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BUSINESS SUCCESS THROUGH RISK ELIMINATIONThe Top Ten Rules of Successful Start-Ups
By Brian Davies
iUniverse, Inc.Copyright © 2013 Brian Davies
All right reserved.
Chapter OneRule #10
EQUITY FINANCING: A STEP TOWARD START-UP SUCCESS
Expect the unexpected when you start a business from scratch.
Rule #10 Start-up successes use equity financing. Start-up failures use too much debt financing.
There are two types of business financing you can use when you start your business. One is debt, and the other is equity. They reside on opposite ends of the risk spectrum. Start-up successes use equity financing—the less risky money. Start-up failures use too much debt financing.
Equity financing is the foundation of a successful new business. This is money that is put into the business by the owners and other shareholders. The people who put this type of money into the company own a piece of the company. Some of the typical sources of this type money are the owners, relatives, venture capital companies, and other business partners. This money is not a loan; it is repaid in the form of stock and dividends.
Debt financing is money put into the company in the form of a loan. These loans typically come from a lending institution like a bank or the Small Business Administration (SBA), via your local bank. This money is paid back usually on a monthly basis. This money is a debt for the company and is paid back out of cash from business activities. Because debt financing must be paid every month, it is a burden on the company and increases the start-up risk.
In the first six months of my first start-up, we encountered several obstacles and unplanned events. Our business was started in 1995 as a contract manufacturer in the health-care industry. Our business plan was based in large part on sales to a company with whom we had personal relationships. It was outsourcing the manufacturing for its consumer retail product.
Two months into the business our customer informed us it was reducing the number of suppliers from five to two. We were not one of the two. This had an enormous impact on our plan. This one customer/prospect represented about 50 percent of our projected sales in year one. Suddenly our sales were short of plan; it was the worst-case scenario. Sales were slow to ramp up and were behind plan for most of the first year. Because of this, our revenues dropped but our expenses did not change. If our business financing had relied too heavily on debt, our cash flow and business would have been in immediate trouble.
This example illustrates the type of unexpected and unplanned events that can occur and the havoc they can create in your new business. The important distinction between equity financing and debt financing is that equity financing isn't a monthly drain on cash flow. It enables you to absorb unexpected events more easily. Debt financing is a loan with a scheduled repayment plan, usually monthly. This loan (debt) will usually come from a bank, the SBA, or another institution. If your revenues suddenly drop, you still have to make this loan payment. This drains cash from your business. And because cash flow is the lifeblood of any business, it is important to maintain the integrity of cash flow at all times.
Equity financing eliminates this payment burden. With equity financing you raise money by selling a part of your company in exchange for ownership (equity). This lump-sum cash infusion is used to pay expenses of the company while sales and profits are being built. When the company receives this type money, it is an investment by the person, institution, or group in the business. This money is not paid back on a scheduled payment plan so it does not drain cash and create a burden on cash flow. The equity investor expects to see the return of the money invested plus growth, usually over several years. Often the equity investors are paid back when the company is sold.
Whether you use equity or debt financing or a combination of the two, make sure you get enough money in the beginning. As a general rule, you should have enough money to take you through your worst-case business/sales plan. You will know the level of financing is adequate when your cash-flow model stays positive—that is, it does not run out of money. As you start the task of building your business, it is very disruptive to have to stop and go back to the activity of raising additional money.
One tool that will help you determine how much money/ capital you need to finance your business is to build a cash-flow statement. You can find standard cash-flow statements in an Excel spreadsheet on the Internet or in the business section of the bookstore. This spreadsheet will use sales and expense projections that model your cash flow. How much money or cash will you be bringing in from customers and how much cash will be outgoing from your operating expenses? You should build your cash-flow model based on your most accurate projections, Plan A, and your back-up, Plan B. The cash in your bank account must last until profits are sufficient to enable the business to operate on its own.
