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SESSION 12
Financial
Start-up financing and Ownership
Session Outline
The business ownership is a main concern in the start-up phase. It can range from a 100% owned sole proprietorship to a multi ownership joint venture. It’s important to determine because while the business may not have significant value at start-up it may be worth quite a bit in subsequent years.
This session will explore the decision of equity (ownership) determination, particularly considering the start-up costs necessary to launch the business. An understanding of start-up costs and 2nd and 3rd round financing needs will be explained along with the implications for ownership. Various forms of financing will also be shown in order to minimize the need to give up equity in the business at the start-up phase when the business risk is high and equity (ownership) is sold cheaply.
Learning Points
- Determining financing needs (start-up)
- Assessing financing options
- Learning financing alternatives
- Determining future financing needs
- Understanding debt/equity options
Concept
The basis for financing begins with a determination of the amount of money needed to launch the business and sustain it until the business revenues can pay the bills. This was calculated in the exercise in session 10 where we determined the “start-up” cost calculation.
The business plan reader will also be interested in the uses of the start-up funding. Financing agencies, in particular, like to see the start-up money being used for hard assets, especially those that are directly related to production/sales (equipment). If the money is being used for “soft expenditures” then the lending agency will be more reluctant to grant funding.
The next thing is to declare how much money you ( and your partners ) will be putting into the business. Most funding agencies want to see a commitment on the part of the entrepreneur(s). The amount can vary but usually is at least 10 to 15% of the total amount needed for start-up. Some agencies permit an “in-kind” contribution. Most are skeptical of the valuation of “in-kind” equity and prefer to see an actual outlay of cash on the part of the entrepreneur(s). No agency wants to be the lead investor in a project – they want/expect the entrepreneur(s) to be the lead investor to prove commitment and take initial risk.
Once you’ve determined your (you and partner's) contribution then you know the remaining amount of start-up funding that will have to come from external sources. External money can come in the form of debt (a loan), equity (sell a portion of the business ownership) or grants (a grant is best because the money becomes the entrepreneur(s) equity).
So, the ownership of the business needs to be indicated in the business plan and the breakdown of debt (loans) and equity (ownership) must be shown.
We have already calculated the start-up funding needs, and the uses of that funding, in session 10. Now you want to maximize your contribution so that you own the business and don’t need to rely on others for loans ( a drain of overhead costs to pay back ) or equity ( you will be giving up too much ownership for little return in the fragile start-up phase ).
Self-financing
Beyond a doubt, the best source of financing is from yourself. Self-financing allows you to be independent and also gives you all the benefits from your investment ( profits don't have to be used to pay interest expense or partners). If you truly believe in the success of your business then you would want to be self-financed because otherwise you will be giving away your business, cheaply, to others.
When your business first starts up it is fragile and often the only one who believes strongly in it is you. Everyone (Banks, institutions, investors) will be reluctant to invest in your business or lend you money to run it. Even granting agencies like Tewatohnhi'saktha and Aboriginal Business Canada will be skeptical of your business idea because of the fragility of new business start-ups (that's why you need to have a good business plan to prove your business concept). So, lending agencies will always want personal loan guarantees and investors will always want an excellent return for the risk they are taking.
The bottom line is that you have to give away a lot, at the beginning, in order to get a little money. Once the business becomes successful, these investors now get huge benefits from their small original investment.
There are times when you have no choice but to get money, at the beginning, through giving up equity (ownership). Before you do, however, you should look at the options you have and particularly look to self-financing methods first. The main reason is so that you will benefit most from the success of the business in the future. There is a secondary benefit also. Every investor, bank, and institution wants to know how much risk you are taking in your business. This is a true test of your belief in your business idea. If you are reluctant to risk then, looking at it from the bank, investor or institution's perspective, why would they want to risk? So, the true test of your commitment to your business idea is to take risk yourself first. Everyone will judge your commitment on this basis. If you show me someone who has sold their house, their car and used their life savings to start a business then it would seem logical that this person needs to succeed in order to survive. It also shows their belief in their business idea. If you show me someone who wants to start a business but will not put anything in themselves and wants others to invest in their business, then that indicates to me that this person will quit as soon as there are difficulties, because they have nothing to lose.
1) Sweat Equity
This is the most popular form of self-financing. It costs nothing except for the time you put in to work on your business concept. Sweat equity is the investment of time you put in your business idea without any salary for doing so. Your investment of time in taking this class in entrepreneurship is "sweat equity". All the exercises you complete in the booklet and all the information you gather about your business is "sweat equity". It is tangible proof of your commitment to your business idea.
