Street Smarts

by Norm Brodsky

  CHAPTER FOUR

  Where the Money Is

  So now let’s talk about money. For people who want to start a business, there’s nothing more mysterious than figuring out how to raise it. I hear from them al the time. A lot of these would-be entrepreneurs have good, solid business ideas that they’ve researched and tested, but—try as they might—they can’t find an investor. “What am I doing wrong?” they ask. “How can I find someone like you?” They don’t need someone like me. What they need is a better understanding of investors.

  Let me tel you about Jordan and Seth, who had a start-up that they thought could become a national provider of Internet development services to smal and midsize businesses. The two of them had invested $200,000 of their own money to get the business up and running, taking sales from $42,000 in the first year to $246,000 in the second. Along the way, they’d learned a lot about the market and come up with a strategy for tapping into it, using the contacts they’d made in another company they owned, a successful print brokerage in Manhattan. They figured they needed $2

  mil ion to ramp up the new business over the next five years, and they were getting ready to approach potential investors. Jordan asked if I’d be wil ing to look over their business plan and offer them some advice. I said I would.

  The business plan arrived the day before our meeting. It was one of the nicest I’ve ever seen—about thirty-five pages long with a hard cover bearing the company’s name and logo. The text was succinct and to the point, providing about the right amount of background information on the business, the market, and the strategy going forward. The numbers appeared to make sense. But a couple of things jumped out at me. When I got together with Jordan and Seth, I asked them whom they were planning to go to for money. They said they had a meeting scheduled with venture capitalists in a couple of days. I said, “No venture capitalist is going to buy this plan.”

  There were at least three problems with it from a venture capitalist’s perspective. For openers, the plan said almost nothing about how much investors could expect to make on the money they put in, or how they would eventual y cash out. That’s a major omission if you’re going to people who invest only in businesses that promise to deliver the particular rate of return they’re looking for.

  Second, the plan cal ed for using a substantial portion of the investment to buy furniture, equipment, and other fixed assets. A venture capitalist was sure to ask, “Why buy? Why not lease?” Venture capitalists like to take advantage of leverage—within reason, of course. The more debt you use to finance a start-up, the greater wil be the potential increase in its equity value. It’s like buying a house with the smal est possible down payment. There’s a bigger risk of failing, but a bigger reward if you succeed. Jordan and Seth clearly didn’t understand the investment philosophy of the people they were asking for money. Strike two.

  But the biggest problem with the plan had to do with a smal note on the page labeled “Projected Source and Use of Proceeds.” It said that more than $200,000 of the $2 mil ion investment would go toward “repayment of loans to officers and affiliates.” I don’t know anyone who’d make a substantial investment in a start-up knowing that the founders were planning to take 10 percent of the money and put it in their pockets. Venture capitalists certainly wouldn’t al ow it. They’d probably see it as a good reason to reject the deal.

  On the other hand, they’d be impressed if Jordan and Seth said, “Look. We’ve financed this business ourselves for the past two years, using our own hard-earned money. Now we need your money, but ours is going to stay there at least until you get your investment out.” That would have been a significant factor in their favor. So what had they done? They’d taken a big positive and turned it into a big negative. I asked if they had any other prospects besides the venture capitalists. They told me they had a lead on a group of doctors.

  I don’t know what it is about doctors, but people who want to raise money always seem to have access to a group of them. You’d think doctors were ready to invest any amount of money in anything that came down the pike. “How much are you looking for from each of these doctors?” I asked. They said the minimum investment amount was $250,000. I said, “You don’t know these people, do you?” They admitted they didn’t.

  There are very few doctors wil ing to invest $250,000 in a start-up business. Wealthy professionals tend to approach these matters the same way that relatives, friends, or other amateur investors do. The first question they ask is, “How much do I have to put in?” Everybody has an investment plateau. It could be $10,000 or $20,000 or $100,000. Whatever it is, you won’t have a chance if you come in too far above it. Even if people are kind enough to sit through your pitch, you’ve already lost them. They won’t seriously consider investing in your deal.

  So it’s important to find out in advance the investment plateau of the people you’re going to, especial y if they’re not professional money managers. If you can’t ask them directly, you can talk to the contact person, or to accountants and financial advisers who know the investment habits of people like those you’re planning to approach. Maybe they typical y invest $25,000, in which case you’d need forty of them to raise $1 mil ion.

  The point is that, once you know their investment threshold, you can tailor the offering to make it possible for them to put in an amount they’re comfortable with—or you can decide it’s not worth asking them at al .

  But you have to do your homework. With most investors, you have just one shot. If you blow it, you’re out of luck. People don’t say, “Come back when you get it right.” If you go in and you don’t know what you’re doing, it’s unlikely that you’l ever get another chance. To make the most of your opportunities, you need to plan your investment strategy just as you plan your business. You need to research the market. You need to find out as much as you can about potential investors—what they want, what their criteria are, how they evaluate a deal—before you ever ask them for money.

