The JOBS Act, passed in 2012, changed rules to make it easier for small businesses to secure funding from investors.
“The Securities and Exchange Commission actually has three initiatives related to the JOBS Act. Crowdfunding has received most of the attention, but the SEC also amended Regulation D to allow small businesses to use general advertising and offers the Regulation A option, which is sort of a mini registration,” says James S. Hogg, a partner at Brouse McDowell.
Smart Business spoke with Hogg about how these JOBS Act options work and what they offer small businesses looking to raise funds.
What has changed with the amendment to Regulation D?
In the past, a private placement had to be done without general advertising, so you would either use a broker to find wealthy investors or you would find them; it was more or less word of mouth. Once you found investors, you would do a conventional private placement.
According to the SEC, $900 billion was raised that way in 2012. Of that, about $8 billion was raised in offerings of less than $5 million each. The amended regulations are intended to allow more small businesses to participate by expanding the pool of investors they can reach. But when you use general solicitation — Internet, newspapers, radio — you can only sell to accredited investors and there are more rigorous procedures to follow to ensure buyers are accredited.
To be accredited, an investor must have a net worth of $1 million or annual income of $200,000. You can still raise funds the old way under Regulation D, which allows for up to 35 non-accredited investors and an unlimited number of accredited investors. But if you use general solicitation, all investors must be accredited.
How can small businesses use crowdfunding?
Nothing is set until the SEC adopts final rules, but based on the proposal, companies are limited to raising $1 million in a 12-month period.
Crowdfunding has hit a couple of snags. One involves regulation; the proposal doesn’t allow for state regulation and some regulators would like to see more safeguards, while other people want to get money to small businesses as quickly as possible.
The SEC proposal requires use of a funding portal such as Kickstarter or Indiegogo and limits purchasers — a person with net worth of less than $100,000 can’t spend more than $2,000 or 5 percent of their net worth a year, and someone with a net worth of more than $100,000 is restricted to 10 percent of their net worth.
Crowdfunding would also require annual reports, although they would be basic — including financial statements that may have to be reviewed by a CPA firm, and if the amount raised was more than $500,000, you would also need an audit. As proposed, the rules might make crowdfunding unattractive. I’m sure that’s part of the comments the SEC is wrestling with.
What is happening with Regulation A offerings?
Historically, if you did a Regulation A offering, which is like a mini registration, it would not be given an exemption from state registration. As a result, only 0.2 percent of offerings under $5 million used Regulation A.
The SEC has made it a two-tier system by adding a new rule that allows an exemption from state securities law registration. You can still raise money the old way, but if you elect to do so under the new rule, there are reporting requirements in return for the state law exemption. The maximum amount that can be raised would also increase from $5 million to $50 million.
This is still in the proposal stage, and comments are being accepted through March 24.
How do businesses decide what route to take?
If you’re really small and raising funds entirely in Ohio, you can sell to up to 10 investors without any filings, but make sure you meet the requirements for this exemption. Most companies with larger offerings will probably continue to opt for Regulation D, but when the regulations are finalized they may consider crowdfunding or Regulation A if those are exempt from state securities registration. ●
James S. Hogg is a partner at Brouse McDowell. Reach him at (330) 434-4106 or email@example.com.
Insights Legal Affairs is brought to you by Brouse McDowell
Together, you should determine what entity type to be, based on the kind of business performed; and the accounting, tax and legal issues that would serve as the basis of selecting a state for incorporation or other selected business entity (i.e., general partnership, limited liability company, limited partnership).
If you’ve thought about an exit strategy, that would affect your selected entity and where you would form that selected entity. Some companies are set up to go public eventually while others might be designed for sale to private equity firms or to remain in the family. If you’re not sure, your professional advisers can walk you through this process. It’s really about getting back to the fundamentals of your business and the related corporate and tax laws, regulations and estate issues.
Right now, a limited liability company (LLC) is a popular setup because the administration is easy. But it’s not always the right vehicle. It works well for smaller operations such as family-owned businesses or ownership of certain types of real estate. But I’ve seen it become problematic with larger businesses that have issues regarding corporate governance.
