Chapter 21
FINANCING YOUR BUSINESS

IN This Chapter
Types of financing
Money sources
Getting ready
Creating a financial proposal

Introduction
One of the main reasons for the high failure rate of small businesses is a lack of adequate capital. Capital is any asset that a business uses to create value and generate profits, including financial resources, equipment and even employees.
Working capital describes a business’s most liquid asset, cash. This is the type of capital that growing businesses usually lack. Obviously, a business can’t survive without cash to pay for labor, equipment, supplies and other expenses.
Securing capital will require selling lenders or investors on your track record, business plan, target market, employees, vision, professionalism and growth prospects.
With a well-researched business plan and a carefully written funding proposal, you can find just the right source of funds.
TYPES OF FINANCING
Entrepreneurs often think only of banks when they look for financing, but there are plenty of other options.
Personal Funds
Here are some common sources of personal capital:
Savings might include money in a savings account, a certificate of deposit or even a shoebox under the bed.
Investments include stocks, bonds, stamps, coins and precious metals.
Life insurance policies may allow you to borrow against the policy’s value.
Employment income from an existing job—or a second job—could be used to cover startup costs and ensure a steady income during the first three to six months of operations.
Home equity. You may be able to borrow a percentage of your home equity; this includes refinancing your house or taking out a second mortgage.
Personal loans. You may be able to obtain a personal loan at a bank or credit union.
Credit cards. Credit card financing is risky at the best of times. We don’t recommend using credit cards to finance your business.
Lenders will usually want to see that you have committed significant personal funds to your venture. This shows that you stand behind your idea and are willing to take a serious risk to make it work. Therefore, you should prepare to commit personal funds even if your goal is to get outside financing.
Debt Financing
Debt capital is borrowed money. No matter how your business fares, you must pay this money back by making scheduled loan payments. This can be difficult during the startup and early growth stages.
In addition to repaying the loan amount (or principal), you must pay interest. The amount depends on what you borrowed, the interest rate and the loan term.
Short-term loans are for less than one year. They typically cover seasonal inventory needs or temporary cash shortages.
Intermediate-term loans usually run for three to five years, and are often used to expand working capital or buy equipment. The interest rate is fixed. An early repayment penalty may apply.
Long-term loans are usually for five or more years, and are used mainly for real estate, construction or high-value equipment. The interest rate is normally fixed. Long-term loans tend to be more readily available to established businesses than to startups.
Lines of credit let you borrow money as you need it, up to an approved limit. It’s like a credit card, but with a lower interest rate, and is normally used to meet unexpected or seasonal working capital needs. Normally, you only pay interest on the amount you’ve withdrawn, although some lenders apply “maintenance” fees. Lines of credit are often demand loans, meaning that the lender can require payment at any time.
Equity Financing
Equity financing is money raised by a business owner in exchange for a share of ownership. This isn’t a loan, so you don’t have to pay it back. However, getting equity financing usually entails sharing profits and giving up some management control to your new investors.
If your business is currently a sole proprietorship, it will have to become either a partnership or a corporation.
If your business is a partnership, the funder becomes a general or a limited partner and has all the rights specified in your partnership agreement.
If your business is a corporation, the investor becomes a holder of common or preferred stock and can exercise the powers of a stockholder as defined in your bylaws. Preferred stockholders receive dividends before common stockholders.
Obtaining equity capital tends to be more time-consuming than obtaining debt capital. Basically, you’re selling your business’s promise of profitability and selling yourself as a qualified manager of your business. Investors usually demand more information and take longer to review it, and you’ll need help from attorneys and accountants to complete the process.
In some cases, a source of equity capital may ask you to guarantee a return on investment. If you agree to this, you will have to pay the investor even if your business fails. Obviously, you should be very cautious about such arrangements.
Angel Money
Financing from friends or relatives is often referred to as angel money. About 65 percent of small businesses start with financing from angel money and personal capital. Angel money can be debt capital (e.g., a loan from your sister) or equity capital (e.g., your brother becomes your partner in return for investing).
If you borrow angel money, handle it just like a regular loan. Give your angel a copy of your business plan and explain it thoroughly (especially the sales forecast, cash flow projections and profitability). After receiving the money, give your angel a promissory note stating the amount, the interest rate and the loan term. (If your angel doesn’t charge you an interest rate, the gift tax may apply.) The note should also say when the first payment is due, how many payments there will be in total, and how much each payment is.
If the angel money is in the form of equity financing, draw up legal documents stating the conditions of the investment. Once it’s signed, the angel owns part of your business and has a legal right to a share of your profits.
Think carefully before borrowing from friends and family. Even if they give you the money as a gift, they may feel they should have some say in how you run your business. This often leads to friction.
And what if you can’t pay them back on time? How will your lenders react if they lose their money?
Remember, no business is a sure thing. You already have a lot riding on your business. Do you really want to gamble your personal relationships on it, too?
…
Much as I loved teaching, metalwork has always been my real passion. I started out when I was just a teen, so I’ve been doing it longer than just about anything else. I could try to give you a bunch of fancy intellectual reasons, but what it really comes down to is that I like the feel of it in my hands.
Ryan Mikus spent 29 years as a high-school teacher in Kalamazoo, Michigan. When he wasn’t correcting tests or coaching soccer, he was indulging in his passion for coppersmithing. He had a studio in the old barn at the back of his property, where he made lamps, vases and candlesticks in the style of the Arts and Crafts movement, which was popular during the late 19th and early 20th centuries.
When he retired, he decided to turn his hobby into a business. He would sell his work under his own name, engraving each piece with the words: “Crafted in Kalamazoo by Ryan Mikus.”
