Financing Your Startup Business
Copyright © 1998 WWWiz Magazine. All rights reserved.
For a list of terms used in this article and in early business and Venture Capital funding see http://www.vfinance.com/glossary.htm.
WWWiz recently talked to Dick Braun of FormNet, a six-person California corporation in need of money. The company develops software that directly ties the consumer to the lender. It also provides a simple way to apply for loans online and quickly, so you can have loan guarantees in your hand when you go shopping.
The FormNet site includes all kinds of useful things like a wizard that will help you determine your monthly payment, the maximum loan for which you could qualify, and the maximum purchase price you can afford. Loan rate search capability will soon be available on the site.
Now FormNet is looking for their second round of financing. In their first round they received several hundred thousand dollars from an out-of-state company. They also sold the rights to some of their software products and received $100,000 from friends and family. The cost of raising this money in percent of the company has been around 30%.
To take the next step they need a lot more money. Doug Russo of MarketPro Solutions (949-770-2237) has helped them in their search for local investments. MarketPro Solutions will help a company put together a plan, then help them get in front of the right people. Dick tells us he plans to have company revenues at $8 to 10 million with around 75 employees by 13-18 months. This growth will take a lot of money.
FormNet is not the only company struggling in this evolutionary process. Business startups are being created at the rate of more than 700,000 per year. And small business is big business: it accounts for more than half the private work force in the country, and a significant proportion of all sales. Small business also has the highest potential for growth of any sector of our economy, creating roughly 60% of all new jobs.
The world always needs good new ideas; never before have we had such capability and the incentive for generating them into products and services. We have recently seen new venture enterprises assume leadership roles in areas such as medical devices, health services, software, electronics, telecommunications, and commerce on the Internet.
To fund that growth, new and expanding companies need access to capital in the form of both long- and short-term loans and direct investment. Yet small firms often don't have the collateral or credit history to qualify for financing through normal lending channels, and may not know where to find venture capital or private investors. More than two-thirds of all new firms begin with less than $10,000 in total capital, according to Census and Federal Reserve surveys, usually provided by the owner, friends and family members.
Southern California has developed into a significant entrepreneurial and venture center. WWWiz talked to Frank Singer, the secretary and treasurer of a group of "Angels," about his organization of investors.
WWWiz: What do you do as an Angel, and what does it take to become one?
Frank: We have two or three presentations a month from high-tech startups. Most of them are software companies. To be an Angel you have to commit to $50,000. We have sponsored about eight companies so far, anywhere from $500,000 to $1,000,000 per. They're literally startups like 1-800-Weddings, which was the first one we funded. Their company is not all that high-tech, although their Oracle database is very high-tech. Our members are tech-oriented, and most of what we do is tech-related. However, one of the companies we're looking at now is a chocolate company, so it's not all tech-based. Our mission statement says we will invest in Southern California companies.
WWWiz: What is the name of your group?
Frank: We called it Tech Coastbecause we wanted it to have some kind of identity like Silicon Valley. Personally I don't think a name will do it. People don't realize the size and scope of our technological business base here. We have more high-tech jobs and business here than anywhere else on earth. It depends on what you call "here." What everyone wants to do is lump it under a single name so it will be treated as one entity. That, I think, is achievable.
WWWiz: What do you think we need to do other than the name change?
Frank: I describe what's happening in Silicon Valley as an economic eco-cycle. By that I mean you have successful entrepreneurs and they invest back into the community, and you have the government and universities which all attract venture capital and other money, and it all goes together to make the cycle, which makes itself grow. [Editor's note: When list of the high-tech areas are put together they include the Boston area, Silicon Valley and other areas known for venture capital raised and high-tech growth. This area may represent half of all the investment money in these kinds of business, but the area is not known by an identifiable handle so it is treated as small pieces, and does not make the big lists.] A lot of VCs are beginning to open offices down here.
WWWiz: Why do you have such a large group of Angels?
Frank: I look at between five to ten business plans per week. That's a lot of work, and a lot of the members don't feel like doing that. Ninety percent of the group is passive, and 10% do most of the work and bring the deals to the table. It's the old rule. To present in front of our group, two Angels have to sponsor the presenter.
WWWiz: So if someone wanted to have you look at their business plan they would come to your Web site and drop off a plan?
Frank: Yes! Then the screening committee reviews all the plans.
WWWiz: What are the most important attributes an entrepreneur must have to be successful in getting funded?
Frank: A credible business plan and a good management team. Whether it's the VCs or the Angels, unfortunately only 2-3% get through. Ideas are abundant; it's the execution of those ideas that's difficult. I like to say that zero-to-one is much easier than one-to-a-thousand. It takes a different skill set to make the first one than to make the next 1000. It's a totally different skill set. Many entrepreneurs don't recognize it; they think "build one and they'll beat a path to my door," and it just don't work that way.
