The Office of Advocacy recently published a study that revealed that the majority of small privately owned businesses opt for debt financing over equity financing. The report studied two competing capital structure theories - the “pecking order” theory and the “trade-off” theory.

According to the “pecking order” theory, small companies finance their assets in the following order: internal capital, debt, equity. The “trade-off” theory, however, says that small businesses prefer the tax benefits of deductible interest and therefore, debt financing.

After extensive statistical analysis, the Office found that the “pecking order” theory most adequately describes the capital structure of small privately owned firms. The study also found that generally a firm’s age, size, profitability, liquidity, risk and use of financial services correlates with the business’s leverage ratio (debt divided by equity). Typically, firms that are younger, less profitable, smaller, riskier, less liquid, and/or obtain more financial services from bank or non-bank institutions have higher leverage ratios.

For more information on the study’s findings, refer to theSBA report.

Biz2Credit recently attended the TIE conference in Santa Clara, CA. At the entrepreneurial network and showcasing conference, we spoke with a lot of small business owners, most of which were in the tech sector and most of which were chasing Venture Capital funds to raise money for their businesses.

Though equity financing may seem like the ideal way to finance business expansion plans, all small businesses should seriously consider the road more traveled by. Debt financing can be a vying contender, if not a superior alternative to equity financing. Today’s Venture Capital market looks barren next to the funding spree of the late 1990s and early 2000s that gave VC financing its sexy reputation.

That’s not to say taking out a loan doesn’t have substantial drawbacks for a small business. Debt financing during the credit crunch can be challenging, unpredictable and expensive.

So which one is better – debt or equity financing? It’s a decision that most businesses face early in the life cycle of the company, and it’s not easy. We’ve outlined three essential situations where debt financing can provide quick working capital relief.

Years in Operation

Small businesses more than 18 months old should aggressively apply for an SBA-backed line of credit product. Even amid the credit crunch, banks will accept stated income from small business owners and lend to established companies.

Cash Flow

Small businesses with a strong cash flow can easily qualify for accounts receivables financing. Most entrepreneurs assume that factoring is the only debt option available, however, banks will accept accounts receivables for collateral on a line of credit product – a much cheaper and better alternative.

Owner Equity

Some banks even have a credit program that lends against the owner’s equity contribution. Small business owners that have invested a substantial amount of their own funds or have used angel financing should strongly consider this option.

Read on for more information on how to get the appropriate financing for your small business:

• SBA Loans
• Small Business Financing Alternatives

Most small business borrowers often struggle to identify the best time to refinance. We outlined five common situations where you should refinance and consolidate your small business loans.

Old SBA Loans
Most entrepreneurs use SBA loans to buy a business. Usually, rates of SBA 7a loans are tied to Prime for a 3-year lock in period where pre-payment penalties apply. Loans that do not include real estate normally span 10 years and those with real estate span 20 to 25 years. Those businesses that were purchased in the last 3 years should refinance and lock in a lower interest rate.

Expanding Businesses
SBA loans put an all encompassing lien on a business and impede company growth and financing options. In this situation, business owners should pay the prepayment penalty, take the tax write-off and refinance their debt to improve credit access and company growth opportunities. Growing businesses that were originally purchased with an SBA loan should refinance with a conventional loan.

Land contracts
In this low interest rate environment, businesses that refinance land contract deals with SBA acquisition loans will save around 3 to 4 percent and extend the term of the loan.

Lines of Credit
Businesses operating for over 18 to 24 months can take advantage of the low interest products like unsecured lines of credit. Businesses maintaining good business and personal credit levels will see the most cost advantage.

Leveraging Accounts Receivables
Growing businesses can leverage high accounts receivables to obtain cheaper financing. Normally, banks lend up to 80 percent of a business’s accounts receivables at rates of around Prime plus 2. This can be used to prepay high cost loans received when the business lacked goodwill and strong receivables to qualify for less expensive financing options.

Read more to find out how to refinance and lower business loan payments.

In a sluggish economy, business owners must maintain a good credit score (above 680) in order to keep their financing options open.

Paying bills on time (especially mortgages) is only part of the solution. Small business owners should keep debt-to-income (DTI) ratios below 50 percent. Because credit bureaus do not track personal income, they monitor the DTI by looking at outstanding credit card bills and other revolving and installment payments such as mortgages and student loans. When credit card payables exceed 50 percent of the total credit card limit, the FICO model puts an individual in a riskier category compared to someone with a DTI less than 50 example.

For example, a person with two credit cards, both with a limit of $20,000 and a balance of $5,000, will have a higher credit score than someone with one card with a limit of $20,000 and a balance of $10,000. Therefore, small business owners who need to borrow more than 50 percent of their credit card limit should apply for another card.

It’s important to note that, business credit cards do not affect the DTI. For more information on building credit check out our recent blog posts:

• Catch Mistakes on Your Credit Report
• How Is My FICO Score Determined?
• What Happens to Your Credit Score when Someone Views Your Report

Never, never, never stop marketing your business. Despite the economic downturn, we can’t stress enough how important it is to maintain brand awareness and promote your product or service.

Here’s a couple of inexpensive marketing strategies that we often see small business owners overlook.

