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Is Finance Really a Four-Letter Word?

By January 16, 2014Blog, The "F" Word

Finance has its share of villains, both in fiction and in real life, who’ve created a distaste for finance that isn’t serving entrepreneurs well.

Because unless you’re independently wealthy (in which case, you’re probably not starting a business to make money), you’ll have to work with some finance types to get your business off the ground and keep it growing.

But (Gordon Gekko aside) finance types aren’t the culprits – in fact, once you understand financial principles, you can make them work for you without feeling slimy or selling your soul. But (and this is crucial in all aspects of your business), you need to take control of your own destiny.

First, you need to understand one of the fundamental principals of finance: the riskier something is, the more you’ll have to pay to get someone to invest in it.

This is referred to as the risk/reward tradeoff*, and it looks something like this:

Risk/Reward tradoff

 

In this illustration, the dark points indicate the general range for risk/reward, and show that depending upon WHO is borrowing (and how the person lending feels about them), the reward required for someone to make that investment increases. As an example, if I want to obtain a business credit line, I know that the bank will expect a potential loss of 35%, and will want a reward (in this case, an interest rate) of about 20%.

The ovals around the dark points show how perception can influence these risk/reward tradeoffs. Within each investment type, individuals and their perception of the risk will influence the rewards they will require to invest. So, continuing my example, if I’m able to develop a great relationship with my banker, and I have a well-thought out response to most of her questions, I should be able to reduce her perception of the risk of MY business, and reduce the reward (interest rate) that she’ll require.

With me so far?

Second, you need to understand that this is not rocket science – you already use this principle every day.

When someone wants to borrow money from you, for example. If you don’t know the person at all, you perceive the risk to be high; so high in fact, that you probably wouldn’t even make the loan. However, if it’s someone you know reasonably well, you’ll review several factors (such as how much they are asking for, whether they can pay you back, how much you think they need the loan, and whether you trust them and communicate openly with them) before you make a decision.

Sound like common sense? Then you’ve already got good insight into a bank/investor’s thought process when you approach them for an investment.

Since your relationship with the bank/investor may be on the newer or more superficial side, you’ll have a lot of work ahead to convince them to provide you with funding. It means that you need to clearly understand where the risks are in your business, and then work on decreasing their impact on your business.

It also means that you need to develop a relationship with your banker/potential investor, so that they get to know you and have a better idea of how trustworthy you are. Being able to answer the following questions will go a long way to building trust:

  • What is your business is capable of becoming and what it will take to get you there, in terms of time, money and personnel?
  • What will you be using the requested funds to do? If your answer is “pay my (or other founders’) salary”, you’re dead in the water. Would you loan someone money to pay themselves a salary?
  • What are the scenarios under which the funds can’t be returned? How likely are they, and how soon can more information about those probabilities be obtained?

When you talk about those risks and how you’ll address them, you’ll build credibility. Once you’ve established a genuine relationship and trust, banks and investors will be much more likely to want to work with you.

If you don’t have enough money to finance your company – which, let’s face it, is where most of us find ourselves – you’ll be looking to banks and/or investors to provide capital (cash, dough, greenbacks, you get the idea). To make the most of what the finance types can do for you, you’ll need to put yourself in their shoes and try to identify any other risks that they may perceive (perception is NOT reality, but in this game, it’s the perception that counts until you build a stronger relationship).

Your assignment: identify three risks in your business that you could improve on, and tell me about them in the comments. Let’s see which ones we have in common!

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