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2012

Body_Hedging.jpgby Sherron Lumley.

 

In financial terms, a hedge is a means of protection against a potential loss. But this notion of hedging can be applied to more than just the financial markets and small business owners should consider steps that they can take to similarly reduce their exposure to risk. What if my costs go up? Will demand stay steady? Am I sure my supplier will stay in business? What’s going on with energy costs, travel expenses, and should I charge for delivery? These types of questions are important, and savvy business owners will look for ways to hedge against not knowing the answers.

 

Jeremy Shepherd is the founder of PearlParadise.com, in Southern California. He started the business 15 years ago when he was just 22 years old and working as a flight attendant. During a layover in China, he bought his girlfriend a strand of pearls, attracted by their delicate beauty and luster. His $25 gift was later appraised for $600 in the U.S., however, and so, sensing a golden business opportunity, he cashed his paycheck and hopped a plane back to China with $3,000—all the money he could get at the time.

 

“It was slow at the beginning,” he says, recalling the difficult early days of cracking a complex supply chain network and then learning how to build his first online auction website. Now his business has expanded globally, grown to 12 employees, and become an online empire with $20 million in annual sales. How this one-time flight attendant came to own the largest online pearl company in the world was by hedging his bets, so to speak.

 

PQ_Hedging.jpgTiming is everything

Part of this success Shepherd attributes to his hedging strategies. For example, he learned early on that the pearl business is highly seasonal, with most of its sales centered around the holidays of Christmas, Valentine’s Day, and Mother’s Day. But when demand is low outside these peak periods, Shepherd takes advantage of a supply chain eager to unload product by buying up pearls for pennies on the dollar. In addition, because pearls have such a long production lead time—it can take anywhere from four to ten years before a pearl is ready for use in jewelry—Shepherd notes, “I learned to never have only one supplier of anything.”

 

This concept of buying when demand is low applies to other operating expenses for small business owners as well. For instance, purchasing energy (such as heating oil) on an annual contract with a set monthly rate is a hedge against seasonal market-rate spikes in prices. Another similar idea is setting up long-term subscriptions with vendors at lower prices. Suppliers appreciate the steady stream of cash this arrangement provides them as well as the fact that it allows them to forecast future production more accurately. Often, they are willing to negotiate customer discounts in exchange.

 

Trading revenue for predictability

This side of the coin, the sales side, is something Andy Sack is familiar with as a serial entrepreneur. He has launched and sold three Internet technology companies, one to New York Times Digital, one to Microsoft and one to Acxiom. “I have had a long experience as an entrepreneur building companies and raising capital,” says Sack. “About two years ago, I switched from being an entrepreneur to being an investor,” he says.  And his new company, Lighter Capital, was started on the premise of a hedging strategy—that it could provide entrepreneurs with a steady source of investment in exchange for a percent of sales, rather than of a share of ownership.

 

“It’s a concept that has been used traditionally in businesses such as mining and entertainment—the movies,” says Sack. “It’s great for companies with seasonal or fluctuating revenue.” As an example, he points to Tomato Battle, a new client of his that—yes—has built a business around organizing giant tomato fights. Because the business is not only seasonal—based on the availability of tomatoes—but also events-oriented, the arrangement of trading a percentage of sales for a steady infusion of investment capital has worked well for both sides.

 

So how is business for Sack?  “We plan to double in size in the next 12 months,” he says. 

 

Get rewarded for what you do habitually

Now what about hard-to-manage expenses that seem beyond one’s control, such as the ever-rising price of a gallon of gasoline and climbing air travel costs?  Travel for business purposes, in particular, has become a hot button issue in the last year, eating into many a small business’s profits. For Shepherd, who travels extensively overseas to countries such as China, Japan, and Vietnam, the answer has been to maximize his flyer reward programs. He uses airline-affiliated reward credit and bank cards for all his business expenses, paying off the balance each month. In turn, he redeems the reward miles to pay for subsequent airline trips to his supplier markets. This strategy has proven so successful that he rarely pays for tickets now, even though he traveled to nine countries last year.

 

Gasoline is a little trickier, however. Again, using a rewards credit card affiliated with retail gas station brands can either shave a few cents off at each fill-up or be turned into points that can be later redeemed to lower your monthly bill. For companies with larger delivery fleets, it’s possible to prepay for fuel at a fixed cost through installment payments. Fuel hedging also exists for companies who want to cap costs.

Body_Debtfinacing.jpgby Jen Hickey.

For most entrepreneurs, starting their own business is a labor of love. The time, energy, and money they spend help bring their dream of being the boss to life. However, after pumping in personal assets and money from family and friends to get their enterprise off the ground, a small business owner may be reluctant to take on debt to expand. Of course, the alternative—equity—has its own cost. Which type of financing will best serve the needs of a small business?

