Financing for Small and Medium-Sized Enterprises (SMEs) can be obtained from several sources. All have their advantages and drawbacks, and before choosing, it is important to carefully consider each one. This section of the site reviews the main types of financing, pointing out strengths and weaknesses in each.

Self Financing
John Shepard, founder of Leigh Instruments and an experienced entrepreneur once stated, that "the best money is your own money". It is perhaps somewhat terse since it seems to convey the rather obvious idea that it is far better to be your own investor and invest on your own terms than to pay others to invest their money on their terms. Indeed, many owners of both high and low tech firms have built successful businesses without any outside funding.

But there's more to it than this.

While everyone would like to be able to build a business without outside funding, self-financing does not fit everyone's needs. For one, the earnings you retain may not provide sufficient cash to allow you to grow your business at the rate required by your customers and business strategy. If this is the case, there are other options

Debt and Equity
Outside funding inevitably comes with terms and conditions imposed by those supplying the funds. For one, you are paying a price to get money, whether it is interest, a percentage of sales or the potential profits you give up when shares are issued. Therefore, like buying any other product, when you are looking for financing it is important to ask yourself three questions. First, do you really need it? If so, which product do you want to buy and from whom? Third, why?

After all, financing costs lie along a spectrum of short-term pain for long-term gain (interest) to short-term gain for long-term pain (sale of equity). As Peter Kemball, the founder of Acorn Partners put it, "just as sales leads have to be qualified to see if you have what they need, so do sources of financing have to be qualified to see if they have what you need." Neal Hill, Managing General Partner of VIMAC, a venture capital firm specializing in start-ups, holds the same view, reminding all of us that it is important to treat prospective venture capitalists as if they were potential customers-learn a lot about them before your initial approach.

Researching what is out there in terms of financing, in conjunction with evaluating your needs, provides a basis for weighing the costs and the benefits of using outside funding to grow your business. A good starting point is to understand the types of financial products offered by different suppliers. Upon reviewing these, a gut reaction such as "this is not for me" or "this looks promising," could save you looking in the wrong place for money.

Banks: What They Can and Cannot Do
Deposit taking institutions are designed to provide funds to those firms where the possibility of non-repayment "cannot" happen. Loans are priced accordingly, on a prime plus two or three basis. Of course reality intrudes on occasion and banks have special loan groups to clean up their errors.

The central economic function of a commercial account manager in a bank is as the "first judge" of the commercial prospects of a business venture. To successfully perform this function, they require at least three years of annual statements to get a glimpse of the business' track record.

Historically, this role has been performed in two stages. First, the bank accepts the firm or entrepreneur for the purpose of opening a business account with their institution. Second, they provide a line of credit, primarily to finance accounts receivable from the business' customers.

The time between the stages is at least two fiscal years.

Within the past decade an additional stage has been inserted into the process. Small loans to firms (under $100,000) are made via credit scoring processes that effectively bypass the account manager. Applications are scored and credit is granted based upon the results so no personal judgment is involved in the basic version of this approach.

This process yields a distinct product well suited to the managerial and economic realities of most small businesses. It permits them to access credit up to a specified limit, and provided minimum interest payments are made on time the capital balance can remain outstanding-forever, if desired. In addition, credit scoring removes the burden of monthly reporting to an account manager. The cost of the supplied funds varies from prime plus to twenty or thirty percent per annum.

The attraction to banks is the lower cost and hence the ability to profitably serve businesses that would be otherwise unprofitable.

The odds of receiving a loan through credit scoring is as follows: 230 000 calls yields 2 300 applications with 650 loans approved. Currently, fifty percent of business loans with Canadian banks have approved lines of credit under $50,000.

Where Does Their Money Come From?
Banks and other deposit taking organizations get much of their money from your pay cheque. We all leave it with them for a few minutes, hours or days, taking it out when needed. Some of the money is left there for a defined term and interest is paid in exchange.

How Do They Make Money?
Money is made in two ways. First, there is the profit derived from the difference between what a bank pays to its depositors and what it charges its borrowers. Second, the bank makes money from the spread between its cost of funds and the interest you pay them, plus fees for services rendered such as the review of a loan application.

However, it is not as easy for the bank as it looks. For example, if you were to borrow $100,000 and pay 8% per year you would be contributing about $6,000 to the Account Manager's salary-not a lot. Clearly, the bank needs many borrowers to pay his or her wages. Since it requires work and is risky to take on a large number of borrowers, it follows that the smaller the amount borrowed, the less attractive it is to the bank.

Another important point is that banks can only make money at the prices they charge (the interest rate you pay) by ensuring that none, or very few of their loans go into default. Therefore they have to be careful who they make loans to, and while they clearly have money, it may not be available to you.

