Inability to meet the Debt prerequisites will bring about extreme outcomes. In the U.S. the enthusiasm on Debt is a deductible cost when registering assessable pay. This implies that the viable interest expense is not exactly the expressed interest if the organization is beneficial. Including a lot of Debt will expand the organization's future expense of getting cash and it includes hazard for the organization.
An alternative to financing through equity is debt. The advantages of using
debt are:
• the time to secure debt financing is usually shorter than equity;
• the cost of the money (principal and interest) is readily measurable;
• documentation costs for the transaction will probably be less than an
equity transaction; and,
• the equity of the company is not diluted by new ownership.
The disadvantages to debt are:
• unlike equity, the company has to pay back debt;
• the company must carry debt on its balance sheet as a liability, which
may make it less attractive to some investors;
• if the cash flow of the business is tight, debt service can put an undue
strain on the finances;
• in many small businesses, commercial lenders require the principals to
personally guarantee the debt and possibly pledge personal collateral; and,
• some lenders require rather onerous record keeping by the borrower,
such as quarterly and annual financial statements—possibly audited—
and impose restrictions on certain business transactions without the
lender’s consent.
Bank Loans
One of the most common types of financing is bank loans. In order toobtain a bank loan for a new business, you may need to present a business
plan or a loan proposal, which are similar documents.
The advantage of seeking a bank loan may be that you or your family has
a preexisting relationship or history with a bank that makes the process easier.
In any event, a bank will focus on several things in reviewing your loan
application.
First, they will want to know about your business (the business plan),
how much money you need, and how you intend to spend it. Equally
important is demonstrating to the bank how your business intends to pay
the loan back and over what time period. Financial projections are most
helpful at this time.
Banks are in the business of loaning money—that is one of their main
profit centers. Your task is to demonstrate to them that you are creditworthy
and that the revenues from your company are likely to pay back the
loan in a timely manner. You demonstrate your ability to pay back the loan
through your financial projections. If you already have a history of running
a profitable business, a historical financial statement coupled with a financial
projection could win the day.
Unless you have substantial assets in your company and healthy annual
revenues, banks are likely to look to the creditworthiness of the owners of
the business. In other words, you and your partners’ credit histories will be
checked and you may be required to submit a personal balance sheet.
Alert!
Keep in mind that it is a crime to submit false information to a bank—tell it like
it is without unnecessary embellishment.
In the case of a start-up business, many banks will require, as a condition
of the loan, that each of the founders (and possibly their spouses) guarantee
the loan. The demand for personal guarantees may also surface when
you are signing a lease for your company office or plant. If you have to sign
a personal guarantee, see if the bank will agree to remove it after some reasonable
period. Commercial landlords tend to be more open to the eventual
removal of personal guarantees than banks, but it never hurts to ask.
Banks charge interest for loans, which is deductible as a business expense
to the borrower. Interest rates vary among banks and can be influenced by
the type of loan made and the perceived credit risk of the borrower. You
should explore the various types of bank loans available to your business to
see what fits. For example, a line of credit allows you to draw funds when
needed and only pay interest on outstanding balances.
Yearly Paybacks: In the case of a line of
credit, you may be required to pay out of the line (i.e.,
pay back all balances) once a year in order to renew it.
An installment loan is usually for a certain sum that you pay back in payments
of principal and interest, similar to your home mortgage. Many business
loans have a floating interest rate that adjusts with changes in a standard
index, such as the prime rate.
Some banks may require that you provide security or collateral for any
business loan. If your business does not have equipment or receivables, they
may require you to put up your house and other personal property to guarantee
the loan. If that is not enough, you and your partners, directors, and
possibly principal shareholders will most likely have to sign personally on
the loans as previously discussed.
If your company is writing a business plan and a bank loan is in the picture,
you may wish to specifically address the issues the lending bank will
consider in making a loan. As a practical matter, you will probably have
trouble getting a loan as a start-up if you cannot demonstrate an ability to
repay the loan from revenues.
You should probably enlist the aid of your
accountant to make certain that you tell your story in believable numbers.
You will also help your case by having substantial clients or orders in the
wings to demonstrate imminent revenues. It also helps if you have invested
your own money in the venture, as this demonstrates your commitment to
the business and its success. In venture circles that is known as having skin
in the game. Pledging collateral is another way to put skin in the game.
