Bootstrap Financing Sources

When you're thinking about how to raise money, one of thefirst things you should consider is bootstrap financing--using yourown money to get your business off the ground. This is one of themost popular forms of internal funding because it relies on yourability to utilize all your company's resources to freeadditional capital to launch a venture, meet operational needs orexpand your business.

Bootstrap financing is probably one of the best and mostinexpensive routes an entrepreneur can explore when raisingcapital. It utilizes unused opportunities that can be found withinyour own company by simply managing your finances better. Bootstrapfinancing is a way to pull yourself up without the help of others.You are the one financing your growth by your current earnings andassets.

There are a number of advantages to using the various methods ofbootstrap financing:

• Your business will be worth more because less money has beenborrowed, and therefore, no equity positions had to berelinquished.
• You won't have to pay the high interest on borrowedmoney.
• Coming from a stronger position (with less debt on hand), youlook more desirable to external lenders and investors when the timedoes come to raise money through these routes.
• You can be creative in finding ways to raise profits, withouthaving to look to external sources. It will give you the addedconfidence of business savvy.

Trade Credit

The first source of business money we'll discuss is tradecredit. Normally, a supplier will extend you credit afteryou're a regular customer for 30, 60 or 90 days, withoutcharging interest. For example, suppose that a supplier shipssomething to you, and that bill is due in 30 days but you havetrade credit or terms. Your terms might be net 60 days from thereceipt of goods, in which case you would have 30 extra days to payfor the items.

However, when you're first starting your business, suppliersaren't going to give you trade credit. They're going towant to make every order c.o.d (cash or check on delivery) or paidby credit card in advance until you've established that you canpay your bills on time. While this is a fairly normal practice, toraise money during the startup period you're going to have totry and negotiate trade credit with suppliers. One of the thingsthat will help you in these negotiations is a properly preparedfinancial plan.

When you visit your supplier to set up your order during yourstartup period, ask to speak directly to the owner of the businessif it's a small company. If it's a larger business, ask tospeak to the chief financial officer or any other person whoapproves credit. Introduce yourself. Show the officer the financialplan that you have prepared. Tell the owner or financial officerabout your business, and explain that you need to get your firstorders on credit in order to launch your venture.

The owner or financial officer may give you half the order oncredit, with the balance due upon delivery. Of course, the trickhere is to get your goods shipped to you, and sell them before youhave to pay for them yourself. You could borrow the money to payfor your inventory, but you would have to pay interest on thatmoney. So trade credit is one of the most important ways to reducethe amount of working capital you need. This is especially true inretail operations.

Despite the urge to use trade credit on a continual andconsistent basis, you should consider it as a source of capital tomeet relatively small, short-term needs. Do not look at it as along-term solution. By doing so, you may find your business heavilycommitted to those suppliers who accept extended credit terms. As aresult, the business may no longer have ready access to other, morecompetitive suppliers who might offer lower prices, a superiorproduct or more reliable deliveries.

The Cost of Trade Credit

Depending on the terms available from your suppliers, the costof trade credit can be quite high. For example, assume you make apurchase from a supplier who decides to extend credit to you. Theterms the supplier offers you are two-percent cash discount with 10days and a net date of 30 days. Essentially, the suppliers issaying that if you pay within 10 days, the purchase price will bediscounted by two percent. On the other hand, by forfeiting thetwo-percent discount, you are able to use your money for 20 moredays. On an annualized basis, this is actually costing you 36percent of the total cost of the items you are purchasing from thissupplier! (360 ( 20 days = 18 times per year without discount; 18 (2 percent discount = 36 percent discount missed.)

Cash discounts aren't the only factor you have to considerin the equation. There are also late-payment or delinquencypenalties should you extend payment beyond the agreed-upon terms.These can usually run between one to two percent on a monthlybasis. If you miss your net payment date for an entire year, thatcan cost you as much as 12 to 24 percent in penalty interest.

Effective use of trade credit requires intelligent planning toavoid unnecessary costs through forfeiture of cash discounts or theincurring of delinquency penalties. But every business should takefull advantage of trade that is available without additional costin order to reduce its need for capital from other sources.

Factoring

This is a financing method where you actually sell your accountsreceivable to a buyer such as a commercial finance company to raisecapital. A "factor" buys accounts receivable, usually ata discount rate that ranges between one and 15 percent. The factorthen becomes the creditor and assumes the task of collecting thereceivables as well as doing what would've been your paperworkchores. Factoring can be performed on a non-notification basis.That means your customers aren't aware that their accounts havebeen sold.

There are pros and cons to factoring. Many financial expertsbelieve you shouldn't attempt factoring unless you can'tacquire the necessary capital from other sources. Our opinion isthat factoring can be a very good financial tool to utilize. If youtake into account the costs associated with maintaining accountsreceivable such as bookkeeping, collections and creditverifications, and compare those expenses against the discount rateyou'll be selling them for, sometimes it even pays to utilizethis financing method. After all, even if the factor only takes onpart of the paperwork chores involved in maintaining accountsreceivable, your costs will shrink significantly. Most of the time,the factor will assume full responsibility for the paperwork.

In addition to reducing your internal costs, factoring alsofrees up money that would otherwise be tied to receivables.Especially for businesses that sell to other businesses or togovernment, there are often long delays in payment that this wouldoffset. This money can be used to generate profit through otheravenues of the company. Factoring can be a very useful tool forraising money and keeping cash flowing.

