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Financing Strategies - How to Fund Your Business's Growth

By: James T. Biehl, CPA, MST

Most business owners aspire to grow their companies. After all, if a business isn't growing, then it is probably stagnant - or worse yet, in decline.

But growth brings many new challenges, especially when it comes to financing. Growing a business requires money - for new equipment, additional inventory, more staff, new marketing initiatives, etc. - which can place a severe financial strain on the company. Owners who don't plan carefully for the financial impact of growth can end up growing themselves right out of business.

For starters, growth usually requires a significant increase in receivables and inventory to support the higher level of sales that will result. This cash must come from either owner's equity (i.e., retained earnings, capital or personal funds) or outside financing.

Debt vs. Equity

Since few companies can finance growth completely on their own, one of the first tasks is to secure financing to support growth. This kind of financing generally takes one of two main forms: debt or equity.

Traditional debt financing is usually provided by banks, which loan money to businesses with the expectation that it will be repaid with interest within a certain time frame. Equity financing, on the other hand, is provided by investors - usually venture capitalists, private equity firms, or so-called "angel" investors - in exchange for a share of ownership in the company.

Generally speaking, debt is preferable to equity financing because it doesn't require giving up any ownership in your business. Each share of ownership you divest to an equity investor is an ownership share out of your pocket, with unknown value in the future. For example, imagine an early-stage investor in Microsoft who secured just 10 percent of ownership in the company in exchange for financing, and what that 10 percent share is worth today!

In addition, most equity investors expect a high rate of return on the companies they invest in - typically 25 percent per annum or higher - because they know that for each home run they hit, there will also be a number of strikeouts.

But with debt financing, you retain 100 percent ownership in your company. That's because banks aren't "investors" - they are lenders. Your cost of funds with a bank loan is simply the interest rate that you pay on the loan.

Taking on Debt

While debt financing is generally less costly in the long run than giving up equity, obtaining a business loan may be easier said than done. Banks have very specific criteria and expectations for repayment and return of their capital and take steps to minimize their risk of loss as much as possible.

These steps include collateralizing loans (i.e., requiring that assets, such as equipment or accounts receivable, be pledged as collateral in case the loan is not repaid) and requesting detailed financial information from potential borrowers to help them analyze their true ability to repay the loan. The challenge for many companies in a growth phase is that they may not have the kind of collateral or balance sheet a bank wants to see before making a loan.

Bankers also want to see that owners are prepared to invest some of their own money into their business - that they have some "skin in the game," so to speak. One rule of thumb is to be able to show one dollar of equity for every three dollars of debt you want to assume.

The two most important factors to consider before approaching a bank for a loan to support business growth are:

1. Your personal creditworthiness - Many banks closely examine the "global" cash flow of small business borrowers - in other words, both the business's finances and the owner's personal finances - and require owners to personally guarantee the debt. This makes it critical to maintain a strong personal credit history if you plan on borrowing for your business, and to obtain a copy of your personal credit report before applying for a loan to make sure that it's accurate
2. Your business growth plan - You should carefully prepare a business plan that details how much money you want to borrow, how much owner's equity you will contribute to your growth plan, and how the money you borrow will be used and repaid. This plan should include detailed financial projections and assumptions.

Also keep in mind that different banks tend to specialize in lending to certain types of businesses; for example, companies in certain industries, at different stages of development, or of a particular size. Do some research to determine which banks in your area specialize in lending to businesses like yours, and don't give up if you're turned down by the first bank you approach.

Taking on Investors

If you're unsuccessful in obtaining a loan to support growth, you may want to consider taking on investors in your business.

Venture capitalists (VCs) seek to identify and fund companies they believe offer opportunities for a high return on their investment, in exchange for a piece of the pie. How much equity this type of funding will cost you depends on many different factors, but primarily on how risky your business venture is perceived to be in relation to the potential reward should the business become successful.

Your business growth plan is especially important when approaching venture capitalists, who will scrutinize it carefully to determine your prospects for success and the degree of risk involved. It is important to note that VCs have an obligation to invest the money they've raised in transactions which match very specific criteria. With this in mind, make sure that any VC you approach has a true mandate to invest in your particular variety of company.

Angel investors are typically wealthy individuals investing primarily in early-stage companies in exchange for ownership shares. Generally speaking, angels invest in start-up companies or entrepreneurs with whom they have a personal connection.

As a result, angels tend to make much smaller investments than VCs - on average, between $25,000 and $35,000 per investor, per company - while VCs may invest millions of dollars at a time. Like banks, VCs and angels tend to specialize in lending to certain types of businesses, so do some research before seeking this type of financing.

The "Bank" of Family and Friends

Finally, if you are unsuccessful in obtaining a bank loan or VC or angel funding, you might consider approaching your family and friends for financing to support business growth. This can take the form of debt or equity, depending on the needs and expectations of both sides.

If you go this route, be sure to formalize the terms of the agreement. Document everything in writing, with repayment terms and interest rate or equity specifics, so that it's not treated casually by either party.

We can help you prepare financial statements in order to secure funds to grow your business. Please contact Jim Biehl at 248.208.8860.

Types of Financing

The primary types of business financing include:

• Line of credit
  A line of credit is a common financing tool that allows you to borrow up to a pre-determined amount of money for any purpose, but usually to plug short-term cash flow gaps, fund accounts receivable or purchase additional inventory
• Term loan
  This is a longer-term loan typically used to finance the purchase of equipment, property, plant or any other type of business expansion that requires long-term financing
• Lease
  Leasing may be an attractive alternative to buying many types of equipment that can help your business grow - everything from computers and high-tech equipment to office furniture and vehicles

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