Getting Money

***These are notes from a seminar I have given in the past.***

Overview of Primary Sources of Money.  For the most part, you have around 5 sources of money:

1.      Family, Friends and Business Associates.  A place to start, but limited – and you may have to deal with personal relationships.  This might be your seed round private placement of company stock.

2.      Lenders.  The price of debt financing is that you must pay interest and fees, and likely secure the loan with your personal assets.  Otherwise debt is a clean source of financing.

3.      Venture Capital.  VC financing is possible for certain industries that have a clear exit event – usually the company being bought out or going public.  The price of VC money is that you will give up a good bit of ownership and control to the VC, and a larger portion of your upside come the exit event.

4.      Equipment Leasing.  Leasing is very similar to secured lending.  You only use it if you need to purchase specific assets.

5.      Government Agencies.  Your handout contains lists of federal and state programs that are available to finance your business.

Know Where You Are Going.

The most important thing you can do for yourself in this process is: know where you want to go.  Have a well developed, thoughtful and careful business plan.   Once you have your business plan, you can answer the 2 basic questions for financing, those being:

1.      Why do you want the money?  Usually you want capital for growth. Your business plan should show how you will use the money, your projected financial results from the use of the money, and the time needed to achieve the results.

2.      How much money do you need?  Your business plan should show how much money you need today, next year and the year after that. The amount of money you need depends on your projected operations, your growth and your revenues.

Early investor money is difficult to get and is expensive.  When I say expensive, I mean interest rates are high and you will give up a larger percentage of equity to the investor.  This is fair given the risks.

Now, given these high costs, you have to think about how much money to get.  There are 2 schools of thought in getting money:  The first is get only the money that you need now, no more.  Don't give up too much equity or incur overly burdensome debt service obligations.  The second school of thought is get more than you think you need, because you always need more than you think, and you don’t know if the money will be available later on. 

You also have to think about what type of money to get – equity or debt.  The wrong type of money can hinder future growth.  For example, too much expensive debt will overburden you, but giving away too much equity early on limits your ability to get more equity financing later on (and dilutes you).

Ideally you will use the early, expensive money to fund your growth and later get cheap money. Cheap financing includes an IPO and the loans that are offered to mature businesses.

Know What They Want.

First and foremost, investors (including lenders) want to see 3 things:

1.      A product or concept that gives you a competitive edge in a growing market.

2.      Alert and motivated management that has the right experience in marketing, production and finances.

3.      A real business plan.

More than one VC has told me that of the 3, the most important is the management team.

Once you have shown the basic 3 elements, then the investor will consider:

A.     The amount of money that you will need to produce a sustained level of earnings and growth.

B.     The rate of return that your business can provide.

C.     The services that you will need, including management assistance and future financings.

Sources of Money.  Let's go through the sources of money again, in more detail.

1. Family, Friends, Business Associates.  You can structure this financing as either debt or equity.

         1.1. Loans. Having family and friends give unsecured loans is your cleanest option.  Business associates likely will demand security.  [Accountant: If you structure the financing as a loan, then document the loan with an interest bearing promissory note.  For non-bank and other non-exempt loans, the maximum legal interest rate is the higher of 10%, or 5% plus the Federal Reserve's discount rate (in August, the discount rate was around 6.2%, so the maximum legal rate would have been around 11.2%).  The minimum rate for the loan would be the discount rate. ]

        1.2. Equity.  If you structure the financing as equity, then beware of giving too much.  Giving too much equity might over-dilute you and affect your ability to get VC financing later on.  If you have access to seed investors, you would carry out this financing most likely as a 1st round private placement of company stock.

2. Lenders. 

        2.1. Types of Lenders. Lenders include banks, non-banks (like factorors of accounts receivable) and government agencies.  I will talk about government backed loans later. 

        2.2. Price of Debt Financing.  The price of debt financing includes interest, loan fees, and loss of some control.  You might lose some control because the lender might require basic covenants from you concerning the operation of your business.  The lender also might ask for a warrant for stock.  Of course, the biggest risk is that you will give collateral to the lender – and if you default, the lender will foreclose. 

        2.3. Security.  Security includes guarantees from you and the other principals, mortgages, and security interests in the assets of the business.  Banks like to see hard assets and a positive cash flow.

        2.4. Equity Kickers.  Silicon Valley lenders more and more like to take warrants and other equity.  Unlike boilerplate loan terms, you can and should negotiate the terms of the equity kickers.

        2.5. Loan Documents. The documents you will see are mostly a commitment letter, a loan agreement, a note, a security agreement, a deed of trust, then a whole lot of little boilerplate documents.  Lawyers work the big loans, but not the small loans.  A smaller loan is around $5 million or less.  For smaller loans, banks do the work using form documents, mostly "Laserpro" documents.

        For smaller loans, you do most of your negotiating in the Commitment Letter: usually interest rate, loan fees, prepayments and prepayment penalties, financial ratios and the like.  A good business lawyer can help a lot here, but should spend only a couple of hours doing it.  You would not much negotiate the other terms of the loan documents.  The documents are for the most part fair, though, because they have standard market terms – for example, you're not going to negotiate away the bank's foreclosure rights.