WWWiz: What is the most common problem you see with these people's plans?
Frank: Most of them have overvalued their entity.
Alternate Methods of Financing Your Business
Angels are not the only way to finance your business. There are three general ways to finance a business: using existing personally owned or available resources, taking on debt, and giving up equity.
Internal sources of financing available to small businesses include the owner's savings, company-retained earnings and depreciation, paid in pension, sale of distribution rights, licensing and royalties, joint ventures, income from other investments, and informal external grants from family, friends and business associates.
Using personal resources may enable you to maintain full control of your business without incurring any debt load.
Sources of debt financing include credit card advances, second mortgages and refinancing of real property, accounts receivable financing and factoring, assigned lease loans, vendor financing, consignment, finance companies, convertible debt, traditional bank loans, commercial and industrial banks, institutional lenders, and various government programs.
Debt financing has the benefit of keeping you in complete control over ownership of your business. You then have to repay only that amount plus interest, regardless of how profitable your company becomes.
A note of caution is needed here. Even though a new company may be able to finance a significant amount of external debt, without an adequate ongoing cash flow for debt servicing the balance sheet can be adversely affected. This can negatively impact chances for raising additional capital in the future.
Loans from banks and other traditional lending institutions are often difficult to procure by new enterprises.
Equity means an ownership interest in the company. In a corporation, an equity investor normally gets stock. In other business organizations an equity investment means taking on a partnership interest or a percentage of ownership of some kind.
Sources for equity capital include family and friends, employees, customers and suppliers, partners, joint ventures, private investors and Angels, venture capital, government programs, private placement memorandums, and ultimately the formal public offering. An equity investment is not necessarily only money--it can also be in goods, equipment, services, or personal guarantee for a loan or line of credit.
Equity financing allows you to avoid the personal risk of taking on debt. Instead of committing to repay a specific amount of money, you instead give the investor a share of the eventual profits. If your company is highly successful, an equity investor may end up receiving back many times the amount originally invested. However, if the company fails to produce adequate profits, the investors may never get their money back.
Equity investors may take seats on the board of directors or even demand an active role in ongoing management.
All equity financing involves giving up some degree of ownership and control in exchange for new capital. Keeping a lesser percentage of a large enterprise might be more profitable than owning all of a small business. But at some point the company founder may find he has little ownership left and even less management control over the business. This can be a difficult transition to make.
Most businesses seeking equity capital start with partnerships, the most common method of financing. The original owners normally keep a large part of ownership and control.
These can include formal partnerships with family and friends who provide startup capital, working partnerships with other knowledgeable persons in the field, investor relationships and strategic partnerships.
In most partnerships, the investment is not easily convertible to cash. In some cases, the investment may also be a loan, with the new partner receiving the principal plus interest over a specified period, along with part of the company. Be aware that unsophisticated partners are nervous about money. They may not understand that it takes time before profits are realized and can have unrealistic expectations. They could view each and every natural minor setback with alarm.
The advantages of partnerships are that they are easier to fund than other investments and there is no set amount to repay. Partnerships are best for companies with no other options and for entrepreneurs having friends or relatives with significant business acumen or industry expertise.
The disadvantages are that they may jeopardize personal relationships, they require long-term involvement, they make a friend or relative a decision-maker in your business, and the chance that the partner doesn't fully understand the risk. Partnerships are worst for very risky enterprises and companies requiring a long development time before profitability.
A frequent source of venture capital for new or small entrepreneurial companies are private investors and "Angels" like Frank Singer.
Private investors are usually well-to-do individuals seeking investments that provide a more personal satisfaction and the opportunity for greater financial reward than offered by more conventional investment instruments such as stocks and bonds.
These investors are usually identified through financial advisors, accountants, attorneys and venture networking organizations. Private investors can be excellent sources of financing at all stages of a company's growth.
However, private investors may have unrealistic expectations regarding the amount and timing of profits. Sometimes they can be unfamiliar with your industry sector and uncomfortable with its risk. They may apply pressure for producing profits far earlier than the business can reasonably manage or that is healthy for the company.
When pursuing private investment moneys, make sure the investor understands the nature of your business and be particularly conservative in your financial projections on how much profit it will produce and how long it will take.
Angelsare wealthy entrepreneurs who recognize potential in other companies and are willing to invest $100,000 to $2 million or more in your company. These investors are often highly interested in specific industries or motivated by belief in certain kinds of individuals. They prefer startups, want high returns on their money and expect to get their money back after a relatively short period of time through acquisition, merger or a public offering.
