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From his first job flipping burgers at McDonald’s and delivering The Washington Post, Craig Willett counts only one and a half years of his adult life working for someone else. Welcome to The Biz Sherpa podcast with your host, Craig Willett. Founder of several multimillion-dollar businesses and trusted advisor to other business owners, he’s giving back to help business owners and aspiring entrepreneurs achieve fulfillment, enhance their lives, and create enduring wealth. The Biz Sherpa.
This is Craig Willett, The Biz Sherpa. I’m wearing a dotted shirt today, and the reason I’m wearing it, is because you need to be spot on when you start your business. The reason you need to be spot on is you need to figure out how much capital you need. If you get too much, it could be too costly. Your borrowing costs or the equity you might have to give away could cost you. The other thing is, if you don’t get enough, then you’ll be out of business before you know it. So there’s a fine balance to determining how much capital you need. Next month, I’m going to talk about examining your cost structure and try to understand and forecast your business.
But for this month, let’s talk about borrowing, and let’s talk about capital sources. You know, the Kauffman Foundation did a great study, I think, that summarizes the access to capital. And one of the things they point out in their study is that between 90 and 95% of business startups require some sort of financing to start their business, of those who hire individuals. Many people may start a business where they’re the sole owner and operator without employees. In that case, I think it’s far less. But consider that, 90 to 95% of business owners who start their business require some sort of financing. And you may ask, “Well, where do you get the financing?”
In my three part series of how to start a business, I talked about some of those methods to get it. And one of the top ones that the Kauffman Foundation said that people use was 64% used friends and family. Or a variation of friends and family takes it up to around 70% of business owners did that. 9% carried the balance that they needed to on their personal credit cards. And some 6.3% used home equity of their home or a family member’s, and only 0.5% were financed by venture capitalists. And get this. Bank financing accounted for only 16.5% of business startup capital as a source for starting.
Now, I know we talked about— in my three part series—about SBA loans and they’re designed typically to help get a business owner who has experience in an industry and with a product financing. But typically in the first two years of a business, you have to prove yourself. And so it’s very hard to find a bank to do that. When you think about it, it is debt financing, and you have to look at the two major types of financing: equity, giving up ownership for money to be invested in your business—which means you’re giving up a share of future profits and ownership to someone else—or debt.
I’ve always said the financial institution is your silent partner. What a great partner to have though if you’re able to repay it back. One discouraging factor that I read in their report was that there was a good number of people, over 35%, who decided not to start a business when they looked at it because they thought the cost of capital was too high. So what can we take from that? If you have an idea and you’d like to be a business owner, now is a good time to start saving for that startup. Given the fact that 70% of all businesses that start use their own capital to get started.
Now, this may mean that you are creative in how you do it so that you maintain ownership, but more importantly, it’s about having adequate savings to give you the opportunity to be successful. You don’t want to give yourself such a small amount of capital that you end up going out of business before you have a chance to really hit your market and prove yourself.
So, what are some of the ways you would approach friends and family? Some of them will give it to you just because of the relationship. Others—you may have a wealthy uncle—and he may require that you put together a business plan proving to him or her, your aunt, proving to her that you have the ability to articulate your business well, and turn enough of a profit that you’re able to compensate yourself and to repay the investment that they make and you can give them a return on their money too. After all, there are options for them as well.
I once had a business partner who was funded in part by a trust, and the trust derived their money by borrowing on margin from a large stock portfolio. When the stock market took a turn for the worst, they got margin calls and needed cash. My partner came to me and needed to be bought out to get the return of capital that they had invested in the business. The business was in the early years and it was tied up in the real estate project. The company didn’t have the money to pay back the partner. Now this wasn’t a loan, this was equity and they were offering to sell their interest in it.
Fortunately, I had saved money. I had money set aside personally that I used to put in the business and retire that partner’s interest in the business, getting them money they needed to desperately keep the trust afloat, and allow me to have 100% control of the business. Now, having 100% control isn’t what it’s all about, but having a savings set aside to give you a cushion to be able to take advantage of opportunities that come your way is really important.
You know I’m an advocate for—no matter what you’re doing—setting aside 20% a month. In the early stages of a business that’s next to impossible. But if you’re in a career and you’re thinking of starting a business, setting that money aside with the purpose of being able to own your own business someday, I think is a great idea.
Some of the other sources of capital that you may want to consider are credit cards. Now, I’m not a big proponent of borrowing on credit cards. If you think bank money is expensive at six, seven, 8% interest rate, credit cards average around 21% interest rate. That’s a huge amount to carry. Yeah, I get it. You get some rewards, cash back, and you get some travel benefits potentially, but it’s not a long-term sustainable idea.
