By: Dileep Rao, Ph.D.
Where and how you finance an operation can be the difference between dominance and failure. All money may sound like good money in this environment. It isn’t.
Often it makes the most sense to tap a few different sources of capital. One deal I arranged involved seven funding sources. That sounds like a hassle, but it ended up greatly reducing the company’s cost of capital and saving it from bankruptcy.
There are myriad financing sources available for American entrepreneurs (see Handbook of Business Finance atwww.uentrepreneurs.com). Here are the 12 best, from least attractive to most. Two glaring omissions: venture capital–VCs fund just 3,500 of the 22 million small outfits in the U.S., and they only tend to hunt for companies with the potential for torrential growth–and a founder’s own savings. If you don’t know by now that financiers want to see some of your own skin in the game, you may already be in over your head.
12. Angel equity. If you must sell an ownership stake to get your company off the ground, start by finding a respected industry executive who is willing to invest a reasonable amount and give your venture credibility with other investors. The advice and networking–without all the heavy-handed demands of a VC–come in handy, too.
In Depth: 9 Alternative Ways To Raise Cash Now
Checklist: The 20 Most Important Questions In Business
11. Smart leases. Leasing fixed assets conserves cash for working capital (to cover inventory), which is generally tougher to finance, especially for an unproven business. Warning: Don’t put so much money down that you end up spending the same amount of cash as you would have had you bought the asset with a down payment. The cost of a lease may be slightly higher than bank financing (see source No. 10), but the cost of the down payment you did not have to make is likely to be less painful than the dilution you suffer from giving away equity.
10. Bank loans. Banks are like the supermarket of debt financing. They provide short-, mid- or long-term financing, and they finance all asset needs, including working capital, equipment and real estate. This assumes, of course, that you can generate enough cash flow to cover the interest payments (which are tax deductible) and return the principal.
Banks want assurance of repayment by requiring personal guarantees and even a secured interest (such as a mortgage) on personal assets. Unlike other financing relationships, banks offer some flexibility: You can pay off your loan early and terminate the agreement. VCs and other institutional investors may not be so amenable.
9. SBA 7(a) loans. Of all the federally sponsored debt-financing programs, this is the most popular, and perhaps the best. It loosens the flow of credit by guaranteeing the lender against a portion of any loss incurred on the loan. Not to say that banks aren’t careful when making 7(a) loans: They are required to keep the non-guaranteed portion on their books.
The interest rate can vary based on the size of the loan, with smaller amounts costing a little more. Shop around. Some banks reap servicing fees and nice profits by selling the guaranteed portion of the loan to insurance companies and pension funds; in those cases, a lender may be willing to offer you a better rate.
8. Local and state economic development organizations. Economic-development organizations can charge tantalizingly low interest rates when lending alongside a bank.
Say you need to raise $200,000 for a building. A bank may offer $150,000 on a first mortgage at a variable interest rate of prime, now 3.25%, plus 200 basis points, for a total of 5.25%. The local development entity might lend you another $30,000 on a second mortgage at a fixed-interest rate of 4%, without seeking equity shares or warrants. (Without the development corporation’s contributions, you would have to scare up $50,000 in equity–expensive.) If you don’t have the cash flow to cover the interest, the development organization may offer extended terms. Some loans are interest-only for the first year or two, and even the interest payments can be accrued for a certain time period.
Development groups may not agree to finance an entire operation, but they make snagging the remainder from other private sources a lot easier. Talk to your local chamber of commerce to find these programs. (Also checkwww.infinancing.com for a list of the types of development finance organizations).
7. Customers. Advance payments from customers–assuming the terms aren’t too onerous–can give you the cash you need, at a relatively low cost, to keep your business growing. Advances also demonstrate a level of commitment by that customer to your operation. About half of the world-beating entrepreneurs in my book, Bootstrap to Billions (seewww.dileeprao.com), were funded by their customers. This strategy allowed them to grow faster and with limited resources, and to operate with relative impunity with respect to their investors.
6. Vendors: Dick Schulze built Best Buy with financing from large consumer electronics firms–in other words, his suppliers. This way, your financiers do not control your growth; you do. Just be sure not to enslave yourself to a handful of powerful suppliers in the process.
5. Friends and family members. If you’re lucky, friends and family members might be the most lenient investors of the bunch. They don’t tend to make you pledge your house, and they might even agree to sell their interest in your company back to you for a nominal return.
4. Small Business Innovation Research (SBIR) grants. Getting past the paper-intensive application process and SBIR grants can be a great way to turn your intellectual property into mailbox money. For more on these grants, check out How To Get Uncle Sam To Fund Your Start-Up.
3. Tax Increment Financing. TIF subsidies are geared toward real estate development in targeted areas. Depending on the state, the subsidies can be as large as 20% to 30% of the cost of the project. Better yet, you may even be able to borrow against this subsidized value. If your own community does not offer a TIF program, look at communities that do. You may end up a little farther from your home or office, but it could be worth your while.
2. Internal Revenue Service. No, the IRS does not lend money. But it does allow you to deduct expenses. If you are paying a heap in taxes, evaluate whether you can use your profits to expand your business–and reduce your tax bill.
1. Bootstrapping: Many billion-dollar entrepreneurs find a way to grow without external financing so that financiers don’t control their destinies or grab a disproportionate slice of the wealth pie. For more on the sound strategic thinking you’ll need in order to live on your own cash flow, check outThe 20 Most Important Questions In Business.
This article was taken from www.forbes.com Dileep Rao has financed over 450 businesses. He is the author of Bootstrap to Billions: Proven Rules from Entrepreneurs who Built Great Companies from Scratch and Finance Any Business Intelligently. For more information, please go to www.uEntrepreneurs.com.
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