Categorized | Financing Your Business

FINANCE, TAXES, AND BANKING 2.2. Financing Your Business

You may have the greatest business idea in the world. You may be smart, hard-working, and totally focused. But if you don’t have the money to turn your ideas into a successful business, you have nothing. Some businesses and shoestring ventures need little or no financing; you can fund them by keeping your day job. But even shoestring ventures, as they enjoy greater success, reach plateaus and can only reach the next level of growth and profitability through an injection of capital. No business has ever grown large based solely on its own revenues, not even Microsoft.

Here’s what Second Venture has to say about the fund-raising process:

Raising money requires a logical process and new funding doesn’t happen instantly. Raising equity capital at various stages of a business’s development is particularly tricky and requires proper strategies. A number of alternatives are available, and choosing the right one for you can help fuel the success of your company. (http://www.secondventure.com)

You can get funding from several sources:

  • Equity investors—these are investors, such as angel investors, venture capitalists, and corporations that provide funding for a stake in your company and its future profits.
  • Loans —you can acquire loans from banks and investors—even by using your credit card—under an agreement that you will pay back the loan with interest.
  • Grants—in rare cases, you can acquire a grant from a government agency or elsewhere that does not involve giving up a stake in your company or paying the money back.

It is not uncommon to combine funding sources from a single individual through creative combinations of equity investment, loans , and grants. I just finished a business plan asking angel investors for 2.5 million dollars in equity investment and a ten-year $700,000 line of credit at 9% interest. The equity investment funded the capitalization of the company and most of its first-year operations, assuming the worst-case scenario of zero revenues. The line of credit was intended to float the second year of operations and any unexpected roadblocks in the first year of operations. As a line of credit, it was a cushion that didn’t cost the business anything until the money is actually borrowed. We worked for weeks coming up with the right funding structure and ended up with this creative combination. It’s only half a joke that the most creative people in a business are in the finance and accounting departments! So you shouldn’t be afraid of being creative and innovative when structuring funding for your company.

When you start moving in the world of investors, there are a number of odd and overlapping terms that you’ll encounter.

  • Angel investors—these are the investors you’re actually looking for; they are the first investors to put money and resources into a business, typically right at the beginning. Initial investors, particularly seed investors, typically take a larger percentage of the company’s equity relative to the investment amount.
  • Seed investors— these are angel investors that provide money and resources to capitalize the business before it starts.
  • Series A investors— Series A is the first round of stock offered to venture capitalists in the seed or early funding stage of a business. Later rounds of stock offerings to private investors are called Series B, Series C, and so on. Typically, Series A stock is convertible into common stock if your company is sold or goes public. It is not uncommon for angel and seed investors to get the lion’s share of Series A stock.
  • Mezzanine investors—as your business grows, you may require another injection of money and resources in a second round of financing: that’s what mezzanine investors do. Typically, they get a smaller share in the company relative to the amount they invest than the first investors.
  • Bridge financing—these are loans to companies that expect an influx of cash either through the sale of an asset or through an additional round of investment; they typically involve giving some stock to the lender.
  • Venture capitalists—these are investors that commit much of their investment resources, if not all, to start-up companies. Venture capitalists often are managing money from multiple investors or they have investment resources they’ve developed on their own; however they’ve come by it, venture capitalists tend to have a lot of money at their disposal and are in the best position to fully finance you. Typically, the goal of a venture capitalist is to sell their interest in your company in a few years at a very high return. While they are not necessarily angel or seed investors (your brother or next-door neighbor could be an angel investor), venture capitalists are the most common source of angel or seed capital for start-ups that require significant financing.
  • Corporate venture capital—Not all investors are individuals or venture capitalists. Big corporations are often eager to fund start-ups or proven shoestring ventures to increase their returns and provide additional value to the products and services they offer. For instance, Apple Computer has $12 billion dollars in cash (approximately 60% of their total assets). Stockholders don’t like companies holding cash like this, so Apple is beginning to make noises about funding startups with all that cash. That’s a windfall for entrepreneurs developing products and services that would drive sales of Apple products. So if you’re start-up is all about a killer app for the iPhone, Apple may want to inject some cash into it. (And you want to follow business and finance news religiously so you know things like this.)

