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New businesses with an established business plan that have begun to make a profit (or are on the verge of making a profit) often need additional funding to grow the business, manage cash flow, enter into new lines of business or hire key employees. This additional infusion of funds is often needed to take the burgeoning business to the next level. Once a business has made the decision that it needs additional funding, the threshold issue will be the form or type of funding that may be preferable and available to the business. In broad terms, there are basically two types of financing a business may obtain - equity financing and debt financing.
For new companies without an established history of profitable operations, traditional debt financing from a financial institution may be unavailable or limited, and the business must seek investments from outside investors such as friends, family, so-called "angel investors" or, in some instances, venture capitalists. An angel investor is generally an individual or group of wealthy individuals who invest in early start-up companies. Angel investors tend to come in earlier and usually invest less than your typical venture capitalist. Venture capitalists are generally a group of investors or a firm which raised a substantial amount of funds to invest in high growth and often high risk new ventures. Typically, venture capital firms are willing to make a larger investment but also generally have more onerous terms of investment than an angel investor.
These types of outside investors generally want to provide equity financing, which is money raised by a company in exchange for an ownership interest in the business. Equity financing allows a business to obtain funds without incurring debt, that is, without having to repay a specific amount of money over a particular period of time. From a cash flow perspective, equity financing can be enticing because it contributes to the capital of the company without an obligation of repayment in the near term. With that said, by allowing an individual or group to purchase equity of the business, it dilutes the ownership of the founders, and the investors may require control over certain management aspects of the business. Along with gaining some control over the business, the new equity investors are given the opportunity to participate in the future growth of the business (as well as any potential downturn). As owners of the business, the equity investors will have certain rights such as rights to inspect the company's books and records and may be owed certain duties of care and loyalty from management or the other owners. While, at the outset, the equity financing option may seem a relatively simple and "cheap" option to raise funds, it must be done with the mindset of having a long-term business partner and not a short-term vehicle for an influx of cash. Also, any equity financing transaction is going to involve a "security" and both the federal and state securities laws must be reviewed, analyzed and complied with as part of the equity financing transaction.
Debt financing from a traditional lender (i.e., banks, credit unions, etc.) or a non-traditional lender (i.e., a friend/family member, state or local government, or certain specific financing companies) means borrowing money that must be repaid over a period of time, generally with interest. The terms of debt financing can vary, but the main terms include (i) the length of time in which the loan must be repaid, (ii) the interest rate, (iii) whether the loan will be secured and, if so, the nature of the collateral, (iv) what financial covenants and debt to equity ratios must be maintained during the term of the loan, and (v) whether it will be personally guaranteed. These terms are driven not only by the credit worthiness of the business and its owners, but also by macro-economic forces (i.e., the current interest rate environment, etc.). Generally, lenders review the business operations in making the lending decision including:
- the company's business plan summarizing the business opportunity, the experience of the management team and the overall expectations for the business' growth and financial projections over the next 3 to 5 years;
- the company's cash flow or "EBITDA" (earnings before interest, taxes, depreciation, amortization) for a period of time (typically a year);
- asset coverage which typically looks at the physical assets and determines the value of assets that are "readily" saleable and its ratio to the proposed debt amount (i.e., 70%); and
- the overall "loan to value ratio" which is a ratio of the loan compared to the value of the business, which may be established by the lender or an appraiser hired by the lender (often paid for by the borrower).
In addition, lenders commonly require the owners of the business to personally guarantee the loan in the event of a default. This provides additional security (in addition to the assets the lender has taken as collateral) to the lender and ensures that the business owners have a sufficient personal interest at stake in the business. Traditionally, it is more difficult to obtain debt financing for small businesses, but traditional lenders are a major source of financing to small businesses for short-term loans (a year or less), seasonal lines of credit, and single-purpose loans for machinery and equipment. Traditional lenders have in the past been more reluctant to enter into longer term loan agreements with smaller businesses, but establishing a relationship with a lender with a short-term or single purpose loan will often open the door to future long-term lending opportunities and the ability to negotiate more favorable terms in the future. It may also be worthwhile to investigate available government programs, such as the Small Business Administration's guaranteed lending programs or regional economic development funds, which often allow lenders to enter into long-term loans to small businesses by reducing their risk and leveraging the funds they have available.
When making these often difficult funding decisions, the business owners must review all aspects of their current business and their expectations for the near and long-term vision of the business. Among other factors, owners must consider the prospect of having another owner (the equity investor) involved in the business, the ability to pay back any loan and the business's overall debt to equity ratio. A company with excessive debt obligations may be very vulnerable to short term or seasonal downturns or fluctuations in the economy that could put the company into default. There are several options and structures for obtaining additional funding for a growing business, but the first step is for the business owners to consider how much funding the business actually needs to reach its goals and what compromises the owner is willing to make to obtain that funding. If you have any questions about the differences in the types of funding, the sources of funding or preparing your business to seek funding, please feel free to give us a call or send us an email. We are here to help.
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The Devine, Millimet & Branch Small Business Practice Group offers this free E-Mail Alert service to provide information on recent developments in business law. If you have any questions about this e-mail, or if you know of anyone else who may be interested in receiving these alerts, please send us an email at smallbusiness@devinemillimet.com.
This is not a legal document nor is it intended to serve as legal advice or a legal opinion. Devine, Millimet & Branch, Professional Association makes no representations that this is a complete or final description or procedure that would ensure legal compliance and does not intend that the reader should rely on it as such.
© Copyright 2013 Devine Millimet & Branch, Professional Association
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