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Equity Financing and Venture Capital Firms

Basically, venture capital is an investment in an unproven business. Venture capital firms provide equity funds to new and young companies. This immediately separates venture capital firms from investment firms, which prefer to invest in existing, financially secure businesses. Venture capital firms do not make outright loans. Instead, they buy an equity interest in the business that gives them the same advantages and disadvantages associated with equity arrangements.  

How do they operate?

Venture capitalists are looking for two basic things when considering whether to invest in your business: First, because venture capitalists are willing to take unusual risks by investing in a new business, they require unusual returns as well, perhaps even seven to ten times their original investment within five to ten years. Second, They require easy exit. Venture capital firms will realize a profit by selling their interest in your business at some future time.

In general, venture capital firms are most interested in investing in new technology and can typically supply large sums of money. Venture capitalists are not passive investors. They play an active role in the strategic planning phase of your business and seek continuing involvement. They will also expect to be fully informed about operations, problems and whether your joint goals are being met.  

Where can you get more information?

Keep in mind that venture capitalists have extremely rigid investment standards and relatively few businesses qualify. Still, this capital source is worth pursuing because venture capitalists specialize in start-up financing and have access to large sums of money. There are many books on venture capital in your local library.  

Closed-end Investment Companies

A closed-end investment company is similar to a venture capital firm but has smaller sums of money available to invest. Closed-end investment companies are most likely to invest in a proven business, but some specialize in new businesses.  

How do they operate?

Like venture capital firms, closed-end investment companies are interested in purchasing the stock of your business. Keep in mind what this means: you will be selling a portion of your business and giving up some control as well. Closed-end investment companies are called closed because they have a fixed amount of money available to invest. The investment company has sold shares of stock to private investors, and these funds are available to invest in your business. As with other types of stock purchases, if you make a profit, the stockholders make money on their investment.  

Because closed-end investment companies have limited amounts of funds available to lend, they may or may not be looking for new investments. It depends upon whether they have cash available at a particular time.  

Where can you get more information?

Legitimate closed-end investment companies are registered with the federal government. Your banker, accountant or attorney may be able to recommend reputable companies.  

Corporate Capital Sources

In order to generate additional profits, corporations sometimes establish corporate venture capital firms, which operate within the overall corporation. These firms differ substantially from traditional venture capital firms. One of the biggest differences is that they are not motivated purely by profit, at least, not in the immediate sense. A corporate capitalist firm typically seeks access to new markets in addition to realizing a financial gain.  

How do they operate?

Corporate capital firms operate in much the same way as traditional venture capital firms. The corporation makes an investment in your business in exchange for an ownership interest. In this way, the needs of both the corporate investor and the entrepreneur are met. The corporation benefits by accessing new markets, the business owner benefits by receiving additional capital. In addition, associating your business with a corporate capital source can add credibility when you seek funds elsewhere. The expertise of the corporation can also be useful in marketing, manufacturing, product development, etc. Its experience represents a valuable asset for your business.

Corporate investment in your business will probably take one of several forms: - Complete purchase - An outside corporation buys your business in its entirety, and you forfeit all rights and control. - Partial purchase - An outside corporation purchases part of your business's stock. - Joint venture - You and an outside corporation create a partnership, typically one in which you run the business and the corporation provides capital and business advice. - Licensing agreement - As the business owner you retain control of your business but receive cash for work performed on contract. Sometimes entering into a licensing agreement means giving up the rights to products developed under this agreement.  

Where can you get more information?

A useful source of further information on corporate capital suppliers is Corporate Venturing News, published by Venture Economics, Inc., 16 Laurel Avenue, Wellesley Hills, MA 02181. You can also contact large corporations in your area to inquire if they invest in new businesses.   Equity Financing   Investment Clubs In many communities, groups of business people form organizations to invest in new and existing businesses, usually on the local level. These clubs are typically less formal than a professional organization might be.  

How do they operate?

