The Numbers Game

How should you fund your growing company? Just ask the Inc 500 class of 2002.
Advertisement

1. How much money do I need to start a growth company?

Not a whole lot. More than a third -- 41% to be exact -- of this year's Inc 500 CEOs launched their businesses with $10,000 or less. And get this: more than a third of those bootstrappers started with less than $1,000. This year's list looks very much like the lists of years past when it comes to the number of founders who started companies with little seed capital.

Of course, that hardly means that starting up with more money will keep you off the list. Consistently, some 20% of Inc 500 CEOs begin with more than $100,000 in capital. (For more about the ways in which start-up capital affects long-term prospects, see " A Little Goes a Long Way.") Founders' funding sources vary from personal savings, to investments and loans from friends and family, to credit cards, to second mortgages.


2. Should I take out a second mortgage on my house?

It's a method that has worked for several entrepreneurs on our list. But expect your priorities to change -- quickly. "In a word, taking out a second mortgage made me feel committed," says Ryan Simons, president of Print-Tech (#358). "By putting your house on the line, failure is not an option. I knew I would have to do whatever it took to make the company successful."

But will you be able to sleep at night? Sure, says Kevin Price, president of AccuCode (#154). "As it was, all my financial resources were dedicated to the company," he says. "So if I failed, I wouldn't have been able to make my house payments anyway."


3. Should I get money from a partner or two?

By all means. Over the past few years, more than half of Inc 500 CEOs said they started their companies with partners -- 62% of the companies on this year's list started with partners, as did 62% last year and 55% the year before. This year 28% of CEOs reported that their cofounders contributed seed capital.


87 % of the Inc 500 CEOs surveyed used personal assets to start their companies.


But evaluate your prospective partner first. Does his long-term vision for the company match yours? Will he want to grow the company as quickly as you do? Thomas Santamorena, CEO of TLS Service Bureau (#450), faced just that issue with both of his partners last year. In 2000 about 80% of TLS's $1.4 million in sales had come from 20% of its clients. Santamorena, worried about depending too much on those customers, wanted to grow the company's client base. But his partners, who Santamorena says were complacent, didn't court new customers. Eventually, Santamorena convinced one partner of the need to pursue new business aggressively and bought out the other. Still, the conflict tainted Santamorena's views on partnerships. Now he advises, "Look for another alternative."

Still think that a partnership is the best way to go? Take some practical advice from Louis Meeks, cofounder of the Service Source (#102). Before starting the company, Meeks and his cofounder had their lawyers draft a buyout agreement -- essentially stipulating the rules of the game. One of those rules: a partner has only 30 days to agree to a proposed buyout or to buy out the other partner himself. An arrangement like that ensures that any serious partnership dispute won't last longer than a month -- and that any partner who wants a divorce can get one. The deal "really puts your feet to the fire," says Meeks.

Meeks and his cofounder each own 40% of the business, with a third partner owning 20%. The third partner serves in the role of "tiebreaker," arbitrating most disputes between the cofounders.

The Money Tree
Among the 1999, 2000, 2001, and 2002 Inc 500 lists, the percentage of the CEOs surveyed who raised seed money from
2002 2001 2000 1999
Cofounders 28% 39% 36% 8%
Family or friends 19% 30% 33% 14%
Strategic partners and customers 7% 11% 6% 4%


4. How can I persuade bankers to lend me money, and what do I do if they say no?

Banks will come through with loans if you can convince them that doing so isn't risky business. If a bank won't lend you money because your company looks iffy on paper, try for a loan backed by your personal assets. That's what Stephen R. Satterwhite, founder of Entelligence (#320), did in late 2000, when a dot-com customer that owed him $250,000 closed down overnight. Suddenly, Entelligence faced a cash crunch and needed financing to meet expenses. Satterwhite explained the problem to his company's banker, who offered to extend a $150,000 line of credit but required that the loan be secured not only by the company's assets but also by the personal assets of Satterwhite and those of an Entelligence investor and board member.


28 % of the Inc 500 CEOs surveyed tapped their cofounders' personal assets to start their companies.


Still in need of $100,000, Satterwhite approached his private banker. The banker gave him a $100,000 line of credit. "He never even hesitated," recalls Satterwhite. "He required only my personal guarantee, and he was just a super guy about it."


5. Credit cards -- how many are too many?

The answer to that question depends greatly on your willpower and personal risk tolerance, because let's face it, the credit-card solicitations will keep coming in the mail. And there's no legislation afoot that's going to stop them from coming, according to Elizabeth Warren, a Harvard Law School professor who specializes in bankruptcy law.


PRICELESS: Entrepreneur Kelli Greene funded her start-up with $50,000 in credit-card debt.


