Congratulations start-up entrepreneur! You’ve got a great idea, a well-written and thorough business plan, and perhaps some product or service sales under your belt. Now it’s time to really grow this passion of yours and let the world know about your product or service. Unless you have access to nearly unlimited funds you’ll need to have a plan in place for how to fund your business’s growth.
In this article we’ll discuss two aspects of business financing. We will review some of the more prevalent sources of business financing as well as the criteria that most financing sources are looking at from you. Finally we’ll share a few tips you can use to increase your chances of securing the capital needed to get your business started, growing and thriving.
Debt vs. Equity
The question of debt versus equity is really misleading. The truth is both types of financing can be of value whether you are a start-up entrepreneur or a seasoned business owner. It’s a matter of what is right for you and your business at the time you’re seeking the funding. So let’s take a look at debt and equity.
Debt or debt capital can typically be defined as a loan that will need to be paid back to the lender over a set period of time. It is shown as a liability on your balance sheet. The payments would include interest and possibly other fees charged by the lender.
Equity capital can be defined as financing provided by individuals or firms who want to own a part of your business and reap rewards should you sell the business or go public. It is shown on your balance sheet under shareholder equity. There is typically no requirement to make any payments to any equity investors unless the business is performing very well and dividends or distributions are paid.
So, the question a start up owner may face is do you want to give away portions of ownership in your business for the cash you need or do you believe that you will be able to make payments on a loan so that you can maintain full ownership and control of your business. Your answer should consider what makes sense for you and your business now and in the future.
Let’s look at the types and sources of equity financing for your business, some traditional and others relative newcomers.
Family & Friends: Often the first place a start-up business owner seeks capital for their venture is from family and/or friends. They know you better and may have more faith in what you are doing and can accomplish. They also may be willing to put their money “at risk” as a favor to you without looking too closely at your business plan and the risks involved.
While this type of capital injection to your business is often treated in an informal way, most lawyers and accountants suggest that you and your lender(s) create documentation to “memorialize” the transaction. Though “Family & Friends” capital is shown here as equity there may be times when it may benefit you and/or your relative/friend to treat their “investment” as a more traditional loan. Both parties may want to consult with their lawyer and/or accountant to determine which method works best.
Venture Capital: Venture Capital or “VC” is defined as money provided by third party, professional investors to start-up and early-stage businesses with perceived long-term growth potential. Venture Capital can be a very important source of funding for start-ups that may not have access to traditional capital markets.
Venture Capital investment typically entails high risk for the investor, but it has the potential for above average returns investment. Often a VC investor will also provide the business with managerial and technical expertise. As Venture Capital is a very competitive form of raising equity capital, a business owner should be prepared to “give” the VC investor a healthy percentage (usually a majority) of ownership in return for its investment and expertise.
Angel Investors: They may not have gossamer wings, but they do have capital and often the time and expertise to invest in your business. Angel Investors can be individual investors or a group of like-minded investors. Angel Investors will invest in your business in exchange for some percentage of ownership. Angel investors often are retired executives or entrepreneurs who want to stay involved in their industry, enjoy mentoring and want to make use of their time and expertise on a less than full-time basis.
Crowd Funding: With roots in the arts community, web-based investment services such as Kickstarter and SoMoLend are online newcomers to the start-up capital landscape. Crowd Funding is defined as the use of small amounts of capital from a large number of individuals to finance a new business venture. Crowd Funding makes use of the easy accessibility of vast networks of individuals through the internet and social media to get the word out about a new business and attract investors and/or lenders. Crowd Funding has the potential to expand your pool of investors and/or lenders beyond the traditional circle of owners, relatives and “professional” investors.
Let’s take a look at two common types of debt financing that may be available to get your new business up and growing.
Installment or Term Loans: These types of loans typically have what’s known as a fixed term, such as 24, 36 or 48 months — the “term” being the number of months or years that you as the borrower have to pay back the lender. Sometimes you pay the principal back in installments over the term of the loan; other times the principal is paid in full at the end of the term. Often an installment loan for business purposes will have a fixed rate — the “rate” being the percentage of interest the borrower pays to the lender for the use of the funds.
