More Information About Starting Your Small Business
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Capital Alternatives |
Understanding
Money Sources |
Never
enough money! How many times have you said that. You need capital
to get sales, buy inventory, pay your employees, purchase assets,
pay taxes, you name it - you need money for it. Your need for capital
is a continuing one. Expansion opportunities or a chance to purchase
cost-saving equipment can also create a need for extra capital. To
just stay in business or to expand, the small business owner needs
capital, but where do you get it? |
HOW THE NEED FOR CAPITAL ARISES |
As
your business grows, so does your need for more and more capital.
Remember there is more than one way and more than one place to raise
the money you need. You need to understand the reasons that additional
capital is needed -- this will play an important role in choosing
the right form of additional capital for your business.
There are many factors that can
create a need for additional capital. Some of the more common are
as follows:
- Sales growth requires inventories to be built
to support the higher sales level.
- Sales growth creates a larger volume of accounts
receivable.
- Growth requires the business to carry larger
cash balances in order to meet its current obligations to employees,
trade creditors, and others.
- Expansion opportunities such as a decision to
open a new branch, add a new product, or increase capacity.
- Cost savings opportunities such as equipment
purchases that will lower production costs or reduce operating
expenses.
- Opportunities to realize substantial savings
by taking advantage of quantity discounts on purchases that
will lower production costs or reduce operating expenses.
- Opportunities to realize substantial savings
by taking advantage of quantity discounts on purchases for inventory,
or building inventories prior to a supplier's price increase.
- Seasonal factors, where inventories must be
built before the selling season begins and receivables may not
be collected until 30 to 60 days after the selling season ends.
- Current repayment of obligations or debts may
require more cash than is immediately available.
- Local or national economic conditions which
cause sales and profit to decline temporarily.
- Economic difficulties of customers that can
cause them to pay more slowly than expected.
- Failure to retain sufficient earnings in the
business.
- Inattention to asset management may have allowed
inventories or accounts receivable to get out of hand.
Combination. Frequently, the cause cannot be entirely attributed
to any one of these factors, but results from a combination. For
example, a growing, apparently successful business may find that
it does not have sufficient cash on hand to meet a current debt
installment or to expand to a new location because customers have
been slow in paying.
Short- and Long-Term Capital.
Capital needs can be classified as either short- or long-term. Short-term
needs are generally those of less than one year. Long-term needs
are those of more than one year.
Short-Term Financing.
Short-term financing is most common for assets that turn over quickly
such as accounts receivable or inventories. Seasonal businesses
that must build inventories in anticipation of selling requirements
and will not collect receivables until after the selling season
often need short-term financing for the interim. Contractors with
substantial work-in-process inventories often need short-term financing
until payment is received. Wholesalers and manufacturers with a
major portion of their assets tied up in inventories and/or receivables
also require short-term financing in anticipation of payments from
customers.
Long-Term financing.
Long-term financing is more often associated with the need for fixed
assets such as property, manufacturing plants, and equipment where
the assets will be used in the business for several years. It is
also a practical alternative in many situations where short-term
financing requirements recur on a regular basis.
Recurring Needs.
A series of short-term needs could often be more realistically viewed
as a long-term need. The addition of long-term capital should eliminate
the short-term needs and the crises that could occur if capital
were not available to meet a short-term need.
Steady Growth.
Whenever the need for additional capital grows continually without
any significant pattern, as in the case of a company with steady
sales and profit from year to year, long-term financing is probably
more appropriate. |
MANAGING INTERNAL CAPITAL
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Internal
sources of capital are those generated within the business. External
sources of capital are those outside the business such as suppliers,
lenders, and investors. For example, a business can generate capital
internally by accelerating collection of receivables, disposing
of surplus inventories, retaining profit in the business or cutting
costs.
Capital can be generated externally
by borrowing or locating investors who might be interested in buying
a portion of the business.
Before seeking external sources
of capital from investors or lenders, a business should thoroughly
explore all reasonable sources for meeting its capital needs internally.
Even if this effort fails to generate all of the needed capital,
it can sharply reduce the external financing requirements, resulting
in less interest expense, lower repayment obligations, and less
sacrifice of control. With a lower requirement, the business's ability
to secure external financing will be improved. Further, the ability
to generate maximum capital internally and to control operations
will enhance the confidence of outside investors and lenders. With
more confidence in the business and its management, lenders and
investors will be more willing to commit their capital.