The cost for you is time, not money. So, any investor, bank or funding agency will expect to see you put in the time necessary to make your business work. You may not have any money but a true test of your commitment is the time you take to move your business idea ahead. Everyone has a busy schedule and only 24 hrs. in a day. How you prioritize your time in those 24hrs. is an indication of what's important for you. If you don't "have time" to devote to your business idea now when will you have time later? If someone is truly committed to their business idea they will "steal" time from other areas of their life in order to make time to work on their business. Looking at it from another perspective, you can always tell people who have a true passion for golf, hunting, fishing, bingo, or any other activity because they are always talking about it or looking to find time to pursue that activity. The same applies for entrepreneurs. They are always talking about, getting information about, and looking to find more time to pursue their business idea. This investment of time and energy is proof of commitment and is visible to all. Once you have made an investment in time and energy then others who see this are much more willing to help out. If you "don't have time" to research your business idea and expect a Business Services Officer to research it for you, does this show total commitment to your idea?
So, sweat equity is an excellent way to show commitment and leads to getting others to help. If I'm painting my house and ask you to help, you would be more willing to help than if I asked you to paint my house, for free, because I was "too busy" to paint it myself. Same goes for your business. Show others you are investing lots of time and energy and they will be very willing to help.
2) Alliances/advisors
Your sweat equity leads to this second form of self-financing. Experts, professionals and mentors are very willing to help others who are investing a lot of time and energy on a business idea. The Business Services Officers are very busy, but they will find time for someone who is truly excited about a business idea and is willing to invest some time in researching that business opportunity.
Bankers, teachers, business people, experts and virtually everyone is willing (and honored) to be asked for their professional opinion, advice and help. Look at how willing the entrepreneurs in the video series were to give their time, freely, to help others become entrepreneurs in the community.
Through your own "proof of commitment" by sweat equity, you can now network with others who can help you move your business idea along. Talk to people who can help. If they can't help they can often refer you to someone who can. You must be respectful of their time,however. Experts, entrepreneurs and professionals are always very busy - they don't have much time to spare. Make sure that you respect their time by doing your research first and going to them for an opinion/advice. E.g. A Business Services Officer would be receptive if you said " I found out that there are 1,000 seniors in Kahnawake. Do you think that would be an adequate base for my business opportunity?"
For other professional help, the next step would be to barter. If you are an artist then an accountant may be willing to accept a painting in return for doing your books. If you are a landscaper then the local newspaper may be willing to barter ad space for lawn care.
Barter is not a cash expense for you, other than your time and the cost of materials to do the job. If the help you're getting would have cost you money then barter is as good as an investment of cash.
3) Reducing your financial need
The third financing option that doesn't require cash is to reduce your need for funding. Buying used equipment, instead of new; leasing, instead of buying; and looking for ways to reduce start-up financing needs, puts money in your pocket. If your original calculation was that you needed $10,000 to start the business, and you were able to reduce this need ( through excellent cost saving techniques such as barter, working from home, not taking a salary, etc.) to $5000, then that is as good as getting $5000 of your own money into the business.
Look to cut corners, wherever possible, at the beginning. The savings are most important at this stage and it will reduce your dependency on others ( and their control over you ). It will also impress others on your fiscal responsibility and get them to perceive you as someone who is going to be a good manager of your organization's resources. When you do need money from external sources they will like to see that you will manage it well and not spend it foolishly.
Another way to reduce financing need is to provide “in-kind” financing. So, you can provide your computer, your car, your furniture for office use, a room in your house, your telephone, etc. instead of putting up the money to buy those things.
One excellent way to reduce the need for funding is to start small, prove the concept and fund growth from profits. That would enable you to maintain total ownership (see case later in this session).
4) Your financial risk
At some point there needs to be an actual investment of money to purchase assets or for rent or other start-up expenses. This is where you have to invest until it hurts. The amount you invest is relative to the needs of your business and your financial ability. The guideline for financial commitment is provided by Aboriginal Business Canada. Their rule of thumb is that the entrepreneur should put up 10 to 15% of the money required ( 10% for youth 15% for others ). So, if you need $5000 then you should put in at least $500 to $750 in the business yourself.
This brings up the primary issue of (debt/equity). Debt is a loan to the business and must be repaid, with interest. The one who lends you money has no claim to any ownership in your business. You are only obligated to pay the loan back, with interest. Equity is ownership in the business. The good aspect of using equity, instead of debt, is that the person who "buys into" the business takes risk, with you, and there is no repayment obligation. The negative side of equity is that someone is now a partner with you in the business and now has a say in decision making and is entitled to a share of the profits in the business. This can be lucrative for the investor.
