“How can I get the financing I need” is probably the most popular question among entrepreneurs. Maybe you have an attractive business concept, but it takes some financing to get into the business. Or maybe you have an operating business with plenty of customers willing to pay for the value of your products – but you need some cash to grow the business or recover from setbacks.
This is the first in a series of blog articles on financing for your business. Our goal is to provide a fairly comprehensive description of financing sources and their requirements for lending, to help entrepreneurs form reasonable expectations and search for financing efficiently.
Over the next few weeks Business Techniques in Troubled Times will post articles on community bank loan standards, SBA loans, microloans, “alternative financing” for distressed operating businesses, lender’s remedies when loans are not being repaid, and “angel” investors who provide cash for equity investments in small businesses.
By the way, you don’t see grants in the list of topics above because grants are generally not available to “for-profit” businesses. For more information on grants, see SCORE on grants.
In this introductory article the focus is on understanding types of financing, and understanding what it takes to attract financiers to lend or invest their money in you and your business.
To understand types of financing, see 15 Sources of Financing for a simple two page list provided by SCORE Fox Valley. The most typical methods for startups are personal savings, friends and family, home equity, credit cards, and leasing equipment. Loans are also feasible, but they all require some personal cash input, often about 25% of your total financing needs. Loans also require collateral and a personal guarantee of repayment. If you are already operating a business and need to grow, other options become available.
Note: 70% of startups use their own savings as the main source of their funding, according to the Ewing Marion Kauffman Foundation quoted in the Wall Street Journal November 12, 2012.
Lenders Consider How You Will Use The Loan
Note that most financiers are NOT interested in providing funds for survival, such as paying routine supplier bills or other debts. Instead, they look for clients whose use of their funds will either create collateral (such as being used to buy assets) and/or grow the cash generation capability of the business through new products, new markets, or new capabilities. This includes working capital to enable purchase of raw materials for your growing volume of orders.
Why would they be so “picky?” Common sense tells them that “growth uses” provide improved assurance that the loan or investment will be paid back with an appropriate return (interest or profit). Survival uses do not change the fundamentals of an underperforming business, i.e. the reason it could not survive on its own cash flow in the first place. That type of business is an unacceptable risk for profitable payback of standard loans.
However, “alternative financing” or equity investments may be available for such firms, because both of those approaches provide the investors with greater returns to compensate for higher risk.
Am I A Good Risk?
This leads to thinking about what it takes to attract someone to give you money to develop your business. Potential lenders are interested in assured payback; potential investors are interested in likely profit. They seek a profit big enough to be worth the risk of investing in a small unknown business, compared to the profit they could get from investing in the stock of more well-known entities. For example, the average annual gain for the Dow Jones Industrial Index has been 9 to 10 percent since 1900.
This means they want to understand both you and your business well enough to have confidence that their investment will pay off. First they will want to understand you, because unreliable management (that could be you!) can destroy even the most promising business.
What do they want to know about you? First, your character and personal reliability; second, your resources; third, how well your skills fit the role you will play in managing the business.
Personal Character: Evidence of your character and personal reliability starts with your personal credit history: credit rating; past bankruptcy; and status of your payments on current loans. The next consideration is whether your personal and business tax filings are up-to-date. They may also look into other matters such as criminal record or other publicly available information.
Your resources are important because lenders will require that you supply a significant percentage of the business’ total financing requirements, usually around 25%. If you do not believe in yourself and the business enough to invest substantial funds, then how can you expect anyone else to believe and invest?
You will also be required to provide collateral for any loaned amount, as well as your personal guarantee of repayment. So lenders will want to make sure that you have these funds and assets available. A natural response is “if I did have them available, I would use them instead of the loan.” If you have these resources, you should indeed consider whether you need a loan or not, because loans can be expensive.
Skills fit role? The other personal issue is your skills vs. the role you have assigned yourself in the business. Your business plan should have already identified the types of skills needed to succeed, and where the business will get those skills. The plan assigns you a role, usually as the overall manager, but not always. If your role is to run the business, the bank will want to know whether you have ever done that before successfully, ideally in the same industry. If not, how can they be assured you can do it now?
The right approach to minimizing management risk is to assemble advisors and other managers who have the skills you are missing, and describe in your business plan how this team will work together.
After lenders are satisfied with your personal risk profile, then they consider the prospects for the business itself. They will be looking for a coherent business plan including marketing and operations, milestones, and most importantly, industry trends and averages that show your own financial projections are reasonable. If you have an operating business already, they will also look at your current debt vs. cash flow to see if the business can support more debt repayment.
For start-ups, a good source is Can I Qualify for a Loan? For an operating business, more detail on loans and the information required to obtain them can be found at The ABCs of Borrowing. Both articles are from the Score Fox Valley website, Resources tab.
Next week’s article will provide more detail on a community bank’s lending standards. To get an email alert as each article in this series is posted, go to Blog | Business Techniques in Troubled Times by Thomas Gray | Thomas H. Gray – Consultant, CEO, Director and subscribe for email alerts. You can post your comments there as well!
Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), a Certified Business Development Advisor, and a Certified SCORE Mentor. He can be reached at 630-512-0406 or firstname.lastname@example.org. See www.tom-gray.com