Internal Sources of Capital.
There are three principal sources of internal capital:
- Increasing the amount of earnings kept in the
business.
- Prudent asset management.
- Cost control.
Increased Earnings Retention.
Many businesses are able to meet all of their capital needs through
earnings retention. Each year, shareholders' dividends or partners'
draws are restricted so that the largest reasonable share of earnings
is retained in the business to finance its growth.
As with other internal capital
sources, earnings retention not only reduces any external capital
requirement, but also affects the business' ability to secure external
capital. Lenders are particularly concerned with the rate of earnings
retention. The ability to repay debt obligations normally depends
upon the amount of cash generated through operations. If this cash
is used excessively to pay dividends or to permit withdrawals by
investors, the company's ability to meet its debt obligations will
be threatened.
Asset Management.
Many businesses have non-productive assets that can be liquidated
(sold or collected) to provide capital for short-term needs. A vigorous
campaign of collecting outstanding receivables, with particular
emphasis on amounts long outstanding, can often produce significant
amounts of capital. Similarly, inventories can be analyzed and those
goods with relatively slow sales activity or with little hope for
future fast movement can be liquidated. The liquidation can occur
through sales to customers or through sales to wholesale outlets,
as required.
Fixed assets can be sold to free
cash immediately. For example, a company automobile might be sold
and provide cash of $2,000 or $3,000. Owners and employees can be
compensated on an actual mileage basis for use of their personal
cars on company business. Or if an automobile is needed on a full-time
basis, a lease can be arranged so that a vehicle will be available.
Other assets such as loans made
by the business to officers or employees, investments in non-related
businesses, or prepaid expenses should be analyzed closely. If they
are non-productive, they can often be liquidated so that cash is
available to meet the immediate needs of the business.
Any of the above steps can be taken
to alleviate short-term cash shortages. On a long-term basis, the
business can minimize its external capital needs by establishing
policies and procedures that will reduce the possibility of cash
shortages caused by ineffective asset management. These policies
could include the establishment of more rigorous credit standards,
systematic review of outstanding receivables, periodic analysis
of slow-moving inventories, and establishment of profitability criteria
so that fixed asset investments are most closely controlled.
Cost Reduction .
Careful analysis of costs, both before and after the fact, can improve
profitability and therefore the amount of earnings available for
retention. At the same time, cost control minimizes the need for
cash to meet obligations to trade creditors and others.
Before the fact, a business can
establish buying controls that require a written purchase order
and competitive bids on all purchases above a specified amount.
Decisions to hire extra personnel, lease additional space, or incur
other additional costs can be reviewed closely before commitments
are made.
After the fact, management should
review all actual costs carefully. Expenses can be compared with
objectives, experience in previous periods, or with other companies
in the industry. Whenever an apparent excess is identified, the
cause of the excess should be closely explored and corrective action
taken to prevent its recurrence. |
TRADE CREDIT |
Trade
credit is credit extended by suppliers. Ordinarily, it is the first
source of extra capital that the small business owner turns to when
the need arises.
Informal Extensions.
Frequently, this is done with no formal planning by the business.
Suppliers' invoices are simply allowed to "ride" for another
30 to 60 days. Unfortunately, this can lead to a number of problems.
Suppliers may promptly terminate credit and refuse to deliver until
the account is settled, thus denying the business access to sorely
needed supplies, materials, or inventory. Or, suppliers might put
the business on a C.O.D. basis, requiring that all shipments be
fully paid in cash immediately upon receipt. At a time when a business
is obviously strapped for cash, this requirement could have the
same effect as cutting off deliveries all together.
Planning Advantages.
A planned program of trade credit extensions can often help the
business secure extra capital that it needs without recourse to
lenders or equity investors. This is particularly true whenever
the capital need is relatively small or short in duration.
A planned approach should involve
the following:
- Take full advantage of available payment terms.
If no cash discount is offered and payment is due on the 30th
day, do not make any payments before the 30th day.
- Whenever possible, negotiate extended payment
terms with suppliers. For example, if a supplier's normal payment
terms are net 30 days from the receipt of goods, these could
be extended to net 30 days from the end of the month. This effectively
"buys" an average of 15 extra days.
