CHAPTER 1
WHY DO YOU NEED BUSINESS CAPITAL?
"Sorry, we can't help you." "Your expectations are out of line with ourguidelines." "It's unlikely you are going to find that much money at this stageof your business."
All funders have uttered one of these three sentences on a majority of all theproposals they have ever considered, although maybe they delivered the messagewith gentler phrasing. Financing is strange territory for many upstartentrepreneurs, who expect that they can ask for and receive the entire sum ofmoney they think they need for their big idea or fledgling enterprise.
Business owners frequently ask investors or lenders for an obviouslyinappropriate sum of capital based on either a lack of acumen to determine theirreal capital costs or failure to recognize the financial risk any funder isgoing to require that the owner share. Closing the information gap about thisfinancing reality will advance the owners' capital search faster than any otherexercise in the early business stages.
As in most of life's transactions, there's a distinct difference in businessfinancing between what we want and what we can get. We all want world peace butoften settle for a cease-fire. We want to win the big Lotto but are happy to getjust a few bucks with a scratch-off card. In business it's great to imaginesomeone would put up all the money to pay for the pursuit of a terrific idea,but the reality is that that probably won't happen.
Capital owners employ funding within established risk parameters with theexpectation of a specified return on investment. Risk is determined withinstringent guidelines that are intended to avoid expensive losses of capital. Thecapital owners generally have the experience of previous disasters or theaversion to taking chances beyond a defined boundary with the funds they manage.These experiences and boundaries will define their appetite for risk and, as wehave learned from the Golden Rule: "Those with the gold make the rules."
Business owners must recognize that the ultimate financial risk of any financingtransaction is always going to be borne by them. Likewise, most of the financialrewards of a very successful enterprise will flow to the business owner as well.It's a risk vs. reward world.
Once business owners reconcile themselves to the idea that they must acclimatetheir capital needs to someone else's standards and accept the brunt oftransaction risk for the enterprise and the capital provider, then they comearound to asking themselves: Why do I really need capital?
The quick answer to that question might be "because I don't have it." More oftenthan not, that answer is not entirely true.
Many business owners initiate efforts to acquire capital from a third partybecause it is perceived to be simpler and less risky than using their ownresources. Depending on one's financial position, appetite for risk, and generalbusiness optimism, the personal risk is generally inversely related to the easeof accessing third-party capital.
If business owners are laden with significant cash resources relative to theircapital request, the pursuit may be effortless but certainly with significantrisks. If the search is a complicated process with many roadblocks to navigate,it's because the request reflects that the capital source is evaluating morerisk.
Entrepreneurs often seek to use third-party capital because it seems easier tomake spending decisions with someone else's money. Compare that to situationswhere they may have been tempted to purchase something frivolous with a creditcard that they would have immediately dismissed if the purchase required paymentin cash.
People seem to consider risk as a matter of possession. Spending another's moneywhile maintaining control of one's own seems to invoke a sense of immunity fromthe possibility of adversity.
This pseudo immunity may be encouraged by the false presumption ofreasonableness on the part of capital owners if things don't turn out asplanned. Others have misperceptions or blind faith in the murky protectionoffered in bankruptcy and falsely believe that the courts will provide them witha universal get-out-of-jail-free card in the event of financial catastrophe.Sometimes that faith is disappointed.
Anyone operating within the reasoning described in the previous paragraph needsto do some serious soul searching before seeking business capital. The personalrisks are very real, and the failure to make judicious choices can have a long-termimpact on one's lifestyle, economic future, and even family.
Self-discipline, good business sense, and patience are the best attributes toexercise in order to build a successful business enterprise. Hopefully thoseattributes will help owners recognize the wisdom in employing their ownresources where possible to avoid handing over control of their futures tothird-party funders.
Tempering the amount of external funding acquired should be one of the primarygoals of all small business owners. Doing so would mean that businessachievements would be created with internally generated funding that ultimatelyeliminates external debt. Only then can businesses realize their greatestsustainability and owners truly control their own destinies.
Obviously, many businesses could not organize or function without externalcapital financing, and there are many good, necessary reasons to employ it forexpansion and growth. However, business owners should understand the negativeattributes of third-party funding and seek it only with full recognition of thepotential consequences.
Define Funding Needs in Concise Terms
Once a business owner has pondered all the reasons to acquire business capitalfrom other sources, the owner must communicate those needs to the capital sourcein concise terms. The definition of what is needed and why is the most importantinformation the funder initially seeks in order to qualify interest in a deal.