Look at where you need to be and get a good real estate broker who knows the area to represent you, particularly for professional service companies. The broker can determine what the market is and what landlords are willing to give, and also connect you with the best attorneys who have done multiple deals with that landlord. Some landlords require a personal guarantee from partners of a law firm, while others will treat it like a corporation, so there’s no recourse if they default on the note beyond the initial guarantee.
“Companies have been moving that way as HR has become more complex — it’s no longer an HR person sitting in an office planning parties. There are complicated employee and compliance issues to address,” says Liz Howe, Director of Business Development at Benefitdecisions, Inc.
“There are so many different laws being passed at the state and federal level that it can be a challenge for any HR team to keep up,” Howe says.
Also, classification of employees has become a growing concern in recent months. Not many small and midsize businesses have the expertise to handle all of these requirements, especially considering that compliance laws change so rapidly. That definitely leads to compliance issues — the federal government estimates that 92 percent of companies are out of compliance with COBRA. That’s particularly a problem among companies that handle it themselves.
Is outsourcing HR cost-effective?
Outsourcing is an affordable way to get the specialized expertise that you don’t need on a daily basis. Maybe they can have someone on-site one or two days a week and, for more complex issues, have the ability to get answers from someone who is a certified Senior Professional in Human Resources.
Why does outsourcing HR make sense for companies moving away from a professional employer organization (PEO)?
It’s a nice next step for companies that had been in a co-employer relationship with a third-party administrator. The PEO environment is popular with small businesses and startup companies that don’t have any claims history, so they would have expensive insurance and benefits. A third party shares the employees, pays them and manages benefit administration. Usually at around the five-year mark or 100 employees it’s good to move away from the PEO environment.
Outsourcing HR can be a good transition in that you don’t have to go out and hire a full HR team. You can take back control of your employees, but you’re still outsourcing the day-to-day, transactional HR functions.
What else can outsourcing provide that companies might not be able to handle in-house?
While you can always hire someone with expertise in any certain area, outsourcing can take care of day-to-day functions like building processes and procedures, writing policies and handbooks, benefits administration, compliance and reporting.
Additionally, you can get assistance with strategy — succession planning, compensation analysis, performance reviews and HR technology evaluations. All of these strategic areas are very specialized and you would potentially need one person to focus on each of them. Many smaller companies don’t want to invest that much into HR. It’s a cost that doesn’t provide quantitative value to the organization. They would rather focus on growing their business and selling their products or services. •
The Payroll Fraud Prevention Act of 2013, introduced in the Senate last fall, seeks to reduce intentional misclassification of employees as independent contractors.
“It clearly reiterates that it is on the federal government’s radar and that they are concerned about misclassification,” says Brendan Feheley, a director at Kegler, Brown, Hill + Ritter.
IRS and Department of Labor (DOL) officials also are aware that the employer mandate in the Affordable Care Act (ACA) may provide more incentive for businesses to classify workers as independent contractors to avoid providing health insurance.
“It’s going to be a heightened issue in 2015 as it relates to health insurance,” Feheley says. “I think the government is trying to get ahead of the issue and increase penalties for misclassification so it doesn’t look like an attractive option.”
Smart Business spoke with Feheley about employee classification and what businesses should do to ensure legal compliance.
How would the proposed legislation increase penalties for misclassification?
New civil penalties of $1,100 will be imposed for each affected individual, and $5,000 for repeated or willful violations. Plus, you would also need to pay for overtime underpayments or other damages related to the misclassification. Also, the Fair Labor Standards Act allows for recovery of attorneys fees for the plaintiff’s lawyer.
You can envision a scenario in which someone not covered by company health insurance has a medical condition and files a claim saying they’re really an employee and have been misclassified and are entitled to coverage, as mandated by the ACA.
What should businesses be doing regarding classification of workers?
