Step 4: How will you finance that business?

Every day thousands of businesses are forced to close their doors.  The most common reason given for the high failure rate of small businesses is lack of adequate capital.  Capital is any asset that a business uses to create value and generate profits, including financial resources, equipment, and even human capital.  Working capital means cash and is usually what beginning businesses lack.

Here are some facts you should know about financing your business:

  • Most businesses are started with money from personal savings, family, or friends.
  • Only about 20% of new business owners start their business with money borrowed from commercial lenders.
  • No conventional lending source, private or governmental, will make a commercial loan for 100% of the funds you need to start your business.
  • As a rule of thumb, without being able to provide a minimum of 25-30% of personal investment toward the total start-up costs of your business, your chances of obtaining outside financing are not good.
  • Your “sweat equity” will not be considered relevant by the lender.
  • As a general rule of thumb, you will need at least $1.50 in quality collateral for every $1 you want to borrow.
  • Although you may think your collateral’s true worth is its appraised value or its original cost, its worth to the lender will be far less than either of these values.
  • Your financial projections must show that any loan proceeds (plus interest and other business expenses) can be repaid from business revenues. The assumptions your financial projections are based on will be examined carefully to determine if reasonable.
  • When the lending decision is being made, having adequate collateral will not override your business’s inability to generate positive cash flow.
  • Acquiring a loan will be more involved and time-consuming than you think. In the best of circumstances, it will normally take 60-90 days to close a loan. If you have a complex situation or if the lender needs additional information, the time span may be significantly longer.

Sources of Funding / Financing

Funding for a business usually comes in two forms:  debt and equity.

  • Debt is obtained from borrowing and must be repaid from cash flow.
  • Equity is contributed by owners or investors and is not repaid from operations.

There are several sources to consider when looking for financing. It is important to explore all of your options before making a decision.

  • Self Funding & Personal Savings: The primary source of capital for most new businesses comes from savings and other forms of personal resources. While personal credit cards are often used to finance business needs, there may be better options available, even for very small loans.
  • Partner(s):  At times a single individual does not have sufficient resources to start a company on his or her own.  With the right mix, a partner can bring both human and economic capital to the table.  Having a partner also spreads the risks involved in starting and running a business.
  • Friends and relatives: Many entrepreneurs look to private sources such as friends and family when starting out. The advantages may include interest-free loans or low interest rates and your friends and family may want to be a part of the company in exchange for the money.  But remember, once you bring friends and family into the business, there is little separation between your professional and personal life.  Also, friends and family can lose the investment they make in your business, potentially jeopardizing your existing relationship.
  • Financial Institutions:  Banks and credit unions may provide a loan if you can show that your business proposal is sound and you have good cash equity to contribute (typically 25-30%).  Many financial institutions who lend money to small and start up businesses participate in the Small Business Administration’s (SBA) Guaranteed Loan Programs.  Click here to read more about SBA loans.
  • Crowd Funding:  Crowd Funding involves the collective contribution efforts of individuals (typically) who network via an online platform to pool their money in support of funding start up businesses and projects.  Individual contributions are typically small and contributors receive some type of perk as incentive to provide capital to the business organizing the campaign.  Alternative types of business Crowd Funding Platforms also exist including equity investment and debt investment platforms. See more information in the Technology section.
  • Angel financing:  In angel financing, a private investor or group of investors will contribute money in exchange for an equity stake in the company and perhaps a seat on the board of directors.  In many cases, an angel will also contribute expertise, management skills and strategy advice.  Angel financing may be appropriate if you are seeking anything from a few thousand dollars to as much as $1-$5 million dollars.
  • Venture capital firms: A venture capital fund is a firm that specializes in financing new ventures with capital supplied by investors interested in speculative or high-risk investments that have the potential to provide them very high rates of return.  They start where angel firms leave off.
  • Community Development Loan Funds-  Local economic development associations (EDA’s) have loan fund pools that are designed to stimulate economic activity by financing small businesses who may not qualify for traditional commercial bank financing.  Contact your regional economic development association to see if these are available in your area.

Accelerators & Incubators: Accelerators and Incubators can be a great way to get your business off the ground while gaining access to resources and mentoring—think of them as a way to help you get jump started.

 Loans

1.  The Six C’s of Credit

Your bank is not a charitable institution. It is in business to make (not lose) money. Consequently, when a bank lends money it wants to ensure that it will get paid back. To maximize the possibility of being paid back, the bank wants to make sure that there is sufficient assurance that a person can pay back a loan and that he or she has met such obligations before. The bank must consider the 6 “C’s” of Credit each time it makes a loan. Review each category and see how you stack up.