I gathered up my three best pieces and took them to design stores in Kalamazoo, Holland and Detroit. I don’t go in for false modesty; I’m a guy who’s always been proud of his work. But even with that, I wasn’t prepared for the positive reaction. One guy asked “How much for 10 like this?” Another wanted 50 lamps in time for Christmas.
I came out feeling a little shellshocked and thought, “OK, I guess I better start getting serious about this.” Which in my case meant trying to find enough money to get some new equipment and really ramp things up.
…
MONEY SOURCES
Every entrepreneurial business will need to raise additional capital at some point. The rules governing this process depend on the type of corporate structure in place.
Sources of Debt Capital
Although most people think of banks when they think of debt financing, many other potential sources exist. The requirements, risks, interest rates, maximum amounts and turnaround times vary considerably, so research your options carefully.
Financial Institutions
Debt financing for businesses typically takes place through banks, which usually have a limited number of financing options geared toward smaller businesses. A detailed business plan is a basic requirement for most bank loans.
Banks
Different banks serve different markets. Small community banks may focus on serving local businesses, while a large commercial bank will usually take a much more conservative approach to small-business lending, especially when it comes to larger loans.
Many banks prefer not to lend directly to startups; they usually prefer to make government-guaranteed loans. Community banks tend to be a better bet for startups.
Almost every bank loan is a secured loan. This means that the business or business owner must offer collateral for the debt. Collateral is a valuable asset that the lender takes instead of cash if you can’t repay the loan. For example, if you pledge your house as collateral, the bank can take it if you don’t repay the loan.
Note that even when a business is a separate entity from its owners, banks normally require the owners to make a personal guaranty for the loan in addition to collateral. Thus, to get a $50,000 loan for new equipment, you may have to sign the loan personally and grant the bank a lien on the title to the equipment. You may also have to put up personal assets as collateral.
Credit Unions
Credit unions are nonprofit, cooperative, tax-exempt financial institutions that are required by law to limit membership to a specific population, such as members of a labor union, a church, an advocacy group or an occupational field.
They tend to offer lower interest rates on loans than a bank, but they also tend to offer smaller amounts. Still, if you are eligible to join, you might be able to borrow some or all of the capital you need. Credit unions tend to be interested in loans that foster community development or otherwise benefit their members.
Microlenders
Microlenders are typically nonprofit agencies funded by community banks, credit unions, community foundations or federal agencies. They specialize in making short-term loans of $35,000 or less to businesses that lack access to traditional loans. They may also offer business classes, mentoring and technical support.
Community Development Financial Institutions (CDFIs)
CDFIs offer loans that aid community renewal by promoting business growth and economic independence in disadvantaged communities. They also serve populations that lack access to traditional credit, capital and financial services. They range from small, local nonprofits to large banks with millions of dollars in assets.
For more information, visit the CDFI Coalition at www.cdfi.org or contact your state office of economic development.
Lending Circles
Lending circles are an interest-free form of microlending in which multiple borrowers pool their funds to form and secure a group loan. Members receive loans one at a time. Once a borrower repays the loan, the next borrower in the circle can use the funds.
To learn more, visit lendingcircles.org.
Peer-to-Peer Lending
Peer-to-peer lending bypasses banks and connects borrowers directly to lenders through social networking. These loans may be secured or unsecured.
There are three basic models:
In the marketplace model, sites like Prosper Marketplace connect qualified borrowers with private lenders through an auction. The lender with best loan terms wins the borrower’s business.
In the crowdfunding model, many individuals each contribute a small sum of money to fund a specific project. Kickstarter and IndieGoGo are popular examples. Funding is usually treated as a loan or a donation, but there are also equity-based crowdfunding options.
In the community lending model, a community or group pools its money and loans it to one of its members. GreenNote, which arranges student loans through the individual student’s social network, is a good example.
Crowdfunding
Crowdfunding can be a quick way to raise money for a new business, or to expand or improve an old one. Usually, fundraising campaigns run for a month or two. The most successful campaigns introduce the entrepreneur (preferably through a short video), tell a compelling story and clearly state the purpose of the funds. The major crowdfunding sites offer tools to help you promote your campaign on social media.
Most businesses offer a reward for pledging donations. For example, if you were trying to expand from a food cart to a traditional restaurant, you might offer each contributor two free meals when the restaurant opens. Another approach is to offer different rewards for different levels of funding: Someone who contributed $50 might get two free meals, while someone who contributed $150 might be invited to a donors-only dinner with live entertainment. If you make handcrafted goods, you might offer each donor an exclusive, custom-made product. Rewards like these give donors a sense of ownership in your success and can have significant marketing benefits.
Campaigns usually start with family, friends and advisors. Once donations start coming in, outsiders are more likely to get involved. To keep donors engaged, send out regular updates on your progress. The more you involve the crowdfunding community in your project, the more likely they are to promote it to others.
Crowdfunders tend to favor unusual, creative business ideas. However, they also respond to stories. The businesses that do best with crowdfunding connect emotionally with donors and give them a strong personal reason to feel good about getting involved.
Consumer Finance Companies
Consumer finance companies make small personal loans (usually a few thousand dollars). These loans are 100-percent secured by collateral. CFCs charge much higher interest rates and fees than banks and credit unions. However, they’re also much more lenient about bad credit.
Some of these firms have been accused of predatory or dishonest lending practices, so research each company thoroughly before seeking a loan. Keep an eye out for hidden fees, taxes, insurance payments and prepayment penalties, all of which can add significantly to the cost of the loan. When in doubt, consult your mentor, a small-business counselor or the U.S. Consumer Financial Protection Bureau (www.consumerfinance.gov).
