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Unformatted text preview: Start Your Own Small Business: Lesson 9 (printer-friendly version) Your Instructor: Kris Solie-Johnson INSTRUCTIONS: • • To print this page, wait for the page to fully load. Once the document is ready to print, simply click your browser's File menu and choose Print. To save this page, click your browser's File menu and choose Save As. Select a disk drive and folder to receive the file, and change the name of the file to less09.htm. To view the file while you are offline, just go to the drive and folder you selected when you saved the file and double-click the file named less09.htm. Your browser will start and you will have access to the file. Chapter 1 Introduction Money is obviously important to starting a business. You want it, you need it, and you have to know where to go to get it. And once you have it, you must be organized enough to keep it and manage it. Unless you have successfully managed a small business before, brace yourself—because you are going to learn a whole new way to think about money! First and foremost, forget all those discouraging words you've heard from the pessimists in your life. You can get the money you need to start and successfully run your business—if you follow the plan I lay out for you in this lesson. More than 500,000 new businesses get started each year. Each one of them started the same way—with an idea and a little money. Money is why most people go into business in the first place. Money means freedom to the small-business person. It means power, too—power to do the things you've always wanted to do. Money can do a lot for you, if you learn to manage it early. You can do it! There is nothing magical about financial planning, and you don't need a lot of formal training to do it. All you need to do is look ahead and imagine what is going to happen in your business, and then use your common sense! We'll begin today by delving into planning the finances for your business. I'll explain the various ways money is used in a business and how to figure out how much you'll need. Then we'll take a look at different ways of generating money. We'll examine debt financing, equity financing, and grants. Next I'll talk about where to go to get your financing, including both traditional and nontraditional sources. You might be surprised by how many opportunities exist to help finance your business. So let's not waste any time. Let's talk money. Chapter 2 How Much Money Do You Need? Planning the finances for a business is challenging work, and not everyone likes to do it. Some entrepreneurs don't realize how important it is. Then, four or six or 12 months later, just as things start to get going, they run out of money. Instead of concentrating on delivering products and services to their customers, they're running around town trying to arrange financing to pay their suppliers and the phone bill so they can stay in business. They begin to neglect their customers, who get frustrated and drift away. Sales and cash flow go down. As the situation gets more desperate, the business owner runs faster and faster, trying to keep it all together. It becomes increasingly difficult to reverse this downward spiral; ultimately, the business runs out of time with the creditors, and the entrepreneur runs out of energy and excuses. It's an all-too-common scenario. Poor management decisions lead to initial undercapitalization, and undercapitalization causes a business to fail. It doesn't have to end this way, however. Undercapitalization is just underplanning. With a little more planning at the beginning, the small business can get more money up front. And that can make all the difference. Few people have difficulty spending money. Every entrepreneur, however, should be familiar with and prepared for some very important uses of money. Let's look at some of the typical uses for money in your business. • Working Capital: This is money you use to buy inventory, pay salespersons, make lease payments, and handle unexpected costs until customers buy and pay up in large enough amounts to keep your business up and running on its own. Inventory: Inventory can consume large amounts of working capital, but it's an essential expenditure. Capital Equipment Purchases: Whether you start a new business, buy an existing one, or purchase a franchise, some of your largest expenses will be for capital equipment. Capital equipment can include machinery, telecommunications systems, and computers. Research and Development: Ideas form the basis for most businesses, large and small. One idea may be enough to start an enterprise, but it is not enough to maintain growth. The importance of improving existing products and developing new ones has never been more evident than it is today. Expansion: A good idea can't be held down. If your retail store is good in one location, two stores will be even better. And 10 stores will create a commanding presence. Purchasing a Business: You never know when the opportunity to acquire a good company will come along, whether in your own business area or in an allied field. Many entrepreneurs have made a career of going from success to success by keeping their eyes open for the right opportunities. • • • • • How Much Money Will You Need to Start? The answer to this question is easy to understand but challenging to calculate. A new business has two immediate needs: • Enough money to buy the equipment, tools, raw materials, inventory, or whatever else it needs to build the products or provide the service it sells Enough to pay the day-to-day operating expenses until the profits begin • Most entrepreneurs are proud, resourceful people. They feel uncomfortable asking for money. So their initial tendency is to ask for too little. Being as optimistic as they are about the future of their enterprise, they assume that they can make everything work the way they want it to. As a result, they start their business with less money than they need. But you can avoid this situation by creating a simple cash flow projection. A cash flow projection is better than a crystal ball! It is a wonderful planning tool, because it can help you imagine the future. By imagining, or projecting, what you think you are going to sell and spend during the upcoming months, you can see problems coming while there is still enough time to do something about them. Losing money on paper is a lot easier to take than losing real money—especially when it's your own! To construct a cash flow projection, all you need to do is estimate what it is going to cost to keep your business going month by month during the next year or 18 months. You can think of it as all of your monthly income statements side by side. Do you remember learning about income statements in Lesson 8? They are the statements that list your sales income, sales costs, and overhead expenses, thereby giving you a monthly profit or loss figure. By adding together all of the bottom lines—that is, the monthly profits or losses—you will be able to see your cumulative cash flow. Let's look at an example for a snow plowing and lawn care business. The owner took the monthly totals from his income statements and plunked them into a new chart—one that accurately projects his cash flow. Note particularly how his bottom line changes over time. With his cash flow projections clearly laid out, the owner can reasonably estimate how much money he will need to get his business started and keep it running. Do you remember our lesson on business plans? In Lesson 4, we talked about how to create financial summaries, including income statements, that estimate how your business will perform over a three-year period. It's those estimated income statements that will give you the information you need to create a cash flow projection. Once you know how much money you'll need for your business, the next step is to find financing. Types of financing fall into three general categories: debt financing, equity financing, and grants. Debt Financing Debt financing is the simplest way to raise money. Basically, debt financing is any kind of loan. The person or organization loaning you the money makes its money on the interest you pay. As long as you continue paying the loan payments, you'll be left alone to run your business as you see fit. Both you and the lender agree in advance on the interest rate. The lender knows how much will be made on the deal before loaning you the money. And the lender's chief concern is whether you will be able to pay back the loan on time. What do you think the most important factor is in securing a loan? That's right, it's your ability to repay it. If you want to borrow money from your bank, your prior repayment history (your credit record) and the viability of your business are key criteria. If it's your brother who's the source of your loan, he'll be looking at much the same criteria. Obviously, if you still owe him from the last $500 he loaned you and he thinks your business idea is pretty shaky, he'll doubt your ability to repay. If you talk to your bank, the same concerns exist. What assurances and evidence can you give to indicate that you can pay back tomorrow what you borrow today? If your business idea seems weak, the bank may ask you to pledge your car or even your house as collateral in case you can't make the payments. Equity Financing Equity financing is different from debt financing. Selling equity means you sell a part of your business to one or more people. What they are purchasing by investing in you is the possibility that you will make a success of the business. They are gambling that, in the long run, their share of the business will be worth many times more than the amount of their original investment. You have to decide two things when considering equity financing: what you want (in other words, what would be the best deal for you) and what will work. You may have to settle for a less-than-ideal arrangement. There are several things you must think through beforehand: • • How much risk you want to take yourself How much risk you want to share with an outside investor • • How much control of the day-to-day operations you want to share How much of the "pie" you want to share, if any Many small-business people eventually conclude that sharing a larger pie and sharing the risk is worth giving up part of the profits and some control. Tip: Sometimes you can combine debt and equity financing. This is called a convertible debenture. The financing begins as a loan and then is converted to a share in the ownership of your business, if and when the business is successful. This is a particularly attractive arrangement to friends, relatives, and certain other investors. If the business goes sour, they fall back on the provisions of the loan. If it is successful, they can convert their loan