Kaufmann

Financing Your Business – 3: The Need for Financing

This is the third article in a series about financing your business.  We previously reviewed potential financing sources and the lender’s perspective.   This time we are going to take a look at the need for financing and the events that cause the need to borrow.

What are the primary reasons a company borrows money or seeks funds from outside investors?  The obvious answer is to obtain cash for the business, but how will the cash actually be used once it is raised?  In other words, what exactly causes the need for financing?

There are actually quite a few answers, but just to summarize a few, the need for cash can occur for a variety of reasons:

1. A company experiences an increase in its costs but is limited in its ability to raise prices.
2. There is a slowdown in the collection of accounts receivable and funds are needed to pay ongoing operating expenses.
3. Suppliers decide to reduce the time you can take to pay their invoices, so you cannot wait for customer to pay you before you pay your supplier.
4. You have to increase your assets to support growth in revenues, which you can sometimes anticipate, but which may also be unexpected.
5. You have not properly aligned your debt structure to match the asset side of your balance sheet.  Short term debt should finance short term needs (working capital) and long term debt should finance long term needs (purchases of land, buildings, equipment).

There are others, but these are some of the most common reasons.  As you can see, each one of these reasons is a symptom of a deeper problem that management must solve, so it is important to remember that the need for cash is actually the symptom of a problem, not the actual problem itself.

It is all good and well to know what some of the causes are that force you to seek external financing, and that if you need cash then you probably have an operational problem that needs correcting.  How can you determine that such problems exist, or may occur, before they actually happen and you find yourself in a cash crunch?

The answer is to constantly obtain and review the information that will provide the answers.  With the proper information about your business, and accurate financial statements, you can identify the causes.  Fortunately, today’s technology can automate the information gathering and processing process so you can devote more time to using the information to make decisions instead of spending a lot of time just gathering and manipulating the data to get the information you seek and need.

The tools you use to get the information you need are:

1. The balance sheet, which shows your financial condition at a point in time, and provides insight into your company’s liquidity and leverage positions.  Liquidity is a concept that relates to how easily or how quickly you can convert your assets into cash.  Leverage is a concept that relates to how much debt you have relative to your total assets or equity.  Generally speaking, the more debt you have, the less able you are to raise cash from the assets you own.
2. The income statement, which shows the results of your company’s operations over a period of time.  In addition to showing how much money you earn from selling your product or service, the income statement identifies the
   1. Operating expenses, which are your costs related to operating your business;
   2. Operating profit, which is the amount of money available to cover your non-operating expenses, such as loan payments;
   3. Net profit, which is an indicator of your firm’s performance over the long term because it reflects how much money you have earned to reinvest in your business.
3. The statement of cash flows, which shows the net inflow or outflow of cash into or out of your business over time.  Remember that you can be very profitable and still go out of business because you lacked the cash you need to survive.
4. Ratio analysis, which makes it possible to compare your financial condition from one operating period to another so you can effectively manage your business and anticipate problems before they occur.

Each one of these tools provides vital information, but you can only get a complete picture of your financial condition if you use all of these tools together.  It’s like building a house—you can’t use a hammer for everything; sometimes you need a wrench, a screwdriver or a pair of pliers.

In the next article we will take a look at ratio analysis and how you can use it to quickly get important data on the financial health of your company.

Bruce Kaufmann

Financing Your Business – 2: Lender’s Perspective

In this, the second article in a series about financing your business, we are going to examine how a lender views your business and what he looks for when you request financing.  To keep things simple, in this article, I will use the term lender to mean both those that lend money to your company—banks, finance companies, factors—as well as those that invest in your company—venture capitalists, angel investors, and investment bankers.

The first thing you want to remember is that every request for financing you make is a selling activity.  No matter how good your business idea, no matter how financially sound your company is, you are only one of many requests that a lender sees every day.  And there is always someone who is in better financial condition than you are, or who will be an easier deal to close than you will.

Those who lend money are judged by the following criteria:

1. How many deals do they review?
2. How many deals do they close?
3. What is the amount of each deal (larger is better)?
4. How profitable is each deal?

Get the picture?  Lenders are salespeople.  Their product/inventory is money, and they don’t want it sitting idle.  Instead, they want it out in the marketplace, where it will generate revenues (interest).

However, you need to understand that selling loans or equity investments is not quite the same as selling a product or service.  For one thing, once a company sells a product or service, they do not want to take it back.  The sale is closed, the profit has been earned.  End of story, on to the next sale.

