Perhaps you are a new entrepreneur about to launch a business or innovation you have been dreaming about for years. Or maybe you have an established business and things are going well, or maybe even too well. In both instances you are going to need capital – the “oxygen” that every business needs to grow and prosper. So now you are writing your first business plan or touching up the old one in anticipation of raising capital.
Capital can only come into a business in one of two ways: capital that is generated internally through positive cash flow from business operations (e.g., selling stuff), or from external funding sources. Obviously, the new entrepreneur is limited to only one option – external funding sources. The established business, on the other hand, is hopefully generating positive cash flow, but may require additional capital in order to fund inventory, growth, or new equipment.
For now, let’s set aside internally generated cash flow and concentrate the search for capital on external sources. Some common sources include:
- Investment capital (equity)
- Shareholder loans
- Bank or finance company debt
- Government programs
- Other options
So, which funding option is best? Is it best that the capital come from only one source, or does it make more sense for the capital to come from multiple sources? How do you decide? How you decide to capitalize the business is called your capital formation strategy. The capital formation strategy you choose will depend on a number of internal and external factors including:
- Your current balance sheet (for established businesses)
- How much capital you require
- The intended use of funds
- Your company’s current credit standing, if any
- Your personal credit standing, especially for new businesses or very small businesses
- The availability of collateral
- Your current cash flow and your ability to service bank or shareholder loans
- Covenants on existing debt
- Current shareholder agreements
- Your current rate of growth
There are undoubtedly a number of other factors to consider depending on your company’s current circumstances, and, quite importantly, where you want your company to go in the next few years.
How do experienced executives determine the best capital formation strategy for their company? First, in considering all of the internal and external factors listed above and, of course, those not listed above, it is time to eliminate those sources of capital that for one reason or another are not available or appropriate at this time. Next, think about the business plan you’ve just written or updated and then build a financial forecast that includes a balance sheet, income statement, and cash flow statement. These forecasts should be presented monthly and annually so that you can see how future changes in the business such as increased sales, additional staffing, or seasonality will affect cash flow. Remember, you don’t want to run out of money.
Here are some typical capital needs and traditional ways of funding those needs:
- Financing high value capital equipment such as transportation, plant (factory), or medical equipment can often be accomplished with equipment leasing or term debt from a bank or finance company. Remember, all lenders and lessors love collateral, especially collateral that holds its value.
- If you wish to finance a building or building addition, check out the Small Business Administration’s 504 loan program.
- And speaking of the SBA, don’t forget that business loans can be funded through the SBA 7(a) program.
- Often, entrepreneurs fund research and intellectual property through Federal government grants, and grants from other sources.
- Another way to generate capital is to factor your receivables. Factoring is not for every business, but when it works, it can really help.
Bringing It All Together
Here are two typical capital formation strategies that we see all the time:
Example 1: The Cookie Factory
A baker in Chicago with 20 years of commercial baking experience hears that a commercial bakery is for sale. He and his accountant meet with the sellers of the bakery and reach an agreement for the purchase of the bakery. The agreed upon price is $120,000. The deal is subject to the buyer getting financing and the buyer has 120 days to close. He will also need $20,000 in working capital to fund inventory and payroll while waiting to be paid by customers, for a total need of $140,000. Our baker has saved $40,000 which he is prepared to invest in the business. His retired uncle has committed to be his partner and will invest $20,000, so now he has $60,000 of equity capital committed to the business, of which $20,000 will be for working capital and $40,000 will be for the down payment to purchase the business. He then came to our firm and asked us to help write a bank-ready business plan that he would submit to a commercial bank for an $80,000 loan to finance the remaining balance. So, our baker’s capital formation strategy is as follows:
- $40,000 of equity capital from savings
- $20,000 of equity capital from friends and family
- $80,000 of debt capital from a bank loan
His cash flow forecast shows that there is plenty of cash available each month to service the bank debt, and, in time, the baker will be able to buy out the uncle’s investment. The strategy works.
Example 2: The Military Robot
In our second example, an associate professor at Utah State University has developed a robot with the ability to evaluate a battle zone and detect the presence of hazardous materials and gases such as nerve gas and mustard gas. It is also equipped with cameras so that it can detect the presence of enemy troops. The competitive advantage that this robot has is that it is very inexpensive to manufacture and therefore more expendable than competing devices.
Our professor has funded the innovation up to proof of concept from funds provided by the University ($200,000). He is now applying for an SBIR grant from the Department of Defense ($150,000). The DoD, as a condition of its grant, has first right of refusal on purchasing the robot or at least the intellectual property. The professor uses the grant funding to further develop the technology, but he still requires an additional $3 million to reach commercial viability. He speaks with various venture capitalists (VCs), and one agrees that the existing business is worth $1 million, and the VC will supply the remaining $3 million, after which the VC will own 75% of the business. The professor’s capital formation strategy is as follows:
- $200,000 of research funding from the university
- $150,000 of grant funding from an SBIR Phase I (DoD) grant
- $3,000,000 in equity capital provided by the VC firm
The VC firm ends up with 75% ownership in the LLC that owns the robot’s intellectual property and the professor and the university together own the other 25%.
Now that you have your capital formation strategy organized and ready to execute, you may want to confer with your stakeholders and advisers (key staff, shareholders, bankers, attorneys) and listen carefully to their feedback.
Getting your capital formation strategy right is critical to the growth and financial health of your business. Keep in mind that, as circumstances change, your strategy may need to change. Our best advice is that capital formation is a very important aspect of managing for success, just like new customer acquisition, product innovation, and adapting to those inevitable changes.