In the first of a two-part series on funding your startup, the author gives the lowdown on loans, equity investment, and grants
Getting access to funding when you need it is essential to both emerging and established businesses. So where can you find it? There are far more sources—which are far more accessible—than you may have imagined.
In addition to maxing out my credit cards (yep, I admit it), I’ve funded my own startups in a lot of ways: I factored invoices (sometimes), used a bank credit line (constantly), and took venture capital (once—and then I started my own fund). Your capital acquisition strategy may include a combination of funding sources. It’s smart to diversify, and a blend of debt, equity, and possibly grants is a great idea. Let’s look at debt-based financing first.
Bank and SBA Loans
Upside: Debt only
Downside: Can be hard to get; excessive paperwork
Banks Determine which bank in your community understands the type of company you have. Every six months or so, ask for an increase on your credit-card limit and on your line of credit. Each small increment is worth something.
SBA loans The Small Business Administration’s (http://www.sba.gov) loans are federally guaranteed by the government and must be repaid. The lender is insured against a total loss, typically receiving 75% of the loan amount even if the borrower defaults. Therefore they’re more likely to do riskier deals, which is good news for businesses with fewer than three years of operation.
SBA loans have eligibility guidelines. For instance, your company has to be for-profit, operate in the U.S., and be majority-owned by a U.S. citizen or permanent resident. The SBA will consider your cash flow, your detailed business plan that includes your exit strategy, two-year (or more) detailed monthly financial projections showing an upward revenue trend for your business, plus past tax returns (if you have any—this doesn’t apply to brand new companies).
Every year, the SBA will want to see improved revenues and decreased debt. If revenues are cyclical, that’s O.K., as long as they can see that your expenses have taken into account revenue fluctuations, and profitability targets remain stable. The bottom line is if you have cash flow and assets for collateral, you will likely get a loan from the SBA. If not, they probably won’t take the risk. Again, this is yet another reason to have a solid relationship with your banker, who will help you fill out the extensive SBA loan paperwork and can serve as a co-lender, too.
Personal Loans, Unsecured Loans, Micro-Loans, Merchant Cash Advances, and Asset-Based Lending
Upside: Easy to get; fast cash
Downside: Many have high interest rates; personal loans carry relationship risks
Personal loans. Approximately $100 billion is informally invested in startups each year. Friends and family members alone provide over $60 billion, according to Babson College’s studies on entrepreneurship. They key here is to have a formal financing agreement drawn up by an attorney, which makes it clear whether the financing is a loan, an equity investment, or a gift.
For a loan, the agreement will state the interest rate and payment terms. For an equity investment, it should state the percentage of ownership in the startup. If the startup succeeds and is sold or taken public, the equity investor can rest assured that he or she will be compensated. If it fails, the lender/investor can write off the loss against taxes.
Unsecured loans and micro-loans. I know of three great resources for unsecured business loans. http://TheSnapLoan.com’s loan is based on stated income, credit score, debt-to-income ratio, and years in business. http://Prosper.com also provides unsecured loans based on credit score and debt-to-income ratio, except their loans are provided by individuals and based on an auction model. Another site, http://Count-Me-In.org, offers unsecured micro-loans as well, but for women-run businesses only.
Merchant cash advances. This is also called credit-card receivable funding. Companies providing this service pay cash advances to businesses who meet certain qualifications based on their credit-card sales history. The business then repays the advance, plus a premium, via deductions on future credit-card sales. The advantage is the business receives cash quickly without having to put up any collateral. The disadvantage is that this industry isn’t well regulated, so fees can be high. But this is an option if you can’t secure funding from other sources.
Asset-based lending. This type of financing provides loans against accounts receivable via a traditional line of credit or factoring. With the former, the lender will review your accounts receivable and offer a credit line with an interest rate similar to a bank loan. With factoring, the lender will loan against an individual invoice. The lender may prefer a combination of purchase orders and invoices, since purchase orders state an intention to buy and invoices are issued when the sale is completed. For purchase-order financing, the lender will likely offer 50% to 60% of the amount of a purchase order, and you will have to prove that purchase orders ultimately become invoices.
