CHAPTER 18
Finances and Your Business
Facts of Life
Before you do anything, look at the following table for some age-old wisdom.
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1 |
The golden rule ALWAYS applies: He who controls the money rules |
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2 |
Ultimate success is logic, clear understanding, and a strong grasp of market niche, your business, and industry. |
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3 |
Irrespective of the type of financing you need, the process of obtaining it is usually the same. A finance plan will help you to profile the business and be helpful to the business owner and your investors, or prospective investors. |
Some Thoughts
Consider the following:
• What funds do you require? This can only be calculated by serious cash flow planning, which requires forecasts of future sales, related costs, and capital and interest funding payments, depending on the type of capital you have raised.
• How will you spend these funds? Will you buy equipment, pay for expansion plans, appoint additional employees, research and development or for development costs?
• Why should we lend you money? One of the primary reasons businesses often fail is lack of managerial experience and skill to properly use funds as they are intended. You will need to convince investors, new directors, and key staff that you have the knowledge, experience, and skill to manage your business and the funds that you have raised. And you will also to prove that you will achieve the forecasted profits.
• What are the supply–demand variables for where your business operates? Even if your business has a great growth potential, if the local economy is slow and restricted with exchange controls and other legislation and rules to the point that it is likely to impede your venture, you will find it difficult to raise funds.
• Do you have strong financial systems in place? The starting point for new businesses is to hire an external bookkeeper to work for you on a periodical basis. As sales and expenses increase as your firm expands, create an internal accounting department, overseen by a financial director.
Financing Your Business
How Much Do You Need?
Simply stated, total cash required is equal to the cost of fixed assets (land, buildings, machinery, etc.), plus start-up expenses, which include operating costs, inventory, and accounts receivable. It is important for all businesses to estimate capital requirements to ensure there is sufficient cash available to pay expenses as they occur.
Financial Projections
Find the latest costs for the following:
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Item |
Assess |
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Start-up |
• Installation of power utilities. • Marketing and promotional materials. • Legal fees for incorporation. |
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Fixed assets |
• Land, buildings, machinery, equipment, and vehicles. • Leasehold improvements. • Deposits on leases and utilities. |
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Inventory required |
• Determine how fast you must pay your suppliers. • What percent of total accounts payable is to be paid in the month incurred? • What percent of total accounts payable is to be paid in 30 days, 60 days, etc.? |
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Monthly sales |
• Estimate sales for each product and service individually. • If part of your sales is on credit, estimate the delayed impact on cash flow. |
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Monthly expenses |
• Rent. • Insurance. • Power utilities. • Salaries and wages. • Marketing, advertising, and promotions. • Legal and accounting fees. • Loan payments. |
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Financing your business |
• Who will you approach to raise capital? • Decide whether you will require equity or debt financing? • Bank loans generally require the following:
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There are two basic sources of funds to start a business, namely equity and debt. Equity is an investment in the business by you or by a partner. Debt can be derived from private sources such as family and friends or from more formal sources, such as banks, capital providers, venture firms, and angels.
The more formal sources of funding will depend on how much you require.
• The amount of funds that you need and how it will be used. This is often determined by the industry that you are operating in.
• Your personal financial situation.
• How much collateral you have?
• Your managerial profile, history, and past successes.
Most start-ups don’t start with bank loans or venture capital but launch their businesses with a combination of personal resources and help from family and friends. In addition, only a small number of start-ups begin with a bank loan and even less with venture capital.
For entrepreneurs who have little cash, personal assets, and bad personal credit, bank loans will be turned down. The only option is to approach equity partners, such as angel investors.
Type of Funding Available
Debt versus Equity
Debt funding is normally cheaper and easier to find than equity funding.
• Debt Financing: It carries the liability of monthly interest and capital payments, whether or not you have positive cash flow. Such financing is usually available to all types of businesses.
• Equity investors expect little or no return in the early stages but require much more extensive reporting as to the company’s progress. They have invested in you and your promises, so they anticipate that goals and milestones will be met. As such, equity is usually focused on businesses with a fast and very high growth potential.
