Capital. You’ll be hard-pressed to find a business that doesn’t need any to function and yet, for most businesses, understanding “capital” and capital needs can be a confusing and murky topic. Over the next two weeks, we hope to take out some of the mystery related to capital (both what it is and how to raise it) in this four-part series, Understanding Capital. In our first installment, we provided a primer on the different types of capital. Today, in Part 2 we’re talking about more traditional ways of raising capital. In Part 3, we’ll talk about the non-traditional ways of raising capital. And finally, in Part 4, we’ll talk about how to get out from underneath capital.
Raising Capital Through Traditional Bank Loans
One of the most traditional ways to raise capital is by obtaining a loan from a bank. Banks, and other lending institutions, work with businesses every day to provide them with the capital they need for operations, expansion, purchases and other needs. The debt is paid back over a period of time at an agreed upon interest rate. While debt capital can impact cash flow, it is usually considered to be the least expensive capital to raise because the costs are predictable and finite.
This type of capital, however, is not available to all businesses — especially startups and newer businesses. Most banks only loan to established businesses with good credit and financials. They may require collateral such as a security interest in property/goods already owned by the business or a personal guarantee from the owners.
Raising Capital Through A Small Business Association (SBA) Loans
Newer, less established businesses may qualify for SBA loans. While the SBA itself does not lend money, it helps smaller businesses obtain larger loans than they would typically qualify for by guaranteeing portions of the loan. The SBA has multiple programs, including assistance with starting a business:
- 7(a) Loan Program: Loans for small businesses and startups seeking a larger loan ($350,000 – $5,000,000)
- Most flexible and common option
- Offers loans up to $5,000,000
- Microloans: SBA offers small, short-term loans to small businesses for specific needs
- Beneficial for small businesses whose needs are below most lenders’ minimums
- Offers loans from $500-$50,000
- Offers entry into credit for small businesses
- CDC/504 Program: Loans for targeted, fixed purchases
- Typically used for purchasing large equipment, real estate, etc.
- Stricter requirements including good credit scores and documentation of success in business
- Disaster Loans: SBA offers a loan to help rebuild business after a disaster
If you think you qualify for an SBA loan, talk with your bank about what to expect from the process. It can be lengthy (and confusing) and working with a lender that deals with these types of loans on a regular basis is key.
Raising Capital By Taking on Investors or Business Partners
Another traditional method for raising capital is seeking outside investment by selling equity stakes. Business owners can raise capital by selling membership interests or stock to outside investors, current owners or employees. In exchange for ownership rights (as defined in your corporate documents), the investor provides the business with capital. They may be entitled to dividend payments and should the business be sold, they would (hopefully) see a return of their initial capital contribution plus their share of any profits from the sale.
Depending on the structure, the investor may or may not work in the business. If they don’t, you need to ensure that you comply with your states “Blue Sky” laws, which govern the sale of securities and are in place to protect investors from fraud.
A Caution About Raising Capital Through Friends and Family
Many businesses, especially those that are just getting started, find that they can raise necessary capital through friends and family. The capital raised through these contacts can be in the form of debt or equity. A common mistake, however, is not treating this capital as you would capital from an unrelated investor. If you choose to raise money through these avenues take the time to set the capital raise up properly. If you take on debt, put a promissory note in place. If you sell equity, make sure the corporate documentation is proper. Mixing family/friends with business can be tricky (and sometime messy), but treating like you would any other business transaction can help alleviate some of the issues that might arise.
Which Method of Raising Capital Is Best?
Different types of businesses have different capital needs. Service-based businesses tend to have less financial capital needs and higher human capital investments, while product-based businesses require larger influxes of cash and equipment to produce their goods. Working with your financial advisors (i.e. your business accountant and CFO / Controller), you should ensure that you understand how much capital is required to operate your business and then seek out the type of capital that best suits your needs. Your attorney can help advise you on the risks associated with the capital and help structure your capital raises to best benefit your business.
This article is for informational purposes only and does not constitute legal advice nor does it create an attorney-client relationship. Always consult appropriate legal counsel for specific questions related to your business. Some states may consider this attorney advertising.
Stinson Mundy is the founder of Linden Legal Strategies PLLC, a Richmond, Virginia-based law firm focusing on small business law and development. To learn more about how Linden Legal Strategies can help you start, grow and protect your business, or to schedule an initial consultation, contact Stinson.