There are as many different ways to finance a business as there are entrepreneurs. But in the end, there are only two kinds of money: debt, which must be paid back; and equity, which represents ownership of the business. These days, smart financiers are blurring the lines between debt and equity with convertible notes, convertible stock and so-called mezzanine financing, which is a blend of both stock and loans.
Many entrepreneurs are tempted by equity investments — not least because it can be attractive to share the risk with an investor. The downside is that equity is usually the most expensive form of finance. Since they are taking risks alongside you, lenders will expect the rate of return to be high enough to make it worth their while. While giving up a percentage of the company can be more expensive, it is still worth considering as it may provide a stable alternative to balance sheet liabilities.
Business owners love to dream that a large venture capital firm will step in with financial backing, but that’s rarely how it works out. Fortunately, alternative sources of cash abound if you know where to look.
Nothing shows how serious you are about succeeding like investing your life savings into your company’s growth. But choose carefully to minimize personal risk and maximize cash flow. Before taking a second mortgage on your home, look first at your life insurance policies and 401(k) plans. Ask your financial advisor if you can simply withdraw part of the death benefit, or, alternatively, take a loan against the cash value of a policy.
Many policies will allow you to pay back the principal at a flexible rate that suits your business cash needs. As a bonus, the interest may be a deductible expense for the business, and tax-deferred income for the individual. Paying yourself back can put extra money into your personal savings, plus create a higher cash balance for the next time a cash need arises.
Finally, don’t forget your investments in public stocks. Traditional stockbrokerage margin accounts can free up cash quickly without liquidating your holdings, giving you a crucial tax advantage. Check with local banks first. Interest rates may be better at a lender than at your brokerage firm where the securities are held. Scout around for best rates.
Turn to a private equity group
Huge private equity groups, or P.E.G.’s, have been providing liquidity for medium and large companies for decades. These days, more and more boutique or “micro P.E.G.’s” are opening their doors, and their checkbooks, to small businesses. While small business owners should carefully consider the downside of equity investments, small P.E.G.’s can offer certain advantages. Sometimes also called pledge funds, these micro funds may manage just a few million dollars, typically gleaned from the personal wealth of one or more successful entrepreneurs. Their dual mission — to buy a substantial interest in high-potential companies and lend a helping hand to the business — is a win-win formula.
Another advantage to working with a P.E.G. is that you can put some of the investment in your pocket while the rest stays in the business for growth.
If rapid growth is creating a cash emergency, traditional bankers, who are generally looking for “slow and steady,” may not be able to help. That’s where a commercial finance company can step in. Finance companies have fewer legal prohibitions than banks, but they still look for one of two things — hard assets to use as collateral or enough cash flow to comfortably make debt payments. If you have the collateral, look for “senior” or “asset-based” loans.
If you can afford to pay back the loan from cash flow, but don’t have hard assets, ask about unsecured, mezzanine or subordinated loans. Subordinated and unsecured credit is widely available to businesses with solid operating profits, sometimes at two or three times the annual cash flow.
Credit card companies can provide unsecured lines of credit up to $100,000. The rates for unsecured loans depend on your credit score and are usually around the same as a credit card.
Raising money from angel investors
There are many benefits to owning 100 per cent of the business you are building, but if you’d rather not go it alone, there’s never been a better time to look for a wealthy partner. According to research done by the University of New Hampshire, during just the first half of 2006, more than 130,000 high-net-worth individuals — or “angel investors” — made investments in private companies, putting almost $13 billion into private companies. Unlike venture capital firms, which tend to invest exclusively in technology hotbeds, angel investors can be found in every state and city.
Since wealthy investors tend to stay out of the spotlight, finding an angel investor takes careful networking. Getting an introduction through a trusted lawyer, C.P.A. or business leader is often the best way to start negotiations with an angel. Somewhat surprisingly, however, more and more angels are banding together in clubs or investing en masse as an angel fund, making them much easier to find. The Angel Capital Education Foundation provides a list of more than 200 such groups at angelcapitaleducation.org.
If you decide to pursue an investment from a local angel investor or angel group, remember that it is incumbent upon you to provide full disclosure about your business — and you should expect the same in return. Learn all you can about the other investments your angel has made. Interview other entrepreneurs who have worked with him or her. Don’t let the excitement of the deal cloud your judgment.
When you’ve found the right investor and are close to agreeing on terms, it’s time to start the paperwork. Be sure to retain experienced legal counsel to prepare a private placement memorandum (P.P.M.) and stock subscription agreement. Without proper documentation, the investment can be rescinded, leaving you on the hook for a refund.
Even the best-intentioned partner may turn from helper to hindrance. If the investor wants to micro-manage your business, or worse, decides that you are mismanaging his money, beware. Too many entrepreneurs have landed in court thanks to a disgruntled partner. Usually, of course, angel investors live up to their name. Many want only to invest in growing companies and provide a small amount of help when they can.