Private investors pool resources to make a business investment. Because the group invests together, small investors are able to make funds available to your business on a scale that would be difficult or impossible if they were operating independently.  Investment conditions and standards vary from club to club. As with other equity arrangements, you will give up a percentage of your business in exchange for funds received from the investment club.   Where can you get more information?

For additional information contact the National Association of Investors Corporation, 1515 East 11 Mile Road, Royal Oak, MI 48067, (313) 543-0612. Investment clubs are often informally structured; contact a local attorney or broker to find a club in your area.   Equity Financing   Employee Stock Ownership Plans (ESOPs) If your business has employees, it may be possible for you to sell stock in your business directly to them. Like other equity arrangements, you will give up a degree of control. But with an ESOP, you will share control with your employees rather than with outside investors. This can be beneficial because your employees will have a vested interest in making your business successful and employees can have a large impact on operations.    

How do they operate?

An ESOP operates in a similar fashion to other equity sales. Employees purchase shares of stock and thereby gain an ownership interest in your business. You gain capital to be used for expansion. Employees may also offer to take a reduction in salary or benefits in exchange for partial ownership in the company. This is a good point to consider if you anticipate problems in meeting a payroll but cannot reduce staff.  

One obvious drawback to an ESOP is that a plan of this type is workable only after you have hired employees. It is not an option when your business is in the very early stages.   Where can you get more information? Both your attorney and accountant can provide information on how to structure an ESOP. They will be very useful in helping you consider all relevant aspects and potential advantages and disadvantages of the decision.

More information is available from the ESOP Association, 1100 17th Street, NW, Suite 1207, Washington, DC 20036. They can provide you with financial help as you start or expand your business. They are interested because an additional supplier (you) provides them with another source for a product or service they need. The addition of your business to the market may also increase price competition, resulting in lower prices for the customer. Each of these aspects translates into important benefits for the customer, just as the customer's funds translate into important benefits for you.  

How does it work?

Both direct loans and equity interests are possible. Again, a direct loan must be repaid, while an equity sale diminishes your control. It is a good idea to consider the advantages and disadvantages of each and prepare a tentative proposal.   You may need to approach potential customers yourself, or the customer may come directly to you with an offer. Be wary if the customer proposes that you sell your product or service exclusively to him or her in exchange for financial help. Securing exclusive rights to your products will give the customer more control over your business operations and pricing than you may wish. This type of arrangement will shrink your potential market tremendously. If the customer stops buying from you for any reason, your business may be in serious jeopardy because you have not cultivated other customer relationships.  

Where can you get more information?

Ask the customer directly. You may find a customer more willing to supply you with financing than you would expect. The customer receives a return on his or her investment and gains a supplier. These are very strong incentives for most businesspeople.   Government Sources In addition to the private sources we've discussed, there are a number of government financing sources that may be available to you and your business. A government agency may be interested in financing new businesses that will have a direct impact on the agency or the client population it serves.  

If your business produces a product or service you feel would be of interest to a government agency, contact the agency directly and request information and applications for grants and other possible business development resources the agency may control. It may be helpful to investigate some or all of the following general sources of assistance available through the government.    

U.S. Small Business Administration (SBA) The SBA may provide a loan guaranty that will help you borrow from a bank. Essentially, the SBA guarantees the lender that up to 90 percent of your debt will be repaid. This helps the lender feel more comfortable about making you a loan. Although the SBA primarily guarantees loans made by banks and other lenders there is a limited SBA direct loan program, generally for Vietnam era and disabled veterans, businesses located in areas of high unemployment and handicapped individuals. Funding for this program is subject to congressional appropriations.  

Loans backed by the SBA usually offer reasonable interest rates and long repayment terms, making them very desirable. It is the SBA's goal to assist those businesses unable to borrow successfully from conventional lenders without the help of the government. You can get additional information on SBA programs by contacting the SBA field office in your area.   Small Business Investment Companies (SBIC)/Specialized Small Business Investment Companies (S-SBIC)  

The federal government may also be able to help you with financing through an SBIC or S-SBIC that makes direct loans to entrepreneurs for start-up and expansion as well as equity investments. SBICs and S-SBICs are licensed by the SBA and operate under its guidelines. They are privately owned organizations, chartered by the state in which they operate.  

