Sources of Capital...

Starting & Operating a New Small Business		  
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Sources of Capital

The Need for Capital Over A Businesses Life


When you begin a business, you need to invest money into that business from one, several or many sources. You must first open a business bank account using your business name. The money either comes from:

  • owner invested capital
  • borrowed capital
When you invest your own money into that bank account or take on partners or stockholders as investors, it is called equity financing or equity capital. When you borrow the money it is called debt financing or liability (a promise to repay). If your ratio of financing is heavy on debt financing, the business is said to be "leveraged."
(Note: In the world of finance and accounting, leverage is the use of borrowed money to make an investment and the return on an investment.)

Whether you borrow or invest the money into the business, this process starting the business financially is called capitalization.

There may be several times during the life of your business when you need additional capital, often more than you originally needed, sometimes just small amounts. You need capital when:

1) Start-up Capital - Start-up Capitalization from scratch, Buying a Business or Franchising
  • Secure the lease
  • pay for improvements
  • initial inventory
  • others - marketing, hiring employees, licenses & permits and so on

2) Operating Capital for Normal Growth at a Location- Working Capital
3) Replacement Capital for Long Term Assets - Capital to Replace Assets
4) Expansion Capital (2nd location, major growth)- Growth Capitalization for serious expansion and scale of business operations

MYB - My brother and I opened our own painting business, specializing in exterior work. We've been in business about a year and are starting to get more work than we can handle. We have a business plan that maps how we will get to the next level of growth by adding employees and getting more equipment like ladders, scaffolds and sprayers, as well as increase our advertising. However, we are having trouble finding capital to expand. The SBDC in Aptos says that for the amount of money we need, it might be better to use a line of credit than to get a term loan; what's this mean? Is it a special type of loan?

Answer: The answer depends on both the amount of money you need and upon what you're planning to do with the money; what you will spend it on. It also matters that you consider how quickly you'll generate the revenue to repay it and on the lender's terms for expected repayment.
Lines of Credit
Term Loan
  • working capital expenses
  • loan is typically repaid in a year, often 6 months
  • Useful for short-term needs: replacing or increasing inventory, paying expenses while waiting for a client to pay or a job to materialize, etc.
    		•
    • Capital investments
    • usually repaid over years, often 5-30
    • appropriate for Long-term investments that take a few years to pay for themselves: opening a 2nd office or location, vehicles, large equipment or a building

    Banks often want 3 years of operations for regular commercial loans, showing ability to repay. Mechanics Bank offers innovative loans such as the SBA guaranteed or line of credit loan that turns into a 4-year term loan after the first year.

     
    Debt versus Equity Capital

    When you borrow money you create a liability to pay it back to the lender with interest. When owners invest in a business they have a claim to their invested equity and any growth equity from profits.

    Debt Capital - costs include interest, fees and points It may require collateral (asset-based) and the payback may be monthly payments or a lump-sum.

    • short-term debt - usually used for working capital; paid back with resulting sales and profits.
    • long-term debt - usually used for purchasing assets, land, buildings; 50-80% of value used as collateral for loan.

    Equity Capital - offer some form of ownership position; share in profits, losses, obligations and pro-rata disposition of assets.

    Capital, whether debt or equity, may come from several general sources including:

    • Private sources - individuals, philanthropists, etc.
    • Commercial sources - Banks, industry, etc.
    • Government sources - SBA Guaranteed Loans, grants, etc.

    Internal vs. External Sources - As your business grows, you may be able to finance capital needs and expansion/growth internally from retained profits. You may even open other businesses where the first business becomes an investor or a lender to the second business.
    Sources of Capital

    Informal and Possible Sources

    • Your Money - Personal Savings, investments cashed out (e,g - stocks, bonds, business sold, retirement funds, CD's, IRA's, $401K's, etc.), coins, cards or stamp collections and so on.
    • Borrow from Yourself - if you have a 401K or similar plan or tax deferred annuity, many allow you to borrow against your contributions, about 90% allow this. Typically it is limited to $50,000 but not more than 50% of the value in your account. You usually get fast and automatic approval because you are borrowing from yourself, attractive interest rates fixed at prime for the loans duration and no restrictions on how to use the funds.
    • Family/Friends Money - (OPM) small loans, advances, debt w/o payback
    • Personal Debt Financing - Secured, Collateral, Home Equity, Life Insurance, Brokerage Margin Account, Credit Cards.
    • Bootstrapping - the tradition of immigrants starting businesses without much capital and pulling themselves up by their bootstraps: dealer credit, cash flow management, Collect Early/Pay Late, Supplier negotiation and vendor financing, consignment inventory, Inventory Turnover, Reinvested Profits, customer contracts that pay half up front, employees or partners work for no cash at first, commission marketing and sales, barter services, use incubators locations and resources, scrounging for free and used items, etc.
      • Four ways: negotiate, shift payment to future, barter and collect early/pay late.

