Last night we were talking about getting angel investment, and valuation, which is one of if not the most important points in the discussion. Valuation is essentially price.

Say you want to bring in $150,000 from an angel investor. The immediate question from the investor will be something like: “at what valuation?” Sometimes that’s called “pre-money valuation,” because the instant the deal happens the valuation will change into post-money valuation, which is always higher — because your company just got some new cash.

Your answer sets your deal equivalent of an asking price. If you say $500,000, then you’re offering the investor 30% of your company for $150,000. If you say $300,000, you’re offering 50%. If you say $1 million, then you’re only offering 15%.

Which leads to the question:

So how do I know? How do I set valuation appropriately? What is that based on? Is it some multiple of sales, or intellectual property, or what?

And that’s a good question, and very hard to answer. Sure, you want some compromise between what you want to give, as a percent of ownership in your company, and what investors would want to buy. Investors will simply say no if it’s not an attractive offer. But that’s still very vague.

• In the case of an existing business, with some history, you do have some formulas you can use. For a great site on that business interpretation of valuation, for existing busineses, I suggest bizequity.com, the zillo of small business.
• When we’re talking about startups, however, you don’t have history and you can’t really apply formulas based on sales, or revenue, or even intellectual property (although that could be more relevant).

So here’s my concrete suggestion:

1. Calculate starting costs. That’s two lists, the expenses you have to incur and the assets you have to have at the starting point — except cash. Leave that blank for a bit.  Add those all-except for cash assets to the starting costs, to get an amount, a number in dollars.  Click here for a lot more on that.  

   So, for example, in the illustration here, that would be about $40,000. Yes, I know it says $38,750, but this is just an estimated guess; always round up. You never guess just right.  

2. Calculate cash flow through the lean period at the beginning, before your sales cover your costs.  Make a good guess at how much money you need to cover the deficit spending to get you to an operational month-by-month break even level of cash. That’s where the cash requirement number in the illustration came from: it seemed like this company would need about $400,000 to survive from startup to break-even.  You can’t see much in the chart below, because it’s small, but it shows a projected 12 months of cash flow (in blue) with a minimum balance, a deficit (in red), of about $400,000.

   

3. That gives you a number. In this case, it’s $400,000. That’s what your cash flow shows you you’ll need to get to cash-flow break-even. In the last two months, the cash flow is positive, so the negative balance starts shrinking. With that estimate as a best guess, you go back into your startup costs calculation, and add in the cash required. It’s $400,000. You can see what that does to the startup costs worksheet in the next illustration here.
4. Having done that, you now know that you need about $500,000 from investors (again, technically it’s $458,750, but you’re using best-guess estimates, so round up.) Set that as the amount of investment you’re seeking. Then — and here it gets hard, to be sure — you need to decide how much of your company you’re going to offer to an investor in exchange for that $500,000.

5. Get some help here if you can. Ask somebody with experience in startups, or dealing with angel investors, or both. Ask an attorney you can trust, who should also be somebody with experience. The thing is, how much of your company you offer to investors is about a compromise between what you’d like — none, free money — and what will entice the investors to write checks.

   At this point a lot depends on your overall business offering, the cards your company brings to the table. Investors want as high return as possible, with as little risk, but in relation to return. How experienced is your team? How defensible is your product? How rich is the market? All these factors determine what kind of a deal will be acceptable to investors.

   • Let’s say, in this case, you’re new at startups, you have very little track record, and you want to attract an active angel investor as a partner. So maybe you set your initial valuation at $750K, meaning you’re offering to give away 2/3 of your ownership to get the money you need. You’re being realistic about what will attract an investor. You better really, really, like that investor, because he or she will essentially own your company. But this is a hypothetical case, and without a lot of experience and defensibility, that may be the best you can do.
   • Or maybe you’ve got better cards to play: you’ve got a team with startup experience, and a defensible new product, with some intellectual property, and it looks like an attractive market. That makes you able to set a stronger valuation, and maybe — we hope — still make it an attractive offer to investors. So maybe you say you’re valuing it at $1.5 million. You’re offering investors one third of your company for $500K.

