SITTING BEHIND HIS DESK at a marketing firm, Chris Baggott often daydreamed of owning his own business. In 1992, he finally took the plunge. At the age of thirty-one, he quit his job and bought Sanders Dry Cleaning, a local store that he eventually built into a chain with seven outlets. To make it happen, Baggott borrowed $45,000 from his father-in-law, James Twiford Anderson, a physician who also agreed to cosign a $600,000 bank loan.
With the financing in place, and ten years of marketing experience, Baggott thought he was set. And then the whole “business casual” trend caught fire. “People stopped wearing suits,” Baggott recalls. Revenue fell to just $60,000 a month, far short of Baggott’s original projections of $110,000. What’s more, he owed $14,000 in monthly payments to the bank. Propping up the business with credit cards, he began missing loan payments—and the loan officer’s phone calls went straight to his father-in-law. Says Baggott: “He’d call us and say, ‘What the heck is going on here?’ And then he’d have to write a check to cover it from his own funds.”
Eventually, Baggott felt he had no choice but to sell the business, pay his debts, and move on. But there was one investor he couldn’t repay: his father-in-law, who ultimately lost tens of thousands of dollars on the venture. “It was painful,” Baggott says, though his father-in-law was “great” about it.
“You win some, lose some; it’s trite to say, but it’s true,” Anderson told Inc. in a 2003 interview, adding that he knew from running his own practice and from some real estate ventures that things don’t always go as planned. “I know whatever project Chris goes into, he puts his heart and soul into it.”
Baggott eventually co-founded two software companies, Exact-Target in 2000 and Compendium in 2007. He again turned to friends and family—but this time, he went out of his way to emphasize the risk involved. “I said, ‘Here’s our business plan, but this is just a plan, and the chances are good that you’ll never see this money again,’” he says.
Ultimately, he raised several million dollars—and investors once again included his father-in-law. This time, the support paid off: Salesforce bought ExactTarget in 2013 for $2.5 billion, while Oracle acquired Compendium for an undisclosed sum.
Baggott, who won an industry award called the TechPoint Trailblazer in Technology Award in 2015, publicly thanked Anderson for the support. Despite the early losses, “he was still the very first person to step up and help us get ExactTarget funded,” Baggott recalled in his acceptance speech. “He was also an enthusiastic supporter of Compendium. So much for not mixing business and family—at least in our family, it’s pretty much the same thing.”
Crowdfunding sites like Kickstarter and Indiegogo can be an effective way to raise money (and awareness) for your business idea, especially if it’s a consumer product. Typically, you set a goal for how much money you’d like to raise over a period of time, say, $1,500 over forty days. Your friends, family, and strangers then use the site to pledge money. The sites have funded hundreds of thousands of creative ideas, from smartwatches to 3D printing pens. One of the more legendary success stories is that of Oculus, a virtual reality headset that raised $2.4 million via Kickstarter and was promptly acquired by Facebook for $2 billion.
The traditional way of crowdfunding is a system where your “backers” get a reward in return for their investment. For example, if you’re trying to launch a new board game, you might send the game as a thank you to people who donate a certain amount of money. Campaigns on Kickstarter are all-or-nothing, meaning you get no funding unless you hit your target, although other sites have more flexible rules. Even if you fail to reach your financial goal, a crowdfunding campaign can be a potent marketing tool, helping you find and engage potential customers.
A newer and more complex type of crowdfunding is called equity crowdfunding. “With this model, people in the crowd are actually buying shares in the business. They’re securing equity. They’re investing in hopes of seeing a return,” says Inc. columnist Steve Farber, founder of the Extreme Leadership Institute. “They want something more than a T-shirt.” About 120 companies raised some level of money in 2016 using this method. Businesses like restaurants and microbreweries—those with strong brand loyalty that can quickly connect to a large crowd of customers and supporters—have been early adopters.
While you can raise up to $1 million through equity crowdfunding, it’s not for everyone: You’ll need anywhere from $8,000 to $15,000 in legal and setup costs. Platforms for equity crowdfunding include CircleUp and AngelList.
It’s never been easy for a small business to get a bank loan. Since the 2008 financial crisis, bankers are more risk-averse than ever. So, persuading one to take a shot on your small but growing company will take work.
