WALKING ON WATER — AN ENTREPRENEURS GUIDE- Part 5 (Financing Your Business)
This Article is part of a series of eleven articles from my book. You will find the links to the next feature article at the bottom of this page.
SKIP TO A PARTICULAR ARTICLE IN THIS SERIES
Part 1- Introduction
Part 2- The Beginning of a Business
Part 3- Planning and Goal Setting
Part 4- Act As If
Part 5- Financing your Business
Part 6- Investment Bankers
Part 7- Your Management Team
Part 8- Lawyers, Accountants, and Auditors
Part 9- Doing Your Homework
Part 10- Strategy & Growing Your Business
Part 11- Exit Strategies & Keeping Your Sanity
Chapter 4 — FINANCING YOUR BUSINESS
Where Do I Find Money?
Let’s face it. You are not Mark Zuckerberg of Facebook fame. So to expect leading venture capital firms such as Palo Alto Investors or Kleiner Perkins to be knocking at your door is completely unreasonable. More so, before these guys come along, you will most likely already have raised some startup capital. Rather than contemplating the various stages of venture capital, let’s examine real and practical sources of funding for your new venture.
I believe there are four phases to any business: the idea stage, the launch phase, the transition, and the exit. For now, we will talk about the first two, as they are most relevant to you.
The Idea Stage
When you are in the early stages of forming a business, the idea stage, you are still forming your idea and figuring out your budgets and pro-forma, which is a five year financial forecast of revenues and profit. Nothing is certain yet, but you have an idea and you want to run with it. There are four sources of capital that you can tap: your savings account, your credit cards, your friends and family members, and your local bank. The amounts you are looking for will generally be in the low thousands, just enough to cover your initial company formation expenses, including incorporation, opening a bank account, registering a domain and building a simple website, legal work, business cards, and setting up a small home (or virtual) office, getting a dedicated cell phone and buying a new PC or laptop. The dollar amounts should be small enough that if they are lost forever you can recover easily from the financial loss. Using your own money for these types of expenses can create an immense amount of value for very little investment. The reason I call this a stage is because that’s what it is, similar to a real estate agent staging a house for sale, or a movie studio setting up a sound stage. It looks great from the front, but there are two-by-fours holding up the set in the back. You are simply creating a platform from which you will do your song and dance to sell your business idea to the world.
TIP: Use your money only to set up the business. Never use your own money to fund operations. If you can’t get others to invest, your business is not worth starting.
The Launch Phase
During the launch phase of your business, you are looking for working capital for items such as inventory, marketing, and salaries. You have put together a formal budget and you have tripled it. (I’m dead serious — whatever you think you need, triple it!) The reason I call it a launch phase is because similar to NASA or SpaceX, in this phase you need to equip your business with enough fuel, oxygen, and supplies to sustain it in space for the next twelve months — with no chance of refuelling. That means everything needs to have at least two or three backup systems. Because this approach requires a larger amount of capital, tens or hundreds of thousands of dollars, this is when you need three sources of capital — angels, equity, and debt. Angels can be anyone from your rich uncle to high net worth individuals among your circle of friends. Equity and debt are best sourced from a larger pool of high net worth individuals or investment funds. Depending on the amounts you require, you can raise money with the help of your lawyer via friends and family, or for larger amounts via an investment bank (more on them later).
The Five Investor Types
In my years of raising money, and in dealing with shareholders and investor relations, I’ve come to the conclusion that there are five categories of shareholders. In no particular order, they are bipolar, spy, angel, friend, and shark. Get to know these types by heart, because you only have twenty minutes in your investor pitch to figure out which type of investor he or she is.
Bipolar
The bipolar investor is the type of guy who will call you one day absolutely happy with the progress you’re making, and then call you the following day yelling down the phone with all the swear words in the dictionary. They are the ones who send you nasty emails every time you’ve hit a fantastic milestone and you put out a press release. They whine and complain and make your life hell, but they won’t take their money out because they know that they are either invested too deeply in your business, or they are actually happy with your performance but don’t want you to know that. I’ve dealt with a shareholder who would take me to the brink of insanity and back with a simple phone call. And most of those phone calls started out praising all the good things I had done before continuing with those three wonderful words, “I am concerned.” And then he would let me have it.
As a side note, I have found the phrase “I am concerned…” to be a fantastic way of getting one’s point across and getting someone’s attention. You will be amazed how easily you can manipulate people using these three little words.