Customers

Customers are another source of bootstrap financing, and thereare several different ways to take advantage of these valuableassets. One way to use your customers to obtain financing is byhaving them write you a letter of credit. For example, supposeyou're starting a business manufacturing industrial bags. Alarge corporation has placed an order with your firm for a steadyflow of cloth bags. The major supplier from which you will obtainthe material the bags is located in India. In this scenario, youobtain a letter of credit from your customer when the order isplaced, and the material for the bags is purchased using the letterof credit as security. You don't have to put up a penny to buythe material.

In your personal financial dealings, you may have had a builder,or someone else working for you, ask for money up-front in order tobuy the materials for your job. That contractor used your money toget started on the job. You were actually helping to finance thatbusiness. This is how customers can act as a form of financing.

Real Estate

Another bootstrap financing source is real estate. There areseveral ways to take advantage of this source. The first is simplyto lease your facility. This reduces startup costs because it costsless to lease a facility than it does to buy one. Also, whennegotiating a lease, you may be able to arrange payments thatcorrespond to seasonal peaks or growth patterns.

If you enter a business for which you will need to buy thefacility, your initial cost will increase but the cost of thebuilding can be financed over a long-term period of 15 to 30 years.Again, the loan on the facility can be structured to make optimumuse of your planned growth or seasonal peaks. For instance, you canarrange a graduated-payment mortgage that initially has very smallmonthly payments with the cost increasing over the lifetime of theloan. The logic here is that you have low monthly payments, givingyour business time to grow. Eventually, you can refinance the loanwhen time and interest rates permit.

Another advantage that the outright purchase of the facilitywill provide you is continuing appreciation of the property(hopefully) and the decrease of your principal amount to create avaluable asset called equity. You can borrow against thisequity. Lenders will often loan up to 75 or 80 percent of theproperty's value once it's been appraised.

This applies to any private real estate you might own. If youhave a desire to get into business and you need startup capital youcan't get in any other way, you may have to borrow against theequity in your home or sell it altogether. If your home isappreciating in value, real estate is a good venue to choose. Ifit's depreciating, it won't be quite as attractive.

Equipment Suppliers

If you spend a lot of money on equipment, you may find yourselfwithout enough working capital to keep your business going in itsfirst months. Instead of paying out cash for your equipment, youcan purchase it with a loan from manufacturers; that is, you payfor the equipment over a period of time. In this way, equipmentsuppliers are a source of bootstrap financing.

Two types of credit contracts are commonly used to financeequipment purchases:

1. The conditional sales contract, in which the purchaserdoes not receive title to the equipment until it is fully paidfor.

2. The chattel-mortgage contract, in which the equipmentbecomes the property of the purchaser on delivery, but the sellerholds a mortgage claim against it until the amount specified in thecontract is paid.

By using your equipment suppliers to finance the purchase ofequipment you need, you reduce the sum of money that you needupfront. There are also lenders who finance 60 to 80 percent of theequipment value. And then, of course, the balance represents theborrower's down payment on a new purchase. The loan is repaidin monthly installments, usually over one to five years, or theusable life of that piece of equipment.

Leasing

Another thing for you to consider is to lease instead ofpurchasing. Generally, if you are able to shop around and get thebest kind of leasing arrangement when you're starting up a newbusiness, it's much better to lease. It's better, forexample, to lease a photocopier, rather than pay $3,000 for it; orlease your automobile or van to avoid paying out $8,000 ormore.

Leasing has been around for a long time. It's common forbusinesses to lease real property for retail facility, officespace, production plant, farmland, etc. There are advantages forboth the small-business owner using the property or equipment (thelessee) and the owner of that property or equipment (thelessor.) The lessor enjoys tax benefits and may gain fromcapital appreciation on the property, as well as making a profitfrom the lease. The lessee benefits by making smaller payments,retains the ability to walk away from the equipment at the end ofthe lease term, and may be able to negotiate build-in maintenanceprovided by the lessor.

Still, there are many ways that a lease can be modified toincrease your cash position. These modifications include:

• A down payment lower than 10 percent or no down payment atall.
• Maintenance costs that are built into the lease package,thereby reducing your working-capital expenses. If you neededemployees or a repair person to do maintenance on purchasedequipment, it would cost you more than if you had leased it.
• Assignment of all executory costs such as insurance, propertytaxes, etc. While this will initially increase your cash-flow, itwill reduce the amount of taxable income the businessgenerates.
• Extension of the lease term to cover the entire economic lifeof the property. Use of the property can be guaranteed for as longas you wish to use it.
• A purchase option, which can be added to the lease allowing youto buy the property after the lease period, has ended. A fixedpurchase price can also be added to the option provisions.
• Lease payments that can be structured to accommodate seasonalvariations in the business or tied to indexes that track interestto create an adjustable lease.

Avoid the Need for Financing

Bootstrap financing really begins and ends with your attentionto good financial management so your company can generate the fundsit needs. Be careful and aware when you buy. Make sure that youdon't go top dollar when you don't have to, and that youaren't in an overly expensive office or location, unlessit's really going to pay off in dollars and cents. If a newdesk isn't necessary for your business, and you have anopportunity to buy a used desk, then by all means do so.

Also, keep a close watch on operating expenses. If interestrates are high, it won't take too many unpaid bills to wipe outyour profits. At an 11- or 12-percent interest rate, carrying anunpaid $10,000 is costing you as much as $120 per month.

One way to foster a profitable cash flow for your firm is tostart each production order off on the right track. Implementthisthree-step payment plan. Negotiate terms and conditions thatrequire payments when you want them. Profitable cash flow willoccur when you establish and execute timely cash-flow concepts intoevery order.

This article was excerpted from The Small BusinessEncyclopedia.