NFIB

Understanding the Different Sources of Capital
10/ 01/ 2002

Today's Workshop is the first of a two-part series taken from the book Raising Capital by Andrew Sherman.

There are many different sources of capital--each with its own requirements and investment goals--discussed in this book. They fall into two main categories: debt financing, which essentially means you borrow money and repay it with interest; and equity financing, where money is invested in your business in exchange for part ownership.

Sources of Debt Financing:

Commercial banks
Smaller companies are much more likely to obtain an attentive audience with a commercial loan officer after the start-up phase has been completed. In determining whether to extend debt financing--essentially, make a loan--bankers look first at general credit rating, collateral and your ability to repay. Bankers also closely examine the nature of your business, your management team, competition, industry trends and the way you plan to use the proceeds. A well-drafted loan proposal and business plan will go a long way in demonstrating your company's creditworthiness to the prospective lender.

Commercial finance companies
Many companies that get turned down for a loan from a bank turn to a commercial finance company. These companies usually charge considerably higher rates than institutional lenders, but might provide lower rates if you sign up for the other services they offer for fees, such as payroll and accounts-receivable management. Because of fewer federal and state regulations, commercial finance companies have generally more flexible lending policies and more of a stomach for risk than traditional commercial banks. However, the commercial finance companies are just as likely to mitigate their risk--with higher interest rates and more stringent collateral requirements for loans to undeveloped companies.

Leasing companies
If you need money to purchase assets for your business, leasing offers an alternative to traditional debt financing. Rather than borrow money to purchase equipment, you rent the assets instead. Leasing typically takes one of two forms: Operating leases usually provide you with both the asset you would be borrowing money to purchase and a service contract over a period of time, which is usually significantly less than the actual useful life of the asset. That means lower monthly payments. If negotiated properly, the operating lease will contain a clause that gives you the right to cancel the lease with little or no penalty. The cancellation clause provides you with flexibility in the event that sales decline or the equipment leased becomes obsolete. Capital leases differ from operating leases in that they usually don't include any maintenance services, and they involve your use of the equipment over the asset's full useful life.

State and local government lending programs
Many state and local governments provide direct capital or related assistance through support services or even loan guarantees to small and growing companies in an effort to foster economic development. The amount and terms of the financing will usually be regulated by the statutes authorizing the creation of the state or local development agency.

Trade credit and consortiums
Many growing companies overlook an obvious source of capital or credit when exploring their financing alternatives--suppliers and customers. Suppliers have a vested interest in the long-term growth and development of their customer base and may be willing to extend favorable trade-credit terms or even provide direct financing to help fuel a good customer's growth. The same principles apply to the customers of a growing company who rely on the company as a key supplier of resources.

An emerging trend in customer-related financing is the consortium. Under this arrangement, a select number of key customers finance the development of a particular product or project in exchange for the right of first refusal or an exclusive territory for the distribution of the finished product. Carefully examine applicable federal and state antitrust laws before organizing a consortium.

Andrew Sherman is internationally recognized as an authority on the legal and strategic aspects of entrepreneurship and business growth. As a senior partner with McDermott, Will & Emery, he manages a multi-million dollar corporate and transactional practice, representing Fortune 1000 corporations as well as hundreds of technology-driven, net-centric and rapidly growing businesses.

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