Spy
The spy investor generally makes a very small minority investment — sometimes in the ballpark of around $100,000. Their goal is not to help your company but rather to obtain information because they have a multimillion-dollar investment in one of your competitors. The key lesson here is not to take just anybody’s money, but to weed out the spies from the start. Throughout the years, I’ve come to the realization at various times that things were being leaked to our competitors. Unfortunately, I realized too late. You now have an opportunity to make sure that the investors you bring on board are fully invested in you and not your competitors. Do as much homework on them as they will do on you.
Angel
The third category of investor is the angel. This is an investor who is patient, most of the time a successful entrepreneur themselves, who invests not just in the business but in the management team you’ve assembled, and who believes in your capabilities. Angel investors are a very patient bunch. They understand the ups and downs of a young business, and time and again they will come to assist you in your time of need. They let you run your business and seldom interfere with your plans, but they will also make the time to answer questions and be a mentor to you. This is hands-down the most valuable investor any entrepreneur can have. We call it smart money.
Friend
The fourth category of investor is your friend. This can be anyone you know through your own circle of friends who has decided to put some money into your company, including a relative, family member, neighbour, associate, former colleague, or simply a good friend. Generally, the friend invests a small amount of money, but is aligned with you nonetheless. Most of the time these shareholders will be sitting quietly on the sidelines trusting you because they know you quite well, and very often these are also the types of people who even with their limited means will come in with a second round of investment because they support you and they see that you can meet your milestones.
Shark
Last but not least, the absolute most dangerous category of investor is the shark. These are the types of people who are waiting for you to make a mistake so that they can take you out ruthlessly, coldly, and without hesitation. It is their single goal to take the company away from you when you are down. And make no mistake, these people exist. They are out there and they are waiting. And most of the time they are disguised in the form of funds that look perfectly normal on the outside. But as I always say, trust your instinct to avoid them. If you lack the instinct, look for character traits such as overt friendliness without them ever giving you a sense of their true personality, probing and backdoor calls to your board, political maneuvering to weaken your position, and a pattern of odd demands, particularly concerning terms of your shareholders agreement or their investment. If you sense that you’re dealing with a shark, call their past investee companies to dig up some dirt before you let them invest.
To really drive home the point about the danger of this type of investor, I will give you a taste of my own experience with a shark.
In December 2005, my most recent startup company had been in operation for little over a year and a half. By Christmas, it had become very apparent that our company had burned through most of the cash we had raised from investors. With only $5,000 in the bank account, it was definitely crunch time for us, particularly because there were some new rules and regulations that required us to put massive cash deposits down with the local utility to get our wind farm connected to the grid. When I went back to my investors to give them the news, it became very clear who was my friend and who was a shark. With my back against the wall, one investor decided it was time to take me out. The way the offer was made was very cunning: he was willing to offer us $1 million in cash at a share price of one cent per share, coupled with the requirement for me to personally give up my entire share ownership in the company and some additional ludicrous provisions that were just there to dilute me out of my ownership.
The pressure that my father and I were under came to a peak at the Christmas dinner table with my mother in tears because I had been on the telephone for five hours trying to negotiate a deal with another group of investors. I was fortunate that most of my investors were angels who had gone through the same bullshit with their own businesses, so they rallied around me and helped me prevent disaster. Some people aren’t so lucky and have ended up losing everything. Christmas 2005 was ruined, but the company was saved. Angels are the types of people who understand that not everything goes as planned, but they are willing to stick it out because they trust you and your management team. Angels are your best insurance policy against shark encounters. The best call I ever made was to tell the shark to go to hell. I also had the subsequent satisfaction of seeing the shark booted out of his own fund two years down the road.
Types of Capital
Equity
Equity is the issuance of common stock or any other security representing an ownership interest in your company. Beware of lonely individuals who will offer to help you raise money on a consulting/commission basis. Once again, most of these people are not qualified, nor are they registered as a securities broker. Always do background checks with the Financial Industry Regulatory Authority (FINRA) or the Investment Dealers Association (IDA) if you are in Canada. FINRA is the largest independent regulator for all securities firms doing business in the United States. They oversee nearly 4,535 brokerage firms, 163,620 branch offices, and 631,640 registered securities representatives. On their website (www.finra.org) you will find the BrokerCheck tool, a free tool to help you research the professional backgrounds of current and former FINRA-registered brokerage firms and brokers. It should be the first resource you turn to when choosing whether to start or continue doing business with a particular broker.
CROWDFUNDING: Crowdfunding websites are an alternative to using a broker, however they can also be quite expensive and there is no guarantee of success. If you have a retail product that can be sold online, then Kickstarter might be the best place to see if there is demand. Another easy way is to avoid raising equity capital altogether, build a quick website on Shopify and drive some traffic via Meta (Instagram, Facebook) using $25 per day. You might find that people are willing to buy pre-order products which will give you the money to manufacture the product and deliver it without the need for equity capital and diluting your ownership.
