When seeking any type of business financing for any sized business, small or large, there are four and only four uses or applications of capital. I’m going to go over each of them and why this is important to know and understand.
First of all, why is this at all important? Identifying the exact use of capital creates greater relevance in the capital procurement process.
OK, I’ll speak English. Locating suitable capital funds, either debt financing (business loans), equity financing(investor capital), or a combination of the two, will depend to some degree on how the funds will be applied in your business.
Lenders and investors can be very specific in deals they will seriously consider funding and one of their key criteria will be how the funds will be applied.
Certain applications of funds will completely remove certain lenders and investors from the mix. By understanding this at the outset, you can create greater relevance in your search to secure capital by screening out the sources of money that will automatically not be interested in your deal.
This doesn’t mean the deal is good or bad, its just not going to be relevant to certain sources of business financing. So you can save yourself a lot of time and aggravation focusing on relevant sources. There are of course other criteria that helps determine relevance, but for today let’s stick with use of funds.
So what are the 4 uses of debt financing and/or equity financing?
– Start Up. The start up of a new business venture.
– Acquisition. The acquisition of an existing going concern business.
– Expansion. The Expansion of the assets of an existing business for the purposes of growth.
– Debt Consolidation/Reorganization. The repackaging of existing and potentially new debt into a modified or new debt instrument or instruments. This predominately relates to businesses in some distress or downturn that need to either inject more capital into the business to cover losses or move short term debt to a longer term debt instrument to improve the balance sheet and security position of lenders.
Within each of these uses, there are even more specific sub uses such as:
– working capital to finance day to day operations
– short term capital to purchase and add value to inventory
– short term capital to finance accounts receivable
– longer term capital to acquire other tangible assets like equipment, buildings, and land.
– capital to acquire intangible assets
If you are seeking business financing for a start up venture, there are many sources of capital that don’t fund start ups. Identify them, and don’t waste your time asking them for money.
If you’re looking to acquire an existing business, don’t seek funds from someone providing trade credit related to working capital type assets only.
As I alluded to earlier, there are other twists to this as well as certain lenders and/ or investors will consider expansion funding, but have other criteria to determine if the deal is relevant to them (amount of funding, industry, debt to equity ratio of the balance sheet, debt service coverage, assets to be acquired, security ratio, etc.)
Each lender will have their own criteria set for each application of funds they will seriously consider. I say seriously consider because most lenders state at the outset they will look at virtually any deal to maximize their marketing efforts, but in reality, they all have a pretty narrow focus.
That’s why its important to understand how to accurately describe the business financing you seek and then qualify the universe of funding sources so that you’re only spending time with a relevant list.
But more in depth lender qualifying is a topic for another day. Stay tuned.
Several times each week, I talk to small business owners who are seeking capital for their new or existing business and several times I have a very similar conversation with each of them that I thought I’d share today.
At the beginning of the conversation, I always ask the same two questions: How much money are you looking for? what’s the purpose of the funds?
I would say that at least 75% of the time, I have to re-ask these two questions two or three times before they’re answered. Most people think that telling me a long drawn out story of what they want to do and how they came to do it will be more important than answering these two questions.
What tends to come out after a few minutes is that the individual is hunting for what I call stupid money. You know, the kind that is prepared to write you a check on a very thin and likely non existent business plan where the lender is taking all or close to all of the financial risk.
Example. Someone has a great idea for a tennis equipment store. They have picked out a location and now need $300,000 for start up costs, working capital, and inventory. They have poor credit, personal debt, zero net worth, and no capital to contribute to the venture.
Is it possible that this individual could secure small business financing of some sort? Yes.
Is it probable? No.
That’s the great thing about the money business, virtually anything is possible, and I’ve seen enough to know first hand. After getting off the phone with me, this would be entrepreneur could go to the coffee shop, strike up a conversation with someone about his or her golf shop idea, and leave with a check in hand for the capital sought. Is is possible? Absolutely. Is it likely to occur? The odds would likely be lower than playing the lotto.
That’s why I’m always careful to not generalize about small business financing, as there is an infinite sea of money out there and strange things happen all the time.
But lets also get real. Just because its possible, doesn’t mean your new business financing strategy is to start going to coffee shops.
For the most part (can never generalize), money has a basic intelligence. If intelligence is not applied, the source of money will disappear very quickly based on making bad decisions.
People supply money to business ventures for a return. If you can show them a path to the return they seek within the level of risk they’re prepared to take, then eventually, you will find a source of capital for your small business financing requirements.
And here’s my tip of the day on this subject: You must have something to leverage and something to lose in order to have a realistic probability of getting business financing, whether it be for a new venture or existing business.
Something to leverage for low risk credit is your credit score, personal net worth, external cash flow, third party guarantee. Something to leverage for higher levels of credit risk would also include things like asset security, established cash flow, signed purchase orders from reputable companies, patents, intellectual property, contracts, etc. Remember also that something to leverage has to have a value to the source of money or there is no leverage.
Something to lose is at the very least the capital that you directly invest into the venture. 100% financing of anything is quite rare unless you’re taking about residential real estate and look what problems that has caused in the markets over time. Personal guarantees and corporate guarantees would also fall in this category if there was enough net worth to make them meaningful.
As the amount of leverage and borrower risk increases, so does the probability of securing capital.