Small Business Financing - Some Guidelines

Venture Capital Financing

Private Market Angel Financing

Alternative Sources of Financing

General Advice

Venture Capital Financing

Some Considerations Prior to Seeking Venture Capital (VC) Financing:

Appropriateness of Seeking VC Financing

• VCs tend to invest in high technology ventures.
• VCs are less interested in financing start-up firms than in financing established, ongoing firms in which they can invest at least $5M.
  • VCs put a very small percentage of their funds into seed capital for start-up firms. In such cases, the VC investment is usually at least $2M.
  • Start-up firms typically require smaller amounts of capital and thus do not meet a $5M minimum VC investment threshold.
  • Start-up firms require more VC business counsel; the limited number of VC partners provides a natural limit on the number of startups in which VCs can invest.
• If the firm's management is not comfortable with the VCs withdrawing its investment in the firm within 3 to 5 years, as well as the prospect of possibly making an initial public offering within that time, then perhaps VC financing is not the best possible choice for the firm.

Some Necessary Preliminary Preparation

• Put a strong management team into place.
  • VCs require proposers to demonstrate a capable and experienced management team.
    • VCs have little desire to run a company.
    • VCs recognize that they invest in many businesses and therefore are not likely to know as much about each particular business as the people in those firms in which they invest.
    • Accordingly, VCs tend to play the role of sounding board, critic, and try to ask the right questions regarding: strategic planning, operations, and hiring key personnel.
  • Successful and experienced management will have a higher likelihood of raising the required capital than management with simply a 'great idea.'
• VCs expect companies to use formal financial and planning procedures.
  • Put a strong accounting system into place.
    • This will also provide the VC with timely financial data to evaluate the prospective investment.
  • Develop a complete, credible Business Plan, and update it at least annually.

Expect VC Factfinding Prior to Investing

• VCs will do most of the following prior to investing:

Internal to the Firm

• Meet with the firm's key management to assess management's understanding of the venture, the industry, problem areas, as well as observe how the firm's managers interact with one another.
• Talk with the firm's chief accountant to determine applicability and credibility of the firm's financial data.
• Analyze pro forma financial data and estimate potential value of the investment at the time of expected VC exit from the investment.
• Tour the firm's facilities.

External to the Firm

• Query the firm's existing and potential customers.
• Consult technology experts regarding the venture's technology.
• Contact the firm's existing outside investors.
• Commission formal market studies by outside consultants.
• Contact the firm's suppliers.
• Contact the firm's outside legal counsel.
• Contact the firm's competitors.
• Check management's references regarding prior positions with other firms, and contact management's other former business associates.
• Query the firm's bankers. (However, the banks are not considered reliable sources if the firm owes them money.)
• Contact other VCs to gain knowledge and explore the possibilities for syndicating to share investment risk.

Expect VC Strong Oversight Subsequent to Investing

• VCs provide intensive oversight of the firms in their investment portfolios.
  • VCs serve on the firm's boards of directors. In many cases, the VC will retain a seat on the board even after exiting the investment.
  • VCs involve themselves in the firm's strategic decisions.
  • VCs frequently contact the firm's key personnel.
  • VCs frequently pay informal visits to firms in the VC's portfolio.
  • VCs may periodically meet with the firm's customers and suppliers.
  • Accordingly, VCs prefer to invest in firms within a short drive away from the VCs location. Therefore, where a firm locates could impact its ability to attract VC financing.
    • Major VC centers: Silicon Valley, Boston, Southwest.

Plan on the Inevitable VC 'Exit' From the Investment

• VCs are less patient than other equity investors. They seek to 'exit' an investment within 3 to 5 years. Exiting the investment is how the VC makes its money.
• Exiting is usually achieved by the firm going public, being acquired, being re-capitalized, finding a substitute investor for the VC, or buyback of the VC's investment by the firm.
• Before deciding to seek VC financing, the firm should be wary of a potential conflict of interest between the goals of the VC and the goals of the firm. The best time for the VC to exit may not coincide with the best time for the firm to be forced into one of the exiting transactions.

Venture Capitalist Investment Criteria:

Venture Concept

• VCs seek uniqueness in the product/service concept.
• Product/service must offer a significant competitive advantage.
• Product/service concept must already work or can be brought to market within 2 to 3 years.

