When searching for external financing, business owners have two primary alternatives, debt and equity. The most common form is debt financing, which includes any form of a loan or receipt of money that must be paid back, typically with interest. In the Private Capital Access (PCA) Survey, a quarterly study conducted to gauge the demand for and access to financing for 3,175 businesses of varying size, we learn that although larger businesses do find it easier to secure financing, more than 68.7 percent of small firms compared to 45.3 percent of large firms stated that they find it difficult to obtain debt financing. The second alternative is equity financing in which a company relinquishes a portion of ownership of the company to the outside investor. Sources of equity financing include angel investors, venture capital, and private equity. In the fourth quarter of 2013, the PCA Index Survey results indicated that 66.5 percent of business owners felt that securing equity financing was difficult, a 1.5 percent increase from the third quarter.
Typically, businesses seek additional capital in order to expand their current operations via growth or acquisition. Other purposes include capital fluctuations, replacing equipment or facilities, subsidizing declining operational conditions, and withdrawing wealth from owners. The ability to access financing for these functions is largely based on size and age of the company. “As business size gets smaller, access to capital shrinks dramatically,” states Jeff Stibel, Chairmen and CEO of Dun & Bradstreet during the Committee on Small Business hearing with the U.S. House of Representatives. In the PCA Survey, companies are considered mid-sized (or lower middle market) if they generate $5-100 million in annual revenue. Small companies are those that generate less than $5 million in annual revenue. We will use these definitions throughout this step-by-step guide.
Step One: Planning a Profitable Path
The first step, of course, is the planning process. Although the size of your firm and the severity of your need for financing determines the duration of the planning process, it is best to attempt to begin 6 to 12 months prior to actually pursuing capital. Smaller firms may need more time during the planning phase in order to organize and create the necessary financial documents to move forward, whereas, a larger firm may have more resources in order to accelerate this step. This allows enough time to assemble and verify the firm’s financial statements. Many sources of financing require three years of historical financial statements. Although it is not necessary at this point to have the past financial statements audited, it is wise to have them in “auditable” condition in case it becomes necessary later. Having this vital information readily accessible will also help determine how much money the company really needs in order to expand.
This process can be enlightening. Upon examining their own financials, many business owners realize that they must change their financial approach in order to attract capital. For example, many owners try to minimize their firm’s earnings before taxes for tax purposes which will reduce net income, only to discover that they should maximize net income in order to entice outside investors to participate who do not recognize the importance of cash flow. It is critical to have enough lead time to make any necessary adjustments, such as reducing or eliminating personal expenses and discretionary items from the business. Business owners must also be prepared to explain to investors why the company needs the money and how the funds will be utilized. Clean financial statements will help tremendously in this effort.
One strategy that should be considered is studying the success of other firms that are similar to yours—either in size, industry, location, etc. Identify where they have had success raising capital and make plans to consider those same options. It is also a good idea to review the satisfaction rates of the types of funding that are being considered. In the fourth quarter of 2013 in the PCA Survey, 7 percent of small firms and 0 percent of large firms secured funding via debt crowd funding, however only 33 percent of those firms were satisfied with the pricing and contract terms. Crowd funding is an approach in which a business accepts small amounts of capital from a large group of people, or a “crowd.” However, with this level of satisfaction, this should be a warning sign to those considering crowd funding and may convince them to consider other sources for their capital needs.
Questions to Answer:
1. How much money do we need?
2. How will we use this money to increase our operations?
3. What types of financing might be available to us?
4. What types of financing have been most successful for companies that are similar to ours?
5. How will this financing choice affect my control and my capital structure?
Step Two: Evaluating Strategic Fit
After formulating the plan, the most suitable type of financing must be chosen. Understanding the various sources of financing is critical. Bank loans are typically the most popular source, but as with all funding sources, it is very important to understand all of the terms and conditions. When deciding between a debt or equity path, you should also consider what materials will be required in order to show your company’s current financial standing and future expectations. These vary between the two financing options. An equity provider, such as a venture capitalist, may require a business plan and proforma financial statements whereas a bank providing a debt loan will only want to see how you’ve been profitable over the past three to five years. Knowing what documents will be required of you and having them prepared can make your financing campaign more manageable.
Just because a source of financing is available does not necessarily mean that it is appropriate. Companies that are small or newer to the market have a unique issue due to the low levels of cash resources available to them. Due to their small size, they may not be able to handle regular loan payments because they need their money readily accessible to cover other expenses and liabilities. Thus, equity financing is often the best option for companies that have not yet garnered the financial strength of their larger counterparts. On the other hand, large companies may have stable finances and more assets. Therefore, debt financing is frequently an attractive option. Since the cost of debt is almost always much lower than the cost of equity, most companies will select the former when they have the choice to do so.
