Financing Small Firms

In studying how a small firm is financed, we will first describe the financing stages a firm experiences during its business life. We will then look at a special group of investors called "venture capitalists" that may be particularly significant for a small growth business, but not for a large business. Next, we will examine the different sources of financing in an effort to identify the more important ones for the small firm. Naturally, the conventional sources of short term and long term debt and common stock apply to all firms, small and large. However, the desirability and the availability of these various funds for the small firm may be different from those for the large firm. Finally, the decision to "go public" may be a serious consideration for a successful growth firm that has expanded beyond the financing capabilities of its owners. The advantages and disadvantages of issuing stock to the public are discussed in the concluding section of the chapter.

Stages of Financing The business firm goes through three primary financing stages in the earlier segment of its business life cycle. Phase one, the initial investment, consists of the owner's personal capital, the credit provided by the commercial banker, and a host of miscellaneous sources. Examples of miscellaneous sources in this phase would include
(1) savings and loan associations,
(2) the Small Business Administration,
(3) friends and relatives,
(4) leasing companies, and
(5) commercial finance companies.

Phase two of a young firm's financial existence may be referred to as the gap. During this period the firm has grown to the level beyond which the owners have the capability to finance all investments; however, the firm is not large enough to justify a public offering. At this point it must sell securities to private individuals or groups. For instance, financial institutions (banks and savings and loan associations), private investor groups, and venture capitalists may be approached either directly or through an investment banker acting as a liaison. On the other hand, large corporations may provide financing for a small firm but are generally approached directly. Furthermore, the kind of financing available from these respective sources varies, with financial institutions providing primarily debt financing and large corporations providing equity financing. Between these two extremes, a mixture of debt and equity capital would be available.

The final stage of development for the small firm in terms of financing sources is the raising of funds in the public markets.

Before looking at specific sources of financing, we will discuss the nature of venture capital.