  • Capacity to repay is the most critical of the six factors. 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 and commercial – is considered an indicator of future payment performance; a good personal credit score is important.
  • Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to make a significant contribution from your own assets before asking them to commit to funding.
  • Collateral and “Guarantees” are additional forms of security the lender will require. If for some reason the business cannot repay its loan from operating cash flow, the bank wants to know there are other sources of repayment. Assets such as equipment and buildings, and in some cases accounts receivable and inventory, are considered secondary sources of repayment if they are sold by the bank for cash. Both business and personal assets can be sources of collateral for a loan. A guarantee, on the other hand, is just that—you will be asked to sign a personal guaranty on your business loans and you may also need someone else (with financial strength) to sign as a personal guarantor.
  • Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender will also consider the local economic climate and conditions both within your industry and in other industries that could affect your business.
  • Character. The soundness of a small business loan is also highly dependent on the trustworthiness of the business owner.  Your reputation in your local area is important and you should be able to provide good local business references.  A good personal credit score plays into character by demonstrating the importance of honoring and paying personal financial obligations.
  • Confidence. Lenders will look upon the Management experience and knowledge of the industry as a means of determining if the company has a reasonable chance of success.  Lenders need to be sure that the person/people making the business decisions have the skill set and experience to lead the company.  Detailing examples of management and business success will help instill a level of confidence from your lenders.  A well-thought out business plan can help promote a level of confidence.

2. Types of Business Loans

Terms of loans may vary from lender to lender, but there are two basic types of loans:

A short-term loan has a maturity of up to one year. These include working capital loans, accounts receivable loans and lines of credit.

Long-term loans have maturities greater than one year but usually less than seven years. Real estate and equipment loans may have maturities of up to 25 years. Long-term loans are used for major business expenses such as purchasing real estate and facilities, construction, durable equipment, furniture and fixtures, vehicles, etc.

3.  How Your Loan Request Will Be Reviewed

When reviewing a loan request, the lender is primarily concerned about repayment. To help determine this ability, many loan officers will order a copy of your business credit report from a credit reporting agency. Therefore, you should work with these agencies to help them present an accurate picture of your business. Using the credit report and the information you have provided, the lending officer will consider the following issues:

  • Have you invested savings or personal equity in your business totaling at least 25 percent to 30 percent of the loan you are requesting? Remember, a lender or investor will not finance 100 percent of your business.
  • Do you have a sound record of credit ­worthiness as indicated by your credit report, work history and letters of recommendation? This is very important.
  • Do you have sufficient experience and training to operate a successful business?
  • Have you prepared a loan proposal and business plan that demonstrate your understanding of and commitment to the success of the business?
  • Does the business have sufficient cash flow to make the monthly payments?

Financial Statements and Worksheets

Now it’s time to put some numbers down on paper.  A lender will usually use four primary financial statements to make a credit decision.

  • Personal Financial Statement:  This statement is made up of two parts: 1) a detailed statement of your sources of income and expenses and 2) a detailed statement of your assets, liabilities and net worth.  It’s important to the lender to see your personal financial condition and assess how you manage it.  It’s also important when you are seeking financing for your business because it provides evidence of personal assets you could pledge to secure a loan.
  • Balance Sheet:  The Balance Sheet is a statement of financial position that shows the assets, liabilities, and new worth of the business at a specific point in time (for example, as of 12/31/2014).  Assets are everything the business owns like cash, inventory, and equipment.  Liabilities (also referred to as debt) are what the business owes to creditors.  Net Worth (also called equity) is what the business owes to the owners – the investment owners have in the business.  As a start up business you will be expected to forecast future Balance Sheets going out one to three years.
  • Profit and Loss Statement:  Sometimes referred to as the Income Statement, this is the summary of sales revenue less the costs and expenses of the business.  Key elements of the profit and loss statement are Gross Profit (sales minus cost of goods sold) and Net Profit (the amount remaining after all expenses have been met).  As a start up business you will be expected to forecast future Profit and Loss Statements going out one to three years.
  • Statement of Cash Flows:  This statement presents the sources of cash in your business – from net income, new capital, or loan proceeds – versus the expenditures, or uses of the cash, over a specified period of time.  In addition to this statement, you will be expected to prepare a forecast of cash flows, by month, going out one to three years.

In addition to these four financial statements, you will prepare a listing of Start-up Costs as part of the financial analysis for your business plan.

Check out our eLearning section to register for the online classes or contact the SBDC office nearest you to find out how to get started.