Bulletin #3008, Capital Sources for Your Business
Home-Based Business Fact Sheet
Capital Sources for Your Business
Adapted for Maine from Iowa by Jim McConnon, Extension business and economics specialist
Not having enough capital is the cause of many small business failures. Adequate capital is needed to start up the business, operate through hard times, and provide a good chance to become a profitable enterprise.
The first place to look for money is to yourself. How much money do you have to invest in your business as equity capital? Look at your savings, stocks, bonds, cash value of life insurance and equity in real property. How many of these assets you are willing to put into the business as equity capital is a personal decision. However, you must put at least some of your own money into the business. If you don’t have enough personal capital, then your first business sale will be selling a lender or investor on your proposal. Your selling ability is very important in determining the type and size of business you can enter.
There is no one best method of raising capital. Financing methods will vary as a result of legal, legislative and economic changes. A 1980 Wisconsin study of small businesses found that 1/4 of the firms interviewed said at least one lender had denied their loan application. However, 3/4 of this group said the same proposal was financed by another lender. Variations among lending institutions can affect your ability to raise funds. Your success in raising funds for a new business depends on good planning, realistic forecasting, and knowing what sources of capital are available.
To raise capital for your new business, you should be able to answer four questions.
- How much capital will I need?
- How much of my own capital can I put in the business?
- How much capital can I get from someone else?
- How can I convince someone to provide me with capital?
Planning your financial needs
Your ability to plan the financial needs of your new venture will play a big part in how much capital you will be able to raise. Prepare a loan package that includes your business plans, market analysis, projected balance sheet, profit and loss projections, and cash flow projections. Lenders prefer these financial projections monthly for at least one year, and then annually for three years.
The amount of detail and research needed in the financial projections is directly related to the amount of outside capital you hope to secure. In addition, a loan package must include the amount of the loan, how the loan money will be used, when the money will be needed, when the loan will be repaid, the source of repayment funds, and the amount of collateral you have to secure the loan. You should also include the amount of equity capital you are personally investing in the business venture.
Another part of the loan package should be personal information about you and anyone else involved directly or indirectly in the new business. Don’t assume the potential lender knows this information. Even if you have known each other for years, the lender may not have an accurate picture of your personal history and current financial situation.
The personal information included in the loan package should include education, work history and business experience of everyone involved in the new business. You should also include credit references, personal income tax statements for three years and updated financial statements. Information about the nature of the loan and personal histories of those involved may be a major factor in getting the loan.
If you seek professional help with the financial projections and loan package, it is vital that you be totally familiar with the financial information. Your knowledge and understanding of the loan package will be important when the lender evaluates it.
The five Cs of credit
What do lenders look for in a loan package? You, the borrower, provide part of the information, but the potential lenders will also use their own credit files and outside sources. A traditional, time-tested checklist is the five Cs of credit: character, capacity, collateral, conditions and capital. By understanding each of these from the lender’s viewpoint, you can anticipate your strong and weak points as they may appear to a potential lender.
To the potential lender, character means that you will make every possible effort to repay the loan. You must be a good manager, be honest, and have a good reputation as perceived by the lender. Therefore, it is important to be honest about your personal strengths and weaknesses.
Will your new business generate the cash flow to repay the loan? Do you have the capacity to repay the loan? Lenders not only look at the business’s financial projections, but also your ability to repay the loan if the business does not work out as planned. Do you have outside income (investments, a working spouse)? Would you be able to return to your present job? Do you have other skills that could produce income? Be prepared to provide solid answers to these questions and be able to offer real evidence.
In case the new venture is not successful and the lender must foreclose, will the collateral cover the loan? Is the collateral adequately insured? Is the collateral marketable? In the past, a co-signer (someone who signs the loan along with you) has been used as collateral for many small business ventures. However, banks and traditional lending institutions now look less favorably at co-signers as collateral. Collecting from co-signers is becoming increasingly hard, and bankers then lose not one, but two customers. You can use your home or other real estate, cash value of life insurance policies or marketable securities as collateral for business loans. However, before borrowing against these items, consider carefully the consequences of the worst possible situation in your business if you are forced to liquidate.
Conditions are those factors over which you have little or no control. The lender will look at the conditions, or trends, in the overall business economy, the trends in your community, the seasonal character of your business, and the nature of your product or service. Other factors entering the decision-making process are whether the lender may have already invested in a competing business and how much competition there is in your market. Be prepared to tell the lender how you plan to deal with these conditions, how you have assessed the market, and how your business will weather economic changes.