So there’s a quick and (I hope) simple summary of how you set the initial (pre-money) valuation when you want to attract investment.

Laws protect inventions with patents, creative works with copyright, and trade names with trademarks, however protecting an idea is a different matter. I don’t think you really can protect a business idea in any practical way. If it is a good idea it will be copied. That’s in the nature of business. Your only hope is to launch it yourself and execute the idea so well that your imitators are scared off.

Business ideas aren’t protected
In 30 years of business and consulting, I’ve never heard of any laws to protect business ideas. Laws protect inventions with patents, creative works with copyright, and trade names with trademarks.

The closest thing to it that I’ve ever heard is recent rulings on “business model” patents related to the Internet and Internet businesses. What I’ve heard is that some patents have been granted for specific flow of information and commerce on specific Internet sites. If you’re serious about that you’d have to talk to a patent attorney.

Real investors don’t sign NDAs
You also hear a lot about “non-disclosure” agreements (NDA), legal documents in which parties agree not to tell secrets that they disclose to each other. These are used a lot in business development and are a good idea in many business occasions. Non-disclosures are often impractical and hard to enforce, but they are used anyhow.

Real investors don’t sign NDAs. They don’t have to because ideas are cheap and plentiful. They don’t want to because an NDA could be used against them for nuisance lawsuits, even if they didn’t disclose. And they really can’t sign an NDA because they can’t afford to promise they won’t do a similar business with somebody else. The next person in the door, right after they turn you down, might have a similar idea and a more convincing business plan. Each time they signed an NDA they would be ruling out some kind of future business, and they can’t afford to do that.

Please remember, however, that I’m not an attorney. My view on NDAs is not an attorney’s opinion. Furthermore, do understand that I am not saying that you should forget about NDAs entirely, I’m just sharing my disappointment for how often they are rejected and how little protection they really afford. It’s a fine point, but important. Do work with an attorney on this.

Good ideas will be copied
So in the business world good ideas are copied all the time. Most successful businesses are copies. Look at sports utility vehicles, or fancy coffee shops, or websites selling books or CDs, or web-based free email. Every good idea gets copied. Expect it.

One of the most important tasks of a small business owner is finding capital for their business. Unfortunately, most business owners are clueless when it comes to finding money, and most self-proclaimed experts they may listen to are equally misguided.

The bottom line is you need capital for your business. Your capital needs will change over time, which is why you as a business owner need to build a strategy for capitalizing your business from the beginning. This is where most business owners drop the ball. They come up with great concepts, good marketing, hire the right people, but they ultimately fail because they never planned for their capital needs.

Digging your financial well
Think of capitalizing your business as digging a well. The wise business owner won’t dig a well that only satisfies short-term needs, but will dig the well as deep as possible or at least lays the groundwork for doing so.

There are at least five layers of the financial well for your business. It starts with the personal assets of the principals. To me, this is the worst possible layer, though the most commonly used. Sometimes there is no other choice, but my preference is to build businesses using other people’s money.

The second layer is the three F’s: Friends, Family, and Fools, another commonly exploited source of funds. The next three layers are credit, loans, and investors. While there should be some order to this, usually business owners are all over the board when it comes to the deeper layers of the well. The biggest tragedy is when business owners wait until it is too late to look for capital. They usually end up out of luck. The reality is no one wants to give you money if they know you need it. Your best bet is to dig your well when you are yet to need the water.

