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SOURCES OF CAPITAL

Robert Muir

 

George Bernard Shaw wrote that 'lack of money is the root of all evil.' Lack of funding is the number one reason given for the failure of so many small businesses. Why? Success today hinges not only on providing a quality and timely product or service, but also on knowing how to finance the business. All businesses face critical periods that can lead to temporary cash flow problems. These problems can be anticipated and overcome if the small business owner has a good working knowledge of the available sources of financing.

 

It's easy to despair when we've struck out for capital at our local bank. Don't. There are many alternative places to raise money: private, institutional, and government. Some sources may be better suited to a particular need: inception, survival, growth, expansion, or maturity. Don't be put off by their size; ask and we shall receive!

 

Finance for small business may be derived from four main sources: equity, debt, leasing, and grants. Before we examine the more common sources of financing, it's important to clearly understand the difference between debt and equity capital.

In its most common (mortgage) form, debt capital requires a periodic payment of interest and capital reduction, or a lump sum balloon payment upon maturity. New enterprises, without adequate cash flow, can often ill afford debt servicing that can also adversely affect the balance sheet, and with it, hopes of raising additional finance. On the plus side, interest payments are tax-deductible and equity is not surrendered.

 

Contrast the trade-off with equity capital financing, which requires an ownership percentage to be given up, but without interest payments (debt service). However, raising equity capital is not without emotional strain on the founder, particularly if the operation of the company becomes subject to the whims of the new partners. Then again, a large stockholder equity can result in a good credit rating. Among the sources for equity capital, we can include:

  • Fools, family, friends (in cash, credit cards, goods, and equipment and services). Most small businesses in America had their beginnings from this source --inception.

  • Employee ownership is broadening its base and can lead to increased productivity, pride, and security. Employees can participate via stock purchases, stock in lieu of salary, and even by providing personal equipment. Employees can also provide direct loans or loan guarantees--inception, survival, expansion.

  • Successful entrepreneurs and wealthy individuals often wish to get in on the ground floor of a new or expanding enterprise. They seek growth beyond traditional returns or tax write-offs to charge against other disposable income or capital gains. In the U.S. these individuals are often called 'Angels'--a term borrowed from show business, where it is used to refer to the investors who put up the money for theatrical plays. 

Angels are investors who typically have $50,000 to $150,000 to invest in deals typically up to $1.5 million and prefer a hands-off approach. Most angels make their own investment decisions. They usually invest in technologies or markets with which they are familiar and in companies which are close to home, typically within a day's drive. They like to stay in touch with ventures they finance, often providing invaluable guidance. They typically require a business plan prior to investing. Finding the first angel is tough. The second and third come more easily. Angels tend to be linked by an informal network of friends and business associates, frequently sharing investment opportunities. Contact used to be made by referrals from CPAs, attorneys, and business incubators. More recently, Angel Investor Groups have been established in Orange County (TechCoast Angels), San Diego, and LA. On the Web, you can check out America's Business Funding Directory for some 13,000 funding sources, including listings of angels and other would-be investors or the U.S. Small Business Administration (SBA) ACE-Net, the Angel Capital Electronic Network. This nationwide electronic network is designed to help match small companies needing $250,000 to $5 million with angel investors seeking promising business opportunities.--inception, survival, growth, expansion.

  • Customers, suppliers, and sales representatives want to expand their customer base and create new markets for their products. Financing assistance can include extending credit, guaranteeing loans, making direct loans, purchasing new stock, and lending/leasing equipment--inception, growth, expansion.

  • Corporate parents wishing to guard against the loss of key employees through entrepreneurial spin off are adopting an 'if you can't beat 'em, join 'em' philosophy by making funds, facilities, and management services available for new ventures. Several F500s (including Intel, CISCO, AT&T) have set up their own internal corporate venture capital funds. --inception, growth, expansion.

  • Venture capital encompasses a fairly wide range of 'risk capital' investments. At one end of the spectrum is seed capital placed into the very newest, very smallest, and highest risk companies. In the middle are first and later rounds of financing for product line additions for established companies. The typical "average" VC deal is now in the range of $3 7 million. The other end of the spectrum is 'expansion capital' placed into older (5 to 10 years or older), more established (annual revenues $10 to 15 million or more) companies. For a list of Venture Capital firms, by industry, region, and financing types, consult Pratt's Guide to U.S. Venture Capital Sources at the local library or access the Private Equity Networkinception, growth, expansion.

  • In 1958, US Congress passed the Small Business Investment Act that authorized the founding of a special class of investment companies, Small Business Investment Companies (SBICs), to make equity capital and long-term credit available to small businesses. SBICs are licensed by the Federal Government's Small Business Administration (SBA), but are privately organized and managed firms. SBICs recently lost their access to the Federal Financing Bank, but are considering new alternatives in the commercial paper market; these new funds would be still guaranteed by SBA. Currently, there are over 270 SBICs nationwide with $3.5 billion in private funds and $1 billion in government money to lend. While there are some general-purpose SBIC's, some focus on a particular industry, geographic area, type of borrower, women, or minorities. SBICs are commonly interested in realizing capital gains from the resultant sale of stock--survival, growth, expansion.