A few rules of thumb: Don’t expect to get a conventional bank loan on day one of your new business. (In the early years, you may have more luck with a Small Business Administration–backed loan. See “Make Mine an SBA Loan” on page 94). Do establish a track record, and keep careful paperwork. Don’t ask for a bank loan when you’re struggling to pay your bills. Do have a very good reason for why you need one. Some of the most common? Expanding into a new location, purchasing inventory or equipment, or boosting working capital.
The loan application process itself can be arduous. From start to finish, it can take two or three months—and you might get rejected in the end, says Inc. reporter Christine Lagorio-Chafkin. “It pays to be meticulous when you fill out your forms, and to provide ample documentation and back-up,” she writes. “You should also plan on answering a series of questions both about your business and about your personal financial situation.”
Because the application process is so important, let’s take a look at how to go about it.
Chances are, you’ll fill out several loan applications in a bid to get money. At the outset, you’ll want to consider whether to target large national institutions with whom you might do other banking, or small, community-based organizations such as credit unions that might be more supportive of local entrepreneurs.
In either case, before beginning the application process, make sure you personally have good credit. A bank will also want to know if prior debts—both business and personal—will affect your ability to maintain a consistent payment schedule. “How you manage your personal finances is very reflective of how you might be able to manage business finances,” says John E. Clarkin, a professor of entrepreneurship at the College of Charleston, South Carolina.
One area where many entrepreneurs are tripped up: Having too much personal credit. If you carry several credit cards in your wallet, each with a high level of available credit, a bank may worry that you might run into more debt by using that extra credit if the business runs into trouble.
Keep in mind, a lender will want to know the answers to these questions: Precisely why do you need a loan? If you intend to buy inventory or equipment, from whom will you buy it? Who at your company will manage the loan, if not you? Having a game plan to tackle these questions will make the process of filling out a loan application easier.
Most loan applications start with the basics: They ask for your business name and contact information, as well as the legal structure for your business (LLC or S corporation, for example), and the date of founding. You might also need to know how your business is covered under the North American Industry Classification System, commonly referred to as the NAICS code. (To learn more, go to the Census Bureau’s website, www.census.gov.)
You’ll also need to provide financial information, such as your current bank account (including recent deposits) and amount of income your business has earned in the past year, plus cash balance, debt payments, etc. Check with your accountant or financial advisor to make sure all your data is accurate. The bank will also want to know if you’ve paid your business taxes.
These days, lenders tend to ask small business owners for collateral or a personal guarantee—or to put up personal money should your business not be able to repay its loan. Weigh your options carefully. “You’ve got to be willing to lose some money, but don’t endanger your entire future, your house, and your children’s college education by pledging too much,” says Dan Short, a professor of accounting at the Neeley School of Business at Texas Christian University.
The loan application will ask for additional personal information, including everything from a breakdown of the business’s ownership (do you own 100 percent of the company, or do you share equity with other principals?) to whether you are married and filing the loan application jointly with your spouse. Additionally, you may be asked to provide personal tax information.
Don’t yet qualify for a bank loan? Enter the U.S. Small Business Administration.
The SBA supports America’s small business owners through its various loan programs, helping entrepreneurs acquire the funds they need to get started and grow.
Contrary to what the term “SBA loan” suggests, the SBA actually doesn’t directly lend the money to small businesses. Instead, the agency works with a number of lenders (see if your bank or credit union participates) around the country to guarantee a portion of the loans, providing a better incentive for lenders to approve small business loans.
One of the best-known recipients is Kevin Plank, founder of Under Armour, who received a $250,000 SBA loan in the early years of his athletic-apparel business. “I couldn’t borrow any more money from friends or family or anybody else that I knew,” he told the Washington Post in 2011. “I was out of options.”
Here’s a look at the SBA’s most popular loan programs:
7(a) Loan. The most commonly used of the SBA loans, the 7(a) loan is flexible in its terms and usage. Through the 7(a) program, small business owners can borrow up to $5 million to be used for working capital, equipment purchases, real estate, and some startup expenses. Under some conditions, business owners can use 7(a) loans to refinance pre-existing debt. Almost any small business owner is eligible for the 7(a) program, though qualification is up to intermediary lenders and will depend on your time in business, annual revenue, and personal credit score, among other factors.