Not all money is created equal
The most important lesson I can impart to you is the fact that all money is NOT created equal. As you look at sources of capital for your business you need to consider the following:

• Debt vs. equity. Any capital that you receive is either going to be debt or equity. Equity requires the surrendering of ownership. You need to be clear on what type of money you are obtaining. For the most part, banks and businesses deal with debt, and investors deal with equity. Equity gives the investor a percentage of future profits. So while it may feel like free money, this is the most expensive capital you can get for your business (if you are successful!).
• Control. Does the money reduce your control? Bringing on investors or partners will lessen your control. A lender may request financial oversight or independent audits. You need to be aware of what you are giving up.
• Security. How is the lender or investor securing the money? Are you personally guaranteeing it? Is there a blanket lien on your assets? If you default, who will they go after for repayment?
• Transferability. Can you transfer the capital to the next business owner? In other words, is the capital for you or is it for the business? It won’t do you much good to sell a business if all the working capital is still tied to you.
• Ease of attainment. How easy is it to get? And how much time will you need to invest in order to secure the capital that you need? Team. Are you adding players to your team that are invested in your success? Pierre Omidyar sought VC money for eBay, not because he needed it, but because he wanted help building a world-class team. Sometimes bringing on investors and surrendering control is exactly what you need to do.

Build a foundation for your business
Regardless of the capital you seek, you must start by building a foundation for your business. As a general rule, you need to separate your personal and business activities as much as possible. The first step is to incorporate. You need to be a corporation (S or C) or LLC if you are serious about raising capital for your business. Without a corporation you are limiting yourself to personal loans in Tier 3, which we will discuss later. You have no options for the other tiers and won’t be taken seriously anyway. Investors can’t invest in a sole proprietorship: You need to have shares or membership units if you want to bring on investors. From this you can see that if you haven’t incorporated you have seriously handicapped your business.

You will give life to your corporation by establishing a corporate credit profile, which belongs to the business that is separate from yourself and your personal credit profile. The process of building business credit will help to ensure that you have the fundamentals in place. The fundamentals include operating in a manner that lends legitimacy to your corporation. The business financing or credit industry has a standard of what a legitimate business should look like, if you don’t meet that standard you are going to be shut out of many financing options. So the next smart step is to build business credit.

The four tiers of financing
There are four tiers of financing available to small business owners. It is important to be familiar with each tier and to develop a strategy for financing your business that cleverly uses these tiers. Here is a brief summary of each:

• Tier 1: basic trade credit. The largest source of capital in the world is business or trade credit. These are companies granting business credit without the need for a personal or business credit check and they rarely require a personal guarantee. Tier 1 is the most basic trade credit and when a corporation is rightly prepared, it will serve as a building block for establishing credit for that corporation. Going after Tier 1 financing without building a business credit profile can be a disaster, but if you are rightly prepared you can benefit greatly from this source of capital.
• Tier 2: advanced trade credit. Like Tier 1, this is the capital extended by businesses to businesses. The difference is that Tier 2 companies will conduct a business credit check before extending credit. Tier 2 usually includes larger credit lines, longer terms and in some cases can be used for equipment financing. If you need to purchase something that is created or sold by another company, chances are you can finance it with the first two tiers of financing.
• Tier 3: bank lending. This is the best-known type of business financing. Typically banks offering unsecured business lines of credit. A personal and business credit check and personal guarantees are required. The most basic level of bank financing, for the most part, is score and business history driven. For larger lines and loans, you need to be prepared with a good business plan and financials. Banks and credit card companies are Tier 3 lenders.
• Tier 4: investors. Tier 4 is a move outside of institutional lending and commercial credit to the world of venture capitalists, angel investors and other private investors. This level requires much more sophistication and a business that is out-performing or will out-perform its industry peers. As a general rule, these investors want businesses that have been around a couple of years and can provide detailed financials and growth strategies.

Article provide by Business Credit Services, Inc.

Venture capital
Venture capital firms want repeat entrepreneurs. They want plans with huge growth rates, in high-growth industries — usually high tech as well as high growth. They want excellent management teams with proven track records. And they want plans needing multiple millions of dollars, generally $4-5 million and up. There are only a few hundred true venture capital firms in the United States, probably half of them located on Sand Hill Drive in Menlo Park, CA. They invest in new businesses in exchange for substantial ownership, generally more than 50%.