Return on Investment

• Must be significant potential for earnings growth.
  • VC expects minimum return on investment (ROI) of over 30%/year.
  • Earnings growth potential may come from rapidly growing market, increasing market share, or significant cost cutting.
• The venture must demonstrate a high absolute potential return (i.e., volume of dollars) in addition to a percentage ROI in excess of 30%/year.
  • VCs avoid financing small investments that offer low absolute returns even if their rates of return are high.
  • However, venture must not have unreasonably high capital investment requirements which can adversely impact ROI and represents unacceptably large financial exposure even given VC syndicating.
  • Be mindful that VCs tend to be very conservative investors because:
    • VCs invest other people's money; more than half of the money invested by VC's comes from pension funds.
• The investment must have a clear 'exit' opportunity for the VC within a 3 to 5 year period.

Top Management

• VCs key on the capabilities and track record of the firm's management team. Specifically, VCs invest in people rather than in ideas or physical assets.
• Key management must objectively demonstrate high personal integrity.
• Key management must demonstrate success in similar positons at prior firms if seeking early stage financing.
• Key management must demonstrate success in current position if seeking later stage financing.
• Key management must demonstrate a thorough understanding of the business and the particular venture.
• Key management must demonstrate ability to identify risk and develop plans to deal with risk.
• Key managers must exhibit leadership and appropriate management experience.

Relative Merits of Venture Capital Financing:

Some Advantages

• In addition to financing, VCs provide the firm with business counsel, discipline, image in the business community, and access to critical networks.
  • VCs serve as a sounding board for the firm's management decision-making.
  • VCs ensure a profit orientation of the firm.
    • VCs force management to focus on a limited number of well-defined objectives.
    • VCs often discipline management decision making to be in accordance with the objectives of an acceptable business plan.
  • VC networks are a valuable source of strategic planning information.
  • VCs join in discussions with the firm's bankers and customers. This gives the firm and its products a certain credibility.
  • VCs have access to networks with knowledge of potential available managers.
  • VCs have access to networks of other potential financiers.
  • VC networks can help find acquisitions or corporate partners for the firm.
• VC financing offers confidentiality regarding commercially sensitive information.

Some Possible Disadvantages

• VCs can apply pressures to the firm's management since VC money is invested at various stages of business development. The pressure is exacerbated since finding new investors is more difficult when the old (i.e., the VCs) investors are unwilling to invest additional funds in the firm.
• Often the firm's board of directors is controlled by the VCs.
• Sometimes VCs decide who will manage the firm and may get involved with interviewing candidates for key management positions.
  • VCs are unlikely to get involved with middle managers; if they do, this could be a sign of an investment in trouble.
• VCs business counsel is not as effective regarding firms in industries outside of the VC's experience base. Therefore, the firm should target appropriately experienced VCs.
• VCs usually have contractual rights giving them control in case the venture fails to perform adequately.

Access to Venture Capital Community:

• VCs generally wait for proposals to come to them; accordingly, VCs develop a network of referrers.
• Most proposals funded by VCs are the result of referrals.
  • Referrer network includes: commercial bankers, investment bankers, investors in the VC fund, managers of firms already in the VCs investment portfolio, consultants having provided prior services to the VC, and the VCs colleagues.
  • Referrer is more likely to understand the type of investments the particular VC might find attractive.
  • VC typically has confidence in the referrer's judgment.
• National Venture Capital Association 703-524-2549 for referrals to VC's.
• Some VC's now promote themselves by offering information via Internet.
• See also: Yahoo! at http://www.yahoo.com/business.

Return to top of page

Private Market Angel Financing

Characteristics of Angel Financiers:

• Angels are silent, private investors who provide start-up firms with seed money financing in exchange for equity or a percentage of revenues.
  • Angels provide seed money for firms too young or too small to qualify for bank loans, venture capital, or public offerings; they prefer to invest at the early stage of a venture.
• Angel networks are oriented to bio-tech and other high-tech companies.
• Angels typically invest in ventures involving markets and technologies with which they are familiar.
• Angels typically invest in ventures close to home within one day's drive.
• Angels tend to co-invest with trusted friends and business associates.
• Angels are active investors, serving on a working Board of Directors or providing guidance through an informal consulting/monitoring role.

Angel Investment Criteria:

• The primary difference between VCs and angels is that angels will accept a longer payback horizon and are willing to settle for a smaller return - 20% to 25%/year compared to the VCs expected ROI of 30% to 35% or more per year.
• A round of angel financing is typically less than $1M and more usually less than $500K.
• Venture exit horizons for angels tend to be 5 years to 10 years or more.
• Firms do not have to demonstrate profitability; they must demonstrate, however, strong market prospects and strong management.
• Angels often take bigger risks or accept lower rewards when they are attracted by the nonfinancial characteristics of an entrepreneur's proposal.
• Angels' investment terms and conditions tend to be briefer and more informal than those of venture capitalists.