- If the business feels that it needs a substantial
increase in time, say 60 to 90 days, it should advise suppliers
of this need. They will often be willing to accept it, provided
that the business is faithful in its adherence to payment at
the later date.
- Consider the effect of cash discounts and delinquency
penalties for late payment. Frequently, the added cost of trade
credit may be far more expensive than the cost of alternate
financing such as a short-term bank loan.
- Consider the possibility of signing a note for
each shipment, promising payment at a specific later date. Such
a note, which may or may not be interest-bearing, would give
the supplier evidence of your intent to pay and increase the
supplier's confidence in your business.
Ready Availability.
Trade credit is often available to businesses on a relatively informal
basis without the requirements for application, negotiation, auditing,
and legal assistance often necessary with other capital sources.
Usage. Trade credit must be used judiciously. Its
easy availability is particularly welcome in brief periods of limited
needs. Used imprudently, however, it can lead to curtailment of
relations with key suppliers and jeopardize your ability to locate
other, competitive suppliers who are willing to extend credit to
your business. Remember, that on the other side of the transaction
there is another business that is trying to manage its sources of
capital, too! |
DEBT - TYPES & AVAILABILITY |
Debt
capital. Debt is an amount of money borrowed from
a creditor. The amount borrowed is usually evidenced by a note,
signed by the borrower, agreeing to repay the principal amount borrowed
plus interest on some predetermined basis.
Borrowing Term.
The terms under which money is borrowed may vary widely. Short-term
notes can be issued for periods as brief as 10 days to fill an immediate
need. Long-term notes can be issued for a period of several years.
Discounted Notes.
In some case, particularly in short-term borrowing, the total amount
of interest due over the term of the note is deducted from the principal
before the proceeds are issued to the borrower. Such a note is called
a discounted note.
Short-term Borrowing.
Short-term borrowing usually requires repayment within 60 to 90
days. Notes are often renewed, in whole or in part, on the due date,
provided that the borrower has lived up to the obligations of the
original agreement and the business continues to be a favorable
lending risk.
Credit Lines. When a business has established itself
as being worthy of short-term credit, and the amount needed fluctuates
from time to time, banks will often establish a line of credit with
the business. The line of credit is the maximum amount that the
business can borrow at any one time. The exact amount borrowed can
vary according to the needs of the business but cannot exceed its
established credit line.
These arrangements give the business
access to its requirements up to the credit limit or line. However,
it pays interest only on the actual amount borrowed, not the entire
line of credit available to it.
Long -term Debt.
Long-term debt is borrowing for a period greater than one year.
This general classification includes "intermediate debt"
which is borrowing for periods of one to 10 years.
Repayment Schedules.
When the terms of a debt are negotiated, a payment schedule is established
for both interest obligations and principal repayment. The dates
on which principal and interest payments are due should be scheduled
carefully. For example, a manufacturer with heavy sales just before
Christmas and receivables collections through January might best
be able to schedule repayments in February. If a payment were due
in October or November, when inventories were high and receivables
were climbing, the payment could be crippling.
Mortgage Loan Repayment Schedules.
Principal and interest payments on mortgages usually involve uniform
monthly payments that include both principal and interest. Each
successive monthly payment reduces the amount of principal outstanding.
Therefore, the amount of interest owed decreases and the portion
of the monthly payment applicable to principal increases. In the
early years of a mortgage, the portion of the monthly payment applied
against the principal is relatively small, but grows with each payment.
Term Loan Payment Schedules.
For term loans, payment of principal and interest is ordinarily
scheduled on an annual, semiannual or quarterly basis.
For example, a 5-year, $50,000
term note bearing 10% interest might have the following payment
schedule specified in the note agreement:
End
of Year |
Principal
Repayment |
Principal
Outstanding |
Interest
Payment @ 10% |
1 |
$10,000 |
$50,000 |
$5,000
|
2 |
$10,000 |
$40,000 |
$4,000
|
3 |
$10,000 |
$30,000 |
$3,000
|
4 |
$10,000 |
$20,000 |
$2,000
|
5 |
$10,000 |
$10,000 |
$1,000
|
Availability. Commercial banks are the ordinary source
of short-term loans for the small business. For small businesses,
borrowed capital for periods greater than 10 years is usually available
only on real estate mortgages. Other long-term borrowing usually
falls into the "intermediate" classification and is available
for periods up to 10 years. Such loans are called "term loans."
