Decide How You Will Finance Your Business
Lack of capital and inadequate record-keeping are major causes of business failure. You must know not only how much money you need to start the project but how much working capital will be needed to carry you through the first months of operation.
Every day, bankers see people who want a business loan for the “opportunity of a life-time” that “just can’t fail.” These want-to-be entrepreneurs usually attempt to explain their notion orally, and have not done the necessary research to determine the feasibility of the idea. In order to be taken seriously about your business loan, it is imperative to write a formal business plan. When a banker analyzes a business loan application he/she looks at the “eight C’s of lending:”
- Credit – It must be good, not necessarily perfect
- Collateral – Something of value to secure the loan
- Cash Flow – Ability of the business to repay the loan from operations
- Capacity – Your personal ability to repay
- Capital – Your cash investment or down payment
- Character – Yours!
- Conditions – Anything that can affect your business (industry, economy, etc.)
- Commitment – Your will to succeed
Each one of these items must be addressed in the business plan. If you walk into the banker’s office with a plan in hand, you have made the first step in separating yourself from the pack.
Facts About Small Business Loans
- You will need good credit. If there are any problems on the report that can be remedied before meeting with a banker, do so. A lender may be able to make exceptions if you can document that a negative report was due to circumstances beyond your control. Include a detailed written explanation with supporting information in your financing proposal. However, if the report shows that you are irresponsible and you have not demonstrated a willingness to repay obligations, the lender will be unable to make a loan.
- There is no such thing as 100% financing. You are going to have to put some money into the business and the more you do, the better chance you will receive loan approval..
- A bank will require you to personally guarantee the loan even if you are incorporated. There is no way to avoid putting personal collateral at risk. If necessary this could include your house.
- Some businesses are easier to finance than others. Since over 60% of all small business start-ups fail within 5 years, lenders know that the odds are against a new business being around long enough to repay a loan. An existing business is easier to finance if profits are sufficient to repay the loan. Also, many sellers are willing to hold some of the financing. Franchises are generally easier to finance than independent start-up businesses.
- The process is not quick. If you must have the money to open by a certain date, make your loan application as far in advance as possible.
- There is no such thing as a grant. We have never heard about anyone – anywhere – who got free money from the government to open any type of for-profit business.
- The Small Business Administration does not lend money. The SBA does have guaranty programs that are designed to provide more security to lenders so that they will have an incentive to lend money to small ventures which would be too risky for a conventional bank loan. SBA guaranteed loans are made and processed by a bank, with the SBA guaranteeing up to 80 percent of the loan. Interest rates and repayment terms are negotiated between you and the lending institution. SBA does limit the interest rate the lender can charge and there is a small guaranty fee. Ask a business counselor with the Alexandria Small Business Development Center for additional information on SBA programs.
Types of Capital
1. Start-up Capital
Start-up capital is the money you need to spend before the business opens. The amount varies widely depending on the type of business. Some examples include:
- Seed money – research and planning (usually for high-tech businesses)
- Security deposits for a lease, utilities, etc.
- Construction, renovations, signs
- Equipment, tools, office equipment, etc.
- Labor – hiring and training staff before opening
- Legal and accounting fees
2. Working Capital
Working capital is the money needed for day-to-day business expenses. You must have enough working capital available to pay all your bills until the business becomes cash flow positive and can support itself. This can take from several months to several years. After you complete your pro forma monthly cash flow projections you will have a very good estimate of the amount of working capital you will need. Allow extra for unexpected things. If you have just enough money to get started but not enough to properly operate the business, you may be doomed from the start.
Types of Financing
1. Debt Financing/Commercial Bank Loans
Debt financing does not give the lender ownership control, but the principal must be repaid with interest. Length of the loan, interest rates, security and other terms depend on the loan’s purpose.
- Short-term: Loans for short periods (30 – 270 days) usually made to cover temporary or seasonal needs for inventory or personnel. These are common for established businesses, but may be difficult for a new business to obtain.
- Medium to long term: These loans may be repaid over anywhere from 1 to 5 to even 10 years depending upon the collateral and how the proceeds are used. The source of repayment is the cash flow of the business. Typical uses are for equipment, fixed assets, etc. Most loans to start a small business will be of this type.
- Real estate financing: Real estate is typically financed over a fairly long term, 10 to 30 years. Expect a down payment of about 20%. Equity in your personal residence or rental properties may qualify as collateral for a commercial term loan.
- Accounts receivable financing: Money loaned against accounts receivable pledged as collateral.
2. Equity Financing
Equity is money put into a business by the owner, private investors, and/or venture capitalists. Equity gives an investor ownership and possibly some control of the business.
- Your own savings and/or investments: It is nearly impossible to start a business without using some of your personal funds. It is difficult to convince someone to take a risk in your idea if you do not. The proceeds of an equity loan (mentioned in 1.c. above) could be used to inject initial funds into the business.
- Friends, relatives, business associates, etc.: Most small businesses are started with this kind of help. They may provide some of the cash or may guarantee a loan from a financial institution.
- Venture capitalists: Groups invest in a new firm (usually high tech or innovative concepts) looking for an extremely high return on investment. Minimum financing rounds are usually $2-5 Million. Amounts below that range are generally funded by private investor groups also known as “angels.”
3. Internal Financing
- Customers can be a source of temporary financing if they provide the raw materials or if they pay a cash deposit. This is not feasible in most businesses.
- Trade Credit: Once you have established a good reputation with your suppliers you may be able to obtain credit for anywhere from 30 to 90 days. You may be able to order, receive, and sell the goods before the bill is due.
- Profit: Hopefully you will earn enough profit to be able to reinvest in and expand your business.
Leasing is simply another form of financing. Leasing reduces the cash needed up front, but like a loan, you are obligated to the payment for a certain period of time. Some lease contracts give you ownership of the leased equipment at the end of the term for a specified amount. If your credit is less than perfect, leasing may still be an option. Leasing companies and manufacturers are sometimes less stringent with their lending practices because they are usually leasing equipment that can be easily repossessed. This might be a good option for vehicles, heavy equipment, computers, phone systems, etc.
Periodically, you will want to update cash flow projections comparing the actual results from the latest month (and later, quarter to quarter) to test the validity of your assumptions and manage your cash flow. This important function can provide a path to growing your business, expanding, answer other “what if” questions and point to possible solutions for working capital needs.
Rather than prepare one forecast, some businesses prepare several: best-case and worst-case scenarios, along with the most likely outcome. This range of possible outcomes will assist with decision making by highlighting the risks and rewards of following certain financial strategies.