How to Capitalize Your Business

You need to know how you are going to raise cash and you need to know, now. Cash is the engine of your growth, the butter for your bread and the gas for your car. No matter your business, you’ll need plenty of it. Want to buy more of a product that is selling well? Your supplier won’t give it to you for free. Want to hire someone to look after the store while you are gone? Guess what: they are not going to work for you out of the goodness of their heart, no matter how kind they are. Ever wondered how to get more cash for your business? If so, read this chapter.

There are two basic ways small businesses like yours raise cash: Debt and equity. I’m also going to a discuss a third approach to financing: Cash flow. There are other, unconventional ways you can capitalize a business that I don’t discuss in this chapter but before you learn about them, you must understand the basics inside and out. While you read this chapter, keep a few things in mind.

Some Forms of Capital are Pricier than Others

Business would be easier if the providers of capital expected you to pay the same price for it. But that is not the case. Always keep in mind that there are no free lunches; aside from the rare case where a friend or family member grants you an interest-free loan, there will be a cost of capital you’ll have to pay.

Remember that the whole reason you want capital is so you can grow, but that does not mean that you should be willing to pay any price for the capital. If you pay too much, you will not grow as fast as you would like. Carefully weigh the costs and the benefits before you sign on the dotted line and be sure to develop a realistic sense of your overall objectives.

What is your Objective?

Most of the time, I can slot small business owners like you into one of two categories:

1. You are running a lifestyle business. You want your business to grow, sure, but you are not trying to hit a massive home run. If you do grow, you are not hell-bent on growing as quickly as possible. Nothing wrong with that, at all – it is your business so you can decide you are not trying to run the next Google and there is no shame in that. Since capital equals growth, if you want less growth, you’ll need less capital.  Because you are not trying to build a huge company, you cannot afford to pay a very high cost of capital.
2. You are hyper-ambitious. You are willing to go balls-to-the-wall to grow your business and build something big. You want the entire world and you want it, yesterday. I get you. I feel you. If this is you, you are on the other side of the equation: More and faster growth requires more capital. If your business is going to be bigger, you can afford to pay a higher cost of capital.

Pick an objective, now. You might be able to get away with changing your mind, but I doubt it. Each objective requires a different business model and thus a different approach to raising capital.

When Business Planning, Entrepreneurs Wear Rose-Colored Glasses

You get that some ways to raise capital are pricier than others and that your capital-raising strategy should reflect your objectives. What you don’t yet know is that when you are choosing an objective, you could fall victim to a common entrepreneurial trap: Too much optimism! Business is hard… harder than you think it will be, especially if you’ve never run a business before. Entrepreneurs, especially first-time entrepreneurs, tend to overestimate their sales and underestimate their expenses.

There’s a reason the first thing I ask Shark Tank entrepreneurs, to tell me, is their numbers: I want to see how realistic they are with me, because it’s a reflection of how realistic and honest they are with themselves. If you fluff the numbers, that tendency to make things seem rosier than they really are will spread to how you manage your entire business. It will show that, at some level, you are not open to the feedback the world is giving you and it may show that you do not yet have the stomach for entrepreneurship. Your odds of success are much greater if you admit the truth to yourself and others. Trust me.

With those thoughts in mind, let’s discuss the three approaches to capital raising.

Equity Financing

Equity financing means that an investor is purchasing a stake in your company. Unlike debt, there is no loan you need to repay – by investing in your company, the investor is along for the ride, no matter how bumpy. He or she knows they may not get their money back. Debt can be scary; many people are frightened of it, so it is psychologically powerful to avoid it. But the price for doing so is high.

The investor who has taken on greater risk by providing you with equity, rather than debt financing, will expect a lot, in return. You will be sacrificing a portion of your company’s future profits – generally a larger amount of money than you would be paying to a creditor. If you picked objective 2 and are planning on building a large, scalable company that you will sell one day, the investor will get a cut of the sale proceeds. Doing so makes sense only if you believe the investor’s money and expertise will help you grow a much bigger pie, overall. If you picked objective 1, an equity investment is generally not ideal because you are not trying to grow a much bigger pie.

An equity investor will also have a say in your company’s decision-making. If you trust the investor and they bring skills to the table that address your weaknesses, this can be a good thing. When I invest in a company, I bring discipline to every aspect of its operations. But this can be a hard pill to swallow for the weak-kneed.

It’s all well and good to get an equity investment from an experienced investor who knows how risky it is. But what if it’s not an experienced investor – what if it’s a friend or family member? They need to know that there’s a good chance they can lose their entire investment. Best to be straightforward with them and control their expectations – equity investments in private companies are risky, risky business. If they expect not to lose all of their money, they will be very angry if they do. Best to nip that kind of problem in the bud. Make sure they can afford to lose their entire stake and everything will be fine.

How Can You Secure Equity Financing?

You will not get equity financing from a bank. Your best bet is to ask people in your network about potential investors. You can also use LinkedIn to find and get introduced to locals who invest in private companies. If you’re building a technology business, Angel List is the place to look. And you can always audition for Shark Tank!