Selecting Type and Term.
The type and term of the loan should be based on the purpose for
which the funds will be used. Your banker or accountant can help
you determine what type of loan is best to meet your needs. See
if you can "pass the test"
and match the loan request with the appropriate borrowing arrangement.
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COLLATERAL |
Loans
may be secured or unsecured. In a secured loan, the borrower pledges
certain assets as collateral (security) to protect the lender in
case of default on the loan or failure of the business. If the business
defaults on the loan through failure to meet interest obligations
or principal repayments, the noteholder (lender) assumes ownership
of the collateral. If the business fails, the noteholder claims
ownership of those specific assets pledged as collateral before
the claims of other creditors are settled.
Typical Collateral.
In long-term borrowing, fixed assets such as real estate or equipment
are usually pledged as collateral. For short-term borrowing, inventories
or accounts receivable are the usual collateral.
Inventory Financing.
Inventory financing is most commonly used in automobile and appliance
retailing. As each unit is purchased by the retailer, the manufacturer
is paid by the lender. The lender is repaid by the retailer when
the unit is sold. Interest is determined separately for each unit,
based upon the actual amount originally paid by the lender and the
period between the time the money is paid the lender is reimbursed
by the retailer.
Accounts Receivable Financing.
Basically,
accounts receivable financing falls into two categories as follows:
- Assignments. The business pledges, or "assigns"
its receivables as collateral for a loan
- Factoring. The borrower sells its accounts receivable
to a lender (factor).
Although these arrangements are
not loans, in a pure sense, the effect is the same.
Receivables Assignments.
When receivables are assigned, the amount of the loan varies according
to the volume of receivables outstanding. Normally the lender will
advance some specified percentage of the outstanding accounts receivable
up to a specific credit limit.
For example, look at the schedule
below. The company can borrow up to 80% of assigned receivables,
up to a maximum of $100,000.
Accounts
Receivable |
Amount
Borrowed |
$100,000 |
$80,000 |
$125,000 |
$100,000 |
$150,000 |
$100,000 |
On the first line, accounts receivable
are $100,000 and the amount loaned is 80% of $100,000 or $80,000.
Similarly, on the second line, outstanding receivables are $125,000.
The amount loaned increases to $100,000 ($125,000 X 0.80). On the
third line, accounts receivable are $150,000. Eighty percent of
this amount would be $120,000. However, this exceeds the established
limit of $100,000. Therefore, borrowing is restricted to the $100,000
limit.
In many industries, accounts receivable
financing is considered a sign of weakness. However, it is quite
common in others. This is particularly true in the garment industry
and in personal finance companies. When accounts receivable are
assigned, the borrower is still responsible for collection. Upon
collection of any receivable, the amount borrowed should be repaid.
Interest is based upon the amount borrowed and the time between
receipt of proceeds by the borrower and repayment.
Factoring Accounts Receivable.
When accounts receivable are factored, they are sold to the factor
and the borrower has no responsibility for collection. The borrower
pays the factor a service charge based upon the amount of each receivable
sold. In addition, the borrower pays interest for the period between
the sale of the receivable and the date the customer pays the factor
Since the factor is responsible
for collection, it will only purchase those receivables for which
is has approved credit. When customers must pay invoices directly
to a factor, it may create doubts about the company's financial
stability and, therefore, its ability to deliver. However, factoring
is also common in some industries. For example, high tech companies
often factor receivables to finance growth and research and development
and consider this a way to outsource part of their accounting activities.
Unsecured Debt.
The secured creditor's risk is reduced by the claim against specific
assets of the business. In default or liquidation, the secured creditor
can take possession of these assets to recover any unpaid amounts
due from the business. Holders of unsecured notes do not enjoy the
same protection. If the company defaults on a payment, the unsecured
creditor, under normal circumstances, can only re-negotiate the
amount due, perhaps by seeking collateral, or force the company
to liquidate. In liquidation, the holder of an unsecured note would
normally have no rights that are superior to those of any other
creditors.