First, look at your industry. If it’s known for using independent contractors — for example anyone using installers, or those in the hotel industry — the DOL has been targeting them. Businesses in these industries may want to take a more conservative approach to classification and make independent contractors part-time employees or seasonal workers.
Companies should audit their workforce and review the independent contractors being used and the work they’re doing. Many times people are initially classified as independent contractors and the relationship evolves so it’s very different from when they first signed on.
How do you determine whether someone is an employee or independent contractor?
There are no absolute rules, but there are tests the various agencies use. The IRS has a 20-factor test, while the DOL’s test has six factors. The few that cross over are the ones that warrant the most attention, and those really go to who has control over what the individual does — setting work hours, determining how the work is done. The more control the company has, the more likely that person is an employee.
Another important factor is whether there is opportunity for profit or loss for the contractor. A contractor typically can profit by finishing a project in less time, while a person paid an hourly wage is more likely an employee. Independent contractors typically are expected to bring materials they need; if you supply equipment and they’re working in your facilities, you’re closer to having a problem.
Another major consideration is whether the contractor’s activity is vital to your business. A cable installer is not an ancillary part of the business, for example. Last November, the DOL settled with a Kentucky company that paid $1.5 million in violations relating to misclassification of cable installers.
If you’re using independent contractors, have an agreement that states everyone agrees on that status. Then think about the permanency of the relationship.
Because there are no hard and fast rules, it’s important to pay attention to your industry and how things are done.
Companies that have the hardest time regarding classification are startups, because they don’t have money to bring people on payroll but what those people are doing is very integral to the company’s interests.
Misclassification is not always intentional, but because it is a tax issue the government is taking a closer look and a more skeptical view. ●
Insights Legal Affairs is brought to you by Kegler Brown Hill + Ritter
Smart Business spoke with Phil Scott of Sequent Retirement and Benefits Group about trends for plan sponsors.
What are some areas of growing interest and focus for plan sponsors?
One area that continues to be explored is automatic contribution enrollment and automatic contribution increases as ways to boost participation.
By providing better education and communication platforms, plan sponsors are enabling employee participants to be more prepared for their retirement.
Finally, plan sponsors are continuing to keep a close watch on their administrative duties and regulatory requirements.
What are plan sponsors doing to help protect themselves and manage fiduciary risk?
They have leaned on third-party administrators, recordkeepers, investment advisors and legal counsel to identify their responsibilities to maintain plan compliance.
Companies that have embraced outsourcing elsewhere in their organizations have also outsourced segments of their retirement plans to 401(k) fiduciaries. That can be 3(38) investment advisors, who assume responsibility for monitoring, maintaining, selecting and removing investment plan options; or 3(16) advisors, who accept responsibility for plan administrative functions.
Some plan sponsors have adopted or explored the option of joining a 413(c) multiple employer plan. The multiple employer plan option provides an alternative for companies seeking relief from the burdens of independently operating and maintaining their own plan.
How do safe harbor plan designs create advantages?
One great advantage for participants is that all employer matching and non-elective contributions vest at 100 percent immediately. Also, all participants, whether they’re considered highly compensated or non-highly compensated, are allowed to maximize their elective deferral limits. Elective deferral limits, set by the IRS in 2014, are $17,500 for those age 49 or under and $23,000 for those age 50 or older.
Without safe harbor protection, highly compensated participants would only be able to defer approximately 1.5 to 2 percent more than the average contribution of the non-highly compensated group.
From a plan sponsor perspective, safe harbor plan designs are great tools for recruitment and retention of top talent. In addition, the IRS permits a safe harbor plan to be top-heavy, meaning that 60 percent or more of plan assets are attributable to key employees: an officer of the organization, whose annual compensation exceeds $170,000; any employee, who owns more than 5 percent of the company, or owns more than 1 percent and has an annual compensation exceeding $150,000.
What are the implications if a plan is deemed top-heavy?
