Show Me The Money

IT TAKES MONEY TO MAKE MONEY

It has been said that there are only three sources of funds for anyone starting their own business: Family, friends, and fools. Better known as the “Three F’s of financing,” these groups are not necessarily mutually exclusive.

In all likelihood, your personal savings are not enough to get your idea off the ground. And long before the cash starts flowing in, you’ll not only face start up expenses, but also initial supply purchases. Furthermore, your idea may require a large operating plant or expensive equipment. Most entrepreneurs immediately turn to their family and friends. But why risk your relationships?

Obviously you don’t want to do business with fools so you will need to carefully consider your choices for outside funding. The entrepreneur has two main choices of financing - equity and debt. Equity means the lenders have an ownership interest (and therefore control), or some level of influence over the operations of the business. The equity holders, or shareholders, have rights to everything the company owns and does. Debt financing is as straight forward as a loan, or as complicated as a syndicated bond offering. The debt holders, or debtors, have rights only to the return of their capital and any negotiated interest payments.

Let’s talk equity choices first. Equity capital provided by an outside investment group to a promising new business is called venture capital. Venture capital is provided by wealthy individuals, investment companies and some pension funds. While the success of the new business is directly related to the entrepreneur who originated the business, a growing business generates the entrepreneur’s capital along with capital contributed by venture capitalists. The big payoff for the entrepreneur and venture capitalist is when the firm goes public. Thus, when you partner with venture capitalist you better have a plan for taking the company public or selling out to a larger player in your market. This is the only way out of these relationships.

But why give up control if you know the business you are starting has a good chance of success? Be very careful sharing your idea to any group of hungry investors. Even silent investors are hungry. Investors without management responsibilities are still liable for any losses, and will therefore speak up when need be. Another key stumbling block for silent and minority investors are any tax consequences. A growing business may produce taxable profits but be stretched to help investors meet the tax obligations since the cash is needed to meet growing demand for the product or service.

Either way, if you and your venture capital partners will want to cash in on the successful venture, then it’s time for the IPO. If the business is going well, perhaps it is time for you to sell stock to the investing public. Before the IPO, you will need an underwriter, or investment bank, to assist in arranging the procedural requirements, to buy the issue from the firm and to sell the issue to the investor public. You don’t need to seek out investment banks. If your business has reached this point of success, the underwriters will find you. Investment banking is a very competitive industry and these firms are always looking for a good sale.

The underwriter has two basic functions: Providing advice and taking risk. They help price your stock and determine the best timing for the offering. By buying the issue from your company and reselling the issue to the public, they take on the risk of a poor market response. If the offering is larger, a group of underwriters, or a syndicate, is formed to share the risk of buying the issue. A larger selling group of underwriters and broker/dealers is formed to sell the issue quickly. The spread is split among the lead underwriter, syndicate, and selling group.

Consider the story of a Boise area company, which shall remain nameless here, that experienced strong growth in its industry in the early 1990s. To meet the growing opportunities, the company decided to go public. The managers and owners didn’t believe debt financing would work as the regular payments would be difficult and most banks were already overextended in their industry. They were introduced to a New York Investment bank and sold a large amount of shares to the public.

The original owners found it hard to believe how much the stock price rose and fell without any word from them or any understandable change in industry conditions. To make matters worse, the investment bank that took them public turned out to be less than reputable, so the stock fell dramatically. Recently, Sarbanes-Oxley legislation has placed enormous and costly reporting requirements on small firms. And investors and stock traders frequently call to learn just how the company is going to grow. All of this stresses out management, who are just trying to run the show and make a profit. While sharing wealth has many benefits, clearly, equity financing has many costs.

This leaves the second type of financing: Debt. Banks have always been the main source of debt financing for small businesses and nothing compares to the value of a good banking relationship. In addition, a good banker will know about programs for which your new entity may qualify for, such as Small Business Administration loans and research credits. These lower your financing requirements and the bank’s risk.

To create this relationship, a strong business plan shows the cash flow required to meet regular interest and principal payments on any debt financing. And ‘regular’ doesn’t mean monthly or even quarterly. It just needs to show that the operations of the business do produce cash for both finance and investment needs as well as the day-to-day operations. Your business plan must therefore focus on cash-flow, not income or sales growth. While increasing sales and profits are important to the success of your business, cash is king. A business plan with strong growth in net income may be a plan with low cash flow, as all operating cash is used up to meet overhead. Similarly, a business plan with strong sales growth may suffer from low cash flows as inventories or other current assets are accumulated to meet all the forecasted growth in sales.

Steven Rogers, author of The Entrepreneur’s Guide to Finance and Business, calls the business plan a “Dual-Purpose Document.” While your plan is initially required to meet cash and financing requirements, it will also serve as your guide. If the plan focuses on cash flow, so will management. Cash flow produces the funds necessary to continue growing your business, such as purchasing new equipment, entering new markets and continuing product and market research.

Consider another local story. This Boise-area business has been around since the mid 1970s, with a niche market well suited to the Northwest and a strong reputation for quality. The company has always relied on bank financing and received tremendous support from local banks. The banking industry experienced tremendous consolidation over the past few decades, leaving few locally owned banks. At the same time, the company’s financing needs expanded beyond the funding capacity of the smaller state and regional banks. The owner needed a new banking relationship, but didn’t need venture capital or the headaches of public financing. This entrepreneur decided the costs of equity financing were too high, and thus decided on bank financing. But that required additional time to review, expand and explain the business plan. It was time was well spent, as the company now has full bank financing, including both short and long-term credit and is expanding into new markets.

In his new book, The Illusions of Entrepreneurship, Scott Shane shows us that the typical US entrepreneur is not the jet-setting, tech guru popularized in the press or on television, but rather the hard-working, hometown hero you remember from high school. The successful entrepreneurs are rarely using sophisticated new technologies or developing fancy new gadgets. They just have good plans for entering viable markets where competition is low. So get your cash flow plan together. Don’t pressure your family and friends or rush it off to some Silicon Valley firm. Take it down to your banker and have lunch.