Angel investors
This group includes thousands of individual investors, investment clubs, local investment groups, and others. They are hard to categorize and hard to describe as a group. Angel investors act a lot like venture capitalists in their dependence on business plans and management teams to evaluate businesses, and they also like high growth and high return, but they are more likely to invest smaller amounts. Angel investors will also sometimes accept less ownership than venture capitalists, in some cases as little as 5-10%. However, there are no simple guidelines or standards on this; everything depends on the specific case.

Commercial bank loans
Banks loan businesses money for working capital and even occasionally for expansion, but not without solid collateral. Banks don’t generally invest in new businesses or new business plans, for good reasons. The government doesn’t want banks taking undue risks with depositors’ money. If you don’t have solid collateral, or if you aren’t willing to risk what you have, then don’t expect to get commercial loan financing.

Small business administration guaranteed loans.
The SBA guarantees loans for small businesses in some circumstances. You still need to have 30% of whatever you need to borrow as collateral, but that’s a lot less than the normal 100%.

Friends and family
Many businesses start with financing from friends and family. This is sometimes the only way to start a business, but it is also full of potential problems. Go very slowly.

Self financed
Many businesses start without loans or investment, and many more businesses do their business plans without needing outside financing. If your numbers are strong enough to go without outside money, congratulations, that’s a very good thing.

Purchasing an existing small business may be a good way to fulfill dreams of being your own boss. But where does the money come from to purchase it?

The best way to have access to funds is to have collateral. Equity in a home is often one of the best resources. If that is not a possibility, here is a list of funding options that you may want to consider for brainstorming purposes. I hope you find it useful.

Traditional funding sources:

• Self financing
• Family and friends – use caution
• Private investors – referred to as “Angels” and “Deep Pockets”
• Banks
• Asset-based lenders
• Government sources

- Small Business Administration (SBA)
- Small Business Investment Company (SBIC)
- State programs
- City programs

• Suppliers (through extending credit)
• Leasing companies
• Insurance sources

Alternative funding sources may include:

• Barter
• Landlord
• Contract sales
• Other people’s credit
• Future commitment
• Unsecured loans through:

- Credit cards
- Credit unions

• Customer financing through:
  - Membership financing
  - Advanced payments

Consider these factors when selecting a source of funds:

• Availability
• Rate of Return
• Acceptable levels of risk
• Timing and form of return
• Amount of control desired

Obtaining funding should start with a solid business plan. If you write a convincing business plan, then your chances of obtaining funding are greatly enhanced. Lenders and investors want to see proof that customers want your product or service and are willing to buy it for a price at which you can make a profit. The more tangible evidence you offer of this claim, the better chance you have.

Other factors that improve your chances to get funded are:

• Your plan should show good profit potential in a short period of time.
• The higher the rate of return you can offer investors and the faster you can produce it, the better your chances. Your plan should target a clearly defined market with enough size and purchasing power to produce a profit.
• Investors also prefer large markets with high growth potential. They avoid businesses that attempt to be “everything to everybody.” Your plan should clearly explain the “competitive edge” your product or service has over rivals.
• You should show an ability to control both the delivery and the quality of the product or service. Also, that managers and employees have the skills and the experience to make the company a success.
• Show that you have made a personal investment in this business venture.
• If you don’t believe in your own venture enough to invest at least some of your own money in it, how can you expect others to? “Sweat equity”—unpaid personal time and hard work—can be important, but lenders and investors like to see an entrepreneur with an important financial stake in the business. It’s a tremendous source of motivation.
• Lay out a clear, well-conceived, workable strategy for getting this business up and running. Show realistic financial projections covering most likely, pessimistic, and optimistic scenarios.
• Potential lenders and investors want to be sure that the “dollars and cents” of the deal make sense, and that’s why realistic projections are important. Most entrepreneurs underestimate the amount of money needed for start-up. Don’t get caught short!