Angels provide "first-round" financing for risky investments--risky either because they are a young or startup company or because their financial track record is unstable. This type of financing is typically used to prepare the company for "second-round" financing or an initial public offering (IPO).
Typically only one or two Angels will invest in a company at a time. They may own a majority of your firm, but normally won't want to be involved in routine management. They additionally bring industry know-how and contacts along with their capital. Angels often participate in a business and can create higher visibility and add luster to the company's image due to their reputations in the area.
It is important to choose the right Angel because they will often sit on your board of directors for the duration of their investment and can assist in getting second-round financing. Research the Angel's track record of successful investments, investment criteria for participation, the size and focus of funding, their expertise in your industry, the added value they will bring to your management team, and especially their relationships with investment bankers and venture capital firms.
Venture capital is an equity investment which funds early-stage, risk-oriented and fast-growing companies with significant capital infusion from professional investment firms.
Venture capitalists typically invest between $500,000 and $5 million in enterprises capable of creating equity worth around $10 to $20 million at the end of five to seven years for an early-stage investment. VCs will want to realize an annual 20-50% compounded rate of return on their investment until the time they are bought out or the company goes public. They want the highest return possible in the shortest period of time. For an example of a VC firm, refer to Draper Fisher Jurvetson.
VCs take an equity interest in the funded company. Normally this is in stock or financial instruments that can be converted into stock at a later date. They will take positions on the board of directors and will want an active voice in the management of the company.
The preferred exit strategies for a venture capital firm are a merger with another company, a buyout by a larger corporation, or an initial public offering (IPO). Each of these can achieve the return on investment that the VC is planning for.
Venture capital is the most difficult source of equity financing to obtain. Although sometimes startup or seed capital can be found from VCs for new technologies or infant industries, most often it will be a secondary source of investment in an established business.
VC firms review hundreds of business plans and interview scores of entrepreneurs for every single company they ultimately fund. The three most important considerations are the experience of the management team, the dynamics of the industry cluster the company is entering, and the strength of the business plan. All of these must be tightly thought out and organized in order to have any chance of venture capital funding in normal circumstances. In extraordinary cases when a business idea is so unique, the industry is exploding with opportunities, or the entrepreneurs are highly regarded in their fields, venture capitalists may fund a company based on the idea and trust in the management team alone.
The advantage of using a venture capital firm is the added value the firm can bring to the company. With a venture capitalist you get partners with highly sophisticated knowledge of the business environment, an extensive network of contacts and relationships, and the ability to use their leverage to the maximum financial benefit of your company.
It is often useful to have a venture capitalist serve on your company's board of advisors. They can give you valuable input on what your firm needs to do to really succeed, share the benefit of their experience, and introduce you to other VCs when you are ready to seek venture capital financing.
In addition to all the private sources investment capital, the government has programs at the state and federal level to assist new and expanding companies. The Small Business Administration (SBA) is an excellent source of information on financing and managing startups. Sometimes the SBA also serves as a money lender, and under certain circumstances may guarantee a sizable percentage of a bank loan. Government sources generally prefer ongoing businesses, not startups.
The Service Corps of Retired Executives (SCORE) has over 14,000 volunteers nationwide to provide expert advice and shared knowledge based on their many years of experience on virtually every phase of a business, from startup through maturity.
Small Business Development Centers (SBDCs) provide a variety of management and technical assistance to small businesses and would-be entrepreneurs. They are a cooperative effort among the SBA, the academic community, the private sector, and state and local governments.
Small Business Investment Companies (SBICs) are unique government-private sector partnerships to provide equity funding and credit for small businesses.
Although SBICs are good opportunities for financing a small business, many of them maintain rigorous evaluation procedures. They may demand the same type of collateral and evidence of credit worthiness as banks.
A final note of caution: regardless of the type or source of financing you seek, a good business plan is an essential part of the process. The business plan will define the reason for the financing, how the capital will be spent and the timetable for the preferred exit strategy. Remember that it is judged on quality, not quantity. Although the final size of the plan depends on the complexity of your business, it must be a relatively concise and highly focused document.
We may not have thought of all the ways to capitalize a business but we hope that we have given some ideas to startup businesses that need it. The people we talked to have equivalent needs and services in your neighborhood, and if you are an investor or someone who needs and investors, start with our Web sites listed, check out our list of resources…and good luck.
Hank Meyer is the Managing Partner of Chameleon Interactive Media (a new media and electronic commerce consulting firm), a Co-founder of The Prospero Group, and on the Board of Directors of the Orange County Multimedia Association