Commercial banks and venture capitalists are important, albeit very distinct sources of small business financing. The Minority Business Development Agency (www.mbda.gov), a federal agency that promotes the growth of businesses owned by ethnic minorities, stresses that banks are creditors and are looking for a business’s service or product to provide sufficient cash flow and sales to ensure repayment of a loan. Venture capitalists, by contrast, are equity providers who become part owners of a business by holding an equity interest it.
According to MBDA, venture capitalists decide whether or not to invest in a company based on whether or not the company can grow rapidly and has the potential to generate significant sales and large profits. They will be most interested in companies with new products or with business models with the potential to see appreciation of at least 300 percent to 500 percent within seven years. Most venture capitalists rarely make investments under $250,000 to $1.5 million, as it can cost several thousand dollars to undertake a preliminary review of possible investments. They argue that smaller investments simply are not cost-effective.
Venture capitalists often consider the following factors:
Management skill. Most venture capitalists will focus on the experience and skill of the company’s management team. They often “bet the jockey, not the horse,” paying attention to management capability more than products or services. In general, they are looking for companies with experienced senior management, with defined roles and responsibilities and with a clear understanding of the market.
Competitive advantage. Most venture capitalists are looking for a unique characteristic in a company’s business plan—some element that provides the company a clear competitive advantage, either through the product, market or business process.
Performance history. Venture capitalists also will look at the performance history of the company making the proposal. While some equity providers look at companies that are just starting out, many more are interested in existing companies moving into new markets or expanding their services or products.
Prospective lenders, including commercial banks, will review the creditworthiness of the business and its owner. A complete and thoroughly documented loan request, including a business plan, helps the lender understand both the business and its owner, MBDA says. The five basic components of credit analysis are:
Capacity to repay. This is the most critical of the five factors and it is the primary source of repayment—cash. The prospective lender will want to know exactly how you intend to repay the loan. The lender will consider the cash flow from the business, the timing of the repayment and the probability of successful repayment of the loan. Payment history on existing credit relationships—personal or commercial—is considered an indicator of future payment performance. Potential lenders also will want to know about other possible sources of repayment.
Capital. The money you personally have invested in the business is an indication of how much you have at risk should the business fail. Interested lenders and investors will expect you to have contributed from your own assets and to have undertaken personal financial risk to establish the business before asking them to commit any funding.
Collateral. This is any additional form of security you can provide the lender. Essentially, you pledge an asset you own, such as your home, to the lender with the agreement that it will be the repayment source in case you can’t repay the loan. It is different from a guarantee, in which another party signs a document promising to repay the loan if you cannot. Some lenders may require such a guarantee in addition to collateral as security for a loan.
Conditions. A description of the intended purpose of the loan. Will the money be used for working capital, additional equipment or inventory? The lender will also consider local economic conditions and the overall climate, both within your industry and in other industries that could affect your business.
Character. The general impression you make on the prospective lender or investor. The lender will form a subjective opinion as to whether or not you are sufficiently trustworthy to repay the loan or generate a return on funds invested in your company. Your educational background and experience in business and in your industry will be considered. The quality of your references and the background and experience levels of your employees will also be reviewed.