Grants to for-profit businesses are virtually nonexistent. Don’t believe promoters who advertise that they will charge you a fee for a list of grants on the books. Grants are generally for nonprofit organizations with a 501(c)(3) designation. They are virtually not available in the for-profit sector unless there’s some esoteric local program in your own backyard.

Many foundations provide funding in the form of grants to nonprofit corporations. They usually require that the grant represent a small part of the total funding for an existing organization that gets the majority of funds from individual donations of its members and fund-raising campaigns. Church-sponsored groups receive more grants that anyone else.

Source for debt financing

1. Yourself! (Savings). You are your own best “lender” if you have the savings. This approach can be quick and easy. CAUTION: Ensure you have adequate savings for both the business and other life contingencies.
2. Friends and relatives. If they believe in you and your idea, friends and relatives are sometimes willing to fund you. Choose this route with care and ensure you execute a formal loan document stating loan terms (interest, terms of repayment). CAUTION: Many friends have been lost and many relatives alienated because of a small-business failure.
3. Banks and credit unions. Many banks and credit unions (check with your own first and with your local chamber of commerce for alternate possibilities) will loan money for starting a small business. This approach will require that you present a formal plan to the bank showing justification for the amount you are borrowing.
4. Small Business Administration (SBA). Check out their website (http://www.sba.gov). Contrary to what many believe, the SBA does NOT generally loan money directly but rather guarantees a loan (normally up to 90%). This can make it a lot easier to obtain a bank loan since the bank’s risk is lowered considerably. The exception is that the SBA does provide direct loans to certain groups including Vietnam-era and disabled veterans and handicapped individuals. In general, the SBA will not offer any assistance until you have been turned down for a loan by a commercial bank.Most loans guaranteed through the SBA are between $25,000 and $750,000. However, there is a “micro-loan” program for amounts from a few hundred dollars up to $35,000.
5. Vendor financing. If your business is one that relies heavily on certain vendors, it may be possible to obtain financing through the vendor. After all, they want you to use their product and therefore have an interest in helping you be successful.
6. State. Some states have small-business financing authorities that issue tax-exempt development bonds to be used to finance land, buildings, and equipment for manufacturing businesses. Check with your local government office for details.
7. Home equity loan. Interest rates for this kind of loan are generally low and the interest is fully deductible for the first $100,000 borrowed. CAUTION: You are placing your home on the line!
8. Life insurance. Some type of life insurance policies (whole life and universal) have cash value which can be borrowed at very low interest rates. You are not obligated to pay this money back but if you don’t, your policy payout is reduced by the amount borrowed.
9. Retirement plans. Some retirement plans (401K, for example) allow you to borrow against vested benefits. Generally, up to 50% may be borrowed as long as this is less than $50,000.  CAUTION: If you quit your employment, the loan must be repaid immediately. If you don’t the amount borrowed is treated as an early distribution and is taxable.
10. Credit cards. These should be used with care because of the excessively high rates of interest usually charged.

There are many would-be entrepreneurs out there with great ideas but no money to invest in their venture.

In the last 14 years I have had so many people say there are grants out there to help finance a business. And I have so many more ask me where that grant-financing money is at. In all that time I have never found a grant that finances the start-up of a business.

There are federal training programs that subsidize part of the wages for a new, qualified employee who is provided on-the-job training and works permanently full time for your company. There are also federal tax incentives to provide the same employment and training conditions for new hires. But I do not know of programs designed to provide investment capital for the start-up and operation of the enterprise.

If you simply do not have sufficient collateral, good credit and/or cash to finance the start-up of your venture, you need to begin looking for a partner or partners who have the finances, desire to participate in this type of start-up and need the skills and ideas you possess to make the business work.

