For years I have read the popular business magazines, all having so-called experts write articles for entrepreneurs on Net Maddy about financing their business. “The top 10 strategies for financing your start-up”, “How the SBA can help your small business,” “Personal credit is the key for entrepreneurs,” and so on. In most cases, I’m willing to bet those writing these articles are journalists that have never had a successful start-up. How can I come to that conclusion, you may ask? Because of the bad advice they give.
Going to the SBA for a loan, using your retirement funds, tapping all your credit cards, or giving up 75% of your idea to an investor are all ideas I have read from popular magazines. The thing is, in every one of these cases, you are using your credit and not separating yourself from your business. You are putting 100% of your credit and assets at risk.
I have worked with thousands of small business owners who have been very successful without using their credit cards or retirement funds or filling out stacks of paperwork and waiting months for a response from SBA-backed banks. I have seen entrepreneurs with access to hundreds of thousands of dollars without giving up a percentage of their company or having any money appear on a personal credit report. Sounds good, right? Well, there is one catch. You will need to go through the evolution of financing your business. You can’t start at the end. This is the problem with most entrepreneurs. They want fast results and aren’t willing to wait. By taking the quick fix, they give up ownership and put their credit at risk.
The evolution of business financing starts with a solid foundation for your business. A solid foundation is comprised of several parts. The first of which is structuring your business entity appropriately. I recommend that every entrepreneur use a Sub Chapter S-Corporation, C-Corporation, or Limited Liability Company to operate the business. This is the first step in separating the business owner from the business. The next phase of building a solid foundation is to ensure the company complies with the lending markets. When reviewing a credit application, several business owners are surprised when I tell them that most lenders we work with will first call directory assistance to see if their phone number is listed. It’s a simple check, but it’s the first flag raised for them if the business isn’t listed. Why would a lender finance a company that doesn’t want anyone to find them?
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A company must go through hundreds of other due diligence phases to ensure the owner and business are not considered “high-risk” for obtaining credit and financing. The more a business has to show that it is real, the more likely a lender will grant credit to that company.
The second step in the evolution of small business financing is to define what the business does, what makes it unique, and why it will be successful. The business owner must create a one-page “sales pitch” for the company, also called an executive summary. The executive summary can be used when applying for credit, seeking investors, and developing marketing campaigns. Business owners must remember that the most important thing for a business is to produce a profit when seeking to finance. Without revenue, there will be no profit. Marketing the company will help make payments, and the executive summary will help create the marketing.
Third, a company must build a business credit report separate from the owner’s credit. By working with trade credit, the largest lending source in the world, a small business can tap into limitless leverage for buying goods and services they need to start, run and grow the company. The beautiful thing about trade credit is, in many cases, it’s free money. If a vendor grants terms of net 30, a business owner can use the vendor’s goods or services for 30 days without interest before paying the vendor. The other wonderful part of trade credit is that companies offering products and services to small business owners must report the credit to a business credit bureau. The tradeline reporting will create a business credit profile separate from the business owner’s credit. Eventually, the business will access more and more credit under the business name only if it maintains a positive business credit score.
The more credit received under the business name, the more likely other companies will grant that business credit. No one wants to be the first in line to give a business $50,000 in glory, but if others already have, they will be more inclined. Fourth is to use the owner’s positive personal and business credit scores as leverage for obtaining hundreds of thousands of dollars in unsecured credit lines for the business. The key is to do this with lenders that don’t report the accounts to the personal credit bureaus but to the business credit bureaus. Many banks offer business lines of credit and loans. However, finding the right product type from these banks can be tricky. A business owner must ensure the loan or credit line they apply for reports only to the business bureau.
A business owner can stay there by separating business debt from the personal credit report. The more a business owner uses their credit, the lower the score. Credit scores determine the ability to buy homes, rates on car insurance, and several other factors. Keeping a credit score above 720 is extremely helpful in the business owner’s personal and business life. The fifth stage of the business financing evolution is to look at another alternative financing the company may obtain. Leasing is one key area. Why use precious cash reserves to buy equipment or software when you can make a small monthly payment? Also, 100% of the price on the lease is expensed.
The final stage deals with investors. Most investors don’t want to look at companies unless they have already progressed through the above business evolution stages. Keep in mind that an investor is not just investing in a business. They are investing in the business owner as well. Suppose the business owner has personally tapped every available resource for credit and cash and never taken the time to establish business credit, financing, or lease arrangements. In that case, an investor will quickly toss that company’s proposal in the garbage.
Not every business owner will find themselves at the stage they need an investor. They may have a combination of enough cash flow, credit, and financing in place from the early stages that they won’t need additional capital. However, an investor will look at the deal in two typical ways if a business needs to grow with additional capital or funding. The first is through debt financing, and the second is equity financing. Debt financing with an investor provides a loan to the business in exchange for a pre-determined amount of interest. Equity financing is where an investor puts money into a business in exchange for ownership. There can also be a combination of debt and equity.
Most small business owners believe this is where they should start, with the investor. In reality, this is the last place a business owner should look. Investors want to use their money to grow a business by having the money spent on revenue-generating activities. The typical small business owner that goes to an investor says, “I need a million dollars to start my business.” When asked what they will use the money for, they say, “start-up costs and payroll.” This is where the investor walks away. No investor wants to fund a project so the business owner can make payroll or buy office furniture, equipment, or supplies.
This is the perfect example of the evolution of business financing. The company starts as an idea; then, the structure is established. Next, the business becomes real with licenses and a sign outside the building. Next, the company creates an identity with the right message. The company then obtains trade credit that separates the personal and business credit to get larger lines of unsecured credit. These are used to build the business’s infrastructure without maxing out all the available credit for the company or business owner. Last, the companies can seek investors because it has done everything required to create a solid foundation.
