by Garrett Fisher
December 10, 2011
I am frequently approached by individuals contemplating starting a business on the subject of getting funded for a business plan. Usually conversations start with something like “I need a bank loan” or “I want VC funding” and revolve around the realities of actually getting desired financing. I was recently engaged in a group discussion regarding government-sponsored start-up funding and was forced to step back and ask “Is there such a thing as start-up funding anyway?”
To clarify, “start-up” is defined as a business that is about to start operations. Most likely, it is in “idea” stage – to be followed by a business plan, setting up operations and locating the first sale. I will define “early stage” businesses as operating, with revenue – small, underdeveloped, probably not profitable yet up and running.
So… is there funding for a business that is in idea or plan stage? The answer, in short is: not really – at least not one that anyone can depend on. Business owners that ask the question seem to have in their mind that once a great idea is born that will quite likely make money, improve lifestyles and/or save lives, that there is an institutionalized pipeline available that naturally connects said idea to being operational and profitable. It is not unrealistic that this idea is rather widespread as political and commercial rhetoric is very prolific on the subject. Governments desire job growth, wish to cultivate it and speak loudly to foster job creation. The problem is, getting from point A to B is a longer road than most are aware of.
That leaves start-up funding as an oxymoron for an entrepreneur with an ingenious idea and a lack of cash. Let’s review various funding methods in the marketplace, challenges for start-ups and alternative approaches to getting a business off the ground.
The overriding idea with all funding forms is that startup funding, no matter who is the source, is unwilling to fund something without receiving commensurate reduction in risk. Put simply, funding sources want collateral, demonstrated earnings and/or a blend of ownership to compensate for early stage risk. What sources require, if they will fund, is usually more than a potential business owner had in mind.
Angel Investors are a skittish group that is impossible to institutionalize into a defined protocol. Usually the easiest group to get money out of that does not ask for too much in return (ie, your Uncle). Difficulty is finding someone that knows you personally well enough, trusts you, has money and has the disposition to part with their money: commonly referred to as good old “friends and family.” Also, current SEC regulations make it hard to raise capital unless individuals are either part of the business operations (“partner”) or somewhat wealthy. There are rumblings in Congress of relaxation in securities regulations for micro businesses which would be very helpful.
Venture Capital: Contrary to popular belief, VC funds look for not only disruptive technology, they also look for trailing (i.e., more than one year) positive earnings that show the potential to be explosively multiplied with a sudden infusion of capital. VC funds’ apparent propensity to “gamble” (as in, willing to lose money on certain portfolio positions) often confuses many into assuming that they will invest vigorously in early stage businesses. Specifically, they require revenue, trailing profits, cutting edge product/service and scalability. There are rare occasions that they will invest in a company that is not presently making money. If a VC is willing to invest, they require a significant portion of the company, sometimes hold the right to fire the founder as an employee and will be rather involved in the business. VC funds also have geographic, industry, size and other targets; hence, requiring knocking on quite a few doors to place a venture-eligible deal.
Banks (including SBA): For businesses up to $50 million in revenue, banks require personal guaranties for all shareholders 20% or greater. For funds loaned, they require collateral at sufficient LTV % to back loan plus proven cash flows to sustain loan payments. Bank requirements ultimately come from the government via FDIC deposit insurance regulations (among other regulators) that limit how depositors’ money can be loaned out. Regulations won’t change from bank to bank. What will change is a bank’s understanding of industry specifics, different collateral types and the willingness to lend against said collateral – knowing that someday they may have to liquidate it. That is why one bank likes real estate, another likes inventory, another likes machinery and so forth. Intellectual property (i.e., software & technology) is one of the harder things for most banks to understand. Sometimes banks will go into gray areas if they really like you – though that world has changed for the worse in recent years. For SBA loans (which are placed through banks), SBA wants owner-occupied real estate – whether commercial or a lien position on the owner’s house.
Non-Bank lenders: Take the banking world, subtract FDIC regulations, increase interest rates and widen the envelope somewhat on what they will lend to. The industry consists a wide range of groups from reputable institutions – such as hedge funds, pension funds, high net worth investors, companies – to folks that are less than savory. They are a bit harder to find than banks and have pricing schemes that are all over the map – from 8.5% APR (hard to get) to north of 40% APR.
Government Funding: Possibly the worst bunch for misleading, these folks tend to tie any funding to two things: 1) jobs created and 2) taxes paid. I.e., most government funds are promised to businesses based on planned job growth, disbursed when jobs are created and “paid” via reduction in property and income taxes. Therefore, businesses not making money won’t see income tax rebates as they are not paying income and/or property taxes. This method works for larger companies, as the accrued benefit of deferring future income taxes can be recognized as present income, so delays in receiving said reduction are not as problematic as lone entrepreneurs strapped for cash. Politicians will sell that they are placing large amounts of capital yet are faced with two realities. First, they announce massive deals when jobs don’t end up always being created (and the incentives are not really disbursed either); hence, there is an illusion of more government money for economic development than there really is. Secondly, the government must prove, for budgeting purposes, that the incentives will pay for themselves (even with fuzzy government accounting), so that creates a typical wall of barriers that restricts funding down to qualified applicants. Funding directly from governments tends to be in large installments to job creators (factories, R&D centers, etc). For the entrepreneur, governments provide incubator style environments typically piped through University systems and/or economic development groups. Some states have VC funds for targeted purposes with VC-style requirements.
The point is to recognize that funding sources, while different and sometimes specialized are looking for something to offset the risk of lending. Since early-stage is the riskiest, availability is the lowest and costs are the highest. Pre early-stage (idea stage) is largely considered impossible to make money on by the marketplace as evidenced by lack of funding availability. As an across the board statement, organizations that will lend or fund based primarily on the merits of promulgating entrepreneurship do not exist – even non-profit advocacy funding groups still can’t lose all of their dollars invested – they need to earn it back to function.
For those in stages, industries or situations where obtaining funding is unlikely, I continuously advocate that entrepreneurs have two plans: one with funding and one without. Those that proceed dependent on large funding amounts with no auxiliary plan historically have the hardest time being successful. Remember that many of the giant tech bellwethers in the industry were started by college students that dropped out, borrowed some cash from a friend and worked on something in their garage while their family thought that they were reckless hippies. Instead of fixating on denials and barriers, start conversations with funding sources, listen to what they have to say and above all else, develop the business plan with or without funding. Forward motion will prove validity of the plan and bring the business closer to get funded.