Commercial Finance Companies
Commercial finance companies are similar to consumer finance companies, except that they tend to focus on business loans that are considered too risky or unique for banks. The Money Store is a good example.
As with consumer finance companies, read the fine print very carefully before signing the papers. Hidden costs can make these loans very expensive. Be prepared to offer lots of collateral, pay a high interest rate and face heavy penalties for early repayment.
Suppliers
Suppliers can be a source of capital in two ways. First, a major supplier may be willing to provide equity or debt capital if your business would benefit them significantly.
Second, suppliers may be willing to provide trade credit, which gives you 30 or more days to pay invoices. For example, you may be able to order raw materials with a trade credit of 60 days, allowing you to sell the finished product before the bill is due. Alternatively, you may be able to pay for the materials over time (e.g., $50 a month). Get these agreements in writing!
…
I’d been selling a few lamps a month, and I had some savings, but I wasn’t in the position to buy the equipment I needed. Most of my tools and safety gear needed an upgrade. There was a lot of it, so the costs added up.
My biggest expense would be a plasma cutting table with CAD software and a computer that could run it. I was very curious to see what would come of combining modern tools with my handmade approach. But I was a lot more curious about how on earth I was going to pay for all this stuff.
Ryan enlisted the help of his accountant, Bob Fuegner, who explained Ryan’s financing options: If he took out a loan, he’d have a new asset (the equipment), as well as a new liability (the loan) on his balance sheet. He’d also have to maintain the equipment and depreciate its value on his balance sheet.
If he leased the equipment, he wouldn’t own it, so it wouldn’t appear as an asset on his balance sheet. Neither would the corresponding liability of the loan. Instead, he’d pay a monthly lease payment, which he’d record on his books as an expense.
After reviewing Ryan’s credit, cash flow projections and equipment needs, Bob recommended leasing. He had several reasons:
Ryan could record the equipment as an expense, lowering his net taxable income.
The equipment supplier would provide tech support, allowing Ryan to focus on his work.
Ryan could upgrade his equipment when better technology came on the market.
…
Small Business Administration Loans
The U.S. Small Business Administration (SBA) was created in 1953 to support the nation’s small businesses. The SBA guarantees a portion of the business loans made by qualified banks and other lenders, which aids small businesses that can’t afford or don’t qualify for conventional loans.
To qualify for an SBA-guaranteed loan, you usually have to meet these requirements:
You must run a for-profit enterprise in the United States or its possessions.
You must not be delinquent on any existing debt to the U.S. government.
You must certify that you tried and failed to get private credit before applying.
You must have a reasonable amount of equity in the business, as shown by your debt-to-worth ratio. The amount of equity required varies depending on the amount, purpose and length of the loan, but 20 to 40 percent is typical.
You must have an acceptable credit history, and you will probably have to provide a personal guarantee.
Your business must be able to earn enough to cover expenses and your salary as well as loan payments.
You must have experience in the type of business you wish to launch, as well as significant managerial experience.
SBA eligibility restrictions vary by lender, amount, business type and industry. For current terms and conditions, visit the SBA at www.sba.gov or call 800-8ASK-SBA. You can also explore your financing options by using Business.gov’s “Access Financing” tool at business.usa.gov/access-financing.
7(a) Program
This is the largest and most popular of the SBA loan programs. It provides long-term financing for such needs as working capital, machinery, equipment, fixtures, building acquisition and construction.
The loan is made by a private lender under the SBA’s terms, and the SBA guarantees a percentage of the loan. For example, if you were to default on a loan of $100,000, the SBA might reimburse your lender $85,000. (Note that this guarantee is for the lender. As the borrower, you owe the full amount.)
Many banks participate in the 7(a) program, as do some microlenders. Borrowers must apply through a participating lender. Your banker or economic development office may be able to help you with the paperwork.
To get a 7(a) loan, you must meet a variety of eligibility factors, including size, type of business, use of proceeds, character, management capability, collateral, owner’s equity contribution and—of course—credit. All owners of 20 percent or more must personally guarantee SBA loans.
Depending on your background and needs, you may be eligible for a special version of the 7(a) program:
SBAExpress offers a streamlined process for qualified borrowers. Loan decisions are usually made within 36 hours. Lower interest rates may apply. The maximum loan is $350,000, and the maximum SBA guaranty is 50 percent.
Community Advantage serves businesses in underserved markets. The maximum loan is $250,000, and qualification is not limited by standard balance sheet numbers or collateral. Lenders will also provide technical and management assistance, including market research and accounting services.
CAPlines helps small businesses cover short-term and cyclical working capital needs. Loans and lines of credit are available. For example, the Seasonal Line Of Credit Program provides funds for seasonal increases in inventory. For more information, visit www.sba.gov/content/caplines.
SBA also offers special 7(a) programs for exporters, which we’ll discuss in Chapter 29 Options for Growth.
Microloan Program
Under the SBA Microloan Program, startups or growing businesses may be eligible for short-term loans of up to $50,000 through community-based nonprofits. The maximum time for repayment is six years, and you can’t use the funds to pay existing debts or to purchase real estate. To be eligible, you may need to meet business training or planning requirements.
Participating lenders have different rules regarding collateral, credit and documentation. They typically require borrowers to submit personal financial statements as well as a business plan.
Loan requests for less than $5,000 are usually processed within a few days; larger loans may take up to a month. The SBA requires all lenders to provide training and technical assistance to borrowers. To learn more, visit www.sba.gov/content/microloan-program.
Certified Development Company/ 504 Loan Program
A CDC is a community-based nonprofit that works with the SBA and private lenders to finance small businesses. There are 270 CDCs nationwide, each of which covers a specific geographic area.
