The State of Small-Business Funding
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Bige Doruk founded Gaia Power Technologies Inc. at a doubly good time. Interest in energy storage and management products has soared in step with record-high oil prices. And opportunities to finance the growth of her New York City company, which manufactures devices to help businesses attain reliable backup power and reduce overall energy costs, have rarely been better. At 4 years old, the company has secured a total of $4 million from three separate financings involving a combination of angel and VC equity investments, a bank loan, and a grant from a state-government-backed research fund.
Gaia’s financing run began in 2003 with a $1.5 million product-development grant from the New York State Energy Research and Development Authority. The next year, a $250,000 loan from a consortium of large banks called the New York Community Investment Co. helped complete the product development effort. Last summer, a group of VCs and angels made a $2.25 million equity investment in the $3 million firm to expand operations and marketing. “It’s been great for us,” Gaia’s 38-year-old CEO says. “We didn’t have to tap into the capital market and give up equity without having a product and a market.”
From banks to VCs, financiers brim with funds, and investors are just short of frantic to put their money to work. “It’s amazing the amount of cash that’s out there,” says Jim Ellis, a management lecturer at Stanford University’s graduate business school who says lenders are willing to fork over “imprudent amounts” of capital. “We’re looking in the rearview mirror and can’t remember a debt market like this.”
The view looks the same in the equity markets. “There’s a massive need to deploy capital in a way that’s productive,” echoes Mike Simon, 41, CEO of LogMeIn Inc., an 80-person Woburn, Massachusetts, remote control software company that has raised $20 million in three years, including a $10-million VC round last November. “If you have a good business, you can get venture financing very easily.”
Commercial banks, the largest source of financing for entrepreneurial businesses, remain less than universally welcoming, however. Charles Ou, an economist in the Office of Advocacy at the SBA, describes the bank climate as only “adequate” for most loans. Ou sees one bright spot in the growing number of credit lines and business credit cards from major banks. “Just think of [all] the ads you see on TV,” he says.
When Linda Pinson thinks of those ads, her tone turns wry. “There’s so much hype,” says Pinson, owner of Out of Your Mind . . . and Into the Marketplace, a Tustin, California, publisher of business-planning books and software. “[Entrepreneurs] get mistaken ideas about what it takes to get money,” says Pinson, who serves on lending committees and boards.
Borrowers still need about as much collateral, dollar for dollar, as they hope to borrow from a bank, Pinson says. They must provide historical and projected financial statements showing the company can repay the loan with internally generated funds. Banks usually require personal guarantees, and even those may not help if your credit score falls below 700. “If you’re in the habit of getting behind on other things, they figure you’re going to get behind on paying your loan,” Pinson explains.
Local and regional banks are most likely to cut entrepreneurs some slack, says Larry Bennett, director of the Center for Entrepreneurship at Johnson & Wales University in Providence, Rhode Island. “There is still a huge difference in banks’ receptivity to lending to entrepreneurs,” says Bennett. The major difference is that local and regional banks will customize loans to fit entrepreneurs’ needs.
Benjamin Richter won’t argue with that. The 40-year-old CEO of Bradford Airport Logistics Ltd., a Houston material management and distribution services company founded in 2001, was dealt a blow last year when a major bank postponed a commitment for $250,000 the day Bradford was to receive the funds to buy equipment for a new installation. “The [banker] said he was working on $100 million deals and took us off the table because we weren’t big enough to push on,” says Richter, who has 75 employees. It boiled down to a likely delay of a week. Unwilling to renege on his own commitment that the installation would occur as scheduled, Richter got on the phone to search for a solution.
He quickly found the local Bank of Houston, which funded the loan in three days and kept Bradford on schedule. Richter now has a new appreciation for smaller lenders. He plans to arrange backup commitments for future loans. And long term, he aims to develop significant relationships with at least two or three banks rather than relying on one. “As much as banks sometimes publicize how sensitive they are to [their] customers, the proof of the pudding is in working with them,” he says.
Banks of all sizes look more favorably at loans that are backed by government guarantees. Andrew Salamone bootstrapped Carsgofaster.com, a Milwaukee maker of inventory management systems for auto dealers, from its 1995 founding until 2001. Since then, three bank loans guaranteed by the SBA have provided a total of $560,000 and helped the company double sales–2006 sales are projected at $1.5 million. “Without [the SBA’s] program, it may have been far more difficult,” says the 32-year-old, who employs 20.
