So you’ve got a sound business plan and all systems are go. Now all you need are cash resources to get things going. Seems simple, right?
While shoddy management is cited most frequently as the reason businesses fail, inadequate or ill-planned financing is a close second. Whether you’re starting a business or expanding one, sufficient, available capital is essential as is the knowledge and ability to manage it well. This ensures that entrepreneurs avoid common mistakes like securing the wrong type of financing, miscalculating the amount required, or underestimating the cost of borrowing money.
In general, there are two types of financing: equity and debt financing. When looking for money, you must consider your company’s debt-to-equity ratio, that is, the relation between dollars you’ve borrowed and dollars you’ve invested in your business. The more money owners have invested in their business, the easier it is to attract financing.
Equity or Debt Financing: Which Way to Go?
Equity Financing: Most small businesses use limited equity financing with the most common source of professional equity funding coming from venture capitalists (VCs). VCs are institutional risk takers and may be groups of wealthy individuals, government-assisted sources, or major financial institutions. Most specialize in one or a few closely related industries. The high-tech industry of California’s Silicon Valley is a well-known example of capitalist investing.
VCs most often prefer three-to-five-year old companies with the potential to significantly grow and return higher-than-average profits to shareholders. While VCs capitalists may examine thousands of prospective investments annually, they only invest in a handful. Important considerations for VCs include the possibility of a public stock offering, quality management, competitive advantage and industry growth. This type of financing is ideal for new businesses since venture capital firms focus on the future prospects of a company when banks use past performance as a primary criteria.
You can contact these investors directly, although they typically make their investments through referrals. The U.S Small Business Administration (aka SBA: www.sba.gov) also licenses Small Business Investment Companies (SBICs) and Minority Enterprise Small Business Investment companies (MSBIs), which offer equity financing. Apple Computer, Federal Express and Nike received financing from SBICs at important stages of their growth.
Debt Financing: There are many sources for debt financing: banks, savings and loans, commercial finance companies, and the SBA are the most common. State and local governments have developed many programs in recent years to encourage the growth of small businesses in recognition of their positive effects on the economy.
Traditionally, banks have been the major source of small business funding. Their primary role has been as a short-term lender offering loans, lines of credit, and single-purpose loans for machinery and equipment. The SBA guaranteed lending program encourages banks and non-bank lenders to make long-term loans to small firms by reducing their risk and leveraging the funds they have available. Moreover, the SBA’s programs have been an integral part of the success stories of thousands of firms nationally.
It’s also worth mentioning letters of credit. A letter of credit is a guarantee from a bank that a specific obligation will be honored by the bank if the borrower fails to pay. Although the bank pays no funds, the credit requirements for a line of credit and a letter of credit are similar.
For additional resources on small business financing options, visit www.sba.gov or www.jumpstartinc.org.
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