Our next unplanned event nearly resulted in an uncollectable account receivable invoice of $50,000 to one of our new customers. As a supplier of disposable medical devices and components, one of the products we supplied was an antifog plastic eye shield that our customer used to make its hospital surgical mask. On a hot July day, we made a large shipment of these shields from our plant in Texas. The plastic shields became stuck together during the hot and humid truck shipment. There was a question from our customer's receiving quality personnel regarding whether or not they would even be able to use the shields. If not, we would be facing a product reject and an uncollectable invoice of $50,000. Would we be able to recover from a cash-flow hit of that magnitude? Meanwhile, our payment to our raw material supplier was still due even if our customer rejected the shipment.
When it comes to equity financing, most entrepreneurs want to hold onto as much ownership of their companies as they can. This is the primary reason they use debt financing. The problem with this approach surfaces when the unexpected happens to your business and plan. If your plan suddenly starts down the worst-case path, will your cash flow survive? If your cash flow does not survive, neither will your business. There is a balancing act between debt and equity financing. More debt financing allows you to hold onto more ownership of your company, but with increased risk.
There is a place for both debt and equity financing in most businesses. The ratio between the two differs from business to business and industry to industry. Your bankers, financial advisors, and investors will give you a good idea about what this ratio might be for your situation.
Remember that it's better to have less ownership in a successful start-up business than more ownership in a start-up failure.
One strategy is to plan your finances so that you can survive for one year (rent, food, etc.) without any income from the new business. If you can implement this strategy without burdensome debt, your new business will be off to a great start and this will substantially enhance your chances for success.
One last note on business financing: there is a little known creative financing secret that can be used to finance your business and retain the most equity possible. It is by entering a joint venture (JV) with another company. This can be a powerful method that benefits both parties. Here is how it works: You give away a certain percentage ownership in your company in exchange for support in the early years of your business. For example, your JV partner will be an established business with infrastructure you can use. Your JV partner will pay salaries, provide office space, warehouse space, accounting services, etc. The exchange of equity for this support can take on an almost endless number of varieties. The benefit of this type arrangement is that some of the support isn't truly an added or new expense on your JV partner.
As an example, in another start-up I was involved with we "traded" equity in our company for salary support for a key individual and free rent; both lasted three years. Not having these two burdensome expenses kept our expenses (overhead) as low as possible. This made it much easier to attain profitability. Your partner company already has a building, warehouse, accounting employees, etc. You will simply use those assets and resources that are already being used by your JV partner. You use this support until your new business gets to break-even.
Debt financing is a loan with regular payments that affect cash flow.
Equity financing is selling part of the business ownership for later dividends; there are no regular monthly payments.
When starting out, plan on having a minimum of one year's personal expenses set aside so that the business cash flow can be maintained without owner salary.
Consider a joint venture equity financing to get started.
LINE OF CREDIT: YOUR SAFETY NET
Start-up successes have a secure line of credit. Start-up failures do not have a line of credit.
Start-up successes have a preapproved line of credit (LOC) to use in their business from day one. This is put in place before it is needed.
Cash flow is the lifeblood of any business. Your line of credit allows you to manage cash flow to the optimal benefit of your company. A business line of credit is a prearranged loan from a lending institution that you pull from and pay back regularly. With the tight credit markets today, obtaining a line of credit may be a tough task to accomplish for a start-up business. However, it is more important today than ever before to help you navigate this economy.
Start-up failures make the mistake of starting their business without a line of credit in place. This is dangerous and is like learning to walk a high wire without a net below you. Your LOC is your cash-flow safety net. What would happen to your business if a large customer suddenly couldn't pay its bill? Could you survive that? What if routine accounts receivable don't come in as quickly as you planned, or if you experience more bad debt than planned? If you have your line of credit in place, you can pull the funds from your LOC to bridge your cash-flow gap. Poor cash flow is the single biggest risk factor for your new business. It is what keeps entrepreneurs up at night and negative cash flow for too long will drive you out of business.
Your LOC is the safety net under your cash flow plan.
There are many normal everyday business situations that will fuel your need for a LOC.
Slow accounts receivable
Rapid sales growth
There are others, and it is likely that you will have to deal with all of these situations early on in your business. Be prepared.
Successful start-ups have a prearranged line of credit in place and ready to use. In most cases, the owner will be required to sign a personal guarantee for the debt. This is not new and is not a result of the current tight credit market. Personal guarantees have always been a fundamental banking requirement for most new business loans.
