How to finance a small business
Money makes your business go, and usually banks make loans only to businesses with operating histories. In this session we will give you some alternatives, strategies, and things to think about in your search for financial help. You will learn how to locate, negotiate for, and maintain sources of money to help you start and expand your business.
- First Things First
- How Much Money Do You Need?
- What do you need it for?
- Unsecured Loans
- Secured Loans
- Loans (Debt) vs. Investment (Equity)
- Where to Get the Money
- Types of Funding Sources
- The Art of Getting the Money
- Business Loans
- Repayment Plan
- Other Quick Tips
- After You Get the Money
- Suggested Activities
- Top Ten Do's and Don'ts
- Business Plan
First Things First
Money makes your business go. But don't try going to a bank to get it when you've just started in business. Banks normally make loans only to businesses with operating histories. This section will give you some alternatives, some strategies and some things to think about as you go about finding the money to make your business work.
A banker's primary concern is your timely repayment of loans. The fuel to make loan payments come from your cash flow. So your management of cash flow is of utmost interest to your banker and you must convince the banker that you are an expert in making cash flow projections that safely include your loan payments. Here is more information on cash flow which is taken from session one of our Business Expansion course.
As pointed out in the first session on picking a business, don't be discouraged by not having much money to start with. Many businesses can be started with no money at all. You can start small and humbly and grow one order at a time. Here is a sample, partial list of businesses you can start with very little cash: Businesses You Can Start for Little or No Money.
Our first reminder is that personal savings should be considered the primary source of funds for starting a business. If you haven't started already, start now to begin accumulating cash through personal savings.
Also, don't overlook the Small Business Administration (SBA) loan guarantee programs available for start-up businesses. With a SBA guarantee program in hand, your bank will be happy to talk with you!
Finally, start your search for financing with a good credit rating. Most all sources of financing or credit have come to rely on a four-letter word to score your credit worthiness: FICO. FICO is a numeric method, using just three digits, to predict the likelihood of paying your credit as agreed. FICO scores range from 365 (not good) to a high of 850 (great). The score evaluates your credit payment history, number of open accounts, overall credit balances and public records such as judgments and liens.
Generally, a FICO score above 680 will produce a positive response while a score below this will cause a lender to be cautious. Before seeking financing or credit, it is a good idea to know where your FICO score stands. A number of credit cards now provide your FICO score on your monthly statement. You can also visit myFICO.com to purchase your credit score and to review your credit reports.
How Much Money Do You Need?
Or, how much can you reasonably expect to get? Refer back to your business plan. If it still doesn't answer the question, let's go step-by-step. In Session 11, Accounting and Cash Flow, you will learn how to predict future cash needs by using a cash flow control form.
The cash flow control form will spell out all of your sources of income and expenses. For example, some expense items might include:
- Buying supplies and inventory while waiting to get paid
- Paying payroll and rent
- Buying equipment and fixtures
- Getting a computer
- Buying the business
Prioritize those areas where your options are limited to paying in cash, and review your alternatives where there may be another way. For example, it is not necessary to pay all cash for a delivery truck when you can rent or lease one. Next, review what might serve as collateral for your loans.
Some credit is granted on an unsecured basis, such as credit cards, but most small business loans are secured by the assets of your business, your personal assets, or both. Unsecured means that there is no collateral granted for the loan. Examples of unsecured are
- Credit cards
- Unsecured lines of credit (like you get in the mail)
- Friends or relatives
Secured loans mean that there are assets pledged to secure the payment in the event you are not able to pay. Examples of this are
- Computer lease
- Home mortgage
- Car loan or lease
- Small Business Administration loan
Common types of collateral are equity in your home, accounts receivable, inventory of the business and equipment. Lenders go through an evaluation of the collateral to determine how much they can lend. Some key variables as to what kind of loan terms you can get are
- Number of years in business - This is your track record and is very important. Banks usually require three years while others are less stringent.
- Size of your company and the amount needed - Financing institutions vary in the way they service the public. For example, you would probably not get a car loan and a large corporate loan at the same place. Do your research. Ask around. Get to the right spot.
Loans (Debt) vs. Investment (Equity)
You are most likely familiar with a straight loan (debt) where the lender gets an interest rate and fees.
Equity is where the money raised gives the investor an ownership interest. This is common in the sale of stock to a limited number of investors or participation by venture capitalists. The sale of stock is highly regulated by state and federal agencies and you will need the help of a corporate lawyer. Normally the initial sale of stock to the public (initial public offering or IPO) is deferred until an earnings history is established.
Sometimes such a discussion arises with friends and family who want to be your partner. Consider this carefully because they will then participate in the increased value of the business and have voting rights.
It is well beyond the scope of this discussion to cover all the aspects of debt and equity. Just be careful! Your lawyer and accountant would be appropriate sources for more information on this subject.
Where to Get the Money
Entrepreneurs have a wide variety of options when it comes to funding. Below is a list of possible options for a small business to research and consider regarding lender types.
Terms will vary considerably from lender to lender; important issues to consider:
- Payback program/terms
- Loan size
As an entrepreneur, you will be legally obligated to have individual responsibility for the credit obligation of your business. Regardless of legal organization (covered in Session 5), lenders will have documentation to circumvent the organizational structure. This is usually called a personal guarantee. Don't panic! It is very common.