There are several conditions your business must meet in order to be considered for assistance from these sources. Typically, an SBIC or S-SBIC is less averse to risk than a bank. They can provide your business with loans and equity investments, as well as technical assistance.

You can obtain the Directory of Operating Small Business Investment Companies by visiting the SBA regional or district office nearest you or by writing to: Deputy Associate Administrator for Investment, U.S. Small Business Administration, 1441 L Street, N.W., Washington, DC 20416.   More information is available by contacting the National Association of Small Business Investment Companies and the American Association of S-SBICs, both located in Washington, D.C.  

Economic Development Commission (EDC)

The Economic Development Commission, a part of the U.S. Department of Commerce, lends to new and existing businesses in an effort to create new jobs in economically deprived regions. There are a number of specific conditions that must be met in borrowing through the EDC, including location. You can contact the EDC through the U.S. Department of Commerce in Washington, D.C., or the local office of the Department of Commerce.   A Last Note about Government Sources As with all types of financing, government sources have diverse requirements. Learn which agencies and/or programs might be a possible financing source for your business and then contact them for the appropriate paperwork to set the process in motion.  

ALTERNATIVE WAYS TO OWN A BUSINESS

In addition to the possibilities already mentioned, you may want to consider two slightly different ways of owning and operating your own business: purchasing either a franchise or an existing business.

Franchises

Buying a franchise gives you the right to sell a particular product or service. You retain a portion of your profits and a portion is paid to the overall organization that sold you the franchise.   How do they operate? One of the easiest methods of becoming a sole proprietor and acquiring the needed capital at the same time is to purchase a franchise. It is possible to start some franchises with relatively little money and to obtain start-up financing directly from the company selling the franchise. If a direct loan is not possible, the seller of the franchise may be willing to cosign a loan with another lender.  

The seller of the franchise supplies you with materials, a recognized brand name and sales and marketing assistance. Some franchises are fairly inexpensive while others may cost hundreds of thousands of dollars.   Strict limits on innovation. The relative ease with which you can become the owner of a franchise is not without its price. By purchasing a franchise, you give up a high degree of control over your business. Most often the product and operations of a franchise are strictly regulated and there is little room for new ideas.   Purchasing a franchise is a sort of middle ground between working for someone else and being an independent business owner. You should, of course, evaluate franchise opportunities as carefully as you would any other type of business. Profit potential, as well as the cash needed to get started, should be considered in your choice.  

Where can you get more information?

Directories of every franchise in the United States can be found in your local library. Information on franchises is also heavily promoted at trade shows and in business magazines. Virtually every type of business imaginable can be purchased through a franchise.  

Purchasing an Existing Business

One path to becoming an entrepreneur is to buy an already operating business from its present owner. Especially with regard to financing, buying an existing business may have certain benefits over starting a business from scratch. In many cases, the current owner will finance the sale of the business.  For example, you read a newspaper advertisement of a small restaurant for sale in a good location. The owner is willing to sell his or her interest in the business for $15,000 if the buyer takes over existing business obligations, e.g., space rental, employee wages, etc. After visiting the restaurant and carefully analyzing the business potential, you decide you are interested in owning this business and decide to purchase it.  

How can you pay for the business?

Let's assume that you don't have $15,000. You have calculated that by using the money you have saved, you can offer the owner $3,000. But this still leaves you $12,000 short. What are your alternatives?

 
  1. Ask the owner to finance the $12,000.
  2. Try to find a way to borrow the money using the methods and sources outlined above.
  3. Offer the owner less than the asking price, thereby reducing or eliminating the amount of cash needed.  

No matter which alternative you choose, remember that the owner of an existing business often will help you to find financing. An owner who wants or needs to sell a business will be anxious to help you find a way to make the purchase possible. Why is it being sold? Learn why the owner is selling the business. Make certain that the reasons do not spell disaster for the next owner. You may have nothing to worry about if the present owner is selling in order to retire; however, if he or she is selling because the business is not profitable due to few customers and/or poor location, you will need to realistically assess your ability to improve the situation. If you do not have a carefully researched plan, you may soon find yourself repeating the mistakes of the previous owner.  