Another useful approach is to plan your presentation to the bank, preferably
on your own turf, so that key employees are included in making portions
of the presentation. If you are in a position to reduce or cut your own
salary for some period of time, that will also impress the bank—they do not
relish your seeking a loan to pay your own salary.
Larger, institutional banks are not the only game in town when seeking
loans. Smaller, community banks are generally more connected with local
people and may be more flexible. Innovative officers in small banks will try to syndicate or farm out portions of loans to other small banks to increase
their lending limit.
You should not necessarily stop with banks as the sole source of lending.
Many venture funds, larger companies like GE Capital, and brokerage houses
have bank-like divisions that could be a source of debt capital or some combination
of debt and equity. American Express has a small business division called
OPEN: the Small Business Network (www.americanexpress.com) that can grant
needed lines of credit for small businesses.
HOW TO...Get a Bank Loan
- Prepare a business plan targeted to a lender rather than an investor.
- Present believable financial statements and projections that demonstrate that the company will have sufficient cash flow to service the debt and meet its operational budget.
- Interview the lender prior to submitting the package and find out exactly what type of presentation and information is expected.
Small Business Administration (SBA)
The Small Business Administration (SBA) (www.sba.gov) has a number of
loan programs for small companies. Its basic 7(a) loan guarantee program is
perhaps the best known. The program is designed for small businesses that
cannot otherwise obtain a loan. The actual loans are delivered through commercial
banks, with the bulk of the loan principal being guaranteed by the
SBA.
The maximum loan under this program is $2 million, but most of the
loans placed are for less. More information on the 7(a) program is available
at www.sba.gov/financing/sbaloan/7a.html.
Another SBA program is the 504 loan program, which provides longterm,
fixed-rate financing to small businesses to acquire land, buildings, or
equipment. The 504 program cannot be used for working capital or inventory.
The loans are delivered through certified development companies (CDC), which are private, nonprofit corporations designed to contribute to the economic development of their communities. A private lender has a senior lien, and the CDC issues an SBA guaranteed debenture for up to 40%
of the loan amount. The debenture is secured by junior lien.
The owner must contribute at least 10% of the equity. The maximum SBA debenture
is $1 million, which can go to $1.3 million in some cases. More information
on the 504 loan program can be found at www.sba.gov/financing/sbaloan/
cdc504.html.
The SBA has a microloan 7(m) program in which a small business can get
a short-term loan of up to $35,000. This loan can be used for working capital,
inventory, furniture, supplies, and the like. Microloans are delivered
through specially designated intermediary organizations, usually nonprofits
with experience in lending. More information on the microloan program
can be found at www.sba.gov/financing/sbaloan/microloans.html.
In addition, there are other, more specialized programs at the SBA that
address the needs of women, minorities, veterans, and Native Americans.
More on these loans and other special interest topics can be found at
www.sba.gov/financing/index.html.
The SBA has a surety bond program for contractors and other special
purpose programs that include an alliance with the Export-Import Bank to
promote export trade, employee stock option ownership plans (ESOPS), and
lines of credit under the CAPlines program.
Information on the SBA programs can be found at www.sba.gov/financing/index.html and the Ex-Im
Bank information is at www.exim.gov/products/work_cap.html.
Several misconceptions about the SBA programs seem to surface now
and then. The SBA programs are not grants or free money. They are generally
loans that constitute legitimate debt and that need to be repaid. It
is generally believed that a business has to be a start-up or in distress to
apply. Neither of these statements is true. The SBA is not a bailout
agency. It finances healthy businesses that need bridge financing or an
extended term loan.
The SBA: The SBA is an often-overlooked resource
for more established businesses that need to grow or
acquire new facilities.
Credit Cards
Many entrepreneurs use credit cards to initially finance their business. If you
go this route, you need to treat the credit card debt as an installment loan
and pay it back as soon as possible. You should also shop around to get the
best rates—credit card interest can be steep.
Establish guidelines for credit card borrowing. For example, do not borrow
any money you cannot repay in ninety days. Make sure to keep accurate
financial records that separate your personal expenses from business
expenses. A good strategy is only to use credit cards for the purchase of a
long-term asset like a computer, or for something that will quickly generate
cash, like buying inventory to fill an order. Do not use credit cards to pay
expenses that are not generating revenue.