If you decide on debt financing, ask yourself the following questions:
• Does my company qualify for debt financing?
• What does this entail?
• How much debt can I afford?
• How will repayments work?
• What happens if cash flow is impacted?
• What happens if interest rates rise?
• Am I willing to be a guarantor and place personal assets at risk?
The following equity considerations should be made:
• What type of investors should do I approach?
• What can I sell shares for?
• Will this value to fair?
• If I do all the work, should I share control and future profits?
• Do I really want investors as partners forever?
• What stake in my company shall I sell?
Investors will want to take a much larger share of a start-up venture than they will of an established company with a profit history.
Angel Investors
Angels are individual private investors who make up a large portion of “informal” venture capital, who tend to invest small amounts ($25,000 to $250,000). Depending on how much you require, you may need to approach an angel. Beware of consultants who charge up-front fees to connect you with investors.
Venture Capital
Venture capital firms will only invest in companies with an expected high growth, and they will only do this by taking a very large stake in your business, sometimes as much as 75 percent of your shares.
Strategic Partnerships
Where two companies have a mutual benefit in setting up a strategic partnership, there is usually a parallel, such as one having the funds to invest and the other the market knowledge or plan. Another example is when one party has the product and the other the means to distribute that product via its network.
Government Small Business Loans and Funds
While this is a tremendous resource, these are usually time-consuming and filled with red tape.
The way these usually work is that firms leverage their private capital into government money to form a sort of venture capital fund to offer both long-term loans and equity participation. They tend to invest mainly in established companies for management buyouts, funds to list on an exchange, strategic partnerships, and bridge financing.
Commercial Papers
These are short-term debt instruments and usually issued for a period of 2 to 270 days. These come in the form of a promissory note that is unsecured and discounted from its face value.
The way it works is that the issue is usually backed by a letter of credit or a credit guarantee. The company may pledge assets to obtain a credit guarantee that is then leveraged into an issue of commercial paper.
Letters of Credit
These are issued to your funding source as a guarantee that you will pay for their services. So if you are not able to pay, the issuer will pay on your behalf. Your bank might issue a letter of credit (L/C) based on your pledge of a receivable or other fixed asset.
Receivable Factoring
Funds are advanced against goods sold and accepted, but funds have yet to be received. Normal advances on accounts receivable are 80 percent to 90 percent. The lenders are looking for ninety days or less to be paid. Funding is available for older accounts receivable, but the rates take a dramatic turn upward.
Purchase Order Advances
If you have purchase orders with your customer base, you may be able to get financial advances toward their completion. The typical advance is less than 50 percent, and the rates are very high.
Equipment Leasing
This is effectively renting assets that you need such as equipment and agree to pay rent for a specific period of time. There is no interest rate, but the rates tend to be higher than commercial loans. Some of this is offset by being able to expense 100 percent the payments.
Asset Sale Leasebacks
Simply put, you sell your assets and lease these back to continue your operations. The downside of this approach may be capital gains or sales tax.
You can raise capital by selling part of your company’s shares to few private investors. Remember that you are effectively selling a part of your business, which also means that you are losing future value and, possibly, control.
Stock Market Listing
There are various forms and methods to list a company on an exchange, from small and medium scale enterprises (SME) exchanges to main boards across the world. These follow strict protocols that must be adhered to and can only be done by registered stockbrokers.
Limited Partnerships
This is another way of having a silent partner, who finances the company, while you take total responsibility to run the operations. There are numerous limited partnerships in the general public domain that have been formed to invest in businesses.
Convertible Debt
This is normally a loan that can be converted into an equity stake in the company. Ensure that there is a timeframe and value attached to this instrument.
Government or State Bonds
Most governments have revenue bonds that are designed as debt instruments, where the company issues the bond and a government agency underwrites it. These bonds are generally issued to promote manufacturing facilities that will create jobs.