The plan must meet minimum contribution and vesting requirements for non-key employees for each year the plan is top-heavy. The minimum contribution to bring the plan back into compliance is the lesser of 3 percent of annual compensation for all non-key employees or a percentage equal to the highest percentage contribution of any key employee. Top-heavy penalties are painful infractions, which plan sponsors are able to avoid when utilizing safe harbor as a strategy within their compensation and benefits package. ●
Phil Scott has over two decades of experience in the financial services industry. He is a registered representative with LPL Financial and investment advisor representative with Advantage Investment Management.
This information is provided as a courtesy and should not be considered specific advice or recommendations for any individual. Please consult your tax professional before taking any specific action. LPL Financial nor Advantage Investment Management are engaged in the rendering of tax or legal advice.
Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Advantage Investment Management, a Registered Investment Advisor and separate entity from LPL Financial.
Insights HR Outsourcing is brought to you by Sequent
Big data can reveal many opportunities for improving your business, but extracting the precise information you need can be a struggle.
“Some companies today have more than 30 years worth of data. Their databases are so large that it’s difficult to get a handle on them,” says Joe Welker, CISA, IT audit manager at Rea & Associates.
Using data analytics software, auditors can analyze the data and prepare reports that enable companies to improve inventory, billing and other processes.
“It allows us to be more efficient, which means lower cost for companies because less time is spent on the audit,” says Michaela McGinn, CPA, principal and director of audit services at Rea & Associates.
Smart Business spoke with Welker and McGinn about how the software functions and the benefits it can provide.
How does the software work and what information does it allow you to find?
McGinn: It’s designed for auditing and is used to find missing vendor address information, vendor payment summaries, duplicated invoices and payments made to vendors with missing address information, to name a few. Reports given to us by a client are imported and converted, allowing us to see the data field by field. For example, we can look at inventory numbers of what the company has now compared to what it had three years ago.
Welker: I just finished an audit in which we imported accounts payable and payroll check registers into the software. We went through that data to see if there were any gaps in check numbers or duplicate checks. We also profiled the data in order to give the company a summary of payroll check registers. This allowed management to see how many times a person was paid and their net pay for the year. It was a new way for them to analyze the data.
So the software makes it’s easier to locate the specific data you want?
Welker: Yes, because you’re reviewing 100 percent of the data rather than picking a sample. In one instance, a company had 8,000 vendor accounts built into their system. How do you control that? What if the same invoice is paid to two different vendors, either accidentally or intentionally?
Ultimately, we found that they had 900 duplicate vendors. The software was utilized to look at the check register to see if any payments were made to both vendors — through the main account and the duplicate. Since names don’t have to be spelled exactly, anything that is close came up. That helped the company identify anything that was out of line or looked like it shouldn’t be paid.
How do you know what to look for?
McGinn: It a good rule of thumb to look for the worst. Not everyone is embezzling or committing fraud, but it happens. The best way to stop that behavior is to let everyone know that someone is watching. Controls sometimes become lax and you never know when someone will get into a situation where they’ll do something they might not otherwise do.
Welker: As a result of audits, controls are usually tightened and we’ll provide suggestions. In the case of the client with 8,000 vendors, it was important they heard about potential problems that can result from that scenario. Data analytic software was able to provide a list of the vendors they had transactions with in the last five years so they could clean up the master file.
What types of businesses can benefit from an audit using this software?
McGinn: It can be used in small- to medium-sized businesses of every type. The benefits go beyond just identifying fraud — finding inefficiencies and areas of cost savings are two big reasons for an audit. Many larger companies have their own internal audit departments to analyze data, but most other businesses don’t have access to this type of analytics.
Welker: A statistical analysis of data for things like increasing costs, missing inventory and invoicing can help a business substantially. And once a company’s data is inserted into the software, the process is easier the next time. Results are produced in minutes, saving time and money. ●
Insights Accounting is brought to you by Rea & Associates
Companies are valued based on a formula that takes into account cash flow and the multiple that a buyer would be willing to pay. Increasing the value of a business amounts to finding ways to affect those two factors.
“Certain businesses, like a developer investing in land, are valued based on how much their assets are worth. But 90 percent of companies are valued based on their cash flow. So you need to increase cash flow if you want to increase the value of the business,” says Mario O. Vicari, a director at Kreischer Miller.
