Rich Dad Education Blog

It’s Important to Ask Yourself Why You Need the Money?

• Do you really need the money? Money, no matter what the source, comes with a price.
• Do you really need more capital or can you survive with your existing cash flow if you manage it more effectively?
• What is the basis for your “need”? Do you need money to expand, or as a cushion against periods of weak cash flow?
• If you need funding because of weak cash flow, is this a temporary problem or a fundamental problem? Temporary problems can be solved with infusions of cash, but fundamental problems can’t be fixed only with money. You can’t borrow your way to success. You need to fix the underlying problem (lack of leads, sales, etc.) before you think of bringing outside money into your business.
• How will you use the money if you get it? Lenders require that capital be requested for very specific needs.
• What is the state of development of your company? Funding needs are usually greatest during start-up and high-growth periods. Don’t assume that once your business gets going, you won’t need additional funding. Many business failures can be chalked up to lack of funding to support fast growth.
• What is the state of your particular industry? Is it alive and well, is it depressed, is it experiencing hyper growth? Different market conditions require different approaches to money needs and sources. Investors and lenders will want to know that you have done your market research.
• Is your business cyclical or seasonal? Short-term funding for seasonal businesses should be identified and arranged prior to a critical need. It is always easier to get funding when you don’t really need it, and you can negotiate better terms if you are not in panic mode.
• How strong is your management team? Management capability is the most important element assessed by money sources, especially equity investors.
• How great are your risks? All business carries some risk, but the degree of risk in your particular business will affect the cost and the availability of financing.
• Are you prepared to ask for financing? Do you have a great business plan that supports your request for funding? A good business plan with financial forecasts that are thoroughly thought-out will help you plan for the future.
• Do you have a presentation prepared that clearly outlines your funding needs, your plan for success, and the benefits to potential lenders and/or investors?

This is not an exhaustive list of questions by any means. Make yourself a list of questions pertaining to your specific business. Imagine you are the person who has funds to invest in a new or growing business venture. What would you want to know about the company, its management, and its marketing strategy before you invested your money?

Why do new businesses fail?

Poor management is usually the number one reason businesses fail, but inadequate or ill-timed financing would certainly come in as a close second. However, just having sufficient funding is not enough – one must possess the ability to manage it, as well. Knowledge and proper planning will help entrepreneurs avoid the four most common financing mistakes:

1. Securing the wrong type of financing for their business
2. Miscalculating the amount of capital needed
3. Underestimating the eventual cost of borrowing money
4. Giving up too much control of the company

Consider Debt versus Equity Financing

Most every business needs funding at some point in the business cycle, but it is important to remember that not all funding is created equal. Funding is defined as money brought into the business, other than what the business generates from its customers. This funding can be used to expand an existing business, to support the business during times of reduced cash flow, or to start a new business venture. Business funding can be obtained from two different sources:

1. Loans – usually from banks, finance companies, business associates, friends, family, credit cards (business and/or personal), or government agencies.

2. Investors – usually from partnerships, angel investors, and venture capitalists.

When seeking financing, the first thing a business owner needs to decide is what is better, incurring debt or losing ownership?

The advantage of a loan (debt financing) is that you are not giving up any ownership of the company and the lender has no management control or direct entitlement to a portion of your business profits. The only obligation you have with a loan is to pay it back on time, based on the terms and conditions of the loan. Any interest can be deducted as a business expense at tax time. The disadvantage of a loan is the debt (monthly payments, even if there isn’t enough business cash flow), potential for personal liability (if you guaranteed the loan), loss of property (if you secured the loan), or a lawsuit if you default on the loan repayment.

A big advantage of raising capital from investors (equity financing) is that you will not have to repay the investor(s) if your business goes south on you, and your personal property will, most likely, not be placed at risk. The disadvantage of bringing investors into your business is that you will be giving up a little (or a lot) of the ownership of your business. You will be obligated to share the profits, which is not bad if the funding was the only way to get those profits in the first place. In addition, many investors seek some control over your business, which can be either a big help or a big pain, depending on the investor and their specific skills and personality.

The final decision rests with you. After all, it is your business. You get to decide what type of funding will be best for you and your business – debt or equity, or a combination of both.

Sources of Debt (Loan) Funding

There are several sources of debt financing available to new and growing businesses. This list is not in any suggested order. You need to check into all available possibilities and choose the one(s) that make the most sense for the profitability of your business.

