Every business needs funding. Depending on the industry, you need money for everyday operating costs (electricity, rent, supplies, salaries and wages), fixed assets (machinery and equipment) and, of course, enough left over to support you and your family.
The question is, where do you get funding to start your new business - or to support current operations - in these times of tight credit? To find the answer, let us first identify the types of financing available and then discuss ways to obtain that funding.
The two general types of business financing are debt and equity. Equity financing is ownership financing. You, or you and a group of others, put cash and other assets into the business with the plan of making a profit and paying yourselves back in the future. In its simplest form, equity financing has this advantage: the company isn’t required to generate enough income to pay the owners back for their initial contributions. Neither principal nor interest payments are required for the business to continue to operate. Debt financing, on the other hand, requires both principal and interest payments. In exchange for a loan, the business must pay the lender both principal and interest over a set period of time.
Equity financing involves giving ownership interests in an entity in exchange for cash, property or services. If you have ever invested in the stock market, you have been an equity investor. The form of equity can vary. For example, if your business is a partnership, your investment takes the form of capital ownership that can be withdrawn from the business at any time if assets are available. If your company is a corporation, you own shares of stock and receive dividends instead of direct capital withdrawals. From a tax perspective, the differences can be dramatic.
The advantage of equity financing is that it never has to be repaid in order for the company to survive; however, the purpose of any business enterprise is to make enough money to repay investors a reasonable rate of return. If the business is going to be successful, then at some point the initial investor will want to receive the amount invested along with a reasonable profit. If you generate funds through equity financing, expect to cash the investor out at some point. Even though this is not a legal requirement, it is a business reality.
Debt financing is nothing more than borrowing money from a lender who expects to be repaid both the amount loaned plus interest. If you must finance a portion of your business operations with debt, there are several things you should be aware of.
First and foremost, you must match the repayment terms to the purpose of the loan. For example, you are purchasing an embroidery machine that you will use to produce custom shirts. It is unlikely that you will be able to produce enough with that machine to pay all your operating costs, plus principal and interest within a year.
Typically, the profit produced by machinery is realized over several years. For that reason, borrowing $100,000 to purchase the machine and promising to repay that amount in one year is not realistic. In this case, you would want to negotiate repayment terms for a period of several years – what we call a term loan.
Suppose you are a contractor and need financing to complete a construction job. If you expect the project to be complete within 60 days and anticipate payment within 30 days of completion, a short-term loan (due date within one year) is reasonable. When a business needs to borrow money for a short period, it is wise to obtain a revolving line of credit. In this type of arrangement, the company has a credit line against which to draw funds without going through a long lending process. When the company has sufficient funds again, it repays the loan plus interest.
Assuming your business is closely held (only a few owners), expect the lender to require collateral along with your guaranty. By requiring your guaranty, the lender puts not only the collateral and assets of the business on the line, but also can compel you to pay off a debt if the company cannot. In this case, you could be forced to liquidate personal assets to pay off company debt.
If you intend to rely on debt financing, do not expect to finance 100% of your company. Lenders will not take on the entire risk of an entity succeeding or failing. Instead, they will generally require you to have some investment at risk as well - normally 20 percent. The reason for this requirement is that a borrower is far more likely to work toward making a company successful if he or she also stands to lose.
What You Need
Regardless of whether you expect to seek debt or equity financing, be prepared to share your business plan with prospective investors and lenders. That plan, which we will be discussing next month, is your roadmap to success. In addition to providing prospective lenders and investors with details of your current resources, your business plan also needs to make a compelling case that their money is safe with you.
Approach prospective lenders and investors with an open mind. Don’t expect to get what you want without questions, suggestions and a good deal of negotiation. While your way might indeed be the right one, allowing input from those who will help you achieve your goals will go a long way toward cementing the deal.
Businesses, like automobiles, need fuel to run on – and for a business, that fuel is cash. Determining your short-term and long-term financing requirements is only half the battle. Securing the needed financing is the other half. Give us a call if you are seeking financing. We can help you determine your needs and map out a strategy to obtain it.
Happy Independence Day!