Lenders, though, definitely want the money back.  Repayment of the loan or investment is absolutely necessary if the lender is to receive the required return on his investment.  In addition, lenders tend to be highly leveraged, which means they make loans with a little of their own money and a lot of other people’s money.  Being leveraged means that any time a loan is not repaid, it will have a significant, and severe, impact on the lender’s financial condition.

So you can understand why lenders are going to be very careful when they decide who gets to borrow their money. 

With that in mind, let’s take a look at the three basic questions lenders consider when they evaluate financing requests and try to decide who gets to borrow money.

These questions apply to anyone that lends or invests money—it does not matter if it is a loan, an equity investment or a combination of both.  However, the specific answers depend on the type of lender and the risk that the lender is willing to take.

For example, banks tend to be short term lenders and avoid very risky credits.  Therefore, they will try to obtain collateral to secure their loan and will not make loans to companies that have insufficient assets to pledge, have a poor financial condition, or inadequate cash flow.

Equity investors, on the other hand, seek out the riskier investments and higher rates of return.  Consequently, they will not necessarily seek hard assets as collateral, and will not be concerned if (at the outset) the company has insufficient cash flow or a poor financial condition.

In both cases, though, these three questions must be answered:

1. Purpose – Why do you want the money?  How will you use it?  What has happened, or will happen, that causes the need for you to seek out financing?
2. Repayment – How will you repay the money?  If you are seeking short term debt, will your ongoing cash flow be the source of repayment?  Will you depend on your customers to pay you in order for you to repay the debt?  If you are seeking an equity investment, do you expect the value of your company to grow to the point where you can sell it and thus raise the funds needed to repay the lender?
3. Collateral – What is the alternative to the lender if your intended source of repayment fails to materialize?  In the case of a short term loan, will your assets have sufficient value so they can be liquidated and pay the loan in full?  How much will it cost the lender if he has to go through the liquidation process?  If you anticipate an equity investment, will the lender be able to take control of your company should you be unable to execute your business plan?

So do not forget the lender’s perspective when you are seeking money for your company.  Anything you can do to give the lender what he needs, and to make it easier for the lender to approve your request, will only enhance your ability to get the financing you need, when you need it.

Financing Your Business – 1: An Overview

This article is the first in a series that will discuss various aspects of financing your business.  Here is a list of the topics that we will cover:

1. The potential financing sources that are available to you.
2. Understanding the lender’s perspective.
3. What causes the need for financing.
4. How to identify the events that cause the need for financing.
5. Using the proper debt structure.
6. Preparing a financing package.

Let’s begin by taking a look at some of the potential financing sources that are available to you.  Most business owners think that their only option is to get financing from a bank, from savings, or from friends and family.  Actually, there are more sources available to you:

1. Private Investors – This group includes not only your friends and family that are willing to take a chance on you, but also such entities as venture capitalists and angel investors.  Keep in mind that your chances of getting funding from a venture capitalist are very slim; even if you have a product or service that can grow quickly, provide a high return, and offer a quick exit, the venture capitalist may still choose another investment over yours.  You may be better off either borrowing money from friends and family, or creating a Regulation D offering to allow your friends and family to participate in the growth of your company.  A note of caution:  if you do tap relatives and friends for funds, be sure to do an arm’s length transaction, i.e., as if you were total strangers.  Do it right, because you want your friends and family to stay your friends and family, no matter what happens.
   
   
2. Banks – This is a very familiar financing source.  What you want to remember about banks is that they can only lend to your business if your business is established and is generating a profit, has a positive cash flow, and does not already have too much debt.  Even if all of these things are true, and even if your company is incorporated, if you are the sole owner you need to be prepared to personally guarantee whatever debt the bank grants to you.  If your company does not meet the previously mentioned criteria, you might still qualify for a loan guaranteed by the Small Business Administration or, if your personal credit is good, a personal line of credit.
   
3. Factors – A factoring company may seem very similar to a bank, but there are critical differences.  A bank bases its lending decision on the overall cash flow and financial condition of your business, and will take assets such as inventory or machinery as collateral.  A factoring company does evaluate your company’s financial condition to verify that your business is viable, but only provides financing against your accounts receivable.  Technically, a factor does not lend money to you.  Instead, he buys your accounts receivable and assumes the collection risk.  Be aware, though, in many cases, the factor may require you to buy back the accounts receivable if your customer does not pay.  A factor is a good alternative if you do not qualify for bank financing, and can also provide additional credit if you have exceeded the limit of your bank line of credit.  Factoring is a riskier form of lending than bank financing, so be prepared to pay a higher interest rate on factored transactions.
   