1. Self Financing – One of the best ways to finance your business is with your own money from savings or from selling personal assets. But don’t treat this as free money. Have your attorney set up a formal agreement between you and your business that spells out how much you are funding or loaning the business, as well as the terms of payback. Your tax accountant can help you get the maximum tax benefits from a self-funding arrangement.
2. Self Financing Through Personal Loans – If you have sufficiently high personal credit card limits, you may be able to fund your business through cash advances and/or purchases on your cards. However, beware of excessively high interest rates, cash advance fees, and all those annoying over-your-limit fees and late fees. Another option is a home equity loan or line of credit, if you have property with equity and can qualify for the loan. Again, use this money very cautiously; you are placing your home at risk if you can’t make the payments! You could also try to get a simple signature loan, but it is getting more and more difficult to get unsecured loans.
3. Life Insurance – Some life insurance policies (whole life and universal) have cash value which can be borrowed at low interest rates. With most policies, you are not actually obligated to pay this money back, but if you don’t, your policy payout is reduced by the amount borrowed.
4. Retirement Plans – Some retirement plans (like a 401k) allow you to borrow against vested benefits up to 50 percent as long as it is under $50,000. (Check with your plan manager and your tax professional to determine the specific rules for your particular plan.) However, if you quit your employment (which is the goal of many who start their own business), the loan must be paid back immediately or it will be treated as an early distribution and would be taxed accordingly.
5. Barter Your Services – Yes, your business needs cash, but in a lot of businesses that cash is used to buy things, such as supplies and materials. If you have skills (like accounting for example), consider offering your services to a supplier in trade for supplies for your business. Use your imagination. Your sources of funding are only limited by your willingness to think outside the box!
6. Banks, Credit Unions, and Other Commercial Lenders – Traditionally, banks have been a major source of small business funding, usually lending on a short-term basis for equipment and machinery. They also have provided seasonal lines of credit for more established businesses. Check with several lenders to see who has the most favorable terms. Quite often, the smaller, hometown bank is a good choice because you can get to know the bank officers on the loan committee and build rapport over a period of time. Your credit will be a big factor, so do everything you can to improve your score before applying for a loan. Know your current credit score so you won’t have any nasty surprises.
7. Vendor Financing – If your business is one that relies heavily on a particular vendor, it may be possible to obtain a line of credit through that vendor. They want your business, so ask them for nice terms on your account.
8. Small Business Administration (SBA) – Go to (www.sba.gov) to get information on the various SBA loan programs. The SBA generally does not loan money directly (although there are some direct loans to certain groups like Vietnam-era and disabled veterans and handicapped individuals), but rather guarantees a bank loan. This lowers the bank’s risk considerably, so you are more likely to get a loan. Most often, the SBA won’t offer help until you have been turned down by a commercial lender. SBA guaranteed loans generally range between $25,000 and $750,000, but check with the SBA for their current limits.
9. Business Associates – Your own network of the people you know may be a good source of funding, especially among other entrepreneurs and business owners, but you won’t know until you ask. After you are prepared with a good business plan, let it be known that you are looking for funding to start a business. Use the back-door approach – ask if they know of anyone who might be interested in getting a good return on their money. If they are interested, they will let you know, and if not, you may get some good referrals. Check with your attorney before attempting to raise money for any business venture to make sure you are compliant with all SEC securities rules and regulations.
10. Family and Friends – Books have been written on the dangers of borrowing money from family and friends, so proceed with extreme caution if you choose this route. However, excluding someone from the opportunity to benefit from your new business just because they are a family member or a friend doesn’t seem fair.

Just make sure that anyone who wants to loan you money knows the risks involved and understands that they could lose their money if your business fails and you don’t have the means to pay them back. Document every detail of the loan agreement in writing! Make sure that anyone who loans you money can truly afford to lose that money.

Sources of Equity (Investor) Funding

The main sources of investor financing are venture capitalists and angel investors. The SBA also licenses Small Business Investment Companies (SBICs) and Minority Enterprise Small Business Investment companies (MSBIs), which offer equity financing. Nike Shoes, Federal Express, and Apple Computers received financing from SBICs at critical stages of their growth.

1. Venture Capitalists – Venture capitalists are institutional risk takers. They may be major financial institutions, government-assisted sources, or groups of wealthy individuals. Although there are venture capitalists who invest in start-up companies, most often they prefer three-to five-year-old companies with the potential to become major regional or national businesses and return above-average profits to their shareholders.

The most important thing that venture capitalists look for in a company is a top-notch, quality management team. The company itself has to have a competitive or technological advantage and the potential for major growth. The possibility of a public stock offering is also considered very important.

Venture capitalists trade their investment dollars for equity in your company (generally 50 percent or more). Thus, you are giving up some of your potential profits and many times, relinquishing some of the decision making. Many venture capitalists prefer to influence a business passively, but will react when a business does not perform as expected and may insist on changes in management and strategy. They may even insist on taking over management in some cases, depending on their equity position in the company. Investment amounts made by venture capitalists are generally $4 to $5 million or more.

2. Angel Investors – Angel investors can really help your business, but they are no “angels” when it comes to scrutinizing your business plan and management team. They invest to make money; they want high growth and high return, and want to know how your business will beat the competition and take its market share. Angels generally invest smaller amounts than venture capitalists ($300,000 to $5 million is a typical range, but lower amounts may be available). Angel investors will generally require less ownership than venture capitalists, in some cases as low as five to 10 percent, but up to 50 percent or more is not unheard of as well. Each individual angel investor or investor group will have its own requirements, so ask lots of questions to make sure you understand their guidelines and what you will be required to give up in return for their investment in your business.

Don’t expect to get money right away. Angels will do a lot of research and carefully investigate your business plan, which may take months, depending on how many opportunities they are investigating. Because angels own part of your company, they will likely want a say in major decisions, and they will watch to see if you listen to them. This could affect future funding. Angels will generally look for a clear exit strategy, perhaps through a public offering or a buyout.

3. SBICs and MSBIs – These SBA-licensed companies offer equity financing. Contact the SBA in your area to determine if any funding is available in your area.

4. Partnerships – Another way to raise money is to take on a partner who has funds available to invest in your company. Rather than loaning the money to the business, the partner invests his money and becomes a part owner of the company. Partnerships should be set up with extreme caution, and all responsibilities and duties of each of the partners listed in detail. Nothing will kill a partnership faster than partners with loosely defined roles in the business. Your legal council needs to be involved in drafting the partnership agreement. Everything, including what happens in the case of the death of a partner, needs to be spelled out. The details of partnerships are a topic for another day.

There are several other methods for raising money for your business, including, but not limited to: public stock offerings, sale of private stock, factoring, private, corporation and government grants. Future articles will discuss details on these additional funding methods and will also discuss the tips for presenting your business to angel investors, venture capitalists, and lenders.

The money for your business is there; you just need to go and get it! Happy hunting.