Smart Business spoke with Vicari about how owners can make businesses more valuable.
What is the formula for determining the value of a company?
Essentially, the two components are how much cash flow the company produces and what multiple a buyer will pay. At a very basic level, a business with a cash flow of $100,000 that finds a buyer willing to pay a five multiple would be worth $500,000.
The multiple is based on the risks associated with the cash flow, which is principally concerned with how sustainable and predictable it is. If a company derives its income from having to bid and win contracts, that cash flow is difficult to predict. A business that has more repeatable revenue, like a building maintenance contract that reoccurs every year, would represent a lower risk and a higher multiple.
What are some steps to take to increase cash flow?
Consider ways to increase revenues, lower costs, or both. At the highest level, that involves looking at your sales plan and marketing programs. Where are the best opportunities for sales growth? Can you sell different things to your existing customers through line extensions or take market share by attracting new customers through a targeted marketing effort or geographic expansion? Pricing and margins are also a significant consideration because sales growth without appropriate margins will not create value in the business, since cash flow will not increase. On the cost side, some consideration should be given to your cost of sales and making sure that your direct costs are optimized and throughput is high. Overheads should also be looked at closely to ensure that costs are optimal to support the sales growth the company is targeting. Overheads can be tricky, since a reduction has a direct impact on the current year cash flow but too much cutting can affect the business’s ability to grow in the future.
It comes down to how you manage your income statement, and how you drive net income through some combination of growth and more efficient use of resources.
How can a business owner lessen risk and increase the multiple?
There are several things an outside party will look at when considering risk associated with a business’s cash flow. If your customer base or product line is not diversified, that’s a much riskier situation because the loss of one big customer or a product would significantly affect the cash flow. If that’s the case, you should consider how to diversify your customer list and product offerings to manage that risk. Supplier concentrations can also increase risk and, where possible, you should diversify your supply chain.
An often overlooked risk is the depth and breadth of the management team and whether you have a succession plan. A company might have good cash flow, but if too much responsibility revolves around the owner it’s not going to be worth as much because it’s not sustainable if the owner were not there. Good management systems and qualified staff can add a lot of value to a company because they increase the likelihood of the cash flow being sustainable. Lastly, there is one element that fits into both cash flow and risk categories — utilization of assets. If you can turn over assets like receivables and inventory in 60 days instead of 90, that means you need less money to finance those assets and your cash flow increases. Additionally, efficient utilization of fixed assets also is important because a company has more cash flow and is more valuable if its reinvestment rate in fixed assets is lower.
For most private companies, the business is the owner’s primary asset. We encourage business owners to look at the business as an investor would and think about these value drivers so they can ensure they are increasing the value of their biggest asset. ●
Insights Accounting & Consulting is brought to you by Kreischer Miller
Smart Business spoke with Tyler A. Shewey, an associate at Berliner Cohen, about three tax issues that are receiving more attention in 2014.
What is happening with sales and use taxes?
The California State Board of Equalization (SBE) has focused on several areas lately.
One area relates to delivery charges. When a business invoices customers, it must provide a separate line item for shipping charges paid to a common carrier in order for that portion of the charge to be exempt from sales tax. If a business ships merchandise using its own vehicles, invoices must specifically state that title transfers to buyer before delivery.
Otherwise, the SBE will require sales tax to be charged on the entire amount.
Custom manufacturers should be aware that the SBE is auditing businesses to determine whether labor charges should have been included in the measure of sales tax. In general, labor charges are not taxable in California.
When it comes to product fabrication, however, this often is not the case.
Why should someone considering an IRS Offer in Compromise act quickly?
An Offer in Compromise allows a taxpayer to settle tax debts for less than the amount owed. A proposed Offer Amount is based on a formula that accounts for income and equity in assets. If assets and income are significant, the Offer Amount must be higher; but if both of those are low, it may make sense to file an Offer.