The only alternative that I can think of is to seek refinancing or a home improvement loan (second lien) on your home, if you own it. If you are determined, it is likely the partnership alternative may be the best way to go. Otherwise, you may need an “angel” investor.

Is it possible to start a business without money or collateral?

Anything is possible and most companies were started from someone’s ideas written down on paper and financed by those who saw merit in the plan. Still, realism is important. This depends a lot on the specifics of the business. Some businesses are relatively easy to start without start-up funds, some virtually impossible.

I think you need to match your ideas to reality. Millions of service businesses start without money or collateral. These tend to be consultants, graphic artists, accountants, and other professionals. You have a skill that other people need, you have potential customers, take a job, and get started. Twenty years ago I started my business plan consulting business without money or collateral, just a skill, contacts, and the will to do it. You probably know several people who have done the same.

On the other hand, some businesses just don’t happen without start-up money. For example, you may want to develop and produce some electronic item that the world needs, but for that business you’ll need money for designers, software engineers, hardware engineers, prototypes, testing, packaging, and lots of other start-up costs.

Even on a smaller scale, few restaurants or retail stores start up without money to pay in advance for the location, fixtures and furnishings, signage, and so on. In these cases, you don’t necessarily have to have the money and collateral yourself, because for a good business the idea is that you raise the money from other people who want to participate in the upside of the investment.

That’s what this whole site, Bplans.com, is about: developing the business plan and raising money.

Contrary to popular belief, business plans do not generate business financing. True, there are many kinds of financing options that require a business plan, but nobody invests in a business plan. Investors need a business plan as a document that communicates ideas and information, but they invest in a company, in a product, and in people.

Small business financing myths

• Venture capital financing is very rare. I’ll explain more later, but assume that only a very few high-growth plans with high-power management teams are venture opportunities.
• Banks don’t finance business start-ups. I’ll have more on that later, too. Banks aren’t supposed to invest depositors’ money in new businesses.
• Business plans don’t sell investors.

Where to look for money

The process of looking for money must match the needs of the company. Where you look for money, and how you look for money, depends on your company and the kind of money you need. There is an enormous difference, for example, between a high-growth Internet-related company looking for second-round venture funding and a local retail store looking to finance a branch store. In the following sections of this article, I’ll talk more specifically about the types of investment and lending available.

Venture capital

The business of venture capital is frequently misunderstood. Many start-up companies resent venture capital companies for failing to invest in new ventures or risky ventures. People talk about venture capitalists as sharks—because of their supposedly predatory business practices—or sheep—because they supposedly think like a flock, all wanting the same kinds of deals.

This is not the case. The venture capital business is just that—a business, and the people we call venture capitalists are business people who are charged with investing other people’s money. They have a professional responsibility to reduce risk as much as possible. They should not take more risk than is absolutely necessary to produce the risk/return ratios that the sources of their capital ask of them.

Venture capital shouldn’t be thought of as a source of funding for any but a very few exceptional start-up businesses. Venture capital can’t afford to invest in start-ups unless there is a rare combination of product opportunity, market opportunity, and proven management. A venture capital investment has to have a reasonable chance of producing a tenfold increase in business value within three years. It needs to focus on newer products and markets that can reasonably project increasing sales by huge multiples over a short period of time. It needs to work with proven managers who have dealt with successful start-ups in the past.

If you are a potential venture capital investment, you probably know it already. You have management team members who have been through that already. You can convince yourself and a room full of intelligent people that your company can grow ten times over in three years.

If you have to ask whether your new company is a possible venture capital opportunity, it probably isn’t. People in new growth industries, multimedia communications, biotechnology, or the far reaches of high-technology products, generally know about venture capital and venture capital opportunities.

If you are looking for names and addresses of venture capitalists, you can look for the Resources links on Palo Alto Software’s website, www.bplans.com. These are updated regularly and are likely to have more specific information.

Otherwise, start with the Internet, with the net search engines. For example, you’ll get at least 50 venture capital firms when you search www.yahoo.com for “venture capital.”