Knowledgeable lenders will not put money into a new business unless they have concrete evidence that you have personally made a sizable financial commitment to the business. They know from experience that if the venture turns bad it will be easier for you to back out if you do not have your own money at risk. From your personal resources, you should try to provide as much of the needed capital as you can afford to put at risk. Depending on the capital needs, you cannot expect any lender to loan 80 percent or more of the capital, as they may for a home or investment real estate. New small businesses fail at a rapid rate and when they do fail, the assets cannot be easily turned into cash for payment of the loan. Therefore, a new business is a much higher risk for them than a home loan. You should expect to invest a much higher percentage of the needed capital for your new business.
Types of capital
Different types of small businesses require different amounts and types of capital to get started. In some cases, the new businesses may only need capital for short periods of time for inventory purchases or salaries. In other cases, facilities and equipment must be bought or leased, inventory purchased, and you must have enough cash left over to run the business until revenue can support the needed cash flow. Knowing the type and amounts of capital needed will help you figure out the best source of capital for your new venture.
Equity versus debt capital
If you do not have enough personal capital, you can sell equity or you can incur debt. If shares of equity are sold in a partnership or corporation, the capital is not repaid, but the investor takes an ownership interest in the business and receives a portion of the business’ profits. Even though equity capital does not burden a new business with loan repayments and interest charges, it reduces the primary owner’s share of the profits. Debt must be repaid with interest, but normally the lender has no ownership control. Borrowing money at the very start of a new business will drain off income to make the debt payments.
There are three types of commercial loans that are usually defined in terms of the length of time the loan is made.
- Short-term commercial loans (30 to 90 days) are the most common loans made to a small business. They usually cover business operation expenses such as rent, insurance, advertising, inventory or salaries. Short-term loans are often unsecured and repayment is usually a lump sum, including interest when the loan matures.
- Intermediate-term loans are for one to five years to purchase business equipment, buy fixed assets or provide working capital. Intermediate-term loans are usually secured by the new equipment or business assets. They sometimes have low monthly payments, with a large balloon payment at the end of the term.
- A long-term commercial loan is for five years or more to purchase an existing business, buy real estate, or construct or improve a building or facility. The long-term loan is always secured by the assets for which the loan was made, usually requires constant monthly payments and often has a variable interest rate.
Ten sources of capital
With your new business plan, financial projections and financing knowledge, you are now ready to secure outside capital for your new venture. The following 10 types of financing sources are ranked according to amount of preparation required and ease of securing the outside capital. Less preparation to secure a loan does not mean it is the best source, nor the least expensive source of capital. Of course, there will be exceptions to these general statements about each financial source.
1. Trade or supplier credit
Payment terms offered by your suppliers are a potential source of credit. Study the discounts for early payment and the penalty for late payment to determine the true cost of the credit. While some suppliers will extend credit only to well-established, proven firms, many will extend limited credit to new businesses to encourage another outlet for their merchandise. Planning for use of trade credit is essential. To establish good trade credit, a new business must make timely payments as agreed. Trade credit is effectively used by large businesses to buy products at lower cost than small firms. Do not depend too much on trade credit from one supplier. If repayment problems arise, you may find your major source for supplies cut off when you need it the most.
2. Life insurance policies
A standard feature of most life insurance policies (except term insurance) is the owner’s ability to borrow against the cash value of the policy. The money can be used for any business or personal need. It normally takes two years for a policy to accumulate sufficient cash value. You may borrow up to 95 percent of the cash value of the policy for an indefinite period of time. As long as you continue to pay the insurance premiums, the interest can frequently be deferred indefinitely. The policy loan will reduce the dollar value of the policy and, in case of death, the loan is repaid first and then the beneficiaries receive the remainder. Some older life insurance policies guarantee very favorable interest rates.
3. Friends and relatives
It is best not to borrow from friends and relatives, but many people do. If you must borrow from a friend or relative, do it on a business basis by putting the agreement in writing. Check with a lawyer if you want a binding, legal agreement. You may also get a sample business loan contract form from a bank or lending institution. Use it as a basis for a written agreement that both parties find acceptable. Unrealistic and/or naive investment expectations have ruined many friendships and family relationships.
When customers pay for work in installments as it is completed or provide some of the materials, they are, in effect, financing the business. For example, a carpenter reduces capital requirements when the customer purchases the building materials for a remodeling project. In addition, it is not uncommon to request a deposit from customers when ordering items, particularly special items.