In recent years the Offer terms have been more lenient; however, the pendulum now is swinging back the other way, so it may become more difficult in the future to make it through the Offer process.
What has changed regarding foreign bank account reporting?
For many years, the U.S. Treasury Department has required U.S. persons with a financial interest in, or signature authority over, any foreign financial account (i.e., bank, securities, or other types of financial accounts) to disclose such accounts if their aggregate value exceeded $10,000 at any time during the calendar year.
These persons were required to report such accounts on Schedule B of their U.S. individual income tax return, and on the Report of Foreign Bank and Financial Accounts (FBAR), which is required to be filed annually and must be received by the IRS on or before June 30th of the succeeding calendar year.
Historically, FBAR compliance was low because civil penalties for the non-willful failure to file the FBAR were nominal and IRS enforcement was weak. Two developments changed this. First, the Jobs Act of 2004 enacted a $10,000 maximum non-willful FBAR penalty which applied to FBAR forms due starting June 30, 2005 (for the 2004 tax year).
For willful violations, the penalty could be up to the greater of $100,000 or 50 percent of the account balance per account per year. Second, the IRS began to prosecute FBAR violators more aggressively. Although a voluntary disclosure practice has been in existence for many years, it became clear that the IRS was applying the voluntary disclosure mechanism to taxpayers inconsistently.
Accordingly, the IRS instituted a new offshore voluntary disclosure program (OVDP) to resolve these cases in a consistent and predictable manner. To date, approximately 39,000 people have applied for the OVDP, which has generated $6 billion in revenue. Still, the U.S. Treasury estimates that offshore compliance is still only around 10 percent.
It is important to note that starting in November 2013, all FBARs must be filed electronically. It is expected that electronic filing will enable the IRS to apply greater scrutiny to offshore reporting. ●
Insights Legal Affairs is brought to you by Berliner Cohen
While it is obvious that directors and officers shouldn’t steal from their company or commit other criminal acts, running a business can be very complex and it’s a good idea to set clear policies and procedures for what should and shouldn’t be done, says Nicole S. Healy, a partner with Ropers, Majeski, Kohn & Bentley PC.
“For public companies, there are rules like those in the Sarbanes-Oxley Act that require certain controls and seek to enhance the directors’ oversight. However, in addition to complying with legal and regulatory requirements, any time there is a significant scandal, lawsuit or regulatory change, companies often react by enhancing their policies and procedures,” Healy says.
Smart Business spoke with Healy about the duties of directors and officers and what companies should do to ensure those responsibilities are clearly established.
What is directors and officers liability?
Directors and officers have fiduciary obligations that are typically defined by state law. As a general rule there are two primary fiduciary duties — the duty of care and the duty of loyalty. Violations of those duties may create liability.
The duty of care requires that, before making a decision on behalf of the company, directors inform themselves of all material information that would affect that decision. The duty of loyalty requires directors to avoid conflicts of interest between themselves and the company. Typically, those involve financial conflicts — usually a transaction in which a director stands to benefit personally.
What policies and procedures should be set for directors?
Most companies, regardless of size, should have a code of conduct. A code of conduct explains the company’s mission statement and values, as well as policies and procedures governing how the company is run. It’s also a good place to address how people can report their concerns, whether to management or the legal or compliance departments.
In general, there’s been an evolution in corporate governance, from a very generic follow the law approach to providing employees with rules and guidelines that are much more detailed.
However, even if a company does not adopt a formal code of conduct, every company is well served by putting its principles in writing, which may include aspirational goals like providing excellent customer service, as well as requiring everyone acting for the company to comply with applicable laws and regulations.
If there is an internal investigation, when is outside assistance needed?
If credible allegations of wrongdoing come to light, companies need to investigate; whether they do that internally or bring in outside assistance is a function of a number of factors.
Those factors include things like the company’s resources and the sensitivity of the issue. If the allegation is that the CEO and the board of directors are complicit in wrongdoing, it may not be possible or appropriate to investigate internally and the company may need to bring in outsiders. What you can’t do is see a red flag and ignore it; that’s when companies get into trouble.
