Small Business Financing

Most small businesses are financed at the outset solely by the assets of the owners and their families and friends. To raise money from other sources a business usually needs an operating history and assets to serve as collateral for repayment of loans.

Equity financing consists of sale of ownership interests in the business - stock or an LLC or partnership interest. This is usually not feasible for small business except when family and friends are the buyers. The business owner usually has no access to the kind of investors who would be interested and those who do have such access to investors are not usually interested in selling small deals. Additionally, there is no group of outside investors who regularly invest in small business in general. There are exceptions, but for most small businesses equity financing is not available.

Businesses with a very good track record or which have assets or prospects in certain hot areas may attract venture capital investors. Also people in the business may be connected with people with money to invest. In those cases private equity financing may be possible.

Sale of stock to the public is not suitable for most small businesses because of the costs involved and because investors in general would not be interested in the average small business. More importantly, the underwriters and sales agents who have the ability to sell the deal, are not interested.

The primary avenues for small business financing are loans and leases. All of these are based on the assets of the business. If there are no assets to serve as collateral, there will be no loan or lease.

For any loan the business should have financial statements prepared and a business plan should be prepared. Books and software to aid in preparing such plans are available in bookstores. The business should also prepare and rehearse its presentation.

The business plan generally describes the business, its products and services, how they are produced, the costs, how they are sold, the revenues, the expenses, how this is all financed, the assets, the liabilities, the competition, the employees and what problems exist and are expected and how they will be met. The plan should also describe how the money will be used and give projections for the business and describe the assumptions behind the projections and the bases for each assumption.

The prospective borrower should contact as many lenders as possible and actually apply to more than one. When the time comes the borrower wants to be able to say no to a lender because the borrower has another possible loan source. That borrower will be in a much better bargaining position.

In this regard, especially with large mortgage loans, lenders and loan brokers often charge high upfront non-refundable fees. This locks the borrower in to onerous terms eventually proposed by the lender. The wise borrower avoids these fees or has them reviewed by counsel before signing for them.

Bank loans are usually the hardest to get and have more reasonable interest rates than some other types of loans. Sometimes it is possible to get a Small Business Administration guaranty and this can help, but it is still the bank's money that funds the loan. Banks usually demand a business with a profitable operating history and sufficient assets to support the loan. They impose operating restrictions on the business to protect themselves. They almost always require the personal guarantees of the owners. Sometimes the banks want the guarantees to be collateralized, i.e., the owner may have to give a mortgage on his or her house or a lien on other assets to secure the guaranty.

The assets ordinarily used to collateralize bank, or other loans, are real estate, inventory, equipment, accounts receivable, and cash and securities. Other assets that are not readily saleable, such as a small business copyright, will usually not support a loan. Banks usually take all the available assets for security and they lend less than the value of the assets.

Some businesses use their accounts receivable for financing. This is called accounts receivable financing or factoring. The mechanics vary, but the accounts receivable and collections from them are turned over to a lender in return for upfront money. This type of financing is usually high cost.

Mortgage financing is sometimes available if a business owns real estate free and clear. If so, this is probably the lowest cost financing.

Money can be raised from non-real estate assets in the same way. Equipment can be financed. The lender takes a security interest in it. The usual form this takes is for a business to buy the equipment in the first place with a loan, either from the seller of the equipment or independent lender.

Real estate or equipment that is owned can be sold instead of mortgaged. The business can retain these assets by leasing them back.

Sometimes a business does not buy its assets, but leases them. This is a form of financing too. The business does not have to put up the acquisition cost.

Finally, there is supplier credit. In some businesses suppliers will give time to pay. This is a significant source of financing in many businesses.

Donald M. Thompson * Chicago Business Financing - 55 W. Monroe #3950; Chicago, IL 60603
Ph: 312-782-0844 * Fax: 312-201-1436 * Email: donthompsonlaw@sbcglobal.net