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Financing While Maintaining Equity*

by Nolo

When starting a new business you may need start-up funds but lack the money to invest yourself. What are your options, can it be done without losing equity in the company?

Start off by thinking about it from the other side. If you had £500,000, what would make you want to give it to you and your business? You don’t want to give equity but you want somebody to take a huge risk for your business. Are you ready to pay extremely high interest rates, and offer a big equity kicker too? How are you going to convince somebody to take that kind of risk without an upside?

That’s why start-up investment usually involves equity. Why else does somebody risk that kind of money?

In your case, the signed contracts may be a bit of an advantage. Are they “bankable” (meaning that the documentation is strong enough that you might be able to borrow off the value of the contracts)? If so, that would be very unusual, but that would also be your easiest route for financing—using the contracts as security.

However, bankable contracts are extremely rare. Banks need to have real security.


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Start-up entrepreneurs and small business owners are too quick to criticize banks for failing to finance new businesses. Banks are not supposed to invest in businesses- the government prevents banks from investment in businesses because society, in general, doesn’t want banks taking savings from depositors and investing in risky business ventures; obviously, when (and if) those business ventures fail, bank depositors’ money is at risk. Would you want your bank to invest in new businesses (other than your own, of course)?

Furthermore, banks should not be loaning money to start-up companies either, for many of the same reasons. Regulators want banks to keep money safe, in very conservative loans, backed by solid security. Start-up businesses are not safe enough for bank regulators, and they don’t have enough security.

Why then do we say that banks are the most likely source of small business financing? Because small business owners borrow from banks. A business that has been around for a few years generates enough stability and assets to serve as security. Banks commonly make loans to small businesses backed by the business’ stock or debtor book. Normally there are formulas that determine how much can be loaned, depending on how much is in stock and in debtors.

A great deal of small business financing is accomplished through bank loans or overdrafts based on the business owner’s personal security, such as the family home. Some would say that home equity is the greatest source of small business financing. This is a hard route to go, but still quite common. I have personally taken out a second mortgage more than once, in keeping my own business afloat, and I know how scary that is because I speak from experience. Still, I did it, the business survived the hard times, and later I paid the second mortgage off and took the lien off my house. The trouble is that if I didn’t come through, we would have lost that house.

Some companies are financed by smaller investors in what is called “private placement.” For example, in some areas there are groups of potential investors who meet occasionally to hear proposals. There are also wealthy individuals who occasionally invest in new companies. In the lore of business start-ups, groups of investors are often referred to as “doctors and dentists,” and individual investors are often called “angels.”

Sometimes you can get a private investor to give you money as a loan, but if so, you better be ready for a very high interest rate and a huge equity kicker if you default. That is a lot of risk they’re taking, and they want to get a lot of money back, or they simply take their money elsewhere.

Some investors are a good source of capital, and some aren’t. These less established sources of investment may be necessary, but they should be handled with extreme caution.

Your next question of course is how to find the “doctors, dentists, and angels” who might want to invest in your business. Look for lists, government agencies, business development centres business incubators, and similar organisations that will be tied into the investment communities in your area. Turn first to the local business link or search online via organisations such as the British Venture Capital Association (www.bvca.co.uk).

Aside from standard bank loans, an established small business can also turn to accounts receivable specialists to borrow against its debtors. The most common debtor financing is used to support cash flow when working capital is hung up in debtors. For example, if your business sells to distributors that take 60 days to pay, and the outstanding invoices waiting for payment (but not late) come to £100,000, your company can probably borrow more than £50,000. Interest rates and fees may be relatively high, but this is still often a good source of small business financing. In most cases, the lender doesn’t take the risk of payment—if your customer doesn’t pay you, you have to pay the money back anyhow. These lenders will often review your debtors, and choose to finance some or all of the invoices outstanding.

Some additional warning:

Be very careful in dealing with anybody who offers to help you find financing as a service for money. These are shark-infested waters. We are aware of some legitimate providers of business plan consulting, small business finance consulting, and related assistance, but the legitimate providers are harder to find than the sharks.

Many entrepreneurs turn to friends and family for investment. I recommend against it, frankly. Avoid turning to friends and family for investment. The worst possible time to not have the support of friends and family is when your business is in trouble. When the business is financed by friends and family, you risk losing friends, family, and your business at the same time. I know an entrepreneur who stuck with a losing business for six years longer than he should have because he started it with money from friends and family.

Never, NEVER spend somebody else’s money without first doing the legal work properly. Have the papers done by professionals, and make sure they’re signed.

Never, NEVER spend money that has been promised but not delivered. It is amazing how often companies get investment commitments and contract for expenses, and then the investment falls through.

*Disclaimer. NB these articles are for informational purposes only. They are not designed to be used as a substitute for legal advice.

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