Raising Money in These Challenging Times

This
week’s topic for the Forbes America’s Most Promising Companies project is from Brett Nelson, Entrepreneurs Editor at Forbes.com:

 

At
its core, the America’s Most Promising Companies project is about getting
capital to entrepreneurs who need it. Many go wanting, especially in this
credit-starved economy. With that in mind, how does America‘s financial infrastructure
need to change—if at all—to make sure deserving entrepreneurs have access
to precious funding? For that matter, what are the keys to raising money, in
this or any economic environment?

I find it very worrisome that there is movement toward more government intervention in financial markets that serve entrepreneurs.  Pumping more money into the SBA to prop up businesses that cannot support that debt is bad policy and a bad business decision.  And now we hear that venture capitalists are trying to get their cut of government funding through the bailouts.  Venture capital investment is, by definition, a high risk affair.  If VCs can’t raise money through private offerings it seems to me that there is a good reason — their expected returns have become too risky.  We don’t need to throw tax payers’ hard earned money into poorly performing funds.

Truly deserving ventures can still get funding, although it has gotten a bit more complicated and challenging. 

Equity funding is still flowing.  The amounts are less and the money can be harder to find, but it is still out there.  Entrepreneurs need to be prepared to be able to offer more proof of concept.  The giddy times of dreams and ideas getting money thrown at them are over for now.  Do what it takes to prove you have a viable business — find customers who will buy your products or services.  This will take more self funding for seed money and more bootstrapping to get the business off the ground so you can demonstrate to investors that your business really works.

Debt markets for entrepreneurs are going back to basics.  This is a good thing, I must say.

Traditionally, bankers have operated with a business model that tries to minimize risk.  They are responsible with protecting the deposits held in their banks.  Many banks strayed too far away from this in the recent past, but they are returning to their old ways of doing business.
 
Businesses must be able to qualify for bank credit on their own standing.  This has very little to do with the things that get entrepreneurs excited about their own business, such as opportunity, upside potential, and vision. To a banker, a bankable business is one that will pay back its loans with very little chance of anything going wrong. So rather than getting excited about untapped markets or product innovations, bankers look to three main factors:

Is there adequate cash flow?

Bankers define “adequate cash flow” not as being just enough excess cash each month to cover monthly loan payments, but significantly more than enough excess cash flow.  Also, bankers want see this cash flow already occurring, not projected in the future within a business plan.  That is why bankers are usually not the best source of funding when you first open your business.  Get a track record and some cash flow and you will find that bankers are much more receptive.

Can owners pay back the loan if the business cannot?

Personal guarantees from the entrepreneurs who have the personal net worth to pay off those loans is the second line of defense for banks. 

Is there collateral?

The reality is that banks don’t want to try to collect your accounts receivable, sell your inventory, or liquidate your equipment – and they certainly don’t want to run your business. Don’t assume that such collateral is what banks like to see in a business loan proposal. Collateral is considered the last resort for covering a loan from a banker’s perspective.

The financial markets will improve for entrepreneurs as the financial prospects of their ventures improve.  Private sector efforts to improve the efficiency and effectiveness of financial markets for entrepreneurs, such as angel networks, web resources, and projects like America’s Most Promising Companies can help, but the wounds in this economy will take a long time to heal. 

Creating a Financial Dashboard for Down Economy

My column in this week’s Tennessean looks at key financial information you need on your dashboard to help you navigate these challenging times:

It’s beginning to look like we may be in this recession for quite some time. Even if your small business has survived to this point, it still could be financially vulnerable to the continued sluggishness in the economy.

Unfortunately there is no single number or financial measure that can fully assess the threat a business faces. It is important to keep your eye on several key numbers and ratios. When put together these are referred to as a financial dashboard — an easy-to-read series of figures that gives a good overview of how a business is faring.

The first category of figures that should be on your dashboard each month helps assess how well you are managing debt. A ratio that bankers pay particular attention to is times interest earned, which assesses how well your business can cover its loan payments owed to the bank.

The percentage of your assets financed through debt is another key ratio. Finally, the overuse of credit card debt can make a business more vulnerable.

The second category on your dashboard should assess the strength of the cash position of your business. Never forget that “cash is king.” Monitor your cash reserves carefully.

Vic Alexander of KraftCPAs recently advised a class of entrepreneurs that I was teaching to have enough cash on hand to cover at least 45 days of expenses. If customers pay on account, monitor the average age of your accounts receivable.

Finally, looking at the ratio of cash to current accounts payable each month is another good test of the strength of your cash position.
Watch your suppliers

Your business is also dependent on the financial health of suppliers and customers. Add some measures to your dashboard that help you monitor them, which can include:

• The number of suppliers that still let you buy from them on credit.

• The increase in new customers you are able to attract each month.

• Your ability to attract returning customers.