Where can I get more information?

The classified section of that you sell your ideas and plans to someone who controls the money you need. In this sense, you shouldn't underestimate the importance of being a good salesperson. The responsibility is on your shoulders to share a sense of excitement about your business with the person or organization evaluating your request. This remains true regardless of whether you decide on debt financing, equity financing or a combination of the two.  

Negotiating Financing

If you plan to borrow money, there are certain elements of the borrowing process that are critical to your success.   You and the investor have different goals. If you are starting or have already started a business, chances are you strongly believe you will be successful. The investor, however, will not have this same degree of confidence in you and needs to be convinced of your sincerity and of the validity of your ideas. The lender's goal is protection of his or her investment, while yours is more likely financial growth.  

The investor will need documentation of virtually every statement that you make. If you say your business will grow by 10 percent per year for five years, be prepared to support your claim with facts and figures. You and the investor need each other. Clearly, you need the investor, because he or she controls whether you will have access to funds integral to the success of your business. Without financing, your ideas may remain just that. But there's another side to the coin: the investor needs your business. He or she makes money from interest, fee income and/or profit generated from your business. Keep this point in mind: the investor cannot thrive without you anymore than you can thrive without the investment.  

Getting financing takes time.

Be prepared to wait weeks or months before any money actually changes hands. Don't approach a lender when you are desperate for cash. You'll greatly harm your chances of having your request approved. Instead, plan for your financial needs well in advance.   Getting financing takes persistence. You may be turned down many times before someone agrees to provide funds. Don't be discouraged; there are many sources that may be willing to help finance your business. Remain determined and don't give up after just a few tries. If your business ideas are good ones, you will eventually be successful in obtaining financing. Ten Rules of Negotiating for Financing  

  1. Prepare a comprehensive business plan.
  2. Be prepared to explain uses and benefits of the proposed loan.
  3. Speak to the appropriate person.
  4. Do not overstate your financial strength. Be realistic.
  5. Give complete information about your business.
  6. Seek a lender with whom you feel comfortable.
  7. Negotiate interest rates and fees.
  8. Give an impression of confidence and competence.
  9. Carefully check all terms of the agreement.
  10. Dress conservatively.

Prepare a comprehensive business plan, including an income (profit and loss) projection for one year and a cash flow projection. An overview of competition, composition of management and staffing, marketing plans and pricing strategy are also important. Lenders respond favorably to applicants who know where they are going and who have done their home- work. See the Appendix: How To Write A Business Plan for an outline of material that should be included in the business plan. Use SBA Form 1100 for Cash Flow Projection. If your strategy can be adjusted to alternative amounts of financing, request the preferred amount first and be prepared to submit the alternative plan if you meet obstacles.  

Be prepared to explain uses and benefits of the proposed loan. Summarize the information in the Sources and Funds Statement in your business plan, and provide specific examples and supporting data for uses of the funds (e.g., estimates, list prices for equipment, etc.).  

Speak to the appropriate person. With banks, as well as with all other sources, find out who will make the ultimate decision about your financing request, and then deal with this person directly. It is a waste of time to present your loan request to an individual who does not have the personal authority to lend you funds.   In banking, most commercial lenders have what is commonly referred to as a lending limit. This is the amount of money they are able to lend on their own authority, without having the request approved by any other parties. It is perfectly acceptable to ask the amount of the lending limit even before setting up an appointment and, what's more, it's advisable.  

Do not overstate your financial strength. Be realistic! Guard your credibility like the very real asset it is. Remember that the investor will almost certainly verify everything you say.   If you tell him your first quarter sales were $4,500, be sure that this is true. Once your integrity and honesty are called into question, it will be difficult, if not impossible, to regain your lost reputation.   Even if your misstatements are the result of a legitimate error rather than a deliberate attempt to make your business appear more profitable, the investor may feel that this is a good reason to question your overall business judgment. It's a very good policy to never say anything you can't support with data.  

