Herman School of Business
Where does the money come from?
Very often people fail to understand credit. How to get money, what you need to obtain a loan, or when to risk your personal finances against a business venture. Let’s talk about a few different situations many people have trouble understanding.
Let’s say you come up with a great idea. Like the jump rope. It’s just a piece of rope and two plastic handles…but you know it will sell like gang busters. It’s not a complicated product, people can immediately see it is fun and, should sell, as many people would enjoy the product. But you are broke. You have just the idea. In fact you apply for a patent so you own the idea, and no one can steal it. But how do you get money to start your jump rope business. You believe you will simply walk into the bank, show one loan officer the product and have all you need to get going. Wrong, Jumping Jack Flash!
Banks lend money on collateral. When they make commercial loans they want inventory, which they typically lend no more than 50% of the value, they want accounts receivable, which means you have shipped the product and they will lend up to 85% of those, or you need machinery and equipment to make the product, perhaps 50% of the liquidation value, not the purchase price, or real estate where the company will do business, maybe they will give you 90% of that. This is for all types of business, and starting out a business usually has none of these things. So people need to understand that a bank is the most unlikely place to raise money in significant amounts to any start-up just on the basis of your idea. Now, we had a client once who had inherited a fortune of 400 million dollars. All of it invested in a particular bank. She wanted ten million to start a company and they gave it to her without a whisper, just her signature to guarantee the loan. After all, they were making more than ten million a year investing her 400 million. So, unless you are a huge customer at the bank, with lots of collateral like real estate, bonds, savings, etc, you probably can’t get money from a bank.
Venture Capitalists lend money on ideas. And they want a huge return for their risk. Some will want 35% a year for the kind of risk they take. After all, most of what they put money into fails, for they have no real Midas touch when it comes to picking what will work and what won’t. And in addition to this great return they also want equity, which might be more than half of the company so they can at least control the situation when it looks bad, and not rely on you, who has no capital at risk, to “drive the bus” off the cliff. They want a great business plan with a great idea, and they will end up controlling you should you win or lose. But on your side of the equation, since your idea will die without money giving you zero return…then any return with their money could be much greater than zero.
Would you sell your house to fund your idea? I did on my first ever business venture. How about selling your cars, and cash in your 401K, and your house through a sale or Home Equity Loan, and then bang up your credit cards to the max? I am not saying do this, I just want to test your mettle when it comes to believing in your idea. Because, if you wouldn’t do this, most outside investors wouldn’t put their money in your hands either.
One of our readers Richard asks how do we isolate risk without putting our financial life on the line? That only comes when you limit your exposure by setting up the amount you will put in; for my publishing company that meant two hundred thousand dollars, and I incorporated under Herman Investments Inc. and then I started doing business. The corporation owns the books that were printed and all copyrights, and all marketing materials. People doing business with HSB Press (our trade name) give credit to that company, not to me personally. The warehouse that handles shipping charges fees to HSB Press for holding the books, and shipping when orders come in. The Editors, Designers, PR people, all contract with HSB Press, not me personally. If the company is unable to pay for those services, the people have recourse against the corporation, not against John L Herman Jr. In other words, one way of protecting yourself is to incorporate, but that would require that the corporation be funded enough to actually conduct business, or vendors would not give credit to it, and no business would proceed.
- Posted: 24 January 2008
- Comments: 0
- Category: Starting a business
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