The 504 loan program provides long-term, fixed-rate financing for fixed assets such as land, buildings and machinery, as well as for renovations to existing facilities. Special terms are available for businesses pursuing certain types of rural development, export, energy efficiency or sustainability projects. Loans can’t be used for working capital, real estate investment, repaying debt or refinancing. Small businesses must create or retain at least one job for every $65,000 guaranteed by the SBA.
Contact your SBDC or chamber of commerce to find the CDC in your area.
U.S. Community Adjustment and Investment Program (CAIP)
This loan program was created in 1993 to help U.S. communities that lost jobs as a result of the North American Free Trade Agreement (NAFTA). Counties may be eligible for this loan depending on their job losses and unemployment rates. CAIP funding covers the substantial fees for eligible loans, which reduces the cost of these loans to the borrower. CAIP can be used with both the 7(a) and 504 programs.
Small Business Innovation Research (SBIR)
The SBIR program, which is overseen by the SBA, promotes technological innovation by giving small tech businesses a competitive opportunity to undertake research and development with the aim of commercializing its new technology.
The allied Small Business Technology Transfer (STTR) program provides funding and public/private joint venture opportunities for qualified businesses.
Participating federal agencies include the Department of Defense, NASA and the National Science Foundation. Visit www.sbir.gov to learn more.
Rural Economic & Community Development Administration (RECDA) LOANS
Through RECDA, the U.S. Department of Agriculture offers various loans and grants for small businesses operating in or benefiting rural areas and towns. These programs usually support specific development goals, such as increasing broadband coverage or energy efficiency.
Business and Industry Guaranteed Loan Program encourages commercial financing of rural businesses. Most types of businesses in rural areas outside cities with a population below 50,000 are eligible, as long as they create jobs, improve the economy or the environment, conserve water, or reduce U.S. reliance on nonrenewable energy.
Intermediary Relending Program (IRP) funds loans for small businesses and other legal entities in rural areas. The loans are made by nonprofit intermediaries such as CDCs and can finance up to 75 percent of a project, with a maximum of $250,000.
Rural Economic Development Loan and Grant Programs provide zero-interest business loans through local utilities for business expansion and other projects that create or retain jobs.
Visit www.rurdev.usda.gov to learn more.
Other Government Loans
Federal and state agencies have created numerous grants, loan programs and other financing devices to help small businesses. In addition, each state has its own unique financing programs and tax incentives for small business. Consult your local economic development organization to find out which resources are available in your area.
Most states will also provide tax incentives, loans and regulatory waivers to out-of-state businesses that are willing to relocate.
Revolving Loan Funds
Revolving loan funds foster small-business development, especially in distressed or underserved areas. These funds were originally capitalized with grants from the Economic Development Administration, the HUD Community Development Block Grant Program and other sources. Loans are limited to eligible borrowers in certain counties or cities. Rules vary by region. To learn more, consult your city, county or state office of economic development.
Other Debt Capital Sources
Business incubators allow multiple startups to operate in a single building. In addition to office and manufacturing space, they usually offer technical assistance, support networks and access to capital. Once a startup is profitable, it moves into its own space. To learn more, visit the National Business Incubator Association at www.nbia.org.
Leasing is a long-term rental agreement that can be considered a form of financing because it frees up funds for other needs. Leasing is tax-deductible, seldom requires a down payment, and may have a longer term than a loan. However, the long-term cost is almost always higher than that of a loan.
Loan guarantors. Small-business owners who cannot support the collateral and capacity requirements of their loan application may be able to find a third party with assets that can be used as collateral. The third party assumes the risk of making loan payments in the event of default. The cost of such a guarantee varies greatly.
Loan brokers locate financing for business owners. They often charge an advance fee, whether you obtain financing or not. Others charge a smaller advance fee and also take a percentage of your loan. Be cautious about these fees and percentages, as they can be steep. Research loan brokers carefully, and always check their references.
Franchising. If you’re buying a franchise, you may be able to borrow startup financing directly from the franchisor. Alternatively, the franchisor may be willing to guarantee your loan.
Accounts receivable financing is secured by your accounts receivable (and in some cases, your inventory). Lenders usually base the loan amount on a percentage of your receivables. The older the receivables are, the less they tend to be worth.
Factoring entails selling your accounts receivable at a discounted rate to a company that then earns a profit by collecting the full amount. As with accounts receivable financing, the age of the receivables affects their value. In addition to the discount, fees may apply.
…
The next step was to get some money together. I looked into some banks, but between my age, the dangerous equipment and the unusual product, they didn’t seem too excited about it. I kept looking for other places to borrow money, but the cost and the risk seemed way too high.
Bob suggested I look into equity financing. That sounded strange at first. But then I thought, well, my whole business idea is pretty strange, so maybe it’s a good fit.
I found Seed Ventures Capital Club while I was poking around online—just trying to learn more about equity—and it looked too good to be true. It was started by four local entrepreneurs who were looking to help other businesses get up and running. Unlike the other angel investors I’d read about, they offered midsize loans and they seemed to take an interest in arts and crafts businesses like mine.
Seed Ventures was looking for projects that would complement their existing portfolio of investments while also fostering arts and culture. Their criteria for investment were:
$20,000 to $100,000 per project
Businesses willing to accept and act on their managerial and strategic advice
Service or manufacturing businesses with a strong management team
Businesses that produce high-quality, “old world” services or products
Businesses that draw on the skills of local artists and craftspeople
It sounded perfect—especially the type of high-quality products they wanted to invest in. The question was, how would I approach them? I didn’t know the etiquette, and even if I did, I had no idea how to make my pitch. Lucky for me, Bob had the answers.
