Financing Basics

While poor management is cited most frequently as the reason businesses fail, inadequate or ill-timed financing is a close second. Whether you're starting a business or expanding one, sufficient ready capital is essential. But it is not enough to simply have sufficient financing; knowledge and planning are required to manage it well. These qualities ensure that entrepreneurs avoid common mistakes like securing the wrong type of financing, miscalculating the amount required, or underestimating the cost of borrowing money.

Before inquiring about financing, ask yourself the following:

  • Do you need more capital or can you manage existing cash flow more effectively?
  • How do you define your need? Do you need money to expand or as a cushion against risk?
  • How urgent is your need? You can obtain the best terms when you anticipate your needs rather than looking for money under pressure.
  • How great are your risks? All businessess carry risks, and the degree of risk will affect cost and available financing alternatives.
  • In what state of development is the business? Needs are most critical during transitional stages.
  • For what purposes will the capital be used? Any lender will require that capital be requested for very specific needs.
  • What is the state of your industry? Depressed, stable, or growth conditions require different approaches to money needs and sources. Businesses that prosper while others are in decline will often receive better funding terms.
  • Is your business seasonal or cyclical? Seasonal needs for financing generally are short term. Loans advanced for cyclical industries such as construction are designed to support a business through depressed periods.
  • How strong is your management team? Management is the most important element assessed by money sources.
  • Perhaps most importantly, how does your need for financing mesh with your business plan? If you don't have a business plan, make writing one your first priority. All capital sources will want to see your for the start-up and growth of your business.
Not All Money Is the Same
There are two types of financing: equity and debt financing. When looking for money, you must consider your company's debt-to-equity ratio - the relation between dollars you've borrowed and dollars you've invested in your business. The more money owners have invested in their business, the easier it is to attract financing.

If your firm has a high ratio of equity to debt, you should probably seek debt financing. However, if your company has a high proportion of debt to equity, experts advise that you should increase your ownership capital (equity investment) for additional funds. That way you won't be over-leveraged to the point of jeopardizing your company's survival.
Equity Financing
Most small or growth-stage businesses use limited equity financing. As with debt financing, additional equity often comes from non-professional investors such as friends, relatives, employees, customers, or industry colleagues. However, the most common source of professional equity funding comes from venture capitalists. These are institutional risk takers and may be groups of wealthy individuals, government-assisted sources, or major financial institutions. Most specialize in one or a few closely related industries. The high-tech industry of California's Silicon Valley is a well-known example of capitalist investing.

Venture capitalists are often seen as deep-pocketed financial gurus looking for start-ups in which to invest their money, but they most often prefer three-to-five-year old companies with the potential to become major regional or national concerns and return higher-than-average profits to their shareholders. Venture capitalists may scrutinize thousands of potential investments annually, but only invest in a handful. The possibility of a public stock offering is critical to venture capitalists. Quality management, a competitive or innovative advantage, and industry growth are also major concerns.

Different venture capitalists have different approaches to management of the business in which they invest. They generally prefer to influence a business passively, but will react when a business does not perform as expected and may insist on changes in management or strategy. Relinquishing some of the decision-making and some of the potential for profits are the main disadvantages of equity financing.

You may contact these investors directly, although they typically make their investments through referrals. The SBA also licenses Small Business Investment Companies (SBICs) and Minority Enterprise Small Business Investment companies (MSBIs), which offer equity financing. Apple Computer, Federal Express and Nike Shoes received financing from SBICs at critical stages of their growth.

Additional Reading
Raising Money through Equity Investments - Inc. Magazine
Debt Financing
There are many sources for debt financing: banks, savings and loans, commercial finance companies, and the U.S. Small Business Administration (SBA) are the most common. State and local governments have developed many programs in recent years to encourage the growth of small businesses in recognition of their positive effects on the economy. Family members, friends, and former associates are all potential sources, especially when capital requirements are smaller.

Traditionally, banks have been the major source of small business funding. Their principal role has been as a short-term lender offering demand loans, seasonal lines of credit, and single-purpose loans for machinery and equipment. Banks generally have been reluctant to offer long-term loans to small firms. The SBA guaranteed lending program encourages banks and non-bank lenders to make long-term loans to small firms by reducing their risk and leveraging the funds they have available. The SBA's programs have been an integral part of the success stories of thousands of firms nationally.

In addition to equity considerations, lenders commonly require the borrower's personal guarantees in case of default. This ensures that the borrower has a sufficient personal interest at stake to give paramount attention to the business. For most borrowers this is a burden, but also a necessity.

Estimating Costs

In order to determine how much seed money you will need, you must estimate the costs of your your business for at least the first several months. Every business is different, and has its own specific cash needs at different stages of development, so there is no universal method for estimating your startup costs. Some businesses can be started on a shoestring budget, while others may require considerable investment in inventory or equipment. It is vitally important to know that you will have enough money to launch your business venture.

