How to Finance Anything

A comprehensive guide to financing a start-up or rapidly growing small business in the '90s.

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Today small-business-capital sources don't look the way they used to. From starting up to cashing out, here's a guide to the new players and changed rules in the money-raising game

Some companies are able to sustain themselves and grow with little, if any, need for outside financing. By creatively holding the line on expenses or by tapping into the resources of suppliers and customers, they're able to get by with less money. But many business owners are finding that bootstrapping solutions can take them only so far. They're concluding that, whether it's to get their new company off the ground, expand to a new stage of growth, or cash out, there's no alternative to raising capital.

Back in the 1980s money was relatively easy to come by. A growing company with a good track record was wooed by bankers all over town. And if the business looked appealing enough, there were always the venture-capital firms, which were rolling in money. But as anyone who has been out seeking financing recently can attest, today's environment bears little resemblance to what was. Most banks are still licking the wounds from their days of aggressive lending and have shunned new loans in favor of cleaning up problems with their old customers. Those that are lending money are structuring deals with a lot less leverage (to give themselves a bigger margin of safety if forecasts go awry). And the venture capitalists? Well, a number of them are out of business, unable to attract new money based on their investment results.

With many of the old deal makers out of the picture -- or at least looking at financing with a different set of eyes -- we decided it was a good time to take a look at the new cast of characters. The sooner you understand who they are and what they're looking for, the better off you'll be.

Start-Up Money
In a discussion of the galaxy of financial resources available to young companies, one myth dies especially hard: that commercial bankers have a fundamental interest in making loans to start-up businesses. True, a lot of bankers refrain from closing the door on owners of early-stage companies too abruptly. Many, in fact, will dutifully flip through your business plan and talk with you about what you need. But when the chips are down, you won't find many of them prepared to make business loans to companies younger than three or four years old. That's especially true today, with industry regulators monitoring banks so tightly. The loans banks do make (ostensibly to companies) are almost always heavily collateralized by homes and other personal assets.

Contrary to what many start-ups wish were true, that practice isn't about to change even if banks begin to loosen up and increase their lending over the months and years ahead. Bankers can't afford to act like venture capitalists, because of the way they're capitalized and regulated. While both bankers and venture capitalists deal in money, Alex Sheshunoff, president of Alex Sheshunoff Management Services, a consultant to banks in Austin, Tex., notes, "When a bank wins, it makes only 4% over its cost of money. And when it loses, it can lose everything, plus attorney's fees." So a banker is judged, first and foremost, on his or her ability to get the money back. Recession or no recession, credit crunch or not, the key questions for a banker are (1) what's the borrower's track record, and (2) if we lend the money, how will we be repaid? The typical young company owner's answers go a long way toward explaining why bankers are seldom keen about lending to early-stage businesses.

Since loans are so hard to get, start-up founders inevitably turn their attention to equity. And the first source that rushes to mind for most is venture capital. By reputation, venture capitalists are out pumping millions of dollars into hundreds of new businesses every year. But the reality is much tamer: The amount of new money in the hands of professional venture capitalists has fallen dramatically since 1987; and what money there is has gone mostly into older, more developed companies, where opportunities for strong returns appear brighter. During 1991, for example, venture-capital firms invested just $60 million (or less than 5% of their funds) in a mere 47 seed-stage companies, according to Venture Economics, publisher of Venture Capital Journal, in Newark, N.J. And their investment in more advanced start-ups -- companies looking for, say, marketing money to support new products -- wasn't a whole lot greater. Though venture capitalists may become bigger players in this market at some point, it's clear that their sights are on young companies with extraordinary growth prospects (that is, companies that have a good shot at being $40-million businesses in four or five years) and managers capable of fulfilling them. "Unless you're highly unusual, I wouldn't waste my time with venture capitalists," says Stanley E. Pratt, a general partner with Abbott Capital Management, in Needham, Mass., and formerly the publisher of Pratt's Guide to Venture Capital Sources. "I'd look for individuals."

Over the past few years more and more people have come to see private investors as the best source of equity for start-ups. Because that market is made up of everyone from parents and ex-roommates to distant business acquaintances who may have struck it rich (in Redmond, Wash., for example, an estimated 1,000 Microsoft employees are at least paper millionaires), nobody knows how big this pool of capital actually is. But a number of analysts see it as both wide and deep. William E. Wetzel, a business professor at the University of New Hampshire who has spent years researching the so-called angel market, figures it is anywhere from 5 to 10 times the size of the institutional venture-capital pool, putting it into the tens of billions of dollars. While some investors have been battered by the recession and soft real estate values, the potential for higher returns in today's low-interest-rate environment suggests there are plenty of opportunities for entrepreneurs in search of $50,000 to $500,000.

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