From the Bplans.com Newsletter – August 2005
Financing While Maintaining Equity
by Tim Berry
When starting a new business, you may need start-up funds but lack the money to invest yourself. What are your options? Can it be done without losing equity in the company?
Start off by thinking about it from the other side. If you had $500,000, what would make the investor want to give it to you and your business? You don’t want to give equity, but you want somebody to take a huge risk for your business. Are you ready to pay extremely high interest rates and offer a big equity kicker too? How are you going to convince somebody to take that kind of risk without an upside?
That’s why start-up investment usually involves equity. Why else does somebody risk that kind of money?
In your case, you might have signed contracts with customers, these may be a bit of an advantage. Are they “bankable” (i.e., is the documentation strong enough that you might be able to borrow off the value of the contracts)? If so, that would be very unusual, but that would also be your easiest route for financing-using the contracts as collateral. However, bankable contracts are extremely rare. Banks need to have real collateral. The law requires it.
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 be loaning 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 we 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 business’ 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. This is a hard route to go, but still quite common. I have personally taken out a second mortgage more than once, in keeping my own business afloat, and I know how scary that is because I speak from experience. Still, I did it, the business survived the hard times, and later I paid the second mortgage off and took the lien off my house. The trouble is that if I didn’t come through, I would have lost my house.
Some 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.”
Sometimes you can get a private investor to give you money as a loan, but if so, you better be ready for a very high interest rate and a huge equity kicker if you default. That is a lot of risk they’re taking, and they want to get a lot of money back, or they simply take their money elsewhere.
Some investors are a good source of capital, and some aren’t. These less established sources of investment may be necessary, but they should be handled with extreme caution.
Your next question, of course, is how to find the “doctors, dentists, and angels” who might want to invest in your business. Look for lists, 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.
Aside from standard bank loans, an established small business can also turn to accounts receivable specialists to borrow against its accounts receivable. Most commonly, 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.
Some Additional Warning:
Be very careful in dealing with anybody 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, small-business finance consulting, and related assistance, but the legitimate providers are harder to find than the sharks.
In general, you should never pay money in advance for investment-finding services, and a request for money in advance should be a warning signal. There are more fakes and frauds in the business of finding investment than there are legitimate finders. Be careful!
Many entrepreneurs turn to friends and family for investment. I recommend against it, frankly. The worst possible time to not have the support of friends and family is when your business is in trouble. When the business is financed by friends and family, you risk losing friends, family, and your business at the same time. I know an entrepreneur who stuck with a losing business for six years longer than he should have because he started it with money from friends and family.
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. It is amazing how often companies get investment commitments and contract for expenses, and then the investment falls through.
About the Author
Tim Berry is a business planning expert, author of several books and planning software packages such as Business Plan Pro
Ask The Experts Question of the Month: Considering subchapter S Corp vs. C Corp.
Should I be a Subchapter S or Subchapter C Corporation? What’s the difference?
Sub S, huh?! Good move. Absolutely nothing wrong with that. A few things to think about:
1. Have you actually incorporated as a “C” Corp? If so, you have 75 days to “elect” to be an S Corp. If you don’t get it done within that period, you have to wait until the next tax year to do it. So don’t forget to file the election.
2. Are you thinking of taking on other investors? You are limited, as a Sub S Corp, to a preset number of investors. Check out the number. Also, as an S Corp, you may not have corporate investors, only individuals.
3. Investors often bring problems with them. So, you get your financial problems solved, but acquire others. If not taking on other partners (three is plenty, in my opinion) means you have to go slower than you want, I think that would be a fair price to pay for keeping your operation as simple as possible.
The Small Business Advocate