Financing a Business
All businesses, but especially small businesses, are at one time or another faced with the necessity of raising money. Even if you started out on a very small scale, in your basement or garage, using your own savings as capital, in order to grow you will need to raise money. There are several ways of doing this, including taking on partners or incorporating and selling stock.
You may borrow money from friends or family or from a bank. You may consider a mortgage if you need to enlarge or buy a building for your business. If you are willing to share ownership, you may want to talk with a venture capitalist. A letter of credit may satisfy your need to improve cash flow if business is a little slow and you have to replenish stock in preparation for the coming busy season.
Whatever you eventually decide, you need to know first how each of these methods works, what it will do for you, and what disadvantages it may have. Once you have decided which way will be best for you, you will need to know how to proceed. There are certain things anyone will want to know before committing himself to lend money to you or invest in your business.In the following pages we will explain ways of raising money for your small business, and take you, step by step, through the often intimidating business of applying for a loan.
Kinds of Financing
When you begin to look for money, whether to start a new business or to expand an existing one, you first must decide where to look. It is usual for new entrepreneurs to put some of their own money, often from their savings, into their business. Generally you should expect to provide at least 25 to 50 percent of your start-up cost. This is evidence, for yourself and for potential lenders, that you take your business seriously and intend to make it work.
Partnerships
You may know someone who shares your enthusiasm for your business; if you are willing to share ownership, equity financing may be a good way to bring more money into the business. Although the person or firm providing the new capital may not be active in daily operations, you will be taking on a partner who probably will expect to have some say in major decisions. General partners usually will contribute both capital and management time; they share in responsibilities and liabilities. Limited partners contribute capital but normally have no management responsibility. (In a sole proprietorship the single owner is responsible for all decisions and debts.)
Corporations
If you establish a corporation, you can include numerous equity investors in your business. Each investor is a stockholder owning part of the company, in proportion to size of his investment. Stockholders in a privately held corporation may be friends, relatives and/or employees. In a publicly held corporation shares are sold to the general public by an investment banking or stock brokerage firm.
Formation of partnerships or corporations should not be undertaken without the advice of a lawyer. Although, clearly, a corporation has some advantages in obtaining funds, it is a good idea to remember that corporations are more closely regulated than most other legal entities.
Venture Capital
Another technique for raising money that requires relinquishing part ownership is through venture capital. Once again, you will be surrendering part of the equity and some control of your business in exchange for the needed money.
Personal Loans
Friends and family may be willing to make loans, sometimes at low or no interest. More often, you will borrow from a bank, or possibly, a credit union to finance your start-up. The loan may be short-term, intermediate- or long-term. It may be a commercial mortgage or take the form of a letter of credit.
It is well to remember that no bank will finance one hundred percent of your needs. How much of your own money you invest in your venture is one measure of how committed you are to making it a success.
Although some lenders consider up to five years short term, usually you should expect to repay a short-term loan within a year. Such a loan may be a lump-sum amount or it could be simply a line of credit that allows you to borrow at will up to a certain limit. You may repay and reborrow as necessary.
Lines of Credit
The line of credit, or revolving credit as it is sometimes called, may be renewed at the end of the year. A seasonal line of credit is useful for a business with a product that has a distinct season. Between peak seasons, when business may be slow, the line of credit provides operating funds. A short-term loan might be used to help with cash flow until accounts receivable come in, or simply to provide working capital. As with any loan, care should be taken to set a limit based on what you need and your ability to repay, in this case, within the year.An intermediate-term loan usually runs for up to three years, probably will require collateral, and will be paid back from profits in monthly or quarterly payments.
These loans are useful for business start-up, purchase of new equipment, expansion of your quarters, or increasing working capital.Long-term loans, more than three years, usually are secured by sufficient collateral to guarantee payment of interest as well as principle. They provide money for start-up, purchase of major equipment, a move to a new location, among other things. Such loans usually are repaid out of cash flow or profits on a monthly or quarterly basis.
The loan agreement may limit the amount of other debt your business may incur, or how much may be paid in dividends or salaries to principals; it may stipulate that a certain percentage of the profits be dedicated to loan repayment. Collateral will be discussed later.
Commercial Mortgages
Commercial mortgages can enable you to buy land or to buy, build or enlarge a building. Property your company now owns may be mortgaged to provide needed cash . The mortgage may be for up to 75 to 80 percent of the appraised value of the property; usually it will be amortized over 10 to 20 years. You should be prepared to pay for an independent appraisal of the property's value. If your property is already mortgaged, you may be able to obtain a second mortgage. In such a case, the interest on the first mortgage should not be affected, but, to compensate the bank for the comparatively higher risk (it will be second in line should your business fail), interest on the second note probably will be higher than that for the first.
Collateral
For most loans, you will need some collateral to pledge as security for your debt. It may be property, including property purchased with the proceeds of your loan, or it may be stocks, bonds, certificates of deposit, cash value of life insurance, real estate or other business or personal assets. In the case of businesses with multiple owners, such as partnerships or corporations, the bank may require a pledge of personal assets.Banks commonly expect the value of the collateral to be somewhat greater than the amount of the loan. The readiness with which your collateral can be converted to cash, or its liquidity, is also important. Your own character and personal guarantee will weigh heavily in this transaction.
Finding the right Lender
Choose your lender with care. There are a number of factors to consider. Different financial institutions may charge different rates because of differences in their costs; some banks charge origination fees, usually quoted as a percentage of the amount of the loan amount (a 1% fee on a loan of $90,000 would be $900). Fees may be paid from loan funds or from the borrower's existing funds. Either way, fees add to your cost. Although a competitive interest rate is important, a lower interest rate alone is not sufficient to outweigh other attractive features.
