by Jeong Oh
So, you want to finance your business start up or expansion, but you’re not sure where to start? Well, consider this a primer on funding sources for start up businesses, and look for follow up articles on financing in the coming months.
Sources of Financing for Entrepreneurs
Securing financing for a new venture is probably the most common concern for entrepreneurs and is often a major challenge during the early stages of a business. This article addresses some of the sources of capital and how they are usually leveraged.
Simply, any lender or investor will use a risk/return model to evaluate a proposal. One of the cardinal rules of entrepreneurship financing is for the entrepreneur to leverage capital at the lowest possible cost to the entrepreneur. Another cardinal rule is for the investor to receive the highest rate of return on their investment. The two seem mutually exclusive, but really aren’t; it’s just a matter of getting both parties to talk in the right language and listen to each other, and it’s the responsibility of the entrepreneur (after all, they are the ones asking for money) to ensure that she or he is speaking the “right language” when interacting with the potential investor(s). It’s also important for the entrepreneur to be honest and objective with themselves when planning an investment strategy, for there is nothing to be gained by donning your rose colored glasses when you’re discussing the green.
If your venture is perceived as a “risky” business, then the lender or investor will usually require a higher return. There are many levels and types of “risky” businesses, and those risks run the gamut. For example, all these things (and more) can be “risky”:
- The actual good or service offered for sale (such things as a bar, an “adult” novelty store, a venture located in an economically unproven area, etc., etc.)
- The inventor’s personal credit history
- The ability of the inventor to explain or market the idea or invention
To prevent having the investors or lenders perceive your venture as “risky”, you can structure the financing in a way so that lenders or investors perceive the risk as minimal. A less risky venture might include, but is not limited to, the following:
- Using personal or corporate assets as collateral against a loan;
- Assuring to repay the money in a short period of time;
- Giving up some control over the business.
The riskiest period for any business is the start up. Thus, access to capital during this period can be very difficult. During the start up period, equity capital is most often the source of financing for a new venture. However, leveraging equity does not have to be viewed in its purest sense. That is, the money from the perspective of the investor is viewed as equity no matter where it comes from. The entrepreneur can acquire equity by mortgaging personal assets such as a house or car, borrowing from friends or relatives, bank loans or even credit cards. The crucial point is that the start-up money is treated as equity and not as debt. This has very practical implications. Lenders or investors view entrepreneur’s commitment as both serious and long-term when they see that personal assets are invested in the venture.
When the entrepreneur has exhausted his/her own money and the business is still trying to prove its commercial potential, it is usually at this juncture that entrepreneurs approach outside sources for equity capital.
A common source of early stage equity capital is private investors who are sometimes referred to as “Angel Investors.” They are basically wealthy individuals looking to take a risk on a new venture, hoping that the return from the investments will be greater than the traditional lower risk investments, (i.e. mutual funds, money market, & common stocks). Many people immediately think of doctors when they think about angels, and with good reason, because doctors represent a significant source of private equity capital. However, there are “angels” all over, and we will focus on where to find those angels in a future article.
With the flattening of the information system, these angels are often organized in a sophisticated network of investors with access to even more sophisticated accountants, lawyers, and other professionals. Therefore, it is important to note that anyone soliciting investments from individual investors must follow the securities law and seek legal counsel to protect themselves and their investors.
Angels are typically considered as a less expensive source of equity capital than traditional venture capital firms. However, unlike venture capital firms (whose only business is funding businesses), these angels are often far less likely to come up with additional funds to invest in your business. Angel investors can be a hindrance to an entrepreneur, especially if there are a large number of them. Because it is their own money tied up in the investment (as opposed to being an employee of a venture capital firm), the angel investor can tend to be more anxious and eager to have more say in things best left to the entrepreneur. Additionally, venture capital firms have access to the best legal, analytical, engineering, etc. minds and do not proceed with businesses based on their “gut” instinct. They do not go into a business relationship without a proper contract and crystal clear expectations on both sides. Angel investors, even the most savvy ones, don’t typically have access to, or the interest in paying for, expert advice on all aspects of the investor/entrepreneur relationship. A relationship with an angel that goes bad can become an entrepreneur’s nightmare, so be sure that this is the route you want to take, and read up on the pitfalls and benefits of such a funding source.
Venture capital refers to a professionally managed pool of equity capital. Usually wealthy individuals invest in these managed funds as limited partners while the general partners oversee the investments for a percentage of the returns. Venture capital firms seek a high return on their investments so that they keep their investors happy while making a profit for themselves. As 50-60% return on investment is not an uncommon expectation for a venture firm.
