Category: Entrepreneurial Finance

With More Access to Credit Comes More Debt

Now that credit card companies have discovered the small business market, small business owners are taking on more debt.
The number of small business loans outstanding under $100,000 increased 25 percent between June 2004 and June 2005, according to a report released today by the Office of Advocacy of the U.S. Small Business Administration. The increase came mostly from credit card use by small business. The report also noted that the number of small business loans outstanding between $100,000 and $1 million increased 5 percent during the same period.
“Access to credit is vital for small business survival,” said Dr. Chad Moutray, Chief Economist for the Office of Advocacy. “That is why we produce our annual lending report, so that trends in small business finance are made clear. One evident trend is the increase in the number of micro business loans outstanding. Coupling that increase with the small increase in the dollar amount outstanding of those loans shows that the small business credit card market continues to be quite dynamic.”
The report also ranks lenders in each state by their small business lending activities, as well as ranking large national financial institutions. The report includes data on American Territories as well as the states. A complete ranking of lenders, including prior annual reports, is available. Lenders are ranked on their overall small business lending, not by lending under SBA programs.
However, with increased use of debt comes more risk should the economy slow down. Just because entrepreneurs have access to funding does not always mean that they should use it.

VC Career Advice

I meet many MBA students studying Entrepreneurship who tell me they are planning to have a career as a venture capitalist. Guy Kawasaki recently wrote a post at his site offering some lengthy, but very good advice to young aspiring VCs. Here is his conclusion (edited to make it “G” rated).

Here’s the bottom line: You should become a venture capitalist after you’ve had the [expletive deleted] kicked out of you. This will yield at least two positive results: First, you’ll stand out from the full-of-[expletive deleted] artists who entered the business when they were young. Second, you’ll really be able to help your portfolio companies–which is what venture capital should be all about. See you in ten or twenty years.

It is similar advice that I offer to those who aspire to teach Entrepreneurship. Go out and be one, or at least work for one. A little miles under your belt and some wear on the tires goes a long way!
(Thanks to James Shewmaker for passing this along).

Strategic Partnerships

Kauffman’s eVenturing has another outstanding collection of materials — this month it is related to strategic partnerships.

For entrepreneurs building growth companies, engaging strategic partners tends to be par for the course. The bottom line is the right partner can drive success for your company while the wrong partner can be stifling. This collection provides entrepreneurs insights on identifying, selecting, and negotiating with prospective partners and covers ways to manage effectively the partner relationship to maximize chances for success.

Pay particular attention to the “wrong partners can be stifling” part of this collection. Getting locked in — and by locked in I really mean locked in — with the wrong partner is more than stifling. Strategic partnerships are most often with large, established companies in your industry. They have enough resources and enough lawyers to make your life miserable if you do not do things their way. Do your homework. Get to know their culture, talk to other companies they have done strategic partnerships with in the past, and hire a really good attorney who is experienced in such matters to make sure the deal it fair.
Go in with your eyes wide open. Don’t sit down to negotiate a strategic partnership unless you are ready willing and able to walk away from the discussions if things don’t look right to you.

Information is Power in Banking Relationship

Small business owners need to start using the leverage they have with banks. And by leverage, I don’t mean borrowing more money. Rather, small businesses have a growing market power that they need to use to their advantage when negotiating with their existing and with prospective new banks.
For the first time, JD Power has conducted a survey on small business banking satisfaction, which was measured across nine factors: relationship with primary contact; problem resolution; depository services; statements; fees; merchant services; cash management; credit services; and online services. PNC Bank, Wachovia, and SunTrust were the top three in their ranking. Interestingly, American Express, which has been advertising aggressively to small business, also ranked fairly well. The biggest banks tended to rate the lowest with small businesses. Impersonal service, high fees and frequent mergers and changes are the likely reasons.
Although they will not show up on all of these rankings, many communities are seeing growth in start-up niche banks that focus primarily on small business clients. These banks can offer a real alternative to the large regional and national banks for many business owners.
Small business is big business for banks these days, providing a growing source of revenues (for many banks more than their retail accounts). Small businesses need to use information to make better decisions on their banking relationships. They should no longer feel intimidated in their relationship with a bank, passively putting up with poor service and high fees. This new JD Power survey, the SBA’s report on small business lending, and talking with other small business owners can provide insight into what you can and should expect from your bank.
If you are not satisfied with your bank, make sure to let them know. It also may be time to shop around. As we saw in the recent NFIB survey on small business banking, service and credit are the top reasons small businesses change banks. And while changing banks is not an easy process, your new bank can help make the process run smoothly with a little planning.