5. Leasing companies
Leasing business equipment is another way to reduce capital needs. Everything from office furniture to food processing equipment can be obtained from leasing companies or commercial finance companies. Leasing is generally more expensive than bank financing and is limited to items that have a long serviceable life, widespread use, and are easily repossessed in the event of default. In many cases, you have the option to buy the equipment for an agreed upon amount at the end of the lease period.
6. Commercial finance companies
Commercial finance companies are generally seen as the place to go when you are unable to secure financing from a bank. Commercial finance companies, like banks, are concerned with your ability to repay the loan; however, they are more willing to rely on the quality of the collateral rather than your track record or profit projections. If you do not have substantial personal assets or collateral, a commercial finance company may not be the best place to secure start-up capital for a business. Commercial finance company capital is usually several percentage points higher than bank financing.
7. Commercial banks
Commercial banks are by far the most visible lenders and make the greatest number and variety of loans. However, banks are generally conservative lenders. Although they accept collateral for business loans, loan approval rests on your ability to repay the loan as shown by your profit projections, management skills and your personal record. Strive to establish and keep a good working relationship with your banker. It may help to involve the banker in the planning process for your new business. Avoiding the banker until you need money may make a loan harder to get because the banker is unfamiliar with the business and its history.
8. Small Business Administration
The Small Business Administration (SBA) is an independent government agency formed in 1953 to help small businesses. The SBA provides loan guarantees, participates with bank loans, and, if funds are available, makes a limited number of direct loans. To receive financial help from SBA, a business must be unable to secure reasonable financing from other sources. A business must also fit the SBA’s generalized criteria for a small business, which vary for different types of businesses.
SBA loan interest rates vary from year to year based on the cost of money to the government. Also, the maturity of a SBA loan is limited to 10 years, except for the purchase or construction of buildings that may have a maturity of 20 years. A loan proposal for the SBA is generally more complex and more documented than one for banks. Unlike commercial lenders, the SBA will sometimes ignore a losing track record if a business shows signs of improvement with a healthy future. For more information, contact the SBA office in Maine:
Small Business Administration
40 Western Ave.
Augusta, ME 04330
9. Small Business Investment Companies
Small Business Investment Companies (SBIC) are privately owned companies that are licensed and regulated by the SBA. SBICs were created to supply equity capital, long-term loan funds and management help to small businesses. There are investment companies in Maine that are ready to help businesses with excellent potential. Most investment companies prefer to lend to established companies or finance purchases of existing businesses. The SBA or your local bank can assist you in contacting one of the SBICs in Maine.
10. Rural Economic and Community Development Agency
The Rural Economic and Community Development Agency (RECD) will guarantee term loans to nonfarming businesses in rural areas. The guarantees can cover up to 90 percent of the total loan from a private lending institution, and there is no loan limit for one company. The RECD requires the same extensive loan documentation as the SBA. However, RECD’s goal is to improve rural areas and, therefore, the agency requires more detail on number of jobs to be created and the impact the new business would have on overall employment in an area. For more information, contact the State RECD Headquarters in Bangor at (207) 990-9110.
There are many sources of capital for the small business with good potential. However, there is no substitute for putting your financial assets on the line in starting your own business. Securing capital for any new business will require well-developed business plans, financial projections and knowledge of sources of financial support. However, like any small business person, commercial lenders are also in business for profit.
The Home-Based Business Fact Sheet Series
This is one of a series of publications designed for the person entering or considering a new business operation. See the University of Maine Cooperative Extension Online Publications Catalog for the complete Home-Based Business fact sheet series.
Information in this publication is provided purely for educational purposes. No responsibility is assumed for any problems associated with the use of products or services mentioned. No endorsement of products or companies is intended, nor is criticism of unnamed products or companies implied.
© 2001, 2008
Call 800.287.0274 (in Maine), or 207.581.3188, for information on publications and program offerings from University of Maine Cooperative Extension, or visit extension.umaine.edu.
The University of Maine does not discriminate on the grounds of race, color, religion, sex, sexual orientation, including transgender status and gender expression, national origin, citizenship status, age, disability, genetic information or veteran status in employment, education, and all other programs and activities. The following person has been designated to handle inquiries regarding non-discrimination policies: Director, Office of Equal Opportunity, 101 North Stevens Hall, Orono, ME 04469, 207.581.1226.