Knowing the ground rules that different kinds of small business lenders follow is tremendously important if your goal is to go out there and find some money.
There are several categories of small-business funders, including small-scale venture capitalists, “angels,” banks, factors, and “irrational investors.” It is very important to present potential funders the right kind of proposals. Don’t make a pitch for venture capital from a bank, for example, and don’t ask a factor for the kind of generous terms that an irrational investor will offer.
Here is what you need to know about “angels,” factors, and “irrational investors.” Each category of lender looks for very different kinds of proposals from businesses, and each expects a very different kind of pay off.
- Angels are wealthy individuals who want to support small businesses, and often enjoy being involved in advising the businesses they invest in. They tend to back businesses in fields they understand well, and generally do not demand controlling interest in the companies they back. They tend to dole out money in relatively small amounts, but on favorable terms. Angels are generally driven by the soundness of your business concept, and will want to see a thorough understanding on your part of how the day-to-day operations of your business will lead to positive cash flow. They tend to expect positive returns on their investments from your business becoming profitable in the near term.
- Factors are businesses that buy your receivables, usually at a steep discount. If you have the opportunity to expand, not enough cash, but outstanding receivables from reliable payers, you might be able to find a factor who will give you a percentage of those receivables in cash right away, in exchange for 100% of the receivables when paid. Factoring is a risk-driven business, and depending of the overall conditions of your industry, and the relative risks in collecting from the people who owe your business money, factors will discount the value of your receivables by as much as 50% to 70%, though these numbers vary quite dramatically, and can be as low as 20%.
- “Irrational Investors” are the kind of investors every small business person can appreciate. These are people who believe in your business, or in you, to the point that they will give you money on tremendously favorable terms. More small businesses than you might realize are funded by irrational investors, whether they are aunts and uncles, mentors, employees, or fellow members of the church choir. In fairness, even though irrational investors will often not bother to ask for any guarantees, you need to document all agreements with these investors, and arrange for fair equity or reasonable repayment terms in exchange for their money. If fairness isn’t enough of a reason in itself, in the event of an audit, you can count on the fact that the IRS will want to see good paperwork and reasonable terms on all of your loans and capital investments.
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