  Some research is easy. Most bankers, for example, are happy to tel you the exact criteria they use in making loans. Venture capitalists wil also explain their philosophy if you approach them the right way. Alternatively, you can go to businesspeople who’ve received venture backing and ask them for advice. But the best research is done while you’re actual y out looking for the money. That’s why I usual y tel people to build a certain amount of failure into the process. I’m talking about including four or five long shots on your list of potential investors—and then making a point of approaching them first, knowing that you’re probably going to be turned down. You’re bound to learn something from each rejection. You should plan to learn as much as you can.

  For example, you can draw up a questionnaire and go back to people who’ve rejected you. Make it clear that you aren’t looking for money this time, that you respect their decision and aren’t asking them to reconsider. Say that you just want to learn from the experience, and you’d be grateful if they’d explain why they said no. Urge them to be completely candid. Was it you? Was it something about the business plan? Was it the amount of money you were looking for?

  The information you gather wil al ow you to strengthen your business plan and improve your presentation before you go to see the people most likely to give you their support. You’l get a better sense of what they’re looking for, and you can make sure you’re offering them what they want. Not that you should be dishonest, but there’s no point in approaching them if their criteria don’t mesh with your needs.

  That’s more or less what I told Jordan and Seth, but they had other ideas. They went ahead and met with the venture capitalists, who turned them down. A couple of weeks later, I got a cal from Jordan, saying that he and Seth had decided to dissolve their partnership. Seth wanted to keep looking for investors who’d let them take their own $200,000 out of the business. Jordan thought such efforts were a waste of time. In the end, al they could agree on was to go their separate ways. Which goes to show, I suppose, that some bus
iness lessons are more expensive than others.

  The Banking Choice

  Getting start-up capital is certainly important, but once the company is up and running, you need to turn your attention to building another financial relationship—the one you’l have with a bank. The question then becomes, what kind of bank?

  That question was on the mind of an Inc. 500 CEO who came to me for advice about securing a line of credit to finance his company’s expansion. He planned to borrow against his accounts receivable. His chief financial officer wanted to use a bank, but his accountant was recommending that he go with an asset-based lender. He said he wasn’t happy with his current bank and was planning to leave it anyway. Was there any reason he shouldn’t use an asset-based lender for the credit line?

  I told him I could think of about ten reasons. How many did he want?

  I know how difficult bankers can be to deal with. I’ve had my ful share of run-ins with them. It’s amazing how poorly they sometimes treat their customers, and how hard you have to work to get them to take you on in the first place. As a group, they are just about the most inept salespeople I’ve ever run into. But every business needs a bank, and you should use every opportunity you have to build a relationship with one. Forget about whether or not you need a loan right now. The truth is, you’re better off if you don’t. What’s important is to have the relationship. Why? Because the day wil come when you do have to borrow money, and when it does, you don’t want your only option to be an asset-based lender.

  Please don’t get me wrong here. I have nothing against asset-based lenders per se. They play an important role in our economy, lending money to companies that can’t get it anywhere else. And unlike bankers, they’re terrific salespeople. Yes, as they wil readily admit, it’s more expensive to borrow from them than from a bank, but they do so much more for you (or so they claim): monitor your col ections, do credit checks on your customers, help you keep on top of your receivables. What’s more, they can close a deal quickly and painlessly, in as little as two weeks, often without even requiring audited financial statements.

  It can al look very tempting to a growing company with little cash and a lot of receivables, especial y if you’re coming off a bad experience with a bank. There’s a catch, however. A loan from an asset-based lender is not the same as a loan from a bank. (By bank, I mean a traditional commercial lender. For the purposes of this discussion, I’m including the asset-based-lending divisions of banks with asset-based lenders.) The key difference can be summed up in one word: control.

  When you borrow from an asset-based lender, you give up control of your receivables. The payments from customers no longer come to you.

  They go into a lockbox at the lender’s bank. You get copies of the checks and a ful accounting record of what happens to the money, but the lender controls the cash. If a dispute arises, or if your business gets into trouble, the lender holds al the cards. While it no doubt would prefer that your company succeed, it has no great incentive to help you get through tough times. After al , it isn’t depending on you to repay the debt. It’s depending on your customers. That’s why asset-based lenders seldom insist that you provide them with audited financial statements. It’s your customers’

  creditworthiness that counts, not yours.

  With a bank, you’re in a total y different position—because banks are not in the same business as asset-based lenders. They don’t make money by managing receivables. Their profit comes from making good loans. A bank wil let you borrow against receivables only if it thinks you’re going to be able to repay the money with interest. It doesn’t want your receivables. It’s not set up to deal with them.

  So the receivables remain in your hands. You’re responsible for managing, monitoring, and col ecting them. Granted, you’re supposed to report regularly on their status, and—if things go badly—the bank can always come after them. But even then, you have much more room to maneuver and a better chance of surviving, because the bank has a vested interest in having you succeed. It cares whether or not you stay in business. It wants to get repaid, and that won’t happen unless you’re around.