• Your dependence on a few large customers.

• Revenue trends from month to month and compared to the same time last year.

• If you carry inventory in your business, watch it closely from month to month to ensure that you are not building excessive inventories.

My friend, Dr. George Solomon, a professor at George Washington University, and I have put all of this together in an online assessment for Entrepreneur magazine that walks you through each calculation.

It is available free of charge at www.entrepreneur.com/quiz/threatindex/index.html and will provide you with an overall score that helps you evaluate your financial vulnerability.

So, pull out your financial statements, grab a mug of coffee and take an honest look at the financial health of your operation.

Just Say No

For all of you entrepreneurs who have been whining “Where’s our bailout?” your time at the public trough has now arrived.  It is not the rent seeking entrepreneurial welfare that was the topic of conversation at this blog a few days ago, but it is darn close.

From the Tennessean:

The U.S. Small Business Administration made a new loan program for struggling businesses available Monday. The ARC loans, which were funded by the American Recovery Act, are interest-free loans of up to $35,000 with no SBA fees for existing businesses that were profitable at one point, but need extra help now.

The program is unusual in that most small-business loans are for businesses trying to expand to fund profitable operations.

Thus my label of “bailout.”  This are not sound loans — these are handouts.

Thankfully, bankers are hesitant to join in this give-away.  From CNN Money:

Before the details were released on Monday, lenders were hesitant to commit, concerned that there wasn’t enough economic incentive
for them. Now, with key details about how the program will work finally
available from the SBA, many haven’t retreated from their initial
wariness.

“While we have received a few requests from our customers, we are still leaning against it,” says John Handmaker, president of Quadrant Financial,
a small business lender based in Louisville. “The guidance from the SBA
indicated rates and terms, which have provided some clarity, but we’re
not 100% certain about what we need to be careful of. We don’t feel we
have a solid grasp of the standard operating procedures and rules, and
we’re not going to jump in until we really understand it.”

Well, at least the government is consistent.  It is ready to rush to enact another program without worrying about the details.  I am sure we will soon hear that bankers are being pressured to get on board with this program. 

Please, just say no to this latest bailout.  If you believe in free enterprise do not become part of the rush to socialism.

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Venture Capital will not be our White Knight

I continue to be concerned about the inordinate amount of attention that Washington is giving to venture capital.  There seems to be an assumption that VC investment is a White Knight that will help spur entrepreneurship in America and pull us out of our recession.

Remember, venture capital only funding a small part of the entrepreneurial sector.  In fact, one study found that 99.962% of entrepreneurial ventures in the US had NO venture capital investment.

Rather than pour money into venture capital markets, as we now see talk of in Great Britain, we need to heed the words of Paul Kedrosky in his recently released study funded by the Kauffman foundation:

It seems inevitable that venture capital must shrink considerably. While there is no question that venture capital can facilitate some forms of high-growth entrepreneurial firms, its poor returns make the asset class uncompetitive and at risk of very large declines in capital commitments as investors flee this underperforming asset. While any estimate is subject to much uncertainty, it seems reasonable–based on returns, GDP, and exits–to expect the pace of investing to shrink by half in the coming years. We should also expect a continuing sharp decline in the amount of money invested in information technology, a maturing sector with declining capital requirements in its remaining innovative segments. Capital will continue to grow in other areas, including clean technology, but the sector must shrink its way back to health if venture capital is to provide competitive returns and secure its own future as a credible asset class and economic force.

Eighteen to Watch?

Scott Austin, a blogger for the Wall Street Journal, reminded us once again that industry defining businesses often come out of the depths of economic downturns:

The week of Oct. 6, 2008, is often referred to as “Black Week,” when the Dow Jones Industrial Average fell 18% in its worst-ever weekly decline.

In the aftermath, venture capitalists tightened their purse strings to reflect the new reality. Sequoia Capital held a now-famous meeting on Oct. 7 for portfolio companies in which a PowerPoint presentation titled “RIP: Good Times” underscored the importance of cutting costs. Young start-ups struggled to attract new investors as investment levels plummeted in the coming weeks.

But some venture firms continued on fueling new companies, perhaps mindful that Cisco Systems Inc. raised money from Sequoia about two months after the 1987 stock-market crash.

He identifies eighteen emerging firms that got financing within 30 days of “Black Week”.

Hat’s off to Belmont MBA alumnus Dr. Jim Stefansic and his co-founders.  Their company, Pathfinder Therapeutics, made this list!

Update on Small Business Credit

With the demise of Advanta business credit cards, which focused on small business credit, one might assume that the credit situation for small business is bleak.  (I got my notice that my card will soon be, as they say here in eastern Europe, kaput).

But a new study from the SBA on small business bank credit shows that there is credit out there.