The SBA reports nearly 96,000 small firms received 7(a) loan funds in fiscal year 2005, compared to 81,000 in 2004. Still, some say the program is rapidly declining. Rep. Nydia Velázquez from New York, ranking Democrat on the House Small Business Committee, says nearly 13 percent, or 3,000, fewer loans closed in fiscal 2006’s first quarter compared to 2005. She blames the drop on higher fees.
Following sharp increases in the past year or so, borrowers now pay SBA guarantee fees ranging from 2 percent on amounts under $150,000 to 3.5 percent on loans over $700,000, with another 0.25 percent tacked on for anything over $1 million. That’s fine with Salamone, who surrendered a $500 loan origination fee and a $4,500 SBA guarantee fee for a $200,000 loan in March 2005. “For us,” he says, “getting the financing was the important thing.”
Send Me an Angel
Entrepreneurs who prefer exchanging equity for cash increasingly find their way to angel investors. Although VCs get more attention, recent studies show angels provide funding to more entrepreneurs, says Marianne Hudson, director of the angel initiative at the Kauffman Foundation in Kansas City, Missouri. Citing statistics from the University of New Hampshire’s Center for Venture Research, she says that in 2005, angels pumped $23.1 billion into 49,500 firms. That’s compared to $21.7 billion invested by VCs in fewer than 3,000 firms, according to the “MoneyTree Report” by PricewaterhouseCoopers and the National Venture Capital Association, based on data from Thomson Financial.
As their numbers grow, angels are changing the way they invest. “You’re seeing growing sophistication,” Hudson says. Angels increasingly join together, she adds, and as groups they can supply larger sums as well as more nonfinancial assistance, such as advice and contacts with customers and suppliers. They are stricter about screening but also more realistic about what they’re buying. “They are not asking for too much ownership of the companies or too many rights to impact decision making,” Hudson says.
If you want angel money, build a big Rolodex–and use it, Hudson advises. “Angels are more likely to invest in a company that was referred to them by somebody they know and trust,” she says. “It’s critical for an entrepreneur to understand that.”
Eighteen-year-old Dave Cook understands. In April 2005, the Pennington, New Jersey, high school student and his 16-year-old sister had an idea for a website where teens could post photos and other memorabilia. Over dinner one night, he described the idea to his brother, Geoff, who had started his own dotcom company in 1997 and sold it in 2002. “As soon as I heard the idea, I thought it was very cool and put in $250,000,” Geoff, 28, says. “We got another $250,000 from another angel investor whom I had worked with on my previous company.”
“We needed [the money] to grow new users,” explains Dave. “We had 13 servers, and [that] gets pretty pricey. We also have a lot of programmers based in India, and a lot of it goes to programmers.” Within a few months of MyYearbook.com’s September 2005 national launch, thousands of teens were signing up for the free service every day. Now the company needs capital to pay for expansion.
The company still lacks revenue, although Geoff is talking with national advertisers about using MyYearbook.com for word-of-mouth referral campaigns. He is confident they’ll get funding. “It really couldn’t be easier,” he says. “We have gotten multiple offers to invest $8 million.”
Venturing Into the Future
Venture capital is similarly awash in liquidity, although VCs remain skeptical of unproven business models, says David Brophy, finance professor and director of a venture fund operated by the Ross School of Business at the University of Michigan, Ann Arbor. “There’s tons of money available,” he says. “But everybody has gotten religion from that last crash.” Venture firms want seasoned teams, big market opportunities and proven technologies in business models already generating significant revenue with profits not far off, he says.
The $21.7 billion worth of VC deals done with a total of 2,939 businesses in 2005, according to the “MoneyTree Report,” matched 2004’s numbers. Funding for later-stage companies rose significantly, while early stage companies experienced a decline. Tracy T. Lefteroff, global managing partner of private equity and venture capital at PricewaterhouseCoopers, says that while due diligence is up, so are the valuations VCs place on firms they buy into. “Valuations are tipping back in favor of the entrepreneur,” Lefteroff says. “Over the past year, that trend has been [toward] higher valuation.”
One thing about VCs certainly hasn’t changed: Bringing them in affects your business in ways that few other sources of capital can. A venture-funded company will almost always eventually either go public or be sold. “If it’s your vision to run a company and hand it over to your kids, [VC funding is] out of the question,” Simon says.
Most entrepreneurs probably find one or more financing avenues closed to them for one reason or another. A few, like Doruk, can employ several on the way to building a growing business. But even now, when the robust state of entrepreneurial finance means that more doors are open to more firms than at other times, it’s worth remembering that obtaining growth capital, in reality, is rarely easy or certain. “There are more opportunities than three years ago,” says Doruk. “But it’s a marathon, not a sprint. Once you commit to it, you have to follow through. And you need a little bit of luck.”
