WHAT DO YOU NEED TO KNOW?
Before you set out to secure financing for your business you must develop a business plan or financing proposal. This proposal will represent your business to potential investors. The following is a list of information that should be included in a financing proposal:
- Information about your proposed market-Who your customer will be; why they will buy from you; how you are going to attract them.
- Information about the operation -Location, hours, staffing.
- Information about yourself-What qualifies you to run the business? (a resume should help); What is your personal financial situation?
- A list of start-up costs - It will help if you have quotes from vendors or suppliers for major equipment.
- Reasons why you need financing - How are you going to use the money; for how long; how will the funds be repaid; will you use your debt or equity.
- A beginning balance sheet- Showing what you will own (assets); what you will owe (liabilities); and what is the balance (net worth) of the first day of business assuming that financing is approved.
- A pro forma cash-flow statement-Showing how much cash you expect to flow into the business and how much cash you expect to flow out of the business, and for what reasons, for each of the next 12 months. Some financiers may ask for a projection of two years.
- A pro forma income statement- Showing how much profit you expect to make at the end of the year. (This is calculated by subtracting all the expenses from sales.) Again, you may be asked for a two year projection.
- If you are buying a business, you will need the income statement of the business for the last few years, information on why it is being sold, and why you will be able to make it profitable.
- Information on your business plan 12 and 24 months from now.
A good financial proposal takes time, research, and thoughtful consideration. You probably want to consult an accountant to check over your figures before you submit the proposal. The proposal will be judged according to the soundness of the business idea, whether the projections are realistic, and whether it is in line with the investment philosophy of the banker or organization. A judgment is also made on whether the reader is confident in your ability as an entrepreneur.
For help in developing a business plan, visit the Massachusetts Small Business Development Center Network at www.msbdc.org. The organization coordinates a network of offices across the state that provide one-to-one free comprehensive and confidential services focusing on, business growth and strategies, financing and loan assistance as well as strategic, marketing and operational analysis. See the section below for more information.
PROJECTING YOUR CASH NEEDS
Cash flow projections help estimate when, how much and for how long financing is needed. You want to borrow only the amount required and for a reasonable period. The goal is to keep interest expense as low as possible. For example, you do not want to finance short-term needs with long-term debt.
Using the projections, you can also determine when and how to repay your loans or, where an equity investment is used, estimate the amount and timing of dividend payments to investors.
Additionally, your projections can help identify when idle funds could be temporarily invested.
SOURCES OF CAPITAL AND FINANCING
Internal. Funds can be obtained by accelerating collection of accounts receivable, controlling expenses, leasing instead of purchasing equipment, disposing of an unprofitable product line and properly planning for federal and state taxes.
External. Financing may be obtained through debt or equity financing. Each potential source has certain criteria for providing financing. Your ability to obtain financing depends on a number of factors, including: your management team, collateral, cash flow, earnings capacity and the marketability of the product.
Family, Friends, and Personal Savings. In the earliest stages of development, traditional or venture capital financing is frequently not available to a new business. During this period, financing assistance from family, friends, and personal savings is often necessary to bridge the gap until you are in a position to draw on other sources of capital. Later, when you need to seek funds from prospective investors, they will take a favorable view of situations where you, as an entrepreneur, have committed a substantial portion of your personal wealth to the venture.
Other Sources. Other sources of debt financing that would provide a more likely avenue for a new venture would include personal loans, loans through finance institutions to riskier and newer companies that a commercial bank might not consider (usually with a high interest rate), credit unions (for small amounts,) re-mortgaging your home, loans against life insurance, pledges or selling of notes, or contracts and bills of lading or accounts receivable (factoring), loans against inventory and credit cards. Sale-leasebacks can be a source of funds for equipment acquisitions.
Banks. While new ventures generally are considered too risky to secure capital from a traditional lending institution, some banks are increasing their commitment to new business ventures. In most cases, banks will provide significant funding only after a company moves beyond the development stage. Some banks, however, are willing to lend to small businesses to finance fixed assets, inventories and accounts receivable. Where substantial collateral is available - including personal guarantees - a bank's risk declines and its willingness to make loans rises.
Massachusettshas a program that has been designed to ease small business owner's access to bank funds. It's called the Capital Access Program (CAP). $5 million has been committed by the Commonwealth of Massachusetts to provide "cash collateral" guarantees to banks willing to make loons to smaller businesses.
Here's how it works:
- The Borrower applies to a participating bank
- Bank and borrower negotiate all loan terms including pricing and guaranty premiums.
- Bank commits and funds loan using its own documentation.
- Bank notifies Massachusetts Business Development Corporation, who then provides the "cash collateral" guaranty to the bank.
For more information on the Capitol Access Program and for a list of participating banks, please contact:
Massachusetts Business Development Corporation
500 Edgewater Drive, Suite 555
Wakefield, MA 01880
If you are starting up a new company, you should not immediately dismiss banks as a potential lending source. Take the time to visit the banks in your area. Many banks have venture capital subsidiaries that operate in essentially the same manner as private venture capital firms. So if you fail to get a loan through traditional bank channels, a bank's venture capital firm might agree to back your company.
Private or Exempt Public Offerings. Where the amount of an offering is small and the number of investments is limited, a small growing business may be able to raise capital without fully registering with the Securities and Exchange Commission or similar state commissions. While this is unlikely to be an attractive source of financing for a start-up venture, it may be of interest to a company in an expansion phase. The entrepreneur should review with consultants the appropriateness of this financing source, considering such factors of money costs, the time lag between initiation and actual financing, the amount of financing required and the complexities introduced by having private shareholders.