Let’s also include leases in this category. A lease that typically falls into the category of an installment loan would be for equipment you need to run your business, such as cash registers, computers, phone systems, machinery and equipment. Leases are usually categorized as a either a Capital Lease or an Operating Lease. As a business owner you should consult with your accountant or other trusted advisor as to which type of lease best suits your business needs.
Line of Credit: A line of credit is most commonly offered by a commercial bank. Unlike a term loan, the borrower can “draw” funds from their line of credit so as long as the borrower does not exceed the agreed-to dollar limit. The amount of debt borrowed changes based on the borrower’s needs and available cash flow to pay back the amount borrowed. The borrower only pays interest on the amount of funds it is using (or has borrowed) until those funds are paid back.
A form of Line of Credit that many business owners have or should have is credit cards issued in the business name. Credit cards are considered a “revolving” line of credit as the user or borrower typically only borrows what it needs, not necessarily the full amount of credit available, and pays interest on the amount of credit outstanding, not on the entire credit limit.
Sources of Debt Financing
Now that we know about the common types of debt financing that could be available to us, let’s find out which institutions we can go to for our financing.
Regional or National Banks: These are typically the larger, “brand-name” banks. We see them on nearly every street corner and many of them have been in existence — in some form or another — for several decades. These banks have a multitude of loan products which are available primarily to larger, more mature companies. When it comes to smaller, earlier stage companies, these banks are primarily concerned with managing deposits and withdrawals. In today’s lending environment it is very difficult to get a loan from one of these banks without two years of financial statements and tax returns, positive net income and good personal credit of the owners.
Community Banks: These banks typically have several characteristics that differentiate them from a traditional bank. A main characteristic of a community bank is that it is an independent, locally-owned institution. Because of its ties to and better knowledge of the local community, it is often easier to obtain a business loan from a community bank. Some researchers have described community banking as “relationship lending” instead of “transactional lending.” Business owners in the COSE geographic area may be interested to know that a recent FDIC study shows that Community Banks are most prevalent in the midwest portion of the United States.
On-Line Banks: Even though most traditional banks offer on-line services there are some banks that are strictly web-based with no “brick and mortar” locations. While currently not considered a strong source of business lending, on-line banks can be an economical way for start-ups and young businesses to do their daily banking.
Credit Unions: A Credit Union is typically a nonprofit institution that is owned and operated by its members. Credit Unions provide financial services to members including savings and lending. Traditionally credit unions would lend only to their members, but over the past several years credit unions have opened up their lending practices to include local businesses and real estate investors.
An article in USA Today from July of 2011 says “credit unions are expanding to fill a void in business lending left by banks since the financial crisis. As banks have been slow to start lending again, credit unions have gotten a head start.” With this in mind, a start-up business owner may want to add credit unions to his or her list of sources from which to seek funding.
U.S. Small Business Administration (SBA): Many of us have heard of and perhaps have sought financing from the SBA. Let’s take a look at what the SBA is, how it works, the types of loans available and what some of the pros and cons of SBA financing are.
The SBA is an agency of the United States government. The agency partners with banks, credit unions, community development corporations and other lenders. These lenders are encouraged to make SBA loans as the SBA offsets their risk by providing up to 90% guarantee to the lender.
- The most common loan program that SBA lenders provide is the 7(a) Loan Guarantee Program. The typical benefit to the borrower of a 7(a) loan is higher dollar amounts with lower interest rates.
- The 504 Fixed Asset Financing Program provides businesses loans to purchase real estate and/or equipment and machinery. Additional uses of 504 loan proceeds can include construction of new facilities or renovation of existing facilities.
- The SBA also has a Microloan program. This type of loan is typically a small, short-term loan that is made through community-based nonprofit organizations. A common type of community-based lenders are Community Development Centers (CDC).
Many lenders and borrowers believe that they benefit from SBA-backed loans by being able to obtain higher dollar amounts at lower interest rates and better terms than a non-SBA-backed loan. Other borrowers may be reluctant to pursue an SBA-backed loan despite the better terms and rates. This is due to the lengthy approval process and/or the lender’s emphasis on the use of collateral and personal guarantees to obtain the loans.
Keep in mind that SBA-backed loans are more detailed than described above. Should an SBA loan be a form of debt financing you consider for your business, please consult with an SBA lending specialist to learn more.
