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Getting other people's money starts here

From startups to expansions, nearly everyone (including nonprofit organizations) will have to use someone else's money at least once. Whether from a bank or from private investors, other people's money brings with it a host of requirements. How you get it, how much you pay for it, how long you get to use it - these are contingent on a number of factors, none more important than your business plan, credit rating and personal investment in the startup or expansion you're proposing. Commonly misunderstood and sometimes even omitted by eager entrepreneurs, these three elements are usually the difference between funding and failure.

First and foremost is, of course, a sound and objective business plan. This document needs to explain the need for the money, what you are going to do with it, what kind of money you want, how you are going to pay it back and why giving you the money makes sense. While some people think of a business plan as a road map for you, the would-be business owner, its main purpose is to convince someone to give you money. Its focus should, therefore, be outward, not inward.

What are you planning to do with the money? You might be planning a new business or developing an expansion plan designed to capture more business. You might want to refinance existing debt because a balloon payment is coming due, or because your existing terms can be improved by refinancing. Whatever the reason, explaining and substantiating your plan requires objectivity, something that is usually (but not always) acquired by having an independent party interview you, review your history and plan, and learn about your community and your competition - the building blocks of a pro forma. Financing sources usually give more credibility to requests either prepared by neutral parties or to those containing independent analyses. This does not, however, mean you can get by with using third-party software or CPA-like cash-flow projections. Those programs do not have any objectivity; they simply take your numbers and put them into a nice, suitable-for-framing Excel worksheet.

The business plan must address weaknesses that are important to lenders or investors - for example, the circumstance in which the would-be business owner has little or no direct management experience. This is a shortcoming that can be dealt with if it is acknowledged and a solution is spelled out - that, for example, you will hire an experienced, hands-on manager to run the daily operation for the first several months.

The plan can (and should) also discuss alternative ways to meet your objective. The lender will want to understand what alternatives you have considered and the probable consequences those options represent - including what you will do, or what will happen to the business, if you do not get the financing. If you are trying to borrow money for new construction, a related (and vital) point is to address possible uses of the building if the plans and cash flow do not work out as anticipated. In fact, your architect will have served you best by having planned, up front, some valid, alternative use for the structure.

The second element in attracting investment capital is your credit rating. Each of the three credit repositories (Equifax, Experian and Trans Union) uses a proprietary and confidential credit scoring system to statistically quantify a person's probability of paying credit obligations. There are approximately 45 different factors taken into account that blend both historical and current data. The broad categories analyzed are length of time credit has been granted to you, new (or recent) credit or debt, the types of credit you are using, the amount owed on the various kinds of credit and your payment history.

The resulting profile is offered as an objective indication of credit worthiness. It is summarized in a FICO score (named after its inventor, The Fair, Isaac Company) that is then classified as A (best), B, C or D. While other factors lend influence, including the overall perceived risk of the proposition and additional, proprietary scoring models used by the repositories, FICO scores pretty much define a lender's financing terms.

An "A" credit rating (with a FICO score of 900 on down to 620) will get the best rates and terms because the financing sources believe the risk of default or significant tardiness is small. (Statistically, only two of 10,000 borrowers with FICO scores above 800 will become delinquent.) "A" ratings indicate good credit during the past two to five years, no bankruptcy within the past two to 10 years, no late mortgage payments and no more than one 30-day late payment on other debt. A FICO score of 620 is generally regarded as a low A-minus. It will, on average, command an interest rate 2 percent higher than upper "A" ratings.

"B" credit scores generally run from 581 to 619. The score tends to mean two or three 30-day late mortgage payments and two to four 30-day late payments on other debts within the last few years. A bankruptcy discharge at least two to four years old might be accepted. This borrower will probably pay a 1 to 2 percent higher interest rate than the lowest "A" borrower, and will face stricter limits on how much debt is allowed and how much can be borrowed.

"C" credit scores generally run from 551 to 580. Three to four 30-day late mortgage payments, four to six 30-day late debt payments and two to four 60day late payments are common characteristics of a "C" borrower. Bankruptcy discharge of at least one to two years prior is OK. But here, the costs of bad credit really start to show. Financing sources charge 3 to 4 percent more than the highest "A" rates to these risks and, again, put more restrictive debt-ratio and loan-to-value limits into the deal.

The poorest credit, "D," belongs to borrowers with FICO scores of 550 or below, all of whom (for example) have been 90 days delinquent at least once during the course of a mortgage. Borrowers with scores lower than 550 cannot usually obtain credit through normal channels. Any money obtained under these circumstances will be very expensive: 10 to 12 points above prime wouldn't be unusual, and the terms would be really tough. To escape a "D" rating, some borrowers will accept the extra costs from a lender, make sure every payment is paid on time for 12 months, and then refinance at a lower rate.

It is a good idea to include a copy of your recent credit reports in your business plan with your financial statements, even though creditors will order their own copies. This is not simply a matter of courtesy; doing so allows you to show responsibility and ensure there are no surprises when creditors receive their copy. It also gives you an opportunity to address weak spots.

The third element is your investment in the plan. Neither lenders nor investors have much interest in completely subsidizing a business venture. Most want to see that borrowers believe enough in their future to invest their own cash.

Accordingly, funding sources will insist on your having cash, equity or both in the deal. Collateral is also important, but unless the collateral is beyond question - worth at least double what you are trying to borrow - it won't take the place of equity requirements. The amount of equity needed will vary, depending on the lender or investor. It is heavily influenced by your business plan and credit rating, but you can count on needing 20 to 25 percent for an acquisition and 30 to 35 percent for a startup if you are seeking traditional financing.

That figure can be made less painful by leasing equipment, credit enhancements or insurance guarantees. It can also be lowered by taking costs out of the project or by taking in silent partners. However, once the lending source has stated its requirement, the numbers and their presentation will have to meet the stated percentage requirement.

Here, one of the most critical components of the business plan comes into play - the Source and Use of Funds Statement. This is a simple presentation of what you want to happen, showing where the money is coming from and what you are going to do with it. (As a point of reference, historical data and statements show what has happened, pro forma projections show what you think will happen and the Source and Use of Funds Statement shows what you would like to happen.) Line items showing the amount you have spent on studies, research and projections, as well as cash and/or equity you are putting into the deal, are detailed. Monies from outside investors, prepaid contracts, dues lines and other sources of funds are specifically listed. And, of course, the amount you are seeking goes here.

If new construction or an acquisition is involved, a key expenditure that would show as equity is an appraisal from an accredited firm. When an appraisal is warranted, it is incumbent on you to order one, pay for it and include it in any fund-request package. This expenditure probably shows a prospective lender or investor more "investment" than any other action and is a non-negotiable requirement - so you are way ahead of the game if you pay for one voluntarily.

The bottom half of the column simply shows what you are going to do with the money - what you are going to buy or pay for. "Working Capital" is a perfectly legitimate line item, although you must use some restraint in the amount shown.

Sometimes the Source and Use of Funds Statement will extend forward five years to show either new or increased sources of revenue and planned expenditures. Usually, however, a clear picture of what you've got, what you want and what you are going to do with the money in the first 12 months will be enough to get past a funding source's initial review.

There are other requirements in any funding request: the last two years of tax returns, audited financials (if available), personal financial statements, a schedule of owned real estate, an exit plan and letters of endorsement and support, to name a few. However, your business plan, credit rating and personal investment are by far the most important. If you put some extra attention into them, your search for funding should be more successful.

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