Perhaps you are a new entrepreneur about to launch a business or innovation you have been dreaming about for years. Or maybe you have an established business and things are going well, or maybe even too well. In both instances you are going to need capital – the “oxygen” that every business needs to grow and prosper. So now you are writing your first business plan or touching up the old one in anticipation of raising capital.
Capital can only come into a business in one of two ways: capital that is generated internally through positive cash flow from business operations (e.g., selling stuff), or from external funding sources. Obviously, the new entrepreneur is limited to only one option – external funding sources. The established business, on the other hand, is hopefully generating positive cash flow, but may require additional capital in order to fund inventory, growth, or new equipment.
For now, let’s set aside internally generated cash flow and concentrate the search for capital on external sources. Some common sources include:
- Investment capital (equity)
- Shareholder loans
- Bank or finance company debt
- Government programs
- Other options
So, which funding option is best? Is it best that the capital come from only one source, or does it make more sense for the capital to come from multiple sources? How do you decide? How you decide to capitalize the business is called your capital formation strategy. The capital formation strategy you choose will depend on a number of internal and external factors including:
- Your current balance sheet (for established businesses)
- How much capital you require
- The intended use of funds
- Your company’s current credit standing, if any
- Your personal credit standing, especially for new businesses or very small businesses
- The availability of collateral
- Your current cash flow and your ability to service bank or shareholder loans
- Covenants on existing debt
- Current shareholder agreements
- Your current rate of growth
- There are undoubtedly a number of other factors to consider depending on your company’s current circumstances, and, quite importantly, where you want your company to go in the next few years.
How do experienced executives determine the best capital formation strategy for their company? First, in considering all of the internal and external factors listed above and, of course, those not listed above, it is time to eliminate those sources of capital that for one reason or another are not available or appropriate at this time.
Next, think about the business plan you’ve just written or updated and then build a financial forecast that includes a balance sheet, income statement, and cash flow statement. These forecasts should be presented monthly and annually so that you can see how future changes in the business such as increased sales, additional staffing, or seasonality will affect cash flow. Remember, you don’t want to run out of money.
Here are some typical capital needs and traditional ways of funding those needs:
Financing high value capital equipment such as transportation, plant (factory), or medical equipment can often be accomplished with equipment leasing or term debt from a bank or finance company. Remember, all lenders and lessors love collateral, especially collateral that holds its value.
If you wish to finance a building or building addition, check out the Small Business Administration’s 504 loan program.
And speaking of the SBA, don’t forget that business loans can be funded through the SBA 7(a) program.
Often, entrepreneurs fund research and intellectual property through Federal government grants, and grants from other sources.
Another way to generate capital is to factor your receivables. Factoring is not for every business, but when it works, it can really help.