Using many years of experience and industry know-how to establish a business is a goal held by many would-be entrepreneurs. In fact, finding a location, formulating a business plan, and hanging the “Open” sign might be one of your long-cherished dreams. However, securing capital to begin operations can often be frustrating and difficult. But, there are a number of potential sources of financing to explore. Some entrepreneurs are able to secure bank loans or venture capital, while others may turn to family members or friends for financing.
Typically, personal funds are one of the most common sources of start-up capital. Indeed, many successful entrepreneurs believe they are their own best source of financing for the following key reasons:
- Control. Entrepreneurs are often willing to assume greater risk in order to retain greater control over their businesses. A dilution in ownership could result in a less focused business direction.
- Speed and Simplicity. Founders usually have an in-depth understanding of their business needs, are sufficiently able to project the initial costs of doing business, and may prefer to avoid the time and intrusion of outside scrutiny.
- Modest Needs. Many owners may be able to begin operations with only a modest cash infusion. Capital-intensive planning for initial operations isn’t always required, depending on the business.
Some entrepreneurs and owners of established businesses may be interested in securing a bank loan when capital is needed. In theory, any business is bankable if the loan proceeds will generate operating revenues to service the debt. When evaluating first-time borrowers, bankers often consider the “Three C’s of Lending:” character, capacity, and collateral. Although character is important, it is also subjective. Credit checks, however, can be used to evaluate the prospective borrower’s credit history and capacity to take on new debt. Bankers may also contact a company’s major creditors to assess credit habits.
Because bankers are often reluctant to expose themselves to risk of loss, the bottom line in analyzing financial statements is to measure a borrower’s capacity to repay the loan and to identify the repayment sources. Primary sources include accounts receivable and earnings. Secondary sources include assets that can be liquidated, such as equipment or inventory. Tertiary sources are generally personal guarantees.
When the bank has more money in the business than the borrower, bankers will focus on the third C: collateral. Since most first-time borrowers have few corporate assets to pledge, a banker will turn to the entrepreneur’s personal assets. The borrower may have to secure the loan with personal assets such as certificates of deposit (CDs), stock, or equity in personal real estate. In addition, lenders are concerned about how loans will be repaid in the event of an owner’s or key person’s death. Sometimes, they will require that loans be covered by life insurance.
A Life Insurance Strategy
Term life insurance is designed to help guard against financial risk for a specified period of time in the event of the insured’s death. With a term policy on your life for the duration of the loan—say five years—the bank’s security requirements may be satisfied. In addition, term life could benefit you by providing a safety net to protect your estate. When assigning your policy, you will transfer your rights to all, or a portion, of the proceeds to the bank. Two common types of insurance policy assignments are the following:
- Absolute assignments—These normally assign every policy right. Once the transaction is complete, the policyholder will have no further financial interest in the policy.
- Collateral assignments—These are more limited types of transfers. They can protect the lender by using the policy as security for repayment. When the loan is fully repaid, the bank releases its interest in the policy.
Generally, life insurance policies can be freely assigned, unless some limitation is specified in the contract. To fully protect the assignee, the insurance company must be notified that the assignment has been made. It is also important to notify the insurer if future assignments are made and/or terminated.
Those who wish to avoid loans may be interested in equity financing, which provides capital that does not need to be repaid. It is particularly attractive to businesses without enough cash flow to service debt, and it has no fixed cost. Typically, the cost depends on the future value of the company.
Equity financing can, however, significantly dilute your ownership interest and may diminish your operating control. Due to the risks involved, equity providers may request a seat on your board of directors or some other position of authority. If your business is well established, this may be an infringement. If your business is new, you may benefit from the investor’s knowledge.
Due to the higher risks usually associated with equity investments, investors may require greater returns than creditors. Second, dividends are not tax deductible, leading investors to expect sizable capital gains from business growth.
The dream of owning your own business may be within your reach. If you are contemplating launching your own venture, local banks, business organizations, trained professionals, and occasionally family members and friends may be ready to lend a hand with financing. A sound financial plan outlining your capital resources and requirements is a good first step on the road to fulfilling your vision.