by Chip Schweiger, The Entrepreneur’s Accountant™
The following is a brief description of the types of capital available for small businesses that will help you understand the options that are most attractive and realistically available for your particular business.
In no way is this meant to be a comprehensive listing. It’s really designed to get you acquainted with the most common terms and sources where you can obtain financing.
Debt Versus Equity Financing
Typically, financing is categorized into two basic types: debt financing and equity financing, and under these categories, there are various modes of implementation. Debt and equity financing provide different opportunities for raising funds and a commercially acceptable ratio between debt and equity financing should be maintained.
Conversely, too much equity financing can indicate that you are not making the most productive use of your capital or capital is not being used advantageously as leverage for obtaining cash. Too little equity may suggest the owners are not committed to their own business.
Debt financing means borrowing money that is repaid over a period of time, usually with interest. Debt typically carries the burden of monthly payments, whether or not you have positive cash flow. Interest on the loan is deductible and the financing cost is a relatively fixed expense.
Debt financing is usually available to all types of businesses and most business owners go to their banks for such loans. In smaller businesses, personal guarantees are likely to be required. Debt financing includes asset-based financing, leasing, trade credit and various loans that require repayment, with accumulated interest, at some future date. Debt financing does not sacrifice any ownership interests in your business.
Equity financing is an exchange of money for a share of business ownership. It generally comes from investors who expect little or no return in the early stages, but require much more extensive reporting as to the company’s progress.
They have invested on the gamble of very high returns and scrutinize how well you have put their money to use. Such investors anticipate that goals and milestones will be met. Equity financing is generally for businesses with fast and high growth potential.
The major disadvantage to equity financing is the dilution of your ownership interests and the possible loss of control that may accompany a sharing of ownership.
Angels are individual private investors who make up a large portion of informal venture capital. These investors tend to invest small amounts, and they can be difficult to locate because they usually don’t belong to networks or trade associations.
Angels are found among friends, family, customers, third party professionals, suppliers, brokers and competitors. There are a few private investor locating services out there. Do your homework, check these people out and negotiate a commission if your request is placed.
The Internet is a good place to find out about angels and so are private capital conferences, and social media. And, if you have technology incubators or venture capital studios in your town, those are great places to meet and interact with networks of angel investors.
Venture capital comes from private individuals, investment bankers, or other private financial syndicates, or, on a small loan scale, the SBA. Venture capitalists offer limited financing opportunities for a small population of companies.
These funding sources get thousands of requests each year and only invest in a small number. Historically, a large portion of a venture capitalist’s portfolio has been in technology, but that’s quickly diversifying into FemTech, BioTech, FinTech (including cryptocurrencies) and investments into historically under-represented founder groups.
Joint Ventures/Strategic Partnerships
This is where two or more companies with parallel interests get together based on their mutual needs: They have the money, you have the plan. You have the product, they have the distributors.
Do your homework. Seek out companies with parallel interests to your own. This requires much more research than simply asking for a loan. Most of these partners will settle for 20 to 40 percent of equity in your company. Be careful to protect your ideas by having any potential partners sign non-disclosure and non-compete agreements.
In a limited partnership, one or more general partners are responsible for the actual management of the business. One or more limited partners provide investment dollars but normally have no management input. Limited partners have no responsibility for debts or litigation losses the company might incur and the general partners bear all those risks. Limited partnerships usually exist for the purpose of investing. The general partner has all the exposure and management duties, while the limited partners have put up all the money.
There are numerous limited partnerships out there that have been formed to invest in businesses, particularly in private equity.
Small Business Administration (SBA)
A tremendous resource, but the paperwork can be a lot to deal with. Still, this is a great place to look. The SBA has many different programs that are implemented through banks. The most common loan program is called the SBA 7(a) loan.
This means that the bank will finance the project minus the required injection and the SBA will guarantee up to 75% of the project. The bank sets the rates and the terms of the loan, which can be from 7 years to 25 years. To learn more about the SBA, click here.
Also, your local bank should have an SBA loan officer who can explain them to you. SBA loans require a personal guarantee. This program is also used for restructuring existing debt.
Small Business Investment Corporation (SBIC)
These firms leverage their private capital into government money to form a sort of venture capital fund. Most SBICs are part of commercial banks. They offer both long term loans and equity participation. They are generally conservative in the placements, investing only in established companies for management buyouts, funds to go public, strategic partnerships and bridge financing.
Programs include government research grants particularly related to science and technology that pay you to conduct the research and development of your product or service. The National Science Foundation, the Department of Energy and the Small Business Innovation Research (SBIR) program are the primary sponsoring entities.
This is a short-term debt instrument typically issued from two to 270 days. An issue is normally a promissory note that is unsecured and may either pay interest or be sold at a discount off the face value that is paid at maturity.
Commercial paper is considered safe by big investors even though the loans are usually not backed by any specific collateral.