  • Regional development corporations have been set up by most states to encourage the growth of new industries or to help existing industries. Organizations such as CalStart have been established to develop energy-efficient and pollution-free transportation technologies. In many instances, financial assistance is available for situations where banks and other conventional lending institutions are not willing to participate--survival, growth, expansion.

  • Retained business earnings may offer a higher rate of return than more conventional investments and may often be the only alternative when a new product is introduced to the market--inception, growth, expansion.

  • The initial public offering (IPO): the ultimate fantasy. If we thrive on pressure, enjoy risk, and admit the possibility of having to give up control of our company, this may be a valid option to consider--expansion, maturity.

Turning now to potential sources of debt capital, there are the following:

  • Commercial and Industrial (nonchecking) banks, and Savings and Loan Associations offer a plethora of debt financing. Financing includes personal loans, secured credit lines, unsecured credit, and term loans. Term loans cover short- and long-term financing for established businesses with qualifiable risk--survival, growth, expansion, maturity.

  • Institutional lenders, such as commercial-finance (GE Capital, Chrysler Capital Corporation) and insurance companies have historically been a major source of long-term debt financing for industry. Investment standards are very high, and new or speculative ventures are rarely considered; public utilities, major corporations, and industrial bonds are their preferred vehicles of investment--expansion, maturity.

  • Accounts receivable financing and factoring. Factoring companies trace their origins back some 150 years to the textile trade in Europe. Today, they are associated with the financing of trade receivables. A manufacturer assigns the receivables to a factor and receives a cash payment with a reserve payment set aside. After the customer pays for the product, the manufacturer receives the balance due less the factor's discount and interest on the funds advanced (often a hefty 20 percent). Still, unlike the more traditional bank financing, the manufacturer pays only for what he needs--growth, expansion, maturity.

  • The U.S. SBA offers direct, guaranteed, and 504 Certified Development Company (CDC) loan programs. CDCs can provide long-term fixed asset (up to $500,000) financing through SBA guaranteed debentures to small business. For inception the SBA also offers LODOC or MicroLoan programs--up to $25,000. SBA programs generally require a personal guarantee from any investor with more than a 5-percent stake in the business--inception, growth.

  • Mortgages on buildings and homes are often used to secure loans. Be sure this is a sure thing before risking primary assets--inception, survival, growth, expansion.

  • Manufacturers and other suppliers may ship goods on extended credit terms. They may even provide the new company with direct or guaranteed loans to establish the enterprise or to support it during lean times. These relationships typically fall under the catch-all of strategic alliances--inception, survival, growth.

  • Government issued (local, state, and federal) loans and grants, such as Industrial Revenue Bonds, may be available to encourage new initiatives. Contact the SBA for a copy of the Directory of State Small Business Programs. Assistance also may be available from other government sources such as the Departments of the Interior and Housing and Urban Development--growth, expansion.

  • Sellers may even self-finance the sale when traditional financing is unavailable or unattractive--growth, expansion, maturity.

The third main source of finance for small business are grants. Government grants (local, state, and federal) are available through programs such as the Small Business Innovation Research Act (SBIRs). Funding up to $50,000 may be made available to confirm the feasibility of a new idea. Over $1 billion in federal R&D funds is available under the federal SBIR program for awards to firms with 500 and fewer employees for R&D and commercialization. The National SBIR Conference is in Washington DC each Spring. The Conference offers an opportunity to meet with R&D program managers from the 11 Federal agencies responsible for 98% of all the Federal R&D spending. Major corporations will also attend seeking innovative technologies.--inception, survival.

Lastly, the final source of finance is leasing.

  • Leasing can be very attractive to small business because it can provide capital assets with little or no initial investment. Products manufactured with the leased asset may provide sufficient cash flow to meet the leased payments. Typically, while the total payments over the lease period, plus the optional buy-out amount, can add up to twice the original purchase price for the equipment, the small business person may have no other choice--inception, survival, growth.

  • Another variation of leasing is the sale-lease back plan. Equipment that has already been purchased is sold to a leasing company and then leased back to the original owner. In this way, the small business acquires cash, which may be sorely needed for working capital, in exchange for the equity in the equipment--survival, growth.

Unfortunately, many entrepreneurs give up the search for outside capital before they learn how the capital markets operate and how to shape their business strategy appropriately. Contacts and a track record in the target markets are critical elements in approaching any funding source. Finally, an absolute 'must' before approaching any source for capital, is a well-prepared business plan that documents how the funds will be used, secured, and paid back!

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