Equity investors usually only receive a return on their investment when the company is sold or goes public. Small, closely held businesses may provide a stream of dividends to the shareholders (often family members or close friends), but these payments reduce the funds available to be reinvested into the business and are an expensive after-tax cash flow. In addition, the return associated with the dividends is usually small. Thus, in order to attract equity investors, the business must be on a growth trend that would allow an acquisition or IPO to occur within approximately five years.
Questions to Answer:
1. How much can we afford to pay in regular payments with our current revenue stream?
2. Which form of financing do we have the best access to?
3. Is it easier for our business to make regular monthly payments or concede equity in order to expand?
4. Is there a realistic path to growing and selling the business fast enough to attract equity investors?
Step Three: Pursuing Specific Capital Providers
Once the preferred method of financing has been selected, there are several key factors that must be considered in finding the right people to help complete the process.
First, it is important to seek out capital providers that have experience with firms in the same industry as well as with firms that are a similar size. These are the providers that will best understand any specific needs that must be fulfilled in order to ensure success. Second, capital providers that have compatible personalities are preferred. They should work well with others and be willing to provide mentorship and guidance. Working with providers that are ethical, accountable, trustworthy, and reliable is very important. It is critical to remember that venture finance is a small industry and working with a financier that has a good reputation with others will open many doors. Third, if a capital provider is legitimate, then they will most likely have an extensive professional network. They can provide the necessary introductions that will facilitate meeting new potential partners, mentors, or clients. Selecting providers close in geographic proximity could also assist in fostering a long-term business relationship.
Questions to Answer:
1. Are the financiers I am approaching well-known and respected?
2. Do they have experience in my industry?
3. Am I being granted access to their network of executives and professionals?
4. Have they “priced” themselves competitively?
Step Four: Negotiating Final Term Sheet
The term sheet is a document that lists the terms and conditions of the deal. Once the term sheet is agreed upon by both parties, it is translated into the actual legal contract for the transaction. Although the term sheet is intended to be comprehensible by all parties, it is often very confusing to people that are inexperienced with these types of deals. Thus it is very important to have an experienced mentor or advisor review the term sheet and explain it. A good advisor can also identify which deal terms are negotiable and which are not. An attorney may be useful, but only if they have significant experience with these transactions. Failure to read and understand the terms can result in missing important provisions such as late payment fees, updated equity percentages, early payment penalties, future company restructuring, and more. The first draft of the term sheet will be written by the investor and thus it will contain provisions that heavily benefit their side. Many of these terms, particularly with equity investors such as private equity groups, venture capitalists, and angels, can be negotiated to the benefit of the entrepreneur. Hiring an experienced attorney or advisor will help ensure that everyone is well-protected in the deal. It is important that both sides discuss any unclear items to ensure a meeting of the minds.
Questions to answer during this step:
1. What do I want to achieve and what am I not willing to give up for this deal?
2. Who can I bring on as an advisor to help understand and negotiate the term sheet?
3. Can I reasonably meet all of the terms in this deal?
4. Are there any ambiguous terms that need to be addressed further?
Common Pitfalls or Missteps Business Owners Make
While searching for external capital, business owners often make mistakes that fall into one of two main categories. The first is being overconfident and unrealistic in their financial expectations. Business owners imagine that they will be able to secure all the financing they need without too much effort on their part and without outside assistance. The second is the shotgun approach. Many business owners fail to follow a plan and begin sourcing capital without doing any homework or having their financial statements in order. The issue with these two mistakes is that they can be extremely damaging to the financing efforts, as well as to the business in general. Failure to formulate a well-developed plan could result in slower business growth, layoffs, hiring fewer employees than originally planned, selling business assets in order to survive, or shutting down the company.
Another common mistake owners make is comingling personal and business assets too heavily. For example, a number of owners utilize business resources when making personal purchases for large items such as vehicles or smaller items such as copy paper. This is commonly and incorrectly considered “owner’s draw” and one must be extremely careful as there are a number of tax implications in taking distributions this way. Owners must be especially careful of this when seeking external financing, as capital providers will want to see that they are funding the business and not the owner’s lifestyle. Equally troubling, some owners transfer their personal assets to their business. Although this shows initiative on the owner’s part, this again is dangerous as investors want to be assured that a business can sustain on its own without having to constantly be bailed out by the owner.
As an owner, it is imperative to approach financing in a thoughtful and calculated manner just as with any other business endeavor. Taking the time to develop a strategic financing plan will demonstrate initiative and improve the chances of securing capital.
One opportunity for related research is to develop and test a hypothesis regarding the ramifications of repeated transfers of personal assets to a distressed business.
Access to capital is an issue for any company at any size. The ability to obtain external financing can be critical to the growth and success of a business therefore it must be approached strategically. Firms that are able to secure additional capital grow at a much faster rate than companies that do not. This article is intended to assist business owners in improving their decision-making process, increase their capital financing success and avoid the pitfalls that many business owners make.
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