What Kind of Money Do They Supply?
Banks typically advance 50% to 75% of the money owed to you by your customers. They provide it in the form of a line of credit that is in effect repaid when your customer pays you. This permits you to give your customers time to pay. Sometimes a bank might provide a 'term loan,' which is usually used to acquire fixed assets and is repaid over a period of years.

When lending to you, they use well-defined rules to avoid losses. Given their source of money and the obligations they assume in obtaining it (e.g. it is available to depositors whenever they want it) banks cannot take much risk on your loan. Thus, even though you may have a perfectly good account receivable from a major business or government, a bank would look at your whole business to make its decision.

In cases where everything goes wrong (e.g. a major customer goes bankrupt or your sales level drops below the break even level needed to maintain profitability), they expect that you will be able to draw on resources outside the business to pay the bank back. It is for this reason that personal guarantees are taken just in case.

Banks supply money that they are certain will come back to them-no ifs, ands or buts. This conservative approach is at the root of the saying amongst entrepreneurs that banks provide you an umbrella only to take it away when it rains. This may sound unfair, but it's really not. You promised there was no risk and they believed you.

Hidden among all this is one key fact: the growth rate you can finance based on this type of money is modest-about three times your after tax profits. If sales were $1,000,000 and profits were five percent of this, say $50,000 a year, you could expect to support an increase in sales of about three times that amount- $150,000. However, this increase is by no means guaranteed since continued financing depends upon the bank's review of your annual financial statements.

The above scenario translates into a fifteen percent growth rate. While a good banker will work hard to keep a good account, the rules effectively mean you can grow only at a modest rate on a sustained basis. If you have an opportunity such as a particularly large order (often the stepping stone to growth) the inability to secure additional financing can be a problem. To grow your business, the most valuable asset is cash on hand.

Venture Capital
Growth on Steroids
Many ask for venture capital and very few are chosen. One venture capitalist, Claude Haw of Venture Coaches, makes one investment for every one hundred business plans presented to him. Others state that they review a thousand business plans, look into 150 seriously (15%) and fund thirty (3%).

While these figures are discouragingly low, the industry average of one success for every ten investments suggests that even fewer should have been chosen.

However, there is a qualifier. That one winning investment will pay for all one thousand business plans that were reviewed and all those that were funded but did not pay off. In this respect, venture capital is at the opposite end of the spectrum from bank lending. It is for situations where the rate of growth is on steroids.

Targets Only a Select Few
Considering the poor odds of obtaining venture capital, it is somewhat surprising that most entrepreneurs, and many advisors to entrepreneurs, believe that they need to raise it. This is not necessarily the case. Consider the following:

1. Venture capital is a highly specialized form of equity capital that very few firms need and can afford.
2. Only between one and five percent of those seeking venture capital will actually receive it.
3. Once obtained there remains the issue of who actually owns the company-the investor or the entrepreneur.
4. Those requiring smaller amounts of capital are at even more of disadvantage, regardless of their prospects.

What is comes down to, is that many SME firms with truly excellent growth prospects could do better with equity capital at a lower cost.

Increasingly, entrepreneurs are looking elsewhere. Some know that in many cases venture capital it is too expensive and takes too long to get. Instead, these entrepreneurs prefer to devote their time to growing their business rather than selling their business plan to the venture capital community.

Successfully growing a business means spending more time in front of customers than in front of investors. Efforts to do so do not go un-rewarded. For one, it creates options for other sources and forms of financing.

Where Does Their Money Come From?
The typical venture capital firm gets its money from pension funds or insurance companies. Less often, the funds come from industrial concerns or private investors. Funds are given to the venture capital firm for a fixed term, usually under ten years.

Those who invest in venture capital generally put a small percentage of their funds into the industry to earn high returns. And they are high. One of the top venture capital firms has returned forty percent per annum to its investors.

In Canada a significant portion of the funds in the venture capital industry come from individual investors who put up a few thousand dollars in exchange for a tax break. These are the Labour Sponsored Venture Capital funds, fittingly named because the tax breaks require a labour organization to sponsor the fund. While the source of funds is different, the dynamic is the same-the investor can earn a high return and may redeem their funds after a fixed period of time, in this case 8 years.

How Do They Make Money?
Venture capital firms make money in two ways. First, as with mutual fund managers, they charge fees for the assets under their administration. Second, they can earn substantial fortunes if their fund(s) perform well.

Venture capital firms are thus hired hands for those providing the funds. Their role is to earn superior returns for their investors and themselves. The only way they can do this is to pull their money out in a relatively short period of time (typically five years), and at a much higher price than what they paid. In other words, they rely on a fast and furious increase in the value of the money they invest.

Venture capital firms get exceptional returns on the total value of their fund in spite of the fact that most of their investments will not make enough money to return capital to the investors, particularly after allowing for the annual fees they pay.

