Where’s the Money?

     Many business owners find that they require outside capital to finance the startup, ongoing operations and growth of their business. Unfortunately, many don’t know where to go to seek funds, or they don’t realize that there are different types of money sources, each with its own financing criteria. As a result, business owners waste a lot of time and effort speaking to the wrong person, or speaking to the right person but giving the wrong information. So let’s take a look at the various types of lenders out there, and what each is looking for.

     First you must recognize that each of these entities is in the business of investing. They expect a return on their investment—in some cases a very sizable return—and if they can’t see, very quickly, how they can realize that return, they will quickly move on to the next deal.

     Also understand that the decision to invest isn’t just based on how much money you are requesting. (In fact, in most cases, entrepreneurs severely underestimate how much money they will really need.) The important criteria are whether you have a viable plan and if you have the management team in place to execute the plan. Think of it this way: if the investor isn’t confident you can make your plan happen—and thus make money for the investor—why should he invest in you?

     Here’s a quick summary of the financing sources available, what they are looking for, and how they like to structure their deals:

• Private Investors provide you with equity for your business. Typically, it is their own money that they are investing. They are not lending against assets; instead, they typically take an ownership position in your business, or at least have the right to acquire an ownership interest under specific circumstances. They take the highest risk of any financing entity and thus expect the highest rate of return—30% or higher is not unusual. Private investors also have a definite time frame in mind; most expect to be out of the deal within three to five years. Their role is to give you the money to get started and get established.
• Commercial Banks are highly regulated institutions and thus there are specific limits as to the type of lending they can do and the structure of their loans. Since commercial banks are financial intermediaries (which means that the money they use is not their own), and since they are highly leveraged (which means they finance their business with a lot of debt and very little equity), they cannot afford to incur large losses. This means they are going to be very risk averse. Banks do not take an ownership interest in your business, but they will require you to pledge most of your assets, as well as personally guarantee your debt. Since the risk they take is relatively low, banks charge a market rate of interest, usually the prime rate (published in the Wall Street Journal) plus a margin.
• Factors, Finance Companies, Leasing Companies are grouped together because their financing is asset-specific and is secured, or collateralized, by the assets that are being financed. Two of these differ from banks in that they actually own the assets they are financing. To clarify, if you obtain bank financing, you pledge your assets as collateral to secure your loan. With factors and leasing companies, you continue to use the assets, but you either sell the assets to these entities, or they “loan” the assets to you for use in your business; in exchange, you get cash for operating your business. Also, be aware that a commercial bank has multiple assets securing its loan, which minimizes its collection risk. These entities only have one asset securing their loan, and sometimes they do not have recourse to you. As a result, they incur a higher risk and will expect a higher return on their investment than a commercial bank.
  • Factors finance accounts receivable. Typically, they will only accept specific receivables, those that are from established, creditworthy companies. If you sell to such companies, factoring may be the best financing alternative for you. If you already have a line of credit with a bank, you can still use factors to cover any financing needs that exceed your bank lending limit.
  • Finance Companies finance your accounts receivable and inventory, if you have any. You would typically use a finance company if you have an existing, operating business, but you cannot obtain bank financing because you are too risky for a commercial bank. This would typically happen if you have too much debt, sales and profits are erratic, and you have incurred significant operating losses in recent years. The finance company will establish a lending limit called a borrowing base, and will carefully monitor all disbursements and payments for receivables and inventory, which will be used to secure your loan.
  • Leasing Companies finance the equipment you use in your business. Just about anything you use in your business, from computers to desks to manufacturing equipment can be financed with a leasing company. When structuring their deals, leasing companies focus on your monthly cash flow, and structure a deal with payments that you can afford. This implies a higher interest rate, of course. Although leasing companies technically own the equipment, you are often responsible for maintenance and repair.

     To learn more about dealing with financing sources, I recommend you read Are You a Nutrition Label or a Picture? and Can You Really Make it Happen?