Part 1 of this two-part series covered innovation. Part 2 will present ways to fund innovation.
“It takes money to make money” is a truism in business. So how do you fund innovation? Surprisingly, it starts with the standard business model. How the business will operate, the size of the market, the target customer, the problem it solves, and the economics of each unit are all important to long-term success.
Management must be laser-focused on what it will achieve in the market and how innovation will solve a pain point for customers. The financial aspect of the business model is linked to several key questions:
- How much capital does the business need and when?
- How will the capital be deployed?
- When will the business generate revenue and profits?
- What are key metrics and milestones?
Answers to these questions will dictate the capital-raising strategy.
Once the business model is nailed down, it is almost time to start raising capital. The capital-raising process takes planning, time, and effort—and is not for the easily flustered. Management must succinctly explain the business case, and at the same time, put on a charm offensive to win over capital sources. And in the end, the business case must make financial sense.
Many successful people are used to getting their way, but when it comes to capital raising, these same people may find their confidence tested. Brendan Burns is an adjunct associate professor at Columbia Business School and an Entrepreneur-in-Residence at Connecticut Innovations (CI). He has raised tens of millions of dollars for businesses.
Brendan says it takes anywhere from six to 12 months to raise capital for startups. However, it is not only about the numbers. Relationships matter. Brendan elaborates further, “The entrepreneur is really best served to be humble. No one is obligated to give you money. You have to earn the responsibility.”
THE CAPITAL ROAD
The capital raising road always leads to a fork with two paths:
Management must decide if debt (a loan), equity (ownership), or a combination of the two is appropriate.
When a business generates consistent free cash flow, debt is the preferred option. Debt payments can be amortized in equal monthly payments over a certain amount of years. This option works well for the business owner who can maintain control of the business but pledge assets as collateral to secure the loan along with a personal guarantee.
Free cash flow is the primary source of repayment. And the “second way out” according to Arnold Ziegel, a retired Citibank executive and author of the book, Fundamentals of Credit and Credit Analysis, is collateral that can be liquidated and converted into cash. He says, “A good lending officer or risk manager can structure a loan to remove some of the risk.”
Debt can put a strain on the business, especially during the startup phase. Take the debt road only if the business can afford to use its cash flow to make regularly scheduled payments of principal and interest. There are creative ways to structure debt with interest-only periods, but debt must be paid back at some point with interest.
Startups are risky, which is why banks seldom fund such ventures. However, a bank may use the U.S. Small Business Administration (SBA) to fund a startup that is likely to succeed. The SBA is not a direct lender but a credit enhancement program in the form of a guarantee for participating lenders. Find an experienced SBA lender to see if your business is a good credit risk.
To get bank approval for an SBA loan, there should be collateral, a good credit history (FICO score of 680 or higher), experience in the industry in which the business will operate, and a credible plan with financials demonstrating that the business can support debt-service payments.
EXPLORE COMMUNITY LENDERS
Not all lenders work for a bank. Another option on the debt road is family and friends, known as “patient” capital. The key benefit of having family and friends fund the business is that the terms can be at or below market rates with more flexible terms for the borrower. But again, debt is a loan that must be paid back. A lawyer should draft loan documents to protect all parties involved.
When a bank is not an option, try community-based lenders, which are mission-driven organizations committed to making capital accessible to small businesses in low- to moderate-income communities. Community Investment Corporation (CIC), Community Economic Development Fund (CEDF) and HEDCO, Inc. are Connecticut-based community lenders. Each organization provides technical assistance to help the business succeed.
FIND A GRANT
The State of Connecticut Department of Economic & Community Development (DECD) Express Program is an option if the business has been operating for at least a year and plans to create and retain jobs. The Express Program can provide a combination of loans and grants up to $300,000, under certain circumstances.
Grants are not free money and are rare. State entities, municipalities, and economic development organizations support public-policy goals of job retention and creation, and may offer a grant as a quid pro quo for jobs. CTNext, a wholly owned subsidiary of CI, supports the technology sector in Connecticut with grants and assistance to startups and fast-growing companies.
The Small Business Innovation Research (SBIR) program, administered by CI, helps Connecticut-based companies obtain SBIR and Small Business Technology Transfer (STTR) grants. These grants are highly competitive and help a small business create technology that will be commercialized for the public and private sector.
Make sure the cost of the grant is worth the time, resources, and overall cost of compliance. It may sound strange, but sometimes, when the numbers are run, grants are more expensive than a loan.
EQUITY IS AN OPTION
Equity is an ownership stake. In exchange for cash from an investor, the business provides an ownership stake in the company. Many early-stage deals are structured as convertible notes, loans that will turn into equity in the future. In general, should the business fail, the owners are not obligated to pay the money back.
Y Combinator, the Harvard of accelerator programs, uses Simple Agreement for Future Equity (SAFE) documents. You don’t have to reinvent the wheel when it comes to legal documents. However, never just copy someone else’s documents. You are best served by hiring an attorney to understand legal documents and your rights and responsibilities when entering into an equity agreement.
Fast-growing companies with potential to grab large market share often prefer to give equity to grow the business. There’s a whole universe of investors that will invest in fast-growing companies, from angel investors (wealthy individuals), venture capital firms, CI, business development companies (BDCs), and small business investment companies (SBICs).
The Angel Investors Forum (AIF) in Connecticut is a group of investors who use their own funds to invest in promising startups. The bar to get capital is very high, but AIF is an option for business owners pursuing funding who can demonstrate management expertise and a market opportunity. Visit AIF’s website to learn about their investment criteria and process.
When you explore the options among debt, grants, and equity, there is no shortage of capital—just a shortage of management teams who can execute. Regardless of your situation, do your homework.
No one is going to look out for your best interest better than you. Take your time to get familiar with the best option for your business. Hire an experienced professional to help you evaluate your options, which could save you time and aggravation in the long run.
In terms of free assistance, many nonprofits and economic development programs on the local, regional, and national level can help your business grow. Tap the free resources of a chamber of commerce, Service Corp of Retired Executives (SCORE) chapter, the Connecticut Small Business Development Center (CTSBDC), Women’s Business Development Council, and community-based lenders.
SUCCESS IS NOT GUARANTEED
Innovation is “the one more thing” when it is linked to a customer’s pain point, but no business is guaranteed capital or success. Businesses must raise capital to implement their plans. No two journeys are the same on the capital-raising road. But if capital is not forthcoming, don’t take it personally. It’s not you, it’s probably your business model.
About the Author
Anthony Price is Founder & CEO of LootScout, which counsels small businesses about how to raise capital. Learn more by visiting www.lootscout.com or follow on Twitter @LootScout. Contact Anthony at firstname.lastname@example.org.