They are normally issued only by very solid firms and may also be backed by bank lines of credit, letters of credit or some other from of credit guarantee. The company may pledge assets to obtain a credit guarantee which is then leveraged into an issue of commercial paper.
Lines of Credit
A revolving account that is continuous in its nature. The funds are available as draw downs against the total line. These types of accounts are most commonly secured with accounts receivable and inventory as collateral.
There are numerous creative ways to finance your business. If one of those comes your way take a moment to investigate it. You can never know too much about how to capitalize your business.
Letters of Credit
A financial instrument used in international trade but can be used for domestic transactions as well. A letter of credit is essentially a set of instruments from a seller’s bank to the buyer’s bank. The instructions stipulate the conditions that both parities must meet in order for payment and delivery to take place.
There are various types of letters of credit. The bank might issue the letters of credit based on your pledge of a receivable or other hard asset.
Factoring is an arrangement in which you raise cash against the value of your receivables for an interest or service charge. It’s a good option for high growth companies, especially for those companies that can’t raise funds from banks because they don’t have two-year’s of operating history.
Basically, funds are advanced against goods sold, accepted and not yet paid for. Normal advances on accounts receivable are 80 to 95 percent. The lenders are looking for ninety (90) days or less to be paid. Funding is available for older accounts receivable, but the rates take a dramatic turn upwards.
Purchase Order Advances
This about this as leveraging your future. If you have purchase orders with your customer base, you may be able to get advances towards their completion. The typical advance is less than 50 percent, and the rates can be very high.
You can think of this as renting assets. You gain the capital equipment you need and agree to pay rent for a specific period of time. There is no interest rate here, but the rates tend to be higher than commercial loans. Some of that is offset by being able to expense 100 percent of the payments. Always consult with your tax advisor.
Asset Sale Leaseback Arrangements
If you are cash poor and asset heavy, this may be a good option for you. Here you are selling your assets for cash to a funding source who leases it back to you (typically with a lease end purchase option). This is most commonly used in commercial real estate transaction but can also apply to various other situations.
The benefits of a leaseback are: it frees up capital; the rent or payments you make can be deducted as a business expense; if you sell and lease back, you maintain an interest in the property; and it may allow you to buy back the property at the end of the lease period.
Private placement is the general term for several kinds of stocks or bonds that are sold directly to investors; cannot be resold on the public market; and are not required to be registered with the SEC. Even though private placements aren’t registered with the SEC, they are subject to state securities regulations and to Federal fraud statutes.
A private placement is a way to raise capital with a small number of investors (typically less than 35). These are now available in a boilerplate format in most states.
Contact your state’s Department of Corporations and consult your attorney for information on what is required.
Initial Public Offerings (IPO’s)
Also known as “going public.” Public stock offerings let you raise more money if you are willing to negotiate the perils and costs of the public capital markets.
In order to go public, a company must register the IPO with the US Securities and Exchange Commission (“SEC”) and become subject to the SEC regulations for a publicly held-company, which is also not inexpensive.
The cost for an IPO is quite high and is, therefore, not the way most businesses raise money. However, for certain businesses, especially those with $100 million or more in revenues, it’s a popular option to raise significant amounts of capital.
Mergers with a Special Purpose Acquisition Company
Another way to “go public” is through a merger with a special purpose acquisition company (“SPAC”) who have no existing commercial operations. SPACS are formed strictly to raise capital through an IPO, for the purpose of acquiring an existing operating company.
Also known as “blank check companies,” SPACs have been around for decades. In recent years, they’ve become more popular, attracting big-name underwriters and investors and raising a record amount of IPO money in 2020.
Convertible debt instruments are typically corporate bonds or preferred stocks that are issued with provisions allowing the holder to exchange them for (or convert them to) a fixed number of shares of common stock at a specified price, and on a specified date.
These are most common with seed or start-up funding where the lender would like a piece of the action in the event you become a tremendous success.
Typically refers to investment funds, generally organized as limited partnerships, who buy and restructure companies that are not publicly traded. Private equity is a type of equity and one of the asset classes consisting of equity securities and debt in operating companies that are not publicly-traded on a stock exchange. You’ll find funds that make investments as “strategic investors” (i.e., seeking to combine with other like portfolio companies) or “financial investors” who are looking for a return on their investment, and sometimes a fund may be both.
A private equity investment will generally be made by a private equity fund, a venture capital firm or an angel investor. Each of these categories of investors has its own set of goals, preferences and investment strategies; however, all provide working capital to a target company to nurture expansion, new-product development, or restructuring of the company’s operations, management, or ownership.
These materials are designed only to provide general information regarding the subject matter discussed. The statutes, authorities, and other laws cited here are subject to change. These materials are not intended to provide tax, accounting, legal, or other professional advice to any specific person or entity. Any advice or opinion regarding the application of the subject matter for a specific person or entity should be provided by a competent professional advisor based on an application of the appropriate law and authorities to the facts and circumstances applicable to that person or entity.
© 2021 The Entrepreneur’s Accountant. All Rights Reserved.