• Create a Web presence: Every small business should have a Web site. In the age where “google it” has replaced “look it up in the phone book,” having a simple and informative Web site builds brand awareness and credibility.
• Blog: Regardless of industry type, web marketing can be extremely rewarding for your business. For example, Butler Sheetmetal Ltd started a blog called Tinbasher. Within 6 months, the company Web site generated over 50,000 unique visits a month. The blog helped the company communicate with potential customers on a more personal level. As a result the company received media awards and coverage on the success of Tinbasher.
• Contribute to online forums: Establish yourself as an industry authority in the blogging community. Contribute your experiences and answer questions in online forums and link it back to your company blog or Web site. You’ll position your company as a leader in your field.
• Circulate a newsletter: Circulate a monthly or quarterly newsletter throughout your client community to maintain a strong brand identity. Take this opportunity to highlight new products, services or company achievements.
• Experiment with multimedia: Video can be an extremely cost effective marketing medium. Blendtec, a company that manufactures blenders, posted a video on YouTube of their product blending an iPhone. The video quickly became an online hit and helped quadruple their sales over a 6 month period. The video only cost the company $100 to shoot.

The Fed cut interest rates March 17 by 75 basis points. The repeated rate reduction drove down prime lending rates to 5.25 percent. As predicted over the past two months, there’s a large possibility of more rate cuts in the future.

The impending recession and rising inflation make this an opportune time for small businesses to borrow money and acquire assets at a low price. The combination of higher inflation and low interest rates will lead to larger margins overall as wage inflation costs decrease.

Also, in this market environment small business owners can expect competition to wane, providing valuable growth opportunities. At the same time, businesses can keep fixed costs low to lower their leverage and increase their revenue streams to improve visibility.

Retail is one of the most prevalent industries in the United States. Basically, there are five factors that determine the valuation of a retail business:

• Nature of Business: Banks tend to avoid lending to certain types of businesses. Typically, they try to steer away from cash-based businesses like delis and restaurants. This lack of access to capital dampers future expansion opportunities and lowers the value of the business.
• Entry barriers: Retail businesses with a barrier to entry over an industry receive higher valuations. For example, franchises are valued more than stand alone retail establishments, which have a high risk of failure.
• Location: Locations for retail establishments can make or break the business. Locations in or near a busy shopping mall or including a drive way or impressive aesthetics can significantly increase the value of the business.
• Lease: Lease terms can influence the valuation of a retail business. For example, longer leases without escalation charges exceeding 4 percent annually improve the value of the establishment. Typically, retail business valuations range from 0.4 to 1.3 times the revenue.
• Revenue Distribution: A corporate client roster can increase the value of a retail business. For example, a restaurant that caters corporate events is highly valued. Supplier terms can also significantly affect business valuation. Terms exceeding 30 days or bulk discounts over 3 percent are extremely favorable.

As banks tighten lending standards, small businesses and startups are running out of capital resources. However, loans guaranteed under the SBA 7(a) program still provide small business owners with access to credit.

There’s a better option for entrepreneurs financing their business ventures with home equity credit lines or personal savings. Through the SBA 7(a) program, lenders will provide up to 80 percent of the project cost if borrowers can foot the remaining 20 percent. Depending on the business plan, viability of the project, current business profile and the borrower’s credit history the lender may take a second lien on real estate owned by the entrepreneur.

For example, a successful limousine business owner wanted to acquire a Coldstone Creamery franchise to diversify across industries. In operation for three years, the business was listed for $400,000. Despite a patchy credit history, the entrepreneur received an SBA 7(a) loan from an SBA Preferred Lender and acquired the business. The entrepreneur only had to cover 25 percent of the project cost personally.

Despite a fragile economy and sluggish capital flow, SBA programs still provide entrepreneurs with valuable financing options and a means to grow their enterprise.

In the United States, small commercial real estate is classified as property worth up to $5 million. There are five factors that determine the valuation of commercial property:

• Income Expense ratios: Rental income should cover at least 1.2 to 1.3 times the cost of property maintenance, which may include taxes, insurance, sewage charges, etc. Generally commercial property is valued around 8 to 12 times the gross income generated from the property. However, valuation may also depend on the expected capital gains from property acquisition and sale.
• Tenancy Mix: Multitenant commercial property lowers vacancy risk and boosts valuation over single tenant properties. In the case of mixed use tenancy, higher valuation is given to properties with 51 percent of the income generated from the commercial tenancy.
• Anchor Tenant: An anchor tenant with a AAA lease and 25 to 30 percent property occupancy increases the overall value of the property by at least 10 to 15 percent. A well-known principle tenant generates foot traffic and increased sales for all tenants, increasing rent and property value.
• Property Taxes: High property taxes not supported by high rental incomes decrease the value of the real estate. Typically, taxes account for about 1 to 3 percent of the overall property value but vary according to state. For example, taxes in Midwestern states hover around 1 percent, but most property owners in Michigan, Florida and New Jersey pay around 3 percent. However, properties that are more than 51 percent occupied by commercial tenants can qualify for federal and state tax refund programs.
• Location: Like other types of real estate, location is key. Commercial real estate located near a national highway or a big shopping mall is valued more than those in remote locations.

There are five factors that determine the valuation of an accounting firm:

• Client Roster: A well diversified customer base of over 500 to 600 small to midsize businesses raises an accounting firm’s valuation – in some cases up to 1 to 1.25 times the revenue.
• Service offerings: Accounting firms that offer a wide range of services like tax preparation, payroll management and consultation have a higher valuation than companies with a one-dimensional revenue model. Multiple revenue streams stabilize the business’s cash flow and can boost valuation to around 1.25 times the revenue.
• Accounts Receivables: Outstanding accounts receivables over 90 days hurts an accounting firm’s valuation (except if client list is primarily composed of blue-chip companies). Ideally, company should strive to keep it under 60 to 75 days.
• Client/revenue concentration: Ideally, an accounting firm should not have a single client account for more than 5 to 10 percent of the total revenues. A revenue model surrounding one client can seriously lower an accounting company’s valuation.
• Liability issues: Unlimited liabilities, INS violations while filing work visas for employees, and a lack luster D&B report can significantly affect a business’s valuation.