How Much, How Long, & For What Outcome?
A financing proposal provides useful information to help investors understand why it would be a good investment for them to put their money in you and your business.
The traditional business plan format typically requires few alterations to also serve as a first-rate financing proposal. There are some areas of your plan that will be of little or no use to prospective financiers. Personal histories, for example, can and should be replaced by resumes. The business plan section on deviation analysis would typically not be required as well. This is an internal control process and one not normally useful to outsiders. The main difference between your business plan and financing proposal lies in the fact that while the main function of the plan is to enable you to understand the complexities of the business, the function of a financing proposal is to show your prospective backers that you not only know what you are doing, but will also be able to make their investment as risk free as possible.
As you begin to establish your financing strategy for your new venture, it is important to be aware of different sources and types. The use of an Financing Matrix (PDF) will help you to determine your financing needs, types, and sources. Venture capital, or other forms of higher-risk capital represent ways in which many high technology ventures have been financed over the past decade. More conventional forms of entrepreneurial financing, such as bank loans and other institutional credit-based services, have consistently served the smaller business venture. In each situation, however, assessing the longer-term viability of the business concept is equally important to the lender.
Although the greatest dollar amounts of financing for many smaller businesses are found in trade credit (that is, money owed to suppliers), the most important single financing source is your local bank. Such esoteric financing tools as factoring or discounting receivables, bonds, convertible debentures, and other such debt instruments are typically not utilized by smaller businesses. If you have need of them, your banker and accountant can help you. If you do not have both a banker and an accountant, you surely have no need of specialized financing and probably should reconsider going into business at all.
In seeking financing, it is essential to recognize the difference between debt and equity. When you go to a bank, you are seeking debt money, a loan which you repay over a period of time at a certain additional cost of interest. The money you and others invest in the venture is ordinarily equity, that is, money invested in a business that will not be repaid unless the ownership rights that it represents are sold to another. Debt financing does not lead to sharing ownership of your business with the financier; equity financing does. Control is another matter: Your banker or some other lender frequently exercises substantial control over a business through various legal documents (for example, agreements not to further borrow, working capital maintenance, cash reserves) or through suggestion but still does not own a share of the venture. Debt pays interest, usually for a finite period; equity pays profits forever.
The distinction between debt and equity is of particular interest to a banker because the more debt there is in relation to equity (that is, the greater the leverage), normally the higher the risk. A high debt-to-worth ratio (worth is roughly equivalent to equity but includes certain kinds of specialized debt) indicates high risk. High risk costs money, if indeed money can be found for such a situation. Why? Because debt money is rented money, and the rent must be paid no matter what the business is doing. A higher than normal debt service obligation requires that a business perform better than normal just to meet this additional demand. Very simply, if you can’t meet your debt payment, you go out of business. The problem here is important. Sometimes entrepreneurs, having read books on getting rich using other people’s money, will find so much debt financing that they can never get ahead no matter how hard they work. Without capital (that is, permanent, non-repayable money invested in the business) they may spin their wheels forever, a problem known as overtrading. The trade ratios of sales/worth are guidelines to follow. References to these and other valuable business planning data may be found at www.bizbound.com/listof.html.
The key here is to fit the financing to the need. There are four needs for cash in almost any venture:
are usually straightforward. This includes machinery, equipment, hardware, software, and perhaps buildings or anything else that is not used up in the normal course of business operation in the short run.
is the initial stock of materials or goods required to start this operation moving. These items are then replaced as they are consumed or sold through normal inventory replacement. The concern is that too often businesses do not plan for sufficient initial stocks and so start out behind the eight ball. Trade averages, specifically turnover ratios, help to determine the amount needed for this initial investment.
is the amount of funds that will be consumed in the cycle of business operations. It is the amount of cash needed to prime the pump and keep the operation running. A working-capital crisis can occur (and frequently does) when a business is rapidly growing as well as when it starts up, and can be anticipated and prepared for in the same way.
The contingency reserve
is the amount of cash you must have available or have access to if everything doesn’t work out as you have planned. If you are a realist, you probably believe by now that contingencies can and probably will occur even under the most carefully planned conditions. It is wise, then, to be prepared for these happenings.
In addition to summarizing your other needs, your projected cash flows will reveal two additional factors which will then help decide what kind of financing you will need: The sum of the negative cash flows will indicate the amount of working capital you need in some combination of debt and equity, while the projected positive cash flows will show how you will generate money to repay any debt you incur. If you don’t arrange for sufficient financing, from whatever sources, your deal will be dead. If you borrow more than you can service, your deal will also terminate, although that result may just take longer. For any kind of venture, Friday-night financing never works. Always make sure that your banker knows well in advance what your cash needs will be. This way you won’t get caught in a cash squeeze that could be prevented by careful nurturing of your business and your banker. Borrowing under panic conditions is extremely dangerous. Don’t do it. This suggestion, of course, is applicable to any aspect involved in planning and managing your operation.
There is another bit of fundamental advice that is critical to the success of any venture. If you have thought through your business plan, you will know how much financing you will need. Make sure that you get it. Less will only make your life difficult, if not impossible. If your banker or financial advisors can give good reasons for borrowing or raising less, pay attention, but think it over carefully. Do not settle for enough financing to get in trouble but not enough to see you through. Also, by knowing what you are borrowing money for and knowing how the loan will earn its repayment, you will avoid getting caught in the wrong loan. Tell your banker what you need the money for and what you think the loan should look like (that is, the repayment schedule). Listen to your banker’s reasons if he/she disagrees with your idea, but make absolutely certain that you will not find yourself committed to repaying a loan faster than your cash flow can handle or paying for a “dead horse” years after the purchase has been used up. There is a middle course, a responsible one that will make the business safer, less risky, more profitable, and more fun. Take it. Plan what the loan is for, how you will pay it back, and be realistic about the risk. If it is an investment, be aware of the full range of consequences (the so-called strings) that may go along with the deal. This way you won’t have any surprises and you will be in control of the situation rather than having the situation control you.
– William R. Osgood