Without good investment prospects high returns are not possible and investors will not provide the venture capital firm with new money for new funds. So, to increase their chances of picking winners, venture capitalists often specialize in an industry or stage of a company's development.

By doing so, they benefit from having the specialized knowledge needed to find the real opportunities. Not only are they aware of what the customers of their portfolio firms need, they have a good grasp of who is trying to meet those needs. This access to knowledge and people enables them to be very helpful to the companies they invest in, particularly by shortening time lines. Of course, opportunities outside their expertise are of little interest and would add little value to their business.

An entrepreneur's scarcest resource is time and so is a venture capitalist's. Since it takes the same amount of time and effort to invest large and small amounts, the former are generally preferred. Even venture capital firms, which are geared towards investing at an early stage of a company's growth, have minimum thresholds-and for sound economic reasons.

Given the odds they face, venture capital firms need to make about thirty investments. Therefore, with a fund of $60,000,000, the average size of their investments is likely to be about $2,000,000. Thus, any investment opportunity of less than $1,000,000 will not likely get attention.

In sum, to secure venture capital investment, particularly from a top tier firm, the potential of the investment must be gargantuan. Not only do the few investments that succeed have to be stellar in their own right, they have to pay the freight for the far more numerous failures. A rough estimate suggests that only 150 of every thousand firms actively seeking venture capital are realistic in their choice of funding.

Presumably, this figure also applies to early stage firms. So, for the majority of entrepreneurial start-ups, venture capital is not a viable source of funds. That many call but few are chosen makes sense.

What Kind of Money Do They Supply?
Venture capitalists are a high cost supplier of funds. In exchange for a big return on their investment they assume the risk that they will lose their investment. Because of the nature of the business, the cost of getting venture capital in terms of legal and accounting fees is also high.

At best, the money supplied through venture capital comes with the knowledge and experience required to create huge value quickly. This is the source of the oft-used remark "would you rather have 5% of a billion dollar firm or 60% of a million dollar firm?" which is basically another way of asking whether you would rather make $50 million or $600,000.

Venture capital is often referred to as "patient" capital since the time frame from investment to exit is about five years. Unfortunately, when venture capital is placed in the context of the time frame most early stage businesses take to develop their products and services and grow their organization (seven years plus in Acorn Partner's judgment), it misses the mark.

In this respect, venture capitalists are perhaps more accurately referred to as impatient suppliers of patient capital. Put another way, they need a much shorter blade on the "hockey stick" of sales projections than can be offered by most high growth SME's.

In a word, venture capital is expensive and may not correspond with your businesses growth rate. However, if the opportunity you offer is going to create an industry, it's worth pursuing it.

For additional insight into the availability of venture capital please see the article What Motivates Investors in the Post-Bubble Era in the section Observations and Advice for Entrepreneurs from Entrepreneurs.

High Trust Networks
The high trust network, or "love money" that one might obtain from relatives or close friends varies in price since such investors do not often think about the real value of the business. This causes real difficulty if later rounds of capital are raised because a knowledgeable investor may not pay as much.

Nor do high trust investors consider how they will make their exit. Lack of an agreed upon exit plan causes problems years later when the money is still tied up in the business and some want it back.

Most importantly, there is a very real social cost of failure. It is hard to keep your head high at a family reunion when you have just lost them $10,000 each!

Angel Capital: Dream or Reality ?
Entrepreneurs dream about angel capital-and sometimes not without reason. From the perspective of the founder of an early stage business, it has the potential to launch them into the big leagues. Concurrently, Angel investors dream of discovering the next Microsoft, enticed by the prospect of astronomical returns on their investment. However, for both entrepreneurs and angels, the experience of financing a business can often be a financial and emotional nightmare.

Where Does Their Money Come From?
For the most part, angels have made their own money-often as business founders and operators. Sometimes they have generated capital to invest from their activities as investors. Occasionally they have inherited it.

Where it comes from is important to discover. This is mainly because an angel investor's success as an entrepreneur does not necessarily reflect their ability or knowledge as an investor.

Investment is a discipline to be learned and most business people have not taken the time to do so. Thus, in spite of their wealth of business knowledge many angel investors in this group are inexperienced when it comes to investing.

On the other hand, if they have made investments and experienced success (and failure), then they are mature angels and bring more value to the table.

Those who have inherited money are the least desirable source of funds. This is primarily because they lack confidence in their ability to make more money should they lose their cash. In this instance it is advisable to use an investment structure that limits their power once they have written the cheque. It may kill the deal but debt is a death spiral with such angels.

