S12. Financing Entrepreneurs:

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1 Tool Summary This tool was created by the VIN for community colleges, and indirectly for the entrepreneurs who use the colleges virtual incubator services, to provide insights on funding options and working effectively with financial institutions. In many cases, entrepreneurs reach out to incubators and colleges thinking they need access to more money. Colleges need to educate entrepreneurs and encourage entrepreneurs to risk smarter and continue with more counseling. Preparing to Provide Financing Advice To use the options described in this tool, a college s financial specialist will need to learn the details like these much more intimately and facilitate an ongoing relationship with the funders. (A separate tool on Financial Models to Build and Sustain a Virtual Incubator for Your Campus focuses on funding the staff and services at the college itself.) Although staff need not become experts in financing, it is important for community college staff to understand the various approaches to finding financial support for entrepreneurs and the options available to them. The VIN team recommends two staffing options. The college may hire a practitioner in loan packaging assistance: someone who is familiar with the financial institutions in the local area and the financing products and criteria for funding and can share this information with clients. Alternatively, the college may consider partnering with the local Small Business Development Center (SBDC) or other organizations in the area that have expertise in accessing financing and refer clients to these partners. The ability to connect entrepreneurs to enterprise funding/financing mechanisms is a necessary core competency for virtual incubators. The most efficient and highly recommended approach is for staff to identify expertise in the local area and partner to provide financing assistance to clients. Partners with expertise in this area will also know about other nontraditional sources of financial available to small businesses, mainly revolving loan funds, through sources such as local economic development agencies, chambers of commerce, downtown associations and community foundations. Business Plan Competitions also may be a valuable source of funds for entrepreneurs, along with narrow constituency programs intended to serve specific industries, groups and communities, such as military veterans, women, minorities, individuals with disabilities and displaced workers. The most robust community college models of virtual incubators add in-house enterprise funding programs. The Small Business Administration (SBA), U.S. Department of Agriculture (USDA) and the Economic Development Administration (EDA) each have programs that facilitate the creation of revolving loan funds. Foundations and other grant-making organizations, like United Way, support narrow constituency loan and grant programs. Banks and credit unions will financially support independent early stage programs for companies that would not meet normal financial institution guidelines. Some key components necessary for put together a package to shop for financing include a business plan, financial statements and projections, and a review of the bankability of the client, based on factors including credit and collateral. Each financial institution has its own lending criteria and types of businesses it is willing to fund. It is wise for virtual incubator staff to seek out alternative sources of financing for its less bankable clients. PAGE 1

2 Pre-Launch (Early Stage) Financing Sometimes an entrepreneur needs money to explore a business opportunity and support the development of prototypes, market and product research and other pre-launch activities. Because that financing is difficult to find, they may need to tap personal resources: Assets. Jewelry, rugs, pool tables, boats, time-shares, second properties and other valuables can be sold to raise money for a business venture. Car. A nice, late-model car can be sold for a net profit of $15,000 to $20,000 and replaced with a less expensive leased car, without a down payment, for a small monthly lease payment. Home. A home equity line of credit is the oldest and one of the best financing sources because the entrepreneur can exert almost total control over the process. If the entrepreneur needs $50,000, the home is worth $250,000, and the existing bank mortgage is $100,000, $150,000 in equity may be tapped. Of course, once the loan kicks in, monthly payments must be made. It is wise to set aside some of the proceeds from the home equity loan to help make these payments until the business can pay a steady salary. Another way to get money out of your home but maintain a lower monthly payment is to refinance the mortgage with a new one. Insurance Policies. Individuals may borrow against whole life policies, typically at fairly reasonable rates that are tied to key money market rates. Most of these policies have some cash value after three years. Entrepreneurs may write to their agent or insurance company to request a policy loan. Most companies will lend up to 90 percent of the cash value, and the policy stays intact as long as the borrower keeps paying the premiums as they come due. However, if the borrower dies with a policy loan outstanding, the benefits may be diminished; this varies by policy. Friends and Family. This is usually the first place a business owner looks for money, preferably before and instead of maxing out the credit cards. Sympathetic friends and family typically will make you a loan at or near the prime lending rate. They will decide to make the loan or not make the loan because they know the entrepreneur. However, investments with friends and family may turn out badly when things don t go as planned, especially because friends and family react to bad news with more emotion than other lenders do. Entrepreneurs should take the following steps to protect everyone: 1. Get an agreement in writing. This will eliminate all conversations that start with, You never said that. Execute a promissory note that states the amount and the interest; have it signed and witnessed or notarized. 2. Emphasize debt (loans) rather than equity (ownership). Most business owners don t want friends and family in their company forever. It is best to make a loan and pay it back as soon as possible. 3. Put some cash flow on their investment. Entrepreneurs should consider paying some nominal interest at regular intervals to provide everyone with a reality check. It is better to make this payment quarterly than monthly so that the lender won t immediately know when things are temporarily teetering. PAGE 2