The most critical component of start-up financing, particularly equity financing, is business valuation. We discussed in our business plan section (1.3) how business valuation is the warp and woof of any business plan aimed at either equity or debt investors, and now we’re going to tell you why.

Business valuation is a complicated but relatively straight-forward process when you’re dealing with an ongoing concern that has a welldocument financial history. But what about a start-up that has no year-toyear financials? What about a business idea that has no equal, so nothing to compare the business to in order to gauge a fair market value?

When you bring on an investor and give them a share in your company, that share is relative to the amount of money they invest. For instance, if a venture capitalist puts $500,000 into your company for a 25% equity stake in the company, you and the investor are valuing the start-up at $2 million. Now think about this for a second. Numbers like that just can’t be pulled out of the air. Your start-up may have no assets outside of a business idea or other intellectual assets. It may have no employees, no money, and no revenues coming in. For all practical purposes, your business is worth absolutely nothing. Zero. Zip. Nada. Yet, here you are, you and your investor, valuing your business at $2 million.

Have you taken leave of your senses? Where does that number come from? It comes from a.) the potential value of the company in the future based on its intellectual assets, current performance and growth (if there is any), and business plan adjusted by b.) the risk that the company won’t realize that potential, with the worst-case scenario being a total business failure and the complete loss of the entire investment.

As the business owner, you want the highest possible valuation for your company. The investor wants the highest possible return for their investment while minimizing their downside. That’s a fancy way of saying that they want the biggest chunk of your company for the least amount of money.

Unless you’re a finance major, many of your sources for equity financing, such as venture capitalists, are far better and more sophisticated at determining both the future value of your business and the risk entailed. The ins and outs of start-up valuation are beyond the scope of this book, but in general, initial equity investors determine the future value of your company based on the expected income of the business over the life of the investment and beyond (because expected income after the investor plans to sell out will determine the value of their stake at that time). Your focus in preparing a business plan and investor presentations, then, is a credible outline of future revenue and earnings growth along with credible solutions to abating the risk of the venture.

Business valuation matters to debt investors, as well. If you finance your business with a personal loan , such as a second mortgage or credit card debt, then future income doesn’t enter into the picture (although personal income matters a heckuva lot). But if you’re aiming for a small business loan from a financial institution or a loan from an investor—yes, equity investors will also inject loans into a business, as well—they will secure the loan based on the future earnings of the company. The return that they expect, i.e., the interest, is solely based on the debt investor’s assessment of the future earnings of the company relative to the risk of default. Debt investors don’t realize the unlimited upside of an equity investment, so they are more concerned to know that you can pay the loan and its interest. Equity investors want to make lots of money and they’re willing to take big risks; debt investors want their money back, so they want to mitigate risk or make you pay through the nose for higher risk. Debt investors aren’t looking for explosive growth, just enough so that you can pay them off. So when debt investors are in the financing mix, the primary job of your business plan and investor presentation is to show stable growth and a very solid risk abatement plan. In particular, debt investors are interested in cash flow (see 2.4 below). It’s not your profits that pay back the loan, it’s the cash coming in relative to the cash coming out. So the financial projections of your business have to show a positive cash flow sufficient to service the loan.

Normally you think of “ investors” as equity investors and banks as sources of loans. However, from a financial point of view, both equity investments and loans are investments—they just have different upsides and downsides. You do not have to approach people as equity investors; you can approach them for a business loan or line or credit, as well.

Why would family, friends, or any other individual want to invest in your company in the form of a loan rather than an equity investment? Well, first, they have a much better chance of getting their money back. If you are a sole proprietorship or partnership, they can seize your non-business assets if your business enterprise heads south. If you are a corporation, they are first in line to get their money if you have trouble; equity investors are last in line for recovering their money. Secondly, a loan has a defined return; a debt investor will want a higher return if the risk is greater. And a debt investor is more or less guaranteed this return; you have to pay interest on your debts before you distribute profits to anyone else, including yourself.

