- Posted by: Jackee Lu
- Category: Articles
Since your startup days, you’ve grown big and strong Expansion Financing. Now you want to invest to grow even bigger. Here are the primary sources you can look to.
You can’t grow unless you have money to invest in growth. That may seem strange at first. After all, growth is supposed to generate additional sales and profits, right? That’s true, but before you can increase sales, you usually have to increase your current assets, such as inventory and fixed assets such as a plant and equipment. Rapid growth means hiring more people, furnishing more offices and perhaps renting new quarters. Since there’s usually a time lag between the moment you need to invest in growth and the moment you receive the resulting sales and profits, you need money before you can grow.
Expansion Financing can take many forms. You can use your own money, borrow from friends and family, use internally generated funds, approach equity investors or tap banks and other lenders. The sources for funding growth are generally the same sources you may have used to start your business. In many cases, you’ll go back to the same sources to pay for expanding your company. The good news is that it’s easier to fund growth in an existing business than it is to fund a startup.
Types of Expansion Financing
As you learned when you were looking for startup capital, there are many places to go when seeking money for the business. As you probably also learned, only a few of those places are right for any given business. Selecting the right type of expansion financing is largely a matter of matching your needs to the restrictions of the source. Each type of financing has its own strengths and limitations.
Self-financing in the form of personal and family savings is the No. 1 form of financing used by most small-business owners. It’s low-cost and has other advantages. For instance, when you approach other financing sources, such as bankers and venture capitalists, they’ll want to know exactly how much of your own money you are putting into the venture. After all, if you don’t have enough faith in your business to risk your own money, why should anyone else risk theirs?
Here are some of the sources of personal and family financing you should consider for growing your business:
- Personal line of credit, including credit cards: Although credit card financing is expensive, it can work for emergencies and small amounts.
- Home equity loan secured by your personal residence: Interest rates are low, but you may lose your home if you can’t repay.
- Cash-value life insurance: Interest rates are reasonable on loans against cash-value policies, and you don’t have to make payments because the loan will be repaid from proceeds of your insurance in the event of your death.
- Individual retirement account (IRA) funds: Laws governing IRAs let you withdraw money from an IRA as long as you replace it within 60 days. It’s not a loan, so there’s no interest, but if you pay it back late, you’ll have to pay a 10 percent penalty plus taxes.
“Friends and Family” Expansion Financing
Friends, relatives, and business associates are popular sources for expansion financing the growth of small businesses. There are two main advantages to friends and family financing. The all-important issue of the character of the borrower is moot–these people already know you. Depending on who you’re borrowing from, repayment terms may be extremely flexible, and you may not even have to pay interest.
The downside is that, if worst comes to worst and you can’t repay the loan, the people who will be hurt will be friends, family, and business associates. Make sure you explain the risks involved in investing in a growth business before accepting financing from friends and family. Otherwise, their wish to help you out may lead them to do something that could damage your personal relationship as well as your mutual finances.
Internally Generated Funds
One of the most advantageous ways to finance growth is through earnings your business is creating and that you retain. The only cost to using retained earnings is the interest you would receive if you kept the earnings in a bank account. Since this amount is likely to be much less than you will earn by successfully investing the funds in growing your business, plowing retained earnings back into your business is usually a smart move.
One risk to expansion financing with internally generated funds is that you will divert too much of your current profits into expanding the business. This can starve your business and create more trouble than if you are financed with a more costly source or never tried to grow at all. Make sure you aren’t rob Peter to pay Paul when you finance with retained earnings, and that your investments in inventories, marketing efforts, production staff, and other outlays required for the existing business are maintained.
Bank Loans and Lines of Credit
Banks exist to lend money, so it’s no surprise that banks offer a wide variety of ways to fund growth. Here’s a look at how lenders generally structure loans, with common variations.
- Line-of-credit loans: The most useful type of loan for small businesses is the line-of-credit loan. This is a short-term loan that extends the cash available in your business’s checking account to the upper limit of the loan contract. You pay interest on the actual amount advanced from the time it is advanced until it is paid back. Line-of-credit loans are intended for purchases of inventory and payment of operating costs for working capital and business cycle needs. They are not intended for purchases of equipment or real estate.
- Installment loans: These bank loans are paid back with equal monthly payments covering both principal and interest. Installment loans may be written to meet all types of business needs. You receive the full amount when the contract is signed, and interest is calculated from that date to the final day of the loan. If you repay an installment loan before its final date, there will be no penalty and an appropriate adjustment of interest.
- Balloon loans: These loans require only the interest to be paid off during the life of the loan, with a final “balloon” payment of the principal due on the last day. Balloon loans are often used in situations when a business has to wait until a specific date before receiving payment from a client for its product or services.
