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Best ways to finance your small business

Posted by admin on August 11, 2009 in entrepreneur

Show me a successful entrepreneur and I’ll show you someone who understands how money works.  Personal finance and entrepreneurship are highly inter-related disciples. What makes one a successful entrepreneur also makes one a good manager of money. Just as improper use of credit card debt can begin a debt spiral for most people, a recent study found that an over-reliance on credit card debt by start-up companies reduces the chances the business will survive past the first three years. In fact, for every $1,000 increase in credit card debt, the probability of survival decreases 2.2%.

This is hardly surprising. Combine high credit card interest rates with the constant need to re-invest in a business and you have a recipe for business failure.

Financing a small business is a larger-scale exercise of personal money management and the lessons of one apply to the other. What then are some best practices to finance a small business?

• Budget your own cash in and build a revenue model around this

In other words, assume no will help you and work around these two pillars of successful boot strap entrepreneurship: (i) build an infrastructure for what you have now and not where you think you will be because who can predict the future? (ii) figure out your break point- the monetary sum you will not exceed putting into your business- and then put that entire amount into the business bank account.Then figure out a revenue model which keeps you in business initially based on that sum of money.

Even if the break point is very modest what it does is it focuses the business on earning revenues quickly rather than to try to chase potential big sales which are cold leads (big sales= long sales cycles = negative cash flow = business death for start-up). As the business gains momentum, the business can think bigger with cash under it to expand (you also work out all the little glitches on smaller sales to chase the big lead successfully).

The alternative, which I had sadly seen too often, is the death by thousand cuts where an owner-manager continually trickles in small amounts of money into the business and exceeds the break point by doing so. The personal finance analogy is negotiate the price of a car based on the price and not what you can afford in monthly payments since if you do the latter you typically end up paying more than your price ceiling.

Can a business be started with no money down? Certainly it can. But if you are seeking financing, one of the first questions that will be asked is let’s see your skin the game. Sweat equity is not valued as greatly by lenders as owner-managers. Thus, if one of your strategies for expansion is to seek financing, you best to put some of your own money in.

• Forget the bank extending a line of credit to a start-up business
  

Unless you qualify under a small business loan program, banks are loathe to take a chance on extending a line of credit to a start-up business. It is a category of business which is seen as too risky. Instead, some entrepreneurs will obtain a line of credit personally while they are still employees and use that line for business purposes first before dipping into credit cards or personal savings.

If a bank offers you a business credit card, take it. In and of itself, a credit card is not a tool of wealth destruction and proper use can build business credit history. It is the reckless use of a credit card that is destructive.

Using a credit card to finance the business is acceptable if one clearly understands the good debt/bad debt concepts. For example, purchasing materials for a closed sale on a credit card would be a prudent use of this form of financing (assuming you build cost of capital into your costs). Racking up thousand of dollars for a staff dinner would not be a wise use of a credit card (there are better and cheaper ways to boast employee morale).

• Assume there are no angel investors or venture capitalists to help you

Angel investors are basically individuals with free cash to invest in your business. For some reason, dentists and doctors are associated with being angel investors (on the theory they make and manage their money well). The issue is that angel investors are few and far between and one could spend their time better selling and marketing then chasing investors.

Venture capitalists are like Trojan horses to many businesses. Most require the owner-manager to cede control and require an exit strategy of selling the business or going public. If this is not your desired exit strategy, the business could be torn apart with competing visions and, given VC’s have the money, the owner-manager is often on the outside looking in.

• Your best strategies are increase cash flow and secure sales

Start producing cash flow and your financing options suddenly open up. In other words, take a “go it alone” financing strategy as much as possible in the beginning and don’t assume a bank will help you (see above). If you are in a business that require heavy capital investment, it may be prudent to start selling services, such as consulting or becoming a reseller, to produce cash flow to scale up. Businesses die not for lack of ambition but for too much ambition. Start steady and build slowly.

If you secure a sale, there are various other types of financing, such as purchase order financing or factoring, that can finance your business. Interest rates can run high so you have to factor cost of capital into your margins (in other words, figure out your costs of sale early in the process).

The key, however, is that most of these types of financing are not typically offered by the banks but by niche lenders. Thus, if there is cash flow and sales in place, one has to ask around. Some banks will refer you off to some of these lenders but you have to do some networking.

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The emphasis here though is, just like in personal finance, don’t expect someone to magically extend you financing when you start up. Worry about what you can control- sales, marketing, expense minimization- rather than hoping that something you can’t control will occur. Best of luck.