3 Investments. Entrepreneurs who are starting a business while keeping a full-time job may potentially borrow against their employer s 401(k) retirement plan. It is common for such plans to allow borrowing a percentage of the fund up to $50,000. The interest rate is usually reasonable, with a specified repayment schedule. The downside of borrowing from a 401(k) is that if employment ends the loan must be repaid quickly, often within 30 days. Entrepreneurs may also consider using IRA funds for short-term needs. Within the laws governing IRAs, money may be withdrawn as long as it is replaced within 60 days. This is not a loan, so there is no interest. However, if repayment is one day late, for any reason, there is a 10 percent premature withdrawal fee and the money that was not returned becomes taxable. Credit Cards. Credit cards are a quick and easy source of money, but if they are not managed well the debt may get out of control and the interest owed may stress a business cash flow and profitability. The attraction of having a low minimum monthly payment could end up costing a lot more with a high interest rate and growing outstanding balance. NanoLoan Programs. NanoLoans are targeted to early stage entrepreneurs whose business concept is not yet bankable and do not meet the minimum qualifications to gain access to traditional credit. An entrepreneur with a pre-bankable business concept may borrow up to $2,500 at attractive terms to complete development of a business concept. NanoLoans originated in developing countries, where they have successfully enabled extremely impoverished people (mostly women) to engage in self-employment projects that help people generate an income and, in many cases, build wealth and exit poverty. Based on the success of NanoLoans, many traditional banks have begun to realize that these borrowers should more correctly be categorized as pre-bankable; thus, NanoLoans are increasingly gaining credibility in the mainstream banking industry. PAGE 3

4 Business Plans and Rocket Pitches In simple terms, a business plan succinctly encapsulates a company s goals, measurable steps as part of a strategic plan to achieve those goals and reasons why the company is well-positioned to take on the task. Business plans typically have the following elements and are laid out in the following order 1 : 1. Executive Summary 2. Market Analysis 3. Company Description 4. Organization and Management 5. Marketing and Sales Management 6. Service or Product Line 7. Funding Request 8. Financials 9. Appendix (as necessary) Increasingly, business plans are created on paper and are accompanied by rocket pitches. While the phrase elevator speech describes a short description of a perspective, product or service that a salesperson delivers to consumers, a rocket pitch defines a marketable good and the value proposition of that good to consumers that an entrepreneur delivers to a potential investor. Investors view most rocket pitches as a rapid way to weed through the many average or poor business ventures to find standout companies and products. These rocket pitches often are presented at regional competitions. Babson College 2 has created a website specifically to define elements of successful rocket pitches, provide a tutorial on creating a rocket pitch and share sample rocket pitches. See for more information. Debt Financing Versus Equity Financing For colleges whose staff want to learn more about how to support their clients in accessing funding, the VIN organized a short list of debt financing and equity financing resources. 1 U.S. Small Business Administration. Elements of a Good Business Plan. Retrieved 11/28/11. Available at: sba.gov/category/navigation-structure/starting-managing-business/starting-business/writing-business-plan/essentialelements-good-busines 2 babson.edu PAGE 4