  I don’t mean to suggest that the main reason to borrow from a bank is to protect yourself on the downside. It isn’t. My point is that, when you borrow money, you enter a relationship, and the relationship wil be a good one only if you understand what the other party is looking for. Banks look for good businesses—and good businesspeople—to invest in, whereas asset-based lenders look for good receivables to acquire. That’s why it’s harder to borrow money from a bank: you have to prove yourself creditworthy. It’s also why you have to do more once you get the loan. Granted, asset-based lenders provide certain services you won’t get from your bank, but they’re things that every business should do for itself anyway.

  And therein lies the real reason to borrow from a bank, assuming you have the option. The loan gives you an opportunity to demonstrate that you understand your responsibilities as a borrower and are capable of meeting them as a businessperson. It gives you a chance to build the relationship by showing that you can hold up your end of the bargain. That is, it al ows you to establish trust.

  Ask Norm

  Dear Norm:

  I need your advice about finding investors. If I have no money to put into a business, what else might I be able to contribute as a form of personal equity to woo investors? The only idea I have is to sign a promissory note.

  Dave

  Dear Dave:

  If sweat equity isn’t enough for outside investors, I doubt that a promissory note wil do the trick, either. You’l probably have to get some Rolodex funding first. By that, I mean you’l have to start cal ing people in your address book, including close friends and relatives. Any money you raise from them wil be seen by outside investors as money from you. By asking for money from friends and family, you’l be taking a risk on your future relationships with them. That counts with outsiders who want to know you’re investing something important besides your time.

  —Norm

  How to Lose a Loan

  In the end, mutual trust is needed to cement a banking relationship, but trust is not what many entrepreneurs feel toward their bank. They live in constant fear of having their loans being cal ed, which could happen at any moment and for almost any reason. I know one company that made a mistake with a bonus payout and was dropped by a bank it had been doing business with for fifty years, through three generations of ownership.

  Another was asked to leave when its bank had a change of policy and decided it would no longer do receivables financing. Yet another company was given the bum’s rush because its principal customer was considered a poor credit risk. I’ve had my loans cal ed twice in my career, and I wouldn’t wish the experience on anyone. That said, one of the experiences was much better than the other and helped me understand what you can do to protect yourself.

  The first time I got dumped was in 1985, when my messenger business was growing like crazy. The business consisted of seventeen different corporate entities, each of which had a relationship with the same bank. I thought everything was fine until one day, without warning, I received seventeen letters informing me that I had thirty days to pay off my loans. I was stunned and furious. I cal ed my loan officer and said, “What the hel are you doing? Couldn’t you at least cal me before sending these letters?” He apologized and then essential y told me to get lost. The bank, he said, was getting out of receivables financing and didn’t want my business anymore. I had a month to find a new lender.

  The next experience, in 1995, was far more pleasant. Again, I had receivables financing from a bank that was changing its policy and getting into new lines of business. This time, however, my banker came to me and explained what was coming. “We’re dividing our customers into three categories,” he said. “The first group consists of those we definitely want to keep. They’re good companies, and they fit into our new business plan.

  Second are the customers we should
never have taken on in the first place. They have thirty days to get out. The third group is another story. It includes good customers like you who just don’t belong here, given our new direction. We’l help you find a new bank, and you can take your time doing it. There’s no pressure, but we’d like to make the transition in the next six months, if possible.”

  His comments were a revelation. I suddenly understood what had happened the first time: I’d landed in group two. Looking back, I realized that I could probably have gotten into group three if only I’d kept my cool. Instead of blowing my top, I should have simply asked my banker, “What’s the problem? Can’t we work something out?” As it was, my behavior no doubt confirmed the bank’s decision to get rid of me as soon as possible. A lot of entrepreneurs make the same mistake.

  In fact, I can think of seven mistakes that business owners make in dealing with their bank, often without realizing the damage they’re doing to the relationship. Avoiding those blunders can save you a lot of grief. Granted, your bank may stil decide to drop you someday, for reasons beyond your control, but you’l have a much better chance of winding up in group three.

  Mistake # 1: Submitting financial statements late. Banks are in business, too, and they have more regulations to deal with than you do. To make sure a bank is fol owing the rules, regulators check its records at least once a year, and internal examiners look at them quarterly, or even monthly. If you don’t submit your financial statements when you’re supposed to, your records wil be incomplete, and you’l create problems for your banker, who gets rated on the accounts he, or she, is monitoring. That’s a strike against you.

  Mistake #2: Running on uncollected funds. To avoid drawing down their credit line, and paying interest on it, some companies wil deposit checks they receive and immediately start spending the uncol ected funds, which has the side effect of keeping bank balances low. A company may save a few bucks in the process, but it does so at the cost of alienating the bank, which is deprived of income it’s entitled to. That’s another strike.