The names and addresses of venture capitalists are also available in a couple of annual directories:

• The Western Association of Venture Capitalists publishes an annual directory. This organization includes most of the California venture capitalists based in Menlo Park, CA, which is the headquarters of an amazing percentage of the nation’s venture capital companies.
• Pratt’s Guide to Venture Capital Sources is an annual directory available online or in print format. It is also available from Amazon.com for $425 (prices may change) plus shipping.

“Sort-of” venture capital: angels and others

Venture capital is not the only source of investment for start-up businesses or small businesses. Many companies are financed by smaller investors in what is called “private placement.” For example, in some areas there are groups of potential investors who meet occasionally to hear proposals. There are also wealthy individuals who occasionally invest in new companies. In the lore of business start-ups, groups of investors are often referred to as “doctors and dentists,” and individual investors are often called “angels.” Many entrepreneurs turn to friends and family for investment.

Your next question of course is how to find the “doctors, dentists, and angels” that might want to invest in your business. Some government agencies, business development centers, business incubators, and similar organizations that will be tied into the investment communities in your area. Turn first to the local Small Business Development Center (SBDC), which is most likely associated with your local community college, or the Small Business Administration (SBA) offices in your area.

You may want to try some secondary listing services and online sourcing businesses. I know the owners and operators of the American Venture Capital Exchange, and I know that they have been working to provide fair and respectful matching services between investors and companies needing investment. However, I haven’t actually used the service. I’ve just dealt with the people (they have occasionally included literature in Palo Alto Software product boxes). They offer an online database of financing sources and a forum to list businesses seeking financing. Their phone number is 650-494-3356, fax number is 765-449-1913; and email is tim@avce.com.

On my personal website, www.timberry.com, I have listed several consultants with whom I’ve had dealings, including people I worked with while consulting for Apple Computers and other companies. For legal reasons, I have to insist that my recommendation is at your risk, not mine, and I can’t be responsible for third parties. I should also note that my recommendation has never and will never be sold for money or compensation of any kind, even in trade.

At your own risk, the following are some of the online services available through bulletin boards and similar sources. Deal with them carefully:

• Venture Capital Resource Library at www.vfinance.com
• Venture Capital Online at www.vcapital.com
• Business Funding Directory at www.businessfinance.com
• The Capital Network, 3925 W. Braker Lane, Austin, TX 78759, Telephone (512) 305-0826. www.thecapitalnetwork.com

Important: Be careful dealing with anyone who offers to help you find financing as a service for money. These are shark-infested waters. I am aware of some legitimate providers of business plan consulting, but legitimate providers are harder to find than the sharks.

Commercial lenders

Banks are even less likely than venture capitalists to invest in, or loan money to, start-up businesses. They are, however, the most likely source of financing for most small businesses.

Start-up entrepreneurs and small business owners are too quick to criticize banks for failing to finance new businesses. Banks are not supposed to invest in businesses, and are strictly limited in this respect by federal banking laws. The government prevents banks from investment in businesses because society, in general, doesn’t want banks taking savings from depositors and investing in risky business ventures; obviously when (and if) those business ventures fail, bank depositors’ money is at risk. Would you want your bank to invest in new businesses (other than your own, of course)?

Furthermore, banks should not loan money to start-up companies either, for many of the same reasons. Federal regulators want banks to keep money safe, in very conservative loans backed by solid collateral. Start-up businesses are not safe enough for bank regulators and they don’t have enough collateral.

Why then do I say that banks are the most likely source of small business financing? Because small business owners borrow from banks. A business that has been around for a few years generates enough stability and assets to serve as collateral. Banks commonly make loans to small businesses backed by the company’s inventory or accounts receivable. Normally there are formulas that determine how much can be loaned, depending on how much is in inventory and in accounts receivable.