In our business, we arranged for two lines of credit from two different banks. Both were based on personal guarantees and both banks offered the same amount of $25,000. So now we had a $50,000 safety net under our business. If you have good credit and a good business plan, you should be able to secure a small LOC.
It is best to set up your LOC before you open your doors for business. If this is not possible, you should secure one as soon as you can. Keep a close relationship with your banker. Get to know him or her. Invite him into your business. Send him monthly and quarterly financial statements so he is aware of your business. Take the time to go to lunch with your banker. He is a key part of your success and team.
The time to ask for and apply for a LOC is when you don't need it. Banks vary in their attitudes toward small and start-up businesses. You will have to interview several bankers to find the right fit. Early in your business, you may have extra cash in the bank. Go get the LOC then. If you wait until cash is tight and you have a real need for a short-term loan, your banker will perceive that as being much more risky than if you had applied for it before the real need was there.
Maybe you have seen the phrase "Happiness is positive cash flow." Until you attain that happiness, your LOC can be your best friend.
Your objective is to have cash flowing so nicely that you don't need to tap your LOC. Even if you don't need to use your LOC, it is a good practice to borrow from it anyway, pay it back, and repeat this. If you do not use your LOC you will lose it. When a bank gives you a LOC, it is tying up that amount of money as if it was lending it to you. If you don't pull from your LOC and allow the bank to lend its money to you and make money on this loan, then it will pull back this reserve for you and use it for more profitable purposes.
Alternatives to LOCs
Credit is very tight today. If the banks refuse your LOC applications, you can turn to credit cards. Most major credit cards come with a cash advance feature, which is essentially a personal line of credit. It is much more expensive than money from your local bank, but it can be nice to have. This credit card LOC can also be used in addition to your bank LOC. As mentioned earlier, one last angle to work is to secure an LOC at more than one bank. Banks evaluate each person and business individually so you can have more than one LOC at a time.
There are more creative—and often more effective—ways to improve your cash flow. Customer financing and vendor financing are great methods. If your customers are other businesses (business-to-business, aka B2B sales), you typically must wait thirty days after you provide your product or service before you get paid. You can simply ask or require a customer to prepay for its purchase either in whole or part. This gives you cash immediately rather than waiting thirty days. You can offer incentives for your customers to pay early. These typically are discounts to entice them to pay in ten days instead of thirty. You can also work with your suppliers so they give you extended payment terms. Normal business-to-business payment terms are net thirty, where your customers pay your invoice 30 days after they receive your goods or service. If you can get your suppliers to extend your payment terms to sixty days or ninety days, you will cash-flow much more easily.
Recently a local business acquaintance asked one of his larger packaging suppliers for ninety-day terms. He got a yes answer almost before he got the request out of his mouth. It is in your suppliers' best interest to help you succeed. This type of partnership will build long-lasting relationships. I am sure these two companies will do business together for a long time.
Your LOC is the bridge between your income statement and your cash-flow statement. Set up your line of credit before you need it. It is almost certain that you will be glad you have it to bridge your cash flow, particularly if you work with credit terms from customers or suppliers.
line of credit Summary
A line of credit is a prearranged loan that allows you to access the funds when needed.
A LOC will assist with cash flow if needed.
Alternatives to LOCs exist: credit cards and supplier financing are two examples.
ACCURATE FINANCIAL MODELS
Successful start-ups have accurate cash-flow and income-statement models. Start-up failures have flaws in their financial models.
Start-up successes have accurate financial models—especially the cash-flow and P&L models—and they use them to guide their businesses. Start-up failures have incomplete, inaccurate, unused, or flawed financial models.
Good financial planning is critical to your success and your ability to minimize start-up risk. You must know what lies ahead with your finances. Your blueprints for this are your financial statements. These include the income statement, balance sheet, and cash-flow statement.
Excerpted from BUSINESS SUCCESS THROUGH RISK ELIMINATION by Brian Davies Copyright © 2013 by Brian Davies. Excerpted by permission of iUniverse, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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