into stock or part ownership of the business at probably a much better profit or gain than through an ordinary loan with interest. Grants A grant is money given to you that does not have to be repaid. Grants for free money to start businesses are hard to find. There are many people out there who would make you think that grants are easy to secure, but this is just not the case. Most grants from the U.S. government are for nonprofit entities, high-technology companies, or other government agencies. Grant programs come and go frequently, and it's hard to keep up on all of them. To find out if any grants are available in your area, call your local city hall, county offices, state office, and economic development agencies to ask if they have any current grant programs. Be aware that applying for grants can be a long and complicated process. If grants were really as easy to get as many advertisers say, wouldn't we all be receiving "free" money? If it sounds too good to be true, be cautious. Chapter 3 What Lenders Think Lending institutions are in the business of making loans. But they expect the loans to be paid back and be profitable for them. They want to make loans, and they really do try to accommodate their customers. At the same time, they have to be careful about whom they lend money to and how they do it. Let's make a comparison. As a business owner, how would you feel if you didn't get paid for the products you sell? That's exactly how financial institutions feel about not having their loans repaid. In addition, lenders have the added responsibility to pay the people who funded the loan in the first place: the checking and savings account holders. Lenders want to lend you money if they can see their way clear to doing it safely. Unfortunately, this is not always the case. There are other concerns that affect a banker's judgment. If the banker grants a loan, his or her reputation, judgment, and perhaps job will be put on the line. So before granting a loan, a lengthy process begins. And this is where your business plan comes into play. It must be convincing, because the lender will review it carefully, prepare a write-up for a loan committee or loan supervisor, and support the loan request under close questioning from bosses and associates. Next, the banker must prepare the loan documentation and the necessary reports. The loan officer also has to follow up after the loan is made and take action if collection becomes necessary. If any problems develop, the lender has to explain and defend the loan. You can see why it is easier, and often safer, for a loan officer to simply turn down a loan. On the other hand, bankers who don't make loans will not have a job for long. A good loan proposal must convince lenders that it is in their interest to lend money to you. A Loan Rejection Is Not a Personal Insult Think for a minute about your attitudes toward borrowing. This is important because it can affect your success in getting financing. Do you have negative feelings about borrowing money? Your challenge is to recognize and overcome any negative attitudes and misconceptions you might have. Then, with a positive attitude and a solid business plan, you can overcome any negative feelings the lender might have. When a lender refuses to make a particular loan, it's usually because there are sound reasons to believe the loan will be a poor risk. It's important for you to remember that a loan refusal is only one lender's estimate of the uncertainty involved in that loan request. It's not a judgment of your worth as a person. So don't let your fear of rejection stand in the way of getting proper financing. If you make a habit of taking a loan refusal as a personal insult, you can get into a mind-set that will make it difficult to obtain a loan anywhere. If you approach a lender with a resentful attitude, the lender may think that you don't have the open-minded attitude needed to run a business. That's strike one against you. You'll get a second strike if you approach a potential lender thinking you'll be turned down. Be positive: Every loan application is a new beginning. Every newly approached lender gives you a fresh opportunity to make your case better. Learn the lessons from your previous rejections and do not repeat them. One mistake some people make is to try to feel out a lender without actually asking for the loan. Here's how not to approach a lender: "I don't really need the money, but would you lend it to me if I asked?" or "What is your bank's attitude toward first-time business loans?" You're fooling no one but yourself. Playing games with bankers, who are practical businesspeople, is poison to the process. Traditional Money Sources There really are unlimited ways to fund a business. Some are traditional, and others are nontraditional. But many new entrepreneurs think only of the most common or traditional sources of funding. So let's start with those before we explore some of the more inventive ways to find money. Yourself For the individual businessperson, the most logical place to look for financing is your own assets. Think about all the places where you have assets. Do you have money in bank accounts? How about certificates of deposit, stocks and bonds, or insurance policies? Perhaps you have real estate or home equity you could tap into. Or maybe you have value in a hobby collection, an automobile, a pension fund, Keogh plan, or IRA. The truth