- Interim loans: Interim expansion financing is often used by contractors building new facilities. When the building is finished, a mortgage on the property will be used to pay off the interim loan.
- Secured and unsecured loans: Loans can be secured or unsecured. An unsecured loan has no collateral pledged as a secondary payment source should you default on the loan. The lender provides you with an unsecured loan because it considers you a low risk. A secured loan requires some kind of collateral but generally has a lower interest rate than an unsecured loan. The collateral is usually related to the purpose of the loan; for instance, if you’re borrowing to buy a printing press, the press itself will likely serve as collateral. Loans secured with receivables are often used to finance growth, with the banker lending up to 75 percent of the amount due. Inventory used to secure a loan is usually valued at up to 50 percent of its sale price.
- Letter of credit: International traders use these to guarantee payment to suppliers in other countries. The document substitutes the bank’s credit for the entrepreneur up to a set amount for a specified period of time.
Despite what you might see on late-night infomercials or some websites, none of the SBA’s loan programs involve free money, government grants or no-interest loans. In fact, the SBA doesn’t even lend funds directly to entrepreneurs–you’ll need to strike up a relationship with a loan officer at your local bank, credit union or nonprofit financial intermediary to access the programs.
But once you do, there’s an array of resources aimed at getting you the capital you need to start or expand your small business. Last year, more than $50 million in SBA loans were being provided per day to U.S. small businesses.
- 7(a) Loan Program. The 7(a) is the SBA’s most popular loan program. As a small business owner, you can get up to $750,000 from your local 7(a) lender, backed by a partial guarantee from the SBA. Note that the SBA is not lending you any money directly. What they are doing is making it less risky for a local lender to provide you with expansion financing. 7(a) loans are typically used for working capital, asset purchases and leasehold improvements. All the owners of a business who hold an ownership stake of 20 percent or more are required to personally guarantee the loan.
Once your lender decides that 7(a) money is what you need, you’ll probably start hearing the names of the different 7(a) programs. For example if you’re borrowing less than $150,000, you may be headed toward the Lowdoc program, which was created in 1993 to reduce burdensome paperwork. A Lowdoc loan application is a one-page form; your application is on one side and the lender’s request to the SBA for the guaranty for your loan is on the other. The SBA responds to Lowdoc applications within 36 hours.
The SBA Express is a program for lenders with a good SBA-lending track record. It’s aimed at getting money–in this case, as much as $250,000–quickly into the hands of entrepreneurs. Based on the success of the SBA Express program, the SBA initiated CommunityExpress, specifically designed to improve access to capital for low- and moderate-income entrepreneurs and to provide both pre- and post-loan technical assistance.
The eligibility criteria for the 7(a) program are the broadest of all the SBA loan programs, but they’re still quite restrictive for startups and businesses related to financial services. In general, all SBA programs are targeted at small companies (that is, businesses with less than $7 million in tangible net worth and less than $2.5 million in net income), but typically most banks won’t lend to startup businesses that don’t have two to three years’ worth of financial statements and some owner’s equity in the business. Some banks will allow you to use money from relatives as part of your equity, but you’re required to formalize these loans with a repayment plan that’s subordinate to the bank debt.
- 504 Loan Program. The 504 loan program is intended to supply funds for asset purchases, such as land or equipment. Typically, the asset purchase is funded by a loan from a bank or other lender in your area, along with a second loan from a certified development company (CDC) that’s funded with an SBA guarantee for up to 40 percent of the value of the asset–which is generally a loan of up to $1 million–and a contribution of 10 percent from the equity of the borrower. This financing structure helps the primary lender–the bank–reduce its exposure by relying on the CDC and the SBA to shoulder much of the risk.
Like the 7(a) program, the 504 program is restricted to small businesses with less than $7 million in tangible net worth and less than $2.5 million in net income. However, since funds from 504 loans can’t be used for working capital or inventory, consolidating or repaying debt, or refinancing, this program tends to exclude most service businesses that need to purchase land or equipment. Personal guarantees are also required for 504 loans.
- 7(m) Microloan Program. The program is intended to provide “small” loans of up to $35,000 that can be used for a broad range of purposes to start and grow a business. Unlike the 7(a) program, the funds to be loaned don’t come from banks; rather, they come directly from the SBA and are administered to business owners via nonprofit community-based intermediaries.
The Microloan program is friendlier to startups than established businesses because the “catch” to the Microloan program is borrowers typically have to enroll in technical assistance classes administered by the micro-lender intermediaries. For some entrepreneurs, this is a very helpful resource that provides cost-effective business training. Others, however, perceive it as a waste of time, although it’s a necessary pre-condition to getting a Microloan.
