getting your loans approved, getting lower interest rates, and even securing a business loan for your new business.

6. SME business loans from other financial institutions. Like the ones offered by Small Business Corporation (SBC) and SSS. SBC even offers debt financing for startups, so just make sure that you have a sound business model and a well-prepared business plan for your new business. You can probably even get lower rates from these institutions than what most banks provide.

To end, just remember two important things before you borrow money for your business. One, by borrowing, you will be committing your business to a fairly large business expense (interest plus principal repayments), so make sure that you can generate enough cash flow (not profits, mind you) to meet these future needs, or your business falls to ruin. Two, even if you organize your business as a corporation or a limited liability company (each of which provides owners with limited liability for business debt, meaning creditors can only run after the assets of the business), almost all commercial lenders will require you, as the owner of a new or small business, to personally guarantee the loan with your personal assets through what is called a surety, a guarantee which essentially wipes out your limited liability. In other words, before you borrow any amount for your business, be ready to lose your shirt (and maybe your underwear too) if you're unable to repay your debt.

Financing Your Business Part 1: Equity

DEAR INVESTOR JUAN

Dear Investor Juan,

Many aspiring entrepreneurs fail to put their business ideas into reality because there's almost no way for them to access external financing, like through banks, for example. Most financial institutions have very strict requirements: banks, for example, require at least three years of operations; and even if the individual has real property that may be used as collateral for a business loan, it does not guarantee approval.

Based on my research and personal experience, banks charge an annual interest rate of 14 to 17%. Individual lenders (loan sharks), on the other hand, charge as much as 8% a month, which is equivalent to 96% annual interest. I guess this is the reality in the Philippines, where wealth distribution and access to capital are dismal.

What's the best way to finance a business startup? I fear that my personal funds won't be enough for the business that I have in mind, so I may have to turn to other sources.

Thanks!

Anonymous


Dear Anonymous,

Raising the necessary capital is the second most important challenge would-be entrepreneurs would have to face in founding a new business (coming up with a sound business model, of course, should be the most important concern for entrepreneurs, but that's a matter for another post). In forming your business, you would need to have enough cash for machinery and equipment, the purchase or lease of real property for your office and/or production facilities, investment in raw materials or merchandise, buffer or contingency funds, and registration costs, among others. And even if you're able to successfully form your business, eventually you'll need to expand, and your profits may not be enough to finance this growth.

Entrepreneurs turn to two main financing sources at the onset of the business: equity and debt (which are both considered external sources; internal financing comes from the business's earnings). Equity represents ownership in a business, and the consequent claims of owners on the earnings and assets of the firm; in other words, equity is money that comes from the owners and investors of a business. Debt is debt, money that comes with an obligation to repay the borrowed amount, plus interest, in future periods. Naturally, startups would have to turn to equity financing first as the business entity would have to first exist before it can borrow money, although entrepreneurs can also avail of personal loans to finance their businesses (something that will be discussed in Part 2).

Here are some obvious and not-so-obvious sources of equity financing.

1. Your own money. As an entrepreneur, staking some of your own money is something you cannot avoid (although in some cases, certain skills and non-economic assets can buy you a stake in a business as an industrial partner); in any case, risking your own money shows other potential investors and creditors that you are confident of the soundness and prospects of your business, so it becomes easier to convince them to take the plunge with you. But since most of the time you what you have won't be enough for your business (like in your case), you have to turn to other sources like...

2. Your family and friends. If you can't convince the people closest to you that you have a winning formula, how can you convince anyone else? But even if you are able to wow your family and friends with your business plan, unless you come from a clan of hacienderos or politicians, available funds will still most probably be limited. Also, before you ask your loved ones to be your business partners, remember that money can fray even the strongest ties, so try your best to convince everyone that it's not personal, just business.

3. Angel investors. These are individuals who have excess capital earmarked for investment in new new and existing firms. Since these investors are presumably very wealthy, they are likely to have more available capital than your family and friends.

Angel investors will likely just be interested in businesses that they are familiar with and industries with which they have extensive experience. Also, with their extensive experience, they can provide helpful advice and connections to you and your business.

I don't know any angel investor personally, but I'm sure we all know the type. The best example I can think of is the character "S.R. Hadden" of Hadden Industries in the 1997 film Contact starring Jodie Foster (it's a great film, you should see it).

4. Venture capitalists. These are organizations whose business it is to invest in startups; by investing early in a business's life, venture capital firms or VCs bet that phenomenal growth will follow if the business becomes successful. Like in the U.S. where the VC industry is much more developed, in the Philippines local VCs are also partial towards businesses that have a high-technology base, so if your just thinking of a kariton food business, forget it. But if you do get VC funding, you get to benefit from value-added services like management and technical assistance, strategic guidance, and network of contacts.

