How will you finance your business? The majority of the funding will need to come from you. Personal savings or loans from family and friends finance the majority of business start-ups. Other sources of funding may include bank loans, partners and private investors.
Personal sources of funds may include checking and savings accounts, personal loans, second mortgages, profit sharing, retirement accounts from former jobs, certificates of deposit, personal assets that can be sold or credit card borrowing. While credit cards are sometimes used, this type of unsecured debt can be problematic for a new business. Often times, entrepreneurs do not include a plan on how they will pay back the money. Financial contributions from family, friends and colleagues may result in a desire to have a voice in how your business is managed.
Debt and Equity Financing
Banks are the primary providers of formal loans. Most banks will make a personal loan to good customers with a good credit rating. Commercial banks, savings and loans, credit unions and finance companies also provide funding. These institutions will require collateral, be concerned with your character and reputation, want to know about the cash flow of the business and your willingness as the borrower to risk your own money.
Types of Financing
Financing is typically categorized into two fundamental types: debt financing and equity financing.
Debt financing means borrowing money that is to be repaid over a period of time, usually with interest. Debt financing can be either short-term (full repayment due in less than one year) or long-term (repayment due over more than one year). The lender does not gain an ownership interest in your business and your obligations are limited to repaying the loan. In smaller businesses, personal guarantees are likely to be required on most debt instruments; commercial debt financing thereby becomes synonymous with personal debt financing.
Equity financing describes an exchange of money for a share of business ownership. This form of financing allows you to obtain funds without incurring debt; in other words, without having to repay a specific amount of money at any particular time. The major disadvantage to equity financing is the dilution of your ownership interests and the possible loss of control that may accompany a sharing of ownership with additional investors.
Selecting Your Financial Institution
How do you determine from which institution to seek financing?
Use an attorney or accountant familiar with your type of business.
Shop around and talk to different bankers to find one with an understanding/appreciation of your type of business.
Network with other small businesses.
Research several institutions to find the one that is the best fit for you. (Banks offer different business services and their rates will vary.)
Questions to ask a financial institution/banker may include:
Have they financed this type of business before?
What is the average size of the loans they finance?
What are their professional backgrounds, especially in terms of whether they are commercial or consumer lenders?
Do they have the level of lending authority you need?
When meeting with the financial institution/banker:
Make an appointment - do not walk in "cold" to make a loan request.
Remember that first impressions are lasting.
Be prepared - the better prepared you are, the better reception you'll get
Find out how they handle loan requests - verbal presentation first, submitting a written loan request prior to meeting face to face.
Follow up on any questions for which you do not have answers.
Listen carefully to their suggestions or proposals.
Set a timeframe for follow-up/review.
Questions you may be asked:
Do you have experience operating a business?
How committed are the chief operators to the business?
Can the business repay the loan? (will the cash flow be greater than debt service?)
Can you repay the loan if the business fails? (is the collateral sufficient to repay the loan?)
How will your business collect its bills?
How will your business control its inventory?
How will your business pay its bills?
How will your business control expenses?
Will you have any discretionary cash flow?
What is the future of the industry?
Who is your competition and what are their strengths and weaknesses?
When you meet with a lender, you should bring:
A listing of personal assets
Credit references and those of any partners
A comprehensive business plan
Banks are not charitable institutions. They are in business to make (not lose) money. So, when a bank lends money it wants to ensure that it will get paid back! To maximize the possibility of being paid back, the bank wants to make sure that the borrower can pay back a loan and that such obligations have been met before. The bank must consider the five "C's" of Credit each time it makes a loan.
Capacity refers to your ability to repay the loan. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment, and the probability of successful repayment of the loan. Payment history on existing credit relationships --personal and commercial-- is considered an indicator of future payment performance. Prospective lenders also will want to know about your contingent sources of repayment. *
Capital is the money you personally have invested in the business and is an indication of how much you have at risk should the business fail. Prospective lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding. If you have a significant personal investment in the business you are more likely to do everything in your power to make the business successful. Banks will want to see what type of investment you plan to make in the business. In some cases, it may need to be at least 25% of the total amount needed to start your business.
Collateral or "guarantees" are additional forms of security you can provide the lender. If for some reason, the business cannot repay its bank loan, the bank wants to know there is a second source of repayment. Assets such as equipment, buildings, accounts receivable and in some cases inventory are considered possible sources of repayment if they are sold by the bank for cash. Both business and personal assets can be sources of collateral for a loan. A guarantee, on the other hand, is just that--someone else signs a guarantee document promising to repay the loan if you can't. Some lenders may require such a guarantee in addition to collateral as security for a loan.
Conditions focus on the intended purpose of the loan. Will the money be used for working capital, additional equipment, or inventory? The lender will also consider the local economic climate and conditions both within your industry and in other industries that could affect your business.
Character is the general impression you make on the potential lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be reviewed. Your credit report or credit score will also help the banker determine your character. (May be a good idea to try and clean up any small outstanding issues on your credit report.) The quality of your references and the background and experience of your employees also will be taken into consideration.
*If you have had credit problems in the past, you may want to work with a Credit Counseling Service. These organizations are beneficial if you need help getting your finances in order, setting up a budget, or arranging to pay accounts. They are often available at low cost. Contact the WI Dept of Financial Institutions 608-261-9555 to see if the organization is properly licensed in Wisconsin or visit www.wdfi.org/wca/consumer_credit/credit_problems.htm
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