But I had to eat crow one day when I had a client as a CPA who came in, and he needed some help with some tax returns. And as I talked to him about his business, he shared with me where he got his idea. And then he told me how he was financing it. And he said, “I have three credit cards and the credit limit is $37,000.” He borrowed almost to the max on those credit cards to get it started. Eventually he sold to a national company. And I guess I was the one that was embarrassed. And I’m the one that ate crow because while I didn’t discourage him from doing that, I certainly went home at night thinking to myself, “I sure hope he can make it. I sure hope he’s profitable enough to repay such a high interest rate to do it.”
Now, each one of us has different levels of risks that we’re willing to take. And I’m not here to discourage anyone from doing anything, but think about it. If you have nothing to lose, I guess, what does it matter? But your credibility is important. And so in the early days you need to be careful where you go for that capital, because you may be able to successfully get it started, but take a bunch of hits on your credit while you miss payments. And I suggest that that’s not a good idea, because to grow your business properly, I would think that eventually as you hire people, you’re going to need bank financing.
Whether it’s a line of credit to help meet payroll, to time your cash receipts with your cash disbursements, it’s going to be important. So to do that you’re going to need to have a good credit rating. Because the bank’s not going to make a loan to a new business startup without a what’s called a personal guarantee. A personal guarantee means that they look to you and your assets and your creditworthiness and your ability to repay that loan. So the pressure’s on you, and how you’ve handled your credit in the past is a great prediction of the future, regardless of your source of income. So I would definitely look to that area to really manage your finances well.
Now you might say, “Well, what can I offer to a business partner if I have to bring in a friend or a family, other than on the fact that they’ll give me a loan and say, ‘Repay it when you can.'” That’s the best type, right? You hope that somebody will say that to you and you don’t want to take advantage of them. And I would suggest that you give them a rate of return on their money, whether they ask for it or not. And maybe you don’t commit to that, but as you’re successful, always remember where you got the funding.
The other thing that I think is important is, how do you know what to give up? There are a number of ways to structure financing a business. You may not want your friends and family to be receiving financial reports to see how you’re doing, whether you’re doing well or not doing well. Another way to do it is if you have a great product that’s innovative that you have a patent on, you may finance the acquisition or the manufacturing of that product by borrowing from a family member. And what you may do, and you see this often—I think this is a method sometimes proposed on the Shark Tank—and that is, pay a royalty, where you pay them so much per unit that sold.
So let’s say you’re in the business of selling cameras and you have a whole new lens and a new idea, and it’s innovative. And so you need to buy your first order and it’s going to cost you $50,000. You may take that $50,000 and you sell the lenses at $100 a unit, you may offer—and they cost you $50 or $60 to make—you may offer $3 or $4 per lens until you’re able to repay the money back to your friend or to your family member. That way, the only thing you have to report is how much your sales are. They don’t get into your business as to what your cost structures are, what it costs you to innovate. They may want to know what it cost to make it, but it’s usually less intrusive.
Another way to structure it is to form a partnership, but there are different types of partnerships. And one of them is to bring in a limited partner or you set up an LLC, which allows them to be a limited member. In other words, you’re the managing member and they don’t have much of a say or vote on much of anything. And you may have to provide some type of reporting to them, but typically they won’t be in managing and working in the business. I recommend that. Unless they bring a particular skill, and I’ve done this before with many people who’ve approached me who’ve needed some money short term to be able to get something off the ground, where l’ll offer either royalty financing—and with that, I always put that I want a board seat, or I want to be a strategic advisor so that they come to me with their questions and problems. Not that they can’t solve them themselves, but I think it’s always good to get another opinion.
But you want someone qualified in your industry or someone qualified financially. And I think in addition to either of those, it would be helpful to hire a good attorney to help structure whatever the agreement is so that you make sure it’s well-documented. It’s one thing to shake a hand and trust people, it’s another thing to remember two or three years later what you agreed to. And therefore, I think a good document is helpful to remind us all what we’ve agreed to.
The other thing that I think is important is to hire an accountant. You’ll find that an accountant can help you put together the right kind of projections that you need to be able to go to a bank. I won’t say that the bank’s automatically going to say, “No,” you need to find a bank that’s a community bank. Let’s talk about banks for a minute. One of the things that I love are community banks. Now, you may say, “What’s a community bank?” Well, there may be a lot of banks in your community, but if they’re in every community you go to in the United States, they’re not a community bank. They’re a national bank, such as Bank of America or Chase Bank, Wells Fargo, you see them everywhere.
But usually they’re locally owned, they’re locally operated. Some of them are credit unions as well, and they operate on a different structure. But they’re set up to try to help the community in which they’re located. They have a vested interest in the success of the businesses and the owners of those businesses in their community. As your business grows, you’re going to become more and more important to that bank and become more and more source of their profitability. They’re always proud to help the local community. And then it’s important within that bank to find the right kind of loan officer. You know, you want to find someone who you can sit down with and talk to and relate with that understands your industry, or is interested and will educate themselves on your industry.