So, if we use the example of needing $5000 to start the business and we put in some sweat equity, get help from others and put in $500 cash, then we have shown our commitment. We still need $4,500. We can get a loan for $4,500 (debt) but we now have loan payments, with interest, to make. If we got a partner we would not have to make any payments, the partner would put up the money, but we would only have 10% of the investment in the business, the partner would have 90% ( based on the total amount of ownership being $5,000 and we only contribute $500 (10%) and the partner contributes $4,500 (90%). This is where negotiation skills are important. If you can show that partner that you have contributed at least $4,500 worth of sweat equity ( based on number of hours you've put in x a reasonable per hour rate of pay ) then you can argue that you put in $5000 ( $4,500 in sweat equity + $500 cash ). So, you can offer to sell a percentage of the business for $4,500 and that percentage is a negotiable amount. You can negotiate to sell it for whatever the two of you agree on, but you will probably want to keep 51%, at least, in order to keep control of the business.
CASE
Eileen’s Bakery and Chad Rice (Old Malone’s)
Both of these entrepreneurs are examples of the strength of self financing. Both businesses are poised for significant growth and both owners still have complete ownership and control in their business. The growth has required considerable inflows of money yet both entrepreneurs have maintained their ownership and leadership position in the business. How did they do that?
1) Both Eileen and Chad started small and self-financed themselves with small grants and loans. Eileen started from home and Chad started with "The Shack" which was a low cost, home made building.
2) Both put in a lot of "sweat equity", working for no salary and doing it themselves or getting friends and family to help. Eileen used family for labor initially, even made her own sign. Chad built "The Shack" himself and his wife was a big contributor to the business success, working without a paycheck.
3) Both kept their expenses down to a minimum and did not spend too fast nor too much. They were very careful on the spending side. They focused on sales and worked hard themselves in their businesses. They were intent on proving the business concept before growing (and spending).
4) Chad has now committed to a new business model. "The Shack" proved itself and gave Chad the experience and confidence needed to go to a larger, upscale restaurant in "Old Malone's". Chad used grants and lots of debt to fund the expansion. There are times when he felt overwhelmed by the debt but that just energized him to work harder. "Old Malone's" is a successful restaurant and it is all his and his wife's. They have debt but no one else owns any piece of their operation.
5) Eileen is ready for growth. She moved to a storefront, from her home base, years ago and she is now ready for a large move forward, similar to Old Malone's. She has purchased the land and envisions developing a mini-complex on the site. She will be looking for funding which should be fairly easy to acquire because of the successful track record she has established. She maintains complete control even though her business has rapidly expanding possibilities.
Both entrepreneurs are a tribute to success based on self-financing concepts, dedication to their business, attention to detail, money saving techniques and the re-investment of profits into the development of their businesses.
The result is successful businesses, which are in growth, with the original entrepreneurs' ownership and control.
There are many financing sources beyond you. These sources are explained below with an assessment for each:
1) Friends/relatives (Grants/Personal Debt)
The most popular form of financing beyond your own savings. Family, in particular will be lenient in terms of expectations for loan repayment. An excellent source of financing because the loans are personal and do not have to be included in the financial statements. So, in actuality, loans from family can be considered as your equity in the financials.
The negative aspects of financing from family and friends is the fact that they are amateur lenders – they don’t understand the ups and downs of small business unless they were entrepreneurs themselves. Therefore they are likely to want their money back at unpredictable times and they will be very upset if your business goes bankrupt.
Despite these potential problems, family and friends are one of the best sources of initial financing.
2) Agency grants and loans (Grants/Debt)
Another excellent source for start-up financing. Tewatohnihi’saktha, Aboriginal Business Canada, NACCA and other funding agencies provide grants and loan guarantees based on the feasibility of your business idea. They are not seeking to take advantage – they are genuinely interested for you to succeed without taking advantage of you.
The grants become your equity which is the best funding opportunity. Also, there is the possibility to get funding from more than one agency. The loans require repayment on a regular basis but the loans are guaranteed without you having to put up personal assets as collateral.
3) Suppliers (Debt)
Considering the requirement for inventory in many businesses, a large portion of start-up costs are often dedicated to inventory. If the supplier can give you terms on the inventory (e.g. net 30 or 60 or 90) then that is financing. Otherwise you would have to use start-up money to buy the inventory. So, a supplier loan for inventory is an excellent financing method.
The problem with this is that suppliers are reluctant to provide credit to start-ups because of the risk factor. Usually they will insist on cash and carry. Suppliers are certainly interested in your success and they want you to promote their product. They are a key alliance partner and you should quickly begin to establish a line of credit with the supplier. Initially pay cash then begin to make arrangements to pay in 7 days, then 30 days, the 60 days and ultimately 90 days. Good customers can get up to 90 days credit from suppliers (3 months). This means you have the inventory for 3 months before you have to pay for it. You could sell the inventory by then which would allow you to pay for the inventory from sales.