5 Debt Financing: In basic terms, debt financing is a loan: money that can be borrowed from an external source typically a bank or the Small Business Administration (SBA) with the understanding that it will be paid back in a fixed amount of time. This type of financing means the entrepreneur will owe money to someone, and the lender has no liberties or ownership over the entrepreneur s business. The relationship continues until the debt is paid back. Debt financing may be short term (with repayment within one year or less) or long term (with repayment over a period of more than one year). Source: Banks generally are most interested in the business owner s debt to equity ratio and the credit score. This is the amount of debt owed compared to the amount of equity currently held. To lenders, this ratio is important because it indicates the amount of money available for repayment in case of default. It also shows if the business is being run in a sensible way, without too much dependence on any one financing source. Advantages of Debt Financing: Entrepreneurs retain maximum control over their business. Interest is tax deductible. Disadvantages to Debt Financing: Excessive debt can cause problems if entrepreneurs begin to rely on it and lack the revenue to pay it back. Excessive debt will make a business unattractive to investors who view it as high risk. Source: Entrepreneurs who use the virtual incubator will likely secure debt financing from any of the following: Angel investors (in rare instances and depending on the type of business) Business plan competitions Community-based loans (from CDFIs, cities, CDCs, etc.) Convertible debt financing (from private investment companies) Family and friends (most common for start-ups) Federal agency loans (from the U.S. Department of Agriculture and SBA) Institutional loans (from commercial banks, credit unions, CDCs, etc.) Program-specific loans (promoting environmental sustainability, energy retrofits, etc.) Revolving loan funds (microloans, SBA, city-run funds, etc.) PAGE 5

6 Equity Financing: Equity financing is selling a percentage of ownership in a company in exchange for capital. Equity financing can be either external or internal. While internal equity comes from retaining profits within a company, external equity comes from selling a portion of the company to friends, family, angel investors, investment bankers or venture capital firms. The sale may be a semi-permanent arrangement, like selling shares, or a temporary one involving using angel investors or venture capitalists. In general, entrepreneurs prefer debt financing over equity financing because the effective interest rate is usually lower and there is no dilution of their control. New firms will have difficulty arranging short-term or long-term debt financing if they do not establish proper equity in the company because they cannot demonstrate proven sales and sustained profits. Advantages of Equity Financing: Investors bring expertise and can assist with various aspects of business development. With the help of investors, a business becomes more credible and may win new attention from the investors networks. Disadvantages of Equity Financing: Equity financing is the most expensive type of financing available, as investors require greater returns on their investment than banks and other lenders do. To obtain equity financing, business owners must prove the business model is scalable to provide a required rate of return and a defined exit strategy. Business owners give up complete control and autonomy and must give investors a say in business decisions. Original source material from and expanded upon by the VIN Community colleges in the VIN caution virtual incubators against relying solely on equity financing as a form of payment for services, given the real costs the college will incur and the potential lengthy timeline for a business to become profitable. Entrepreneurs also should not be overly reliant on equity financing because in many cases funder expectations grow faster than the results that start-up businesses can deliver. PAGE 6