…
Sources of Equity Capital
The most obvious and common form of equity capital is the business owner’s personal funds. Other options vary considerably, but all of them entail giving up some measure of control and profits in return for financing.
Angel Investors
Angel investors are wealthy individuals or groups who invest their money in promising early-stage startups in return for equity shares in the company. Many of them are successful entrepreneurs or retired business owners. Apart from seeking a financial return, angel investors are often motivated by an interest in economic growth, scientific innovation or community development.
Because angel investors often have expertise in the type of business they choose to fund, they can often provide valuable guidance and credibility. Of course, if you don’t find their guidance helpful, you may be stuck with it anyway. Also, angels tend to expect high rates of return—25 percent is typical.
To find an angel group in your area or industry, visit the Angel Capital Association at www.angelcapitalassociation.org.
Strategic Partnerships
Large corporations often invest in small businesses that will help them enter new markets and provide a return on investment. The motive is more than profit; they are looking for businesses that fit into a strategic mission or long-range plan. For this reason, these relationships are commonly referred to as strategic partnerships. Common forms include:
Stock purchase. The corporation buys some of your stock and becomes a stockholder in your company.
Joint venture. The corporation and your business form a partnership and the corporation provides capital. They may also provide infrastructure (office systems), technical expertise, mentoring and new customers.
Licensing agreement. You retain total control of your business, but sell the corporation rights to your products.
Small Business Investment Company (SBIC)
This is the only venture-capital program sponsored by the federal government. The SBA licenses private venture-capital firms and guarantees a portion of their financing. SBICs then provide equity capital and long-term debt to small businesses with high growth potential. The cost of loans and debt securities is regulated by the SBA. For more information, visit the SBA’s website.
Selling Stock
A corporation’s stock consists of shares that each represent a percentage of ownership interest. Shares can be of common stock, which entitles the owner to vote on corporate decisions, or preferred stock, which usually doesn’t carry voting rights but does entitle the owner to receive dividends before common shareholders.
Selling shares to investors is a common method of raising equity capital. These shares can be offered publicly or privately. Public offerings are extremely complex and expensive; they are beyond the scope of this book for the simple reason that they are beyond the scope of most small businesses.
Securities Regulations
Shares offered as an investment opportunity are a form of security, as are limited partnership interests and membership interests in an LLC. As such, they’re regulated by the federal government and all 50 states. Federal regulations may apply if you offer a security across state lines, sell more than $5 million, or solicit more than 35 non-accredited investors (i.e., investors with a net worth of less than $1 million, whose annual income in the past two years was less than $200,000 if single, or less than $300,000 if married).
Private Placements
Private placements offer stock to a small, select group of prospective investors. Due to the private nature of the offering, many of the SEC regulations that apply to public offerings are waived. However, they may still be subject to state securities laws (also known as blue sky laws) and to federal antifraud provisions. Consult an experienced lawyer before making a private offering of shares in your business.
Employee Stock Ownership Plans (ESOPs)
ESOPs allow you to sell shares of stock to your employees rather than to outside investors. This can provide equity capital for expansion, while also giving your employees a vested interest in your success. Consult your attorney and accountant to learn more.
Small Corporate Offering Registration (SCOR)
SCOR enables small businesses to sell stocks to investors with a minimum of cost and regulation by filling out Form U-7. Most small businesses can raise up to $1 million per year, provided their equity is equal to at least 10 percent of the amount of capital being raised. Many restrictions apply, and legal assistance is a must. Visit www.nasaa.org to learn more.
Venture Capitalists
Venture capitalists make investments in young, unproven companies with the potential for explosive short-term growth, millions of dollars in sales, and a large market share.
VCs often demand a majority interest in the company through shares of its stock, so you may find that your lender is also your majority shareholder. To avoid the possibility of a squeeze-out, always consult your lawyer and accountant before agreeing to such terms.
Other Equity Capital Sources
Investment bankers provide equity capital to early stage businesses by selling shares of stock in the business to their customers. They rarely deal in amounts less than $1 million and are interested only in startups that offer very high rates of return. They seek out the same types of businesses as venture capitalists but are less willing to take risks.
Investment clubs. In some areas, local business people pool their money to invest in new and established businesses. This allows smaller investors to participate and larger investors to spread their risk. There is no official listing of these groups. Your chamber of commerce may have information.
Professionally managed pools. Large institutions often pool their money to invest in small businesses.
Bonds are a cross between a stock and a loan. A corporation can sell bonds to a third party for a fixed price and agree to pay interest on that amount. The face amount of the bond is then repaid from future profits on a certain date. The bond holder receives no collateral.
Private exchanges allow stakeholders to exchange their shares in startups for hard cash. The object is to create a market for exchange in startups as an avenue for raising capital. For more details, visit Sharespost.com or SecondMarket.com.
…
Bob told me I needed to get together a business plan and financial projections before I could make a pitch to Seed Ventures. So we worked on it, and we figured out that I’d need $30,000 for the first year. If things went like we hoped, I’d only need $10,000 in year two.
The hard part came when we tried to justify those hopes on paper. We did a lot of research and plugged in a lot of what-if numbers, but we kept coming up short.
In the end, we widened our net and looked at other opportunities, like custom replication of old fixtures for Arts and Crafts bungalows, craft breweries in old buildings and stuff like that. I was spending a lot on CAD capabilities, so it made sense to squeeze a little more business out of it, even if I would have to hire an assistant. After we looked at that market and plugged the numbers in, things looked better.