I remember one time I went to a bank and I was starting into a new segment for me in the marketplace. And I don’t know if they were just checking it out, but certainly the loan officer—I saw him at a trade show and he was checking out my booth and how people were receiving my product at that trade show. It was really interesting to me to see the kind of interest that they took to determine my ability to penetrate that market. I think it’s important to find someone who’s interested in your success, not in your failure. You want it to work out. They want it to work out. But understandably, a bank makes a very small margin because they charge a small amount of interest, really, at the end of the day for the money they give you. So they take a lot of downside risk.
But I wouldn’t take “No” from one bank. I would submit to three banks. I would put together a good package and sit down and find the right kind of loan officer, not just any. And the way to find them is to talk to people in the community. Sometimes your local chamber of commerce, sometimes other business owners who are either your competitors or are just your neighbors, and ask them who they do their banking with, and then get acquainted with them. You’ll get a feel. And if you’re not able to discern what they’re able to do, most CPAs should have a good feel as to what banks in their area might be best for the size business you have and the type of industry you’re in.
And when you’re able to find that, you’ll see that there’ll be a synergy that will allow you to get approval and get adequate funding. I’ve told you about the banker before who told me when I was a CPA—he came to pick up his tax return and I was working for another firm. And he said, “Craig, let me tell you a story. When I first started my CPA practice, I took my business plan to the bank and I thought I had it really good, right? I’m a CPA. I gave it to them saying I needed a line of credit to help me during the slow times of year, and I’d repay it during the good times of the year.” And when he saw the banker again, the banker said, “I’m not approving your loan.” And it kind of shocked the CPA. He knew he had a good credit rating, a good reputation in the community, but he said to me, he goes, “Craig, you know why I got turned down? I didn’t have anything budgeted in my plan to take a vacation. He didn’t want me to be burned out. He knew and must have known that other people in that industry burn out. And when they burn out, it’s hard to get them to make good decisions.”
So, I would say you can learn a lot from your banker, but you need to gain their trust. And they also need to be able to provide you with some insights as to what, how, and why they make their credit decisions. They shouldn’t go to a back room where no one knows what’s going on. You should ask them what the weaknesses are in your business and how you can strengthen them. This becomes a dialogue that’s important for the future. When things are good, they’re going to be happy. But when things get tough, they’re going to want to hear from you. You’re going to want to establish that relationship so that you don’t end up in a situation where you’re contrary to them without having given them some kind of heads up as to what might be happening in your life.
Now, there are other sources too, and I mentioned venture capital, but only half a percent of all businesses that start, start out using venture capital. And so it has its place in certain industries, technology and in life sciences for sure, because those are big markets that require a lot of capital to try to penetrate those markets.
There are groups of angel investors. You can find them in your community. Investment clubs—they’re another source you can go to. But again, it’s important to understand what their objectives are and probably a referral to them would be important. And then to be able to feel comfortable with who they are. You know what it’s like. There’s always a honeymoon at the beginning. Everyone’s excited for the prospects of the success of the business. But what’s important is to forge a relationship early on and understand what the fundamentals are that they’re going to be analyzing on your business so that you can achieve those objectives. These fundamentals should be ones that you want to achieve too anyway that would make you successful.
It’s not always profits. It might be margins. It might be certain operating costs. It might be certain receivables, days of collections, where they don’t want you to exceed certain days because they feel that that’s dangerous to give too much credit to too many customers, or that they don’t want you to have a concentration. One big contract and no other source of revenue, because you know what can happen. If you lose the big contract, you don’t have any business to sustain yourself.
So there are things to be aware of. There are incubators in towns, and while they may not always have money, but they know some access, they may know angel investors and they have access to grant programs that they can tell you about. But where they really help is how they helped one of the businesses that I helped start. In the early days of a biotech company, I was approached by a friend and asked me to invest in it. I told him I would invest, but I needed to look more—I was interested in investing, but I needed to look more into the details. As he answered my questions and gave me more and more information, it became apparent to me that one of the costs he had was to operate a lab, and to equip that lab was very expensive, whether he leased the equipment or purchased it.
It just so happened that in the city that he was living in that one of the large international companies set up an incubator lab for biotech companies. And guess what? In that lab they had access to all the equipment he needed and just charged him on a per diem or per use basis. All of a sudden his business model became way more viable to me as an investor, and it gave me the confidence to invest.