3. Venture Capital.

        3.1. Local VCs.  One frequently overlooked source of VC financing are SBICs.  An SBIC is an SBA licensed, privately owned small business investment company.  SBICs usually provide debt financing, and they take equity kickers.  SBICs frequently go in alongside ordinary bank lending, where the SBIC takes a subordinate position to the bank.

        3.2. Price of VC Financing.  The price of equity financing is this – to get the money, you give up a percentage of your company and some control over your company.  That's the nature of the deal.  How much you give up for what amount of money depends on your bargaining strength. 

        Your equity in the company will be diluted.  For a VC backed company that reaches IPO, a rough estimate of the percentage of stock retained by all of the founders together at the time of the IPO is: (get ready) less than 10%.  The other 90% goes to the IPO shareholders, the VCs and the option plan.  That's a lot of dilution, but then again, this smaller piece of something is better than 100% of nothing, which could be the alternative if you can't find financing.

        3.3. Smart & Dumb Money.  Given the cost of VC financing, you may consider the difference between smart and dumb money.  Smart money brings you something more than just money – maybe industry knowledge, management assistance, ability to line up additional financing, and relationships with investment bankers. Investment bankers can help with ultimate liquidity through IPO or the sale of the business.  Dumb money is money without any other benefits.

        3.4. Control and Poison Money.  A VC can get control over your company in 2 ways: first, directly through its percentage ownership of your company, and second, through the right to veto certain actions of the company.  For example, you might want to merge with or be acquired by another company, and then go work for the new company.  Your VC investors likely will have the right to block the sale if they want to.

        Poison money – take it and you die.  Poison money is money that comes with VC control attached, and where you have a problematic relationship with the VC.  Officers at the VC might not like you, and you might not like them.  Everyone has an ego, and things can get personal.  At some point, the VC might decide that the company would be better off without you.

        3.5. Exit Event.  VCs like to see an exit.  Most VCs don't want to keep their money in your company for more than 5 to 10 years or so.  VCs want to see a clear exit event – usually IPO or the sale of your company.  To get VC money, you should be in an industry where this kind of exit is foreseeable.

4. Side Note: Keeping You On The Hook.  Here's a little side note for you: most lenders and VCs want to make sure that you, the founder and key executive, will stick around with the business.  Devices to keep you on the hook include:

        4.1. Personal Guaranties.  There is no better way to show your commitment than offering up your house.  Lenders use guaranties. 

        4.2. Repurchase and Buy-Out Rights.  A VC might require that you sell some or all of your stock back to the company if you were to walk away within a certain number of years.

        4.3. Deferral of Compensation.  You might be required to sign an employment agreement where you defer some of your compensation to future dates.  No investor wants to see you pull funds out of the company.

5. Equipment Leasing.  Equipment leasing is very similar to secured lending.  The biggest difference is that you only use leasing if you need to buy a specific asset.  You don't use leasing if you need money for working capital, R&D and the like.  The basic idea is that, legally, the lessor owns the asset, and you have the right to use it and eventually buy the asset for a nominal price.  You pay the lessor lease payments that basically look the same as principal and interest on a loan.  [Accountant: One good thing about a true lease (in accounting speak, an operating lease) is that it can be off-balance-sheet financing.  This means that the lease will not appear as a liability on your balance sheet.  You really can't hide the liability, though, because you'll have to disclose it in the notes to your balance sheet.  But you might not need to take the lease into account, for example, for a debt-to-equity ratio requirement in a bank's loan agreement. ]

6. Government Programs for Small Businesses.  Last, we'll say a few words on government programs.

        6.1. Many SBA and California Programs help finance small businesses. On the handout I describe for you the major programs, and I give you contact information.

                   6.1.1.  [SBA Lender: Banks Provide the Money.  Usually it's a bank, not the government agency, that gives you the money.  Therefore your contact will be your loan officer at the bank.  This is good, because it begins a relationship with the bank that might lead to future loans. ]

                    6.1.2.  Loan Guaranties.  The government agency usually helps by giving the bank a partial guaranty of the bank's loan to you.  This persuades the bank to give you the loan.

                    6.1.3.  Security.  Sometimes the government agency requires personal guarantees from the principals, and a security interest in the assets of the business. 

Some Final Thoughts.  Well, we've covered a lot of ground today.  I hope that you've found this program useful.  I hope even more that you take advantage of this opportunity to get to know some of the lenders, accountants and other professionals in this room.  We all can help you develop your business.  Let me leave you with these final thoughts:

1.      Get yourself the help that you need, including a good accountant, a good lawyer, and payroll service people.

2.      As I'm sure you know, make sure your business plan is ready, including financial projections and market studies. 

3.      Know what dilution and control that you are willing to give up for the money.  For example, if you're not willing to give up a large stake of equity and some measure of control in your business, then debt financing might be your best option.

4.      Determine whether you can support the payment of interest and principal.  You will need to compare your present and projected income to the cost of servicing your debt financing, to determine what (if any) debt you can afford.

5.      Are you willing to put your home on the line?  For debt financing, you may be required to give a guarantee.

Thanks for coming.  I wish you all great success.

Call me to schedule a legal consultation: 510-796-9144