Financing the Startup

1. Fundamental Questions

Financing your startup may seem like a headache. It should not be. Organize your thinking by considering the following 10 questions:

1. How little money do you need to start?
2. What are your personal sources of funding?
3. Do you want to grow within your existing funding?
4. If so, have you calculated your potential cost levels vs. revenue flows?
5. If not, have you considered the relative merits of short and long term finance?
6. Can you borrow loan capital, committing to repay principal and interest and over what period?
7. What are your net liquid/fixed assets and how much can you risk?
8. What is the quality of your credit history and can you improve it?
9. Can you find equity capital from the right sources and be prepared to give up a share of ownership?
10. Have you listed the costs and benefits of alternative funding sources?

2. Conventional Sources

Do not imagine that it is simply a matter of writing a business plan and then tapping a venture capitalist for investment. First, VC money is for a tiny minority of startups and most have highly targeted funds with expectations of huge increases in value. Second, you could waste months of vain effort and the delay the start of your business. Both will cost you very dearly.

“Oh yes.” you say, “that’s right, but I can find a business angel. They are much easier to convince.” Wrong again. And in both cases, the relationship or introduction from a credible reference are likely to be much more important than an all-singing, all-dancing business plan. How many high net worth people do you know?

In the US, for an individual to be considered an angel, the status of ‘Accredited Investor’ is required. An Accredited Investor must have a net worth of at least $1 million or have made at least $200K each year for the last two years. So, I ask again, how many such people do you know?

To come back down to earth, know that startup finance raised by Inc. magazine ‘500′ companies (the fastest growing private companies in the US) in 2007 came from these sources:

Among the larger list, the Inc. 5000′ high fliers, also bear in mind that while 62% of them had an exit plan, only 28% of those aimed at going public. Thus, almost every startup should forget the dream of an IPO. Basically, the stock market is not a viable source of funds for the startup.

Even among the ‘Inc. 500′ companies (the top echelon of startups) as many as 14% raised $0 to start the company! Pre-launch, the median for funds raised by the fast-growing companies was $50K. You can compare the funding sources in the table below from Entrepreneur magazine & PricewaterhouseCoopers’ 2006 ‘Hot 100′ listing of fastest-growing new entrepreneurial companies:

There are two kinds of capital finance that may be important to you. The first is short-term and medium-term loans and the second is risk, or equity capital. There are variants of each.

3. Alternative Sources

There are also other means of funding the business, especially the small business. These include:

• Personal or business credit cards, which I strongly advise against given the dangers of high rates of interest, the speed that indebtedness can compound and the likely damage to credit ratings;
• Grants that may apply to your business, which should be grabbed, but should not be the condition for success, or the business will fail;
• Bootstrapping, or finding ways round conventional means of financing—the best source, especially combined with the business’s own revenue, the cheapest source of finance;
• Business Social Loans, or (P2P) finance, which can often be at rates of interest that are lower than those offered the banks, but watch out for personal relationships;
• Supplier finance programs, which are now begriming to appear—an example is Whole Food Markets Local Producer Loan Program—they are good but may reveal more than you want to your customers;
• British high-end chocolate maker and retailer Hotel Chocolat, currently operating over 40 stores in the UK, the Middle East and the US, wants to expand even further. But rather than turning to banks or big investors for money, they’re inviting customer to buy bonds. Bonds that will pay chocolate returns.
• Consignment programs where vendors supply product on a sale-or-return basis;
• Take a look at the opportunities for Community Supported Business;
• Strategic partnerships or partners may offer you a source;
• ‘Soft loans’, such as those offered or backed by the SBA or other development institutions (e.g., regional, disadvantaged)
• Leasing, rather than buying capital equipment or vehicles—and you can consider joint purchase of capital equipment that you won’t use full time;
• Financing accounts receivable, often called factoring, but in my book this is expensive and risks customer relations through someone else chasing payment;
• Enter business plan competitions—there are many examples both at business schools and at development organizations (a startup called Yodle won the Wharton Business Plan Contest in 2005 and pulled in $12 million in VC money in 2007; John Ready of Ready Seafood won a $60K business plan competition in 2004 and, with his brother Brendan, now has a $10m business in Maine; my local Brattleboro development corporation in Vermont offers $20K as a top prize).
• If you are buying an existing business, new financing creativity is often necessary. Acquirers accustomed to providing only 30 percent equity (ie hard cash) and funding the remainder of a deal through bank loans are now lucky to get even 50 percent of the purchase price. Increasingly, they are looking to the seller to supply a separate loan (often called a note), to cover the remaining 20 percent. The seller is becoming the lender of last resort.
• In the US, under the Hiring Incentives to Restore Employment (HIRE) Act, companies can save as much as $7,621 per qualified employee under HIRE. Most governments periodically introduce such incentives and though a certain amount of red tape will always be involved, savings like these amount to grant money and should be taken whenever offered. Do not however base your business plan upon them. If the business does not stand up on its own, it will probably not be sustainable anyway. Like HIRE, most of the schemes are of limited duration.
• You may not have thought of PayPal as a source of finance. Well, it’s not exactly, but you can use their online invoicing by email  service to ensure early payment of your invoices.
• If you have a creative project–it can be a business–take a look at Kickstarter. They’ve got a pretty broad definition of creativity: art, music, design (fashion, product, game, app, etc), film/video, food, journalism, and other projects that spring from the imagination. Funding is always all-or-nothing. A project must reach or exceed its funding goal or no money changes hands. Why? It’s fun, dynamic, and really efficient. Creators keep 100% ownership. Kickstarter is a new form of commerce and patronage, not a place for investment or lending. Project creators inspire people to open their wallets by offering products, benefits and fun experiences. Kickstarter collects 5% from the project creator if a project is successfully funded.

