Financing a Business
One of the most important questions that face all businesses is how to secure financing to begin, continue, or expand operations. In evaluating financing options, a business must consider a variety of factors, including: what types of financing are or will become available, the businesses current balance sheet and financing, the owner’s resources, the length of time the financing is needed for, and the impact on ownership and control of various financing options.
The simplest form of financing is known as “boot strapping.” Boot strapping is a term used to refer to an owner or group of owners financing a start up business via their own personal funds. Often owners not only finance the business with their own funds, but forego receiving a salary until the business becomes profitable. Boot strapping is also occasionally used to refer to financing a business with money borrowed from family and friends. If more than one party is providing funding to boot strap a business, it is imperative all parties involved draw up and sign a basic agreement articulating the terms of the financing. The most important of these terms is a description of the amount given, the terms of repayment, any collateral or equity that is given, and whether the party operating the business will draw a salary and if so, how the amount of the salary will be calculated.
The most important single decision a business will make is whether to seek equity financing or debt financing. Debt financing is traditional borrowing – the business takes out a loan and repays the loan with interest. Equity financing is the process of giving up a portion of ownership in the business in exchange for capital. There are various forms of both debt and equity financing available to businesses.
Debt Financing
Debt financing is the chief method of receiving financing for companies that do not want to give up a portion of their equity. To receive debt financing, a company or its owners agree to repay the loan, with interest, by a stated date. Often debt financing will also involve pledging assets as collateral for the loan. The most common forms of debt financing are:
- Fixed Term Loans: In a fixed term loan, the company receives money in exchange for an agreement to repay the loan in installments over a period of time. Fixed term loans are ideal for purchasing assets with long life-spans and for expanding existing businesses. Fixed term loans will likely be unavailable to fund general business operations, particularly for young businesses. Fixed term loans are the most common form of debt financing.
- Short Term Loans: Loans that come due in a year or less. Short term loans are generally repaid with interest in one lump sum. Short term loans are often used to help finance short term inventory buildups and are generally only available in limited amounts.
- Equipment Loans: Loans that are given for the purchase of equipment and secured by taking the equipment as collateral. Because these loans come with a built in security, they are often easier to get and are often given at lower interest rates than other loans.
- Factoring: Factoring is the name given to a common type of loan in which a business borrows against its receivables. In a typical factoring agreement, a business “sells” its invoices to a third party for a fee, often 2-5%. The business is paid a large lump sum, generally equal to 80% of the value of the invoices. Once the lending company collects on the receivables, they pay the remainder of the amount, minus the agreed upon percentage. Factoring is common among small businesses who have a mismatch between collections and expenses or whose customers take a long time to pay.
- Small Business Administration (“SBA”) Loans: Small business administration loans operate like regular loans, except they are partially guaranteed by the federal government, making them easier to receive. Small business loans are only available to businesses that satisfy the SBA’s guidelines for what constitutes a small business. The SBA defines a small business as one that is “independently owned and operated and not the dominant business in its field.” The SBA also applies specific limits on revenue and number of employees, which vary depending on the type of business. SBA loans require any owner of more than 20% of the business to personally guarantee the loan.
Equity Financing
Equity financing refers to any financing received in exchange for an ownership stake in the business. In a typical equity financing agreement, the business receives cash (and occasionally additionally resources such as consulting services) in exchange for giving up ownership of some percentage of the company. Equity financing is generally “raised” in chunks, known as “rounds.” Early “rounds” of financing are generally more “expensive” (meaning a greater percentage of ownership is required in exchange for the same amount of money) than later rounds because early rounds have a higher risk and the eventual return is further away.
Equity financing can generally be broken down into four types of financing, with several other forms of financing overlapping the four general types. These types are:
- Venture Capital: Also known as “VC”, venture capital funding is the most widely known form of equity finance and also the most difficult to secure. In VC, a venture capitalist or venture capital firm seeks out companies with the potential for extremely large returns. Companies are forced to give up equity and often some degree of control to receive venture capital funding. Venture Capital investors may also provide their expertise and resources to help steer the company towards profitability. Because the ultimate goal of a venture capital investment is to take the company “public,” companies receiving venture capital funding may have to agree to seek an IPO within a certain period of time if circumstances permit.
- Angel Investors: Angel investment is a type of venture capital that occurs earlier in the process (generally investing in the first or second round of financing). Angel investors often invest in riskier businesses than venture capitalists and do not expect immediate returns. In exchange for investing earlier and being more patient, angel investors seek greater portions of equity than venture capitalists. Like VC funding, angel investors want assurances the company will eventually seek and IPO and will often require some form of control in the company. Angel investors will often be more “hands on” with their investments than venture capital firms, making angel investors more appealing to companies in need of additional assistance and less appealing to companies that seek autonomy. Angel investors are often high net worth individuals, but increasingly angel funding is available from angel investing “clubs” or small partnerships.
- Small Business Investment Companies (SBICs): Companies that are licensed and regulated by the SBA but privately owned, SBICs use their own capital, which they can borrow from the SBA at favorable rates to make venture capital investments in qualifying small businesses.
- Sale/Merger: Often a company in need of financing will give up equity by merging into a larger business or selling off a portion of the business to another business to raise capital.
Valuation
A company’s “valuation” is the key to any equity financing arrangement. The valuation is the total value ascribed to the business. Because equity financing is done on a percentage basis, the person providing funding will always argue a business should have a lower valuation (and thus that it takes a greater amount of equity to justify a given investment) and the business will always seek a higher valuation (so the business needs to give away the least amount of equity).
To determine what value was ascribed for a company based on an equity investment, you multiply the amount invested by the inverse of the percentage of equity received. For example, if an investor invests $100,000 for a ¼ ownership stake, the valuation of the company is equal to 100,000 x (4/1) or $400,000.
Other Financing Assistance
Federal, state, and local governments often provide a variety of programs to assist start-up businesses. These forms of financial assistance are often limited to specific types of business, limited duration, and/or specific geographies. Although there are a variety of programs available, two common forms of assistance are:
- Incubators: Incubators are collectives which provide outside support for start-up businesses. Incubators are often sponsored by local governed or non-profit organizations. Incubators vary widely in terms of both the services they offer and the requirements they place on companies that participate. Incubators serve primarily to reduce a start-ups expenses by providing reduced rent in a communal building, office space, and access to reduced rate professional services such as legal services and accounting services. Additionally, some incubators provide for pooled facilities such as secretarial, security, and consulting services that are made available to all participating businesses.
- Grants: Federal, state, and local government entities often provide grants for businesses meeting certain criteria. One of the most diverse grants is the Small Business Innovation Research Grant (SBIR) which is a federally mandated program in which each agency is required to set aside money to invest in small high-tech companies who are developing or marketing products consistent with the agencies mission. Other large grant programs are available to female and minority owned businesses, though competition for these grants is often extremely stiff as funds are limited.
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