For many businesses, trade credit is an essential tool for financing growth. Trade credit is the credit extended to you by suppliers who let you buy now and pay later. Any time you take delivery of materials, equipment or other valuables without paying cash on the spot, you are using trade credit. One drawback to trade credit is that it can be expensive. A supplier who offers a 2 percent discount on bills paid within 10 days, with the full or net amount due in 30 days, is actually charging a 36 percent annual rate of interest.
An angel investor is an individual who invests his or her own money in an entrepreneurial company. This distinguishes them from institutional financiers, who invest other people’s money. Angels come in two varieties: those you know and those you don’t know. They may include professionals such as doctors and lawyers; business associates such as executives, suppliers and customers; and even other entrepreneurs. Unlike venture capitalists and bankers, many angels are not motivated solely by profit. Particularly if your angel is a current or former entrepreneur, he or she may be motivated as much by the enjoyment of helping a young business succeed as by the money he or she stands to gain. Angels are more likely than venture capitalists to be persuaded by an entrepreneur’s drive to succeed, persistence and mental discipline.
Initial Public Offerings
Large amounts of capital have been raised in recent years by small companies that went public. Initial public offerings (IPOs) have made instant billionaires of entrepreneurs such as Yahoo’s Jerry Yang and Broadcast.com’s Mark Cuban. The same IPOs flooded the coffers of the companies with millions, if not billions, of dollars.
Going public isn’t for every firm, however. The ideal candidate for an IPO has both a well-established track record of steadily growing sales and earnings, and operates in an industry that currently is in the news. You may be able to go public if you have a whole lot of one of these characteristics and not much of the other–for instance, little earnings but lots of public interest have characterized many biotech and Internet-related IPOs in recent years.
The stringent requirements for IPOs leave out most companies, including those that don’t have audited financials for the last several years, as well as those that operate in slow-growing or obscure industries such as car washes and paper clip manufacturing. And IPOs take lots of time. You’ll need to add outside directors to your board and clean up the terms of any sweetheart deals with managers, family or board members as well as have a major accounting firm audit your operations for several years before going public. In other words, if you need money to grow today, an IPO isn’t going to provide it.
An IPO is also probably the most expensive way to raise money in terms of the amounts you have to lay out upfront. The bills for accountants, lawyers, printing and miscellaneous fees for even a modest IPO will easily reach six figures. For this reason, IPOs are best used to raise amounts at least equal to millions of dollars in equity capital.
Employee Stock Ownership Plans
Employee stock ownership plans (ESOPs) allow owners of privately held companies to share ownership with employees. Technically, ESOPs are defined-contribution employee benefit plans that invest primarily in the stock of the employer company. As such, most ESOPs distribute the stock to employees as a benefit, rather than selling employees the shares. ESOPs are commonly used to give retiring owners a way to cash out all or part of their holdings without selling the entire company. But creating a market for shares of the company can also be used to raise funds for expansion. ESOPs are easy to set up and are used by thousands of employers.
Venture capitalists represent the most glamorous and appealing form of financing to many entrepreneurs. They are known for backing high-growth companies in the early stages, and many of the best-known entrepreneurial success stories owe their growth to expansion financing from venture capitalists.
Venture capitalists (VCs) can provide large sums of money, advice and prestige by their mere presence. Just the fact that you’ve obtained venture capital backing means your business has, in venture capitalists’ eyes, at least, considerable potential for rapid and profitable growth.
VCs make loans to–and equity investments in–young companies. The loans are often expensive, carrying rates of up to 20 percent. Unlike banks and other lenders, venture capitalists frequently take equity positions as well. That means you don’t have to pay out hard-to-get cash in the form of interest and principal installments. Instead, you give a portion of your or other owners’ interest in the company in exchange for the VCs’ backing.
The catch is that often you have to give up a large portion of your company to get the money. In fact, VC financiers so frequently wrest majority control from and then oust the founding entrepreneurs that they are sometimes known as “vulture capitalists.” But VCs come in all sizes and varieties, and they are not all bad.
Venture capitalists typically invest in companies they anticipate being sold either to the public or to larger firms within the next several years. Companies they will consider investing in usually have the following features:
- Rapid, steady sales growth
- A proprietary new technology or dominant position in an emerging market
- A sound management team
- The potential for being acquired by a larger company or taken public in a stock offering
Venture capitalists seek very high rates of return; a 30 percent to 50 percent annual rate of return is typical. To generate these returns, they look for firms with proprietary technology, distribution systems or product lines that other companies might want to possess.