    More Formal and a Little Less Likely Sources

    • Home Equity Loan - interest is tax deductible and the principle can be used for any purposes
    • Notes Payable - promissory note from friends, family and acquaintances
    • Other Businesses and Interested Parties - Professionals, Customers, Landlord, Suppliers
    • Partners - full, limited or joint ventures
    • Private Stock Offer - incorporation, LLC members

    Formal and a Lot Less Likely Sources

    • Banks - 1-3 years in business; given to about 2-5% of new businesses
      • Banks often want 3 years of operations for regular commercial loans, substantiating past earnings and showing ability to repay.
      • They charge fees for the Loan Packaging; consultants charger for business plan writing (usually part of the loan package)
      • They want an established business credit history and a positive personal credit history.
      • May lend to a new business if you can show a strong business plan, good personal financial status (collateral, personal equity, etc.), and a solid credit rating
      • Required Documents: Business Profile and Business Plan, Loan Request, Collateral, Personal and/or Business Financial Statements, Last 3 Years Balance Sheets, Last 3 Years Income Statements, Cash Flow Projections, Accounts Receivable and Payables Aging.
      • Your personal credit report: banks will pull these but you can review them and take steps to demand correction of errors. If you have legitimate late payments or bankruptcies, prepare a letter of explanation of the circumstances.
      • SCCCreditunion | Coast Commercial Bank | Wells Fargo
    • SBA - Often given to new businesses or 1-3 years in business. They will also work with expansion capital loans, working capital loans and and marketing plan loans. Money is usually available for special groups, targeted for support: new and emerging businesses, low-income borrowers, disabled business owners, veterans, exporters, rural businesses, special groups (women in business http://www.countmein.org/, etc.) and specialized industries.
      • SBDC Link
      • SBDC Services

        The SBA, through your local SBDC, will work with businesses starting from scratch. They don't grant loans but do guarantee the loan repayment or most of it for the actual lender, The SBDC helps you prepare the package and business plan and pre qualifies you. They work with local lenders like banks, Savings & Loans and Credit Unions. SBA programs substantially lower the lender's risk, gain quicker approval and likely approval, and usually are at attractive interest rates.
    • Grants/Funds - government and foundations, industry and private: almost always limited to nonprofit organizations and companies. Some grants are for companies that will do scientific research or benefit our technological infrastructure and so on but very rarely any for traditional businesses like restaurants. However, some of these nonprofit's use their money to fund loans to small businesses and special Internet businesses as nontraditional lenders.
      http://foundationcenter.org/getstarted/faqs/       | Foundation Center Home
    • Angels - typically invest in smaller businesses and invest their own money, unlike venture capitalists. They may put up from $10,000 t0 $250,000 in early stage businesses. They typically aren't limited partners, preferring larger scale business opportunities and rewards but often do look for regional and local opportunities. They are often wealthy individual investors and want an exit plan after a few years to sell out to a larger company or take the business public. They may offer their experience and expertise and may be more patient than traditional lenders. They require a sound business plan. Many do not fund non tech companies.
      http://www.angelcapitalassociation.org/

      Angel Investors and Venture Capital

    • Venture Capitalists - They have their own funds but generally draw upon money from large institutions. They usually require 1-3 years in business; only .05% funding of new businesses. They generally require the following conditions for them to invest in your business:
      • ownership, usually controlling
      • management in key positions
      • exit plan
    • Public Stock (IPO) - requires an underwriting firm that agrees to purchase your stock at an initial price and resell it or sponsor it on the major exchanges (Pacific, NYSE, NASDAQ, International exchanges) or OTC (over-the-counter) informal exchange (90% of IPO's are through NASDAQ)

    How Businesses Use Debt: