How will you finance the business?

Every day thousands of businesses are forced to close their doors. The most common reason given for the high failure rate of small businesses is lack of adequate capital. Capital is any asset that a business uses to create value and generate profits, including financial resources, equipment, and even human capital. Working capital means cash used to operate the business is usually what growing and beginning businesses lack.

Here are some facts you should know about financing your business:

• Most businesses are started with money from personal savings, family, or friends.
• Only about 20% of new business owners start their business with money borrowed from commercial lenders.
• No conventional lending source, private or governmental, will make a commercial loan for 100% of the funds you need to start your business.
• As a rule of thumb, you will need to provide a minimum of 25-30% of personal investment toward the total start-up costs of your business. If you have less than this, your chances of obtaining outside financing are not good.
• Your "sweat equity" will not be considered relevant by the lender.
• As a general rule of thumb, you will need $1.50 in quality collateral for every $1 you want to borrow. For new, and some existing, businesses this typically means equity in your house that can be used to coloateralize the bank loan.
• Although you may think your collateral's true worth is its appraised value or its original cost, its worth to the lender can be far less than either of these values.
• Your financial projections must show that any loan proceeds plus interest and other business expenses can be repaid from business revenues. This option is referred to as "cash flow lending". The assumptions that you base your financial projections on will be examined carefully for reasonability. When the lending decision is being made, having adequate collateral will not override your business's inability to generate positive cash flow.
• Acquiring a loan will be more involved and time-consuming than you think. In the best of circumstances, it will normally take 45-90 days to close a loan depending on conditions in the market and the completeness of your loan package. If you have a complex situation or if the lender needs additional information, the time span may be significantly longer.

Sources of Financing

Funding for a business usually comes in two forms: debt and equity. Debt is obtained from borrowing and must be repaid from cash flow. Equity is contributed by owners or investors and is not normally repaid from operations.

There are several sources to consider when looking for financing. It is important to explore all of your options before making a decision.

• Personal savings: The primary source of capital for most new businesses comes from savings and other forms of personal resources. While credit cards are often used to finance business needs, there may be better options available, even for very small loans.
• Partner: Very rarely does a single individual have sufficient resources to start a company on his or her own. With the right mix, a partner can bring both human and economic capital to the table. Having a partner also spreads the risks involved in running a business.
• Friends and relatives: Many entrepreneurs look to private sources such as friends and family when starting out in a business venture. Often, money is loaned interest free or at a low interest rate, which can be beneficial when getting started. Your friends and family may want to be a part of the company in exchange for the money. Remember, once you bring friends and family into the business, there is little separation between your professional and personal life.
• Banks and credit unions: The most common source of funding, banks and credit unions, will provide a loan if you can show that your business proposal is sound and that you have some money to contribute (typically 20%).
• Angel financing: In angel financing, a private investor or group of investors will contribute money in exchange for an equity stake in the company and perhaps a seat on the board of directors. In many cases, an angel will also contribute expertise, management skills and strategy advice. Angel financing is appropriate if you are seeking anything from a few thousand dollars to $3 - $5 million.
• Venture capital firms: A venture capital fund is a firm that specializes in financing new ventures with capital supplied by investors interested in speculative or high-risk investments that have the potential to provide them very high rates of return. They start where angel firms leave off.

Seek legal counsel to help you review documents and potentially develop the written agreement(s) for ALL loans or equity investments. The first rule here is that if it is not written it is not real!

Loans

Your bank is not a charitable institution. It is in business to make (not lose) money. Consequently, when a bank lends money it wants to ensure that it will get paid back. To maximize the possibility of being paid back, the bank wants to make sure that there is sufficient assurance that a person can pay back a loan and that he or she has met such obligations before. The bank must consider the 5 "C's" of Credit each time it makes a loan. Review each category and see how you stack up.

1. Capacity to repay is the most critical of the five factors. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships--personal and commercial--is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment.
2. Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding. If you have a significant personal investment in the business you are more likely to do everything in your power to make the business successful.
3. Collateral or "guarantees" are additional forms of security you can provide the lender. If for some reason the business cannot repay its bank loan, the bank wants to know there is a second source of repayment. Assets such as equipment, buildings, accounts receivable and in some cases inventory, are considered possible sources of repayment if they are sold by the bank for cash. Both business and personal assets can be sources of collateral for a loan. A guarantee, on the other hand, is just that--someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan.
4. Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender will also consider the local economic climate and conditions both within your industry and in other industries that could affect your business.
5. Character is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. The quality of your references and the background and experience of your employees also will be taken into consideration.

Terms of loans may vary from lender to lender, but there are two basic types of loans:

1. A short-term loan has a maturity of up to one year. These include working capital loans, accounts receivable loans and lines of credit.
2. Long-term loans have maturities greater than one year but usually less than seven years. Real estate and equipment loans may have maturities of up to 25 years. Long-term loans are used for major business expenses such as purchasing real estate and facilities, construction, durable equipment, furniture and fixtures, vehicles, etc.

When reviewing a loan request, the lender is primarily concerned about repayment. To help determine this ability, many loan officers will order a copy of your business credit report from a credit reporting agency. Therefore, you should work with these agencies prior to going to the bank to help them present an accurate picture of your business and personal credit history. Using the credit report and the information you have provided, the lending officer will consider the following issues:

• Have you invested savings or personal equity in your business totaling at least 25 percent to 50 percent of the loan you are requesting? (Remember, a lender or investor will not finance 100 percent of your business.)
• Do you have a sound record of creditworthiness as indicated by your credit report, work history and letters of recommendation? This is very important.
• Do you have sufficient experience and training to operate a successful business?
• Have you prepared a loan proposal and business plan that demonstrate your understanding of and commitment to the success of the business?
• Does the business have sufficient cash flow to make the monthly payments and build a cash reserve?

Financial Worksheets

Now it's time to put some numbers down on paper. A lender will usually use four primary financial statements to make a credit decision.

• Personal Financial Statement
: This indicates your net worth and is important to the lender, particularly if you have never received financing for your business before, because it gives him or her evidence of personal assets you could pledge to secure a loan.
• Balance Sheet
: This provides you with a snapshot of your business at a specific time, such as the end of the year. It keeps track of the company's assets (what the company owns including cash) and liabilities (generally loans from others). It also shows the capital, or equity, put into the business.
• Profit and Loss Statement: Also called the income statement, the profit and loss statement takes the sales for the business, subtracts the costs of goods sold, then subtracts other expenses. A lender will typically need a 3 year projection.
• Statement of Cash Flows: This statement presents the sources of cash in your business - from net income, new capital, or loan proceeds - versus the expenditures, or uses of the cash, over a specified period of time.

We recommend that you prepare the following two financial statements:

• Personal Financial Statement
• Start-up Calculator

If you take the NxLeveL class for Business Start-ups, you will learn more about financing your business and will put together the financial documents that you need.

Once you've compeleted this step, you're ready to move onto Step 5.