The study finds that for the year that ended in June 2008, the total value of small business loans outstanding increased 4 percent and the value of microbusiness loans outstanding increased 6.8 percent.  Both rates were down from the previous one-year period, but they were still in positive territory. 

The largest increase was in the number of microbusiness loans (under $100,000), which were up by 15.7 percent.  This may be an indication that more loans are being made through business credit cards.  The number of mid-sized loans ($100,000 to $1 million) fell by 23.3 percent.

Small businesses that are looking for loans will find the report useful because it provides state-by-state rankings of banks and other financial institutions on their small business lending.  These rankings show who made the most small and microloans in each of the 50 states and the District of Columbia.  

Small Business Lending Working without SBA Interventions

Are markets getting out ahead of government intervention when it comes to small business lending?  It seems that small business lending is starting to heat up, but the SBA is mired in the complexity of trying implement their part of the “stimulus.” 

From the Wall Street Journal:

The increased activity comes despite the fact that the SBA has been slow to
implement some measures aimed at stimulating lending and loan sales on the
secondary market. The agency missed a March 4 deadline to create a secondary
market specifically for 504 loans, capped at $3 billion. The government hopes
this will facilitate the buying of bundled 504 loans….

The SBA had said it plans to finalize the regulations by June, but an
announcement may come this month. The agency says the delay is the result of
sophisticated financial modeling and complicated legal-documentation changes
that need to be made in order for these new programs to work.

I see two possible outcomes once the SBA gets its act together.  Neither are particularly encouraging and they are not mutually exclusive.

One outcome would be the flood of small business lending that the administration wants.  That will inevitably lead to a small business loan bubble that will surely pop sometime in the not too distant future.  Too many small businesses will be given loans that they cannot afford.  The SBA programs often put social agendas ahead of economic ones, just as we saw with the home loan disaster fueled by government meddling in those markets.

The other possible outcome is that the bureaucratic complexity will bog down SBA programs,adding nonproductive costs to the lending process.

Since the markets are working on their own, why not step out of the way?  After all, as blogger Matthew Bandyk from US News points out, 58% of small business owners have no interest in SBA loans.

Seeds of Creative Destruction

There is some evidence of the seeds of creative destruction at work in the economy.

Although venture capital spending was down in the first quarter of 2009, innovation and entrepreneurship are steaming ahead without infusions of VC dollars.

From an article by Scott Harris at MercuryNews.com:

The sheer volume of entrepreneurial activity is striking, and often seems utterly independent of the investment dollars available. One reason is that so much can now be done so cheaply via the Web.

Consider the thousands of applications that techies have developed for Facebook and the Apple iPhone — business platforms that didn’t exist a few years ago. Consider the startups launched on shoestring budgets by Y Combinator and other incubators. Consider the boom in back office software-as-a-service (SaaS). Consider, also, the boom in clean tech — startups that require serious money — as well as the abiding interest in the life science sector.

This is clearly becoming the age of the bootstrapper.  Don’t focus on investment dollars or massive infusions from the SBA as a sign of activity.  Focus, instead, on the grassroots bootstrapping entrepreneurs who will reinvent our economy — if we just would get out of their way!

Important Lesson

I have been preaching about the need to build strong cash reserves in small businesses ever since I first started teaching entrepreneurship.

While some people have taken my words to heart, many assumed that the good times will always roll.  This latter group of entrepreneurs acted as if the truism “cash is king” was a mantra for spending more, rather than saving more.

Most of the ventures that come out of the other end of this recession intact and ready to roll, will be those that went into the recession with healthy cash balances in their bank accounts.

Times are getting tight for many entrepreneurs, as seen in this piece by Simon Covel in the Wall Street Journal:

During past downturns, business owners might have turned to a home-equity line of credit, a personal loan or credit cards to shore up finances. But this time, real-estate values have plummeted, leaving many with less equity to tap, and bank credit is virtually nonexistent.

It’s not uncommon for owners to give up salaries from time to time to give their companies a temporary lifeline, but business advisers and owners say the prevalence of salary cuts now is unusual where to buy topamax even for a recession.

So what should you do if your cash is tight and you are hanging on by a thread?  Realize that your options are few and that it is time to tighten your belt both for your business expenses and for your personal finances.  Employment continues to soften, so the prospects of a paycheck from someone else’s business are not that great.  And starting another business to replace the one that is struggling will likely require even more cash that it will take to keep this one afloat.

And once you survive?  Remember the lesson you have learned.  Cash is indeed king.  Don’t ever let yourself get complacent about your business’s future success again.

Once your business begins to recover, build up your cash as soon as you can.  Thirty days is the minimum you should always carry — it will get you through the short term bumps in the road.  Then work toward ninety days of cash reserves, or more if you can.

If this recession teaches you anything it is that rainy days are not your biggest worry — “rainy years” are what you need to plan for.