Business capital is distributed by a large number of sources that individuallyaddress only a narrow set of market needs. There are investors and lenders forevery purpose, including those that exclusively fund to real estate, equipment,business acquisitions, working capital, and numerous other commercial purposes.But even these broad categories are subdivided into many niche markets thatcontinue to be defined as the economy evolves. Some niches expand due to thecreation of new funding sources or to the newly developed expertise of thefinanciers.
For example, there are some real estate funders that choose to invest funds onlyin residential property mortgages. Other funders focus only on home-equity linesof credit, owner-occupied commercial properties, investor-owned properties,industrial properties, condominiums, vacation properties, restaurant properties,undeveloped land, land developments, construction projects, foreclosedproperties, and even properties obtained through tax foreclosures.
Obviously it's necessary for the owner to thoughtfully define the purpose forwhich money is needed in as much detail as possible in order to determine theappropriate funding source. As important is the requirement to provide thefunder a thorough explanation and justification as to where and when the capitalneeds to be disbursed.
Clearly a business seeking funding to buy a new building has an obvious businesspurpose needing less explanation. But additional clarity is required to defineeach party's expectations of the extent that funding will be injected by eachparticipant. If both parties assume such details based only on their preferencesor self-interests, there will be some confusion at the closing table when oneparty is surprised to learn of its greater-than-expected obligations in thetransaction.
For example, do the owner and funder agree that the closing costs are to beconsidered part of the acquisition cost? The answer will directly impact thesize of the loan from the money source and equity contribution from the owner.
Detail Every Dollar Requested
When obtaining business capital from a third party, sometimes owners havedifficulty acclimating to the fact that the funder will assert restrictions asto how the funds will be used. In fact, the proceeds from most term debtfinancings will be spent via direct payments from closing to the agreedexpenditure.
When preparing a loan proposal the owner should carefully consider the entirecapital requirement to ensure that the external funding request reflects anaccurate sum of the money needed. Under- or overestimating true enterprise needscan present problems for both the business and funder.
Chiefly, an inaccurate proposal signals to the funder that there could be amanagement issue to consider. If the owner can't get a handle on the cost ofbusiness needs, how can the funder hope to meet those needs?
Intentionally overestimating the project costs leads the lender to suspect thatthe business is either building a funding cushion in the transaction or notactually injecting the owner's agreed-upon portion of the funding. Either wouldincrease the funder's risk and raise questions about the owner's projections orcharacter.
Underestimating the cost might lead the funder to conclude that the owner isincapable of assessing the required capital budget and hence will alsodisappoint the funder with estimates of other deal components, such as revenues,expenses, and profits.
It's very important to carefully evaluate the true costs that need externalfinancing and ensure the funding proposal closely mirrors these needs. Bestmanagement practices dictate that every prospective cost and expense beidentified to assure all parties that the comprehensive costs of the transactionand operation have been projected as accurately as possible.
For example, purchasing a $500,000 building cannot be viewed as merely a capitalcost of $500,000. The business will incur additional costs to perform duediligence and the closing transaction according to the contract conditions orfinancing qualifications. Hopefully all of these costs are identified not onlyahead of entering into the purchase contract but definitely before seekingthird-party financing.
Due diligence and real estate closings cost money. All of these expenses must beaccounted for as the owner assesses the cost of owning the building before theproperty is actually purchased.
And what about the building costs after the acquisition? What will the businesshave spent to prepare the property for occupancy? Will there be architecturalfees, builder's fees, or painter's fees? Certainly there will be utilitydeposits, telephone system installations, new stationery, movers, networkdesigns, signage, public relations, and many other direct costs associated withrelocating to the new site.
Recognizing the full costs of such a business decision on the front end enablesthe business owner to make better decisions and execute a strategy with moresuccess. Providing the funder with a detailed explanation of these impact costsand how they will be covered will assure the funder that management has theacumen to plan a safe course for business operations.
This level of planning also protects the business by considering the full effectof such a decision ahead of commitment, which allows for reconsideration iffinancing capacity is insufficient or the business cost is too great.
A very detailed cost examination is vital, even for the most routine businessstrategies, to ensure the funder that management is in command of the financialimpact of implementation, that the business is capable of managing operations orexpansion successfully with adequate resources (subject to funding), and thatthe project has a strong potential to contribute to the business's success.
