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VENTURE CAPITAL - STARTUP PLANS

March 1, 2011

 

BUZZWORDS: ANGELS AND OTHERS

Venture capital is not the only source of investment for start-up businesses or small businesses. Smaller investors in what is called “private placement” finance many companies. For example, in some areas there are groups of potential investors who meet occasionally to hear proposals. There are also wealthy individuals who occasionally invest in new companies. In the lore of business start-ups, groups of investors are often referred to as “doctors and dentists,” and individual investors are often called “angels.” Many entrepreneurs turn to friends and family for investment.

WORDS OF WARNING

Don't take private placement, angels, and friends and family as good sources of investment capital just because they are described here or taken seriously in some other source of information. Some investors are a good source of capital, and some aren't. These less established sources of investment may be necessary, but they should be handled with extreme caution.

Never, NEVER, spend somebody else's money without first doing the legal work properly. Have the papers done by professionals, and make sure they're signed. Never, NEVER, spend money that has been promised but not delivered. It is amazing how often companies get investment commitments and contract for expenses, and then the investment falls through.

Avoid turning to friends and family for investment. The worst possible time to not have the support of friends and family is when your business is in trouble. When friends and family finance the business, you risk losing friends, family, and your business at the same time. I know an entrepreneur who stuck with a losing business for six years longer than he should have, because he started it with money from friends and family.

Where to find them? Your next question of course is how to find the “doctors, dentists, and angels” that might want to invest in your business. Look for lists of government agencies, business development centers, business incubators, and similar organizations that will be tied into the investment communities in your area. Turn first to the local Small Business Development Centers.

WARNING

Be very careful in dealing with anybody who offers to help you find financing as a service for money. These are shark-infested waters. I am aware of some legitimate providers of business plan consulting, small business finance consulting and related assistance, but the legitimate providers are harder to find than the sharks. In general, you should never pay money in advance for investment finding services, and a request for money in advance should be a warning signal. There are more fakes and frauds in the business of finding investment than there are legitimate finders. Be careful! Beware of experts asking money in advance for finding investment.

BANKS

Banks are even less likely than venture capitalists to invest in or loan money to start-up businesses. They are, however, the most likely source of financing for most small businesses.

Start-up entrepreneurs and small business owners are too quick to criticize banks for failing to finance new businesses. Banks are not supposed to invest in businesses, and are strictly limited in this respect by federal banking laws. The government prevents banks from investment in businesses because society, in general, doesn't want banks taking savings from depositors and investing in risky business ventures; obviously, when (and if) those business ventures fail, bank depositors' money is at risk. Would you want your bank to invest in new businesses (other than your own, of course)?

Furthermore, banks should not be loaning money to start-up companies either, for many of the same reasons. Federal regulators want banks to keep money safe, in very conservative loans, backed by solid collateral. Start-up businesses are not safe enough for bank regulators, and they don't have enough collateral.

Why then do we say that banks are the most likely source of small business financing? Because small business owners borrow from banks. A business that has been around for a few years generates enough stability and assets to serve as collateral. Banks commonly make loans to small businesses backed by the business' inventory or accounts receivable. Normally there are formulas that determine how much can be loaned, depending on how much is in inventory and in accounts receivable.

A great deal of small business financing is accomplished through bank loans based on the business owner's personal collateral, such as home ownership. Some would say that home equity is the greatest source of small business financing.

OTHER LENDERS

Aside from standard bank loans, an established small business can also turn to accounts receivable specialists to borrow against its accounts receivables. The most common accounts receivable financing is used to support cash flow when working capital is hung up in accounts receivable. For example, if your business sells to distributors that take 60 days to pay, and the outstanding invoices waiting for payment (but not late) come to $100,000, your company can probably borrow more than $50,000. Interest rates and fees may be relatively high, but this is still often a good source of small business financing. In most cases, the lender doesn't take the risk of payment - if your customer doesn't pay you, you have to pay the money back anyhow. These lenders will often review your debtors, and choose to finance some or all of the invoices outstanding.

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