Financing Basics

While poor management is cited most frequently as the reason, inadequate or ill-timed financing is a close second. Whether you're starting a business or expanding one, sufficient ready capital is essential. But it is not enough to simply have sufficient financing; knowledge and planning are required to manage it well. These qualities ensure that entrepreneurs avoid common mistakes like securing the wrong type of financing, miscalculating the amount required, or underestimating the cost of borrowing money.

Before inquiring about financing, ask yourself the following:

	Do you need more capital or can you manage existing cash flow more effectively?
	How do you define your need? Do you need money to expand or as a cushion against risk?
	How urgent is your need? You can obtain the best terms when you anticipate your needs rather than looking for money under pressure.
	How great are your risks? All businessess carry risks, and the degree of risk will affect cost and available financing alternatives.
	In what state of development is the business? Needs are most critical during transitional stages.
	For what purposes will the capital be used? Any lender will require that capital be requested for very specific needs.
	What is the state of your industry? Depressed, stable, or growth conditions require different approaches to money needs and sources. Businesses that prosper while others are in decline will often receive better funding terms.
	Is your business seasonal or cyclical? Seasonal needs for financing generally are short term. Loans advanced for cyclical industries such as construction are designed to support a business through depressed periods. How strong is your management team? Management is the most important element assessed by money sources.
	Perhaps most importantly, how does your need for financing mesh with your business plan? If you don't have a business plan, make writing one your first priority. All capital sources will want to see your for the start-up and growth of your business.

Not All Money Is the Same

There are two types of financing: equity and debt financing. When looking for money, you must consider your company's debt-to-equity ratio - the relation between dollars you've borrowed and dollars you've invested in your business. The more money owners have invested in their business, the easier it is to attract financing.

If your firm has a high ratio of equity to debt, you should probably seek debt financing. However, if your company has a high proportion of debt to equity, experts advise that you should increase your ownership capital (equity investment) for additional funds. That way you won't be over-leveraged to the point of jeopardizing your company's survival.

Debt Financing

There are many sources for debt financing: banks, savings and loans, commercial finance companies, and the U.S. Small Business Administration (SBA) are the most common. State and local governments have developed many programs in recent years to encourage the growth of small businesses in recognition of their positive effects on the economy. Family members, friends, and former associates are all potential sources, especially when capital requirements are smaller.

Traditionally, banks have been the major source of small business funding. Their principal role has been as a short-term lender offering demand loans, seasonal lines of credit, and single-purpose loans for machinery and equipment. Banks generally have been reluctant to offer long-term loans to small firms. The SBA guaranteed lending program encourages banks and non-bank lenders to make long-term loans to small firms by reducing their risk and leveraging the funds they have available. The SBA's programs have been an integral part of the success stories of thousands of firms nationally.

In addition to equity considerations, lenders commonly require the borrower's personal guarantees in case of default. This ensures that the borrower has a sufficient personal interest at stake to give paramount attention to the business. For most borrowers this is a burden, but also a necessity.

Equity Financing

Equity investors buy a piece of your business. They become co-owners and share in the fortunes and misfortunes of your business. Like you, they can make or lose a bundle. Generally, if your business does badly or flops, you're under no obligation to pay them back their money. However, some equity investors would like to have their cake and eat it, too; they want you to guarantee some return on their investment even if the business does poorly. Unless you're really desperate for the cash, avoid an investor who wants a guarantee. It's simply too risky a proposition for someone starting or running a small business.

Most small or growth-stage businesses use limited equity financing. As with debt financing, additional equity often comes from non-professional investors such as friends, relatives, employees, customers, or industry colleagues. However, the most common source of professional equity funding comes from venture capitalists. These are institutional risk takers and may be groups of wealthy individuals, government-assisted sources, or major financial institutions. Most specialize in one or a few closely related industries. The high-tech industry of California's Silicon Valley is a well-known example of capitalist investing.

Venture capitalists are often seen as deep-pocketed financial gurus looking for start-ups in which to invest their money, but they most often prefer three-to-five-year old companies with the potential to become major regional or national concerns and return higher-than-average profits to their shareholders. Venture capitalists may scrutinize thousands of potential investments annually, but only invest in a handful. The possibility of a public stock offering is critical to venture capitalists. Quality management, a competitive or innovative advantage, and industry growth are also major concerns.

Different venture capitalists have different approaches to management of the business in which they invest. They generally prefer to influence a business passively, but will react when a business does not perform as expected and may insist on changes in management or strategy. Relinquishing some of the decision-making and some of the potential for profits are the main disadvantages of equity financing.