Microloan. The SBA offers very small loans (average size is $13,000) to new or growing small businesses. The money can be used for working capital or the purchase of inventory or equipment, but can’t be used to refinance existing debt or purchase real estate. The SBA provides the funds to specially designated intermediary lenders, typically nonprofit community-based organizations with experience in lending as well as technical assistance. Some microlenders give priority to minority business owners, women, and low-income applicants in an effort to encourage entrepreneurship among these groups.
CDC/504. The SBA CDC/504 Loan Program is designed for business owners making major tangible purchases, such as equipment, office space, and buildings. Though strictly regulated, CDC/504 loans are a powerful tool to help businesses grow in a decisive way. Borrowers (typically, “larger” small businesses) can take out up to $5 million to acquire or improve any fixed business asset. Think: opening a second location, making a major technological upgrade, or purchasing a large piece of real estate for development.
Lines of Credit Versus Traditional Loans
As a business owner, you might seek a business line of credit, which is similar to a personal line of credit, like a credit card or home-equity loan.
Unlike a traditional loan, which provides you with a lump sum of cash to be repaid at a fixed or variable interest rate over a certain time frame, the business line of credit allows you to tap into funds as you need them. This gives you control over how much money you take and when you take it. Additionally, you are only required to pay interest on what you use.
A business line of credit is commonly called revolving credit. This means the lender offers access to a certain amount of capital for an unspecified period. As payments are made, you get access to those funds back.
In some cases, a business line of credit may have lower interest rates and closing costs compared with a loan. But similar to a personal credit card, you may wind up paying more if you are late with a payment or go over your limit.
Typically, business owners seek out traditional term loans for specific purposes, such as the purchase of equipment that may take several years to pay off. A business line of credit may be better for short-term financing, such as payroll, supplier costs, or temporary cash-flow shortages.
Very few startups will raise money from angel investors or venture capitalists—despite all those eye-popping headlines from Silicon Valley. By some estimates, fewer than 2 percent of entrepreneurs will receive cash infusions from professional investors. The more common sources of funding, by far, are personal savings and credit, followed by friends and family.
But if you’re a cash-strapped entrepreneur with an idea that you think is the Next Big Thing, then equity financing—that is, selling shares in your company in return for capital—may be for you. Here’s how these types of funding work.
Broadly defined, angel investors are high net-worth individuals who invest in entrepreneurial companies, usually at an early stage. Like institutional venture capital firms, many angel investors provide cash to young companies and take equity in return. One difference is that angel investors typically invest smaller amounts of money in individual companies than venture capitalists do, making them a possible resource for companies that have exhausted their “friends and family” financing options but are not ready to approach VCs for capital.
Some angel investors are members of angel groups, allowing them to increase their access to investment opportunities and giving them the possibility of investing jointly with other angels to hedge their risk. If you’re looking for an angel, tapping into these networks (examples include New York Angels, Investors’ Circle and Golden Seeds) is a good place to start. Also make use of your personal network—talk to entrepreneurs who have received angel funding, ask attorneys or accountants who deal in the venture field for referrals, and seek out connections by attending investment forums or pitch events. Your network may well be able to suggest potential angels.
In looking for angels to target, don’t forget that choosing an angel investor is a great opportunity to gain an advisor. So, do your research. The best investor for your startup will be the one who can contribute significant experience, knowledge, and networking opportunities, as well as the cash you need to grow your business.
Keep in mind that there are drawbacks. When you take on an angel investor, you inevitably lose total control of your startup. An angel will want to ensure that his or her money is being spent wisely, and will likely take an active role in your company’s decision making. In some cases, the angel will also want a board seat. You might also face new pressure to hit financial milestones. Before taking on an investor, make sure you feel comfortable that your company can grow at the rate the angel expects.
Many high-growth startups raise money from angels before going on to secure larger rounds of venture capital, which we’ll outline next.
Unlike angels who invest their own personal funds, venture capital firms pool cash from institutions or individuals into an investment fund, typically disbursing that money into any number of startups. Since they have a fiduciary responsibility to partners, VCs generally don’t like to make risky, early-stage investments. VCs often have larger sums to invest—in 2016, the median first or “Series A” round was about $6.6 million, according to Crunchbase. Because of the piles of cash being invested, venture capitalists can be demanding. Aside from taking a percentage of your company, VCs generally want to be actively involved in your company’s strategic direction, taking board seats and sometimes managing operations. And they want an eventual exit strategy—an initial public offering, an acquisition, or some other event that promises a return on their investment.
