Small business owners contribute heavily to the creation of jobs and expansion of our economy. According to the Small Business Administration (SBA), small businesses create more than half of the nonfarm private GDP in the United States, employ half of all private sector employees, and have generated more than 60% of net new jobs over the past 17 years. It is clear that any strategy to jump-start the economy must have a robust small business component that helps and encourages owners to access capital and retain cash flow in order to reinvest, create jobs, and expand their enterprises.
In this resource, the Giersch Group discusses capital as it pertains to small businesses in the United States: why capital is needed, how it is used, potential sources of capital, and the process for obtaining capital. Although many institutions claim they are lending, our experience shows that the average small business has difficulty in acquiring capital when it is truly needed. Therefore, it is critical that business planning occurs to ensure that the business will have the capital when needed for growth inflection points or a potential downturn.
Uses of Capital
Working capital (current assets less current liabilities) is the lifeblood of a company. Without it, a firm cannot maintain short-term operations. Capital in a small business primarily provides the short-term assets that a company needs to operate. In addition to its normal levels of accounts receivable and inventory, a business requires a minimum cash balance to meet basic day-to-day expenses, to provide a reasonable reserve for unexpected costs or increases in accounts receivable.
Seasonal or cyclical working capital needs also require adequate capital. See our resource: The Budget Process – Budgeting Revenues to Cash Flow.
A third use of capital is to finance growth. The strategic planning process allows a company to anticipate what capital expenditures will be needed in order to facilitate growth of the company. A planned surge in business for a PR firm will necessitate additional hiring, with the related investment in infrastructure. A production plant may need bigger storage facilities or larger equipment for expanded customer orders.
Sources of Capital
The sources of capital for a small business depend on the stage of the business and capital structure desired. It is ideal for the business to generate the required cash flow to self-finance growth or seasonality. Outside capital may be required. Outside capital is obtained through either debt or equity sources.
Personal Funding – Using personal finances of the owner or owner’s family or friends is often one of the first sources a company turns to in order to obtain capital. Such sources are referred to as “friends and family.” The Giersch Group recommends that capital from these sources be treated consistently with the practices for other sources of capital.
Debt Financing – Debt financing means a loan. When business owners use debt financing, he/she will borrow money from the lending party and promises to pay them back over time, with interest that represents the cost of money. There are many different types of loans, but for this Topic of the Month, we will only discuss the sources of obtaining this type of capital.
- Family and Friends –It is an important discipline to take the obligation to friends and family just as seriously as other outside sources. Therefore a company should present family and friends with a credible business plan and create a formal, documented agreement between parties. The agreement should be complied with fully. The Giersch Group finds a significant performance contrast between companies that honor these types of capital commitments as compared to those that do not.
- Bank Loans – Commercial banks are the largest financing source for business debt, including working capital lines of credit, equipment financing, term loans, and other debt products. Very few banks will provide financing to businesses less than two years old. The ability to demonstrate the business viability and capability of debt service is critical.
- Small Business Administration – The SBA does not make loans. Rather the SBA guarantees loans of other institutions, such as banks. The Giersch Group’s experience has shown that the paperwork required and the criteria can make it a challenge for many small businesses to obtain SBA loans outside of a real estate purchase.
- Factoring and Alternative Lenders – Factors provide a loan against receivables or contracts that allow the business to gain immediate working capital to fulfill the order prior to client payment. While the cost of factoring is quite high relative to bank financing, it is often a wonderful source of financing for small businesses that may not qualify elsewhere. There are many other lenders that specialize as well, whether it is Accion USA which helps solo-entrepreneurs with loans under $50,000 or institutions that specialize in loans to a specific industry or against specific assets.
Equity financing – Equity financing is an exchange of money for a piece of ownership in a business. Equity financing needs to be strategic as it is typically more expensive that debt financing based on the principle that you are giving up ownership of your company, and a portion of future profits. There are several sources of equity financing which include:
- Friends and Family Network – This is the primary source of funding for small businesses. Either people that the small business owner knows, or people that they know, invest in the small business because of the trust that they have in the owner. While they will likely want to see some form of a business plan, their basis for investing is typically the owner and not the projected ROI.