is, if you had sufficient capital, there would be no need to turn to other sources for your financial needs. But it's far more likely that you'll need to use other people's money to finance your new business. A Word of Caution: Most of us have one or more credit cards. And it's tempting to take advantage of the easy availability of your credit line. Remember, though, that most credit card companies advance money at a much higher rate of interest than you would normally pay a lending institution. Equally important, although your monthly payments may appear to be small, high interest rates will compound your debt quickly. Family and Friends If you are fortunate enough to have relatives or friends who have money to invest or loan, they can be an excellent lending source. Exercise great caution, however, when borrowing money from a relative or a friend. Most of these loans go well, but about one in three turns sour. Before seeking a loan from a relative or a friend, consider what future effect a loan may have on your relationship. Too often, money gets in the way of good relationships. Use extreme care in approaching a family member or a friend for a loan. If you do decide to secure a loan from a relative or friend, you can take steps to make sure the process goes smoothly. One way you can avoid problems is to have a written agreement. Spell out clearly what you have agreed on: • • • • • • • • Date of the loan Loan amount Date the loan will be repaid in full Dates loan payments are due Frequency of payments (monthly, quarterly, annually) Amount (percent) of interest Collateral Signatures by both parties Here's one final point to consider: It's wise to make sure the relative or friend from whom you are borrowing has notified his or her spouse about the loan. It's always best to head off problems before they arise. Commercial Banks and Credit Unions Commercial banks and credit unions are the largest single source of loans to both small and large businesses. Banks are in the money business. They make money by lending money. Many banks have a special department that focuses on small business loans. Loan Companies Loan companies, which exist in most U.S. cities and communities, represent one of the largest sources of money in the country. Unlike banks, which obtain their funds from many different sources, loan companies have to rely upon their own capital. Otherwise, they raise money just as other businesses do. Thus, their interest rates are usually higher. In some instances they can be several percentage points above the prime rate. Loan companies are considered collateral lenders. That means they rely heavily upon the borrower's ability to back up every dollar of their loan with an asset. For example, you may have to pledge accounts receivable, put up the mortgage on your house, or assign the value of an insurance policy, stocks, or bonds. Loan companies often have different operating policies, and the interest rate they charge may vary as much as 5 percent from one firm to another. Therefore, it's prudent to shop around before you settle on a particular loan company. Certified Development Companies A Certified Development Company is a company that has been established by local communities to attract business into their community. The most common type of CDC is one that develops a shopping mall or business development center. An example of the latter would be a geographic area set aside in a community for a commercial or industrial park. If your business would fit into a mall or a business center, it might be possible for you to find funding through a local CDC. Check the Supplementary Material section for this lesson to find links to Certified Development Companies for each state. In our next chapter, we'll talk about how the Small Business Administration can come into play in helping you to finance your business. Chapter 4 More Financing Sources Before we look at some nontraditional financing sources, let's first talk about the Small Business Administration. The SBA is a federal agency that provides management and financial assistance to small businesses. In most states, the SBA has a Lender Certification Program. Under this program, participating certified banks will accept your loan application, investigate your credit, establish a loan limit, and approve your loan. The incentive for the banks to do this is that the loan is guaranteed by the SBA. It's a quick procedure that takes three to six days. Noncertified banks can participate in the SBA program, too. But the loan process may take four to six weeks. Your bank will help you decide which SBA loan programs will fit your needs. These are the basic conditions of SBA financing programs: • SBA does not loan money or give grants to small businesses. The SBA guarantees loans for banks or other agencies. Business must be a for-profit entity. Business must have less than $2 million net profit and fewer than 500 employees. Business owner must be of good character and demonstrate ability to run a successful business. Loan applications must detail how the loan will be repaid. Business owner must typically put in money equal to one-third of the total amount of financing. Maximum loan limit is $2 million. Loan may be used for working capital, inventory, machinery and equipment, and improvements. Personal guarantees will be required from owners with 20% or more ownership in the business. • • • • • • • • The SBA has