Small Business Innovation Research (SBIR) grants aim to stimulate technological innovation among small businesses. They let small businesses propose research projects designed to meet the federal government’s R&D needs. If approved, the research projects may receive grants of up to $75,000.
Direct Public Offerings
Direct public offerings (DPOs) allow you to sell stock directly to the public without the registration and reporting requirements of an initial public offering. DPOs are specifically designed to let small businesses access the public capital markets with less cost and complexity than is involved in IPOs.
DPOs typically raise amounts of less than $1 million, but you can raise up to $25 million with a DPO under certain circumstances. You can also advertise and promote the sale of your own stock if you hold a DPO, something other public companies are forbidden to do.
DPOs’ main limitation is the lack of a secondary market for securities. That means the stock of a DPO company is illiquid, so shareholders may have difficulty finding buyers for their shares in the event they want to sell. That is not necessarily bad for you, but it can be a deterrent to investors.
Small Corporate Offering Registrations (SCORs) let small companies raise money by issuing stock directly to the public without the help of an underwriter, as is used with IPOs, who buys the stock and resells it to the public. SCORs feature much less complicated regulatory oversight and document filings compared to standard IPOs and can be used to raise amounts of up to $1 million.
Selecting Your Expansion Financing Source
Choosing among the many possible sources of financing may be as simple as going with the only option that will take you. Ideally, you’ll have a choice of several options. And at least to start with, you should have a good idea what would be your preferred form of financing so you can go after the most comfortable choices first.
Your options will be dictated by several considerations, including how much money you need, how long you’ll need it, what you’ll need it for, and how much control you’re willing to relinquish. For instance, if you need to raise several million dollars, then venture capital, a stock offering or perhaps a well-heeled angel investor will be your best bet. On the other hand, if you need only $10,000, one of the SBA’s Microloans may be your best bet. expansion Financing lasting more than a few years is usually going to come from equity investors such as venture capitalists, angels or friends and family, unless you are financing real estate, when a bank loan would be suitable.
The reason you need the money will also come into play. A bank is unlikely to lend you money to allow you to increase your salary–that is going to have to come from someone with personal interests, such as an angel or family member. That same family member, on the other hand, will be unable to help if what you need is an international letter of credit to wrap up an across-the-border deal. Matching your financing source to your need will eliminate many possibilities. Control is another issue. If you want to maintain maximum control of the business, stick to family, friends and bank financing. Angels, venture capitalists and public markets are much more likely to want to see themselves or their hand-picked henchmen in the driver’s seat.
Who Wants What
Not all investors and lenders are looking for the same thing. Some are interested in preserving capital and generating interest income, while others are willing to risk everything for a shot at great wealth. Knowing what financing sources want can make the difference between getting expansion financing and having to do without.
Bankers are looking for interest income from a loan, along with a high likelihood that the loan will be repaid. They don’t want to control the business other than making sure it meets loan convenant standards, and they take collateral in lieu of repayment only as a last resort.
Venture capitalists want very high rates of return, usually through a sale of the company to another firm or the public via a stock offering. They usually want to have lots of input into how the business is run because they’re willing to take risks others avoid.
Angel investors vary widely, but they are typically willing to accept risk and demand little or no control in return for the chance to own a piece of a business that may be valuable someday.
Family and friends may be motivated more by personal concerns, such as showing that they care for the small-business owner, than by financial issues. They often fail to appreciate either risks or potential returns. They may ask for no control but later demand it if things go sour.
Estimating How Much You Need
When you started your business, you had to estimate the amount you needed to get going by combining your personal living expenses with startup costs and outlays required to keep the business running. It’s easier now because presumably all you have to worry about are ongoing expenses and expansion costs.
Thoroughness and caution are the keys to making a useful calculation of how much you’ll need to expand. Use the work sheet on page 86 to figure out how much you’ll need. To start, list all expenses related to running your business, as well as expanding it, in one column of a ledger pad or spreadsheet. Then add two more columns, labeled expansion costs and ongoing costs. In a separate area, place two lines labeled estimated income and other sources of funds.
Add up expenses projected for the coming year, including expansion and ongoing costs in the subtotals and total expenses lines. Put your estimated net income for the coming year in the estimated income line. Place the total of other sources of funds, such as savings and loans, in the other line and add these two together. Now subtract the total expenses from this amount. If the number is negative, this represents approximately how much financing you will need to pay for expansion.
There are many places to look for financing for your growing company. You can look to the same sources that helped you start your business or tap savings, profits, friends and family, banks, venture capitalists, or the stock market. Whatever you do, you’ll find it a lot easier to fund a growing company–and grow a company that is well-financed.