Ryan wrote up an executive summary and a cover letter that clearly outlined how much funding his business needed. He had professional pictures taken of his best pieces and enclosed them in a nicely organized binder. He doublechecked his spelling and grammar, had Bob triplecheck his figures, and sent the package to Seed Ventures.
That was probably the longest two weeks I ever spent. I tried to put things out of my mind and get back to work, but that’s not easy when it seems like everything’s up in the air. I remember one day Bob told me I needed to uncross my fingers and get some work done.
Ryan needn’t have worried. His summary was one of nearly 30 that Seed Ventures received that week. It took them a while to get to his, but they were intrigued by what they saw and they decided to take a closer look. They liked his ideas, his straightforward writing and his numbers. After a brief consultation, they decided they wanted to meet with him.
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Getting READY
Here are some of the main factors lenders and investors look at when evaluating a financing proposal:
The growth potential of your business
The riskiness of your business venture
The length of time you need the money
The kind of money you need (debt or equity)
The amount of interest you can pay (debt), or the amount of ownership you’ll give up (equity)
The strength and experience of your management team
Market potential for your product
Sales forecast and cash flow analysis
Completing your business plan and making a confident presentation to prospective financing sources is the best way to address these issues. The Debt and Equity Financing Worksheet will help you get ready.
Identifying Your Needs
Why do you need financing? Are you planning a new venture, or expanding a successful one? This section describes common financing needs.
Research and Development
This seed capital typically funds market research, technical research, strategic planning and product development. This funding is usually too risky for bankers, so it’s provided by business owners, investors or government agencies.
Startup and New Growth
Startup costs include professional fees, inventory, equipment, deposits and marketing materials. Growth-related costs might include upgrading equipment to expand capacity, compensation for additional employees, research and development for new products, bulk purchases of supplies or inputs, or additional working capital.
Buying a Business
An entrepreneur who buys an existing business usually finances only the portion of the price that is linked to tangible assets like equipment, inventory or buildings. In addition to these basic costs, it’s often necessary to finance goodwill, which might include an established brand name, a favorable location or a highly trained staff.
Real Estate Acquisition
A typical example would be a restaurant that leases a building for 15 years and then buys it when the owner decides to sell.
Equipment Acquisition
A business’s equipment can only serve a limited number of customers, so expansion often means buying new equipment. Commercial banks usually provide this type of loan. Choosing flexible forms of assets, like leasing equipment instead of buying it, allows you to use your capital for other necessary purposes.
Working Capital
To be successful, a business owner must anticipate working capital requirements. Many small businesses suffer from a disproportionate level of cash versus fixed assets, so they depend on daily receipts to meet operating expenses. If income from sales slows, or the business grows too fast, lack of working capital may force the business into bankruptcy.
Seasonal working capital covers seasonal fluctuations in expenses. For example, ski resorts must overhaul their equipment and groom ski slopes over the summer, which means they have many expenses but little revenue during those months. Loans for seasonal capital are usually paid back within one year.
Permanent working capital covers ongoing expenses like payroll, debt repayment, utilities, marketing campaigns and rent. Permanent capital loans are financed as term loans and repaid over several years.
Differentiating between permanent and seasonal working capital needs will help you to calculate how much money your business needs. Take a look at your sales records for the past year or more. Are there seasonal fluctuations in revenue? Do you have different levels of expense at different times of the year? Note that you may need both types of funding.
Choosing a Loan Amount
There are two things to consider when deciding how much funding to request. First, the amount of the loan depends on the purpose of the funds and the type of collateral you can offer. For instance, the financing available for a piece of equipment may be determined by a bank rule limiting such loans to 75 percent of the purchase price. Financing for real estate and fixed assets is usually limited to a maximum percentage of the transaction.
Second, your cash flow projections show the amount of money you need to borrow, as well as the loan payments you can afford.
Determining the amount you need for permanent or seasonal working capital is more difficult, since it depends on the accuracy of your financial forecasts.
The number of years required to repay a loan depends on the length of financing being sought. A one-year cash flow projection may be sufficient for a seasonal working capital loan.
Debt or Equity?
Your decision to seek debt or equity financing, or a mix of the two, depends on a number of variables.
Cash Flow
The more debt financing your business uses, the greater the monthly payments you must make to repay that debt. This increases the risk that your business’s cash flow will not be adequate to meet debt payments.
Carefully managed debt can carry many benefits, most notably financial leverage. Leverage exists as a result of the fact that interest payments, or the interest expense of debt financing, is a fixed cost agreed upon at the outset of the debt contract (e.g., a fixed rate term loan, equipment loan, or mortgage). It holds steady over time, while the business’s operating income may rise. This means that the business has the borrowed funds at its disposal to invest, producing a greater return than what it must pay on its debt. In this positive scenario, the business benefits.
However, if the business operations are not as profitable as forecasted, the business will earn a lower return and have difficulty meeting its fixed debt obligations.
Equity financing doesn’t require loan payments, which gives you more cash to reinvest in your business. However, remember that you must give up some ownership or management control.
Risk
Debt financing always carries the risk that you will be unable to repay your debt, especially if sales plummet or interest rates soar. The primary risk of equity financing is that you will have a falling-out with your investors and wind up being marginalized or even forced out of your own business.
Ownership
Equity financing grants your investor a share of future profits and the ability to exercise some control over operations. This loss of control is permanent unless you negotiate a buy-out clause that allows you to buy the shares back from the investor at an agreed-upon price.
How much of your business the investor will own is a matter of negotiation. If you want to be the only person in charge, you may have a hard time working with an investor. But if you like the idea of having another voice in management, or need access to special expertise, you may welcome the right investor. In that case, it’s important to get professional legal advice on the terms of your agreement.