Restriction On business.
When accepting an unsecured note, the lender will often place certain
restrictions on the business. A typical restriction might be to
prevent the company from incurring any debt with a prior claim on
the assets of the business in the event of default or failure. For
example, a term note agreement might prevent a company from financing
its receivables or inventories since this would result in a prior
claim against the assets of the business in liquidation. Such restrictions
may have no effect on the business' ability to operate. However,
in other cases, such restrictions could be severe. For example,
a business may have a chance to sell to a major new customer. The
new customer may insist upon 60 day credit terms which will require
the business to seek additional external financing. Normally, this
financing might be readily available on realistic terms from a factor.
However, the restriction of the unsecured note could prevent the
business from taking advantage of this significant opportunity for
sales and profit improvement.
Personal Guarantees.
The liability of a corporation's shareholders is generally limited
to the assets of the business. Creditors have no normal claim against
the personal assets of the stockholders if the business should fail.
Therefore, many lenders, when issuing credit to small corporations,
seek the added protection of a personal guarantee by the owner (or
owners). This protects the creditors if the business fails, since
they retain a claim against the personal assets of the owners to
fulfill the debt obligation.
Interest Rates.
The interest rates at which small businesses borrow are often relatively
high. Banks and other commercial lending institutions normally reserve
their lowest available interest rate, the so-called prime rate,
for those low risk situations such as short-term loans for major
corporations and public agencies where the chances of default are
slim and the costs for collection, credit search, and other administrative
tasks are minimal. Because of the higher risks involved in loaning
to small businesses, lenders often seek greater collateral while
charging higher interest rates to offset their added costs of credit
search and loan administration. |
EQUITY CAPITAL |
Unlike
debt, equity capital is permanently invested in the business. The
business has no legal obligation for repayment of the amount invested
or for payment of interest for the use of the funds.
Share of Ownership.
The equity investor shares in the ownership of the business and
is entitled to participate in any distribution of earnings through
dividends, in the case of corporations or drawings in the case of
partnerships. The extent of the equity investor's participation
in the distribution of earnings of a corporation depends upon the
number of shares held. In a partnership, the equity investor's participation
will depend upon the ownership percentage specified in the partnership
agreement.
Voting Rights.
The equity investor's ownership interest also carries the right
to participate in certain decisions affecting the business.
Legal liability.
The personal liability of equity investors for debts of the business
depends upon the legal form of the organization. Basically, the
investor who acquires equity in a partnership could be personally
liable for debts of the business if the business should fail. In
a corporation, the liability of equity investors (shareholders)
is limited to the amount of their investment. In other words, if
a partnership should fail, creditors could have a claim against
the personal assets of the individual partners. If a corporation
should fail, the only claims of creditors would be against any remaining
assets of the corporation, not against any personal assets of the
shareholders.
Equity Investor's compensation
. The purchaser
of an equity interest in a business expects to be compensated for
the investment in any of the three following ways:
- Income from earnings distribution of the business,
either as dividends paid to corporate shareholders or as drawings
in a partnership.
- Capital gain realized upon sale of the business.
- Capital gain realized from selling his or her
interest to other partners.
Capital Gains .
Capital gain is the term used to describe any excess of the selling
price of an investment over the initial purchase price. For example,
if you purchased an equity interest in a business for $5,000 and
later sold it for $8,000, you would realize a capital gain of $3,000
($8,000 - $5,000).
Tax Advantages .
Long-term capital gains are those realized on investments held for
a period longer than six months. These gains are subject to federal
income tax at a lower tax rate than on ordinary income. Therefore,
income tax advantages are often a major reason for the investor's
desire to acquire an equity interest.
Earnings Distribution.
The equity investor in a partnership is entitled to a share of all
drawings paid out to partners at a percentage established when the
interest was purchased (and defined in the partnership agreement).
For example, assume an investor acquired a 20% interest in a partnership.
The distribution of earnings to all partners in a given year is
$20,000. The holder of the 20% interest would receive $4,000 ($20,000
X 0.20).