How Do they Make Money?
Angel investors make money by earning a return on their investments. However, all too often they expect to beat the odds and look for more reward through ownership of shares when the business goes the IPO route. More experienced angels use convertible debt to recover capital with interest. But even that has its weakness. For one, the payments can cause a cash drain when it is least needed by the young business. Royalties subject to a breakeven level are a better fit.

Ownership and returns can be a major point of disagreement between angel investors and the entrepreneurs they support. This is because they are likely to clash over the price of equity given the split between them over economic and legal control of the firm. Angel investors are concerned with the value of their shares while entrepreneurs are more focused on the percentage of shares they control. Getting agreement on a "price" in the midst of an IPO is thus unlikely.

What Kind of Money do they Supply?
Angel capital is a scarce commodity. Whether it is because of their lack of financial experience, their fear of losing money or the potential for conflict with the entrepreneur over equity ownership, many angels are hesitant to invest. Second, in terms of logistics, angel capital is hard to obtain. From the perspective of both entrepreneurs and policy makers in government, getting a handle on who provides angel capital, how much is provided, to whom and how is often prohibitively difficult.

Nonetheless, a market place does exist for angel capital and in some instances it is remarkably efficient. Witness the National Angel Organization, Robert Chatworth Muster's efforts in British Columbia and the Ottawa Capital Network.

There are two generalities about the angel capital market place. First, it is not a low cost source of funds. Investors seek returns in the venture capital range-about twenty times the funds invested over a period of about seven years. This translates into fifty percent per annum. Second, at between $250 000 and a million dollars per deal the amounts invested are typically modest.

With this in mind, the entrepreneur's key to making good use of angel capital is being aware that they have only got between a quarter of a million and a million dollars with which to become cash positive. Any additional funding would be expensive and difficult to acquire and their business strategy had better reflect this.

Rare exceptions do exist. If the opportunity is going to make the earth move, then follow-up rounds of venture capital may be obtainable. However, it would not be prudent for an angel or entrepreneur to see this as the way to obtain a profitable exit. Remember, nine out of ten venture capital investments do not pay off.

The best advice for most entrepreneurs is to spend their time selling to paying customers, not searching for angel investors.

Valuation of Early Stage Companies for Initial Round of Angel Capital
The chart below depicts the process underlying the valuation of an early stage company.

Enter your own numbers in our Angel Calculator:

Valuation Of Early Stage Companies For Initial Angel Round

Cost Of Equity Vs Sales Driven Financing®

This Calculator was devised by Acorn Partners, Merchant Bankers To Emerging Companies and The Leader In Sales Driven Financing®

Factoring: The Unseen Financing Option for Most Growing Businesses
There are many SME opportunities whose potential growth rates are beyond the banks capabilities to finance but below the thresholds for venture capital. A number of these can and will grow into multi-million dollar businesses over a decade or two, becoming an important part of the economic and social foundation of their community as they do so.

Who Finances Such Opportunities?
Sometimes it is angel investors who opt not to be involved in the highly visible world of venture capital. In other cases it is IPOs-what might best be described as the company sale super-growth freeway.

Very often John Shepard's rule is observed and the business uses its own money to bootstrap growth customer-by-customer, sale-by-sale.

What we refer to here as the Unseen Financing Option is another choice. Based on an established form of financing known as factoring, it is an arrangement whereby a firm sells title to its accounts receivable at a discount in exchange for an advance on their value.

It is unseen by most investors because the financer, or factor, takes a different stance on the opportunity offered by an entrepreneur than bank lenders or venture capitalists. The factor is able to do so because their success relies not on the creditworthiness of the entrepreneur seeking the financing, but on that of his/her customers.

Where Does Their Money Come From?
An independently owned factor obtains their money from people who have profited as entrepreneurs and/or investors. They know how to make money and know that it can also be lost, yet they are willing to take managed risks to get better returns than can be earned in 100% safe investments. In sum, it is money for entrepreneurs from entrepreneurs.

How Do They Make Money?
Money is made by putting time and effort into the management of risk. This is done with two objectives in mind:

1. earning a rate of return that is higher than the bank's.
2. establishing a price based upon the value the entrepreneur places on having funds available.

What Kind of Money Do They Supply?
Unlike the banks, individual investors, or angels, are not the lowest cost source of funding. This is because as an entrepreneur, you have to compete with the returns that such investors could get elsewhere. For one, they might choose to invest in second mortgages. In doing so a few are able to make thirty plus percent and are also able to manage their own risks.

As with all money obtained from parties outside the business, factoring comes with terms and conditions attached. However, they are more likely to be tailored to the entrepreneur's individual situation than a bank loan or venture capital investment.

At this point, you might be curious to learn more about this type of financing. You may also be questioning its seemingly specialized nature. However, what we are talking about is actually a service that is widely used and has been around for a long time. It has just been tailored to fit the markets of today.