Calling On The Family And Friends For Start-Up Cash

William D Bygrave describes the limited finances on which most businesses are started.

For would-be entrepreneurs there are two types of start-up capital: debt and equity. Simply put, with debt they do not have to give up any ownership of their businesses but they have to pay current interest and eventually repay the principal with equity they have to give up some of the ownership to get it but they may never have to repay it nor even pay a dividend.

So it is a trade off between paying interest or giving up some of the ownership. This is discussed in more detail in the accompanying article by Peter Kelly. Debt and equity funding are discussed separately on pages 4 and 6.

 

In practice, what usually happens depends on how much of each type of capital an entrepreneur can raise.

Most start-up entrepreneurs do not have much flexibility in their choice of financing. If it is a risky business with little or no assets, it is impossible to obtain bank debt without putting up collateral other than the businesss assets that collateral is most likely to be personal assets. Even if entrepreneurs are willing to guarantee the whole loan with their personal assets, the bank expects them to put some equity into the business, probably equal to 25 per cent of the amount of the loan.

It is no surprise that the vast majority of entrepreneurs have to start their businesses on a shoe string and leverage their own savings and labour. And they start with remarkably little capital.

For example, one quarter of the Inc 500 Inc magazines annual list of its 500 US small business stars began with less than $5,000, half with less than $25,000 and three-quarters with less than $100,000. Fewer than 5 per cent began with more than $1million.

Typically, entrepreneurs start their businesses with sweat equity and personal savings. Sweat equity is ownership earned in lieu of wages. Then a wealthy investor who knows something about the entrepreneurs or the industry, or both sometimes called an informal investor or business angel invests some personal money in return for equity.

When the company is selling a product it may be able to get a bank line of credit secured by its inventory and accounts receivable. If the company is growing fast in a large market, it may be able to raise capital from a formal venture capital company in return for equity. Further capital for expansion may come from venture capitalists or from a public stock offering or merger with a larger company.

Most new companies are not high-potential businesses and will never be candidates for formal venture capital. Nevertheless, they must find some equity capital. In most cases, it comes from the 4Fs the Founders initially dig deeply into their personal savings (often to the point of exhausting them) then they turn to Family, Friends and foolhardy investors.

It can be a scary business. Entrepreneurs often find themselves with all their personal net worth tied up in the same business that provides all their income. It is double jeopardy because if their businesses fail they lose both their savings and means of support. Such risks can be justified only if the profit potential is high enough to yield a commensurate rate of return.

How can the owners of private companies get a satisfactory return on their investments without taking their companies public or selling them?

The two ingredients that determine return on investment are the amount invested and the annual amount earned on that investment. Hence, entrepreneurs should invest as little as possible to start their businesses and make sure their companies will be able to pay them a dividend big enough to yield an appropriate annual rate of return.

For income tax purposes, that dividend may be in the form of a salary bonus or fringe benefits rather than an actual dividend paid out of retained earnings. Of course, a prudent company ought to be generating cash from its operations rather than by borrowing more money externally before that dividend is paid.

It is said that happiness for an entrepreneur is positive cash flow. However, if a company is growing rapidly, every penny of internally generated cash is ploughed back into the enterprise to sustain growth, leaving nothing to be distributed to the entrepreneur and the investors.

Perhaps, it is more correct to say that real happiness for an entrepreneur is free cash flow the internal generation of more cash than a business needs to sustain its optimum growth rate.

Free cash flow can be distributed as dividends to the owners or used to buy back shares from owners who want to realise their investment in the company or be retained in the business.

No wonder Bill Gates is smiling a lot these days. Microsoft, the company he started on a shoe string in the late 1970s, is generating so much free cash flow in the late 1990s that it adds millions of dollars daily to its $7billion war chest while Netscape, its arch rival in the battle for supremacy of the Internet software market, has had to sell more equity to raise $96 million with its second public offering in less than 18 months.