If small businesses power our economy (99% of all U.S. companies), capital is the “rocket fuel” that powers small businesses. Without capital, businesses can’t start or grow. In fact, the two most common reasons cited for small business failure are no market need (42%) and lack of sufficient capital (29%).
Uses of Capita
Businesses seek capital for a variety of reasons including:
- Starting a new business
- Purchasing equipment
- Working capital
- Acquiring a business
Companies in rapid growth mode require significant capital because increased sales typically result in higher inventory levels and increased AR, both of which need to be funded. Without sufficient capital, a company may not be able to “digest” its own growth.
Sources of Capital
While sources of capital vary depending on the industry, needs and stage of the business, funding sources can be grouped into four major areas:
Grants are generally awarded by federal, state or local government entities or local economic development organizations. They are typically targeted to specific industries and often require a match of cash and/or in-kind services.
Examples of State grant programs include Innovate ND, Agricultural Products Utilization Commission (APUC), the Bioscience Innovation Grant Program (BIG) and Operation Intern. The SBA Small Business Innovation Research (SBIR) and Small Business Technology Transfer (STTR) programs award grant dollars to small businesses for research and development of a technology with the potential for commercialization.
2. Debt financing
Debt financing typically is credit extended by banks, credit unions or other financial lending institutions with specified repayment terms. The most common types of loans are long-term loans for financing fixed asset purchases and short-term loans and lines of credit for financing temporary or seasonal needs such as inventory or construction.
Lenders typically evaluate loan requests on the basis of what is commonly referred to as the “5 C’s of Credit:”
- Capital (borrower equity contribution, typically cash)
- Capacity (sufficient cash flow to repay the loan)
- Collateral (assets that provide a secondary source of repayment)
- Conditions (may include loan terms or market conditions)
- Character (credit score, industry and business experience, drive to succeed)
When you meet with a lender, be prepared to answer the following questions:
- How much capital do you need?
- How will the money be used?
- How will the loan be repaid?
- What collateral do you have to offer as a secondary source of repayment?
- How much equity are you investing?
In deciding on a lender to work with, start with your current financial institution. If you don’t have a current lender, look for banks or credit unions that work with small businesses and are familiar with and use SBA and/or Bank of ND loan guarantee programs. The result is less risk for the lender and often reduced equity required for the borrower.
If you are declined, ask for the reason in writing and find out if this is a permanent denial or if the loan request can be resubmitted if concerns are addressed. Consider meeting with at least one other lender, or if the amount needed is less than $50,000, you can apply for an SBA Microloan.
3. Alternative financing
Founders may look to alternative financing (alternative to banks and credit unions) for a variety of reasons such as lack of capital or collateral, to test market demand or generate pre-sales for a product launch.
Examples of alternative lending include:
- Online Marketplace Lending
- Peer-to-Peer Lending
- Merchant Cash Advance & Alternatives
- Program Related Investments (PRI) via foundations
- State/city economic development programs.
Crowdfunding can be donation-based (GoFundMe), reward-based (Kickstarter, Indiegogo), lending-based (kiva) or equity-based (Wefunder). Campaign size and success rates vary based on the type of program.
Examples of online marketplace lenders include Lending Club, Prosper, Funding Circle, OnDeck, Kabbage (lines of credit), PayPal Working Capital and Square Capital. Marketplace options can provide fast and easy access to capital (typically for smaller amounts), but do your homework as interest rates, fees and penalties can be substantially higher than a bank or credit union.
4. Equity financing
Equity financing (aka venture capital) involves raising capital by offering investors shares of ownership in the company, typically in the form of preferred stock. Potential investors often include family and friends or accredited angel investors (or angel funds) who can leverage their industry or business expertise and connections to advance the business. Investors are looking for a return on their investment over a specified period of time. The most important tools in approaching potential investors are a pitch deck and pro forma.
Paul Smith is Director of the Fargo and Southeast Center of the ND Small Business Development Centers (ND SBDC). Last year, the program assisted nearly 1,500 clients through nine service centers located across the State. The Fargo Center is located in the NDSU Research and Technology Park. For more information, please visit ndsbdc.org.
State venture capital programs include:
- ND Innovation Technology Loan Fund (LIFT)
- ND Development Fund
- Venture Capital Fund (managed by ND Development Fund)
- ND Growth Fund (direct and indirect investments)
Regardless of whether a small business is seeking financing through grants, debt or equity investment, having a business plan is vital. Depending on the objectives and audience, a business plan can take several forms from a one-page plan (Business Model Canvas) to an investor pitch deck to a detailed plan, which generally includes a narrative section, financial projections and appendix of supporting documents.
A business plan should address the following questions:
- What’s the BIG IDEA? (your “pitch”)
- What’s the problem you’re solving?
- How does your product or service solve the problem?
- How big is the market opportunity?
- How have you validated sufficient demand for your product or service?
- Who are your competitors?
- What’s your competitive advantage?
- Does the company have differentiated technology or IP?
- How is the team uniquely capable of executing the plan?
- How are you going to make money?
- How will you grow your business?
- What resources and capital will it take?
- What are the potential risks to the business?
The plan should include detailed three-year financial projections– balance sheet, profit & loss and cash flow statement–which are consistent with the narrative and supported by critical assumptions, which explain the “logic” behind the numbers.
Capital is vital to business startup, survival and sustainability. If you would like assistance with business planning, financial projections and/or information regarding financing and programs which might be a good fit with your business and needs, please visit our website ndsbdc.org to register for our free, confidential business advising services delivered by certified small business advisors.