CHAPTER 1
Rule #10
EQUITY FINANCING:A STEP TOWARDSTART-UP SUCCESS
Expect the unexpected whenyou start a business from scratch.
Rule #10Start-up successes use equity financing.Start-up failures use too much debt financing.
There are two types of business financing you can use when youstart your business. One is debt, and the other is equity. Theyreside on opposite ends of the risk spectrum. Start-up successesuse equity financing—the less risky money. Start-up failures usetoo 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 andother shareholders. The people who put this type of money intothe company own a piece of the company. Some of the typicalsources of this type money are the owners, relatives, venturecapital companies, and other business partners. This money isnot a loan; it is repaid in the form of stock and dividends.
Debt financing is money put into the company in the form of aloan. These loans typically come from a lending institution like abank or the Small Business Administration (SBA), via your localbank. This money is paid back usually on a monthly basis. Thismoney is a debt for the company and is paid back out of cashfrom business activities. Because debt financing must be paidevery month, it is a burden on the company and increases thestart-up risk.
Case Study
In the first six months of my first start-up, we encounteredseveral obstacles and unplanned events. Our business wasstarted in 1995 as a contract manufacturer in the health-careindustry. Our business plan was based in large part on salesto a company with whom we had personal relationships. Itwas outsourcing the manufacturing for its consumer retailproduct.
Two months into the business our customer informed us it wasreducing the number of suppliers from five to two. We werenot one of the two. This had an enormous impact on our plan.This one customer/prospect represented about 50 percent ofour projected sales in year one. Suddenly our sales were shortof plan; it was the worst-case scenario. Sales were slow to rampup and were behind plan for most of the first year. Because ofthis, our revenues dropped but our expenses did not change. Ifour business financing had relied too heavily on debt, our cashflow and business would have been in immediate trouble.
This example illustrates the type of unexpected and unplannedevents that can occur and the havoc they can create in your newbusiness. The important distinction between equity financingand debt financing is that equity financing isn't a monthly drainon cash flow. It enables you to absorb unexpected events moreeasily. 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 fromyour business. And because cash flow is the lifeblood of anybusiness, it is important to maintain the integrity of cash flowat all times.
Equity financing eliminates this payment burden. With equityfinancing you raise money by selling a part of your company inexchange for ownership (equity). This lump-sum cash infusion isused to pay expenses of the company while sales and profits arebeing built. When the company receives this type money, it is aninvestment by the person, institution, or group in the business.This money is not paid back on a scheduled payment plan soit does not drain cash and create a burden on cash flow. Theequity investor expects to see the return of the money investedplus growth, usually over several years. Often the equity investorsare paid back when the company is sold.
Whether you use equity or debt financing or a combination ofthe two, make sure you get enough money in the beginning.As a general rule, you should have enough money to take youthrough your worst-case business/sales plan. You will know thelevel of financing is adequate when your cash-flow model stayspositive—that is, it does not run out of money. As you start thetask of building your business, it is very disruptive to have to stopand 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-flowstatement. You can find standard cash-flow statements in anExcel spreadsheet on the Internet or in the business section of thebookstore. This spreadsheet will use sales and expense projectionsthat model your cash flow. How much money or cash will you bebringing in from customers and how much cash will be outgoingfrom your operating expenses? You should build your cash-flowmodel based on your most accurate projections, Plan A, andyour back-up, Plan B. The cash in your bank account must lastuntil profits are sufficient to enable the business to operate on itsown.
Case Study
Our next unplanned event nearly resulted in an uncollectableaccount receivable invoice of $50,000 to one of our newcustomers. As a supplier of disposable medical devices andcomponents, one of the products we supplied was an antifogplastic eye shield that our customer used to make its hospitalsurgical mask. On a hot July day, we made a large shipmentof these shields from our plant in Texas. The plastic shieldsbecame stuck together during the hot and humid truckshipment. There was a question from our customer's receivingquality personnel regarding whether or not they would evenbe able to use the shields. If not, we would be facing a productreject and an uncollectable invoice of $50,000. Would webe able to recover from a cash-flow hit of that magnitude?Meanwhile, our payment to our raw material supplier was stilldue even if our customer rejected the shipment.
