Sources of Capital For Your Small Business

Each small business will have different capital needs depending on its growth rate, industry or type and overall economic conditions.  Capital professionals such as commercial bankers, equipment lessors and venture capitalists all know how your company’s business and its place in the business cycle meets with their portfolios.  Following are some general descriptions of types of capital sources and how they may look at your business as their next potential investment.

Commercial banks. These are the local, regional and national banks which comprise the backbone of small business lending in the United States.  Their loan instruments include secured and unsecured (rare) loans, lines of credit and commercial mortgages.  They price their products as a function of the “Prime Rate”, generally described as that loan rate the bank offers to its best customers (least risky).  Loans to borrowers who the bank thinks are more risky investments are priced at “P+” (Prime + 1%, 2% and so on).  These financial instruments are generally secured by your company’s assets and probably a personal guarantee by the principal owner(s).  Assets including accounts receivable, inventory and property, plant and equipment and are part of a “borrowing formula” used to calculate the amount the company can borrow…and repay.  An example of such a formula might be 80% of eligible (ex. 60 days or under) receivables; 50% of inventory and 50% of property plant and equipment.  Typical customers range from low-to-moderate growth businesses to higher growth companies with quickly-turning, top quality receivables and higher product profit margins.  Because a commercial banks products are priced on a risk basis, in an economic downturn costs borrowers pay may be higher – either through higher interest rates or due to decreases in the borrowing formula parameters.

Asset-based lenders and finance companies. These are the more strict secured lenders, willing to take risks that your average commercial bank will avoid.  Their security provisions, credit terms and loan covenants are generally more strict and their borrowing formulae will probably offer less latitude than a commercial bank.   Remember these lending officers have very tight guidelines and lending policies, but they will not shy away from more risky investments if they believe underlying collateral can secure their loan.  They are also prone to moving very quickly to perfect their secured interest and to liquidate assets so that loans can be repaid if a downturn triggers borrowing covenants.  Typical customers range from low-to-moderate growth. 

Equipment leasing firms. These lenders will help you obtain necessary new equipment by buying it and leasing it back to you.  They are very good sources of information regarding the underlying and residual market values of equipment you wish to buy or sell.  Many smart small business owners will contact an equipment leasing firm as a standard procedure before making purchases of significant equipment.  They believe that knowing the amount a leasing company will “lend” and at what rates will offer a window of knowledge on both the equipment’s market value and your perceived ability to pay the lease.

Venture capital firms. Venture capital firms are equity investors…they will own a share of your business. While there are equity investment firms that will look at small businesses, growth, growth and growth are the orders of the day.  Most small businesses are not in the sectors or industries which can support this need for growth and thus this type of investment.  This capital source makes the most risky investments and expects the highest rewards, but they are generally financial investors, looking for a return on their investment rather than a say in the day-to-day affairs of your business. 

SBIC’s.  Small Business Investment Companies licensed by and partially funded by the SBA are considered equity investment firms.  More accurately, they are “mezzanine” capital firms, with investment instruments having both debt and equity characteristics.  A typical SBIC investment may be a high rate (P+4 or higher) five year loan with limited security but a significant option to purchase common shares. 

TIP:  If your business is cash flowing and the term sheet from a VC firm is starting to look more like a commercial bank term sheet, you may want to meet several SBIC’s to get an expression of their interest.  Without knowing any special circumstances, it may be that the capital market is viewing your company and its risk factors differently than you and your advisors.  It may also mean that you may want to continue searching the venture capital markets for firms more in tune with your industry or business plan.

Angel investors. These are individual investors, generally of higher net worth.  They may be friends of yours, associates or network contacts of your advisors or other business people you know.  Angels generally purchase shares in your business and may be able to provide direct industry contacts and skilled business insights.  A possible issue with angel investors is their willingness to “cut corners” on due diligence or the documentation process.  While it may sound heavenly if badly-needed capital comes in your door sooner, you don’t want your angel to become a devil due to missed expectations.  Take the time to make sure that a well-drafted shareholder agreement or other such document spells out the expectations of both parties.

Strategic capital sources. Strategic capital sources typically are those business firms in your industry who make equity investments in companies like yours.  Generally an offshoot of an existing business relationship, these kind of investments may be very attractive on the surface.  Many small business owners would love to get the “seal of approval” of a better-known and larger industry colleague.   But remember that these people recognize some value in your business which can make their business better.  Because you are in the same industry, the reality is that a poorly-designed investment by a strategic partner or even the information exchange during the process itself may cause real harm to your business. 

TIP:  Remember to protect your business ideas, assets and trade secrets with non-disclosure agreements (NDA) which also contain non-competition or use clauses.  This is a standard process and many large companies such as Intel, Sun, AT&T and Lucent will not even open discussions with you before you execute a mutual NDA.  Most others recognize this as a standard operating procedure and will comply with a little negotiation back and forth.

There are many different types of capital sources for your business.  Knowing what they are and what they look for may help to analyze your prospects and focus on those segments of the capital market which can most benefit your company.