many different programs available. There's a good chance one will suit your purposes. Your first step in exploring SBA financing is to check with your bank to see if it is an SBA lender. If not, ask your banker to refer you to one that is. Small Business Investment Companies (SBIC) An SBIC is a privately owned company licensed and insured by the Small Business Administration to provide capital to small firms. SBICs focus on specific industries such as medically oriented or hightechnology enterprises, agricultural, manufacturing or real estate companies. Normally these types of companies have proprietary and high-growth-potential products. So far, we've covered only traditional sources of financing. But there are an unlimited number of less traditional ways to fund your business dream. Next let's learn about nontraditional ways to fund a business. Nontraditional Money Sources Nontraditional sources for your start-up business are unlimited in number and type. In fact, they are limited only by your creativity to acquire. You're about to discover some new and inventive ideas for funding. Customers Customers or potential customers can be an excellent source of funding. Consider this scenario: Two engineers work together at the same company. On their own time, they develop a new plastic. They determine that if it were used as raw material, their plastic would cost one-third the amount of the product customers are currently using. But to manufacture it will require a very large capital investment. The engineers contact a very large potential user. She realizes that the new plastic could reduce her raw material costs significantly. So she lends the two engineers the necessary money to start their own business. In return for her investment, she receives a contract assuring her company of getting 75 percent of the manufacturing output of the new plastic. Here's another example on a smaller scale: A cosmetologist wants to open her own salon. In conversations with a customer, it turns out that the customer likewise wants to have her own business. The customer invests in the salon, and the two form a partnership. The cosmetologist manages the salon and the other employees. Her partner participates in the day-to-day affairs of the salon, handling bookkeeping, advertising, and customer service. Suppliers Depending on the type of business you're planning, your suppliers could be an excellent source of money. For example, one of my clients is a family in a medium-sized southern city. They decided to open a convenience food store. The first thing they did was to go to their food wholesaler and make a deal. The wholesaler loaned them the money for their shelving in exchange for a promise. The family promised they would make at least 80% of their purchases from the wholesaler's firm, providing the prices were fair. The family made a similar arrangement with their meat supplier. They were able to borrow money from the supplier to purchase their refrigerated meat display cases. Thus, they were able to purchase all of their display cases and shelving with money borrowed from suppliers. It's an unorthodox financing method, but it worked beautifully for them. Leasing Companies Another way entrepreneurs have been able to finance their business is through a leasing company. Instead of actually borrowing money, you make arrangements with a leasing company who would provide items you need for your business, such as a truck, office furniture, or computer equipment. Then, you lease the items from the leasing company over a certain period of time. Title and ownership to the goods or property is retained by the leasing company. But your lease payments would typically be less than if you were purchasing the items outright. Business Brokers and Investors Some individuals specialize in making small business loans either on a straight interest basis or a shared equity basis. Often these people will advertise in the classifieds section of the Sunday newspapers and in the yellow pages of the telephone book. This can be a viable and shrewd method of financing. Keep in mind, though, if you elect this method of financing, you must be certain you're dealing with someone who is reputable and has a good track record with such loans. Think of it this way: If your lender wanted a piece of your business, would you want him or her as a partner? Do your homework. Get references and do some background checking. Invoice Discounting and Factoring Invoice factoring is the process of using your accounts receivable to generate cash. If you can generate invoices to customers for future products or services, there are companies that can help you. Factoring firms will purchase your accounts receivable at a discounted rate, usually about 80% of their value. This is an excellent way to raise immediate capital. In the Supplementary Material section for this lesson, I've included a link to a directory of factoring companies. Advertise for Money You can actively seek funding by running a display advertisement in the business section or in the classified ads of your local newspaper. You can even advertise online. Specify the amount of money needed and the type of business for which it will be used. Check the Business Opportunities section in your local newspaper for sample ads. I hope by now your head is filled with ideas for raising financing for your business idea. Your potential for finding sources for funding is