A SOURCES OF BUSINESS FINANCING
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One of the most important issues facing all businesses, whether a business in the start-up phase or well-established, is the obtaining of appropriate levels of financing. Whether it is needed for investing in land, buildings or equipment, hiring new employees, investing in inventory or moving into new markets, obtaining sufficient financing to accomplish these goals is a dilemma nearly all business owners face.
This law letter will provide a general overview of various sources of financing available to businesses both large and small. A listing of all the different possible avenues for raising funds to finance your business is beyond the scope of this law letter. The objective is to provide you with a basic working knowledge of various types of financing and things to watch out for with each.
The most common sources of business financing which will be discussed in this letter are as follows: personal savings/“love money”, conventional debt financing (banks/credit unions), government assistance, business partners/strategic alliances, venture capital and “going public”.
Personal Savings/”Love Money”
The greatest percentage of businesses are financed for start up using personal savings. The most obvious advantage of using personal savings to start up or expand your business is that you relinquish no control over your business. However, it is relatively rare for a business owner to have sufficient personal savings to completely finance his or her business. Personal savings are often used in conjunction with other forms of financing, i.e., bank loans. Bankers tend to see a significant investment of personal savings as an important indication of a business owner’s commitment to the business.
“Love money”, a gift or loan from family or friends, is another commonly used source of business financing, particularly in the start-up phase. This also enables you to maintain control of your business. However, in the event a business does not succeed and loans from family and friends are unable to be repaid, this can create significant strains on personal relationships. As with personal savings, “love money” is often used in conjunction with other sources of financing for businesses.
Conventional Debt Financing
Banks, credit unions and other financial institutions are commonly used by business owners as a source of financing. The most common financing instruments used with debt financing are lines of credit or operating loans (used to finance inventory or accounts receivable), term loans (used to finance fixed assets, i.e., equipment and machinery), mortgages (used to finance purchase or construction of land and buildings), and credit cards.
Most financial institutions will require a business to produce a detailed business plan before loaning them any money. These business plans commonly consist of financial statements for the business (including projections if the business is just starting up), a personal statement of net worth, a discussion on industry and target markets, management capability, etc., and a resume of business owner.
Financial institutions will analyze your business plan very carefully to determine what level of risk you represent. This risk assessment will ultimately determine whether the financial institution is prepared to lend to your business, how much they are prepared to lend, how loans will be repaid and what security for their loan they will require. The areas of your business plan which lenders pay particular attention to are as follows: cash flow and profitability, management capability, levels of working capital, levels of debt to equity, personal net worth of the business owner, margins and historical trends and ratios in your business’ industry.
A properly prepared business plan will significantly increase the likelihood of you obtaining debt financing from a financial institution. You may wish to consult with your professional advisors (legal and accounting) for assistance in putting your business plan together. Their assistance can be invaluable.
Most financial institutions will require some form of security before providing financing. These can include securities in assets of the business, including land and building, equipment, accounts receivable or inventory. Further, with most small owner-managed businesses, financial institutions may require personal security from the business owner in support of the business’ obligations. This can include personal guarantees of the business owner and his/her spouse and mortgages against real property and personal assets.
Various forms of government assistance are available for business owners in the form of grants or loans from the federal, provincial and municipal levels of government. These grants and loans are often targeted at specific industries or areas and have criteria which must be met by the business before it is eligible for financing. Some examples of government agencies and organizations which have such programs are Atlantic Canada Opportunities Agency (ACOA), Nova Scotia Business Inc, and InNOVAcorp.
These government grants and loans can be a very valuable source of financing for business owners. However, business owners must be prepared to invest a substantial amount of time to complete the application process. Approval can be slow to obtain due to extensive review procedures.
Different levels of government also offer tax credit programs which provide tax credits in the event a particular method of financing is used. Examples include the Nova Scotia Equity Tax Credit Program and Labour Sponsored Venture Capital Corporations (LSVCCs). As with other forms of government assistance, detailed and stringent application procedures and eligibility requirements apply with these tax credit programs.
Business Partners/Strategic Alliances
Creative business owners may obtain financing to pursue business opportunities by entering into partnerships or alliances with other business owners or entities. Means by which these partnerships/alliances are structured are limited only by the imagination of the parties involved. These can include formal partnerships, joint ventures or joint ownership of a subsidiary company.
The advantages of pursuing such partnership/alliance can be great. A business owner who enters into a partnership/alliance with a compatible, strong partner can take advantage not only of their partner’s sources of financing, but also their business acumen, employees, equipment and other resources. However, it is very important to decide issues such as sharing of profits, control and decision-making issues and responsibilities at the outset. Failure to do so and failure to properly document these issues with the appropriate form of agreement, can lead to disputes down the road. Another important issue to address is to ensure that your partner represents a good fit for your business and the opportunity being pursued.
Venture capital is an alternative form of financing which may be sought at times when a business is unable to attract appropriate financing from other conventional sources. Venture capital is normally a source of equity financing which is sought by medium-sized business (i.e., $5 million – $25 million in sales) from one of two sources: “angels”; and institutional venture capital.
“Angels” or informal venture capitalists are generally individuals with significant capital to invest in businesses with strong growth potential. “Angels” may be more willing to invest in smaller businesses than institutional venture capitalists. “Angels” are often successful businesspersons in their own right and are prepared to offer advice and expertise in areas that can benefit the business in question. They also have contacts in the financial and business communities which can be beneficial to the business. Some “angels” may wish to have an equity position in the business before contributing financing. This may be an issue for business owners who do not want to relinquish control over the business.
Institutional venture capitalists are often structured as corporations or a pooled fund of money raised by both public and private investors. Some common examples are pension funds and mutual funds with a venture-capital focus, branches of industrial or financial corporations or labour-sponsored funds.
Institutional venture capitalists will usually conduct the same kind of detailed review of your business as would a conventional lender. However, unlike financial institutions, institutional venture capitalists will often look for equity participation in the business and also active participation within the company’s management structure. Investments by institutional venture capitalists are generally for a longer term – up to eight or ten years. Some venture capitalists will be prepared to offer debt financing subordinated to conventional bank financing. However, such subordinated debt financing will normally have to be secured by business or personal assets.
Taking on a venture capitalist, whether an “angel” or an institutional venture capitalist, as an investor in your business, generally has similar advantages and disadvantages to bringing in a business partner. Control may have to be sacrificed in turn for a substantial cash infusion and the expertise of the venture capitalist.
For companies that have grown to an appropriate size or which have a particularly valuable and exciting business opportunity available to them, “going public”, i.e., selling your company shares to the public and possibly listing them on a stock exchange, may be an option. “Going public” can give a business access to huge pools of capital and substantially increase the value of the business owner’s shares which they retain. However, there are significant costs and other disadvantages which must be carefully considered before making the decision to “go public”. These can include: limiting management’s freedom to act, the significant time and expense associated with “going public” and fulfilling the requirements of securities legislation, loss of privacy (i.e., public availability of financial and other information), constraints on sale of the business owner’s shares, potential negative tax consequences to the business owner and loss of control.
Discussing these issues in detail is beyond the scope of this lawletter. We recommend you consult your accounting and legal advisors in considering the issue of “going public”.