Our October, 2002  newsletter is entitled "Start-Up Financing."   Our newsletters feature articles on various aspects of preparing a business plan and over time should lead you through the entire business planning process.  

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Start-Up Financing

One of the most important, and usually the most difficult, tasks of starting a new business is to obtain the required financing. You must ensure that you have the funds required to purchase all the assets you need to start your business, and to enable your business to operate and grow. Not only do you need sufficient financing to meet these requirements, but you must also have the right type of financing.

Financing will probably be needed for the following:

Start-up - Whether you are starting a new business, buying an existing business, or buying a franchise, you will need funds to purchase property, equipment, inventory, and other assets. You will also require funds to cover unexpected start-up costs which you may not have anticipated, and to cover operating costs during the first few months, since sales may be slow in developing.

Daily operations - You will probably need financial assistance to ensure that you have enough working capital. This means that you will need to have enough money to pay your expenses and continue operations until your inventory can be sold and cash collected. This is called financing your inventory and accounts receivable. Also, if your business is seasonal, financing may be required to get through the slow periods.

Expansion - Additional funds may be required for growth, expansion, or diversification of your business.

Forms of Financing
Generally, financing can take two forms: debt or equity.

Debt financing is borrowed money which has to be repaid, usually with specific terms and interest rates. Lenders usually do not assume any ownership in your business, but they do assume a risk. They have to be confident that they will receive their money back at some point in the future. In order to reduce their risk, most lenders demand that you put some form of security, or collateral, against the loan. This may be a charge on a specific asset, or a personal guarantee.

Equity financing relates to the funds that the owner(s) put into their business and to funds raised by selling additional ownership interests. The funds are usually put into the business as share capital, or as shareholder loans that are subordinate to other debt. Equity financing implies some degree of ownership in your business. Owners usually do not receive interest on their investment but they may receive a dividend from company profits. Their investment is not repaid unless the company redeems the capital or the ownership interest is sold to another party.

Types of Debt Financing

Term loans are repaid over a fixed period of time, and are usually used to finance long-term assets such as equipment and vehicles. The term of the loan will usually match the expected life of the asset, usually for three to five years. However, in some situations, the term may be for as long as ten years.

Mortgage loans are used to finance expensive assets with a long life, such as land and buildings. These loans often extend over 20 or more years.

Operating loans or lines of credit are used to finance current assets such as accounts receivable and inventory. The amount of loan is based on the size of these assets and will fluctuate with the assets.

What Lenders Look For - The "5 Cs"
Lenders will often consider the "5 Cs" of lending to evaluate loan applications:

Character - This refers to the borrower’s trustworthiness. Your integrity, credit history, financial track record, reputation and personal commitment are important factors lenders will consider.

Capital - This is the equity that you will be personally putting into your business. Investing a considerable amount of your own money demonstrates a high degree of commitment to potential lenders.

Capacity - This is the capacity of the business to pay back the loan. Will the business be able to generate enough cash flow from its operations to make the loan payments?

Conditions - This refers to outside conditions, such as interest rates, industry trends, competition and other factors in the economy that may effect your business.

Collateral - Collateral includes company assets such as accounts receivable, inventory, property or equipment. It may also be in the form of personal guarantees or mortgages on personal property.

Equity Financing

Most businesses will also have equity financing, even if it only amounts to the initial capital the owner puts into the business. Usually lenders will look for a debt to equity ratio of about two-to-one. This means that the equity in your business should be 50% of debt. In order to obtain this balance, you may have to seek additional equity in order to borrow the full amount you require to start your business.

Sources of Equity Financing:
- Your own funds, or funds from family and friends.
- Employees, major customers or suppliers, or other private individuals.
- Government equity programs.
- Venture capital firms interested in high-risk businesses where there is potential for a high return on their investment.

Approaching a Lender
Starting a new business is a risky endeavor and no one is more aware of this than a banker. Since starting a new business is a risk, financing a new business is equally as risky. The lender must be convinced that the business proposition is sound and profitable and that you have the ability to make a success of it.

Some helpful hints about dealing with lenders:

Plan your requirements well ahead and approach the lender early in the planning process. This will give the lender time to access your proposal and obtain the required approval within the bank.

In choosing a bank, ask business acquaintances or local merchants for referrals. Look for a banker who is interested in your business and your aspirations. It is often easier to build a relationship with a bank that is familiar with your type of business. Local bankers are well informed about the business operations in their area. This helps them to understand and evaluate your proposal.

It is advisable to approach more than one lender but do not shop around too extensively.

Set up an initial meeting to discuss the bank’s policies before you spend a lot of time working on your proposal.

Put your proposal in writing. Make sure that your financial data is included.

If the lender turns you down, find out why. It is possible that with some adjustments to your proposal, it may be accepted.

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