Give complete information about your business. It is wise to present all the information the investor requests. Most investors are required to have certain documents on hand to invest. Some are requested just as a formality and some are thoroughly analyzed. Unfortunately, there is no way for you to tell the difference between the two. Prepare all documents carefully and double-check all facts and figures before turning over the information. It will be far better for a negative aspect of your business to be handled openly than for it to come up later under less favorable circumstances. This does not mean that you are under obligation to reveal all your fears and concerns about the business and its operations. It does mean, however, that you have an obligation to disclose material or relevant facts about your business.  

Seek a lender with whom you feel comfortable. There can be wide variations among investors. Because you are turned down by one source does not mean that you will be turned down by the next. Avoid putting all of your eggs in one basket. Carefully scrutinize potential investors in the same way that you investigate any other major business decision. Investors and lenders are just like everyone else! You will feel good about working with some and not with others. Be sure to settle on one who can give adequate attention to your account and who explains all aspects of the financing relationship clearly and thoroughly.  

Negotiate interest rates and fees. We've already noted how a small difference in interest rates can have a big impact on your payments. Fees, too, can drastically alter the total amount you are paying for financing. Typically, you will be asked to pay points, which are a percentage of the total loan, due at the time the loan is originated. If, for example, you borrow $20,000 and are told that there is a 2 percent origination or commitment fee, you can expect to pay $400 in fees to borrow from this source. The length of the loan is also important. The shorter the term, the less total interest you will pay.   All lenders charge different rates and fees. Be aware of what you are paying. If the lender seems receptive, attempt to reduce the charges you will incur. In the worst case, the lender will tell you that the lending conditions cannot be changed. You've lost nothing by trying to minimize your costs.  

Give an impression of confidence and competence. No one likes to borrow money. It is perfectly reasonable for you to feel a little nervous when applying for financing, but be careful not to let your nervousness cloud your judgment. The investor needs to have a high degree of confidence in your ability to repay the debt or generate a profit. Be sure of your facts and rehearse what you will say. Give some thought to the types of questions you may be asked and consider the best responses.   Again, remember that the investor is dependent upon you, just as your business is dependent upon the investor. You are both in a position to help one another.  

Carefully check all terms of the agreement. Be sure you know what you are signing. It is perfectly appropriate to ask that your attorney or accountant review the conditions of the agreement. If you or your advisors do not feel comfortable with some aspect of the agreement, don't hesitate to raise it   as an issue. The time to discuss alternatives is before the deal is finalized. Once you have signed an agreement, you are legally bound by it. The investor will prepare the agreement self-protection. Given this, it is not unreasonable to expect the terms to favor the investor. To a certain extent, this is inevitable, but try to prevent the insertion of any clauses or conditions that may present a serious hardship for you. Also, it is a good idea to dress carefully when meeting with an investor, even if you do not normally do so when running your business. A suit and tie are recommended for men, a jacket and skirt for women. Avoid overly elaborate accessories. Remember that you are trying to give an impression of conservative good judgment. Dress to fit the environment.  

SOME FINAL POINTS

No one ever said that starting a business would be easy. Without a doubt, finding the money to start or expand your business requires hard work and determination. It may be the largest obstacle you will face when planning to own or expand a business. Don't despair; financing is available. It's all a matter of knowing where to look, and now you know!   Perseverance makes all the difference. Most successful entrepreneurs have been turned down many times for financing. Remember that it is your job to sell your ideas and to pursue every possible means of securing capital. If you truly wish to finance your business, and if your ideas are good ones, you will be successful.   Don't hesitate to consider a variety of financing alternatives. Most of the sources described will not alone meet all of your needs, nor are they intended to. It is far more likely that you will find a number of sources interesting and you may be able to borrow successfully from all of them. Most businesses use a combination of financial sources to adequately fulfill their changing needs for capital. Be aware of the advantages and disadvantages of each approach and determine which ones seem most relevant to your situation. Above all, remain determined. If you persistently seek financing you will eventually obtain it.

 

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