There is, however, a movement in Congress to pass a bill that would make it a lot harder to file for personal bankruptcy. (At press time, in early September, the bill was days away from coming to the floor in the House. As you read this, the bill may in fact be a law.) According to Warren, the legislation hits entrepreneurs harder than it hits anyone else. "About one in seven filers is a failed businessperson," she says.

In principle, the bill (the Bankruptcy Abuse Prevention and Consumer Protection Act of 2002) aims to prevent consumers from using bankruptcy laws to escape from debts that they have the money (but not the will) to pay. The bill claims such a determination will be made by focusing on a filer's income and expenses. But by focusing on just household expenses -- and not including business expenses -- the bill will have a disproportionate effect on entrepreneurs, claims Warren, because household income "tends to be higher for entrepreneurs, even though their expenses are also higher -- and the bill makes no allowances for business expenses."


62 % of the Inc 500 CEOs who raised additional financing borrowed money from a bank.


So if you want to start a business with a dozen low-rate credit cards, go ahead, but know that it might get a whole lot harder to use bankruptcy as a safety net.

Despite their potential pitfalls, credit cards offer the advantage of speed. Unlike loans from banks, for which you have to prepare forecasts and impress your lenders in person, credit-card capital requires little legwork. That was the main appeal of credit-card financing for Kelli Greene, who used 10 credit cards plus her savings to launch Pacific Data Designs (#160) in 1994. Greene had a day job and spent all of her downtime developing the software that would eventually become the company's hallmark product. "I had no time to talk to a bank, and I didn't want to make the effort of writing a plan," she says. The credit cards, which together accounted for about $50,000 in cash advances, funded Pacific's first 20 months. After that the company generated enough cash flow from its operations that it didn't need financing.


6. I don't want to mix family and business, but I might have to in order to get the money I need. What might make it less painful?

"The borrower should commit in writing to the plan," says James Olan Hutcheson, president of Regeneration Partners, a Dallas-based consulting group that specializes in family-owned businesses. "Write down how the money will be used, how it fits in with the business plan, and how it will be paid back." Hutcheson also suggests running the arrangement by your accountant so that the IRS doesn't misunderstand your intentions. Among a handful of potential problems: the IRS may construe an investment or a loan as a gift. Imagine, for instance, that after your brother has lent you money, your company fails and you're unable to pay your brother back. The IRS will not allow your brother to take a tax loss on a "gift." And then there are the emotional issues surrounding family money.


NEVER AGAIN: CEO Michael Fuori borrowed from his father to start a bar. Now he frowns on family funds.


Back in 1985, when he was 23, Michael Fuori, CEO of Lindin Consulting (#338), borrowed $25,000 from his father to open a bar in Levittown, N.Y., on Long Island. Twelve months later Fuori sold the bar and paid back his father, but his year with a liquor license was one he won't forget. He says that even though the bar broke even, his relationship with his father changed. Simple family conversations about how his day had gone grew touchy. If Fuori lodged the slightest complaint about his venture, his father was quick to say, "Twenty-five thousand is a lot of money," or, "You wanted into this business, not me."

Things bottomed out one Friday night when Fuori noticed two bouncer-sized men sitting at the bar, drinking nothing but water. Whenever Fuori moved to another part of the joint, the two men followed him. Finally, he asked them what they were doing. "We've been sent by your father to make sure nothing happens to you," was their answer, he recalls. A few months later Fuori got out of the business. "Believe me," he says, "that was the last time I ever borrowed from relatives."

To prevent family capital from interfering with family caring, Hutcheson recommends that entrepreneurs approach their relatives only after they have secured investments or loans from unbiased outside sources. "Go and get matching funds," he says. "If you need $25,000, then first get $12,500 from others before asking your family for the rest. If you can't do it that way -- and if you don't have your own skin in the game -- then you need to think twice about why you're asking someone you love to give you money. I believe you should get others to back the idea as well, so a parent or relative doesn't feel as though the money is a gift but rather a worthwhile investment. It puts a higher level of accountability into the entire process."


"Think twice about why you're asking someone you love to give you money."



7. Should I think twice before signing on with VCs or angels?

Yes, especially if you can get money somewhere else. Raphael Amit, professor of entrepreneurship and management at Wharton, describes the current investing climate as an "onerous" one for entrepreneurs. "Today you have to realize that venture capital is the most expensive financing you can get," he says. These days, notes the professor, venture capitalists aren't content to give cash for equity. To offset the increasing risks of today's market, many VCs are structuring their investments as a mix of debt and equity.