enormous. So I encourage you to use your imagination. Let's head over to Chapter 5 now, where we'll wrap things up for today. Chapter 5 Summary Here's something to remember: A good business plan always finds money. If you truly believe in your business, you will find a way to fund it. You can find financing. There is nothing magical about financial planning. Finding financing always starts with good planning and a good understanding of your business. Your first step is to determine exactly what you need the money for and then create a cash flow projection for the next 12 to 18 months. Next, decide if you want to use debt or equity to fund your business. Your biggest decision is to determine if you want to share your profits (and losses) with someone else for the life of your business. It may seem like a good idea now, but it might not be such a great idea later. Another question to ask is, can you grow faster if you have someone else invest in your company as a shareholder? Whether you acquire debt or equity financing, your funding source will want to get its money back. Lenders have an obligation to their investors, including checking and savings account holders, to get the money back with interest. Equity investors want their money back also with substantial extra for the risk they are taking in giving you the funding. Some of the most common ways to find financing are the following: • • • • • • Your own money and collateral Family and friends Bank or credit union Loan company Small Business Administration (SBA) Small Business Investment Company (SBIC) • Community development company Some of the best financing sources are really limited only by your creativity. These are some nontraditional sources: • • • • • • Customers Suppliers Leasing companies Business brokers and investors Invoice discounting or factoring companies Advertising for money Every funding source will have advantages and disadvantages. Evaluate each option based on your situation and what you are willing to give up to get the appropriate financing in place. It's commonly understood that undercapitalization is the main reason for business failure. But failure is really based on underplanning. Understanding your business financing needs from the beginning will increase your chances of success. In the next lesson, you will discover the most valuable human asset of your business: how to hire and motivate the best employees. In addition, you will learn the best way to manage an employee that no longer fits with your company. Until next time, take this thought with you: Your business can receive financing with the right plan. Supplementary Material Small Business Administration http://www.sba.gov You'll find a wealth of resources on the government's SBA site. Pay particular attention to the Services section because this is where you'll find information about business financing. SCORE http://www.score.org SCORE is a nonprofit SBA resource partner. Thousands of retired and active businesspeople volunteer their expertise to help new entrepreneurs. Certified Development Companies http://www.sba.gov/gopher/Local-Information/CertifiedDevelopment-Companies Visit this site to find links to CDCs in every state. Small Business Grants http://usgovinfo.about.com/library/weekly/blstategrants.htm Even though grants are difficult to find, they aren't impossible. This site has links to agencies in every U.S. state where you can research potential grant money. Invoice Factoring http://www.business.com/directory/financial_services/commercial_fi nance/factoring If you're interested in learning more about invoice factoring, this directory provides a list of dozens of factoring companies. FAQs Q: How can I make a cash flow projection before I begin my business? I'm finding it impossible to project imaginary figures. Is there an easy way? A: A cash flow projection is an essential component of your business plan, one that requires a lot of analysis and study. But if you've completed your business plan, you'll be able to use the financial summaries you've already projected. From your income statements, you can take the bottom-line figures to project a reasonable estimate of your cash in and cash out for a year or more in advance. Projecting your financial summaries is often the most difficult part of any business plan. And it's an area that might require some help. So I encourage you to take advantage of the assistance offered by the SBA and its resource partner SCORE. Assignment For your assignment today, I'd like to you explore the Small Business Administration's Web site. Become familiar with the many services offered by the SBA, particularly in the Financial Services section. Even if you don't plan to apply for an SBA loan, I think you'll be pleasantly surprised by all the practical advice offered by the SBA. Small Business Administration Next, I'd like you to visit SCORE's Web site. SCORE is a nonprofit SBA resource partner consisting of thousands of volunteer businesspeople dedicated to guiding and advising entrepreneurs. You can ask a question online or even make an appointment at your local SCORE office to get help with tasks like making a cash flow projection. SCORE Course content © 1997-2009 by Kris Solie-Johnson. All rights reserved. Reproduction or redistribution of any course material without prior written permission is prohibited. ...
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- Spring '09