4. Sources Compared

There are advantages and disadvantages in each means of financing your business. It is important to select the one that suits your business, or which you can access.

This is only a summary and each source—or a mix—requires more careful consideration. Whichever source you choose, there are consequences to take into account. Here are some important ones (the numbers are marked against the sources in the table above):

1. need credit/personal assets report
2. business plan required or an advantage
3. secured, against fixed or financial asset
4. unsecured, but some may require security or personal guarantee
5. offered against future product delivery
6. personal, not business risk
7. expensive, third-party deals with customer

Angel investors are probably the only group that you are likely to appeal to and even then it may be a stretch. An excellent place to start (I have in the past and may do again) is Angelsoft. They have startup funding tools that simplify the process of raising startup funding. There is a directory of nearly 500 angel groups hat include 15 thousand or more individual investors.

5. Equity, Loans and Working Capital

Separate in your mind the differing roles of different purposes of finance.

1. Equity is for the long term and in many ways at the level you work at, equity capital will imply that whoever supplies it is a partner of some kind. It seems very appealing to get finance without having to repay the capital or interest. But there is a price to pay. The financier will expect a return on the investment and will quite likely want to have a say in major decisions. Plus, you will have to meet some objectives that may be different to your own. Many entrepreneurs resist this more strongly than losing some of the equity.
2. Loans can come from many sources and be of many types. They may even come from equity owners. If you want to seek a loan, prepare your ground properly. I suggest a very help tool is the Loan Builder.
3. Working Capital is best sourced from revenue, but there are external sources and can be expensive. The most natural is your bank, but in times of credit squeeze, even this may be problematic and/or expensive.

6. Compatible Financial ‘Partners’

Years back when I ran a fast-moving service business, I made a mistake in trying to align my business with the requirements of our bankers. It was a hard lesson.

For years as the company grew, with very limited assets, the banker continually suggested that we should build tangible assets into our balance sheet. Finally we caved in, also being seduced by the idea of buying a property befitting our business.

However, we had no need to be property owners; we were not in the real estate business. But the banker felt more secure with us having what he called a ’security’ in our books—something with which he could reassure his superiors. In fact it turned out to be an ‘insecurity’ The mortgage crippled the business.

In the same way as is natural in marketing and recruitment, where you seek appropriate customers and staff members—without even thinking about it, so should it be with your financial partners. Make sure that their interests and values coincide with your own. You don’t want them calling the shots, especially when the going gets tough.

Take the trouble to avoid falling into the arms of the first banker who will open an account for you or lend you money. Find one who’s scale and culture is compatible with yours. If you are seeking an investor, do not cozy up to one who is simply in it for the dividend, because in hard times it will no longer be so cozy.

If your business is ‘environmentally friendly’, find a ‘green’ investor. If your business serves the local market, choose a community bank or the neighborhood Savings and Loan.

7. Right Finance–Right Time

When you are seeking finance, you will probably be thrilled to get any money from anywhere, but take great care.

Why take care?

Because not all finance is created equal. At different stages and for different purposes, the right kind of financial source should be used. You may have heard about ’rounds’ of finance, where larger or high-tech startups are concerned. They may follow a sequence like

• personal funding
• friends and family
• bank
• seed round
• angel round
• ‘A’ round
• ‘B’ round
• mezzanine round
• IPO.

But don’t worry about that. At each stage one source or other is going to be appropriate, because of the needs of the business at that stage.

At the pre-launch stage, you will want to keep as many of your options open as you possibly can, so your own resources are generally the best form of finance, supplemented perhaps by a line of credit. The line of credit only needs to be called upon if needed. No need, no repayments or interest.

Next most flexible, probably, are loans from friends or family, but make sure that you arrange these in a formal way with a promissory note, to avoid squabbles if things do not work out as planned. Use either Virgin Money or Zimple Money to undertake the formalities for you. It is not expensive and may save a lot of cost later.

At which ever stage, just make sure you think about the consequences of tying yourself up with a particular source. In most cases you will be making a medium to long term commitment.

8. Readiness to Negotiate

Are you ready to negotiate? There is no point in walking into your local bank with your super duper prototype that is the best thing since sliced bread and expect to walk out with a bag of money. It is not going to happen. One of the best things you can do is to have a business plan in your hot and sticky hand. But above all, you need financial numbers.

Remember that anyone, I repeat anyone, from whom you seek a loan will want to know one thing above all: will you be able to repay the loan in a timely manner? In order to show that you will be a good bet, the lender will want to know about:

• your relevant track record, and those of any associates;
• your investment in the business;
• your other assets, especially your liquid ones and your willingness to pledge them;
• your sales: actual revenue banked to date and evidence for the near future;
• your fall-back plan, if your forecasts don’t pan out.

Get ready. If you are going to seek help from the SBA for a 7(a) Loan Guaranty, for example, there is a whole list of documents and information required for a submission. You will find that much of what is required will also be asked for by the bank, too.

There are examples of startups that go through the stages like greased lightning—an example is NComputing whose co-founder Young Song says, “There is nothing more exciting than to build a company from zero to nearly a billion dollars in sales in only one year.” Take a look at CEO Stephen Dukker talk about it in the video Forget the $100 Laptop.

9. More Financing Help

Financing is a vast field and you are going to navigate it in the way that suits your particular business. It may be that you will find what you are looking for at Bootstrap Finance: Thrifty is Nifty; in the Finance section of the Useful Website Links page; at the Startup Owl’s Bookstore; or among the products in the Tool Chest. If you are bamboozled by financial terminology, then go to The FT Lexicon to get the explanation.