Now that you’ve chosen or possibly started down your entrepreneurial path, the next step is to determine how to finance the start or the ongoing operations of your business. But first, there are certain things you should think about.
Questions to ask yourself before seeking Financial Assistance
1. Do you need more capital or can you manage existing cash flow more effectively?
2. How do you define your need? Do you need money to expand, as a cushion against risk, to manage cash flow, or what?
3. How urgent is your need? You can obtain the best terms when you anticipate your needs rather than looking for money under pressure.
4. How great are your risks? All businesses carry risks, and the degree of risk will affect cost and available financing alternatives.
5. In what state of development is the business? Needs are most critical during transitional stages.
6. For what purposes will the capital be used? Any lender will require that capital requested is for very specific needs.
7. What is the state of your industry? Depressed, stable, or growth conditions require different approaches to money needs and sources. Businesses that prosper while others are in decline will often receive better funding terms.
8. Is your business seasonal or cyclical? Seasonal needs for financing generally are short term. Loans advanced for cyclical industries such as construction are designed to support a business through depressed periods.
9. How strong is your management team? Management is the most important element assessed by money sources.
10. Perhaps most importantly, how does your need for financing mesh with your business plan? If you don’t have a business plan, make writing one your first priority. Most capital sources (especially if you are seeking debt financing) will want to see your business plan for the start-up and growth of your business.
Not All Money Is the Same
There are two types of financing: equity and debt. When looking for money, you must consider your company’s debt-to-equity ratio—the relation between dollars you’ve borrowed and dollars you’ve invested in your business. The more money that owners have invested in their business, the easier it is to attract financing.
If your firm has a high ratio of equity to debt, you should probably seek debt financing. However, if your company has a high proportion of debt to equity, experts advise that you should increase your ownership capital (equity investment) for additional funds. That way you won’t be over-leveraged to the point of jeopardizing your company’s survival.
Equity financing is when the money is in the form of an investment that buys shares in the company. Most small or growth-stage businesses use limited equity financing. As with debt financing, additional equity often comes from non-professional investors such as friends, relatives, employees, customers, or industry colleagues. However, the most common source of professional equity funding comes from angel investors and/or venture capitalists. These are institutional risk takers and may be groups of wealthy individuals, government-assisted sources, or major financial institutions. Most specialize in one or a few closely related industries. The high-tech industry of California’s Silicon Valley is a well-known example of capitalist investing.
Venture capitalists are often seen as deep-pocketed financial gurus looking for start-ups in which to invest their money, but they most often prefer three-to-five-year old companies with the potential to become major regional or national concerns and return higher-than-average profits to their shareholders. Venture capitalists may scrutinize thousands of potential investments annually, but only invest in a handful. The possibility of a public stock offering is critical to venture capitalists. Quality management, a competitive or innovative advantage, and industry growth are also major concerns. You’ll also want to know what kind of return they are looking at. For example, there have been periods when venture capitalists are looking for an ROI (return on investment) of 5 times their original investment within three years.
Different venture capitalists have different approaches to management of the business in which they invest. They generally prefer to influence a business passively, but will react when a business does not perform as expected and may insist on changes in management or strategy. Relinquishing some of the decision-making and some of the potential for profits are a main disadvantage of equity financing.
Debt financing is when the money is in the form of a loan. There are many sources for debt financing: banks, savings and loans, commercial finance companies, and the U.S. Small Business Administration (SBA) are the most common. State and local governments have developed many programs in recent years to encourage the growth of small businesses in recognition of their positive effects on the economy. Family members, friends, and former associates are all potential sources, especially when capital requirements are smaller.
Traditionally, banks have been the major source of small business funding. Their principal role has been as a short-term lender offering demand loans, seasonal lines of credit, and single-purpose loans for machinery and equipment. Banks generally have been reluctant to offer long-term loans to small firms. The SBA-guaranteed lending program encourages banks and non-bank lenders to make long-term loans to small firms by reducing their risk and leveraging the funds they have available. The SBA’s programs have been an integral part of the success stories of thousands of firms nationally.
In addition to equity considerations, lenders commonly require the borrower’s personal guarantees in case of default. This ensures that the borrower has a sufficient personal interest at stake to give paramount attention to the business, in addition to the bank being able to take possession of the collateral in case of default. For most borrowers this is a burden, but also a necessity.
Type of Financing
Which type of financing is best for you? If you are just starting off, probably the most important factor is the type of business you are starting. For example, if you are considering purchasing a franchise, that has a proven business model, then most likely you will want to pursue debt financing. However, if your goal is to create a new technology startup, then your venture is very risky and likely will require some sort of equity financing. A good place to start is your local SBA, who can answer many of your questions and help you determine what’s best for your specific venture.
The SBA provides a number of financial assistance programs for small businesses. They have been specifically designed to meet a business’s key financing needs including the need for debt financing (loans), equity financing (investment/seed money), and surety bonds. SBA does not provide grant funds to finance small businesses. SBA addresses these needs through the following three broad finance programs, but before reviewing these programs you will benefit from SBA’s online course, Finance Primer http://app1.sba.gov/training/sbafp.
Debt Financing – SBA’s Loan Programs
SBA does not make loans directly to borrowers; it works with thousands of lenders and other intermediaries, who will make the loan if the SBA guarantees that the loan will be repaid. However, you might not want an SBA-guaranteed loan, if you have access to other financing on reasonable terms. Additional information on SBA loans, including credit and eligibility requirements, how to apply, etc., is available at http://www.sba.gov/offices/headquarters/ofa/resources/4151.
SBIC Financing – SBA’s Small Business Investment Company Program
SBICs are privately owned and managed investment funds, licensed and regulated by the SBA. SBICs are similar to venture capital, private equity and private debt funds in terms of how they operate and their ultimate objective to generate high returns for their investors. However, SBICs limit their investments to qualified small business concerns as defined by SBA regulations. Additional information is available at http://www.sba.gov/inv.
Surety Bonds – SBA’s Bonding Programs
The Surety Bond Guarantee (SBG) Program was developed to provide small and minority contractors with contracting opportunities for which they would not otherwise bid. SBA can guarantee bonds for contracts up to $2 million, covering bid, performance and payment bonds for small and emerging contractors who cannot obtain surety bonds through regular commercial channels. SBA’s guarantee gives sureties an incentive to provide bonding for eligible contractors, which strengthen a contractor’s ability to obtain bonding and greater access to contracting opportunities. A surety guarantee, between a surety and the SBA, provides that SBA will assume a predetermined percentage of loss in the event the contractor should breach the terms of the contract. More information is at http://www.sba.gov/category/navigation-structure/loans-grants/bonds/surety-bonds.
In the rest of this series, we will take a deeper look at some of the factors that you need to consider when applying for a loan.