- Angel Funding – This is generally used by a new formed business. This kind of investment usually warrants a business plan, a management team, and a sound financial analysis. Most angle investing comes from a wealthy individual who provides capital for a startup business in exchange for convertible debt or equity.
There are many other equity tools, such as multiple rounds of financing, mezzanine financing, etc. which are not covered in this resource as they tend to be available for larger companies or those focused in the technology or pharmaceutical industries.
Because of the time and preparation required for financing, planning is important. The typical process will take a minimum of 90 days for the average small business. Regardless of what form of funding you pursue, the funder will likely require a financial information package in order to allow the capital source to assess the company and risks associated with extending capital to it. The Giersch Group helps many clients obtain capital from investors or banks in order to finance operational costs or growth opportunities. The process is typically the following four phases:
- Assessment of Need
- Determine the amount of funding that is sufficient to lead to a self-sustaining business, whether this is the launch of a new product line or the extension of current services
- Discuss the most appropriate sources of funds. Seasonality is typically best funded through securing a line of credit while equipment purchases are best funded through equipment loans or leases.
- Evaluate the preparedness of the company to approach potential financing sources. The inability to provide clear and accurate financial statements will diminish your opportunity to get capital. If your tax returns are also showing continuous losses, this is a hindrance to demonstrating viability. Any tax liens or judgments also need to be cleared and disclosed.
- Determine that adequate cash flow will allow for timely repayment, or adequate ROI, depending on the funding source.
- The scope of preparation required is dependent on what the client wants to accomplish and the Assessment Phase.
- A presentation package needs to be prepared in a format most appropriate for the funding source and contain the information that funders are seeking. An email with scattered attachments responding to a funder’s request typically does not clearly represent the opportunity and value. The package needs to tell the story along with the financial information.
- The presentation must clearly outline the amount of funds needed, what the funds will be used for, when the investment will be repaid, and what the return on investment will be
- A critical component is the creation of the financial model, which will be based on historic numbers as well as a realistic projection of the future opportunities. This will demonstrate the ability to issue distributions or repay debt along with any interest.
- Educate yourself on the going market rates for interest or prepare yourself for the amount of equity that an Investor will require for their capital. Expectations need to be realistic based on the financial forecast, not your vision for the future.
- Determine who you will approach for funding. If equity, provide the same package for each prospective investor or meet in a group setting so that everyone hears the same information. If debt, begin with your current business banker to see what options are available for your business. Other local or regional banks might be a better fit if your current banker is not interested.
- Negotiation and Closing
- Negotiations will vary dependent on situation. For equity financing the ideal is to get a known individual to commit which will allow you to utilize that information to infuse confidence in other potential investors. Negotiations should arrive at a term sheet which sets forth all of the agreed key points for investment.
- For debt financing there is typically little leverage with institutions other than the threat of moving your business banking elsewhere. Rates and terms are pretty standard and an application will need to be completed, including a personal financial statement.
- While negotiations are fun, the success of the deal is in closing the required capital. The final phase is a push and requires persistence with bankers or investors to receive the funds.
- Review the seasonality of your business for any potential need for a line of credit. A line of credit is best secured at a time when it is not needed.
- Maintain a good relationship with your business banker and be informed on what your bank offering and requirements are for additional capital.
- Do annual budget and strategy planning to be aware in advance of capital needs.
Articles for Further Reading
- http://www.cfaw.com/library/200/CFA-Effective-Business-Plan.pdf - This short check list from Corporate Finance Associates offers effective tips for putting together a business plan to help obtain capital from potential sources.
- http://www.devisscher.com/articles/FIBMatching_sources.pdf - This article by Family Business Magazine explores the important questions of what type of capital to obtain and when.
- http://www.canteyhanger.com/content/Raising%20Capital-v4-CHdwc(012111)Published.pdf Elaborate on the major types of financing for a small business and some tips for raising capital.
- http://www.sba.gov/category/navigation-structure/loans-grants/small-business-loans - Link to the SBA website for small business loans.
For more information, please visit the Giersch Group at http://www.gierschgroup.com/ or contact us at email@example.com