Of course, you might be in a start-up situation where you need funding from VCs or angels to survive. If that's the case, then Amit advises you to perform as much due diligence on the investors as they'll perform on you. "What will their attitudes be when your company hiccups? What will they do if you don't meet your forecasts, sales slow down, or you're out of cash? Talk to the other companies in their portfolios and ask, 'Did they work with you, help you, or fight you?' "

Then there's the valuation problem. Chances are, you and your prospective investors will have different ideas about just how much your company is worth. What accounts for those differences? Self-interest and subjectivity, to be sure. Another factor, according to Amit, is that entrepreneurs and investors disagree on how a valuation should be calculated. "With private companies, there's no correct method that everyone uses," he says.


19 % of the Inc 500 CEOs surveyed tapped family or friends for seed capital.


How can entrepreneurs make the best of things, in the absence of an objective valuation technique? Amit suggests that you avoid relying on a single investor. "Attempt to get multiple offers," he says. "Competition keeps people honest." By learning what several investors think of your company, you'll obtain a range of valuations -- and learn which valuation methods put your company in the most positive light.

You should also consider your own personality before signing on with VCs or angels. Could you tolerate reporting to anyone, let alone a group of investors with great expectations?

Brent Habig can't -- at least not now. The CEO of Tigris Consulting (#221) doesn't rule out the prospect of equity financing down the road. But for now Habig is sticking with his bank. "When you deal with the bank, it takes maybe several hours a month. I can do that," he says. But he turns up his nose at the idea of interminable meetings with investors. "I don't want that level of distraction for me or my management."

Even if you embrace that level of distraction, you're unlikely to encounter it at start-up -- only 2% of this year's Inc 500 companies received seed capital from VCs. Most Inc 500 CEOs who get venture capital receive it as later-stage financing. Of the 61% of this year's companies that raised later-stage capital, 19% got VC money.


8. At what point in my growth should I try to raise more money?

It depends on your long-term goals. If you're happy with your company's rate of growth, then there's really no need to raise more money. But if you're dissatisfied with the rate, then it's time to raise capital.


23 % of the Inc 500 CEOs surveyed turned to their buddies or relatives for additional money to finance their companies' growth.


For a couple of years Andrew Field, founder and president of PrintingForLess.com (#285), had been happy with his company's growth rate. Then, in 2000, his company reached critical mass in both the number of employees and the number of projects it was handling. Suddenly, Field needed more high-powered software -- something called an "internal-work-flow database" that could help him track each and every project and employee. "We were at a pivotal point in our development, when we literally needed to go into the red in order to grow larger," recalls Field. "Investments in infrastructure and marketing simply couldn't wait for internally generated capital." Field raised a total of $500,000 from two venture-capital firms. In addition to hiring programmers to develop the database, he also spent money on marketing, since the database system gave PrintingForLess.com the ability to handle many more projects. "Both investments have more than paid for themselves, from both an ROI perspective and an internal-efficiency standpoint," says Field, whose company grew 143% in the year following the investment -- the largest percentage increase in the company's history.


9. Should I go for a larger credit line, or is it worth my while to get a round of formal investment?

It's no surprise that virtually every Inc 500 CEO has asked himself or herself that question at some point -- a capital shortage is one of the primary symptoms of fast growth. Entrepreneur Rick Inatome once said, "I've always heard that the definition of an Inc 500 entrepreneur is a person who's guaranteeing $3 million at the bank and has $15 in his pocket."


49 % of the Inc 500 CEOs who raised later-stage financing got it from venture capitalists or other private-equity investors.


One easy way to make that decision is to examine how you're putting your existing credit line to use, says Richard McGinity, founder of School Street Capital Group, an Ann Arbor, Mich., consultancy that advises owners of private companies. Most banks require that companies pay down their credit lines once a year. If you're struggling to do that, it probably means that you're using your credit line not for short-term cash crises but to provide working capital -- a sign that your company needs additional investment. If your banker is on his toes, he might even detect such a problem before you do. "When a credit line starts to be used for long-term purposes, bankers get nervous," says McGinity. "If you can't pay off your line once a year, your banker will probably say, 'What's going on here?' And it's either that the company is not generating the cash that it hoped or that it's growing much faster than it expected." Bankers have a healthy suspicion about the ways in which growth companies use their credit lines, which isn't surprising, given the stresses of hypergrowth and the brashness of Inc 500 CEOs.

So if you find yourself looking like Inatome's definition of an Inc 500 entrepreneur, it may be time to take an angel investor out to lunch.


Ilan Mochari is a staff writer at Inc.


The Capital Gang

The Numbers Game
A Little Goes a Long Way


Please e-mail your comments to editors@inc.com.

Last updated: Oct 15, 2002




Register on Inc.com today to get full access to:
All articles  |  Magazine archives | Livestream events | Comments
EMAIL
PASSWORD
EMAIL
FIRST NAME
LAST NAME
EMAIL
PASSWORD

Or sign up using: