Funding a Business
Almost all businesses need funding from time to time, or even on a regular basis. Where those funds come from is vitally important to a business. Making a bad decision, like finding yourself locked into bad repayment terms, may affect a business for many, many years. So, how does a business access capital?
First, and likely the most common, is traditional bank debt financing. This is either a term loan (generally with a three or five year term and a much longer amortization, resulting in a balloon payment at maturity) or a revolving line of credit. Depending on the amount of the loan, the industry, and the company’s track record, getting that loan can be easy and fast or can take much longer. Interest rates are either fixed for the life of the loan, or are variable and tied to a certain benchmark (e.g., the WSJ Prime Rate or the Secured Overnight Financing Rate (SOFR)).
When applying for a commercial loan, keep in mind that most lenders evaluate the so-called Five “C”s. Lenders ask (a) do you have good Character, (b) do you have the Capacity to generate cash to pay the loan, (c) do you have sufficient Capital, (d) what is your financial Condition, and (e) what Collateral can you pledge for the loan. To assist your lender and make the process easier, be prepared to provide her with good books and records and expect her analysis to be comprehensive.
The advantages of debt financing with a bank are that the bank generally has little ability to manage how you operate your business, the interest you pay on the loan is generally deductible, and the repayment terms are a known expense that you can rely on for planning purposes. On the flip side, especially when the economy turns sour, access to traditional bank financing may not be available. And financing may not be available for startup businesses at all. For this reason, the government created the Small Business Administration – which provides certain assurances and protections to banks that make small business loans to decrease the risk the bank would otherwise have to accept. Don’t forget to look into the various SBA programs.
The opposite of debt financing is equity financing. Just like on Shark Tank, investors purchase shares of a company and become part owners. Sometimes you hear the words “venture capitalist” and “angel investors.” More frequently, however, is the involvement of friends and families who invest in a small business owned by someone they know and trust.
The prime advantage of equity financing (other than not having to make regular payments like with a loan) are that if the business goes South, the company does not have to pay back the investor – they take a loss along with you. On the other hand, with investors you are essentially taking on partners and no longer have sole discretion to run your business as you want. Minority owners also have certain protections under the law. This all restricts how you operate your business.
Further, the sale of securities is subject to stringent registration laws at both the federal and state level. All sales of securities must be registered with the government (think of an IPO) unless there is an exemption to registration. Thankfully, there are many such exemptions – some that are time consuming and expensive to comply with, while some are quite easy (think crowd-funding). The most common exemptions are: (1) private offerings to a limited number of accredited persons or institutions; (2) offerings of limited size; (3) intrastate offerings (which still require registration with the State); and (4) securities of municipal, state, and federal governments. This is a complicated area of the law, and if you plan on selling equity in your business by way of general solicitation, you would be well advised to contact an attorney conversant in this area of the law. Failure to comply can lead to significant penalties, criminal charges, and the prospect of civil litigation by your former investors seeking great damages.
For larger startups and new businesses, there are a few less familiar means of raising capital. One is Mezzanine capital, which is designed to span the gap between bank financing and equity financing. It is a hybrid mix of debt and equity financing. Essentially, the lender has a right to convert the debt to an equity interest in the company if it defaults under the loan or once angel investors and traditional bank financing is paid off. As such mezzanine debt is typically subordinated to traditional bank financing but is superior (and would be paid off before) pure equity investors. It is also generally unsecured. Because of these risks, mezzanine financing almost always comes with a significantly steeper price than pure debt financing, but it is less “expensive” that equity financing. Also, it is treated as equity on the company’s balance sheet, which helps paint a rosier financial picture. Finally, mezzanine loans generally only require interest, but not principal, payments prior to maturity.
The second less familiar way of accessing capital is “off book” financing. Thanks to companies like Enron, this term has some very negative connotations. Still, if used properly, it can be an effective means of creating capital. Generally speaking, off book financing involves recording corporate assets or liabilities so that they don’t show up on the balance sheet. This helps keep various financial ratios in line such that they won’t cause a default under debt financing documents (e.g violating a required debt to equity ratio). Done according to the rules, this is a completely legal practice. It becomes illegal only when it’s used to hid assets or liabilities from government regulators or investors.
No matter how you raise capital, the process can be exhilarating or panic inducing, or even both. Tread carefully, educate yourself, and consult with knowledgeable professionals in the fields of law, tax and finance.