Every Business Needs Capital
Whether a business is starting up, scaling (growing/maturing), or transitioning, some form of capital needs to be in place. If a company is “homegrown,” the capital comes from the owner (commonly referred to as “bootstrapping”). If a business is scaling, it may come from operating cashflows. When owner capital is not available, or cash flows are not enough to cover conditions such as seasonality, expansion, or restructure, a business will look for funds from outside sources.
It is essential to know:
- How much capital the business needs
- What type of capital should be used
- When the capital will be needed
- How to go about obtaining the capital, and
- The source of the capital
How Much Capital is Needed?
When a business is starting up, a comprehensive business plan should be in place. A well thought out business plan will identify the vision and mission and analyze market conditions with a marketing plan and a financial plan. The financial plan should include short-term assumptions with budgets and long-term assumptions with projections. From this plan, cashflow forecasts are generated, identifying how much working capital is needed at any given time throughout the period being planned.
For a scaling business, having a comprehensive business plan is advisable to ensure that capital is available to meet the needs that arise during each stage. When prepared properly, this plan identifies how much capital should be available to keep the business on track.
When a business is preparing for a transition, a valuation helps determine if enough capital is available for the company to provide the owner (seller) with the expected proceeds. If the business supports this valuation, the buyer should be better positioned to obtain the capital necessary to fund the purchase.
In each of these cases, having outside professional advisors can help assure that the right amount of capital is available to run the business under varying conditions successfully.
What Type of Capital is Needed?
Capital comes in two forms: Debt and Equity
Debt is borrowing from a lender, and the debt must be paid back at a specified time, usually with a specified amount of interest. Debt becomes a liability for the business on the balance sheet. Often, this debt must be secured by something of value, and the lender (the creditor) will have priority rights to get repaid per the agreed-upon terms.
Equity is a form of capital that provides an investor with some ownership in the business. Generally, equity does not get paid back but gives the investor a percentage of profits and dividends.
A professional finance expert can help determine which form of capital works best, based on the circumstances and needs.
When will Capital be Needed?
A fundamental reason for planning is to ensure there is enough capital in the business when it is needed to keep operations running smoothly. Sufficient lead time should be given for this purpose. It can often take several months to get funding. Therefore, the process should begin early enough, so that capital can be in place when it is needed.
How will Capital be Obtained?
Investors will require that specific information be provided, including the following:
- Comprehensive business plan
- 2-3 years historical financial statements for an existing business
- Two years of income tax returns for an existing business
- 2-3 years financial projections, possibly longer for a startup business
- Explanation of how the funds will be used and how they will be repaid
- Personal and business credit history/score
The information provided to prospective investors should be professionally-presented. All financial information be consistent and accurate. It will be essential to demonstrate to the investor there is reasonable comfort that the expected return will be realized.
It is always good to have the presentation of information prepared by, or reviewed by, a professional finance expert. There may be only one chance to make a good impression.
Possible Sources of Capital – Debt
If the best source for capital is determined to be from debt, there are several options to consider. The right choice will depend on the amount of capital needed and how quickly it can be repaid.
Family or Friends – If there is a good chance that this can be done, it may be the easiest way. Agreements with family and friends should be in writing, with the appropriate risk disclosures, to avoid misunderstandings. The possibility of strains on relationships should also be weighed.
Credit Cards – This method can be a fast source of capital but can become expensive if abused. If done wisely, it can also help build a strong credit report.
Traditional Bank Loan / Line of Credit – Banks are in the business of lending money. If the business has a good history and solid plan, loan terms can be favorable. The sooner a relationship is built between the bank (lender) and the company… there are better opportunities for favorable loan terms.
SBA Loans – This is a method to try when a business can not get a traditional bank loan. The application process can be more cumbersome, but the qualification requirements may be easier to meet. SBA loans are funded by banks but guaranteed by the SBA.
Crowdfunding – There are several forms of crowdfunding available. In the past, most of these methods were designed to get a small amount of funding in exchange for non-cash exchange, such as discounts or products. At the current time, there are several funding sites which provide a facility for reaching investors (generally multiple small investors).
A financial professional can provide guidance and advice on which of these options, if any, would be good for the business.
Possible Sources of Capital – Equity
If a business is willing to concede some percentage of ownership and profit sharing in exchange for capital, an equity offer can be a good option. There are several ways this can be accomplished:
Family and Friends – If this is a more enticing way to get acquaintances to invest, this can be an option that works. As in the case above, be sure everything is written and disclosed, so there are no misconceptions.
Angel Investors – These are investors who are knowledgeable in this business, usually an individual or small group, who will provide equity and want to be involved in the management or other ways. The amount received under this arrangement is typically under $1 million, and they generally are looking for a 25% or higher annualized return.
Venture Capitalists – These tend to be investment groups that are industry agnostic and manage a portfolio of investments to diversify. Venture Capital firms are very selective in their investments and generally don’t want to have any direct involvement. The average investment size is currently over $5 million, and VCs tend to look for annualized returns above 20 percent.
Private/Public Offerings – If a business is willing to spread control around multiple investors in exchange for a large amount of capital, this method could work. It can be offered privately (e.g., Private Equity) if limited to 100 accredited shareholders; or offered publicly through an “IPO.” Public offerings are regulated by the Securities and Exchange Commission (SEC) and require significant disclosure. There is virtually no limit to the funds that can be raised through this option. However, the expense involved, using an investment banker, can be significant.
Other Financing Alternatives
The more common ways to raise capital are those mentioned above. Some other ways can be very acceptable, and in some cases, very appropriate:
- Factoring – This is a financing method that involves a business “selling” its customer receivables to a financing entity (or “factor”) at a discount (generally 2-5%) in exchange for cash upfront. The factor will also hold back as much as 20-30% of the receivable amount until collected as a risk “reserve” for non-collectability. This reserve is released (paid) once the funds are received. The factoring entity, in turn, invoices and collects from the customer. A better credit standing of the customer can result in a lower discount and smaller risk reserve withheld from receivables. This is a way to accelerate cash flow but should be used wisely.
- Vendor Financing – This would involve a supplier agreeing to defer payment on invoices for the business’s products. Depending on how preferred the business is as a customer, favorable terms can be negotiated at a savings compared to using a line of credit.
- Customer Discount – Offering a special discount to a customer to pay in advance or early can be a way to avoid the need to use a factoring facility.
- Joint Venture – This can be a form of equity exchange, perhaps where the business provides a service, and the JV partner provides the capital in the arrangement. In this case, each partner is getting something of value out of the relationship.
Which Method for Raising Capital is Right for the Business?
Clearly, every business situation must be evaluated on its characteristics. Having the right type and amount of capital is important to determine. Too much capital can become unnecessarily costly to the business. Not enough capital can cause a business to miss an opportunity or even fail. A business plan is an essential document to develop and monitor. The dynamics of a business will require constant reassessment and modification. The level of capital and the mix of capital need to remain in sync with the business to keep it on a path for success.
Due to this process’s complexity and the importance of managing multiple action plans, it is very wise to consider using outside professional consultants and advisors. The investment made in these services can be well rewarded in terms of the greater value which can be realized.
Copyright © 2020 by Eugene J Gross, CPA – Business Advisory Services