Debt financing may cause you to lose management control if the loan agreement contains restrictive covenants, such as limitations on payment of dividends and salaries, or a required minimum level of inventory.
Tax Considerations
The interest portion of a loan payment is tax deductible, but the principal portion is not. Dividends paid to owners, including passive investors, are not tax deductible.
Cost of Proposal
Any business that is seeking financing of any kind (including financing from friends and family) must prepare a financing proposal to communicate the business’s financial position, the quality of its management, and its degree of risk.
You may need help from your lawyer, CPA, SBDC or business consultant to prepare and review financial statements and projections, legal documents, and marketing and technical information. The cost of such services varies depending on where you live and the amount of assistance you need.
Timing
In most cases, securing debt capital is quicker and simpler than finding an investor and crafting a satisfactory legal agreement.
Legal Considerations
When obtaining debt capital, you may not need legal services until it’s time to sign the loan agreement; it’s always wise to have an attorney review your loan terms.
Before searching for prospective investors, meet with your attorney to verify that you are in compliance with state and federal securities regulations.
…
I met with the Seed Ventures people a few times. They had a lot of questions. What if this happens, what if that happens? How many Craftsmen bungalows are there in the Kalamazoo-Portage Metropolitan Statistical Area? Why do you want this plasma cutter and not that one?
My answers must’ve been OK, because they finally did agree to fund me—with a couple of conditions.
The investors’ main concern was that Ryan was a sole proprietor with limited management skills. They decided they would invest in Ryan’s business provided he took on a partner with strong management and marketing skills. They would help Ryan to identify and recruit this partner.
If he agreed, they would invest $30,000 in Ryan’s business in year 1 and $10,000 in year 2. After that, they would reevaluate his operations and profitability and decide whether to invest additional funds.
…
Identifying Financing Sources
Once you’ve calculated how much financing your business needs, you can begin shopping for sources.
Acceptance guidelines vary from one financial institution to the next, so research the person or organization you intend to approach and find out what they require:
To whom should you submit your proposal?
What information do they want?
How do they make decisions about financing?
What types of business have they previously lent to or invested in?
Do they normally lend to businesses like yours?
If they don’t supply the funds, can they help you find other financing?
How long will the loan decision take?
Understanding Credit Factors
Here are six factors lenders will consider when evaluating your financing proposal.
Credit. Your lender will check your personal credit report as well as your business’s credit rating, so it’s important to know beforehand what they’ll find. Review both reports carefully, and take steps to fix any errors or problems that might affect your application. If your credit problems stem from a specific situation, explain the situation and detail the steps you’ve taken to fix it.
Character. The soundness of a business loan usually depends on the character of its owner. If you have good credit and excellent references, you’re more likely to get a loan.
Capacity. Your past performance and financial projections should demonstrate an ability to make loan payments from profits. If projections are too optimistic, or cost estimates are too low, lenders may not see them as realistic.
Collateral. Before approaching a lender, take stock of your collateral—including inventory, equipment, vehicles, accounts receivable and real estate—and be prepared to offer it as security.
Conditions. This can refer to the economic situation locally, in your industry and nationally. A poor economic outlook may affect the availability of funds as well as your ability to repay the loan. What steps have you taken to reduce risk, take advantage of opportunities and overcome obstacles? How are similar businesses faring? What makes your product superior in your competitive landscape? What are the consumer trends? How much competition do you have? You assessed these issues in your business plan. Now, you should share your assessments with your banker.
Capital. As we noted earlier, lenders want to see that you’ve committed personal funds to your venture. Generally, lenders prefer at least 25 percent of a business’s funding to come from the owner. They also want to know if you have enough savings or income to make payments if anything goes wrong.
Creating a Financing Proposal
Your financing proposal should educate the lender about your business and make the lending decision easier by showing that you understand the factors that will determine your business’s success. Your financial proposal draws heavily from your business plan, but is not a substitute for it; lenders will want to see your business plan as well.
You are selling the promise of your business, so approach your financing proposal as you would any other marketing effort. First, get to know the lender. Then, tailor your proposal to speak directly to the lender’s interests, concerns and needs. You should also personalize your proposal with the name of the recipient, the name of the financing source, and the name of the financing program you’re requesting.
Although the contents and format of financial proposals vary depending on the lender, most will include these sections:
Cover letter. This is a one-page letter on business stationery, addressed to the person who will be reviewing your proposal. It should thank the person for previous assistance, briefly describe the contents of your proposal, explain how the requested financing will help your business, and confirm any future appointment.
Summary of financing request. This first page should quickly and clearly summarize the major points of your proposal. Specifically, it should cover the purpose of the financing, the amount and terms requested, the source of funds for repayment, and the collateral offered.
Business description. This section should summarize your business, its location, its facilities, its products, your industry, your target market, your marketing plans, and your growth plans.
Management. This section should introduce your management team and any key employees, detail their experience and qualifications, and explain how that expertise will help your business succeed. You may also need to submit resumes for key personnel.
Sources and uses of funds. This section states the requested amount and terms of the loan. It explains why you need the money and how you will use it. It also highlights your equity contribution to the business.
Loan repayment. This section explains how you will repay the loan on schedule, based on your sales forecasts and cash flow projections. Document any assumptions you made to arrive at these numbers, and be prepared to defend them or offer alternatives.
Collateral. If you’re seeking secured debt capital, list the assets you will use as collateral and their current market values. Collateral is negotiable, so don’t begin by offering every asset you own. (Skip this section if you are seeking equity financing or an unsecured loan.)