What are key steps to take to avoid liability issues?
It’s not enough to just set policies, procedures and controls — you have to evaluate and test them. For example, if you have a workforce overseas and your materials haven’t been translated into the local language, they aren’t going to be helpful to employees. It’s the job of directors and officers to ensure that policies, procedures and controls are in place and are effective. Larger companies may have compliance departments, but every company should assign someone to be in charge of compliance.
Particularly with startup companies, so much attention is focused on getting the business running. But the sooner you have a good compliance structure in place, the better off you are. Then the structure needs to grow and change as the company grows.
Finally, directors and officers should reach out to experts for assistance. Experienced counsel can give you tremendous guidance regarding compliance, and help companies to develop appropriate corporate governance policies and procedures. ●
Insights Legal Affairs is brought to you by Ropers Majeski Kohn & Bentley PC
Much of the country is still recovering from the recession, making it difficult for companies to secure financing. Northern California, however, is an exception.
“It’s definitely a bifurcated market right now. The environment for financing is very robust here in Silicon Valley and other tech hubs,” says Kelly Cook, senior vice president and market manager at Bridge Bank. “If you read the Wall Street Journal or the Economist, they say banks are still not really lending. That’s not the case here.”
Smart Business spoke with Cook about the financing environment and methods available for companies to get funding.
Why is the financing environment good locally? Is it the market or the technology industry that’s here?
In the Bay Area, the unemployment rate is low, even for nontech companies. There’s a ripple effect — a lot of nontech companies service the tech industry.
There is a large amount of new capital available from all different investment sources from corporate venture arms, to traditional venture capitalists, to the angel groups that are forming, as well as private equity and hedge funds getting back into the tech financing market. All of that is rippling through the local economy and job market.
When does equity financing make sense?
Equity financing is readily available for entrepreneurs and management teams that have a good track record and offer a new technology or new way to address a big problem in a big market. In the earliest stages of a company, equity financing is the way to go. The decision is about what type of equity to raise.
Options include sweat equity — using the founder’s money and/or knowledge, raising money from friends and family, or angel investors. If you are far enough along in terms of product and initial customers, you may attract institutional equity financing.
There are various theories/approaches on how much ownership stake to give up for that equity. Savvy entrepreneurs know how to raise just enough to reach the next value-creating milestone. Once a company generates annual revenues approaching several million dollars, more choices will open up on the debt financing side.
Do you have to show consistent profitability before banks will offer debt financing?
A lot of entrepreneurs, CEOs and CFOs don’t think they can raise bank debt financing when the company is still cash-flow negative, but that’s not the case. A true technology-focused lending group has a number of solutions including working capital lines of credit, which are underwritten based on the strength of a company’s accounts receivable. There also are invoice-specific financing structures, asset-based lines, and traditional, revolving, borrowing-based lines of credit.
How do you determine what form of debt financing is right for your business?
That’s a consultative discussion among a company and its finance partners. If a company has revenue and cash tied up in the accounts receivable cycle, it should consider a working capital line of credit such as a line tied to specific invoices or a collection of invoices. With regards to a more permanent source of debt financing, a potential lender will look at your business plan and determine whether it can support typical financial covenants and a term debt structure. If so, then typically that’s the least expensive form of term debt financing.
But if a company’s forecast won’t support covenants, or you don’t want to be burdened by managing covenants because there’s too much uncertainty, then a venture debt structure makes the most sense.
Banks also can be used in conjunction with other financing partners. Banks are regulated entities, and are limited in terms of providing venture debt. But they can participate with a venture debt provider and combine that with a working capital line of credit from the bank. That combination can be a powerful solution because it gives short-term financing at a low cost and flexible term debt that extends cash runway to allow a company to execute its business plan.
There are flexible, customized solutions for each company, but it takes some digging into the plan, market and financial history. A good lender will conduct a diligent underwriting process to determine pricing and structure that meets a client’s needs. ●
Insights Banking & Finance is brought to you by Bridge Bank