Home Equity Lines
In the initial start-up phase of the business, other direct sources of
financing include home equity lines. The home equity line is essentially
asset-backed borrowing.You could do the same thing with the business if it
had assets to pledge. To obtain a home equity loan, you apply to a bank or
financing institution and the loan is secured by a lien on your home, usually
a second mortgage.
Retirement Funds
You can always use self-directed IRA accounts of investors as a source for
financing. Owners of self-directed plans can make investments in private
companies. However, there are certain disqualified persons who cannot
engage in prohibited transactions with the IRA.
Common occurrences of IRA prohibited transactions are
(1) purchasing investments that will benefit
the IRA holder (as opposed to the IRA itself) and
(2) using the IRA as security for a loan. An example of the direct benefit example is having the
IRA purchase a vacation home for your family. Disqualified persons include
the IRA holder, his or her spouse, ancestors and lineal descendants of the
IRA holder and spouse, and any corporation, partnership, trust, or estate in
which the IRA holder has a 50% or greater interest. In calculating the per-centage ownership of the IRA holder, the IRA attribution rules apply so
that the interest of spouses, ancestors and lineal descendants are included.
In some circumstances, investors can utilize their 401(k) plans to invest in
private companies.
Consult with a tax professional before making any investments from
retirement accounts. If your investor is having trouble convincing your
custodian to make an investment with their retirement account, you can
set up a new self-directed account with a company like Trust
Administration Services Corporation (www.trustlynk.com) that specializes
in self-directed retirement funds. Other sources for self-directed plans are
www.lincontrust.com and www.pensco.com.
Life Insurance Borrowing
You may also consider borrowing against your life insurance policy,
assuming that you have the kind of whole life policy that builds cash
value. The interest rates are less than credit cards, and the loan will stay
in place as long as you continue to pay the premiums. If you die while
the loan is outstanding, the benefits of your policy will be reduced.
Financial Brokers
You will undoubtedly cross paths with financial headhunters or brokers
during your quest for financing. These individuals or companies usually work
for a commission and typically want a portion of your company’s equity as
part of their fee. You should exercise caution when employing a financial
broker, since they are generally not licensed like stock brokers, attorneys, and
accountants, and there is little public information available on them.
Always insist on references and do a thorough job of due diligence on
the brokers. Avoid paying up-front fees if possible. If travel expenses are
required, approve them on a case-by-case basis. Avoid signing an exclusive
agreement with the broker, but if you must, have the period of
exclusivity expire after thirty to sixty days if no meaningful results are
forthcoming. In all events, make certain that the broker is not paid theirfee unless financing actually occurs. Make sure you have the absolute
right to decline any financing offered for any reason.
Alert!
Many brokers will try to convince you that your business plan needs upgrading
to an investor-grade business plan before they can present it, and that will cost
you several thousand dollars for the makeover. If you have a solid business plan
with CPA-blessed financials, politely decline the offer.
Reverse Mergers
The subject of reverse mergers, where a company merges into a publicly
traded shell company, is well beyond the scope of this book. Any start-up
company would be well-advised to avoid a reverse merger until they have
raised several rounds of financing—and maybe not even then. While there
are successful reverse mergers, the field is strewn with wrecked companies
that have insolvable regulatory problems. Caution is advised. Make certain
you consult with competent professionals before undertaking this route.
Factoring
Factoring, also known as receivables financing, is a popular form of raising
capital. While it is not for everyone, it can be useful if your business has a
large volume of receivables. Essentially, a factoring company advances to
your company the value of a percentage of your receivables, less a fee, and
assumes the responsibility to collect the factored receivables.
When you factor your receivables, you usually end up with between
50% and 90% of their value, depending upon the creditworthiness of
your clients and your company’s collection history. When the factor collects
the receivable, it forwards the balance to you less a fee that can
range from 2%–7%. The advantage of factoring is immediate cash flow to
the business without a long-term debt obligation. The disadvantage is
that the process is fairly costly.
Factoring Guides: A source for factoring companies
can be found in Edwards Directory of American
Factors, Edwards Research Group, Inc., Newton, MA
(www.edwardsresearch.com). This factor guide is
usually available at public libraries as well.
