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Finance Your Business 2: Investors

There are four main types of investors for startup businesses: yourself, friends and family, angel investors, and venture Finance your business - investorscapitalists. “Crowdfunding” is a way to cast a wider net for angel investors, and is described in Brief 05.10.

Within these categories, an investor may be accredited or unaccredited. To be accredited, an investor must meet certain criteria on net worth and income. At this writing the requirements are on the order of $1m net worth and/or annual income of $200k. There’s an exemption from strict security law that is allowed because friends and family investment does happen—but there are strict limits on the number of unaccredited investors allowed. For more information see “Accredited Investors.”

You

Startup capital is generally an investment. Future capital requirements may be treated as loans, which could have some tax advantages. For more information, see “Lending to your business? Do it right.”

Friends and Family

Friends and family are best used only at the beginning of a company, when there are few or no alternatives available. They also make sense for very long-term investments motivated more by friendship or family than by strict return on investment. They might also provide the earliest seed money for companies that grow and receive other investments later on. For more, see

When using friends and family, always be sure to document everything thoroughly. They should also sign a document acknowledging the risk and clarifying that they may not be getting their money back.

Angel Investors

What distinguishes angel investors from friends and family is that angel investors are accredited. They do meet the securities law requirements of income or wealth to be legally allowed to invest in your business. Unlike venture capitalists, angel investors invest their own money, not other people’s.

Angels often join groups, and invest in groups. They are usually more comfortable investing in the same industry from which they originally profited. There’s a huge range with angels in how sophisticated they are about analyzing a business (called due diligence) before they invest, and what sort of terms and deals they’ll take. They tend to pool together tens of thousands of dollars to invest a larger sum of hundreds of thousands of dollars, rather than tens of thousands or millions.

Depending on the successes of angel investment, it often leads to venture capital investment later on. The process and thinking of sophisticated angel investors is very much like that of professional venture capitalists.

Venture Capitalists

Venture capital is generally difficult for a startup to acquire. Exceptions might be high- tech ventures, or those expecting a high rate of growth. Another limitation on their use by new small businesses is that venture capitalists are not interested in deals where the amount requested is less than some threshold, which may be on the order of $3m. Still, it is important for startups to be aware of the venture capital process and at what stage of growth that it might be appropriate.

Let’s answer some basic questions about venture capitalists:

Who are venture capitalists? Generally they are investors that make “high risk” investments in young companies. These investments typically involve equity (ownership) positions, but are often combined with debt and sometimes involve several lenders/venture capital companies working together.

Why would I seek venture capital for my company? If you are experiencing or expecting rapid growth, you may need financing that exceeds your personal resources, those of “family and friends” and funds that you can borrow from traditional lending institutions like banks. Venture capital may be the answer.

What does it cost? It’s not unusual for a VC firm to target a return of five times their initial investment, which equates to an annual return of about 35% over the expected life of their investment. They make most of this money when they sell their investment, and they like an “exit strategy” that materializes within 3 – 7 years. An exit strategy typically involves an IPO (“going public”), selling to a large competitor (or other investor) or refinancing.

Would my company be attractive to venture capitalists? Following are some of the important criteria that VC’s look for, since companies that meet these criteria are most likely to be able to achieve the investment returns sought:

  • a product or service that is unique and has high growth potential – frequently this translates into a heavy emphasis on companies in technology, life sciences, etc.
  • a product or service that is “scalable” in that revenues can be quickly expanded by reaching national and perhaps international markets
  • a strong management team with a proven track record of success
  • a management team that is “coachable”
  • a product or service that has been proven as a concept and has a market. While there are exceptions, this usually means that the company has been in business rather than a “start up”.

How would I choose a venture capital partner? VC’s should bring more to your company than just money. Look for those with experience in your industry, have contacts that could help you, etc. Remember that the VC will own a percentage of your company and likely have a presence on your Board. Be sure that you’ll work well together and that they will be in a position to add value. You should also check on the reputation of the VC and talk to the founders of other companies in which the VC has invested.

Look at the web sites of the VC’s in your geographic area to see if your company matches well with their investment criteria. You’ll also be able to see the names of the other companies they’ve invested in along with their industries. Look at the names and backgrounds of the principals. If you can find someone to refer you to one of the principals, that’s certainly helpful (your bankers, accountants and lawyers could help here).

You should avoid sending your full business plan out at this stage. Prepare a two or three page summary that you can provide. At this point, you’ll also need to place a value on your company since you’ll be selling a percentage to the VC. There are valuation professionals who can help you with this.

Is there venture capital available locally (Cincinnati)? It is useful to separate VC’s into two groups, angel investors and all others.