Debt
When you start a business, no bank will lend you money unless you put a personal guarantee on your line of credit, normally encumbering your house, your credit, or some other collateral. I have found this to be too risky for my own liking. I suggest you avoid this at all cost. Never risk the welfare of your company or your home, and all the things that you have worked so hard to attain in life. But my businesses are more complex and significantly more capital intensive than a typical small business startup, so it is up to you to make this determination.
The general rule with a bank is that, as an entrepreneur, you will be unable to get any sort of financing. Most banks or loan companies that provide lines of credit or loans look for at least three years of financial statements, preferably audited. Because your business does not have a track record, banks are going to be unwilling to lend you money unless you provide a personal guarantee. If you have an asset such as a house, you could put up that asset as a guarantee against the loan for your business. But I highly recommend not doing this for the reasons stated above. Furthermore, to extend you a line of credit, most banks require 100 percent security. For example, if you want a $50,000 line of credit, you have to provide a $50,000 cash deposit to be held in trust with the bank. This might establish a credit record for your company, but it doesn’t actually infuse new working capital into your business, and this guideline was in place before the financial crisis of 2008 that has turned into an ongoing recession and still exists at the time of this writing in 2012. Today banks are even less likely to lend you money, so you have to find creative ways to fund your business. Banks are not in the business of lending money to start-ups anyway. The sooner you come to that realization, the quicker you can find other means of financing elsewhere.
One more important note: Never, ever get loans from loan sharks, pawn shops, or high interest sources, even if they may look semi-legitimate. It is not worth the risk and the stress. These people are in the business of keeping you in debt, and most of the time the sources of these funds are highly questionable. If you are going to take on debt, it’s best to source it from your local bank or through a registered investment dealer, also known as an investment bank or broker. There are also crowd-sourcing options via the Internet. This is where a large group of people give a small amount of money towards a larger loan, but again the terms of the loans can be very harsh.
Hybrid Debt
As dangerous as debt is to a startup, there is another form of debt called a convertible debenture, which might be more beneficial because it has some unique conversion features. It is essentially a debt instrument that can be converted into stock by the holder. These can be secured or unsecured against assets of your business, or a floating first charge of security on the entire business. By adding the convertibility option, the issuer pays a lower interest rate on the loan compared to what would be paid if there was no option to convert. You can also negotiate the interest payments to be made in the form of stock, which can reduce your default risk quite dramatically. You can use these instruments to obtain the capital you need to grow or maintain your business at an earlier stage than would otherwise be possible by raising equity. But remember, this is still debt. Very often, these debt instruments contain clauses that require lender consent on certain business transactions — which leaves you open to some negotiation risk. Generally, a private lender will want something in return for approving the deal, and that’s where things can get expensive and time consuming. Because of the conversion feature, the document is quite expensive to draft. In my experience, debentures are the most expensive form of money because of the time and effort that goes into negotiations and legal work. The first $250,000 dollars I ever raised was in the form of a convertible debenture with an investment fund that later converted the loan into equity when we went public.
Crypto Tokens/Coins
Some startups have successfully raised money by issuing their own crypto currency or tokens. Usually these are then used as a form of payment on the platforms they are building. If you are in the United Kingdom, Switzerland or Singapore where markets in these tokens are regulated then this is an option. Sadly, if you are in the United States, or plan on raising money from United States based investors you will be treading on thin ice as the Securities and Exchange Commission has not set rules that deal with crypto. Many an entrepreneur have found themselves in the crosshairs of the agency who interprets laws dating back to the early 1900’s. Unless there is a formal law and process in place, I suggest you stay far away from this form of capital raising.
Hoard your cash
The biggest mistake I see entrepreneurs make is that the second they have money in the bank they go on a spending spree. As an entrepreneur, you got into this business because you wanted to get more cash in your bank account. Now that someone has given you money, you want to show that you are successful, so you go and buy that brand new office furniture suite, the bells-and whistles POS, the overpriced secretary and the fancy company car. There is only one problem. You didn’t earn that money; it was entrusted to you by people who believed in your idea and your personal abilities to execute on your business plan.
My business partners and I have seen this on many occasions consulting for various startups. The sheer stupidity of some entrepreneurs has led some really promising companies to go under before they ever had a chance to get off the ground. The successful new record label that went insolvent because of mismanagement of funds and the A.I company that was about to challenge OpenAI went of business because of an out of control spending spree by the principal to furnish his new office space. We have seen it all. In fact, that is partly why we got out of consulting altogether; we were sick and tired of people not heeding our warnings.
