A Real-World guide brought to you by NEOinc

Acquiring the necessary capital to start a business can seem like a very daunting task to the first-time entrepreneur.  The sources of capital seem complex, and many times, illogical.  Understanding a few basic principles will help the entrepreneur navigate their preferred path through the start-up capital maze.

There are three primary types of business capital or financing.  They are Free, Debt, and Equity.

However, before inquiring about financing, ask yourself the following:

• Do you really need more capital or can you manage existing cash flow more effectively?
• How do you define your need? Do you need money to expand or as a cushion against risk?
• How urgent is your need? You can obtain the best terms when you anticipate your needs rather than looking for money under pressure.
• How great are your risks? All businesses carry risks, and the degree of risk will affect cost and available financing alternatives.
• In what state of development is the business? Needs are most critical during transitional stages.
• For what purposes will the capital be used? Any lender will require that capital be requested for very specific needs.
• What is the state of your industry? Depressed, stable, or growth conditions 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 needs for financing generally are short term. Loans advanced for cyclical industries such as construction are designed to support a business through depressed periods.
• How strong is your management team? Management is the most important element assessed by money sources.
• Perhaps most importantly, how does your need for financing mesh with your business plan? If you don’t have a business plan, make writing one your first priority. All capital sources will want to see your plan for the start-up and growth of your business.
• 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, experts advise that you should increase your ownership capital (equity investment) for additional funds. That way you won’t be over-leveraged to the point of jeopardizing your company’s survival.

“Free” Capital

“Free” capital includes any personal, family, or friends money that can be gathered together to fund the business enterprise.  It is considered “free” since in many cases, no interest or company ownership will have to be paid out for the use of the money. 

An entrepreneur should always focus first on “free” capital.  Generally, other sources of capital are not available until the entrepreneur has exhausted his own  money and is fully committed to his personal involvement in the business start-up.  One of the greatest myths of business capital acquisition is that third-party investors will invest in great ideas without substantial capital investment by the entrepreneur. 

Financial institutions will also not make loans to start-up businesses without asset participation by the entrepreneur.  The entrepreneur makes a statement of belief in the business by the level of his personal capital involvement. 

A few sources of “free” capital from foundations or other organizations do exist in Northeast Ohio when the business activity of the entrepreneur is within their focus area.

The Lorain County Community College Foundation’s recently created Innovation Fund is a great regional example of this type of funding.  The LCCC Foundation Innovation Fund will make awards up to $100,000 to help an entrepreneur get his or her technology business started without taking an equity position in the company.

The Federal SBIR/STTR program is another potential avenue for “free” money.  The U.S. Small Business Administration (SBA) Office of Technology administers the Small Business Innovation Research (SBIR) Program and the Small Business Technology Transfer (STTR) Program. Through these two competitive programs, SBA ensures that the nation’s small, high-tech, innovative businesses are a significant part of the federal government’s research and development efforts. Eleven federal departments participate in the SBIR program; five departments participate in the STTR program awarding $2 billion to small high-tech businesses.

Debt Capital

“Debt” capital means loans which are given by financial institutions or individuals with the express purpose of receiving income through interest earned on the money loaned. 

It is important to realize that debt capital or loans are always asset-based which means that they are given based on the ability of the entrepreneur to repay and generally must be supported by hard assets within the business or by assets committed by the entrepreneur personally. 

Institutions or individuals who do debt financing are very risk-averse and conservative; therefore, anyone who pursues this type of financing must have a very sound, operationally-based business plan developed.  The business plan must be based on the ability of the business to repay the debt and not on potential earnings in the future.  Financial institutions in Northeast Ohio have put more focus on loans to business start-ups in recent years in the hope of spurring increased economic activity.

There are many sources for debt financing: banks, savings and loans, commercial finance companies, and the U.S. Small Business Administration (SBA) are the most common. State and local governments have developed many programs in recent years to encourage the growth of small businesses in recognition of their positive effects on the economy.

