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Capital Basics
Many attribute the "lack of capital"
to explain the high rate of early stage business
closures. We believe that the lack of capital
is more a symptom of inadequate growth planning
which can lead to the inability to compete which
is a more likely cause for business failures.
Our focus is to help you understand
and identify the types of capital available for
small business. Once understood, the business
owners can develop a mix of financing methods
that minimize the costs of capital and/or increase
the rates of return on owner's equity.
There are three basic forms of business
financing:
Equity is is the
ownership stake in the firm. Early stage firms
begin with all equity until the point they owe
someone. The amount of equity in dollar terms
depends upon the financial resources available
to the entrepreneur(s). This equity is usually
derived from personal savings. Some entrepreneurs
may obtain funds from friends and family members
who have been convinced that the business concept
has merit. These are the first "venture capitalists". Fortunately,
these outside investors are more forgiving that
either angel investors or the real venture capitalists
or institutional investors. Friends and family
do not routinely perform due diligence before
they entrust their money with you. If they did,
they might be less willing to give you the money
to start your business.
Only sophisticated "Accredited"
investors as defined by law are permitted to be
solicited. Friends and family are not always sophisticated
investors. For this reason, you are generally
NOT permitted to solicit the public at large for
equity capital without all the financial disclosure
required by the Securities and Exchange Commission,
and in some cases state governments.
Debt is simply
borrowed money. You can borrow money directly
by taking out a bank loan or you can borrow money
indirectly by using "OPM" (Other Peoples Money)
when you use trade credit for materials and other
goods and services. Your employees also lend you
funds when you pay them some days after they actually
worked. The important issue here is that unlike
equity (risk capital) YOU ARE LEGALLY AND MORALLY
OBLIGATED TO PAY THEM AT SOME POINT IN THE FUTURE. Interest
on business debt is tax deductible which lowers
its after tax cost. Furthermore, because return
on investment excludes borrowed funds, the investor's
rate of return is actually higher. This is termed
financial leverage.
Failure to pay the firm's current
bills is what usually causes the firm to close
and the entrepreneur to be sued by creditors. Simply
incorporating the firm rarely protects the entrepreneur's
personal assets (home, etc.) from being liquidated
to settle unpaid bills because entrepreneurs are
usually required to personally guarantee secured
loans to the firm. While unsecured creditors may
not be able to put a lien on your home, secured
creditors can, and unpaid employees can force
you to close very quickly.
Finally, no matter how dire your
financial situation is NEVER use your employee
tax withholding funds to pay anything other than
the employee's taxes. Doing so can cause you great
financial pain and may result in imprisonment.
Retained earnings
is a method of financing that uses the unspent
cash of the business' earnings to finance growth. This
method is the safest method because you are not
using your own household money or someone else's
money. However, the safest is not always the best. Money
reinvested cannot be used to pay dividends to
the investor who may want an income stream from
his/her investment. Also, using all of your available
cash to finance a growth strategy may create a
cash crisis during an unanticipated slowdown.
Each of these methods have advantages
and disadvantages. Generally the most efficient
financing plans employ a little of each to optimize
the ROI and the liquidity of the business venture. Unfortunately,
many small business owners eschew all debt and
would rather own 100% of a firm that generates
$500,000 per year in sales rather than a 20% owner
of a firm that generates $5,000,000 in sales. Financial
decisions made by such a criteria is not a financial
decision but a personal preference that is not
a quantifiable financial performance measure.
Financial performance is gauged
on the net proceeds returned to an owner/investor
for a given amount of financial investment and
risk. This is detailed more fully in the finance
section of this web site.
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