You may contact these investors directly, although they typically make their investments through referrals. The SBA also licenses Small Business Investment Companies (SBICs) and Minority Enterprise Small Business Investment companies (MSBIs), which offer equity financing. Apple Computer, Federal Express and Nike Shoes received financing from SBICs at critical stages of their growth.

Limiting Risk

Because equity investors are co-owners of the business, they may be exposed to personal liability for all business debts unless your business is a corporation, limited partnership, or limited liability company. If you recruit equity investors for what has been your sole proprietorship, your business will now be treated as a general partnership. This means your equity investors will be considered to be general partners, whether or not they take part in running the business. And as far as people outside the business are concerned -- people who are owed money or who have a judgment against the business -- general partners are all personally liable for the debts of the partnership.

Equity investors often want to limit their losses to what they put into the business. An investor who puts$10,000 into a business may be prepared to lose the $10,000 but no more. In short, the investor doesn't want to put the rest of his or her assets at risk. The investor will want to avoid being -- or being treated as-- a general partner.

Fortunately, there are three common ways to organize your business so that you can offer an investor protection from losses beyond the money being invested.

Corporation. Form a corporation and issue stock to the investor. A shareholder who doesn't participate in corporate activities and decision making is virtually free from liability beyond his or her original investment. A shareholder who does help run the company is liable to outsiders for his or her own actions -- for example, making slanderous statements or negligently operating a piece of equipment -- but isn't liable for corporate debts or the actions of corporate employees.

Limited partnership. Form a limited partnership and make the investor a limited partner. A limited partner's freedom from liability is similar to that of a shareholder, as long as the limited partner doesn't become actively involved in running the business.

Limited liability company. Form a limited liability company -- now allowed in all but three states -- and make the investor a member. The investor will be protected in much the same manner as a shareholder or limited partner.

Encourage investors to determine their own degree of risk. As mentioned, an investor in a business organized as a corporation, limited partnership, or limited liability company usually stands to lose no more than his or her investment. However, state laws must be followed carefully to achieve this result. To avoid having investors accuse you of giving misleading assurances, recommend that they check with their own financial and legal advisers to evaluate if their investment exposes them to the possibility of incurring additional losses.

Return on Investment

Someone who invests in your business may be willing to face the loss of the entire investment and not insist that you guarantee repayment. But to offset the risk of losing the invested money, the investor may want to receive substantial benefits if the business is successful. For example, an investor may insist on a generous percentage of the business profits and, to help assure that there are such profits, may seek to put a cap on your salary. The terms are always negotiable -- there's no formula for figuring out what's fair to both you and the investor.

Here are just a few possibilities:

John, a former police detective, decides to start a business to offer security training seminars to midsize manufacturing companies. He forms STS Limited Liability Company and invests $10,000, which is only half of his $20,000 start-up budget. His aunt Paula, recently widowed, invests $10,000 of her inheritance in the company. The STS operating agreement states that John will be in full control of day-to-day operations. John and Paula agree in writing that John will receive a salary of no more than $4,000 a month from STS for the first four years, and that Paula will receive 60% of STS profits during that period. After that, John's salary will be tied to gross receipts, and John and Paula will share profits equally.

Stella wants to start a travel agency. She approaches Edgar, a friend from college, who has just sold a screenplay to a major studio and is looking for investment opportunities. They agree that Stella will form a limited partnership and act as the general partner. Edgar will invest $60,000 in the business and become a limited partner. Stella will work for $3,000 a month and use the first profits of the travel agency pay back Edgar's $60,000 investment. After that, the profits will be split 50/50.

Larry, an experienced carpenter, wants to become a general contractor so that he can build custom homes and do major remodeling jobs. He's able to invest his savings of $30,000 in his new venture but needs another $20,000 to get started. Larry forms a corporation, Prestige Homes Inc., and invites his friend Brook, who owns a building supply business, to invest $20,000 in return for a 40% interest in Prestige Homes. Brook agrees, on the condition that the new corporation will buy all its lumber and other building materials from Brook's company -- and, iin addition, pay Brook $5,000 for each home that's built by Prestige Homes. They sign a shareholders' agreement containing those terms.

Compliance with Securities Regulations

The law treats corporate shares and limited partnership interests as securities. Issuing these securities to investors is regulated by federal and state law. In some cases, an investor's interest in a limited liability company may also come under these laws.

This means that before selling an investor an interest in your business, you'll need to learn more about the requirements of the securities laws. Fortunately, there are generous exemptions that normally allow a small business to provide a limited number of investors an interest in the business without complicated paperwork. Chances are good that your business will be able to qualify for these exemptions. In the rare cases in which the exemptions won't work for your small business and you have to meet the complex requirements of the securities laws -- such as distributing an approved prospectus to potential investors --it's probably too much trouble to do the deal unless a great deal of money is involved.