Revenue Participation/Royalty Financing
Revenue participation or royalty financing occurs when an investor buys a
percentage of a future revenue stream of the company. This type of financing
can be risky for the investor if there are no sales revenues or revenues do
not occur for a time. When sales do occur, payment to the investor comes
before any other expenses of the company, regardless of profitability.
In the current market of hybrid securities, a revenue or royalty component,
coupled with some equity participation by way of warrants, can be an
attractive option to investors seeking both cash flow and equity participation.
A version of royalty or revenue participation can be structured within
a class of preferred stock or LLC membership units. The tax and legal
aspects of this creative form of financing are complex, and careful planning
with your legal and accounting team is advised.
Merchant Banking
Historically, merchant banks have not been commercial banks that accept
deposits, but private banks with access to private equity funds. That said,
many of the traditional lending banks have ventured into the private equity
market in the past few years. With a little research, you may be able to
uncover a source of equity financing from your bank.
Larger banks have been investing in private equities for quite a while, and now small banks are
getting in the game with some banks syndicating the investments with other
small banks. It is unlikely your local branch officer will know much about
these programs, and you may need to do a bit of digging to get to the right
person in the bank. If you have a preexisting relationship with the bank, you
will probably get answers a lot quicker.
In addition to the private equity groups of commercial banks, there are
other private equity nonbanking groups, such as insurance companies,
hedge funds, large and small angels, private equity funds, and other institutional
investors who invest in early stage companies. Like an entrée into
venture capital, an introduction to the group, especially from a person who
has previously raised money from that sector, is extremely helpful.
SBIC Financing
The Small Business Administration (SBA) also sponsors an equity investment
program known as the Small Business Investment Corporation
(SBIC), which is a series of privately owned investment funds licensed by
the SBA. Essentially, the SBIC program is a public-private partnership
designed to flow venture dollars in to emerging companies.With the SBA
contribution, the SBIC funds can vastly leverage their private investor
dollars. Essentially, they are SBA-sponsored venture funds that may or
may not have a debt element.
Between FY 1994 and 2002, the SBIC funded 8% of the venture market
investments for a total of 23.7 billion dollars—and this figure represents
only the financings that contain equity features. 2.7 billion dollars was
funded in FY 2002 alone. A large percentage of fund dollars go to low and
moderate income businesses in more diverse parts of the country than the
investments of conventional venture funds. Information on the SBIC program
can be found at www.sba.gov/INV, as well as a list of SBIC sponsored
funds in your area.
Private Debt
A company can raise capital by offering a debt instrument to investors asopposed to an equity instrument. For example, the company could offer
secured or unsecured promissory note obligations payable over time at a
competitive interest rate. Private company debt, particularly the unsecured
variety, is considered risky, and an above-market interest rate is necessary to
attract private investors or lenders.
Alert!
Be sure to check the state usury laws before setting the interest rate.
Many start-up companies offer a convertible promissory note in their
early seed rounds. The convertibility feature of the note allows the holder
(lender) to convert the amount due for principal and interest to an equity
interest in the company.
The conversion rate would be the amount at which
equity interests in the company will be offered to new investors or at a discount
to make the investment more attractive. If you use convertible notes
or any debt instrument to raise early money, you should organize the entity
first and have the note be issued by the entity rather than you personally.
Combining Equity and Debt Financing
Recently, there have been some offerings that combine both debt andequity in order to give the investors some liquidity in a debt instrument and
a possible upside for growth with an equity component.
One method is to use unsecured promissory notes that give the lender the option to convert
all or a portion of their investment into an equity interest in the company,
usually at a discount below any current offering price of the company’s
stock. Using any method that involves the sale of securities by the company
means federal and state securities laws must be observed. Chapter 5 discusses
some of the issues surrounding securities offerings.
Several years ago, it was common to see real estate development loans containing
a provision that allowed the lender to participate in the equity or
income potential (or both) of the underlying real estate project.Your company
can offer a debt instrument coupled with equity or income participation as an
inducement to invest.
The LLC format is particularly suited to this type of investment because of the flexibility of the partnership taxation rules. Again, these are fairly complex offerings that require carefully drafted documents as well as compliance with the securities laws. As you enter the arena of hybrid
debt instruments, a do-it-yourself approach is not advisable.
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