Business loans are incredibly complex, for they usually involve covenants requiring you to follow certain rules to protect the lender’s investment. For instance, lenders will want to cap the ratio of debt to equity in your company. They may require certain covenants that put them right at the front of the line if your company should fail. They may want a covenant giving them the option to call the loan—that is, ask for all their money back—before its final payback date. Or, you may want a covenant allowing you to call the loan and pay it back early without any penalties.

I have put together business plans for people that have involved equity investments from banks and loans from individuals. I have put together deals where one investor makes an equity investment, a loan, and provides a line-of-credit. There’s no end to how you can structure loans and equity investments from other people and institutions.

When all is said and done, investment always comes down to risk. You’re asking investors to risk losing some or all of their investment. The higher that risk, the bigger the return they’ll want to offset that risk. An equity investor will demand more equity for higher risk and a debt investor will demand higher interest. Your business plan, presentation, and pitch needs not only to show credible returns, it needs to reduce the business risks as much as believably possible. There’s no other way to do that except by doing your homework and checking it twice.

A WORD OF ADVICE

While financing comes easily to some folks, for most of the rest of us, finding investors is a long, frustrating, and dispiriting process. All I can do to ease your way is repeat something Chazz Palminteri once said to me about his career as an actor: “Success isn’t about knocking at the right doors. It’s about knocking at EVERY door.” So get your knocking arm in shape.

2.2.1. BusinessFinance.comhttp://www.businessfinance.com – BusinessFinance.com is probably the best source for learning how to finance your business and finding investor sources online. The site contains a look-up engine for finding angel investors, venture capitalists, and lenders willing to finance various aspects of your start-up business: equity investing, working capital investments, equipment finance, and small loans. The site also contains a number of articles that cover the basics of finding funds:

  • The Art and Science of Obtaining Venture or Angel Capital
  • How to Prepare & Present a Successful Funding Request
  • Business Credit Profile—How to Build Yours Fast

2.2.2. Second Venture Corporationhttp://www.secondventure.com/ angel-investor-directory.asp – Second Venture publishes a helpful set of online articles and resources for funding your start-up business. Calling themselves “for and by serial entrepreneurs,” they make available a variety of services, including business plans, specifically designed for those people who can’t resist starting up one business after another. Online articles include:

  • Angel Investor Directory—a short discussion and some links about finding an angel investor and securing funding
  • Loans for Starting Up a Business—a highly useful article about a variety of traditional and non-traditional loan sources.
  • Small Business Grants—how to acquire grant financing.
  • Ways to Raise Capital—A particularly valuable article that teaches you the various stages of financing your business through investors, loans , and grants.
  • Business Valuation Methods—normally something that the MBAs do, it behooves you to familiarize yourself with these methods since much of your funding depends on the value of your business.
  • Seed Stage Venture Capitalists—how venture capitalists make investment decisions when investing in a start-up.
  • Corporate Venture Capital—how corporations make investment decisions when they fund a small business or start-up.

2.2.3. University of Michigan Libraries: Funding for Business and Economic Development http://staff.lib.msu.edu/harris23/grants/2biz.htm – A very exhaustive and helpful set of links to Internet resources that can help you fund or finance your small business covering all aspects of financing a business and where to find and secure funding. Resources include:

  • 5 Ways to Get Angel Money
  • 34 Federal Programs to Assist Businesses
  • Best Banks for Entrepreneurs
  • Borrowing Money for Your Business
  • Doing Business with U.S. Government Agencies
  • Financing Options for Start-Up Manufacturers
  • Locating and Getting the Money You Need to Start a Business

2.2.4. Angel Capital Associationhttp://www.angelcapitalassociation.org – The Angel Capital Association is a North American professional alliance of angel investing groups. While the site primarily serves the interests of angel investors, it contains valuable information about what angel investors care about and a priceless directory of angel investor groups at http://www.angelcapitalassociation.org/directory/, which sorts angel investors by region including Canada. You can follow links to association Web sites to help you in your search for angel investors.