Angel investors are wealthy individuals who are interested in investing in young companies for any number of reasons. This may be your neighbor, a friend of a friend or a retired executive living across town. Since they invest as individuals, their investment criteria can vary widely and can be affected by a passion for a “cause” like curing a disease. Unfortunately, it’s hard to find these investors and it’s difficult for them to find companies to invest in. As a result, these organizations have emerged to facilitate this process in the Cincinnati area:

  • C-Cap (c-cap.net) was formed to link entrepreneurs with angels. Their activities include an annual “bootcamp” to educate entrepreneurs and introduce them to investors and business experts. “Mentoring Mornings” are held monthly. They allow entrepreneurs to meet individually with a small group of investors and business experts.
  • Queen City Angels (qca.com) is a group of Cincinnati angels. The investments are still made by individuals, but QCA serves as the administrative arm and screens investment opportunities. Their web site indicates that they are interested in investments of between $200,000 and $1,000,000, though it appears they’ve invested less in some cases.
  • Queen City Angels First Fund (qcafirstfund.com) will make investments typically in the $50,000 to $100,000 range. Much of the funds come from Ohio’s Third Frontier Project. Recipients must be Ohio companies (or willing to move to Ohio). Heavy emphasis is given to technology companies.

Other locally based venture capital firms in the Cincinnati area include:

  • Cincy Tech http://cincytechusa.com/entrepreneurs/application-process/ is also funded by Ohio’s Third Frontier Project. They have two funds, a seed fund and a fund for “imagining grants”. Companies eligible for seed funds must be less than $5 million in sales and could be start ups. The focus is on information technology, biosciences and advanced manufacturing. “Imagining” grants are typically in the $50,000 range and are designed to help entrepreneurs turn ideas into prototypes, etc. There is also some portion of these funds carved out for women and minorities.
  • Blue Chip Venture Co. (bcvc.com) was founded in 1990 and has invested over $1 billion in 170 portfolio companies. Their executives have P&G backgrounds and their focus is on later stage, venture capital funded, digital media and data analysis companies.

There are many other regional and national firms that are based outside of our local area. You should consider them particularly if you believe they may have a unique understanding of your product or service.

If you are not local to the Cincinnati area then contact your local SCORE chapter as they will be able to direct you to funding opportunities in your market place.

Need a free SCORE mentor to help you prepare for successful funding? Request your free mentor here.

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Finance Your Business

finance your businessThere are several potential sources of funds for start-up businesses. Among these sources are loans, which could include: funds from the owner’s savings (treated as a loan); a second mortgage loan; charging against credit cards; loans from friends or relatives; bank business loans; credit union loans; and, loans from federal/state /local government programs. There are many sources of microloans, which are generally loans of up to $30,000.

Historically, however, the seed money for most businesses has come from the owner’s personal savings. On average, less than 10% of capital comes from banks.

This post focuses on what the start-up entrepreneur should know about obtaining loans from banks and other conventional lending institutions: the terminology; what the lender is looking for; repayment plans; and, loan guarantees. Some of these items also apply to in-business borrowers.

Businesses that have existed for a period of time and have a good track record are more likely to be approved for a bank loan. Businesses that show potential for significant growth and a high rate of return, and need a substantial influx of capital, generally need to seek investors (see Brief 05.07).

Terminology

Equity is the amount of money you can put into the business on your own: money that you don’t have to borrow or pay back. Equity may also be effort that has been put into the business in order to get underway. This type of equity can include developed operating systems, patents or inventions, original ideas and other resources.

Collateral is that property that you offer to the lender for that lender to sell to pay off the balance of your loan in the event that you default or are become delinquent on loan payments. unable to make regular payments against it. Types of collateral (and the typical loan value to the lender as a percentage of face value) include:

Inventory raw material: 50% of its cost
Equipment: 50% of its appraised worth
Real estate: 75% of your equity
Marketable securities: 75% of their current value
Accounts receivable: 90% of the invoice value
Cash savings account, C.D.s: 100%
Client Sales Order: 90% using a co-payee check for project loans [ very very common].

In general (and dependent upon a number of factors including the type of business and the quality of your presentation), lenders would like your equity to represent 20 to 50 percent of the funding required to sustain the business until it become self-sustaining. Personal guarantees are often required; until a business is well established, a lender may require the owner(s) to pledge personal assets against the loan. This reinforces the commitment of the borrower to insure the success of the business.

Considerations of the Lender

Small business loan criteria vary considerably from one lender to another, with many factors receiving different emphasis when a loan is considered. For example, some stress hard asset collateral, while others stress profitability or continuity of the business. However, lenders (banks in particular) generally hold the following points to be important:

The adequacy and quality of the equity and collateral you have to offer.

Personal balance sheet – As a borrower with a new business it is normal for the borrower to personally sign for the loan, which means pledging personal assets against the loan. A personal balance sheet will reveal assets and liabilities about which the lender needs to know. A credit report is often required; before seeing a lender you may want to see if you can improve yours.

Ability of the business to generate cash flow sufficient to pay off the loan is vital for loan approval.

Appearance, personal traits, “people skills,” and body language; your promptness in showing up for your appointment; the manner, clarity and enthusiasm with which ideas are presented; preparedness in anticipating and answering the banker’s questions.

