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 is a growing opportunity for funding businesses. Actually, 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.
- Bank loans are the most likely option for funding a new business. Actually, 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 sell investors. Actually, they don’t—a well-written and convincing business plan (and pitch) can sell investors on your business idea, but you’re also going to have convince those investors that you are worth investing in. When it comes to investment, it’s as much about whether you’re the right person to run your business as it is about the viability of your business idea.
I’m not saying you shouldn’t have a business plan. You should. Your business plan is an essential piece of the funding puzzle, explaining exactly how much money you need, and where it’s going to go, and how long it will take you to earn it back. Everyone you talk to is going to expect to see your business plan.
But, depending on what kind of business you have and what your market opportunities are, you should tailor your funding search and your approach. Don’t waste your time looking for the wrong kind of financing.
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 second location. In the following sections of this article, I’ll talk more specifically about the types of investment and lending available.
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. 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, start with the internet.
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.
“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.
Turn first to the local Small Business Development Center (SBDC), which is most likely associated with your local community college.
You can also post your business plan on sites that bring angel investors together. The two most reputable sites in this area are:
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.
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.
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.
Maybe, your idea and your situation is a better fit for crowdfunding—that is, creating a profile and pitching your business idea or product on a site like Kickstarter. In fact, this method of raising money has become so popular that here are dozens of crowdfunding sites to choose from, all offering different terms and benefits.
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.
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.
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