Worst Case Scenarios and a River in Egypt

A common practice in writing business plans is to offer three scenarios: most-likely, best case and worst case.
When I see worst cases presented in most business plans, they are almost always not the worst case scenario. They are most often a less optimistic variation of what the entrepreneur thinks will actually happen. The real worst case should be this: if things don’t go as planned and the deal fails, what is the outcome for investors and lenders?
Entrepreneurs seem to operate under the assumption that if they don’t plan for failure, it can’t happen. If they don’t ever address the real worst case, investors and lenders won’t think about it.
I get push back on thinking and planning for worst case from my students. “Don’t you think my idea is any good?” That is not the issue here. Even good ideas can fail, as most opportunities come from a dynamic, changing environment.
All of this came to mind after a conversation yesterday with my father. We were talking about a potential deal, and he made the statement that he wants “protection” in a deal. That was an interesting word to me. After all, we aren’t a bank that can get a personal guarantee on debt. Any investment would be at risk.
But, he meant something else. He simply looks at every deal and imagines what it will look like if it goes bad. What can he hope to take away from it? He thinks this way because his generation saw the ultimate worst case — they lived through the depression. It is not that he is risk averse as a result — to the contrary. Rather, he is always soberly realistic that deals go bad, and we should understand where that will leave everyone involved. That is a perspective that we seem to be losing in our society.
Failure is real, and it can happen to even the best among us. So plan for it. Just in case it does happen, and hopefully the odds of that are slim if you have done your homework, you will be ready to move on to the next opportunity. You will have created a deal in which you have actually planned the worst case and have created a business where the worst case is not the end of the world for you — just for that deal.
And just so you don’t go in the wrong direction with this, your outcome in the worst case should not be to declare bankruptcy for the deal. That is a reputational scar you do not want in your background as an entrepreneur if you can avoid it. To plan for bankruptcy is in my opinion, unethical. Once in a while it unavoidable, but that should not be the predetermined plan.
Don’t be in denial about the worst case. Understand it. Plan for it. Make it an outcome you can move on from.

Don’t Ever Lose that Bootstrapper’s Edge

Once again this semester I had Charles Hagood, co-founder of the Access Group and Healthcare Performance Partners, come into my class to close out our unit on bootstrapping. (Here is an overview of his talk from last semester that offers several great tips on creating a bootstrapping mentality). Charles and his partner are great examples of what bootstrapping can accomplish building a highly successful business.
This semester he added a new point to his talk that is often overlooked by entrepreneurs once they get beyond the start-up phase. They get out of their bootstrapping habits, get a little lazy, and start spending cash on things that are not going to create sales or take care of customers.
Something like this happens with a golf swing. We start scoring well, and soon forget all of the subtle little things that got our swing to that point in the first place. We assume it is now natural and get a little lazy. That is why professional golfers never stop working on their swing. They hit thousands of golf balls every day. They know that without constant attention to the details of their swing it will not hold up. The same is true in how we manage the scarce resources of our businesses.
Being prudent stewards of the cash we have in our business takes the same concentration and attention to details. Once the cash starts coming in, we relax and think we can go on cruise control. But just like with a golf swing, bad habits and laziness can creep in to take you off of peak performance. And then when your business hits a tough patch or a crisis hits, you are not as ready to meet it as you thought you were.
For Charles this was 9-11. They had gotten out of their bootstrapping ways — not completely, but enough so that when the economic aftermath hit their business, they could see all of the ways in which unnecessary costs and lazy habits had evolved int their business. Luckily, they got back to their bootstrapping roots, and eventually came back stronger than ever.
Never lose that bootstrapping edge. Every dollar you can save while still achieving the desired result makes you more competitive, strengthens your business for the future, and builds your wealth.

Are Angels Changing Their Strategy?