For instance, the State of Ohio’s GrowNow program offers a 3% reduction to the interest rate of loans made to qualifying small businesses through participating lenders.

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. The SBA’s programs have been an integral part of the success stories of thousands of firms nationally.

In addition to equity considerations, lenders commonly require the borrower’s personal guarantees in case of default. This ensures that the borrower has a sufficient personal interest at stake to give paramount attention to the business. For most borrowers this is a burden, but also a necessity.

Bank loans are attractive because they don’t require entrepreneurs to turn over equity or company control.  However, servicing debt can drain a young company with limited cash flow.

In general, banks prefer to make loans of over $10,000 or so, as the administrative cost on a small loan is too high to make it profitable.  Businesses seeking loans of smaller amounts often pursue personal “loans” (home equity loans, credit cards, equipment leasing, etc.).

Equity Capital

“Equity” capital means money that someone invests in the business in exchange for some degree of ownership in the business. 

This type of financing is based on ROI (return-on-investment).  Equity investors are focused on the potential earnings power of the business, not its asset base or current earnings.  A business plan to pursue equity financing must be based on future earning potential, not the past or current cash flows.

Northeast Ohio has made tremendous strides in the early-stage equity capital availability over the last few years with the creation of JumpStart, the North Coast Angels, and the Akron ArchAngels.  These groups, through a disciplined submittal and approval process and subsequent mentoring, not only provide development capital for start-up technology businesses, but they also establish a sound base for further investment by larger established venture capital funds.

In Central Ohio, the East Central Ohio Tech Angel Fund (ECOTAF) was established to invest in all types of companies including opportunities that are technology-based and also those firms that have developed competitive advantages in other industries. 

Also, don’t overlook the potential for strategic alliances to become a source of capital.  Having customers or development partners contribute cash to your business through a variety of arrangements is another source of funding.

Later stage equity financing may come from venture capitalists.  Venture capitalists are often seen as deep-pocketed financial gurus looking for start-ups in which to invest their money, but they most often prefer three-to-five-year old companies with the potential to become major regional or national concerns and return higher-than-average profits to their shareholders.

Venture capitalists may scrutinize thousands of potential investments annually, but only invest in a handful. The possibility of a public stock offering is critical to venture capitalists. Quality management, a competitive or innovative advantage, and industry growth are also major concerns.

Different venture capitalists have different approaches to management of the business in which they invest. They generally prefer to influence a business passively, but will react when a business does not perform as expected and may insist on changes in management or strategy. Relinquishing some of the decision-making and some of the potential for profits are the main disadvantages of equity financing.

Of the 500,000 startups each year, only 500 receive venture capital investments.  The major source of equity for a new business comes from friends and family.  Ninety percent of the investment outside of friends and family comes from angel investors.

So, what is the best financing alternative for me?

The type of business financing that best fits a particular start-up or developing business situation depends on two primary elements:

1). Where does the business currently fall on the innovation continuum?

2). What is the ultimate vision for the business?

A determination of where the business or business concept falls on the innovation continuum will guide the entrepreneur to the right funding sources for that stage of development.  A clear vision of what the entrepreneur wants the business to be in five to ten years will help him to make decisions on financing consistent with that vision.

If the business concept or idea is at the “start-up” stage or earlier, the entrepreneur should focus first on free sources of capital.  Only after the entrepreneur has consumed all his or her available cash as well as other free capital sources should debt capital options be considered.

In addition to personal credit cards and loans, there are government sponsored micro-loan programs that are available to the entrepreneur.  As the business develops and grows, other debt-based programs such as small business administration (SBA) loans, standard commercial loans, and a business line of credit loan become viable.

Once a business idea or concept has been developed, tested, and reached the incubation stage, the first level of equity or capital investment can be pursued.  Equity capital investors at this stage are called seed or angel investors.  In businesses that they feel will give them a high level of return within three to five years, they will invest generally in the $25,000 to $250,000 range. 