Do Your Homework (Your Funder Will)
Once the business owner identifies the various costs facing the business plan,it is necessary to tie down the actual figures with exact detail. Mostly for theowner's own benefit but particularly before presenting to a funder, it isimportant to extend the costs to know to the penny what the total costs will be.
To protect the integrity of the calculations, it is important for the owner toobtain cost quotes in writing from the various vendors, professionals, or otherparties to whom such expenses will be paid. Inclusion of this kind ofdocumentation in the financing proposal gives weight to the projections andbuilds others' confidence in the due diligence the owner performed.
This process is labor intensive for sure but will save much frustration oncespending starts, since there is a commitment in hand. A written estimate removesambiguity and shows the extended costs, including add-ons such as sales tax,delivery, and installation. Such hidden costs can increase the final expense 5to 15 percent, which is disruptive if unexpected, particularly on larger costcategories.
Minimize Where Possible, Maximize When Necessary
When seeking financing, there is a tendency among business owners to ask for asmuch money as they can with a straight face, under the auspices of "get it whilethe getting is good." Other business people may challenge that notion.
Owners should start and end with the amount of funding that they alone havedetermined is actually needed. They should resist the temptation to accept allthe money that may be thrown at them, since it may cause them to fall prey toother businesses (other funders) achieving their own objectives at the owner'sexpense.
Too often business owners start with "what can we get" rather than "what do weneed?" There is a huge difference. One the one hand, they have a plan, and itmay be more conservative to grow the enterprise deliberately with internallygenerated funding. Accepting external funds may (or may not) accelerate thatpace, may (or may not) drive the enterprise to greater results, or may (or maynot) cause owners to lose everything for a shot at faster or higher results.
Think about the different views of the word affordable. Depending on one's riskappetite and financial discipline, one party may believe something is affordableonly if there is cash on hand to pay for it today. Another may take a moreconservative view that affordability requires more analysis of a largerfinancial scope, which may assess the investment value and what return will begained from the expense.
Still others may assess affordable as just being able to make financing paymentstoday.
Affordability should be assessed on enterprise liquidity over and above adefined contingency reserve and the retention of earnings over time. Whenconsidering financing strategies, the financial payoff should be tangibly higherand obvious to predict.
Spending everything one earns is not a wise financial strategy. The accumulationof some portion of past success provides the financial footings for futureexpansion. The constant commitment of future earnings through paymentobligations is management by the next dollar. This strategy leads to a crisiswhen the next dollar is delayed or never appears.
While fancy expenditures may impress others, unless they contribute to long-termprofitability, growth, or sustainability, they are frivolous. These threeattributes are essential to long-term success of any business enterprise.
Business owners should view any decision to leverage funds carefully and ensurethat other resources are considered before jumping into a loan. Utilization ofinternal resources where possible is much less expensive and lowers the risksconsiderably to the future of the enterprise.
To maintain discipline and focus on the prospects for long-term businesssuccess, it is important to minimize external funding to the greatest extentpossible.
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Sometimes a business will need capital financing for reasons that do notrepresent an extravagant expansion but rather a wise financial strategy.Sometimes decisions must be made fast in order to take advantage of a changingmarket or sudden opportunity. Sometimes a business needs more money than it maynormally have an appetite to acquire.
In those circumstances where the right reasons exist to fund strategies thatserve the business well and move the company's purpose forward, seeking tomaximize such opportunities with third-party financing may make sense. Whileprudence should be maintained, financing the business is certainly not taboo.
Seeking the maximum funding leverage should be done responsibly, weighing theinternal need and opportunity against the external terms and cost. Managementmust be comfortable with the business strategy and move forward withoutreservation that success is likely. Internal resources should still be utilizedin a prudent proportion to the external funds. If the business risk is in anacceptable range, external funding can enable it to accelerate its success.
Because You Can, Doesn't Mean You Should
Have you ever concluded a search for business financing by "losing the battlebut winning the war"? You are offered some funding that basically meets yourgoal, but something isn't right. Maybe the terms are too short or there's toomuch collateral required, or perhaps the loan covenants are overbearing. Maybeyou think the funder is squeezing too hard and setting you up to fail? Ithappens.
Sometimes in their zeal to lower their risk, funders impose unreasonable terms,like requiring too much security or pricing the deal too high or settingrepayment terms too short. Owners could be offered funding that they may beunable to repay. They shouldn't take it.
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