Access to Angel Networks:

• There are no directories of private investor angels, no public records of their investment transactions.
• The private investor angel market tends to be regional rather than local or national.
• Angel networks are typically run by non-profit groups.
  • Most angel networks originate from college campuses, business incubators, state economic development agencies, and other nonprofit entities.
  • A large number of universities have established angel networks to match entrepreneurs with investors.
  • VCs are also a source of information regarding locating angels.
• Firms can join an angel network for a nominal fee. Firm provides its vital statistics: type of business, market potential, amount of funding required. The angel network distributes this information, but keeps the company name anonymous. The firm's name is revealed if an investor is interested.
• A possible information source regarding angel networks is the National Business Incubation Association at 740-593-4331.

Return to top of page

Alternative Sources of Financing

Commercial Banks:

• Commercial banks are one of the cheapest sources of borrowing for small companies, typically charging interest rates just one to two points above prime for small business loans.
  • Small firms should seek banks where small business loans are a priority, not a sideline.
  • Small banks make most of their loans to small business customers.
  • Small community banks are an excellent source for loans less than $1M.
  • To find a small business friendly bank, obtain Small Business Lending in the United States, published by the SBA.
• In financing ventures, commercial banks typically seek security in the form of the business owners personal assets.
• Be mindful that bankers will query why alternative sources of financing are apparently not being successfully pursued.
• Most start up firms cannot attract bank loans because they cannot demonstrate sufficient assets and a healthy financial track record or any financial history at all.

Strategic Alliances:

• An alternative to VC financing or more debt is a strategic alliance with another firm; the two companies must have different, complementary strengths.
• A strategic alliance, as a source of financing, can benefit both firms.
  • For example, it can be an access to new markets for one, and access to manufacturing capability for the other.
  • Most corporate partners seek to buy into smaller companies and use them as R&D arms.
• In a strategic alliance, each partner entity retains its own identity.
  • A 'joint venture' is a type of strategic alliance in which a separate legal entity is formed for the same purposes.
• Strategic alliances can be arranged by third party intermediaries.

Private Market Financing Other Than Angels:

• Private equity markets typically provide small amounts of money ranging from $8M to $25M per venture.
• Private equity interests typically take an ownership position of between 10% and 30% of the firm.
• Private equity investors include: insurance companies, pension funds, high net worth individuals, and foreign investors.
• Private equity deals usually get structured in the form of convertible preferred stock. Investors are allowed options to sell their stock back to the company at market price beginning after the fifth year, with payout schedule over the next three successive years.
• These private 'placements' are:
  • Exempt from SEC registration statements
  • Not limited to SEC dollar amount limitations.

Factoring:

• Example: Small firm sells its accounts receivable at a discount. The factor provides cash upfront (e.g., 80%) and then collects on the invoices. Once the money is collected, the firm gets the balance minus a fee for the factor's services. The factor's fee ranges from 1.5% to 5% of the accounts receivable face value.
  • Going to a bank for a loan can take a few months; whereas, obtaining financing from a factor might be achieved within ten days.
  • Factoring is particularly attractive for younger firms with relatively few fixed or financial assets.
    • Factors are less concerned with the firm's financial condition since they rely on the creditworthiness of the firm's customers.
• See 'Accounts Receivable Factoring', 'money sources', or 'factoring' in the Yellow Pages; also, consider contacting the Commercial Finance Trade Association: 212-594-3490.

Vendors and Customers:

• The small firm's suppliers, customers, manufacturers, and distributors are possible sources of financing. These people have some interest in the firm's survival.
• Accordingly, the small firm might seek to:
  • Negotiate extended credit from suppliers; however, the firm must be able to to show suppliers an ability to pay (e.g,, evidence of a large customer order);
  • Negotiate advance payments from customers;
  • Exchange equity for outside services and supplies;
  • Pay vendors with products or services instead of cash.

Bartering:

• The small firm might join a barter network which would enable the firm to exchange goods/services with fellow members. There is usually a required cash fee per transaction.

Lease:

• Operating Lease - lessor owns the equipment and enjoys any tax benefits of ownership. Lessor is responsible for maintenance. Lessee pays a fixed fee to use the equipment for a specific period.
• Net Lease - same as operating lease, except that the leasee pays maintenance costs.
• Capital Lease - lease is backed with an asset, money in the bank, or another guarantee.
• Consider contacting the Equipment Leasing Association of America at 703-527-8655.

Licensing:

• Licensing is a form of avoiding the financing of a capital investment if the firm's strength is technology development and it has little desire to invest in production facilities.
• Licensing agreements should carefully specify the conditions and limitations under which the firm's technology is being made available and the revenues it is to receive.