Lines of Credit
These funds are available as drawdowns against the total line of credit and are most commonly secured with accounts receivable and inventory as collateral.
The first lesson to learn is to say NO.
Most entrepreneurs approach the issue of negotiating with great stress, which leads directly to weak negotiations and a less-than-beneficial result. In order to avoid this from happening to you, take note of the following:
• Determine what you are negotiating for.
• Express what you are offering and want in return.
• Get it in writing.
• Leave nothing to verbal agreements.
• Relate everything to your long-term goals.
• Pay close attention to deal breakers.
• Establish what is acceptable and what is not.
• Ensure that there are no penalty clauses.
• Ensure that you have first option to buy back your stock at a fixed price.
• Pay attention to covenants, conditions, ratios, restrictions, or other clauses that can have serious long-term effects.
• Try to avoid pledging personal collateral. You may need these assets in the future to raise additional capital.
• Seek professionals before you sign. Lawyers and accountants can help spot details that may burden you in future.
Closing the Deal
Remember you are out there selling yourself and your company. Only accept “No” as being one step nearer to Yes.
Amount Requested
The simple rule is to get it right the first time. If you underestimate what you require and have to go back to investors, it will be looked on with disapproval. The fact is that if you can’t estimate what you need how can you be trusted to use the funds effectively.
• Conservative request: Ensure that financial projections are based on a sound foundation of research that fully supports the amount of funds that you are requesting. If you are seeking debt financing your request must be specific. Investors may be inclined to stop financing your business if you can’t make the funding work.
• Downside planning: In addition to correct forecasts and loan requirements, make sure that you take account of possible market anomalies that can cause temporary downsides and a slowdown in sales. It is far better to overestimate your capital requirements than to run short and be forced to return to investors.
• Assumptions: Both lenders and investors are going to want to know that you have reasonably estimated and supported your costs and projected revenues. Your financial forecasts should be linked to international best-practice research and ratios.
The Terms
Know what you want, what you can afford, and what you will give up.
• Timeframe: This should be linked to the useful life of the asset being financed. Receivable and contract financing are less than 1 year; equipment 1 to 5 years; and real estate and other long-term assets 5 to 20 years.
• Amortized versus interest only: Many ventures can take up to 18 months to reach breakeven before it starts to make money. Think about an initial period of interest only, or skip payments to help bolster cash flow.
• Interest rate: The rate that you pay for the funds that you need can directly affect your profitability, so negotiate a rate below the prime interest rate, thus giving you a buffer against unexpected market changes in rates. This may be fixed or free floating and depend on the country in question.
• Penalties: Funding sources are in control, and having spent time and money selecting deals to invest in, they will often insist on prepayment penalties to insure you’ll leave the funds in place.
• Blanket loans: This will restrict your ability to raise cash in the future from alternative sources. Always attempt to have specific loans and not blanket ones.
• Personal guarantees: How committed are you? If you won’t sign personally, then you may not get any money. If you don’t believe in your success, why should anyone else? As you and your company begin to perform, you should be able to get these guarantees released.
• Covenants: These spell out just what you can and cannot do—no management or ownership change, regular filing requirements, no alternative sources of funding, deposits maintained, collateral pledges, and so on. Carefully read and evaluate the fine print.
• Selling a stake: What’s fair? You must define it, support it, and defend it. While most lenders won’t ask, most investors will demand.
• Stock repurchase: Negotiate an escape clause that will allow you a way out if you need it or can afford it. Ensure that you have the option to buy your stock back at a predetermined price.
• Management controls: Most entrepreneurs make decisions for the company to achieve its goals and ultimately profits. Some investors insist on participating in the decision-making process. Know what you are looking for and what you are willing to give up.
• Collateral, anyone? Will you risk it all? If you don’t believe, neither will anyone else.
Rainmaker Observation: With investors, because there is no debt, they are concerned with profit margins and retained earnings. The projections should support ratios of better than 2.0 to 1 to generate any serious investor interest.