2.2.5. National Association of Seed and Venture Fundshttp://www.nasvf.org – The National Association of Seed and Venture Funds (NASVF) is a nonprofit organization of private, public, and nonprofit organizations dedicated to funding innovative entrepreneurial projects. Their site is dedicated to the interests of this group, but you will find an invaluable directory of members pointing you to investor funds that may be interested in your business.

2.2.6. vFinance, Inc. – http://www.vfinance.com – The vFinance Web site offers valuable resources for finding and approaching venture capitalists including:

  • Free venture capitalist directory—the site also includes a look-up tool for venture capitalists and angel investors in your area and industry relative to the amount of financing you require.
  • Free business plan review—you can send your business plan to them through their site for a free, top-level critique of the plan.
  • Plug and Print Business Plans—a business plan template for $50.
  • The site also offers free advice and the opportunity to post your business plan for venture capitalists and angel investors to read.
  • The site also sells a PowerPoint template for $60 for you to insert your information in preparation for a VC or angel investor pitch.

2.2.7. FundingMatch.comhttp://www.fundingmatch.com – FundingMatch is a Web site that matches entrepreneurs with investors. You submit an online business summary and the site automatically distributes that summary to investors who are interested in your type of business. FundingMatch has over 1,000 different investors signed up on the site. These investors include angel investors, banks, venture capitalists, individual investors, and others. For a business looking for funding, the setup cost is $99 and monthly fees are $19. The site comes with a 100% refund if you receive no response within the first month of posting your business summary.

2.2.8. Circle Lendinghttp://www.circlelending.com – Circle Lending is an Internet service that mediates loans between you and your acquaintances—family, friends, and other acquaintances. The site offers guides for structuring these loans and also offers services in setting up, structuring, mediating, and executing loans between you and people you know. Since business loans are complex instruments involving covenants and call provisions, you should at least consult the Circle Lending site before borrowing money from a sister, brother, or neighbor to get your venture off the ground.

The Circle Lending Web site offers a valuable booklet—the best of its kind, in fact — The Small Business Private Loan Guide, which is available for free if you register on the site.

2.2.9. Prosperhttp://www.prosper.com – Prosper is an online marketplace that connects individuals, including small business owners, who want to borrow money with individuals who want to lend it. The site limits loans to a maximum of $25,000; you, as the borrower, must also have a personal credit score of 520 or higher. The Web site connects borrowers and lenders together and mediates the lending transaction between them. Say, you want to borrow $1,000. You put the request online with the maximum interest you want to pay. Individuals who want to lend money submit interest rate bids and amounts, which can be less than the amount you’re looking for. The site collates the lowest bids until it reaches the amount you want to borrow, in this case, $1,000. Prosper takes a 1-2% transaction charge. It’s an innovative way to find funding for personal or business reasons, but you should be careful. A single small loan of two or three thousand dollars could mean having multiple lenders, each with different expectations. Better than a credit card, though!

The Circle Lending Web site offers a valuable booklet—the best of its
kind, in fact — The Small Business Private Loan Guide, which is available for
free if you register on the site.

2.2.10. Venture Capital Finance Onlinehttp://www.vcaonline.com – VCA Online is a Web-based marketplace for venture capitalists and private equity investors. Unlike most of the sites listed in this book, nothing on this site is free. The site allows you to post your business plan (for $30), access a database of venture capitalists, and allows you to purchase sample investor pitches and sample business plans. For-sale resources on the site include:

  • Sample business plans.
  • Sample investor pitches.
  • Sample private placement memoranda (usually the first document you produce when looking for a private equity funder).
  • Series A Term Sheet (the contract and appendices for a Series A venture capital investment including an Investor Rights contract, Right of First Refusal for Co-Sale contract, Voting Agreement contract, Preferred Stock Purchase agreement, and a Certificate of Designations).
  • Non-disclosure contracts and other documents.
  • Employment agreements.
  • Bridge financing agreement.
  • Angel Investor Due Diligence Checklist.
  • Venture Capital Glossary.
  • Venture Capital 101 (a $39 downloadable guide to raising venture capital).
  • Online investor directory.
  • Advisory services directory.
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