Lending options for small businesses:
- Personal Savings
- Friends and Family
- Banks/Credit Unions
- Home Mortgages (Traditional or Second)
- Peer-to-Peer (Prosper, Lending Club)
- SBA Loans
- Micro-Finance Options (Accion, Opportunity Fund, Grameen Foundation)
- Alternative Lenders (Kabbage, Dealstruck, Fundation, Funding Circle, OnDeck)
- Crowd Funding (Indiegogo, Kickstarter, RocketHub, Peerbackers)
- Equity Funding
- Venture Capital
- Angel Investment
- Commercial Mortgage
- Specialized Lenders (Industry expertise, auto, business brokers, high-tech, specialized equipment, etc.)
- Lending Companies (OneMain)
- Finance Companies
The Art of Getting the Money
This starts by knowing what your lender wants. A common way is to simply ask. A better way is to ask a friend or business advisor such as your CPA. Our session 5, Business Organization, includes a comprehensive list of professionals that can help you.
For a business loan, the most common things are
- Business financial statements
- Business tax returns
- Business plan with budget or projection
- Personal financial statements
- Personal tax returns
Be ready to answer questions about your business, and be ready to highlight your financial performance both in the past and in the future. You will be more impressive if you have carefully thought out and become familiar with your plan. Bring your accountant if you need help.
Be prepared to tell lenders why you need the money. "I just need the money," does not inspire confidence or the fact that you have thought it through. Earlier in this session, you studied a number of different purposes. Give them some detail.
Propose a repayment plan. Examples of different structures are
- A line of credit, payable at your discretion but subject to renewal annually by the bank
- Term loan payable monthly over ___ years starting on ____ date
Most places have some flexibility. Potential lenders appreciate that you are thinking about paying them back instead of just getting the money.
Other Quick Tips
- Needless to say, being well dressed and neat in appearance at bank meetings will reflect positively.
- Most lenders (including the SBA) will want to see your business plan.
- Keep your lenders informed on the status of your business: the good and the bad.
- If you are unable to make a loan payment on time, call your lender in advance, advise him or her of the problem and request the extension you need. Explain the sources of repayment.
- Virtually all lenders will do a personal savings and corporate credit check through a company called TRW or by other means. Be prepared to discuss any prior credit issues/problems. The best access to a lender is through a referral. Lending is a people business. Have your CPA, attorney, or friend introduce you to a lender.
- The first thing that will spook lenders or investors is the fear you are "puff" rather than "substance." Avoid giving the impression of being an over optimistic, "pie-in-the-sky" operator.
- As a start-up, do not plan to spend money on expensive entertaining. Your lenders will be more interested in knowing how their money is being used to grow your business.
- Do not depend on a bank to loan you money to start a business. Most small businesses are funded by personal savings.
- Make a shrewd appraisal to minimize your risks and to limit losses to a predetermined limit.
- Your suppliers and vendors can be sources of financing. For example, if you need an illuminated sign for your storefront, the company you contract with to make the sign may provide financing so you can make monthly payments rather than pay cash. Examples of financing from your suppliers include
- Longer payment terms
- Advertising and marketing assistance
- Furnishing or financing of equipment, signs or inventory.
- Advertising and promotional programs
- Bartering, which is to trade by exchange one commodity for another, can provide a source of financing. For example, your advertisements in the local newspaper might be paid for by the bagels you make!
After You Get the Money
Getting the money is only the first step. You should strive to be a good customer so you can get cooperation if you need help later. A good customer sticks to his/her agreement. Make sure you understand the requirements and perform to them as much as possible. In a business relationship, lenders will ask for regular financial statements, which you should produce on time.
There may be covenants. A covenant is a written agreement in which you promise to meet specified obligations such as submitting the agings of your accounts receivable. The "agings" report will show the lenders if your credit customers are paying on time or not.
Be proactive. Contact them if there is a problem. Be sure to stay in touch even if nothing new is going on. Get to the next highest level within the organization.
Sources of financing can surface from unexpected sources: List at least five of them:
Some possible answers are
- Suppliers: Ask for longer terms of payment.
- Your landlord: Ask the landlord to provide you with tenant improvements.
- Your customers: Ask for either cash or prompt payment.
- Your capital investments: Ask the suppliers of your fixtures, equipment and signs to finance your purchases. They will be interested in doing so in order to get your business.
Top Ten Do's and Don'ts
THE TOP TEN DO'S
- Live frugally and begin saving up money now to start your own business.
- Use your cash flow projection as your key tool to determine financing required.
- Complete a business plan for meetings with potential lenders or investors.
- Have your business plan critiqued by appropriately informed people. Revise as necessary.
- Ask the Small Business Administration for advice. (Have your business plan with you.)
- Maintain a current financial information packet including financial statements and recent tax returns.
- Consider bartering services if appropriate.
- Use your CPA or attorney as referrals to lenders.
- Keep your lenders informed of your progress and any potentially adverse events.
- If you need a loan for 6 months, ask for 12 months to be on the safe side.
THE TOP TEN DON'TS
- Expect a bank to help finance your new business.
- Ask for a loan without a detailed repayment plan in hand.
- Overlook vendors and landlords (for tenant improvements) as sources of financing.
- Avoid being the bearer of bad news to your lender.
- Ask for less than enough to meet your realistic needs.
- Exaggerate. (Instead, be conservative in your presentations to lenders.)
- Write a check without adequate funds in your bank account.
- Risk losing your home by taking a "Home Equity" loan unless you are certain of your ability to repay.
- Sign personal guarantees unless absolutely necessary.
- Budget or spend money on expensive entertaining of potential lenders.
Business Plan for Session 4: Financing the Business
You can continue to assemble your business plan. We provided Microsoft Word templates for this section below:
Section 4: Financing
The full template for all sessions can be downloaded as one document: