Getting a small business off the ground is a huge achievement, but establishing financing on a solid footing is critical to whether an enterprise ultimately succeeds or fails.
As a banking officer dealing with financing requests every day, the most common question I hear from founders of startups is, “Should I finance with equity or debt?” I’m here to tell you, there are no pat answers. And even worse, it can be a life and death decision: More than 500,000 businesses are established in America annually but half of them fail within five years. The No. 1 reason for failure is a bad strategy backed by surplus optimism, but the next biggest cause of failure is a lack of funding.
Small businesses attracted nearly $1.2 trillion in financing in 2015, according to the Small Business Administration — almost $600 billion in bank loans and $593 billion from other sources, such as finance companies, angel capital and venture capital. However, when it comes to funding startups, only 8 percent of capital comes from bank loans.
Bootstrapping startups requires financial creativity. Personal credit cards are used for 8 percent of funding with another 2 percent from business credit cards. Home equity loans supply 3 percent of capital needs while other personal assets made up 6 percent of startup capital. One quarter of all startups use no capital to get going while 57 percent draw on personal savings.
Here are some considerations for startup entrepreneurs seeking capital.
Credit card debt: This type of high-interest debt, often costing 13 percent or more, can work for small capital needs like those required by a services firm that needs some computers and office equipment to start selling its services and generating cash flow. For larger amounts, capital should be established on a more permanent footing.
Personal savings and home equity: Business owners should invest their own equity first before taking on debt or seeking investments. Savings should be considered first because there is no required repayment and you won’t have to share the profits later. Home equity lines can also be good sources of inexpensive capital and are the next obvious personal source, but should be established before you need the capital. A key consideration for home equity loans is how you will repay the loan if the business takes longer to turn cash positive.
Friends and family: Investments from friends and family often have favorable terms. Family members can be the most patient investors, perhaps not demanding profits or only seeking their principal returned if the business is sold. Friends may offer less onerous terms than other equity investors, too. Such equity builds the firm’s balance sheet before adding debt.
Angels and venture capital: Angels are accredited investors with expertise in a particular industry who buy equity in early-stage startups and can offer invaluable mentoring. The average angel investment is $345,000. Only certain types of startups can attract venture capital. VCs are only interested in rapid-growing companies that they can sell at a significant profit, typically within five years, by selling to other investors or by taking the startup public. VCs seek out firms with low starting valuations, such as tech companies and medical devices makers, that can rapidly build a higher valuation. These deals average about $12 million, however, venture and angel capital combined make up less than 2 percent of all small business financing.
Debt: Businesses without cash flow will have a hard time securing debt, but Small Business Administration loans, available at SBA-approved lenders, can offer more flexibility than conventional loans. Many small businesses start with a series of several SBA loans before graduating to conventional loans when they have an established track record. When seeking any kind of bank debt for a startup or early stage business, the owners need to be able to demonstrate certainty of their ability to repay the loan.
Don’t forget the five C’s.
By the time a company seeks capital, it should have a solid business plan that will address the five Cs of credit — how much capital is being invested, is there collateral that will serve as a backup source of repayment if the business fails, is there historic cash flow to support the loan or an ongoing outside source of repayment, how solid is the character of the borrower (as evidenced by his or her credit score and ability to handle debt) and finally, what are the conditions impacting the industry.
Cash flow is the most important consideration, so being able to demonstrate the ability to repay from historic cash flow is very important. SBA loans allow borrowers to extend the repayment period and qualify for a loan when a shorter conventional repayment structure might not work. Startups and businesses with a shorter track record may be able to get an SBA loan, but they need to demonstrate solid sources of revenue that will support the debt.
Lenders will want a first lien on business assets and will also look for personal collateral, such as home equity, in the event of a shortfall. SBA rules do allow lenders to look past collateral issues, but they are required to take personally owned real estate if it holds worthwhile equity.
When it comes to character and credit history, lenders are wary of borrowers that have used a high proportion of their available revolving credit, so business owners should reduce such debt before seeking bank financing. If you pay off your credit cards each month, paying a few days before the due date can dramatically change these ratios. Any slow payments, judgments and bankruptcies will also be problematic.
Bankers will also consider market conditions. A couple of years ago, for example, credit markets were inundated with loan applications for yogurt shops — a sure indication of a fad.
Beware tactical and structural errors.
Before seeking a loan, borrowers should compile their accounts correctly. For example, firms that are investing to expand quickly can have a negative cash flow — a tactical error when seeking funding. Instead, cash flow from existing products should be separated from R&D, with those expenses put on the balance sheet and amortized. SBA loans can overcome some problems, but it’s almost impossible to overcome a lack of cash flow.
The company’s structure also informs funding. A sole proprietorship, for example, cannot sell equity. An S corporation can only have a maximum of 35 owners and must distribute profits in proportion with its equity. For example, a 5 percent ownership must yield 5 percent of profits or losses. However, an LLC can separate profits from losses. For example, an early investor with 5 percent equity might have a 10 percent call on profits and only a 5 percent responsibility for losses until all equity has been returned, after which it becomes an equal profit and loss distribution.
A C corporation can have many investors but has some features that can help with initial funding. For example, a C corporation can have a self-directed 401(k) and the owner can roll over retirement savings into that plan and then invest those funds in the business. (This is tax efficient, however, if the business fails those retirement savings can be lost.)
The bottom line is that entrepreneurs need an effective capital strategy to expand and build a business. That strategy can be created with the help of a small business banker, lawyer or a CPA specializing in small business formation. Free or low-cost advice is also available at local SBA offices or from such mentoring organizations as the Service Corps of Retired Executives Association or Mi Casa, which helps women realize business goals.
Getting the structure of the company and the capital set up correctly at the start is a lot of work, but it can save a lot of headaches later.