This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
As soon as the promoter starts to develop a new proposition, he begins to establish - if he has not previously done so - the banking connections that will be of greatest use in connection with the enterprise. These connections should be with banks that are already familiar, through their own experience, either with the line of business or with the field of operations of the business in which the promoter is working. To be specific, if the project is to establish an interurban railroad near Dallas, Texas, the promoter will look for his financial connections either among the New York, Boston, Chicago, and St. Louis banking houses that are accustomed to investigating and floating interurban properties, or among the Dallas bankers who thoroughly know the local situation and can perhaps assist in raising funds from local people. The active cooperation of interested bankers is quite essential to the success of most promotions. The first stage of the financing in which the banker plays his part may be reached when the purchase of options or the outright purchase of property is under consideration. The bankers interested may, at this point, create a syndicate which will advance money to the promoter for the purchase of options on the property, with the agreement that repayment is to be made as soon as the promotion is success-fullyjloaled. If the expenditure at this stage is for options only and the promoter's personal means should not allow him to go ahead unassisted, he very likely would attempt to organize a small syndicate among his personal acquaintances who would be willing to share with him equally the risks and the profits of the promotion. Ordinarily, the bankers would not step in unless outright purchase on a large scale was called for.
The next stage at which bankers' co-operation may be called for is during the period of development, when the promotion involves a great deal of construction; or the period of waiting, when the promotion is a combination that can-not at once be financed by the sale of securities to the public. Let us take an assumed example for the sake of clearness. A new manufacturing company is to put up a plant costing $1,000,000, and provide machinery and equipment amounting to $500,000. Let us assume that the product is of such nature that there can be no question as to its marketability. It may sometimes be desirable and possible to raise the full amount of required capital - $1,500,000 in this case - at the outset and expend it gradually in the construction of the plant, but in other cases this plan will be found impracticable and the question will arise as to how to secure the funds with which to keep construction going while at the same time taking care of the sale of securities.
The customary, plan is to place a mortgage on the property acquired or later to be acquired, and to issue bonds up to the extent of the mortgage. These bonds, however, will not be salable until the property has actually been developed. The. difficulty may best be met by depositing them with bankers as security for short-term loans and using these loans to provide funds for construction. The banker receives these bonds as collateral, which will eventually be salable and, in case the whole proposition is sound, may consider himself at least fairly well protected. Usually the arrangement is that the bonds shall be delivered as construction goes on, so that the banker may never have on hand a great many bonds representing property that exists as yet only on paper.
The analogous difficulty in case a combination is formed, the securities of which are not at once salable, is met in the same way. The securities are posted as collateral for bank loans and the loans are later paid off as the securities are disposed of.
By means of this preliminary financing, an enterprise can be financed even though the promoter and his immediate friends may have limited funds up to the point when the sale of securities to the public brings in the required amount of capital.