Even if you’re willing to give up all that control, venture capitalists are still quite picky about what companies they’ll invest in. “One of the first hallmarks we look for is whether this is a high growth area or does this company have the potential for exceptional growth,” says Maha Ibrahim, a general partner in Canaan Partners, a venture capital firm with offices in the United States and Israel. “We want to invest in companies that will grow by leaps and bounds over the next five-to-ten years so that it justifies going to the public market or provides an exceptional exit that creates enterprise value.”
If you’re looking for a VC, do your homework. Figure out firms’ investment philosophies (often on their websites), the companies they have backed, and whether they invest at the early stage or later rounds. Talk to everyone you know who has been through the process of raising venture capital. And then tap into both your own and your management team’s networks to find personal connections with your targets.
“The best way to get the attention of a potential venture capital investor for your startup is to have a mutual contact make an introduction by sending an executive summary/teaser document, which should be no longer than two pages,” says attorney Lori Hoberman, whose New York City firm, Hoberman Law Group, advises entrepreneurs on how to navigate VC financing. “Remember, your intended audience has a very limited attention span. If they’re interested after reading the executive summary, they’ll come back to you for more.”
If you do get a meeting, bring a prototype or a working model of your product. If interested, VCs will begin to conduct due diligence. Some companies perform due diligence on the product itself, hiring experts to examine the product or its market either from a technical standpoint or reviews from customers or potential customers.
The next step would be for the VC to issue a “term sheet,” in which they make their financing offer. The term sheet will spell out the following:
The dollar amount of the investment the firm wants to make.
The level of ownership—basically a percentage of the company—they expect in return.
Other terms the VCs need to protect themselves, whether that includes board seats or conditions such as that the company cannot be acquired without the investors’ approval.
Make sure to thoroughly review and evaluate term sheets before closing any deal. Most VCs will want regular progress reports after the documents are signed, and funding has been granted. “We tend to be involved in our companies but we don’t want to micromanage,” Ibrahim says. “It’s a delicate balance.” Companies should expect to make regular updates to investors. Often this is done at board meetings.
For entrepreneurs having trouble accessing traditional financing, there is an entire world of lending alternatives to help keep them afloat.
Once you start looking, “you’ll realize alternative lenders have different standards than bank lenders do, and aren’t necessarily looking for three years of perfect balance sheets,” writes Inc.com reporter Jeremy Quittner. Many will focus on the potential your business has to grow, and will lend based on your future revenues or on the value of your other assets.
A word of caution: Do not jump into alternative lending blindly. “Rates can still be high and terms can be dubious,” Quittner writes.
Here’s a look at some of the options.
Sure, factoring has a notoriously bad rap from the old days when factoring shops operated like sleazy used-car dealerships, where you’d risk sinking your business with usurious rates. But a lot has changed, and many reputable factors can lend you money at reasonable rates.
Factors lend you money by financing the value of your receivables, usually up to about 80 percent of their value. For that, they take on the task of bookkeeping and collecting plus any risk, such as the danger of a customer filing for bankruptcy.
In return, you get a loan that functions somewhat like a credit line. You’ll be charged a commission for the credit, plus interest. The commission is likely to be about 1 percent of the total, and interest is likely to be prime plus about 3 percent. As a benchmark, rates on the SBA’s guaranteed 7(a) loans range between prime plus 2.25 percent and prime plus 2.75 percent. Rates on non-guaranteed commercial loans will be even higher.
“Small businesses will come to a factoring institution because factors [unlike banks] are more focused on the collateral not the actual balance sheet,” says Mike Stanley, managing director at Rosenthal & Rosenthal of New York, which factors for five hundred businesses, many in the small and mid-market.
Jonathan Levine is president of Lancer & Loader Group of New York, which for many years imported and distributed electronic consumer products. The company started distributing its LEDs to established retailers like Bed, Bath & Beyond, Costco, Sears, and Walmart in 2006. At the time no banks would lend, because the company couldn’t provide several years of earnings, even though it had an impressive client roster.
Levine says he secured a $1 million credit line secured against receivables from Rosenthal & Rosenthal for rates comparable to a bank loan.
“Factoring is a good alternative for new companies who really need to focus their internal resources, both financial as well as human capital resources, toward growing the business,” Levine says.