When I start a business, I start it from the ground up. My approach has always been to hoard as much cash as I possibly can. I do this by limiting staff, keeping a low profile, paying contract wages rather than salaries, sharing office space, and stretching out our payments to suppliers. I require my CFOs to have fantastic people skills. They need to be able to manage suppliers and pay bills late and get away with it. How they do it always amazes me, but it is a much needed startup skill. When we would get an invoice that was due within thirty days, my CFOs would somehow manage to pay the bill off over a period of six months. Now that’s stretching the dollar. Our CFOs do this by managing our relationships with suppliers, including managing their expectations, being loyal, and playing a bit of the good cop/bad cop routine between our suppliers and us. Of course, you can only do this for so long until you have to pony up the money. But for the first three years, it’s a critical tactic. And it works. Always ask for a payment plan.
Pay yourself first
When you start a business, figure out the minimum salary you need to survive. Set up your payroll systems and raise enough money to last you for a year. No matter how many creditors call or knock on your door, no matter how important the letter sounds that lands on your desk, always and without failure pay yourself and your employees first. This is a golden rule. It comes from personal experience.
By paying yourself first, you ensure that your focus is on the business at hand, not whether you can pay your mortgage. Running your own business is all about focus. If you can focus your efforts on solving the money problems of your business, you will find a solution. If you have to deal with your personal finances on top of that, forget it. And the reason why you need to pay your employees first is to build and maintain loyalty. As a business owner your primary responsibility is to shield your employees from the harsh realities of the business world. If people know that they will get paid and know they are taken care of, they will go through fire with you, even in times of crisis. Never in my life have I asked my employees to skip a payday, ever. Make it a golden rule.
Your banking relationship
I have a love/hate relationship with the banks, partially because they have rarely loaned me money when I needed it, and when they have loaned, there has always been some fine print that allows them to change the terms in their favor. Furthermore, in my early years of being an entrepreneur, I had some snooty customer service rep close a business bank account on me for accidentally bouncing one single check. I learned a lesson out of that.
But I have learned that two banking relationships are critical to being a successful entrepreneur. The first is your relationship with your personal banker, and the second is your relationship with the branch manager of your company’s main bank.
You might be thinking, wait a second — I don’t have a million dollars to be able to qualify for a personal banker. That’s not what I mean by a personal banker. What I mean is you need a person at your bank, preferably two, who you can call for assistance. This is someone who can help cushion the blow even if your financial outlook is bleak. When I was nine years old and opened my first account, my father introduced me to his customer service/relationship manager, Karen. I am happy to say that I have known Karen for over twenty-four years. I have moved to subsequent branches together with her (I think somewhere in the neighbourhood of five times). Even though she is now a retired manager of a branch, I still stay in touch with her, in particular when it comes to critical items. It is imperative that you have someone you can turn to, because undoubtedly you will get knocked about financially a couple of times. Karen stuck with me through my “stupid” years when I didn’t know better than to bounce checks, get behind on my line of credit payments, even forcing her to close it on me and some other things of which I am not too proud. But I am grateful that I had someone like Karen in my life who helped me through many a rough patch. At the same time, I was always grateful for her help, and without fail I sent her a $100 Christmas gift basket — my own unique way of saying, “I know how stupid I am. Thank you for your patience; it is tremendously appreciated.”
Your second relationship has to be with your branch manager at your business bank. I try not to mix the two for reasons of avoiding comingling. What I mean by that is that people have a very hard time separating your persona from your company. Just ask my controller; you wouldn’t believe how many times people have billed the company for something that had absolutely nothing to do with business and vice versa. It just happened that my company shared the same name as me. Business bankers are not only there to help you with a transfer, but to help you work through the rough patches. I make it a point to update my bankers on a regular basis. I have never shied away from letting my branch manager know when we are going through some tough times or cash shortages, because the manager was always aware of the other side of the equation — every time I had a multi-million dollar amount in my bank account, the commercial arm of some competing bank would try and lure me away. But we stay. We are loyal. That trust and loyalty can pay off. And if you feel like you are not getting your money’s worth, then just open a second bank account at another branch. See if they like you better there. In fact, when we start a new company, we normally open two or three bank accounts at various financial institutions because that way we can see how we like the people. But more importantly, once you start making money (i.e. three years of audited financial statements with a solid history of positive cash flows), you can ask three banks for a line of credit, instead of just one.
