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Obtaining enough capital
After estimating the capital requirements for your business, you will decide how much of your own equity to provide and how much to raise from external sources. The two main sources of external funding are lenders and investors.
Giving a current business plan to a prospective lender or investor gives them a basis for making an informed lending or investment decision. Even if you have financial statements or tax returns from an existing business, a business plan shows your strategy to generate sales and profits. To a lender, your forecasted profits and cash flows represent a source of repayment. To an equity investor, the forecasts represent a potential return on their investment.
In addition to your forecasts for sales and profits, a prospective lender or investor will be interested in your marketing plan, production plan, and the experience and depth of the management team. The more of these questions your business plan answers, the more successful your funding request will be.
After reviewing your business plan, an investor or lender may still decide to provide only enough funding to cover a part of the capital requirements you seek from external sources. On the other hand, they may decide to fund only an amount necessary to cover forecasted cash flow shortages. As a result, it helps to forecast as accurately as possible.
For example, say you forecast $200,000 in net cash outflows for the upcoming year. Your lender provides a working capital loan of $200,000 to make up for the forecasted shortage. Two months later, you forecast net cash outflows to increase to $250,000. Unable to gain access to additional funds from the same source, you will have to look elsewhere, perhaps even turning to a personal credit card.
Investors contribute capital to your business in exchange for a share of equity in your business. As a small-business owner, you have to decide what percentage of equity in your firm you are willing to exchange for the investment. For example, you may decide to sell a 10% stake in exchange for a $250,000 investment.
In most cases, small-business owners want to retain a majority stake, or at least 51% of total equity. In other cases, they may be only willing to exchange a much smaller minority stake, perhaps 10% or 20% of total equity.
How much equity you are forced to exchange for a desired amount of investment capital depends on your negotiating skills. If you are planning a new business in a field that promises great profits, you may find equity investors willing to accept a minority stake. Investment firms that contribute equity to a new company without a history of business success—whether in exchange for a majority or minority stake—are sometimes called venture capital funds.
In fact, most small businesses in the U.S. are either too small to gain access to equity investors or are not interested in selling equity. Instead, these companies rely on banks and other financial institutions for loans to help bankroll their capital requirements.
Lenders do not require an equity stake in your business. However, they do require a lien on some or all of your fixed assets. If establishing a new banking relationship, some lenders choose to place restrictive covenants on how a small business uses its funds.
Banks offer a range of loan services, including
lines of credit, term loans, and SBA loans. SBA loans are guaranteed by the U.S. Small Business Administration (SBA), a government agency that helps provide credit to small businesses in the form of loan guarantees.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Next Topic: Debt versus equity
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