A written business plan that describes the business, the nature of the market and potential for growth in it, the organization and its people, the process, projected profit and loss statements, balance sheets and cash flows, how much financial help is required and how much you and others can contribute. SCORE has a number of Briefs that can help in the preparation of your business plan.

The business plan must include reasonable financial projections of sales, costs and income based upon a thoughtful analysis of the market and the potential for the penetration and growth of the product or service you intend to offer.

Don’t let anyone prepare your business plan for you. The fact that you wrote the plan will become readily apparent to the potential lender during your loan application meetings and the lender might well question your dedication and competence.

Presentations and business plans should avoid non-essential “fluff.” This includes newspaper and magazine articles relating success stories in California or New York, franchise propaganda, pretty binders, and endless technical discussions of the product.

Experienced and competent management and supporting functions (attorney, accountant, business consultants)

Honesty: If there is something in your personal or credit background that is questionable, disclose it up-front to the lender because he or she will find it out eventually anyway.

Existing businesses need to present essentially the same information to a lender except they have the advantage of having historical financial data to support their future projections.

Considerations of the Borrower

Evaluate the bank by finding out what it has to offer that will fit your needs, and your capability for assuming the debt. Your own bank should be your first consideration because you are established there, so, if it meets your criteria, stay put. It is alright to talk with more than one prospective lender. Be sure that any financial institution considered can service all of your present and future needs.

Offer to move all your other banking to prospective lenders.

Your evaluating process should seek answers from the lender to such questions as:

Do you have any small business loan officers with whom I may speak?

What small business loans do you handle? Do you handle SBA guaranteed loans?
Do you have any connections with federal/state/local loan programs for which I may be eligible? Are you presently lending on my type of business?

Steps Involved in Obtaining a Loan

Before applying for a loan for a new business venture, visit the lending institution to find out what the loan officer will expect from you, such as what forms you must use. The visit may save you from wasting time and may be the start of a solid commercial relationship.

Make an appointment with the lender to make a presentation on your business and its needs.

After you have prepared your business plan, including the details of how much you wish to borrow, for what purpose and how it will be repaid, send at least two copies of it to the lender in advance of the date of your scheduled presentation.

If you have a place of business, give the lender a tour. The workplace should be clean, neat and organized with an atmosphere of activity.

Make your presentation, mindful of the considerations for which the lenders are looking. If a bank appears reluctant to lend you money, ask if you can be considered for an SBA loan guarantee. This limits the bank’s liability.

Be prepared to answer questions on the spot. Beforehand you may wish to practice and time your presentation while trying to anticipate likely questions the banker might ask. It will be helpful to have a succession plan in writing. It also can help to get a “key person” life insurance policy on yourself in an amount equal to the value of the requested loan.

Loan Repayment Plans

Your proposal and repayment plan should be formulated in light of the bank’s requirements. First, if the loaned funds are to be used to purchase a specific asset, the asset must last at least as long as the loan period. Second, the assets should generate the repayment funds by increasing sales, cutting costs or increasing productivity. Third, your cash flow projections should show your company’s capacity to meet interest as an expense and to repay principal from net profits.

Lending officers will assist in preparing a repayment schedule. See the Resource section for a sample installment note.

If Your Loan Request is Rejected

If the lenders ultimate decision is negative, don’t hesitate to ask why. You’ll enhance your chances of making the next attempt successful. You might also ask the rejecting loan officer for recommendations on how to improve your presentation (including your business plan).

Grants/Non-Profits

Grants awarded by foundations and government entities are generally limited to not-for-profit, tax-exempt organizations operated for educational, literary, religious, charitable and scientific purposes (most fall under IRS 501-C-3 regulations).

Suggested sources for further information on establishing a non-profit organization and/or identifying providers for grants:

  • Web site: www.sba.gov
  • Grants Resource Center, Cincinnati Main Library (8th & Vine Streets)
  • Executive Service Corps of Cincinnati
    10921 Reed Hartman Highway, Blue Ash, Ohio, (513) 791-6230
  • Dayton Metro Library, 215 E. Third St., Dayton, Ohio 45402, (937) 463-BOOK (2665) A free, 3-hour orientation to the Library’s Grants Information Center is offered each month. For schedule details and to register call 937-463-BOOK(2665), ext. 6501.

Resources

The following references provide links to various State, County, City and private loan programs available to help small businesses obtain financial help. This list is not all-inclusive, but can serve as a reference point for the major programs in our area. Many government organizations offer loan programs. New programs, such as Micro-Loans, are frequently added and old ones eliminated or de-funded. Therefore, you should check with the county and municipality where you are doing business or are planning to do business to determine whether they have programs that may help you.

Download the Brief #05.01 for a Loan Package Requirements Checklist and sample Installment Note.

Want to work through the application process and some support? Request your free SCORE Mentor here.

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