7 Debt Financing Options Commercial Loans Banks and other lenders are for-profit companies that pay for their salaries, buildings, utilities and other business costs by loaning out their depositors money. Banks operate on the difference between the interest they pay to bank depositors and the interest they get from their investments, including loans. Because market forces keep this differential fairly small, banks avoid risky investments. A start-up business with an untested owner is considered a risky investment, particularly if the owner does not have a lot of money. Presenting a commercial loan officer with a solid business plan reduces that risk by demonstrating that an appropriate level of research has been done to identify and reduce uncertainty. There is an old motto: The risk determines the rate. As the risk increases, so does the interest rate charged, so a plan that shows how risk is managed and reduced is important. In making decisions about term loans, lenders look for the five C s : Character: Has the borrower managed and repaid other business and personal loans? What is the borrower s business experience? Credit capacity: Does a full credit analysis, including a detailed review of financial statements and personal finances, demonstrate the borrower s ability to repay the loan? Collateral: As the primary source of repayment, is the borrower s collateral sufficient, typically meaning larger than the loan amount? Capital: What assets does the borrower own outside of the business that can be quickly turned into cash if necessary? Does the borrower have bonds, stocks, apartment buildings and other assets that might be an alternate repayment source that would be tapped before the bank s assets in the event of a loss? Will the borrower provide a personal guarantee? Comfort/confidence with the business plan: How accurate are the entrepreneur s revenue and expense projections? What is the condition and potential impact of the economy and the industry? SBA Loans Although it is a common misperception, the Small Business Administration (SBA) does note make loans to individual companies. SBA provides loan guarantees to enable banks to make higher-risk loans and also makes loans to financial intermediaries. The three most commonly used SBA programs are known as 7(a), 7(m) and 504. SBA 7(a) Loan Guarantee. SBA guarantees approximately $12 billion in loans annually. A bank or commercial lender can receive a guarantee for up to 80 percent of the principal (up to $1 million) for a term of up to 10 years. These loans are frequently used for purchasing equipment or buying a business. The guarantee helps the borrower overcome a loan application that is weak due to inadequate collateral or a brief operating history. PAGE 7

8 SBA 7(m) Microloan. These relatively small microloans of up to $50,000 are made by a financial intermediary. The intermediary, such as a community college, borrows an amount from the SBA and lends it to entrepreneurs within its service area. The intermediary is obligated to pay SBA back. SBA 504 Loans. The 504 program provides long-term, fixed-rate financing for major fixed assets, such as real estate, facilities construction or expansion and other fixed-asset needs, such as long-term capital equipment. Loans of up to $1 million are available for up to 10 years for equipment and 20 years for real estate. The loans are made through Certified Development Companies (CDCs) working in conjunction with a private lender. USDA-Backed Revolving Loan Funds Restricted to low population areas, USDA-Backed Revolving Loan Funds (RLF) are designed to assist with new business development or business expansion. The RLF aims to produce job creation or job retention as a result of the loans. Project activities that may be funded through the RLF include but are not limited to: machinery and equipment, furniture and fixtures, start-up operating cost and working capital for business start-up, expansion activities and technical assistance for private business enterprises. The RLF may not be used to produce agricultural products through growing, cultivation and harvesting. Applicants with the greatest anticipated economic impact for the community receive the highest priority. Equity Financing Options Angel Investors An angel investor, or angel, is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity. An increasing number of angel investors organize themselves into angel networks or angel groups to share research and pool their investment capital. To successfully accommodate angel investors, a business owner must also be able to provide them with an exit strategy in the event of the company s recapitalization, public offering or buyout by a larger firm. If the business is doing very well, entrepreneurs should be sure their agreement contains an early out clause to remove the angel investor sooner at less cost. Some angel investors want an active management role in the business and a voice in how the business is run. Business owners are advised to think through how this kind of involvement would affect the business. Venture Capital Venture capital is a type of private equity capital typically provided by professional outside investors in new, growth businesses. Generally provided as cash in exchange for shares in the company, venture capital investments are usually high risk but offer the potential for above-average returns. A venture capitalist is a person who makes such investments. A venture capital fund is a pooled investment vehicle, often a limited partnership, that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or banks. Venture capital may also include managerial and technical expertise. PAGE 8

9 S12. Financing Entrepreneurs: Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies, or ventures, with limited operating history, who cannot raise funds through a debt issue. The downside for entrepreneurs is that venture capitalists usually have a voice in company decisions, in addition to a portion of the equity. See example of a micro loan program flier in use at Northeast Wisconsin Technical College in the inset box. PAGE 9