5 What Do Potential Investors Want? I nvestments come in two broad categories: credit and equity. Small businesses rely far more on credit than on equity. Bank loans are important, as are trade credit and leases of various kinds. Asset-based loans, such as loans against accounts receivable, play a role. Equity investment after startup depends largely on performance. If the busi- ness is profitable and needs capital to grow, the business can attract both inside investors (current owners and management) and outside investors. It can also generate capital from operations, and should, but that is only indirectly an investment. Lenders look for the return of their capital plus interest. Investors look for return of capital, significant gains, plus in some cases, so- cial returns. Investors range in sophistication from individuals with little business sense to the most experienced and cold-blooded ven- ture capitalists. 28 A Crash Course On Financial Statements Who Invests in Small Businesses Part One Besides Banks? You You have to invest your personal savings and assets in your business before other investors will risk their capital. Your investment shows your belief in the business model and a willingness to accept the risks Be Prepared to Be Prepared: Before Seeking Financing and rewards that your business generates. You should be the most cautious of all investors: you face personal, financial, career, and fam- ily risks, while other investors only risk capital. (Fortunately small business owners and other entrepreneurs are willing to barge ahead anyway. Otherwise there would be no new enterprises.) What do you want? If you’re like most people, you want a profit- able business that affords a living first, with the possibility of signifi- cant capital gains second. Perhaps you have a vision of establishing a family business or a fortune. You can raise cash from your savings and other investments, from the sale of assets (such as a boat or a car or art), home equity, or refi- nancing a major asset such as a house. You might have an insurance policy with cash value. After conferring with your accountant for pos- sible tax consequences, you can tap retirement assets such as your 401(k) or IRAs. People have been known to use credit cards, but that route is expensive and risky. Friends and Family These are people who essentially invest in you. This has good and bad consequences. They want you to succeed (all investors want this) but if you don’t they are not likely to hound you. It’s a good idea to docu- ment their investment: Do they want interest on their investment or are they willing to let their capital stay with you until such time as you can cash out? Do they want part ownership? Do they want some say in the management of the business or are they willing to be passive investors? The more you understand their wants, the better. Hidden agendas have wrecked many a growing business and even more relationships. Yes, friends and family are more willing to invest in your business than outside investors. There are compelling legal and tax reasons to spell out the terms of the investment. Is their investment a loan to be repaid? What are the terms? Or is it an equity investment that gives them partial owner- 29 ship? The IRS has been known to impute interest income to people Chapter 5 who have informally loaned money to a small business. SBA The SBA has two main functions. First, it provides a wealth of free and low-cost advice to small business owners through publications, What Do Investors Want? its Web site, trainings, seminars, and workshops. Second, it guaran- tees bank loans, principally through the 7(a) program. What it doesn’t do is provide direct investments or grants to small businesses. While there are a few programs on the books that purport to do this, they aren’t funded—so don’t waste energy pursuing them. The SBA’s mission is to help small businesses prosper. It won’t back just any loan application; the applicant has to have a good chance of suc- cess. The SBA doesn’t want to squander its resources on high-risk ven- tures, so in many ways it operates with the mindset of a careful banker. The loan guarantees can make a difference between qualifying for a bank loan or not. The SBA can guarantee up to 85 percent of the principal, thus limiting the bank’s exposure to loss. Who’s eligible? If you’re unable to secure traditional bank financ- ing, you are probably eligible. Go to the SBA Web site (sba.gov) to see if you qualify for any of the specialized SBA programs. This Web site has been greatly improved and is worth a visit, if only to get an idea of what the SBA can provide. Your Business Your profitable business should generate capital. This isn’t a speedy process by any means, but over time it’s the major source of capital for growth. For a short-term source of funds you might sell assets (equip- ment that you don’t use, for example) or refinance assets. You might be able to sell a major asset to a leasing company (see below) and arrange to lease it back, thus enjoying use of the asset at a lower monthly cost. Factors Factors are big players in some industries. A factor will buy some or all of your receivables, either with recourse or without, and take over the collection of those receivables. The advantage to you is immedi- ate cash. The downside is that this is an expensive mode of financing. The factor’s interest is in establishing a continuing relationship with 30 A Crash Course On Financial Statements your business—repeat business in which they get to know and under- Part One stand the rhythms of your sales and collection cycle. Trade Credit Trade credit is another major source of financing. Your suppliers want to continue to sell you their products and services, and if you a. are profit- Be Prepared to Be Prepared: Before Seeking Financing able, and b. have a good credit history, they may be willing to extend terms to you. New businesses have a tough time getting trade credit, but once up and running you’ll find this a valuable part of your financing plan. Leasing Companies Leasing companies range all the way from banks to manufacturers’ internal leasing programs. Think of car leases—the leasing company owns the asset and gets the depreciation on it, which makes it possible for you to enjoy the use of the asset at a lower monthly cost than you would otherwise. What gets leased? You name it: airplanes, railroad boxcars—equip- ment of all kinds. Angels and Venture Capitalists Angels and venture capitalists play an interesting role in financing small businesses. Authors like to include them in financing books be- cause angels and VC investors are exciting. However, their role in small business is tiny. Consider this factoid: Of the 750,000 new businesses that spring up each year, only 900 will get the attention (let alone the cash) of these investors. That works out to about one tenth of 1 percent, concentrated in high tech, medical, and big media industries. That said, angels (individual investors, sometimes ad hoc groups of individual investors) provide seed capital for small businesses with significant growth potential. They tend to invest in areas where they have experience (doctors in medical software, for example). They invest through loans, direct equity, or a combination, such as convertible loans. They want to get their money back, of course, and want to get a good rate of return on their capital, but often have other motives than purely finan- cial. Some want to help their community, others want to encourage the coming generation of entrepreneurs, and some just want to keep busy. Venture capital firms invest to make money. If you don’t have a blowout technology or a huge potential secured by a proprietary lock on some important process, they’ll ignore you. Excerpt from A Crash Course on Financial Statements for Small Business by David H. Bangs. Copyright © 2010, by Entrepreneur Media, Inc. All rights reserved. Reproduced with permission of Entrepreneur Media, Inc.