Investor return. If you’re seeking equity capital, state the amount of financial return investors can expect. Also, state whether you will have an option to buy out their investment at a future date for a predetermined amount. (Skip this section if you are seeking debt financing.)
Business plan. Your entire business plan should be included with your financing proposal.
Bank statements. Lenders may request a full year of personal bank statements as well as business bank statements.
Financial statements. You will need to submit current or projected income statements and balance sheets for your business (three years is the norm), as well as a current personal financial statement. Include key financial ratios where applicable.
Tax returns. Some lenders will require you to submit personal and business returns for the past three years.
Supporting documents. These might include price quotes or purchase agreements for equipment or materials; business licenses or permits; patents and other intellectual property documents; partnership agreements or articles of incorporation;
As you’ve probably noticed, much of this information can be copied or adapted from the relevant sections of your completed business plan. That’s all the more reason to create a thorough and well-organized plan!
…
Once Ryan agreed to Seed Ventures’ terms, they introduced him to Betsy Dykstra, a 31-year-old business development manager for a major lamp company in Holland, Michigan. She also had an MBA from Michigan State. Ryan’s business was just the kind she wanted to work with, and they hit it off well.
The partnership between Ryan and Seed Ventures also worked well. In the first six months, he met with them several times to get guidance on finding wider distribution and moving to a larger workspace.
The simplest thing I can say is, I’m a very happy guy. And a very lucky one. Seed Ventures has guided me, but never in a heavy-handed way. It was more a matter of helping me to see what my best move was. I know things don’t always work out that way with equity, so I’m grateful.
And Betsy is terrific. I have to admit, I worried about having to take on a partner. But in reality, she’s just incredible. We have similar tastes in artwork, she’s great at her job, and as happy as I am with how the business is going, I think I’m even happier that we’ve become good friends as well as business partners.
What I like best, though, is going downtown to get a beer—in a nice old brew pub where you can see my lamps on every table—and hearing people say, “This is so beautiful. I wonder if they’d sell it?” For a guy who takes a lot of pride in his work, that’s always a joy to hear.
…
Conclusion
As you can see, there are many ways to finance a growing business. But before you talk to any prospective financing source, you must know exactly how much money your business needs, and what its projected revenues and expenses are.
When seeking financing, you need to pay close attention to the fine print. Always have your lawyer and accountant review any offers or contracts that come your way.
Remember: Perseverance, excitement and confidence in your idea will inspire lenders and investors to become as enthusiastic about your business as you are.

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| NxLeveL® TECH TIP BUSINESS RESOURCES AND THE WEB
Equity-Based Crowdfunding In the wake of new rules for equity-based crowdfunding mandated by the JOBS Act of 2012, portals such as EquityNet and SeedInvest have the potential to simplify the process and reduce the cost of raising equity capital for small and growing businesses. Like any offer of securities, equity-based crowdfunding is subject to federal regulations as well as to varying degrees of state regulation. The assistance of a securities attorney is a necessity when contemplating the sale of securities through crowdfunding portals. To stay on top of new developments in this evolving market, visit Crowdfund Investment Regulatory Advocates at www.cfira.org.

Venture Capital Tips Answers to investment requests usually come within 21 days. If you don’t get an answer within this time, focus on other investors and funding sources. Make your calculations simple and concise. Investment analysts hear many pitches and respond better to straightforward math. Demonstrate that you are at risk. Investors are more likely to fund your business if they know you have a high incentive to succeed. Don’t pay yourself too much. Show that money is going to essential expenses. Have a plan for getting to market. Venture capitalists want to see aggressive plans for generating sales and profits. They want to know your exact timetable for entering the market and making a profit. Spend most of your presentation on demonstrating that you have a viable market. Show them that you have something unique or different that will allow you to capture customers’ dollars. Toot your own horn. Highlight any awards or media coverage you’ve gotten, and point to established organizations with whom you’ve done business or partnered.

| When Needed
| Now | This month | This quarter | This year
Amount Needed
$20K or less | Personal savings Friends and family Peer-to-peer lenders Commercial finance companies | Friends and family Peer-to-peer lenders SBA Microloan Home equity loan Equipment leasing Bank line of credit Bank loan Equipment leasing Customer or supplier financing | Crowdfunding Strategic partners SBA Microloan Friends and family Bank loan Community fund loan Equipment leasing Customer or supplier financing Asset/Receivables financing | Strategic partners Banks
$20K-100K | Microloans | Peer-to-peer lenders Microlenders Bank loans Bank lines of credit Home equity loan Equipment leasing | Strategic partners Asset financing | Strategic partners Banks
$100K-1M | Angel investors | Bank loans Bank lines of credit SBA 7(a) program | Bank loans Bank lines of credit SBA 7(a) program | Venture capital Banks Strategic partners SBA 7(a) program

Financing Proposal Tips Find a banker near your business. Local banks often support local businesses and may be more receptive. Choose a more distant banker only if local bankers do not understand your needs. Find a banker you trust. You should feel like your banker will listen to your concerns and share her own concerns. Find a banker who is interested in your type of business. A banker with knowledge of your industry may be able to offer advice or act as your advocate. Present a complete financing proposal. Most entrepreneurs turn in incomplete or poorly executed proposals, so getting your proposal right the first time is very likely to impress your banker. Be honest. Your financing proposal should present your business situation in a factual but positive light. Don’t hide problems. Instead, name them and explain how you will overcome them. Practice your presentation. You should be fully conversant with all the elements of your proposal so that you can answer questions logically and concisely. Be prompt and patient. The loan process may take longer than anticipated, and your banker probably has no control over delays. Start the process well in advance, and get your banker exactly what she needs exactly when she needs it.