One of the most important things a business owner can do early in the pursuit of opportunity is establish relationships with multiple financial sources. Do this by laying out your goals, and committing to specific milestones and timeframes. This isn’t the time to ask for money, but to learn from each funding source what specific results you have to deliver for them to be interested in working with you in the future. This builds trust and confidence and an important relationship. Then, meet with the bankers or funding sources periodically to update them on your progress or explain any deviations from the plan.
Once you proceed with your plan and reach various milestones, it’s time to talk about your funding needs.
IN THIS STEP, WE'LL TACKLE FIVE WAYS TO FUND YOUR BUSINESS:
- Vendor and Customer Financing
- Debt Financing
- Angel Investors
- Sophisticated Financial Partners
- Initial Public Offering (IPO)
Vendor and Customer Financing
The least expensive way to finance growth is to work with your vendors and customers. If you‘re established and have a great supplier base, go to them and explain your growth plan and various initiatives. Ask them to work with you on extended payment terms. If you have 30-days, get them to stretch it to 60, 75 or even 90 for a defined period of time. Once you get through, use the experience to look for other forms of financing. Your cooperative suppliers will be rewarded with a bigger customer (you) and more timely payment terms.
If you have long-standing customers who depend on you, ask them for a large purchase order that can be factored (see below), or to accept early delivery of goods, or to pre-pay for a large order. If the value you propose in return is meaningful and hard to replace, it could be the best and least expensive form of financing there is.
- You maintain complete financial and operational control over your business.
- No equity-holders to pay off if the company hits it big.
- You grow your operations with new and/or existing customer and vendor relationships that will only get stronger.
- Typically, this form of funding limits the amount of money you have for strategic purposes, so your business growth can be slowed way down as it starves for cash.
- If you miss delivery to a customer or overextend with vendors, you may damage business relationships that you can’t afford to lose if you hope to recover.
There are various types of debt financing and different kinds of lenders:
Some sources lend money to businesses based on such assets as receivables, inventory, equipment or real estate – all forms of collateral. If you’re an established business with a proven history and solid customer base, a bank can be a good source of inexpensive financing (prime +1 or 2 points). And if your relationship’s good, your business is healthy and your assets have enough value, it may not require personal guarantees or additional collateral.
- Market-based interest rates.
- No equity relinquished.
- Business assets are collateral.
- This may require personal guarantees, and if there’s a downturn in business, it could have big, bad economic consequences for you personally.
Cash flow lenders
Some cash sources specialize in lending against the current and projected cash flow of the business. Many companies don’t have hard assets like inventory, heavy equipment or real estate, but may have an excellent history of profitability and positive cash flow. Having a long-standing relationship with the bank, building trust and confidence as it sees you grow, and periodically sitting with the bankers when you don’t need financing, can be among the best ways to win this kind of inexpensive financing. Generally, personal guarantees and other collateral are required for small- and medium-sized, closely held businesses.
- Market-based interest rates.
- No equity relinquished.
- Business operating history and projections are collateral.
- May require personal guarantees, and if there’s a downturn in the business, it could have terrible economic consequences for you personally.
Factoring receivables (for growth companies) and purchase orders (for newer businesses)
Some lenders specialize in credit risk financing (they’ll review your customers’ credit quality) and loan money against your receivables for less than their face value (12 to 30 percent depending on credit quality). They then assume the risk of collecting your receivables.
Similarly, and more useful to newer businesses, these same lenders assess your customers’ credit quality and related purchase orders and, if credible, advance funds against the POs at less than face value. Like a factored receivable, when your customers pay for your goods or services, the lender gets the difference between the discount and the actual face value of the transactions.
These approaches should be used only fallbacks or stop-gaps, not routinely, unless you can pass on some or all of the financing costs to your customers -- not likely.
- Immediate cash flow from your sales activities.
- Sizable discount from the face value of your receivables -- a material cut in your selling margins and profits.
This plays second fiddle to other types of bank debt, usually at a higher interest rate because there’s more risk in being a lower priority than other obligations. This debt almost always includes a “kicker” on the end of the loan, a piece of equity that increases the overall take for the lender. Mezzanine debt is often used to finance acquisitions and buyouts.
- The debt comes second to existing loans.
- It’s a great source of capital for specific transactions, like acquisitions and divestitures.
- It’s more expensive than traditional bank debt, but generally less costly than equity.