4) Partners (Equity)
There are partners who will be active in the day to day operations and the other category of partners are the “silent” partners. Both types are investors and both have ownership (equity) in the business. The major difference is that the silent partners are only investing to get a return on their investment (ROI). Usually they expect a return that is at least four times the return that they would get from a risk-free investment elsewhere.
Active partners are good if they have skills that can add value to the business. Silent partners will expect good returns and will not want to be involved in day to day operations.
5) Banks (Debt)
Banks are not risk lenders. They would rather lend money to someone who has a regular job and wants to borrow money to buy an asset (a vehicle e.g.) that the bank can seize if the borrower defaults on the loan.
An entrepreneur, in a start-up business, is too risky for the bank. Income is not regular and not highly predictable. The money will also be used for purchases that may lose their value quickly (inventory, salaries e.g.) and therefore not be seize-able in case of default.
So banks are only debt lenders if you can put up personal guarantees (collateral). In essence it is a personal loan not a loan to your business.
Contingencies
Whenever you think of financing a start-up, you need to realize that funding sources (debt and equity) are concerned because of the high risk associated with start-ups. So, they are very reluctant to provide “rescue financing” later on. Rescue financing occurs when a start-up miscalculates the amount needed, doesn’t meet sales projections or incurs unforeseen expenses. That’s when the start-up needs to go for rescue financing (to avoid bankruptcy). When this is necessary the funding sources perceive that the entrepreneur(s) have poor planning or poor management skills and they are more reluctant to fund than at start-up.
So, with this in mind, and anticipating that whatever can go wrong will go wrong, the entrepreneur(s) at the start-up phase should request 15 to 20% more than calculated (for contingencies – the “what ifs”). Another technique to cover this is to get pre-approved loans (line of credit) that will not be needed (or used) at start-up. In the event that supplementary
financing (rescue financing) is needed then the pre-approved line of credit can be used then.
Unexpected costs, cost overruns and revenue projections less than anticipated are all part of the realities of business start-up. Be prepared by providing for contingencies at the start-up phase.
Future Financing Options
You always have to consider future financing even at the start-up phase. If you do start small and strive to prove your concept before expanding then you need to think of the 2nd, 3rd, and 4th levels of financing as you build on success.
This has implications for debt/equity decisions. Most entrepreneurs want to retain control of their business for as long as possible. If you give up a lot of equity in the first round (start-up phase) then you will have to fund almost exclusively with debt in the following rounds. As a rule of thumb you need to have about 30% equity remaining for sale in the subsequent rounds. Ideally you have 30% for sale in the start-up round (if needed), you keep 40% and leave 30% for sale in subsequent rounds. This is applicable in business start-ups that have considerable expansion potential.
Summary
It is important to know how much money you require to start your business and then challenge your own projections to reduce your start-up needs even further. Then, following your commitment of funds, or “in-kind” financing, you will know what financing needs remain.
Then you’ll need to determine the type of financing you would want (debt/equity) and explore the potential sources of funding available. Make sure that you allow for contingencies (the unexpected) by securing more start-up financing than projected (15% to 20%) and/or getting pre-approved loans for use later on if needed.
Consideration also needs to be given to further funding needs for expansion in certain businesses.
EXERCISE # 1
Below is a copy of exercise # 2 from session # 10. Re-enter the calculations you did in session 10. Now re-examine the numbers you entered to look for opportunities to reduce the needs. (e.g. Start with a different business model that allows you to work from a home-based location).
Estimated Start-Up Costs:
First 3-Months
Rent
Renovations
Auto
Insurance
Computer(s)
Phone/cellular
Equipment
Office furniture
Inventory
Salaries
Other
EXERCISE # 2
Considering the unexpected, determine the amount of contingency funding you will need.
EXERCISE # 3
Determine the source of your start-up financing and the type of financing you will get. Also detail the amount of ownership (equity) you will give up in those situations where equity financing will be used.
Amount of financing needed (Exercise 1 and 2)_____________________
SOURCES
AMOUNT
% OWNERSHIP (If applicable)
YOU ________________________
FRIENDS ____________________
FAMILY _____________________
PARTNERS __________________
AGENCY #1 _________________
AGENCY #2 _________________
BANKS _____________________
SUPPLIERS__________________
DISCUSSION QUESTIONS
1) Whether you use bank financing at start-up or not, bank financing will certainly be important in subsequent financing rounds because the business will have a track record and be less risky. Discuss so ways to develop a rapport with the bank manager to increase the likelihood of a bank loan at some point of expansion in the future.
2) Discuss some opportunities that you would have for barter. What are some business services/products that you could use and what could you provide in return?
3) Who are your key suppliers? What process can you use to work them to give you 90 day credit? How long do you think it would take you to get to this stage?
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