I recently got a call from an entrepreneur who wanted money that very same week in order to meet payroll. He also said he was willing to pay "any reasonable return" to get it.
This wasn't exactly the sort of plea that inspires confidence. Though I could have commanded a serious rate, the guy didn't get a cent from me.
See, financiers have this strange notion that they should get their money back, along with a reasonable risk-adjusted return. That's why strong businesses have more financing options, enjoy lower interest rates and suffer fewer restrictions, while weaker ones go wanting.
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This is completely intuitive, of course, and yet countless entrepreneurs make the same mistake: They go looking for money when they really need it instead of raising it—on far better terms—when they don't.
While the travails at Bear Stearns,
Fannie Mae (nyse:
FNM), IndyMac and others have drawn serious attention, you don't need a full-on credit crisis to get a glimpse of how fast things can unravel when financials falter and you are short on capital.
The fact is, undercapitalized small businesses crumble by the scores in any economy. Lines of credit (not committed until you draw down the money) get cut, loans get called in, more assets (like houses) get pledged and toys get sold.
Even if the business hangs on, your hands may be tied. Consider that regular bank-lending rates for small businesses usually range from "prime" (the rate that banks charge on loans to their most credit-worthy commercial customers, now at five per cent), to prime plus 200 basis points (usually backed by a personal guarantee).
Asset-based lenders, the kind that step in where banks fear to tread, charge as much as prime plus 1,000 basis points. Factoring companies, which buy receivables at deep discounts, demand even higher equivalent annual rates.
And then there's merchant cash advance shops. These lenders of last resort give small businesses cash today in return for a percentage of their future credit card sales. Annualized cost of those funds is often north of 70 per cent.
As for equity investors (those who haven't tried to bail out), they will teach you the joys of a "down round"—during which new financing terms will be crammed down your throat. It's not a pretty sight.
Rather than wait for disaster to strike, take some precautions. Here are four:
Act now. If you fear rough waters ahead (or at least a measurable, short-term dip), draw down your credit line before your bank cancels it. You may end up paying interest on unused funds, but it's better than not having them when credit gets tight.
Pig out. Raise as much capital as you can as early as you can. Sometimes start-ups have an easier time selling the dream than a few quarters worth of reality. And even if you don't think you can drive a hard bargain, don't sell your company short: The first assessment of what your business is worth will color the valuation in later financing rounds. If you disagree with an investor's valuation, avoid bickering about the specific dollar amount. Instead, address the assumptions that went into the valuation, like projected growth rates and overall industry prospects.
Stress test. Speaking of projections, don't fall in love with yours. Run a host of scenarios, and make sure you can weather the worst of the bunch.
Manage by metric. Develop leading indicators that will warn of impending crises so that you can tap resources long before you obviously need them.
Dileep Rao is the president of
InterFinance Corporation, which consults with governments, lenders and businesses on venture growth. Rao is also an adjunct professor of entrepreneurship and venture finance at the Carlson School of Management. He holds a Ph.D. in business administration from the University of Minnesota. Dileep can be reached at drao@infinancing.com.
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In Pictures: How To Chose A Bank For Your Small Business