   
4. Finance Companies – Finance companies are similar to factoring companies in that finance companies are asset-based lenders.  In other words, they lend to you based on the value of your assets, as opposed to banks, which base their decision more on your overall financial condition and cash flow.  Finance companies establish a “borrowing base”, which is the maximum amount of money that you can borrow.  The borrowing base is based on the value of your receivables and inventory.  This financing is a good alternative if your company’s financial condition is less than stellar, but you have receivables and inventory that have good value.  The finance company is more involved in the management of your credit line and also takes a bigger risk than a commercial bank because the finance company relies only on specific assets for repayment.  Since the lending process is more labor intensive and the risk is higher, the finance company will also charge a higher interest rate than a commercial bank.
   
5. Leasing Companies – Leasing companies are an excellent source of financing if your primary need is to purchase a piece of equipment.  You also have to meet certain credit standards to qualify for lease financing, but a lease transaction is a good way to manage your cash flow.  This is because a good leasing company will try to match your monthly payment to an amount that is within your monthly budget.  Also, the leasing company will factor in any residual value of your equipment at the end of the term of the lease.  For this reason, the leasing company may be able to provide longer terms than a commercial bank.  You may pay a higher rate with a leasing company than you would with a bank, but the leasing company may be more likely to provide a monthly payment you can afford.
   
   
6. Purchase Order Financing – You may find yourself in a situation where you receive a purchase order for a very large amount, yet you do not have the money available to purchase or manufacture the product for your customer.  A purchase order lender will advance money to you so you can buy inventory and manufacture your product to fill the order.  This type of financing is not technically lending.  It is really an equity rental; the purchase order lender “lends” his equity to the transaction.  For this reason, the interest cost is much higher than in other types of short term financing.  Be aware that this type of financing is only viable if you have very high gross margins and the transaction has a short (less than 45 days) time frame.
   
   
7. Suppliers – Finally, do not forget trade credit, which is an excellent source of financing if you can get it.  It is a resource you should strive to obtain and, once you get it, fiercely protect.  Over the long term, a good relationship with your supplier, more so than with any other lender, can make the difference between your company’s survival or failure.

In the next article in this series, we will look at financing your business from the lender’s perspective.

Copyright 2007 Kaufmann Capital Advisors

Inside the Black Box

Every day, technology becomes a more integral part of our lives.  As the technology gurus find even more ways to automate daily tasks, either with new, compact hardware or a sophisticated software program, I am seeing more requests for funding to develop and commercialize a new technology.  Such requests are often referred to as “black box” requests because, to the financial investor, the entrepreneur is offering a piece of hardware that looks pretty simple on the outside, but inside is filled with all sorts of technological hardware, or sophisticated software, that the average person just would not be able to understand.

What many entrepreneurs do not understand is that the odds are immediately stacked against you if you present a black box funding request to an investor, even those who specialize in funding high technology investments.  This is because investors have learned that black box funding requests typically focus too much on how the black box works, instead of discussing how the black box can make money.  Not just a little money, mind you, but enough money that the investor can exit within five years and realize a proper return on the investment.

I am not saying that you should not explain how your product works, but keep that explanation in context, part of a more comprehensive explanation of the existing market problem and how your product solves that problem.  Keep in mind what the investors want to know:

1. How large is the market and how fast is it growing?  Is it big enough that if I only get a very small slice of the pie I can still make a lot of money?
2. What is the problem, now and in the future, that your product attempts to solve?
3. How does your product solve the problem and why is your product a better solution than what is currently available?
4. What is your plan for bringing your product to market and generating revenues?  Will you be able to earn a profit?  How soon will you earn a profit?
5. Are you capable of executing the plan to make money from your product?  Who else is on your management team?  Does your management team collectively have the experience and ability to make your plan work?

Notice that only item 3 asks about product information.  Even then, how the product works is only a partial answer to this question.

Also keep in mind that you will have a much harder time obtaining financing if your technology represents a radically different way of doing something, instead of an improvement over current processes.  There is a much bigger risk in being first to market.  If you are first, you will be viewed as less likely to survive, much less be the dominant player, in the long term.  This is because those that follow you will not have to educate the market on the benefits of your product, and they will be able to learn from your mistakes.

Copyright 2007 Kaufmann Capital Advisors