Factoring and Corporate Venture Capital
Factoring is an old financing tool, and corporate venture capital is a new one, but both are currently popular and potentially powerful ways to finance growth in entrepreneurial companies. Dennis Hauser Jr. needed working capital to help meet payroll and other short-term cash-flow needs for Tampa, Florida-based DCH Roofing Inc., the 70-person company he founded in 2001. “The banks didn’t want to talk to us,” says Hauser, 42. His accountant suggested factoring.
Factoring firms buy a company’s accounts receivable and then collect on the invoices themselves. Factors typically charge a fee of 2 percent to 4 percent for each 30 days it takes to collect, says Hauser’s factor, David Wolf, president of Hennessey Capital Southeast in Tampa. Factoring doesn’t work for companies with low profit margins or those that need and can get long-term financing. “If you qualify for a bank loan,” Wolf says, “then factoring is probably not the right solution for you.”
Hauser says factoring is fast–funds are available hours after submitting his receivables to Hennessey–and affordable. DCH Roofing started factoring in 2004 and grew annual sales from $3.5 million to nearly $5 million in a year. Sales are expected to reach almost $6 million in 2006. “And I don’t have near the amount of stress as far as making sure I have money in the bank every week to make payroll,” Hauser adds.
In the 1990s, many big corporations set up VC investment arms only to suspend or close the operations post-bust. Lately, corporate venture is enjoying a resurgence. “You have Amgen and other big companies actually starting new corporate venture efforts,” says Gary Dushnitsky, assistant professor of management at the University of Pennsylvania’s Wharton business school. Corporate venture concentrates on life sciences and IT, but is also in some other fields, Dushnitsky says.
Corporate venture offers advantages over institutional VCs. Big firms have seasoned executives to mentor entrepreneurs, can provide introductions to customers and suppliers, and may even let entrepreneurs peek into R&D labs. On the downside, big companies sometimes have uneasy relationships with small firms they invest in. “A small company with an idea is a wonderful opportunity for a large corporation, but it’s also a threat,” Dushnitsky says. “In some cases, a small company’s idea has found its way into a large company, and lo and behold, the bigger company has come out with a competing product.”
Before you look into corporate venture, get your intellectual property protections in place, and consider the potential effects of allying with a major player. “If you are willing to accept investment from Microsoft, for example,” Dushnitsky says, “how likely are you to sell to Oracle?”
Growing Fast? No Questions Asked
When CEOs of the fast-growing companies surveyed for Entrepreneur magazine and PricewaterhouseCoopers’ 2006 “Entrepreneurial Challenges Survey” sought financing recently, they found the environment welcoming. Patty Brown was financing her 12-person San Diego information management software company internally and with a bank line of credit. But that’s likely to change. “Venture capitalists are talking to us right now,” says the 46-year-old founder and COO of BlackBall Corp. “I can see the light at the end of the tunnel.” With money raised from selling equity in the $1.5 million company, Brown intends to roll out a new wave of products this year.
Evan Giniger avoided using debt financing to grow Dynamic Resources Inc., his 15-person New York City retail project management company. But when a client hired the $10 million company last year for a $1.2 million job, he had to ask his bank for help with managing cash flow. “I was thrilled, really surprised and happy,” Giniger, 40, says of his bank’s response. A $1 million line of credit at the prime interest rate allowed him to take on the job and, hopefully, future jobs like it. “When you have a purchase order from a Fortune 1000 company in hand,” Giniger reports, “people are tripping over themselves to lend you money.”
Mike Manners lines up multimillion-dollar loans as often as monthly to fund the activities of Elan Development LP, his Houston land development company. “We’re having no problems getting financing,” reports Manners, 50. The five-person company has 2006 projected sales of $27.5 million and last borrowed $13 million from a group of banks. If anything, Manners feels banks have been too ready to lend. “They are becoming a little more selective,” he says, “but it’s actually going to help my company because we’re a strong company, and we’ll continue to get financing.”
In a recent survey of fast-growth companies, PricewaterhouseCoopers’ “Trendsetter Barometer” found that net profits, increased bank credit and new loans were the three sources used most often for financing growth.
The top 5 nontraditional financing sources that companies plan to consider over the next 12 months are:
1. Debt restructuring
2. Private placement
3. Angel investors
4. Venture capital
Don’t Bank on It?
Businesses appear to be going beyond banks in their search for growth capital these days, according to Pricewaterhouse-Coopers’ “Trendsetter Barometer” survey. The percentage of Trendsetter companies completing new bank loans in the first quarter of each year has gradually declined over the past decade.