On Friday we published part 1 of this article, focusing on various ways to leverage your own cash and credit for your new venture. In today's post, guest author Michelle Hoffman covers opportunities to fund your business with other people's money.
Other People’s Money – Background Basics
Before seeking the money of others, it’s important to understand and review what others will look at when considering your application or funding your business. There are three things you need to know:
1. Credit Score/Credit Report
Banks and investors will want to know your credit score. Your credit score is based on information in your credit report. The information is grouped into five main categories, payment history, amounts owed, length of credit history, new credit and types of credit used. Credit or FICO scores range between 850 and 300, with scores below 580 resulting in difficulty getting financing.
Three major credit reporting companies keep your credit report and credit score: Equifax, Experian, and TransUnion. You are entitled to a free credit report and credit score every 12 months. Go to www.annualcreditreport.com for more information. It’s important to review, and often correct, information on all three reports.
Sources: MyFico.com, bad-credit-advisor.com
2. Personal Financial Statement
When applying for bank financing, you will typically be asked to provide a personal financial statement, in additional to business financials. While each financial institution has its own form, most will accept the SBA format which can be found at www.sba.gov/content/personal-financial-statement.
3. Business Financial Statements
If you are a startup looking to grow, it’s going to be important to generate and share with banks or investors financial information in the form of what is most commonly known as a Profit & Loss (what you made less what you spent) and a Balance Sheet (a snapshot picture of your assets, liabilities and company’s equity). You may also be asked to provide a Statement of Cash Flows, which breaks down sources and uses of cash over a given time period. Private investors will also need to see your business plan and a five-year financial forecast.
So, now you are ready for other people’s money. Here’s where you can go:
Banks and Lending Institutions
Some of the most common lending instruments for young companies include:
- Unsecured Bank Line of Credits – Many banks will extend an unsecured line of credit of up to $25,000, directly to the business, or business owner, if your credit is fairly good. All that is typically needed for this is a good credit score and short bank application.
- Term Bank Loans and Larger Lines of credits – If you need more than $25,000, you will likely need to look at a term bank loan or secured line of credit. While each bank evaluates how much they will lend differently, some general rules of thumb are that banks will not lend more than 80% of sales revenue or your accounts receivable balance. Additionally, banks are going to want to see a credit score at least the high 500’s, and more likely the mid-600’s, before they will loan you money.
- If you only marginally meet of the banks lending requirements, they may be willing to do the loan as a Small Business Administration (SBA) loan. The SBA is a federal entity which guarantees or insures certain bank loans that lenders may otherwise not have made because they exceeded its risk tolerance. Expect to pay more in interest for an SBA-backed loan. An interesting SBA loan program right now is the CDC/504 loan program, one use for which is to allow the borrower to purchase a building with 10% down. This loan program is especially interesting for anyone considering buying a building to work from.
- Factoring Companies – Factoring is when a business sells unpaid client invoices to the factoring company. The factoring company advances a percentage of the value of the “factored” invoices to the business and then charges interest on the value until the time the invoices are paid by the client. This form of financing is generally used by established companies that don’t qualify for bank financing because of low credit scores or other reasons. The interest rates charged by factoring companies are extremely high, similar to that of credit cards. However, for non-bankable companies experiencing rapid growth, factoring might be one of your only options for getting the cash you need while you improve your credit.
Private equity consists of individuals or private funds which invest in businesses. Below are three categories of this type of “other people’s money.”
– Friends and Family – Technology companies in particular often use a “friends and family” model for generating cash at the start of the business. Cash received is typically exchanged for convertible debt. Friends and family is exactly what its sounds like, people you know who are willing to give you their money for your new business venture. The money can be raised all at once, or incrementally, as your friends and family are persuaded they want in. We’ve seen friends and family approach $1 million before a company is ready for broader financing round.
– Angel Investors – As described by Wikipedia, an Angel Investor is an affluent individual who provides capital for a business startup. Angels invest their own funds, different from venture capitalists (VCs) who manage the pooled money of others in a professionally managed fund.
The most recent quarterly report published by the UNH Center for Venture Research (CVR) states that historically, angels have been the major source of seed and startup capital for entrepreneurs. While the dollar amount of angle investment has trended down in recent quarters, angel investors continue to provide billions of dollars to new companies. The sector breakdown of Q2 2010 investments was: Healthcare 24%, Biotech 20%, Software 12% Industrial/Energy 11%, Retail 9% and Media 5%.
The Angel Capital Association’s “What Every Entrepreneur Should Know About Angle Investors” reported 2008 angel investments totaled $19.2 billion with 55,480 companies, mostly in early stage, receiving funding. Comparatively, VC Investments for 2008 were at $28.3 billion with 3,808 deals, mostly later stage.
– Venture Capitalists – Venture Capital funds are professional managed private equity and continue to be an important source of capital for emerging companies. The Cooley Venture Financing Report – November 2010 calls Q3 2010 Venture activity “A Continued Mix of Optimism and Caution” but notes a “continued increase in early round valuations” which is “clearly a positive trend for early-stage companies raising money.”
Locally in DC, the Washington Business Journal recently released it 2010 Book of Lists which includes a ranking of 18 DC area Venture Capital Firms with the most capital under management.
This article is by no means comprehensive with regard to the types of financing and funding available. The information and resources listed here are intended as a starting place for early stage entrepreneurs as they consider their options, and reflect the experiences and most common options taken by the companies we’ve helped grow.
This is a guest post by Michelle Hoffman of Hoffman CFO Consulting. HCFO helps lots of young companies understand their finances and put solid internal practices in place. You can reach her on Twitter @hoffmancfo. Join their free webinar, sponsored by Women in Public Policy (WIPP) Understanding Your Funding Sources, Tuesday, January 25th, 1-2pm ET / 10-11am PT – register here by January 24.