Registered Public Offerings. Full-scale registration with the SEC and the state authorities is required when the amount of financing or the number of investors involved exceeds certain limits. The SEC registration requirements for small public offerings are not as stringent, but since some state lows are more restrictive, these relaxed requirements may have little significance. As with private placements, most small ventures will not view public offerings as an attractive financing source due to the time, cost and registration requirements involved, including substantial accounting and financial statement information and the acceptance of ongoing obligations of outside shareholders. Legal and accounting consultation is, of course, imperative.
For a database of financial resources available in Massachusetts, click here. (link to wherever our financial resources database is).
Partners. Equity financing can be obtained by forming a partnership or by taking in additional general or limited partners.
Incorporation. Another decision might be to incorporate and issue (or, if you are already incorporated, issue additional) common or preferred stock, convertible debt or debt with warrants attached. Your issue could be privately placed or you could go public. Venture capitol could possibly be obtained, depending on the stage of your firm's life and the industry.
Briefly, common stock pays dividends according to profits, whereas preferred stock generally pays only a fixed amount each year. Convertible debt is debt that can be converted into common or preferred stock. Warrants enable the holder to buy shares of stock at predetermined prices. Private placements are made to a limited number of investors, as opposed to a public offering, which is made to the general investing public. Generally, venture capital is provided by sophisticated investors willing to undertake high risk on the chance that the payoff will be very large.
The U.S. Small Business Administration (SBA) provides financing to small businesses through guaranteed loans made by private lending institutions. Contact any commercial bank for more information.
The SBA 504 Program uses local development companies to provide long-term financing for fixed assets with a useful life greater than 15 years. For further information contact the SBA at (617) 565-5590.
Small Business Innovation Research (SBIR) Grants were created as part of the federal Small Business Development Act of 1982. Coordinated by the SBA, the SBIR program is designed to fund research and develop efforts which will result in bringing new products and services to the marketplace. An SBIR grant provides "idea" money for would-be entrepreneurs to use as seed capital in business start-up and for innovative science and technology-based companies to use in bringing new ventures to commercialization. By leveraging this government-funded "risk" research with private-sector financing, the SBIR program not only converts new innovations into useful products and services but also creates new business and jobs in the process. The goal of the Act is to stimulate technical innovation and encourage small scientific and high-technology companies to participate in government-funded research. The Act also provides funds for converting the results of research into commercial applications.
In order to qualify for SBIR grants, companies must conform to the federal government's definition of a small business at the time of the award. According to the program's criteria, a small business must be:
- A U.S. corporation.
- Independently owned and operated with 500 or fewer employees.
- A for-profit publicly or privately held corporation, sole proprietorship, or partnership.
- The primary source of employment for the principal investigator during the grant period.
These rules do not require that the business be established at the time a research proposal is submitted. The applicant can be employed by another company and start a new business upon receiving an SBIR grant. Also, two or more companies can enter into a joint venture, provided they qualify under the above criteria.
Under the Act, all federal agencies with research and development budgets in excess of $100 million are required to award a portion of those funds to small business through an SBIR grant program. Eleven federal agencies are now required to set aside portions of their R&D budgets under the program. They are:
- National Association of State Development Agencies
- National Science Foundation
- Nuclear Regulatory Commission
- Environmental Protection Agency
- U.S.Department of Transportation
- U.S. Department of Health and Human Services
- U.S.Department of Defense
- U.S.Department of Education
- U.S.Department of Energy
- U.S.Department of Agriculture
- U.S.Department of Commerce
The Research and Development Limited Partnership. This creation of the federal income tax laws has been used by both new companies and established businesses to finance research and development costs related to specific products. Because of tax law changes, R&D limited partnerships have gone through a transformation during the past few years. They used to be private placements with significant leverage. Now they are public funds without leverage and a broad portfolio of projects that are more similar to venture capital funds than anything else.
In this type of partnership, limited partners invest a specific sum that is managed by one or more general partners. The partnership then contracts with the entrepreneur to conduct research and development in exchange for certain ownership rights in the results of the R&D work. The entrepreneur retains a right to buy back the end product of this work. Because RED expenditures are currently deductible, the partners share in deductions in amounts equaling up to 80 or 90 percent of their investment in the year the R&D expenditures are incurred. However, as with other tax-favored investments, the "passive loss limits" and other provisions of the Tax Reform Act of 1986 may serve to limit or eliminate the deductibility of losses flowing from an R&D partnership and thus reduce the after-tax rate of return on the investment. If the R&D work proves successful, the entrepreneur will exercise the right to buy back the technology, generally in exchange for a percentage royalty payment based on future sales.
Even after tax reform, the R&D partnership continues to be a viable financing source for project-oriented research in the right situations. There are risks, however, caused in part by the complex structure involved and by the fact that tax law in this area is still developing. Accordingly, consideration of an R&D limited partnership will necessarily require the careful and continuing involvement of an attorney and accountant.
Further, the majority of R&D limited partnerships meet the definition of a tax shelter and may be required to be registered with the IRS as such.
Venture capital firms are generally privately owned. In most cases, they seek to generate a high rate of return by investing in rapidly growing businesses in all stages of development. Venture capital firms may be formed as general or limited partnerships composed primarily of institutional investors or wealthy individuals, Small Business Investment Corporations licensed by the federal government, subsidiaries or divisions of major corporations or lending institutions.
Most venture capital firms will seek investment where they expect to make a high rate of return - often 10:1 or higher - in order to maintain an annual rate of portfolio return of at least 30%. Since most new ventures fail, these high rates of return are required to offset the risk the venture capitalist assumes.