The business plan must present them with a clear exit strategy within a three to five year time frame or the likelihood of investment on their part is low.  These are not long-term partners.  They want to participate in the business, earn a substantial return on their investment, and then exit.

In pursuing seed/angel investors, an entrepreneur should be aware that many myths exist about these types of investors. 

Many entrepreneurs seeking equity funding for the first time believe that as the name implies, “angel” investors are few in number and act like true angels.  They swoop-in, give money to the worthy entrepreneur, bless him or her, and then fly away.  The reality is that there are a lot of angel investors for the right business concept, but most have an operating bias.  They swoop-in, give money and then stay around to help run or guide the business. 

Individual seed/angel investors typically know one another and have extensive networks, and generally talk to each other about all opportunities.  If you expose your business concept to one, you have probably exposed the business to all of them.  These investors are driven almost solely by a profit motive.  One idea or concept is not better than another unless it makes more money. 

The amount of equity capital available through seed/angel sources is also dependent on economic times.  If the general economy is depressed, and investment returns are down, availability of seed/angel capital will be down.

If a business idea has achieved seed/angel funding and continues to drive successfully down the innovation continuum, the next level of equity funding would be for development or growth capital. 

This level of funding would be between $250,000 and $1,000,000.  This level of equity financing is generally the most difficult to obtain since there are few, if any, formal investment funds or mechanisms in this space.  Most of the time, seed/angel investors have to be convinced to expand their comfort level of participation above $250,000; or venture capital funds have to drop below their normal levels of funding.  In spite of a great deal of positive verbal assurances, neither group is comfortable doing this. 

Equity capital investments at the development/growth level are only made when the business case is clearly articulated by a solid, earnings potential-based business plan.  To fill this funding gap in Northeast Ohio, JumpStart, Inc., a venture development organization, was established and is focused on providing growth capital for businesses that reach this stage of development.

Additionally in Northeast Ohio, group angel funds such as the North Coast Angel Fund and the Akron ArchAngel Group have been established to provide further development equity capital after JumpStart in the $1,000,000 to $3,000,000 range.  A few early stage seed capital funds such as Glengary Early Stage Partners and Ohio Venture Capital Fund also provide help in this arena.

A business concept that has been developed, thoroughly tested, and now needs the final level of “equity” investing to become a profitable, sustainable enterprise is ready for true venture capital funding.

These funds are the equity capital sources for financing above the development/growth stage.  This level of financing is above $3 million.  Although most venture capital funds are raised on a regional basis, the competition to obtain these funds is national in scope.  Once again, the venture capitalists are only interested in ROI.  If a Cleveland, Ohio venture capital fund determines that their best opportunity to achieve returns is by investing in a California-based company, that is where their money will go.  As before, to be successful you must have a world-class business concept supported by an excellent, future earnings-based business plan.

The time horizon from introduction to funding with a typical venture capitalist can easily be 6 months to a year, and companies should be realistic about their chances of receiving VC funding.  Venture capitalists also rarely invest in deals that come to them “off the street”.  They usually look more seriously at deals that are referred to them by people and organizations they know and whose opinions they trust.  If a company is seeking venture capitalist investment, they are best off looking for an introduction from someone whose opinion the VC firm holds in high regard. 

NEOinc not only is familiar with Venture Capital firms in the region, we’re also familiar with all types of funding for startup and early stage businesses.  We can help you decide what type of funding is most appropriate for you, and we can provide direct links to the best contacts within those sources.

In Summary

Financing a business idea or concept is never easy.  It takes persistence, dedication, and hard work.  Although viewed by many entrepreneurs as a necessary evil; it is, after all, the grease, which makes the machinery of a successful business run smoothly.

In summary, as you pursue your business financing, the following guidelines should be followed:

• Know where you are on the Innovation Continuum
• Have a clear vision of the end game
• Exhaust all “free” money sources first
• Decide what method of capital funding best fits your ownership criteria
• Position your business plan consistent with your chosen funding option
• And, last but not least, remember that money is a commodity and, as a result, obtain it at the lowest possible cost!