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CHAPTER FOUR - Financing a New Business

Introduction - It is a well-known fact that the principal reason that new businesses fail is because of the lack of adequate funding. In almost every type of business, CASH IS KING. If you do not generate cash from the business it will not succeed. In our work at SCORE we have seen people go into business and generate reasonable sales, but due to the nature of the customers to whom they have sold the product or service they cannot collect the money -thus having a shortage of cash. If you have no cash you can't pay expenses or invest in the future of the business. If this situation continues you will fail!

Cash for a business comes essentially from two sources. One is the revenues you generate from selling your product or service, assuming you can turn the revenues into cash. This is a particular problem of many service businesses that perform the service for the client/customer but have difficulty collecting the money in a timely fashion -or at all. The other source of cash is your own pool of money that you have generated from your own savings or from outside sources. This chapter will identify the various options for a small business relative to generating funds to finance the start-up and the on-going operations of the business.

The Five Cs of Lending - All sources of lending hope to get their money back with interest in the future. Other than very close relatives, the motivation for investing in a business is to make a profit on the investment. In the case of a start up, the hope is to make a large percentage on the investment, since the risk is so high. One simple measurement tool the investment community looks at in evaluating potential investors is the 5 C's, which are as follows:

 Capital - This refers to the amount of money you have put into the venture. Lenders like to see that the borrower has some significant ' skin in the game' before they are willing to take chances on the investment.

 Collateral - This is the amount of liquid assets you would have to protect the lenders investment in your business. To this end,it is very common for a borrower to have to pledge their home, car, boat or other major assets in order to borrow money.

 Cash Flow - This refers to the cash that the business will generate as a result of the operations. The cash flow is what will tell the investor whether they are likely to get their money back from the investment. If the investment does not show a very positive cash flow within 12- 24 months it is unlikely that the lender will be anxious to participate in this investment.

 Character - This generally refers to the credit score you would get from the three rating agencies. If you do not have at least 700 in the current environment, it is very unlikely that you would be able to get attention from the more traditional lenders.

 Conditions - This refers to the market conditions at the time of the loan. When business is good and lots of cash is flowing it is much easier to get a loan than when conditions are tight and there is not a great deal of money available for lending.

Sources & Uses of Funds Report - One of the most important documents that a new business will be asked to generate by a prospective lender is a ' sources & uses' report. This is a very simple report that simply outlines where the money is coming from to finance the start up of the business, and how the funds are to be used. It requires to new business owner to lay out in some detail the various places where money will be generated, and then how specifically it will be spent during the start up and the initial 6 months of the business.

Sources of Capital - There are many different potential sources of capital available to a small business during the start-up phase. However, more than 90% of all new business start-up are funded by personal financial resources and from monies obtained from friends and family. The following will summarize the most common sources of capital that are available to the entrepreneur, as we believe it is important that you understand the various options, even if they are normally not available to the start up company:

 Personal Financial Resources - Most small businesses obtain the bulk of their funding from personal financial resources of the entrepreneur. This includes such things as personal savings accounts, credit cards and home equity loans. It is for this reason that the start-up of a new business is so risky that if the venture does not succeed, the entrepreneur could lose their savings and/or their home. However, the reality is that the easiest source of money to get to start a new business does come from your own resources.

 Friends and Family - The second most common source of start-up funds for a small business is friends and family. More often than not this is family. It is very common for a young entrepreneur to go to his or her parents seeking money (in the form of a gift or loan) to help start their business. Another very frequently used source of funds is your friends or acquaintances. They may have an interest in what you are planning, and are willing to invest in the business as either an equity partner or under a basic loan agreement in which you sign a legal document promising to pay X percent interest annually on the money they provide, with the plan to pay back the entire capital investment within 'Y' months or years.