Sale (or Liquidation) of business. If a business is sold or liquidated, the equity investor
shares in the distribution of the proceeds. As with an earnings
distribution, the share of the proceeds in a corporation sale depends
upon the number of shares held. In a partnership, each partner's
share of the proceeds is based upon the percentages specified in
the partnership agreement. If the proceeds received by the equity
investor exceed the original purchase price, this excess is considered
a capital gain and taxed accordingly at effective rates more favorable
than those for ordinary income. If the business were liquidated,
the assets would be sold and the proceeds would first be used to
discharge any outstanding obligations to creditors. The balance
of the proceeds, after these obligations had been fulfilled, would
be distributed to the equity investors in accordance with their
shareholdings or percentages of interest.
Sale of equity Interest.
As a business prospers and grows, the value of an equity interest
grows with it. Therefore, the equity investor may be able to sell
his or her interest at a price higher than the initial acquisition
cost. For example, an equity investor in a corporation may have
purchased his or her interest at $10.00 per share. As the business
grows, he or she is able to sell the shares at $15.00 per share,
realizing a capital gain of $5.00 (15.00 - $10.00) on each share
sold.
Capital Gains vs Dividends.
In many cases, the equity investor in a small business is primarily
interested in capital gains. Aside from the tax advantages described
earlier, the equity investor usually realizes that the earnings
of the small business are better retained in the business than distributed
as dividends or drawings. Retention of earnings permits the business
to grow so that the value of the equity interest increases. The
investor can realize a return on the investment through a capital
gain derived from selling his or her shares or upon sale of the
business.
Public Stock Offerings.
When businesses are first organized, equity capital is usually secured
from a combination of sources such as the original owners' personal
savings and through solicitations from friends, relatives, or other
persons known to have financial capability for such investments.
As the need for equity capital becomes greater, say $50,000 to $200,000,
it is customary to seek capital through the services of professional
finders, who receive a fee for securing the capital needed. These
professionals normally have access to wealthy individuals, capital
management companies, estates, trusts, and others with sufficient
capital to make such an investment.
As higher levels of capital need,
shares are sold through public offerings. The public offering seeks
to attract a large number of investors to purchase stock, in large
or small amounts. A market is then created for the stock. Shares
purchased by the public, as well as the shares held by the original
owners and any subsequent equity investors, can also be sold at
the going market price. These transactions do not have a direct
effect on the business' capital position since it does not receive
the proceeds from the sale. The equity investor can realize a capital
gain by selling shares at prices higher than the original purchase
price.
Risks of Equity Investment.
The equity investor assumes substantial risk. Unlike the secured
creditor, the equity investor has no specific claim against any
assets of the business. In liquidation, all claims of all creditors
must be satisfied before any remaining assets become available for
distribution to the owners. Even then, the equity investor's participation
in the proceeds is restricted to a share that is proportionate to
the number of shares held or the partnership interest. Since the
risks of equity investment are so substantial, particularly in the
case of small businesses, equity investors expect a considerably
higher return than the lender. >
A lender might be willing to loan
money to a business at an interest rate of 10% or 12% since it has
certain legal protections in the event of default or liquidation.
The investor of equity capital in the same business might seek a
far higher return, perhaps 20%, 50% or even more in order to compensate
for the added risk of equity investment. |
SUMMARY
OF KEY POINTS |
Note the following key points:
-
There are various sources of capital available to
the small business owner. Terms, collateral, cost (interest rate
and control) vary for each alternative.
-
The need for additional capital occurs frequently
in many small businesses.
-
The ability of the owners to anticipate the need and
to match the type of capital with that need will help them secure
capital on the most favorable terms.
-
Those businesses that are alert to opportunities for
internal capital generation will often find that this effort not
only minimizes the need for external capital, but also opens the
doors of the outside money market to them.
-
You can minimize your need for external financing
through proper asset management, cost control and retention of earnings.
-
Trade credit can be utilized to maintain favorable
supplier relations while taking full advantage of the credit that
is available to you from this vital and convenient source.
-
Various types of loan arrangements were also explored,
considering both short- and long-term needs as well as typical requirements
for security through pledging of specific assets or the owners'
personal guarantees.
-
Finally, the equity capital market was included so
that you understand what the equity investor expects in return for
a commitment of capital and the effect that the equity investor's
interest can have on your business.
- With this information you should
now understand the advantages and disadvantages of various capital
sources. This will help you select the source or combination of
sources that is most appropriate for your needs.
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