December 11, 2010

Brother, Can You Spare a Dime: Financing a Start-Up

Mary MahoneyBY Mary Mahoney

J. Robinson Group Blog

No one hurries faster than entrepreneurs seeking to launch a company. All too often, in the rush to transform their vision into reality, they hit a wall called “money.”  Their subsequent struggle to secure adequate funds conjures the hit tune of the Great Depression, Brother, Can You Spare a Dime.

In fact, plenty of start-ups owe their beginnings to generous brothers – as well as sisters, parents, aunts, uncles and other family members.  The wisdom of financing a business through family hinges on everyone’s risk tolerance and willingness (and ability) to separate their personal relationships from their business relationships.

Happily, there are other ways to raise money and multiple resources to help find them.  Foremost among the latter is the Financial Assistance section of the U.S. Small Business Administration’s website for borrowers, which describes the financial programs it offers.

A good place to start is the section entitled Understanding the Basics, which provides a step-by-step approach to determining financing needs, borrowing money, sorting out personal vs. business finances, estimating start-up costs, managing growth and understanding financial statements.

Writing for The Entrepreneur Network, George Levy and Thomas Vaughn present a 10-step model for targeting and acquiring funding. The article, How to Target and Land Financing for Your Start-Up, stresses the importance of targeting appropriate financing from the right sources.

“Banks and other lenders evaluate the safety of their money, focusing on the factors that ensure that they will get their money back when it is due,” they said.  “On the other hand, venture capitalists and other early professional investors are willing to risk their entire investment, but only when a realistic possibility exists that their investment will be multiplied many times.”

Success identifying the right type of investor will eclipse the value of the money invested, Levy and Vaughn suggest:  “Once you have one or more initial outside investors, they will act as advocates for your business,” and “their standing in the investment community will affect your future financing.”

David H. Bangs Jr., author of A Crash Course on Financial Statements for Small Business Owners, provides advice for getting a bank loan: “Your job is to provide the banker with as many reasons to feel safe as you can.  You start with a loan or financing proposal – a statement of what you need, why you need it and how you plan to repay it.”

Entrepreneurs should cultivate bankers at more than one institution for their advice and support. “A good banker is a terrific asset, so shop around to find a banker you can work with,” he said.  “The role of your banker is to help you make your business successful.”

Kate Lister, author of Finding Money:The Small Business Guide to Financing, said banks give primary consideration to several ratios, key among them the “cash coverage ratio.”

This ratio is calculated by taking the borrower’s net income and adding back depreciation and amortization, which aren’t cash expenses.  That number is divided by the annual loan payments.  Bankers want to see a ratio of 1.5 or higher.  An example would be annual loan payments of
$20,000 and a net cash flow of $30,000.

Bankers also review personal and business credit scores and calculate a “debt to worth ratio,” also known as “debt to equity ratio.”  Lenders want borrowers’ debts to be no more than three or four times their equity. An example would be $50,000 of equity and $150,000 to $200,000 in debt.

As difficult as it may be to get a bank loan, other sources of financing are even more challenging. According to the U.S. Census Bureau’s most recent Survey of Business Owners, only 2.7 percent of start-up businesses successfully raise money from a venture capitalist, strategic investor, friend or family matter.

Scott Shane, professor of entrepreneurial studies at Case Western Reserve University, believes most start-ups are just too small for venture capitalists.  In a Businessweek article entitled Why Equity Financing Eludes Startups, he said start-ups must project sales of at least $10 million in sales within six years to attract outside investment.

Where does that leave most entrepreneurs?  “Most businesses are founded with cash from the founder’s pocketbook,” said small-business expert Tom Ehrenfeld, author of The Startup Garden: How Growing a Business Grows You and The Startup Garden website.

Pundits have coined a term for self-funding: “bootstrapping.”  As Ehrenfeld puts it, “Bootstrapping means using whatever resources you have on hand to help you get your business to the next level.”  What resources?  Half of all start-ups are funded with credit cards, according to Timothy
of the University of Michigan’s Stephen M. Ross School of Business.

Inc. magazine chronicled the success of self-proclaimed bootstrapper Greg Gianforte in a story entitled Start With Nothing.  It told of his success launching his first company, a software maker called Brightwork Development, selling it for more than $10 million and creating a second major venture, RightNow Technologies, which grew from a bedroom in his home to 230 employees and $30 million in sales in five years.

While bootstrapping offers “pure control and ownership,” the downside is potential risk, warns Ehrenfeld. “It’s great to read about risk-takers who take out second mortgages on their homes and borrow from their retirement funds to launch businesses that turn them into millionaires,” he said, writing in Inc. magazine. “There are far fewer stories in the news about the many people who take great risks – and fail.”

At J. Robinson Group, we help our clients examine a broad spectrum of funding possibilities and choose the method that maximizes potential return on investment while reducing risk.

In my next blog, I’ll examine the final countdown to launching a start-up.

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