SBA:

• Small Business Investment Companies (SBIC) - program established by federal government; made up of private investment companies that provide venture financing and management assistance to small companies.
  • Government backed equity financing; securities issued by SBA and sold on bond market.
  • Proceeds from sale of the securities go to SBIC's which then buy stock in small businesses in exchange for ownership roles in the companies. SBICs are prohibited from taking control of the firms.
  • When the small companies are sold or go public, the SBICs and the SBA theoretically receive a return on investment.
  • Investors in the financial instruments receive quarterly interest payments and the return of principle when the securities reach maturity.
    • SBA assumes responsibility for paying interest to investors until the SBIC is sufficiently profitable to repay the SBA and begin making payments itself.
• SBA can guarantee up to 85% of a private loan with maximum guarantee amount of $750K and 25 years to pay.
• SBA is attempting to make more credit available to small companies with less paperwork. (The SBA guarantees such loans up to 90% of outstanding balance.)
  • Business borrowers have up to 11.5 years to pay most SBA loans vs. 3 years for commercial bank loans.
  • SBA loans are particularly designed to make more credit available to women, minorities, and very small businesses.
  • The SBA LowDoc program offers a simple one page application to minimize paperwork requirements and loan processing time for small businesses on loans up to $100K.
    • Typical interest rates are 2.25% over prime.
    • Designed for companies of 100 or fewer employees, and annual sales for the three preceeding years not to exceed $5M.
    • LowDoc applications focus on the borrower's character, credit history, and business experience.
    • Loan processing time has been shortened from months to weeks.
  • SBA MicroLoan program - loans up to $25K to startup companies in inner cities and rural areas, a large percentage of which are owned by women and minorities
• For information on SBA backed loans call 800-827-5722.

State Agencies:

• To find available state public money, small firms might also contact their respective state economic development agency.
  • Many states have their own venture capital funds which are more willing to work with early stage companies.
  • Firms seeking seed money should have financial statements and Business Plans prepared.
• List of state agencies to be compiled and inserted in this SBIR Mall regarding state supported financing assistance to small businesses. This information is available in the public library.

Initial Public Offerings (IPO) of Stock:

• Make the company visible; court the media, target trade publications for press coverage; routinely present at industry seminars and investment conferences.
• To launch an IPO in the public markets, select an underwriter who is experienced in the firm's particular industry.
• Make sure that the timing is right for entering the public financial markets:
  • Ensure that an appropriately experienced board of directors and quality management are in place.
    • Investors seek companies with seasoned management.
  • Be sure that strong financial accounting systems are in place. Underwriters and stock and bond market analysts require accurate quarterly information.
  • Ensure that market conditions are conducive to acceptable prices for the firm's securities issue.
• Be mindful that:
  • Associated underwriter, attorney, and accountant's fees regarding IPO's can very significant.
  • The SEC will require disclosure of some information prior to its approval of an IPO that is likely to be commercially sensitive and result in some loss of competitive advantage.

Return to top of page

General Advice - Regardless of Financing Source

Some Important Preliminary Actions:

Expert Advice and Factfinding

• Seek the advice of founders of successful companies in related fields. For example, consider contacting:
  • The Center for Entrepreneurial Management (a nonprofit membership association of entrepreneurs and CEO's) at 212-925-7911.
  • National Association of Small Business Investment Companies at 202-628-5055.
  • National Association for Female Executives at 212-445-6235.
  • U.S. Dept. of Commerce Minority Business Development Agency at 800-487-7389.
• Seek the advice of individuals on boards of non-profit entities. These typically are people who have been successful in their industries and who are trying to give something back to their community.
• Contact lawyers, accountants, bankers who specialize in serving early stage companies; seek their expert advice.
  • The probability of obtaining financing is greater when made through an introduction by one of these professionals.
• Six months to one year before seeking financing, start developing a list of prospective investors.
  • Write letters directly to the individuals. Provide an executive summary of the venture's Business Plan. Include facts and figures and specifics regarding how much money is needed and what the investment will likely be worth in five years. Close the letter by asking for an informal meeting to discuss the idea. Follow up with a phone call to set a date.
  • The entrepreneur must make a personal effort to gain the confidence of the potential investor.
• Engage in extensive networking - especially on the Internet.
  • List the venture with a venture matching service that matches entrepreneurs with investors.
  • Create a homepage for the venture.
    • The World Wide Web is the fastest growing source of business opportunities and financing.
  • Requests for funding need to be worded carefully to meet SEC requirements:
    • Business Plans and executive summaries should include a statement that they are not solicitations for sale, but are simply advertisements.
      • Be mindful of legalities - Federal and state laws dictate how offers and sales can be made and what information must be disclosed to potential investors.