Early stage ventures do receive value-added services from venture capital firms in exchange for those high returns, however. Venture firms can provide a high level of useful legal and business expertise that has been accumulated from past experiences and they know the issues that early companies are faced with.
Venture capital firms receive hundreds of proposals from entrepreneurs seeking equity and expertise, so a business plan targeted to venture capital firms should be different than a business plan targeted to wealthy individuals. The business plan for venture firms should attempt to stimulate further interest in a short and concise manner because, speaking frankly here, venture capital firms are not going to read anything else, and sending them an unsolicited 1000 page document outlining your entire business plan and strategy, cash flow projections, etc. should not be done initially. If they are interested in your business, they will tell you what they want, and when they want it. Conventional wisdom says that an initial business plan seeking venture capital should not include the details of the terms of financing.
Unlike wealthy inventors, venture capital firms will provide several rounds of financing through equity, both equity and debt, convertible debt or convertible preferred. A debt/equity deal allows venture firms to get some of their investments back with interest, which is deductible to the company, and thus results in a tax savings. Convertible or convertible preferred debt gives the venture firms a preference if the company becomes solvent. If the venture should fail, the venture firm has priority rights on the assets of the business.
Another source of financing for entrepreneurs is debt capital. Debt is usually categorized as a low risk capital due to a set schedule of payments of principal and interest. Accessing debt usually requires a venture to possess either assets or cash flow and creditors will lend you money based on how much asset or how much future cash flow a company expects. Cash flow financing, also known as unsecured financing, can be difficult for start-ups because it requires an earning history that new ventures lack.
Cash Flow Financing
Commonly available sources of cash flow financing include commercial banks, savings and loan institutions, finance companies and other institutional lenders like insurance companies and pension funds, and these institutions typically provide different types of cash flow financing. There are basically three types of cash flow borrowing: short-term debt; line-of-credit; and long-term debt.
Short-term debt: Short-term financing is available to cover working capital needs for a period of less than one year.
Line-of-credit: A company can arrange for a line of credit to be drawn upon as needed. Interest is paid on the outstanding principal, and a “commitment fee” is paid up front. Usually, a line of credit must be paid down to an agreed upon level at a given point during the year.
Long-term: Usually available for creditworthy companies and can be available for up to 10 years to be repaid according to a fixed schedule of interest and principal.
Lenders who provide cash flow financing will require the borrower to sign covenants that place certain restrictions on a business. These covenants are imposed to reduce the risk and protect the lender from situations which would increase the chances of the loan not being fulfilled (i.e. the lender doesn’t get their money back). Some of the typical covenants include:
- Limits on the company’s debt/equity ratio;
- Minimum standards on interest coverage;
- Lower limits on working capital;
- Minimum cash balance; and
- Restrictions on the company’s ability to issue senior debt
Asset Based Financing
New ventures interested in early stage financing are more likely to obtain asset based financing than cash flow financing because new ventures rarely have earnings history. Therefore, asset-based financing is more typical. Asset-based financing usually involves the company giving the lender a first lien on the assets. In the event of a default on the loan payments, the lender can repossess the asset. Here are some types of asset based financing:
Accounts receivable: Creditworthy companies can use up to 90% of their accounts receivable for their financing. This requires lenders to conduct a thorough investigation to determine which accounts are eligible for this kind of financing.
Inventory: As much as 50% of finished goods inventory can be financed. It is typically merchandise which can be easily and quickly sold.
Equipment: Typically, 50-80% of the value of the equipment can be financed, depending on the liquidity of the assets. Equipment can usually be financed for up to 10 years.
Real estate: A building owned by the company can be mortgaged up to 75 or 85% of the value of the building.
Personally secured loan: If a principal owner of the business can pledge a sufficient amount to guarantee the loan, lenders are always happy to lend you up to the pledged amount.
Letter-of-Credit: A letter-of-credit functions in a way similar to a credit card, where the lender guarantees the purchases made by the business. Letter-of-credit is used most often in international trade where the business does not have a relationship with foreign banks.
Government Secured Loans: Federal and state governments will guarantee loans to allow, usually, small businesses to obtain financing if the business alone cannot obtain it on their own.
This article describes some of the financial resources an entrepreneur has available to him/her during the early stages of the venture. This is not a complete list but an outline of the most common forms of financing. As you can see, financing requires understanding the needs of the new venture and the needs of the lender. In other words, the lower the “risk” of your business, the higher the likelihood of obtaining financing.