The “Five C’s” of Credit Analysis
Regardless of the source of debt financing you pursue, it is helpful to understand what criteria most lenders use during their loan application process. The most common of these criteria are often referred to as the “Five C’s.” Let’s take a look at what the “C’s” are.
Capacity: The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships – personal or commercial – is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.
Capital: This is the money you personally have invested in the business, which is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding. This is often referred to as “having skin in the game.”
Collateral: Collateral and guarantees are additional forms of security you can provide the lender. Giving a lender collateral means that you pledge an asset that you and/or the company own, such as your home or equipment used in the business. That asset will be the repayment source in case you can’t repay the loan. A guarantee, on the other hand, is just that — someone else signs a guarantee document promising to repay the loan if your company can’t. This guarantee may be from you as the owner, or it might be from a third person, such as a friend or family member. Some lenders may require such a guarantee in addition to collateral as security for a loan.
Conditions: This is a focus on what the purpose of the loan will be. Will the money be for working capital, additional equipment or inventory? The lender will also consider the local economic climate and conditions both within your industry and other industries that could affect your business.
Character: This is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to pay the loan or generate a return on funds invested in your business. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience of your employees may also be taken into consideration.
Though you now have knowledge of the type of financing that best fits your business needs and the sources to pursue to obtain that financing as the owner of a start-up or young business, you may find those financing sources are reluctant or unable to help you. Do not despair. There are additional sources of funding available to you. Often referred to as alternative or interim financing, these sources often have programs available to start-ups or young businesses that may not yet be considered “lendable” by traditional banks or investment-worthy by equity financiers.
Alternative financing comes in many forms. For our discussion we’ll look at a few types of this funding that can assist your start-up or young business to grow and help get you ready for more conventional financing.
Unsecured Business Line (UBL): There are several programs available that can provide business owners with unsecured lines of credit in the form of credit cards — in the name of the business only — issued by financial institutions. These lines of credit are typically a revolving line of $25,000 to $150,000. Other features of a UBL can include no restrictions on the use of the funds and credit that is in the name of the business, not in the name of the owner. Another benefit for start-ups is that a business can often qualify for funding without providing business or the owner(s)’ personal financials. Many UBL programs just require a solid personal credit profile to qualify for financing. However, in order to maximize the amount of credit you can obtain and avoid other potential pitfalls, you should engage the services of a reputable financing professional.
Accounts Receivable (A/R) Factoring: Many businesses that make sales to commercial customers often need to offer payment terms to those customers. While the good news is you’re making sales, the bad news is that now you must wait to get paid while your suppliers, landlord and employees need to be paid. A/R Factoring is a method that converts your A/R into cash so that you can meet your obligations as well as continue to grow your business. Many business owners that try A/R Factoring continue to do so because it is very flexible, provides them the cash they need to operate and grow their business, and it takes them out of the credit and collections business (this is done by the finance company) and lets them concentrate on doing what they know (and enjoy) best — operating their business.
Purchase Order (P.O.) Financing: A funding family cousin to A/R Factoring, a P.O. funder will provide short-term financing to allow your business to purchase pre-sold goods from your suppliers. P.O. Financing can be a method to allow start-up or young businesses to expand their businesses without having to give up equity or take on debt.
Business Revenue Loans (BRL): This type of financing is a short-term loan often based on daily or weekly sales. Benefits of BRL financing include quick underwriting decisions as well as fixed daily or weekly payments.
Tips for seeking business financing
Though you’re now armed with a basic understanding of the types of financing and sources of financing available to you as a start-up business owner, it can still be a daunting task to be successful in obtaining the financing your business will need to grow and thrive. Here are few tips to keep in mind as you approach sources of funding.
- Seek advice from trusted advisors like accountants, lawyers, mentors and finance professionals.
- Talk to your friends. Where appropriate, ask them for financing recommendations.
- Engage with other successful entrepreneurs. Many are willing to help others succeed.
- Make friends with a banker.
- Have a well-prepared business plan.
- Be confident.
- Consider alternative financing sources. A reputable, professional alternative finance source is often the difference between getting the needed financing for your business and not having sufficient capital to operate your business.
- Keep in mind that nearly 80% of loan applications from small businesses are declined by banks.
- KEEP TRYING!