External Sources of Cash
External Sources of Cash
This is the process of raising capital for your business from external sources, such as lending institutions, venture capitalists, or even you, the owner. If you have been in business for any length of time, chances are you're you are familiar with many of them.
External sources of cash can be broken down into two basic categories: Equity (Invested Funds) and Debt (Borrowed Funds).
Equity (Invested Funds)
Also called Equity Financing, this is the sale of some percentage of your business in return for an infusion of funds. The best option is for you (the owner) to invest funds into the business yourself, but this may not always be possible. If this is the case, you may choose to take on a new business partner (active or silent) in return for the money.
To maximize this opportunity, shares should be sold when the value of your business is high. In other words, try not to use this as a source of cash if you are going through hard times. This is a much better source of cash for fuelling a period of growth.
Some sources of invested funds are:
a. Angel Investors — These are individuals who invest in businesses. The relationship is typically arms length, although the investor may wish to join the Board of Directors. Angel Investors are quite rare.
b. Venture Capitalists — These are more formal institutions that invest in businesses.
c. New Business Partners — These are individuals or businesses that invest in businesses, typically with the intention of taking an active part in its ongoing operation.
As attractive it this may seem, involving others in the ownership of your business should be approached with extreme caution. In many ways, it is like a marriage, so spend a great deal of time making certain that you are involving yourself with the right people. Unlike a marriage, however, you should get your lawyer involved early on in the negotiating process. You'll want all of your agreements to be in writing, plus, you'll want an exit strategy, should things not go as planned.
Debt (Borrowed Funds)
Also called Debt Financing, this is the process of raising money by borrowing it. Most commonly, lenders will require this type of loan to be secured by fixed assets (such as your building). This can be an effective method of generating cash for growth since it provides financial leverage; that is, it allows your business to make significant financial moves based on the future success of those moves. Also, any interest paid on a business loan is usually tax deductible, but not always. If at all possible, interest rates should be locked in when you do this in order to facilitate the budgeting process.
With borrowed funds, care must be taken that your debt does not get out of control. Too much debt increases your risk of not being able to pay back your loan. Also, too much debt can make it more difficult to get additional financing down the road, should it be necessary. While there are no hard and fast rules here, as mentioned before, a ratio of more than 3:1 should probably raise a flag of caution, depending on your industry.
In general, it's more difficult to get financing to pay off bills, than it is for growth. The moral is to secure sources of money when times are good so you don't have to go looking for it should times get tough. A credit line can be a good option because it costs you little or nothing until you use it.
Some sources of borrowed funds are:
a. Banks — This is usually the place to start, but the banks are not your only option as a business owner.
b. Government — Government programs are always changing, so check with your local representatives. Be sure to check for programs at all levels of government. There may be grants, tax breaks and other types of support available as well.
c. Commercial Lenders — These include credit unions, life insurance companies, leasing companies and pension funds and foundations.
d. Private Lenders — Some individuals are willing to lend money for a rate of return, rather than an equity stake in your business.
e. Suppliers — Your suppliers have a vested interest in seeing you succeed. They may be willing to extend your credit with them in return for some type of purchasing guarantee.
f. Friends and family — You may know people who would be willing to loan money to your business for a reasonable rate of return. No matter whom you borrow from, it's usually a good idea to sign a contract with them. Mixing business with friendship can be more complicated than other forms of business, so it is wise to keep it as formal as possible.
g. Personal savings or credit — If you have the money, funding your business yourself is an extremely safe option.
Following are the three basic types of loans to consider for your various needs.
Lines of Credit (Operating Loans) — These are revolving loans that can be used as needed. You may currently use one as an operating loan, dipping into it during the slow time of the year and paying it back when sales pick up. If your business is doing well, you may receive offers of this type from lenders to help you grow your business, and now is a good time to accept. An unused line of credit is an excellent source of growth capital.
Short-Term Loans (Current) — These are temporary loans that must be paid back within one year. A contractor might use a short-term loan, for example, to bridge the financial gap between the start of a project and the time the money comes in, using the value of his receivables as collateral.
Long-Term Loans (Fixed) — These loans take several years to pay back. They are larger loans such as property mortgages, and depending on the asset base of your business, you may be required by the bank to personally guarantee this type of loan. In fact, if your business is still young, you may be required to personally guarantee any loan from a bank.
It's much easier to find investors to help you fly higher than it is to find investors to pull you out of a downward spiral. So manage your finances carefully and establish credit when times are good. This kind of foresight will keep you out of trouble should times get ever tough.
Consider the ideas for externally generating cash listed above, and then develop a list of your own in the space below. We'll use this list when designing your Financing Systems.