Financing your business

The more money, or equity, you have invested in your business, the easier it is to attract financing.

by Bruce L. Hodgman  — 

While poor management is cited most frequently as the reason businesses fail, inadequate or ill-timed financing is a close second. Whether you are starting a business or expanding one, sufficient ready capital is essential. Of all the business skills that must be mastered to be a successful small business entrepreneur, learning to access capital when needed is a critical attribute.

Before inquiring about financing, ask yourself the following:

• Do you need more capital or can you manage existing cash flow more effectively?
• How have you defined your need? Do you need money to expand or as a cushion against risk?
• How urgent is your need? You can always obtain the best terms when you anticipate your needs rather than seeking funding because you’re under pressure.
• Have you identified existing sources for capital, including often-overlooked alternative sources? Do you understand the “rules” about approaching many sources?
• How big is your risk? All businesses carry risks, and the degree of risk will affect the cost and availability of your financing alternatives.
• In which state of development is the business? Needs are most critical during transitional stages.
• For which purposes will the capital be used? Any lender will require that the capital be requested for very specific needs.
• What is the state of your industry? Depressed, stable and growth conditions each 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 financing needs generally are short term. Loans advanced for cyclical industries such as construction are designed to support a business through depressed periods.
• Do you know the type of credit that will meet your needs? Is it a term loan, short-term loan or specialized need? What are the typical terms, costs and risks associated with each?
• How strong is your management team? Management is the most important element assessed by money sources.
• What are the successful credit factors lenders review for businesses in your industry? Do you have sufficient collateral to protect the loan? Do you have an acceptable credit history?
• Perhaps the most important consideration is how your need for financing meshes with your business plan. If you don’t have a business plan, write one — or hire someone to write one for you. Lenders will want to see your plan for the start-up and growth of your business before they finance it. Most, if not all, lenders in Arizona consider a business that has been open less than two years as a “start-up.”

There are two general types of financing: equity and debt financing. The more money, or equity, you have invested in your 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, you should increase your equity before you borrow additional money. That way you won’t be over-leveraged to the point of jeopardizing your company’s survival.

There are many sources for debt financing: banks, savings and loans, commercial finance companies and the Small Business Association (SBA) are the most common. Many state and local governments have small business programs. 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. For more information on SBA loan programs visit www.sba.gov/financing/index.html.

Additional equity can be sought from non-professional investors such as friends, relatives, employees, customers or industry colleagues, although venture capitalists are the most common source. Most specialize in one or a few closely related industries. Most venture capitalists prefer three-to-five-year old companies that have the potential to become major regional or national businesses and return higher-than-average profits.

You may contact these investors directly, although they typically make their investments through referrals. The SBA licenses Small Business Investment Companies, which make venture capital investments in small businesses. For more information check www.sba.gov/INV/forentre.html.

Additionally, SBA’s resource partners offer free training and counseling to future entrepreneurs including assistance in business plan preparation. The local SCORE Chapter in Phoenix (602-745-7250) offers special loan clinics on how to apply for an SBA loan. These free clinics include a presentation by the SBA and a participating lender on how to prepare the application, types of credit available, ways to approach a lender and which lenders may be interested in your loan needs.

For a broad discussion on start-up business topics, visit www.sba.gov/starting_business/index.html.

Bruce Hodgman is the deputy district director of the Small Business Administration in Arizona and can be reached at [email protected].

Reprinted from AzNetNews, Volume 25, Number 2, April/May 2006.