Three Sources of Small Business Capital

03-January-2013
03-January-2013 14:17
in Practical Small Business Advice
by Colin Smith

I've just got off the phone with a client who called to discuss with me how he could obtain a bank loan for his business as he needs access to capital to fund the start up.  I answered him somewhat pedantically that taking out a bank loan might give him what accountants call working capital but that the proceeds of a loan should not be confused with capital.  He seemed a little confused.  Whilst I explained what I meant, it struck me that this would make an interesting topic for our blog.  I'll endeavour to repeat my explanation here in the hope that understanding what capital really is will enable you to avoid the dangers of believing that just because you have access to money you have adequate capital in your small business and to choose the right source of capital for you and your business.  

There is tremendous confusion about the word capital.  For many years, I fundamentally misunderstood what capital was and this led me to into some pretty hairy situations.  Today, I would define capital as the difference between what you own and what you owe.  Another term that could be used synonymously is equity, which is the difference between assets (what you own) and liabilities (what you owe).  The confusion arises as business owners often say things like my client said earlier on the phone; "I need access to capital so let's approach our bank for a loan".  If I had to sum up the important business lesson I learnt on this topic that led me to being so pedantic with a client of mine as to challenge his definition of the word "capital", I would say the following:

"Debt is not capital" 

 Yes, there are times when you can use term debt as a bridge to give you enough time to build capital through creating and retaining profits in your business.  However, you have to be absolutely sure that you have a plan to get over the bridge and on to the other side before the bridge collapses.  Debt is debt.  Every loan must eventually be repaid and the terms are remarkably inflexible.  Debt is a liability.  It cannot therefore be properly called capital.  They are two completely different things.

There are only three basic choices when it comes to how you will obtain real capital:  your own money, other people's money and sweat equity.  This was ultimately my answer to my client who asked how he could raise capital for his expansion plans.  Each one has it's price as I will now explain, hopefully to enable you to make an informed decision about how you will capitalise your business.

Source #1: Your Own Money

I remember a friend of mine from University whose career followed a parallel path to mine.  He left University at the same time as I did, starting his career in the corporate environment but after a few years began to look for opportunities to go into business for himself.  We had bonded whilst studying Entrepreneurship together as part of our business degree and vowed that we would each start our own businesses one day rather than spend our lives working for "the man".  Anyhow, what surprised me was the way that he proposed to fund his new business.  Just as I was putting together my first business plan to raise bank finance for that particular venture, he proposed to split his large garden in half and to sell the plot of land.  He seemed to have a pathological aversion to debt and politely declined when I offered to help him source a loan.  It took him eighteen months to do it (versus about four weeks to obtain the bank finance for my business venture).  However, when he eventually received the proceeds from the sale of the plot of land. he was able to start his business without the spectre of debt hanging over it and was able to make a real success of it.  He sold the business early in 2008, as the storm clouds where really starting to gather over the economy, and he used the proceeds to buy a new family home in cash.  He lives mortgage and debt free to this day.

In my experience, this attitude is unusual.  Almost all entrepreneurs, including myself, have a tendency to look to the banks or to friends and family or even outside investors first before falling back on whatever resources we might possess almost as a last resort.  Whilst this is not an unusual attitude, there is just something about using your own money that makes you take your business that much more seriously.  Whereas I spent the money that I had lent furiously, my friend was careful with every penny of the money he invested from the sale of his land.  He demanded a good rate of return on his money invested as well as a market rate salary and worked hard to make that happen.  Meanwhile, I deluded myself that I was doing really well as my ROI was high, due to the bank loans.  In the end, when market conditions changed, I learnt the hard way that I wasn't doing as well as those ROI figures had suggested, as I hadn't built up any real capital or equity in the business.  When I decided to sell, I realised that I would be left with very little after all our liabilities were paid.

There is much to recommend in my friends approach and that is why I suggest it as the first source of capital for a business.  Look to your own resources first and see if you can avoid debt.  Unfortunately, this is simply not possible for many wannabe entrepreneurs.  They are often stuck working for someone else and they don't make enough money to save any towards their own business venture.  So, what can you do if you simply do not have the money?

Source #2: Other People's Money (OPM) 

 Many businesses simply cannot be funded with debt.  Some businesses can take years to achieve profitability and thus require patient investors who are willing to forego profits today in the hope of greater returns in the future.  The most common source of investment or OPM are the so-called "3 F's": friends, family and fools.  Research in the US shows that more than three times more OPM comes from this source than the other sources combined. This is because most start ups can get up and running on less than £50,000, which would be a small investment for an angel investor or venture capitalist but is an amount within the reach of an individual or a collection of individuals within in the entrepreneurs network.  

Lending from the "3 F's" is common but not without it's problems.  If the busines goes wrong, you can lose friends, become estranged from family members or end up in court with the fool from whom you successfully parted money.  From personal experience, I would stringly recommend that if you try to access money in this way, make sure that you very clearly manage their expectations from the outset and throughout the lifetime of the investment.  

 Lending from professional investors is less common, especially in the UK.  There are however angel investors actively looking to fund new businesses and venture capitalists looking to get in on the act a little further upstream.  The danger with these investors is that once expectations have been set, you have an obligation to deliver exactly as you said and, much more so than with "3 F's" investors, there will be consequences for you and your business if you do not perform.  The right profesional investors will bring more than money to the table but the pros and cons of a professional investment need to be carefully weighed up.

As a general rule, I would recommend OPM as the funding source of last resort.  If you don't have the money to do it properly, then I would wait until you do.  

Source #3: Sweat Equity

 This might not work for every business opportunity, but my favourite source of capital is what I call "sweat equity".  It is created by deferring the payment of a market salary and leaving that money in the business instead.  Suppose you need £30,000 to fully launch your business and your market based wage should have been £30,000.  If you pay yourself £10,000 in year one and £20,000 in year 2, you have created £30,000 of capital in your business before you pay yourself a full salary in year 3.  You may need to supplement your meagre salary with savings in years 1 and 2 or alter your lifestyle so that you can live on very little money for a time.  However, if you are prepared to bootstrap your business in this way, you can create the necessary capital via building up sweat equity.  This source of capital can be difficult on a personal level for a while and will take longer than simply lending the money from a bank or investor, but my experience has been that entrepreneurs committed to building up "sweat equity" in their businesses have the most focus and work the hardest.  

 Here at Continuous Business Planning, we exist to help small business owners build capital or equity in their businesses.  We guarantee to add significant value to your business.  We can help clients obtain finance from banks or investors through the writing of a compelling business plan, but the most important work we do is to help the small business owner create the capital that will eventually repay the loans or investors and will leave them with a strong, valuable business that will either sustain them or be sold.  If you want to raise adequate capital in your business for your needs and aspirations, contact us today.  Not only can we help draw up a map from where you are today to where you want to be, but we can help and guide you every step of the way. 

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