 Community Development Financial Institutions - These are non-profit organizations authorized through a program run by the U.S. Treasury. Every state has them and their focus is on businesses that are domiciled in the state. They receive funds from commercial banks as part of their community development obligations, from the state and federal governments and from grants. They are different from banks in that they usually have a social policy priority that guides their lending practices. It might be to increase employment within a particular city or locality, or it may be to encourage minority and woman owned business. It could even be to encourage the development of a particular industry like clean energy. Their criteria for lending might be a little less rigorous than those of a bank though a business still needs to address the same questions that a bank might ask. The names of the organizations and contact information can be obtained from your local SCORE office, which can be contacted via www.score.org. Their interest rates are almost always 1-3 percentage points higher than would be charged by a community bank. Some of the state organizations will require you to be first turned down by a community bank before you can qualify for a loan with them.

  Micro Lender - This is a category of lenders that will normally provide up to $35,000 in funding for a start up organization. They are community-based non-profit organizations, normally under the supervision of the Small Business Administration. The average loan from a micro lender in 2009 was approximately $13,000. They normally charge a higher interest rate than one would pay to a community bank, should funding from that resource be available.

  Traditional Bank Lenders -The most well known source of lender for small business is the community bank. This is typically a small bank or chain of banks in a region that service the local business community. The attitudes of banks toward start-ups depend heavily on the financial conditions in the marketplace and the availability of funds. In recent years, most community banks have been quite reluctant to risk lending money to small start-up organizations, unless they are very well collateralized and have demonstrated a strong business idea via their business plan.

 SBA Loans - This is a misnomer. The SBA does not make direct loans. They guarantee certain loans that banks might make. The process is the same as seeking a loan from a bank. The bank may turn down the loan but suggest that the applicant apply for an SBA guaranteed loan. Or the bank may not inform the applicant that they might qualify for an SBA guarantee (some banks do not place much marketing value on the SBA relationship). In that case, it is up to the applicant to seek help from the SBA directly. The SBA guarantee is not a given. The SBA will employ much of the same approval criteria as the bank, though it may be guided more by a social policy or program rationale.

  Angel Investors - Angel investors are independent business organizations that typically invest their own funds to lend to a new business organization. The funding organization may be a trust, a business, an investment fund, a LLC or a variety of other types of structures. Typically angel investing is a second round of financing for high growth start-ups, as the angel investor is generally looking for a return of at least 10 times the original investment within a 5 year period through a well defined exit strategy such as an IPO or an acquisition. Angel financing is very difficult to obtain due to the selectivity of the lenders, as their criteria are very stringent. There are over 250,000 angel investors in the U.S. with the average loan approximately $500,000.

 Investment Bankers - This is a very well known, visible source of funds, but is almost never viable for a small business start up organization. They seek to provide funding for large companies in amounts exceeding $1MM via the issuance of stocks or bonds for the client organization.

 Grants - One of the great wishes of many small business start-ups is they will be able to get a grant to start their business. While there are definitely grants available for start-up's, they are extremely difficult to obtain, normally are restricted to specific demographic groups (i.e.,veterans, minorities, etc.) and projects that have a proven societal need such as technology R&D, community action organizations, etc. To search for available grants, we suggest going to www.sba.gov -- a website that will guide you through the process of qualification for grants and then determining whether there is a grant available to match you specific business plan.

 Credit Cards - A new business owner should use credit card debt very carefully...or not at all. The interest rates are extremely high compared to traditional lending sources, and they are often so high that it may be very difficult to ever pay off the principle. Also, credit terms keep changing and there are expensive penalties for late or insufficient payments. There are few third party lending sources that are interested in loaning money to pay off existing debt.

SUMMARY - Financing a new business can be the biggest challenge that the entrepreneur will face. A key point to remember is that CASH IS KING and you must have sufficient cash available to start and then run your business. Therefore ensure that you have done careful planning for you cash needs, and then have generated sufficient funds to have on hand to start your business. Lack of operating funds is one of the three main reasons that small businesses fail. Plan for your cash needs so you do not jeopardize your venture.