At one of my startups, after maxing out my credit cards—and paying 20% interest—I discovered factoring, which only charged 5% interest. If you’re paying a 5% interest rate to the factoring company, you may want to offer your customers a discount on their invoices as an alternative. If your customer agrees to pay in 10 days in exchange for receiving a 2% discount on their invoice, you’ve saved the 3% difference you would have paid to the factoring company, assuming a 5% interest rate. And the savings are passed on to your customer.
Upside: Use rapidly depreciating items as collateral
Downside: Can be hard to get or have prohibitive terms
Leasing often makes a lot of sense for computer hardware, cars, and software—things that lose their value quickly and have a high initial cost. A lease line enables you to buy the business equipment you need, using your purchases as collateral for this type of credit line. Search the Internet for equipment-lease lenders in your community, and ask your banker too.
Whew. Let’s take a deep breath and move on to equity-based financing, where we will consider venture capital and angel financing.
Upside: Sophisticated financiers; have lots of money
Downside: Only some will add value; loss of control—meaning they can fire you
Venture capitalists (VCs) generally play many roles, including seeking companies to invest in, assisting in the development of new products or services for their portfolio companies, and adding value to those companies through active board participation. They take high risks by investing in ventures that haven’t yet demonstrated success with the hope they will provide high returns. They typically have a very long-term view. The harsh reality is that VCs assume most startups will fail.
VCs carefully evaluate and screen both the technical and the business merits of the company. During this due diligence process, the VC will conduct research on the market potential, competition, references, financial analysis, and product assessment. Commercial, legal, and personal aspects of the company will be considered, too.
VC financing is very tough to get, and not necessary to build a strong business. That said, many breakthrough businesses have been funded by VCs, including Apple, FedEx, Intel, Microsoft, eBay and Google.
Upside: Increasing amounts are available; money with fewer strings attached
Downside: Sophistication/contribution of investors varies widely
Angel investors are high net-worth individuals who may or may not be savvy in your particular product or industry. “Friends and family” investments can be considered angel financing. Angel investors often have a similar investment philosophy to VCs: They believe in the entrepreneur more than the actual product, so they place their bet on the person with the compelling idea. Investment may take the form of a loan that converts to stock, preferred stock, or convertible bonds. Rarely will the investment be in exchange for common stock.
And the last, but not the least of your funding sources is government grants.
Upside: Free money!
Downside: Government bureaucracy
There are various types of government grants for small business innovation and research. The best thing to do is to check out the Web site http://www.grants.gov to learn more about grants for which you might be eligible. I’ll just mention a few programs where you might start.
The Small Business Innovation Research (SBIR) program helps fund small businesses in research and development efforts that have potential for commercialization. I know one entrepreneur who received over $1 million from the National Institute of Health (NIH) under this program, and she claims that it wasn’t hard to go through the process. Her company secured an SBIR Phase I grant for $150,000 to allow it to prove that its product would work in principle.
Then it received a Phase II grant for $1 million for product development. This helped it attract financing from venture capitalists. Another entrepreneur launched a company to help the hearing-impaired. He received $6 million in both government grants and direct funding from the Army!
Other programs include the Small Business Technology Transfer Program, offered through the NIH, and programs offered via universities. For example, the University of California has a BioSTAR grant program which doubles the money an entrepreneur receives for a project.
Each grant will take about a year to write, submit, get approved, and get funded. If you have the patience, though, you will not only get free dollars but credibility and a pre-fab customer (the government) that will help you attract additional types of capital later.
Know the facts before you accept any type of grant—in some cases the sponsor may insist on owning the intellectual property you develop. Why give away the rights to your company’s product? They’re likely your greatest asset. Research the best type of grant for your needs before you dive in.
Regardless of which financing method you choose, keep your options open. Rarely does it make sense to take on all of the financial risk alone. But if you want to, in a future column I’ll discuss the three ways to finance a company internally, without external money.