CIT, Rosenthal & Rosenthal, and Wells Fargo are three of the largest factors. You can also check out Factors Chain International, a network of over four hundred factors internationally, for more information.
This is similar to factoring, but instead of lending against outstanding invoices, lenders extend credit against the value of your assets. In some ways asset-based lending is similar to a bank loan, because unlike factoring, the lender does not take an active role in business collections.
An asset-based lender will go down the asset side of the balance sheet, assessing the value of items like inventory, equipment, machinery, real estate, and even intangible items like the worth of your name brand. It will then lend a percentage of the total value, usually up to 80 percent or more.
The asset-based lender takes a senior secured position in the loan, using the assets as collateral. Like traditional bank loans, asset-based loans have a closing fee between 0.5 percent and 1 percent of the total. All told, asset-based loans can be 1 to 3 percentage points higher than a bank loan, experts say.
Robison Oil of Elmsford, New York, found itself shut out of its bank’s asset lending services when the bank pared back its energy division after a merger over ten years ago, says Dan Singer, a co-president of Robison. One of the things the bank was looking for was a strong balance sheet year after year. But since Robison is seasonal, it often showed a loss at the end of the year, which didn’t fit its new bank’s criteria.
It turned to Rosenthal & Rosenthal, which was willing to extend an $11 million term loan and $18 million credit line.
“We thought about going back to a bank, but we have found this segment of lenders much more flexible,” Singer says, adding that total financing costs were about 1 percentage point more than the company would have gotten with a traditional bank loan.
Other asset-based lenders include Triton Financial Solutions and Simplified Leasing. Check out the Commercial Finance Association for more information on asset-based lending.
A host of companies provide financing against future income. These companies have proliferated online since the banking crisis, but the loans tend be for smaller amounts. These are basically merchant advances secured against cash in the bank or potential credit card sales. One such lender, Kabbage, of Atlanta, does its underwriting over the web, looking at nontraditional criteria like PayPal information and number of sales on Etsy, as well as whether you communicate with customers on Facebook and Twitter. In that way, it compiles a credit score using alternate sources, unlike the credit score and credit bureau check that banks do, while considering the potential of your future business.
“Having more cash available is especially important in the online world when you have so many opportunities flowing by in a river and you have to scoop it up or it is gone,” says Marc Gorlin, chairman and one of three co-founders of Kabbage.
Quick access to capital was important for Adam and Kit Chase, the owners of Trafalgarssquare.com, an online store for children’s cards and wallpaper. The company was founded in 2008, and no bank would look seriously at it for financing, even though sales have been strong. In 2012, the Chases wanted to take advantage of a trend they had noticed in wall stickers and decals, for which they needed to buy special printing equipment.
“Banks had high interest rates, or they did not want to lend, or they were not flexible, they either wanted to give us an amount that was too large or too small,” Kit Chase says.
Kabbage approved the Chases for a $2,000 loan, and the same day funds were in the couple’s PayPal account.
“We have done a couple of things with flash sale sites, and often we won’t have the money for materials, and with Kabbage we can get the money before events and produce products and pay it back,” Kit Chase says.
Other similar providers include Lighter Capital and On Deck Capital. Amazon and PayPal also provide financing services to online merchants. A good resource to find a merchant advance lender is the North American Merchant Advance Association.
Brokers that specialize in small business loans can do the legwork of tracking down lending companies for you if you don’t feel like doing this yourself. They can recommend a wide range of products and services, including things like merchant cash advances, accounts receivable and inventory financing, lease buybacks and purchase order financing, as well as more conventional loans like those offered by the SBA or even by the U.S. Department of Agriculture.
Such is the case for MultiFunding of Broad Axe, Pennsylvania, which checks these alternatives and others, for its clients.
“It is difficult for most small business owners today to know where they fit into the funding trajectory, there are so many moving parts,” says Ami Kassar, chief executive of MultiFunding.
Generally speaking, small business owners consult with brokers at no cost, then pay a fee only if they successfully get financing. (In some cases, the broker charges the lender a fee.) Other online marketplaces include Biz2Credit, Fundera, and Lendio.
If there is anything more important than financing your young business, it’s getting the word out about your new products or services. We’ll take a look at a mix of marketing and sales strategies in the next chapter.