Debt Financing

Debt financing means that you are borrowing money. You pay interest to the lender to compensate for the risk the lender is taking that you will not re-pay the loan. It goes without saying that if you are a good negotiator, you will try to negotiate as low an interest rate as possible.

Many financial institutions will want more than interest to incent payback and compensate them for the risk of non-payback. If you need a larger loan, you’ll be asked to provide collateral: assets the lender can seize if you do not repay the loan. Lenders prefer hard assets, like real estate or blue chip stocks, so they can easily assess their value.

Many small business owners are afraid to take on debt because they fear they may not have the cash flow to repay the debt (plus interest) in a timely fashion. Others may be concerned that they don’t have the credit-worthiness to get a bank loan, and so don’t want to even bother applying. That caution may make a lot of sense. But remember that you need to consider the cost of capital – and with debt, you typically have the lowest possible cost of capital.

Unlike equity financing, debt will allow you to maximize your ownership interest. Always be very careful about giving away a chunk of your company, especially if your company is your only source of income. If you give away a chunk of your company, you are not just forfeiting a portion of profits and the sale proceeds when the time comes to exit; you are also giving up some control. And if there is anything we entrepreneurs need, it is control. We do not want someone else being the master of our destiny. For that reason, you should be particularly concerned about giving away half, or more, of your business.

Not all debt is created equal. There are many different kinds of lenders with which you can work. You need to know about them.

Who is Your Lender?

Traditionally, small business owners borrow money from banks. Many still do. But not everyone can, and should, get their loans from a bank. In order to get a loan from a bank, you’ll need a great credit rating as banks are more risk-averse than they used to be, due to the great recession of 2008. For the same reason, they may only be willing to loan you money at an unreasonable rate. You’ll probably also need sophisticated financial statements and be willing to obtain a home equity line of credit or provide property or hard assets as collateral – assets you may not wish to risk. These truths are particularly determinative if you are talking to a large bank, which required a cookie cutter approach in order to scale so massively. If you treat every lender the same way, you do not have to spend as much time creating a special arrangement for each one. Big banks are bureaucratic and may take more time than you’d like to make a decision on your application. Luckily, there are great alternatives.   

More and more small business owners are choosing alternative lending companies. We live in a golden age of financial innovation in which technology helps us devise new ways to better serve customers. One such company is IOU Financial, part of the O’Leary Financial Group. Some of the companies, I fund through Shark Tank, use IOU. They’re more flexible than a traditional bank; they care less about your credit score and are more interested in factors like the percentage of the business you own and your annual revenue.  They will approve or deny your application far more quickly than a traditional bank. They will get to know your business model so they can serve you better. In contrast to most other alternative lenders, they allow you to reduce your interest payments if you pay the debt earlier than anticipated. And if your circumstances change, they will listen to you and do their best to help. How refreshing is that?

Some desperate business owners consider Merchant Cash Advances. This is a sale of a portion of your future accounts receivable. This is distinct from a loan and thus, in most states, not subject to state lending and usury laws. This means that your cost of capital can be extremely high. There’s a strong argument that this defeats the chief purpose of choosing debt over equity: the lower cost of capital. Luckily, IOU Financial is subject to those laws and thus a cheaper and safer option.

Always remember which category of business owner, you are. If you see yourself as a lifestyle business owner and you are not trying to be the second coming of Steve Jobs, you should think seriously about debt financing. It makes perfect sense for a solid cash flow type business because there is no need to worry about repaying the debt. Slow and steady wins the race.

Cash Flow Financing

Cash Flow Financing means you are bootstrapping; re-investing your profits back into your business. You can only do this when your business is cash-flow positive and you know that you’ve more than enough profit to handle overhead and pay your employees.

The major advantage is that you avoid having to pay the costs of equity and debt financing: control and future profits or placing personal assets at risk and having to re-pay a lender. You also get the pride of knowing that you did not have to rely on anyone else. If you decide that you want to raise equity or debt financing and you’ve previously been using cash flow financing, you can point to a strong track of growth and discipline – that will impress investors.

The disadvantages are twofold:

1. It takes awhile to get to the point where you can raise serious cash from cash flow. You have access to equity and debt financing earlier in your business’ lifecycle.
2. There is a risk that after investing all of the time and energy necessary to become cash flow positive, that you spend the profits unwisely. It is very tempting to lose track of the discipline that got you to this point. You think “now I can relax!” Wrong. You can never relax! You must ensure you continue to run a tight ship.
   
   

Conclusion

There are three major ways you can raise capital. They’ve got different strengths and weaknesses – so the first step is to know your business extremely well and decide on your objectives. Only then will you know which of the three makes sense. Many businesses will use more than one approach. Now that you know what’s out there, you can make a sensible decision. Good luck!

Read more in the Cold Hard Truth on Small Businesses and Capital, available exclusively on IOUFinancial.com!