When it comes to equity financing, most entrepreneurs want tohold onto as much ownership of their companies as they can.This is the primary reason they use debt financing. The problemwith this approach surfaces when the unexpected happens toyour business and plan. If your plan suddenly starts down theworst-case path, will your cash flow survive? If your cash flowdoes not survive, neither will your business. There is a balancingact between debt and equity financing. More debt financingallows you to hold onto more ownership of your company, butwith increased risk.
There is a place for both debt and equity financing in mostbusinesses. The ratio between the two differs from businessto business and industry to industry. Your bankers, financialadvisors, and investors will give you a good idea about what thisratio might be for your situation.
Remember that it's better to have less ownership in a successfulstart-up business than more ownership in a start-up failure.
One strategy is to plan your finances so that you can survivefor one year (rent, food, etc.) without any income from the newbusiness. If you can implement this strategy without burdensomedebt, your new business will be off to a great start and this willsubstantially enhance your chances for success.
One last note on business financing: there is a little known creativefinancing secret that can be used to finance your business andretain the most equity possible. It is by entering a joint venture(JV) with another company. This can be a powerful method thatbenefits both parties. Here is how it works: You give away a certainpercentage ownership in your company in exchange for supportin the early years of your business. For example, your JV partnerwill be an established business with infrastructure you can use.Your JV partner will pay salaries, provide office space, warehousespace, accounting services, etc. The exchange of equity for thissupport can take on an almost endless number of varieties. Thebenefit of this type arrangement is that some of the support isn'ttruly 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 keyindividual and free rent; both lasted three years. Not having thesetwo burdensome expenses kept our expenses (overhead) as lowas possible. This made it much easier to attain profitability. Yourpartner company already has a building, warehouse, accountingemployees, etc. You will simply use those assets and resources thatare already being used by your JV partner. You use this supportuntil your new business gets to break-even.
Financing Summary
• Debt financing is a loan with regular payments that affectcash flow.
• Equity financing is selling part of the business ownershipfor later dividends; there are no regular monthlypayments.
• When starting out, plan on having a minimum of oneyear's personal expenses set aside so that the business cashflow can be maintained without owner salary.
• Consider a joint venture equity financing to get started.
Rule #9
LINE OF CREDIT:YOUR SAFETY NET
Rule #9
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) touse in their business from day one. This is put in place before itis needed.
Cash flow is the lifeblood of any business. Your line of credit allowsyou to manage cash flow to the optimal benefit of your company. Abusiness line of credit is a prearranged loan from a lending institutionthat you pull from and pay back regularly. With the tight creditmarkets today, obtaining a line of credit may be a tough task toaccomplish for a start-up business. However, it is more importanttoday than ever before to help you navigate this economy.
Start-up failures make the mistake of starting their businesswithout a line of credit in place. This is dangerous and is likelearning to walk a high wire without a net below you. YourLOC is your cash-flow safety net. What would happen to yourbusiness if a large customer suddenly couldn't pay its bill? Couldyou survive that? What if routine accounts receivable don't comein as quickly as you planned, or if you experience more bad debtthan planned? If you have your line of credit in place, you canpull the funds from your LOC to bridge your cash-flow gap. Poorcash flow is the single biggest risk factor for your new business.It is what keeps entrepreneurs up at night and negative cash flowfor too long will drive you out of business.
Your LOC is the safety netunder your cash flow plan.
There are many normal everyday business situations that will fuelyour need for a LOC.
• Slow accounts receivable
• Bad debt
• Rapid sales growth
• Unexpected expenses
There are others, and it is likely that you will have to deal with allof these situations early on in your business. Be prepared.
Successful start-ups have a prearranged line of credit in place andready to use. In most cases, the owner will be required to signa personal guarantee for the debt. This is not new and is not aresult of the current tight credit market. Personal guarantees havealways been a fundamental banking requirement for most newbusiness loans.