- If the business underperforms or there’s an economic downturn, this debt can actually be more expensive than the equity value when things were good.
- Cash-flow needs can cut into earnings if the acquisition or other reason for the loan doesn’t pan out as expected.
Angels are generally retired executives who invest their own money in young and/or growing companies, but like to have a say in business operations. They look for opportunities to add significant value and leverage to their investment dollars by using their contacts, industry knowledge or personal areas of interest. They can be great coaches and mentors, but unlike commercial cash sources, they’re investing their own money.
- Equity capital from knowledgeable sources.
- They generally come with industry and related contacts.
- They generally insist on tougher corporate governance and stronger business processes.
- They usually offer excellent opportunities for mentoring and executive coaching.
- They often have pre-formed opinions about how to grow your business that may not dovetail with your own.
- They can be hands-on partners, and if you’re not equipped emotionally for this, you’ll invite problems into the boardroom and corner office.
- With their requirements for belt-tightening and changes in business processes, you’re no longer the last word.
- Giving up equity can cut deeply into your returns if the business is only mildly successful.
Sophisticated Financial Partners
Private Equity Firms
So-called PE firms are great sources of growth capital, but most want to take equity and ownership control. They can be an excellent choice in a succession plan or to exit a business. It’s common for PE firms to rack up multiple players by targeting “fragmented” business arenas, those in which a given company isn’t much different from its many competitors.
PE firms often put their funds to work through such higher yielding instruments as mezzanine debt and equity. Again, they’re ultimately interested in gaining control of, or influencing, the exit of the business altogether.
- As with angels, they can bring tremendous resources and contacts to help with sales, manufacturing, financing, communications and media relations.
- They have deep pockets to assist in difficult times as a company grows and experiences downturns in business or the economy.
- They’re the most sophisticated financial experts on the planet and play for keeps. They generally invest for economic gain over time, and control or heavy influence. on the overall direction of the business and its exit.
- This is a succession-plan financing decision, so be prepared to let your baby go!
Venture Capital Firms
In recent years, VC firms have moved to investing in later-stage growth because of a backlog of companies looking for strategic exit strategies that don’t include IPO’s (see below). They’re generally interested in businesses that have clear buyers, strategic investors or PE Firms as next-stage investors that might provide liquidity. But unlike other equity investors, VCs tend to specialize, investing only in business areas they understand and where they can have a heavy hand in getting returns on their investments.
- Like angels and PE Firms, VCs bring tremendous resources and contacts.
- They have deep pockets and relationships they tap to keep you going.
- They play for keeps.
- Serious financial risk takers, they expect returns and will change anything in the business to get them.
- They’ll insist on board seats, voting rights, influence on value creation and exit events, etc.
- They’re judged by their own investors on ability to turn their investment in you into a 30 percent+ internal rate of return (IRR). It can get pretty hot in the boardroom even when things are going well.
- You’re less important to them than the business itself – this puts you at additional risk.
These companies are interested in your company’s technology, team, customer base, geography, brand, differentiation, etc. They can provide significant funding, but often only with strings attached that may not be desirable in the long run. This is also the most common form of business exit – selling to a company or player in your space. The strategic partner might be a competitor, a collaborator, or a selling or manufacturing partner.
Identify these possibilities as early as possible in your business development. Extend yourself to these partners early on and, like banking relationships, be sure they’re part of your audience as you enter the market or increase market share.
- They need your product or service.
- They’re less interested in return on their investment and more interested in what you can bring to their top or bottom line.
- They will be more forgiving on terms and valuation when negotiating the financing.
- They could preclude a channel opportunity with another potential partner.
- They could deter an exit opportunity for you with one of their competitors.
- You may have to give up valuable rights to get their money.
Initial Public Offering (IPO)
An IPO is the sale of shares in your company to the general public – the ultimate diversification of your shareholder base. It’s extremely involved and expensive, often requiring considerable man-hours to reconfigure and prepare for such an event, unless you started your business with this in mind.
- The cachet of being a public company in hiring, media, compensation, attracting investors, other financing and more.
- If you catch a wave in certain conditions in the market or your particular segment, it could help increase your value.
- IPOs have mandated standards of operation and disclosure that are complicated, expensive and intrusive.
- They come with a loss of control over long-term vision for your business and pressure to deliver results today at the expense of better business judgment for tomorrow.
- Any changes in the overall economy or your business segment can hurt the valuation of your business regardless of how well it operates.