StartupJournal reports on a study from the Center for Venture Research at the University of New Hampshire that reaffirms a trend that we have been observing for a while now. Angel investors seem to be shifting to later stage deals. Rather than providing seed funding, which has been their bread and butter investment, angels are now doing deals that were once the focus of VCs. And VCs are shifting to even later stage deals.
A few years back 75% of angel money was seed investments in start-ups. in 2005 it had dropped to 48%. It is now around 40%, according to this report.
But before we panic and predict the end of the entrepreneurial economy we need to step back and look at the context of all of this.
– There are more angel investors than ever with lots of cash. There are only so many seed deals to go around that meet their requirements for investment.
– Some angels are gathering in packs, called angel networks, that are mimicking venture capital firms in many ways, including more pooling of funds on deals and professional management. It is not surprising that this also includes developing investment strategies that look a lot like those of venture capital firms.
– Angels that do smaller deals are off the radar. They are hard to get data on in the first place because there is no formal reporting mechanism. Add to that their intense desire for privacy, and it is no surprise that we are seeing mostly the larger deal angels working in networks.
– Our entrepreneurial economy is dynamic. As the percent of GDP that is created by smaller companies surpasses 50%, we can expect that there are more deals that have grown to need more capital. Supply follows demand. We must also take into account that it is beginning to look like success rates are climbing for new ventures, due to both a favorable economy and better education for the entrepreneurs.
Here is my fear from this report. Policy makers and politicians eager to get their claws into the entrepreneurial part of the economy will use this to say, “We have a crisis!! We need to develop programs for government seed capital funds or the economy will stumble.” Or how about this one: “We need to get control of this to make sure we understand what it going on so we can enact effective legislation. It is time to call for registration of private equity placements so we can track all of this.”
Mark my words — we are moving toward socialized entrepreneurship. Our government is no longer ignoring our entrepreneurial economy and once they pay attention to it, can not leave it alone.

Valuation of High Growth Start-ups

A graduate student from Norway e-mailed me about how high-potential businesses are valued during seed financing, since there is nothing really to base a valuation on — no sales and no cash flow. He suggested that any valuation seemed like holding a wet finger up to measure wind speed. The truth is, valuing a business during seed round is more like assessing wind speed by holding up dry finger in the air!
They answer to his question is this: they don’t really even try to value the business.
The most common approach these days for seed financing is to use a convertible promissory note. It really delays any need to value the business until there is clearer information to use for valuation. It is convertible at the time that Series A money comes in, usually from VCs, at some multiple over the share value at the time Series A money is secured. Series A round financing usually occurs when sales have begun, or at least a clearer picture of market potential is evident.
For example, let’s assume a start-up needs $1 million in seed funding. The investors issue a convertible promissory note with a 10% interest and with a 1.25 conversion multiple. So in effect, they give them a loan that can be converted to stock. At the time of the Series A round investment, which in this simple example is a $5 million VC investment one year later, the conversion occurs and they get shares that were equivalent to the $1 million seed money they originally put in the business times 1.25 plus accrued interest. So a year later the seed investors get shares that would be the same as if they invested $1,000,000 * 1.25 * 1.10 = $1,375,000. The logic is that by the time they are ready for Series A investment (in this case another $5 million) there is a clearer basis for valuation. They have begun to sell product, or they have a better idea on the size and scope of the market, they have time lines to product sale, etc. etc.
Seed money is most likely going to come from angel investors, angel networks, or small, boutique VC firms. The big boy VC firms will join in at the point of Series A or even Series B funding.

And for the Little Guy….

Clearly, the owner of a small business must take a different route to financing than the high potential, high growth entrepreneur. The myth is that they finance it all by credit card. While this may be true for many start-ups, USNews reports on a survey by Visa and SCORE that finds that only 21% of small businesses use business credit cards. The truth is that credit cards have not always been very convenient for small businesses. Traditionally the business cards issued to small businesses are really not very different from consumer cards.

Small-business owners don’t use their cards as consumers do, but they also don’t have access to capital as larger companies do. They may need credit, but many suppliers don’t accept cards, forcing business owners to pay with checks.

Credit card companies are finally beginning to understand the needs of small business and are responding by issuing cards that better meet their needs for access to working capital. I guess the 23 million small businesses finally got their attention.