Case Study
In our business, we arranged for two lines of credit from twodifferent banks. Both were based on personal guarantees andboth banks offered the same amount of $25,000. So now wehad a $50,000 safety net under our business. If you have goodcredit and a good business plan, you should be able to securea small LOC.
It is best to set up your LOC before you open your doors forbusiness. If this is not possible, you should secure one as soon asyou can. Keep a close relationship with your banker. Get to knowhim or her. Invite him into your business. Send him monthlyand quarterly financial statements so he is aware of your business.Take the time to go to lunch with your banker. He is a key partof your success and team.
The time to ask for and apply for a LOC is when you don'tneed it. Banks vary in their attitudes toward small and start-upbusinesses. You will have to interview several bankers to findthe right fit. Early in your business, you may have extra cash inthe bank. Go get the LOC then. If you wait until cash is tightand you have a real need for a short-term loan, your banker willperceive that as being much more risky than if you had appliedfor it before the real need was there.
Maybe you have seen the phrase "Happiness is positive cashflow." Until you attain that happiness, your LOC can be yourbest friend.
Your objective is to have cash flowing so nicely that you don'tneed 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, andrepeat this. If you do not use your LOC you will lose it. Whena bank gives you a LOC, it is tying up that amount of money asif it was lending it to you. If you don't pull from your LOC andallow the bank to lend its money to you and make money on thisloan, then it will pull back this reserve for you and use it for moreprofitable purposes.
Alternatives to LOCs
Credit is very tight today. If the banks refuse your LOCapplications, you can turn to credit cards. Most major credit cardscome with a cash advance feature, which is essentially a personalline of credit. It is much more expensive than money from yourlocal bank, but it can be nice to have. This credit card LOCcan also be used in addition to your bank LOC. As mentionedearlier, one last angle to work is to secure an LOC at more thanone bank. Banks evaluate each person and business individuallyso you can have more than one LOC at a time.
There are more creative—and often more effective—waysto improve your cash flow. Customer financing and vendorfinancing are great methods. If your customers are otherbusinesses (business-to-business, aka B2B sales), you typicallymust wait thirty days after you provide your product or servicebefore you get paid. You can simply ask or require a customerto prepay for its purchase either in whole or part. This gives youcash immediately rather than waiting thirty days. You can offerincentives for your customers to pay early. These typically arediscounts to entice them to pay in ten days instead of thirty.You can also work with your suppliers so they give you extendedpayment terms. Normal business-to-business payment terms arenet thirty, where your customers pay your invoice 30 days afterthey receive your goods or service. If you can get your suppliersto extend your payment terms to sixty days or ninety days, youwill cash-flow much more easily.
Case Study
Recently a local business acquaintance asked one of his largerpackaging suppliers for ninety-day terms. He got a yes answeralmost before he got the request out of his mouth. It is inyour suppliers' best interest to help you succeed. This type ofpartnership will build long-lasting relationships. I am sure thesetwo companies will do business together for a long time.
Your LOC is the bridge between your income statement andyour cash-flow statement. Set up your line of credit before youneed it. It is almost certain that you will be glad you have it tobridge your cash flow, particularly if you work with credit termsfrom customers or suppliers.
line of credit Summary
• A line of credit is a prearranged loan that allows you toaccess the funds when needed.
• A LOC will assist with cash flow if needed.
• Alternatives to LOCs exist: credit cards and supplierfinancing are two examples.
Rule #8
ACCURATEFINANCIAL MODELS
Rule #8
Successful start-ups have accurate cash-flow and income-statementmodels.Start-up failures have flaws in their financial models.
Start-up successes have accurate financial models—especially thecash-flow and P&L models—and they use them to guide theirbusinesses. Start-up failures have incomplete, inaccurate, unused,or flawed financial models.
Good financial planning is critical to your success and yourability to minimize start-up risk. You must know what lies aheadwith your finances. Your blueprints for this are your financialstatements. These include the income statement, balance sheet,and cash-flow statement.
(Continues...)
