Finding the cash required to fuel the needs of your business can be challenging. While there are many sources of capital – from friends and family, to banks and professional private investors –not every source is right or even possible for every business. Choosing the right financing for your business involves a variety of factors, including the life stage of your company, how much ownership or control you’re willing to surrender, and what kind of collateral you have to secure the financing.
Early Stage Companies
Many businesses start out with capital from personal savings, a home equity loan, or credit card debt. This is often referred to as “bootstrapping.” When founders have tapped out their own resources, they typically turn to one of three outside sources – friends and family, banks, and professional private investors such as angel investors, private equity companies, and venture capital firms.
Friends and family are often the only source of additional capital for start-up businesses or those that are still too new to have a track record of success. Friends and family may be willing to lend you money based on their longtime relationship with you, without the stack of documents that other capital sources require. Repayment terms are often flexible.
Don’t take money from friends and family without properly documenting the transaction. For anything more than a nominal amount of money, draw up a written agreement stating the nature and terms of the transaction. Friends can easily become ex-friends if disagreements arise down the line about their loan or investment. Keep in mind that the IRS requires that interest be charged on any loans over $10,000, and will impute that interest if you get audited.
Banks require far more persuasion than friends and family before they will part with any cash. They will almost always require financial statements, tax returns from both you and your business, a budget or forecast going out at least two years, and many other documents to help gauge your ability to repay the loan. They will also require you to personally guarantee the debt with collateral such as the equity in your home or investment portfolio (referred to as the “secondary” source of repayment).
In deciding whether to lend to early-stage companies, banks focus on current and projected cash flow or the “ability to service the debt.” They want to know that there will be more than enough money coming in the door to cover your debt payments. But different banks weigh factors like cash flow and collateral differently, so shop around to find one in synch with your particular situation.
Micro-lenders may be one of your only options if you’re seeking less than $50,000 because your business may be too small to interest most traditional lenders. If that’s the case, consider nonprofit organizations that specialize in micro-loans to small businesses. Some California micro-lenders include Urban Solutions, California Economic Development Lending Institute (CEDLI), and the Valley Economic Development Center. The U.S. Small Business Administration has a list of micro-lenders around the country on its Web site.
Professional private investors are not creditors: they don’t want to lend your company money, but rather seek an ownership stake in your business. Most small businesses are not of interest to these investors, who typically look for companies with extraordinary growth potential and a clear exit strategy such as a public stock offering or acquisition. If you choose to go this route, take a hard look at how large a cash infusion you really need, and how much ownership and control you are willing to surrender to get it.
These investors will demand a complete business plan, background on your top management, and detailed information on customers, products, patents, etc. You will likely need an attorney to ensure compliance with securities laws, along with financial professionals to help you prepare the data required by the VC firm. You’ll spend more on professional fees with this type of funding than with a bank loan. And you may be required to give up significant control of how your business operates – possibly even relinquishing the CEO slot to an experienced manager of their choice.
Growth Stage Companies
Financing needs don’t end when a business survives its start-up phase and develops a steady stream of customers and revenue. Sustained growth often requires a sustained inflow of outside capital. Banks are your most likely source of business capital at this phase, along with some credit unions and nonprofits like the micro-lenders mentioned above.
Some things to consider in these lenders:
Cash Flow: Banks will look primarily to the cash flow of your business to determine if it’s strong enough to service the loan. If you have other loans in place already, the bank will require that those debts become subordinate to the bank debt.
The bank isn’t the only one who should be thinking about cash flow and liquidity in relation to a loan: you should have the same concern. What will happen to your business and personal finances if the economy or your industry suddenly hits a downturn and you are burdened with debt payments? A good forecasting model can help you think through this question with “what if” scenarios.
Business Assets: In addition to cash flow, the bank will also secure the assets of the business as collateral. Which assets are secured depends on why you need the loan. Typical types of loans at this phase are working capitals loans, accounts renewable financing, equipment loans, and expansion loans. Most private companies in today’s lending environment will still need to have the owners personally guarantee the loans.
Mature Stage Companies
This is the stage in the life of your business when you are thinking about exit strategies and reaping the value of your investment. As you prepare to sell your business, financing takes on a different slant.
Some business owners seek financing for a final expansion drive before they sell the business, but this is a risky strategy. More often, owners realize that additional debt may drive down the value of their business and thus they try to limit or pay off their loans. A line of credit, however, is always useful for short-term needs and unexpected bumps in the road.
Perhaps there’s a younger generation in your family ready to take over the helm, but they don’t have the money to buy the business from you. One option is to have the company borrow from a bank in order to buy you out. If that’s impractical, another option is seller financing, where you agree on a purchase amount and then take payment out of the company’s earnings over the next few years – making you in essence a lender to the business.
If your firm is a corporation, another exit strategy for firms is creation of an Employee Stock Ownership Plan (ESOP). The ESOP would borrow money to buy the business from you when you retire. ESOPs offer significant tax advantages to both the business and the owner/seller. But since ESOPs are a form of retirement plan, they involve a heavy load of regulatory documentation and paperwork. And the bank would have to be convinced that the ESOP management is strong enough to maintain the company’s success without you, as well as meet all the normal lending requirements.
Ultimately, you should discuss all of these options with your trusted advisor to understand the various financing methods available to your business. Besides where your business is in its life cycle, there are many other considerations that will impact your decision.
This publication contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.