In dealing with my clients and their financing needs, I often have to approach the rough spot of financing equity. It seems that everyone wants to find some type of 100% loan to value financing for the next big internet start up. I hate to break the news to them, but it's not going to happen. Unless it is for some form of consumer lending, 100% financing is very hard to come by.
The reason is simply, lenders are not venture capitalists. In any financing proposal, there is always a certain percentage of the deal that is too risky for loss adverse bankers to finance. Usually this is around 20%. I, therefore, tell my clients point blank that 20% of their financing proposal will not be financed using commercial debt. 20% of the proposal is going to have to come from somewhere else.
This condition imposes several possibilities. First and most auspicious one is that the client already understands this fact and has 20% of their own money ready to go into the deal. The second possibility is that an investor can be lined up to cover the 20%. Finally, the financing proposal can be altered by either waiting for more time or asking for less capital. The take home message from this article is that whether you are financing a local hair shop, a new restaurant, or a $100 million land acquistion, you have to have the 20% down payment.
Operating Lease vs. Capital Lease
If your business ever decides to lease equipment, you will face the questions of
"What is the difference between an operating and a capital lease?" and "Which option is right for me?" The differences involve several areas including accounting treatment, company credit, useful life of the equipment, and obsolesense. These differences you should consider when looking at equipment leasing options.
Operating Lease:
- You are essentially renting the equipment and will return it at the end of the lease. This can be good or bad. For example, if equipment doesn't age much in your industry you at somewhat of a disadvantage, however, if you are in an industry (let's say networking hardward), this is great because you don't get stuck with equipment that is obsolete.
- For accounting purposes, this lease is a pure expense. It's only place is on the income statement and it has no bearing on your debt-to-worth ratios or other balance sheet ratios that can effect business credit.
- In the long run, you usually pay more than if you could have obtained the equipment with a capital lease or a loan, but in the short-run (when you are cashed pinched) it can be a life saver.
Capital Lease:
- You are essentially making payments to own whatever equipment you are leasing. At the end of the term, you will usually pay a nominal amount (like $1) to obtain ownership of the equipment.
- For accounting purposes, you must capitalize the lease on the balance sheet (ergo capital lease). It will effect your long-term liabilities and assets such as bank loan would.
- Despite that it capitalizes like a typical term loan, capital leases are usually easier to obtain and consume less initial capital than a typical bank term loan.
Many people often talk about the C's of Credit. Often, the most important C is Character. The question is those, how does one show the correct Character when it comes time for financing?
Characters is much more subjective than any of the other C's of Credit. There is no where to put a number on Character. There is no magic bankers formula that says ABC has 100 character points. It's not like the guy making a net profit of 5% has more character than the guy making a net profit of 6%. Although there is not financial number for Character, it is as important if not more important than anything else in the financing proposal.
Let's think about Character from your lender's perspective. No matter how good the numbers look if I can't trust this company nothing else matters. Thus, when Cheatway Inc. says "That's not how much I really made." It's definitely not gaining any leverage on character. On the other hand when ACE Corp. says "Yes, we actually had less sales that year even though our profit looks better that year," it gains the lender's trust and confidence.
To summarize how should one approach character, just be honest. It's not as hard as any of the other steps to obtaining credit, there is no math to do, etc. Just be honest and forthcoming. Trust me, if there is a character flaw or something else you are hiding your lender is damn well going to find out.
When a business buyer and seller come to the table, the often tough question of how much is a business worth must be answered. There are many valuation methods that are used, some very simple to understand and some very complex often involving higher level differential math. In most cases, parties are more happy with simpler methods that are easy to conceptually grasp. Here I will show you the most simple method of valuating a business, the Balance Sheet Method.
In the balance sheet method, one only looks at the business's assets and liabilities to determine exactly how much it is worth. Let's take a look at a quick simple example.
ABC Corporation has this balance sheet:
Assets Liabilities
Cash $100,000 Accounts Pay. $50,000
Factory $1 million Mortgage $500,000
In this example, there are $1.1 million in assets and $0.55 million in liabilities. The business is therefore worth $0.55 million, or $550,000. If you are familiar with GAAP, the body of general accounting standards, assets are carried at book value, which is often much less than market value especially for appreciating assets like real estate. Many will therefore use the Adjusted Balance method which takes into account the market value of assets.
Let's say we reconsider the above example, and we see that ABC bought the factory 10 years ago. The industrial real estate in its market has appreciated so now the factory would sell for $1.5 million today. Now the worth of the business is $1.05 million instead of $0.55 million.
Whether one uses the balance sheet method or more popular adjusted method, the approach is looking at what the business is worth based off its asset alone. It takes nothing into account of how much a business has in earning power. The balance sheet method lets one take the perspective of "I walked away from this business tomorrow, sold everything that it owns, how much do I get?"
Most people looking for business financing, be it in the form of a bank loan or from a venture capitalist, could benefit greatly from considering their efforts from a sales view point. By that I mean, treat obtaining money on credit or equity the same way you would treat obtaining more money from bigger sales or new clients.
Before you launch a new product or service you ask, "Why should my customer choose me over my competitor?" (Or atleast you should!). In the same way, remember that you are competing for financing dollars in the same way that you are competing for sales dollars from your competitors. Your banker or potential investor probably has more businesses asking for her money than she could ever finance even if she wanted to.
He is going to make decisions in the same way that your customers do now. "Does this parts distributor meet all its orders on time?" "How long has this marketing firm been around?" etc. More likely, the questions are going to be tougher than these and strike right at the core of your business's flaws. He is going dig around your income statements and ask why didn't the company meet sales projections two years ago. You'd better be ready with convincing answer backed with hard facts.
The take home message is to come prepared with a plan of attack and to remember that you are competing just as fiercely for financing capital as you do for sales.
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