Services are important as well, and an extremely low interest rate should make you wonder "Why?"Ask if the bank will give you a lower rate if you maintain a minimum balance, called a compensating balance, in the bank. Some banks offer only variable-rate financing, that is loans for which the rate of interest may rise or fall, depending upon a given economic indicator. Others have fixed-rate loans as well. Of course, a drop in interest in a variable-rate loan could seem to be a windfall, but you must also realize that rising rates could create awkward situations for you. In deciding which will work better for you, consider how long you expect to need to repay as well as whether your business might be expected to go through slow periods (as some seasonal businesses do) just when your interest might be going up.
Does this bank make a specialty of lending to small businesses? If there are any small business people on the board of directors this may indicate a special interest in businesses such as yours. Is this bank interested in a long-term relationship with its customers? What other services does the bank offer small businesses - for example, cash management and investment and trust services - and what is the quality of their service? A bank may offer many services with the best of intentions, but unless you can count on them when you need them, it's all so much window dressing. Find out if this bank participates in programs of the U.S. Small Business Administration (SBA). Although the SBA rarely makes direct loans, it often acts as a guarantor for loans made by private lenders. SBA-guaranteed loans may go up to $500,000; the SBA guarantees 85% or 90% of the loan balance to the bank. The average SBA-guaranteed loan is $175,000, and the average maturity eight years. SBA also has a Microloan Program for loans up to $25,000. The loans are available through nonprofit organizations. Information is available from your local SBA office.
How will you know? Where can you get this information? A good way to start is by asking other small business owners in your field or in your area. If they are happy with their bank, feel that interest rates are fair, financial advice sound, you may like it too. Ask your lawyer and accountant.Consider the bank that has your personal accounts - you know them already and they may be happy to serve your business. Interview as many bankers as you can. Finding a bank you are comfortable with is not unlike finding the right doctor; it takes some time and effort. But if it results in a long-term relationship of mutual trust and good advice, it will be worth the effort.
Asking For Your Loan
In addition to providing a statement to present to the bank, writing a loan proposal will help you organize your thoughts in preparation for your meeting with the loan officer. A good proposal describes your business, explains how you plan to use the loan and how you plan to repay it. Your proposal should be straightforward and concise, avoiding extravagant claims or promises that you may not be able to live up to. (You should avoid as well what might be called false modesty, the tendency not to describe your business as successful lest you seem to boast.) Here are the elements of a proposal that you and the bank can be happy with. If you have a business plan, it will be very useful in planning your proposal. If you haven't prepared a business plan, don't wait any longer! Start by identifying you business by name and address. Introduce yourself and, if there are any, your partners. You need not go into detail - names and Social Security numbers will do here.
Now you're ready to discuss the purpose of this loan. Once again, keep it simple. Be very specific about how the money will be used. For example, if you plan to expand, describe the new building you plan to rent, or construction plans if you want to build. If you will be adding more lines to a retail business, describe them and say, briefly, why you think they are good for you. If you want to start a new business, launch a new product or design of your own, describe it and what its appeal will be for your customers. Try to convey, without being gushy, enthusiasm for your plans.
Once you've covered your plans for the money, ask for what you need; be as exact as you can. Include enough of your research results to convince your banker that you know who your customers are and that they'll be interested in your new product. Do not ask, "How much can I borrow?" Such a question does not inspire confidence in your business sense or your determination to be successful - you must show your banker that you are knowledgeable and serious.Now describe your business in some detail, a brief history, what you've accomplished since you began the business, how you conduct the business or deliver your service. Explain more fully what changes you plan to make with the loan and how it will improve your business. If you are planning a new business, include the same basic information, expressing it as what you plan and expect. Remember, cover all the relevant points but keep it simple and direct.
After profiling your business, do the same for the business' management. Include resumes of all the principals, with emphasis on experience and talents that will be particularly useful to your business. Include personal references and be prepared to provide copies of your personal tax returns for the past three years. Then move on to your market.
Expand your description of your product or service: What makes it different or better than others? With whom are you, or will you be, competing? What are their strong points and weaknesses? Who are the customers and how will you convince them that what you are offering is better? Collect your business financial information into a business financial statement. Your accountant , if you have one, can be helpful and should be involved. Be sure that you include: a balance sheet from the most recent fiscal year, an income statement, showing profit and loss for the last three years, right up to the end of the current year; cash-flow projections, showing how much cash you expect to generate in the future to enable you to repay the loan; accounts-receivable and accounts- payable agings showing receivables and payables broken into 30-, 60-, 90-, and more-than-90-day-old catagories, and, finally, a ratio summary, presenting several ratios that, together, give a quick overview of your business. The quick ratio or acid test is the relationship between your cash plus accounts receivable plus marketable securities (if any) and your current liabilities. It is found this way:
- It should be close to your industry's average; if it is not, you may have a liquidity problem.
- Inventory is included in the current ratio, but because inventory can't instantly be turned into cash to pay bills, this test is considered a less precise measure of liquidity.
- The amount of debt on your company's balance sheet, compared to the amount of equity in the business gives a picture of how leveraged the business is; two ratios apply here:
- The debt-to-net-worth ratio measures the extent to which your firm depends upon borrowed funds, and gives the lender an idea of your ability to repay
- The debt-to-total-assets ratio is concerned with the company's ability to repay long-term debt.
An accurate report of inventory, especially if yours is a wholesale or retail operation, is necessary. Besides being a simple statement of how many pieces you have, this count will help determine inventory turnover. You may have to count the inventory, but calculating with this formula often produces a useful figure for a given period:
- Your turnover or activity refers to the turnover of receivables, inventory and sales. By measuring these items in relation to one another and to fixed assets your banker gets an idea of the amount of activity in the company's day-to-day operations.
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