Accounting System and Financial Statements

• Firms seeking financing should have strong accounting system in place and updated audited financial statements prepared.
  • The firm should hire top notch accountants; disorderly financial records will discourage potential investors.
  • Audited financial statements for the current and past three years are essential to investor analysis. The financial statements should include: balance sheet, income statement, sources and uses of funds, and statement of cash flow.
    • Statement of cash flow is of particular interest to creditors and investors since it is cash, rather than accounting income, that is used to repay loans and pay investor dividends.
    • The firm's balance sheet should reflect a debt/equity ratio of not more than 3 to 1.
  • The financial statements should appropriately value intangible assets such as trademarks, patents, and goodwill.

Preparation of a Credible Business Plan

• Firms seeking to finance a venture should prepare a well thought out Business Plan for the venture.
• Business Plan should include pro forma financial statements for at least three years into the future which include a detailing of the use of the requested funds.
  • Projections of future performance should be very realistic and err on the side of conservatism, particularly regarding estimates of future sales, prices, and all elements of operating expenses and necessary capital investment costs.
  • Provide logical support for all pro forma figures; support pro forma figures with clear, objective evidence.
  • The pro forma financial statements should reflect a target capital structure (i.e., type of equity and type of debt).
  • Ensure that the financial plan is consistent with the overall Business Plan.
• Business Plan should:
  • Present a clear picture of the venture's economics.
  • Focus on cash flow to maximize attracting investors.
  • Be realistic and not be overly optimistic.
    • Venture weaknesses and problems should be directly addressed - before the investor identifies them on his/her own.
  • Recognize exposure to all elements of business risk and identify plans for management of that risk.
  • Reflect the factors that can create future value of the venture.
  • Identify financial goals regarding all foreseeable future financing needs.
    • Clearly define, in quantifiable terms, how the firm's planned future activities are expected to be financed.

Exercise Common Sense:

• Consider all available forms and available sources of financing before deciding upon seeking any particular one; be knowledgeable regarding the advantages and disadvantages of each.
• Seek financing consistent with planning for success rather than planning merely for survival.
  • Do not underestimate financing needs:
    • Be realistic from the outset, even if the capital investment to be financed seems large.
    • It is more difficult to raise financing the second time around
  • Seek financing before actually needing it and particularly when the firm can demonstrate the strongest financial position possible.
    • This preserves some leverage and facilitates the firm's negotiating a better financing arrangement.
• Anticipate a realistic cost of capital:
  • Expect equity investors to seek high returns. (e.g., returns ranging from 25%/year to 50%/year amounting to an absolute return of up to 5 times the investment within a 5 year period.)
  • Small firms present a significant risk to creditors since the entrepreneur inherently has little incentive to repay debts that remain if the firm fails. This risk is reflected in the interest rates that will be demanded by creditors.
• Consolidate the firm's debt.
• Prepare personal financial statements:
  • Creditors look to past and current personal credit worthiness of the entrepreneur as a strong indicator of the credit worthiness of the small business venture.
  • Bankers assess the extent to which an owner can be relied upon to repay loans that his/her firm is unable to repay.
    • The entrepreneur's net worth and prior credit history is critical.
• Minimize venture start-up costs.
• Use capital wisely:
  • People who fail in a venture often claim they were undercapitalized; rather, it is more likely that they did not use their capital wisely.
  • Do not be foolishly concerned with image. (e.g., do not rent expensive offices just to act the part.)
  • Keep executive salaries in check.
• Seek investors who understand the industry, the firm's products, and the particular business venture:
  • For example, venture capital groups or angels who invest primarily in the particular industry.
  • This also introduces credible, expert sources of advice to the firm.
• Make the distinction between working capital loans to finance day-to-day operations and capital loans to finance expansion.
  • This distinction is important in negotiating appropriate terms of the financing agreement.
  • Negotiate all financing terms up front and include them explicitly and unambiguously in the financing contracts.
  • Be sure to genuinely understand the financing arrangement; in particular, be sure to understand the long term consequences of whatever financing arrangement is being negotiated.
• Recognize that raising capital involves a costly and time consuming personal networking process.
• After obtaining the necessary financing, be mindful that financing a business is a never ending process; accordingly, never quit searching for possible investors:
  • Frequently attend seminars on financing.
  • Frequently network with venture capitalists, investment bankers, other members of the financial community.
• There are numerous sources of information regarding telephone and Internet access to investor and creditor networks that cannot be listed here because they are profit making/ possibly profit making. These leads can be easily found by researching financial literature in the public library.
• BEWARE: Investment scams are hitting the Internet.

Return to top of page