To determine your startup costs, you must identify all the expenses that your business will incur during its startup phase. Some of these expenses will be one-time costs such as the fee for incorporating your business or price of a sign for your building. Some will be ongoing, such as the cost of utilities, inventory, insurance, etc.

While identifying these costs, decide whether they are essential or optional. A realistic startup budget should only include those things that are necessary to start that business. These essential expenses can then be divided into two separate categories: fixed and variable. Fixed expenses include rent, utilities, administrative costs, and insurance costs. Variable expenses include inventory, shipping and packaging costs, sales commissions, and other costs associated with the direct sale of a product or service.

The most effective way to calculate your startup costs is to use a worksheet that lists all the various categories of costs (both one-time and ongoing) that you will need to estimate prior to starting your business. The following tool will assist you in performing that task:

Startup Cost Estimate Calculator
Finding Capital

Raising capital is the most basic of all business activities, but it may not be easy; in fact, it is often a complex and frustrating process. However, if you have studied and planned effectively, raising money for your business will go as smoothly as possible.

Finding the Money You Need

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 personal resources. While credit cards are often used to finance business needs, there are usually better options available, even for very small loans.

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.

Banks and credit unions: The most common sources of funding, banks and credit unions, will provide a loan if you can show that your business proposal is sound.

Angel Investors and Venture capital firms: These individuals and firms help expanding companies grow in exchange for equity or partial ownership.

A source of venture capital is the SBA's Small Business Investment Company (SBIC) Program. SBICs, licensed and regulated by the SBA, are privately owned and managed investment firms that use their own capital, plus funds borrowed at favorable rates with an SBA guarantee, to make venture capital investments in small businesses.

Read SBA's Venture Capital Primer for Small Business

Additional Sources of Capital

Related Information on Additional Sources of Capital

Read SBA's Financing for the Small Business
Borrowing Money

It is often said that small businesses face difficulty borrowing money, but this is not necessarily true. Banks make money by lending money. However, the inexperience of many small business owners in financial matters often prompts banks to deny loan requests. Requesting a loan when you are not properly prepared suggests to your lender that you are a high risk.

To successfullly obtain a loan, you must be prepared and organized. You must know exactly how much money you need, why you need it, and how you will pay it back. You must be able to convince your lender that you are a good credit risk.
Types of Business Loans
Terms of loans vary from lender to lender, but there are two basic types: short-term and long-term.

Generally, a short-term loan has a maturity of up to one year. These include working ­capital loans, accounts receivable loans and lines of credit.

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.

SBA loan programs are intended to encourage long-term small business financing, but actual loan maturities are based on the ability to repay, the purpose of the loan proceeds, and the useful life of the assets financed. However, maximum loan maturities have been established: twenty-five years for real estate; up to ten years for equipment (depending on the useful life of the equipment); and generally up to seven years for working capital. Short-term loans are also available through the SBA to help small businesses meet their short term and cyclical working capital needs.

Read SBA's "The Benefits of Making Your Banker Your Friend"
How to Write a Loan Proposal
Approval of your loan request depends on how well you present yourself, your business, and your financial needs to a lender. Remember, lenders want to make loans, but they must make loans they know will be repaid. The best way to improve your chances of obtaining a loan is to prepare a written proposal.A well-written loan proposal contains:

General Information

  • Business name, names of principals, Social Security number for each principal, and the business address
  • Purpose of the loan - exactly what the loan will be used for and why it is needed
  • Amount required - the exact amount you need to achieve your purpose

Business Description

  • History and nature of the business - details of what kind of business it is, its age, number of employees and current business assets
  • Ownership structure - details on your company's legal structure

Management Profile

  • Develop a short statement on each principal in your business, provide background, education experience, skills and accomplishments.

Market Information

  • Clearly define your company's products as well as your markets.
  • Identify your competition and explain how your business competes in the marketplace.
  • Profile your customers and explain how your business can satisfy their needs.

Financial Information

  • Financial statements - balance sheets and income statements for the past three years. If you are starting out, provide a projected balance sheet and income statement.
  • Personal financial statements on yourself and other principal owners of the business
  • Collateral you are willing to pledge as security for the loan

Related Information

Read SBA's "How to Prepare a Loan Package"

Read SBA's "Never Take No for an Answer - (When the Bank Says No)"
How Your Loan Request Will Be Reviewed
When reviewing a loan request, the lender is primarily concerned about repayment. To help determine its likelihood, many loan officers will order a copy of your business credit report from a credit-reporting agency. Therefore, you should work with these agencies to make sure they present an accurate picture of your business. 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, no lender or investor will finance 100 percent of your business.
  • Do you have a sound record of credit-worthiness 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?
SBA Financial Programs
The SBA offers a variety of financing options for small businesses.

Whether you are looking for a long-term loan for machinery and equipment, a general working capital loan, a revolving line of credit, or a microloan, the SBA has a financing program to fit your needs.

For additional in-depth information on the financing programs available through the SBA visit the Financing Your Business section of the SBA's main web site.