A great deal of small business financing is accomplished through bank loans based on the business owner’s personal collateral, such as home ownership. Some would say that home equity is the greatest source of small business financing.

The Small Business Administration (SBA)

The SBA makes loans to small businesses and even to start-up businesses. SBA loans are almost always applied for and administered by local banks. You normally deal with a local bank throughout the process.

For start-up loans, the SBA will normally require that at least one third of the required capital be supplied by the new business owner. Furthermore, the rest of the amount must be guaranteed by reasonable business or personal assets.

The SBA works with “certified lenders,” which are banks. It takes a certified lender as little as one week to get approval from the SBA. If your own bank isn’t a certified lender, you should ask your banker to recommend a local bank that is.

Other lenders

Aside from standard bank loans, an established small business can also turn to accounts receivable specialists to borrow against its accounts receivables.

The most common accounts receivable financing is used to support cash flow when working capital is hung up in accounts receivable. For example, if your business sells to distributors that take 60 days to pay, and the outstanding invoices waiting for payment (but not late) come to $100,000, your company can probably borrow more than $50,000. Interest rates and fees may be relatively high, but this is still often a good source of small business financing. In most cases, the lender doesn’t take the risk of payment—if your customer doesn’t pay you, you have to pay the money back anyhow. These lenders will often review your debtors, and choose to finance some or all of the invoices outstanding.

Another related business practice is called factoring. So-called factors actually purchase obligations, so if a customer owes you $100,000 you can sell the related paperwork to the factor for some percentage of the total amount. In this case, the factor takes the risk of payment, so discounts are obviously quite steep. Ask your banker for additional information about factoring.

Friends and family funding

If I could make only one point with budding entrepreneurs, it would be that you should know what money you need, and understand that it is at risk. Don’t bet money you can’t afford to lose. Know how much you are betting.

I’ll always remember a talk I had with a man who had spent 15 years trying to make his sailboat manufacturing business work, achieving not much more than aging and more debt. “If I can tell you only one thing,” he said, “it is that you should never take money from friends and family. If you do, then you can never get out. Businesses sometimes fail, and you need to be able to close it down and walk away. I wasn’t able to do that.”

The story points out why the U.S. government securities laws discourage getting business investments from people who aren’t wealthy, sophisticated investors. They don’t fully understand how much risk there is. If your parents, siblings, good friends, cousins, and in-laws will invest in your business, they have paid you an enormous compliment. Please, in that case, make sure that you understand how easily this money can be lost, and that you make them understand as well.

Although you don’t want to rule out starting your company with investments from friends and family, don’t ignore some of the disadvantages. Go into this relationship with your eyes wide open.

Words of warning

Don’t take private placement, angels, friends and family as good sources of investment capital just because they are described here or taken seriously in some other source of information. Some investors are a good source of capital, and some aren’t. These less established sources of investment should be handled with extreme caution.

Never, NEVER spend somebody else’s money without first doing the legal work properly. Have the papers done by professionals, and make sure they’re signed.

Never, NEVER spend money that has been promised but not delivered. Often companies get investment commitments and contract for expenses, and then the investment falls through. Avoid turning to friends and family for investment. The worst possible time to not have the support of friends and family is when your business is in trouble. You risk losing friends, family, and your business at the same time.

Submitting a plan

The information you submit to investors depends a great deal on what your objective is. Sometimes you’ll submit a complete business plan, sometimes a Summary Memo. In most cases, even if you submit a short summary, you have to have the complete business plan ready to go as soon as the investors or lenders ask for it. If you’re looking for lease financing, receivables, or a bank loan, you’ll want to submit a loan support document to the lender.

When the search has provided you with a list of useful names, you can print your Summary Memo or loan support documents and send a copy to each of the investors, along with a brief cover letter.

Summary

Most businesses are financed by home equity or savings as they start. Only a few can attract outside investment. Venture capital deals are extremely rare. Borrowing will always depend on collateral and guarantees, not on business plans or ideas.