A critical success factor for business owners is the effective management of cash reserves and cash flow. This holds true no matter the industry, business model or stage of the business cycle in which the venture operates.

The commonly stated goal or expectation when starting a business is that it will generate incredible profit, the business will become self sustainable, its accounts will be swollen with cash and the owners will retire into the sunset.

Before this can happen however, the business' financial engine must be primed. Today's article will discuss three traditional sources of financing: 1) personal savings, 2) friends and family, 3) bank financing.

We will discuss tips for more successfully leveraging these financing sources and also look at some pros and cons. Whether you are starting a business or raising cash to address liquidity needs, this article should prove useful. A future follow-up article will build on this foundation and will explore other, non-traditional sources of financing.

Personal Savings

Instinctively, the first place that most of us look for financing is in our own pockets. How much money do we have in our piggy banks or under our pillows?

When a venture is just an idea in the entrepreneur's mind, we combine cash with 'sweat equity' to develop the business plan, educate ourselves about the market and prepare ourselves. For those who are fortunate enough to have amassed sizable savings, they can look to finance equipment purchases, all or part of a business purchase and more.

Pros:

No external oversight - The entrepreneur can spend the funds as they see fit without having to provide an accounting of funds, explaining expenditures or other administrative matters which might otherwise distract from your goal

Fast turnaround with no bureaucracy - Getting the cash is as fast as 'cashing in one's chips'. Maybe the entrepreneur has to withdraw money from a personal bank account maybe they have to sell off an asset. There are no forms to fill out, no wait for a committee; once the decision is made, it's full speed ahead.

Cons:

Limited availability of cash - few people have sufficient financial liquidity to personally foot all of a business' initial and ongoing financing needs.

No external accountability - The entrepreneur who has no-one to report to and who is not required to follow any processes by a lender or investor is vulnerable to co-mingling of business and personal funds, lack of proper financial record-keeping and other mistakes.

Expense - The experienced entrepreneur will recognise the acronym OPM (other peoples' money). A generally accepted principal of 'cost of capital' dictates that when available and used appropriately, borrowing money or getting investment from external sources provides greater economic benefit to the entrepreneur than self-financing.

Friends And Family

This is when that football jersey you bought two years ago for your uncle becomes really important. Friends and family can add significantly to the pool of available funds. Several options are available: a) invest cash in the company in exchange for equity, b) lend directly in the form of a personal loan, c) co-sign loan documents from an external financing source and/or d) provide collateral to guarantee a loan.

Pros

Perspective - Friends and family will have followed the progress of the entrepreneur and when making the investment decision will have better insight into the reliability, strength of will and other personal character attributes of the entrepreneur. This can all assist in the decision about providing financing and expanding the pool of available funds.

Non-Financial Contributions - Some, who become emotionally invested in may also contribute access to their network of relationships, sweat equity, emotional support and any number of less tangible yet important inputs.

Flexibility - The entrepreneur should provide financial transparency with regular updates, keeping this investor group informed of progress, but they are commonly more forgiving of miscues such as late payments. They are also less likely to require usurious rates of return on their investment.

Cons

Impact on the personal relationship - If not managed properly, the change in dynamics can negatively impact the personal relationship. What will the new expectations and perspectives of the investor and the entrepreneur?

Success of the venture may bring jealousy, failure may bring resentment - can these negative elements be avoided?

Banks

At this moment, somewhere in the world, a frustrated entrepreneur can be heard muttering some version of the old adage: "Banks only lend you money when you don't need it and never when you do."

Despite the challenges involved with establishing and maintaining a strong banking relationship, if effectively managed, it can provide significant benefits. Options abound.

Entrepreneurs may use a business loan secured by a personal guarantee and/or collateral, they may tap into a home equity loan, they may use credit cards (which are actually unsecured personal loans), they may leverage a guarantee from the BSBDC (Bermuda Small Business Development Corporation) and more.

Pros

Perspective - The banker's perspective will generally be one of disciplined risk mitigation. Enforcing this discipline in the form of due diligence can encourage the entrepreneur to take a conservative approach and better prepare for possible negative outcomes.

Alignment of Interests - Lending is a key part of the consumer bank's business model. To put it succinctly, if they don't lend effectively they will go out of business. The entrepreneur who recognises and leverages this will benefit from the symbiosis inherent in their banking relationship.

Availability of Cash - Banks are the financial clearinghouses of the business community and their lending reserves are sufficient to meet the needs of most business projects.

Cons

Perspective - Bankers are generally conservative in nature. In their role as a lender, the bank focuses more on the downside and figuring out recourses for negative outcomes. This perspective may conflict with the equity investor, who focuses more on upside and may be inappropriate for startups, high-risk ventures or other opportunities that do not fit easily into the bank's assessment frameworks.

Red tape - The level of due diligence required by banks, as well as the bureaucracy and methodical nature of the lending process can frustrate and delay action-oriented entrepreneurs.

Closing Advice

Some closing advice as you lay a foundation for future financing: 1) Keep feeding your piggybank, 2) Pick flowers for your favorite aunt and 3) Breathe deeply.

This article is part of a series reflecting on some of the 'best practice' issues and considerations relevant to owners of privately held companies. Asgill Post Ltd. provides assistance with Business Valuation, Financial Strategy and the Purchase and Sale of Companies. More information, visit www.asgillpost.com or contact Kumi Bradshaw MBA, CBA, BVAL via email at kumi@asgillpost.com or phone 295-3301 Patterson Partners Ltd. provides Bermuda/US cross-border tax, estate and investment planning services. For more information, visit www.patterson-partners.com or contact Jennifer A. Patterson, CFP®(US), CIMA®, TEP via email at info@patterson-partners.com or phone 296-3528.