There are active VCs operating in the Philippines: perhaps the most notable of these are Narra Venture Capital and ICCP Venture Partners. For smaller scale businesses, there's the Small Business Corporation, a government-owned and -controlled entity that provided financing (both equity and debt) to small and medium businesses.

If you're considering approaching an angel investor or venture capitalist for additional financing, the most important issue you need to think of is having to give up partial control of your business to strangers. If you want to maintain absolute control, or at least keep it within your circle, you might want to just borrow your capital shortfall, which is something we'll discuss in Part 2.

Petron Sets P100/share Price for Preferred Stock Offering

IN THE NEWS from Inquirer.net

Petron is set to issue 50 million perpetual preferred shares from February 15 to February 26 at 100 pesos per share. The offer features a dividend rate of 9.5281% per year.

The issue is aimed to finance the company's retail expansion program, which involves the construction of new service stations in remote areas. Petron also plans to allocate 3.9 billion pesos for the repayment of short-term debts.

Should the company be successful in increasing the issue from 50 million to 100 million shares or 10 billion pesos, it plans to set aside about 5 billion pesos for the construction of a new power plant within the company’s refinery compound in Limay, Bataan.

5 Ways to Get the Most Out of Your Credit Card

Credit cards are the most convenient source of financing available to almost everyone. With credit cards, you won’t need to carry a lot of cash for both planned and unanticipated purchases. And as Internet commerce continues to flourish, credit cards have also become essential to people who frequently buy and sell stuff online.

Unfortunately, this convenience may come at a very steep price: apart from the annual membership fee which ranges from 1,000 to 1,600 pesos, credit card debt also comes with very high (effective) interest rates, oftentimes as high as 51% per year! That means if you buy something worth 10,000 pesos today using your credit card, your debt may balloon up to 15,000 pesos in one year; that is, if you don’t play your cards right.

There are many ways of maximizing the benefits of credit card use and avoiding repressively high financial charges. Here are a few tips that will ensure that you get the most out of your credit card (and not the other way around).

1. Take advantage of the free stuff.

Do you know that you don't have pay the annual fee even once? Just call your credit card company and ask that your annual fee be waived; you'll be surprised how accommodating they can be to your request. Mine came with a condition, though: they requested that I sign up for SMS alerts that don't cost anything. Who was I to refuse?

Don't forget that you earn points for your purchases, points that can be converted to air travel miles, gadgets, food, and other freebies. Don't even complain if you just earn a 500 pesos Jollibee GC after a year of using your credit card: 500 pesos is infinitely better than nothing.

2. Get a free ride.

Most personal finance blogs or guides would advise you to always use cash whenever you can and avoid using your credit card to avoid financial charges. But remember, you’ll only have to pay interest on your credit card if you don’t fully pay your Total Amount Due before each monthly Payment Due Date. Paying off your credit card bills completely each month (not just the Minimum Amount Due) has the same effect as getting a short-term loan at zero percent interest; you’ll never find a sweeter deal anywhere else! By doing this, you avoid thousands of pesos in interest payments and accumulate very high savings in the long run.

3. Avoid being in debt (virtually) forever.

If you only pay the Minimum Amount Due, which is around 5% of the total amount, month after month, you’ll soon find yourself in a very deep financial hole that is almost impossible to get out of. For example, if you owe a credit card company 20,000 pesos and you only pay the minimum amount (let’s assume 5% of the total) every month, it will take you more than 16 years to bring down the debt balance to under 1,000 pesos and you will have paid a total of more than 40,000 pesos in interest charges! This happens because credit card payments go to interest first; by paying only the minimum amount, all your payments go to interest charges, leaving the principal almost untouched.

4. Pay more than the minimum.

If getting a totally “free ride” and paying the entire credit card balance every month is unrealistic for you, then just increase your monthly payment to a level that is significantly above the Minimum Amount Due and bite significant chunks off the principal every month. Taking another look at the above example, if you pay Php 1,200 religiously every month, it will now only take you a little over two years to completely pay off your 20,000 peso debt ; compare that to the 16-plus years it will take you if you only pay the minimum amount!

5. Don’t bite off more than you can chew.

The only reason why you’ll find it hard to pay off the entire Total Amount Due of your credit card bill is if you continuously spend more than what you earn. Because credit cards give the illusion of enhanced spending power, it is important to know what your true spending limit is and try your best to avoid going beyond this amount.

In the end, it all just boils down to using your credit cards sensibly and responsibly. By following the above tips, you can avoid being a slave to credit card companies and make your credit card work for you instead.