So you may look at that. What are the ways you could start out so that your costs are low? We’ve all seen it. Steve Jobs in his garage or Michael Dell in his college dorm room, right? No overhead at that point, or low overhead. And it’s something that you need to watch for. We all plan for success. And while we hope for success, we also need to be careful to manage our costs.
I remember starting out my CPA firm, and believe it or not, this is how old I am, in the days where there was a 10-key calculator with a tape that ran through it. I needed one of those. I didn’t have one. And when I was starting my business I went to a business machine store, which doesn’t exist anymore anywhere. But I went to a business machine store and there were all these refurbished business machines, whether they were typewriters or whether they were calculators or 10-key pads, I looked at one and it was more expensive than what I wanted to pay.
I had just used—if you remember my story—my last savings for a down payment on a house. And so I had very little when I wanted to start my business and I had painted the office building to pay for the security deposit. So when he told me how much it was, I hesitated and I could sense that the owner of the shop knew that I probably didn’t want to pay that kind of money that day. And he said, “You know, you need to plan on success, Craig. I’m going to finance it for you. I believe in you.” And he did, and I paid him off over the next four months. I think it’s important to find people who believe in you and then be honorable in repaying what you’re able to borrow, whether it’s from friends, family, or banks.
It got to the point in my career where I was with one particular bank that each year, they would meet with me and have me come in and make a presentation to their senior loan committee. And in the senior loan committee, I was asked all kinds of questions for what I needed the next year. I finally one day asked my loan officer. I said, “Why do they have me come every year?” And they said, “Craig, you’re one of the only borrowers who ever did what they said and usually exceeded your projections. Not only that, they needed to set aside the capital to lend to you as much as you wanted, because you were one of the better customers.”
I don’t say that to pat myself on the back, but to make the point that you want to establish that kind of credibility. And I know, I’ve been there. You’re discriminated against as a small business owner. Nobody wants to believe in you. The failure rate is high. Why is the failure rate high? We have high expectations and sometimes our expectations don’t match the results. Other times we haven’t allowed for enough capital, or we don’t have adequate experience in that area.
I’m not suggesting that you be afraid to start a business. I’m just suggesting you surround yourself with the right people who believe in you and that you develop your expertise, like I said, in a niche market, find out what you’re good at and know how to solve someone else’s problem. As you do that, the capital will become more apparent, because you’ll be able to take the profits from that business and reinvest it.
While I’m on that point, this is something very important to always remember. And that is, look at your living costs before you start a business. Look and see how you can scale back to live on as little as possible so that in those initial years you can plow as much as you need to, to expand and grow your business. I promise you, you won’t regret that.
I think of the times where I’ve really stepped back and focused and didn’t become a draw or a drain on my business. There’s nothing more difficult to discuss with an investor, a friend, a family member, or a banker than, How are you going to pay back their investment when they watch you draw out so much to live on? I remember somebody I know well telling me about one of his top sales managers, and the sales manager called him and said, “I need a raise.” And he said, “Well, why do you need a raise? You’re doing well, and you get a bonus.” He said, “I need a raise because we want to buy a new house and the house is going to cost more than what we make right now to be able to make all of the payments we have.”
The need for capital is not always the reason someone’s going to lend it to you. You need to prove how you’re going to repay it. Just because your living expenses are high doesn’t mean others should wait. So you need to be careful and manage that well. I think it speaks to your integrity. It speaks to your understanding of your business when you’re able to do that.
Again, access to capital is important. When you hire that first employee, 90 to 95% of the time, people need some sort of financing for their business. So make yourself creditworthy and then search out for that capital. Make sure you go to a number of banks and make a number of applications. Make sure you search for all the resources in your community. You may say, “I don’t have time.” But I would say you can’t not afford to take the time to see what’s available.
I know there’s a company today worth 1.3 billion because they took the time to apply for an incubator. And they were one of 20 companies of 400 that had applied and got approved. And they were in very early stages with hardly even a concept of a product. And now they’ve developed that product out well over the last eight years. I promise you that as you seek for all those resources, you’ll identify the ones that you can take advantage of, or that were meant for you.
Establish relationships with your banker, with your customers. Sometimes you can get a large order from customers and they’ll wait for delivery and pay you deposits upfront. That’s another way called bootstrapping, where you can do that. But you have to be careful. Remember, they gave you the money upfront and then when it comes time to deliver, maybe they pay you the other 50%, but you’re not going to get a 100%. And so make sure you’re running it profitably.
There’s a lot of ways you can use your expertise to help you in that. I hope that none of us allows capital to be the barrier to entry. There’s sources of it out there. Be careful, some of them can be expensive. But I think if you find people that believe in you and you have a product or service that solves problems for other people, that you will be able to find someone to support you in that. This is Craig Willett, The Biz Sherpa. I’m glad you joined me today to talk about sources of capital to start your business.
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