Control Issues

“Equity investors have a completely different set of goals than organizations that provide debt,” notes Daniel Feiman, author of The Book on Business from A to Z and managing director of Build it Backwards, a global management consulting and training services firm based in Redondo Beach, California. Because of the higher risk they assume, equity investors usually expect to play a larger role in the decision-making and that can cause problems. “An investor’s growth ideas may be different than yours,” points out Feiman. “You may even be forced out if the investor doesn’t think you’re driving the company in the right direction.”

PQ_Debtfinacing.jpgTherefore, small business owners must be prepared to give up some control when taking on investors. That may be a bitter pill to swallow after putting so much personal effort into creating a business. “If you bring other people in with lots of money and expertise, your business will be bigger and you’ll probably be richer, but you’re likely to have a much smaller piece of a larger pie,” says Mitchell Weiss, who spent two decades in the commercial lending industry before becoming a consultant, author, and professor at the University of Hartford. “If you want control, you’ll have the whole pie, but a much smaller one.”

Think long-term (costs)

With debt, a small business owner is beholden only to a lender for the principal and interest of a loan over a set period (with set payments). “Debt is higher risk but less expensive because you’re paying a small fixed charge and you know exactly what it is,” points out David Worrell, author of The Colors of Money and principal at Rock Solid Finance based in Charlotte, North Carolina. “Some debt is good for business because it helps free up cash to expand and that helps you grow faster.”

 

Another consideration: Over time, equity ends up being more expensive than debt. “Equity investors demand a premium to debt investors,” explains Weiss. “If you can’t generate enough profits to make a sizable return, then you should look at debt.”  Because equity investors take a greater risk, he notes that when your business does generate profits, investors expect a bigger and bigger share for as long as they invest.

 

Get only what your business needs

Venture capitalists and angel investors tend to only lend large amounts, typically millions of dollars. For small businesses in fast-growing industries—such as tech and biotech—that need a large cash infusion to keep up with growth, an equity investment may be the way to go. But for companies looking for a much smaller amount to smooth out cash flow or purchase property, equipment, or inventory, debt financing makes more sense. “If you’re like most businesses, you’re going to take much longer to grow and to collect cash and receivables,” notes Feiman. “Your business will not be best served by having equity as the primary source of financing.”

For a startup that has yet to make a profit, a business loan can be hard to come by unless significant collateral, such as real estate or equipment, is pledged. After using his personal savings to develop “Incredible Greens”—a condensed vegetable powder made up of 35 different greens, grasses, and probiotics—and launch Health Kismet, Jonathan Bechtel took out a three-year $15,000 personal loan to develop a new berry-flavored powder and introduce different packaging sizes. “You have more control over the lending amount,” notes Bechtel. “I didn’t need a huge amount, as the cost of manufacturing in the supplement industry has decreased.”

For Bechtel, seeking out investors would have served as more of a distraction. “If I had spent three or four months looking for investors, I wouldn’t have been able to focus on the daily workings of my business, which probably would have killed it before it started,” says Bechtel.

Although Health Kismet is now cash-flow positive, having reached its first five-digit month in gross sales after just a year in business, Bechtel prefers to keep as much cash as possible available “in case the unknown happens,” he says.

In the red, in the black

When Michelle Furyaka joined NPD Global as an executive VP in 2010, the small IT staffing and recruitment firm was looking to expand after weathering the worst of the recession. “If we were going to stick to the business plan we devised and meet our goals to grow in a certain way, then we had to borrow money,” says Furyaka. She and her partner were able to secure a loan for their company through a small business program offered by one of the big brokerage houses.

While it was not cash flow positive at the time, NPD Global already had some established clients. The loan helped finance their move from New Jersey into Manhattan to be closer to their clients, which include some large finance and insurance companies. After signing a few new customers and turning a profit, the company was able to turn to debt financing again—this time for a revolving line of credit—to cover the lag between getting paid by their customers and paying their employees. “Sometimes we’re waiting 40 to 60 days to get paid,” notes Furyaka. “[The line of credit is] like an insurance policy we can dip into and then immediately pay back.” Since 2010, NPD Global has expanded from five to 40 employees and grown 300 percent, with another doubling of growth projected for this year.

Caveat Debtor

Before taking on debt, small business owners must consider both business and personal risks. “You are taking on the full burden of that money personally,” says Worrell. “Almost every SBO must give a personal guarantee when taking out a loan.” Personal credit history is weighed along with the health and growth prospects of your business. So if you default and your business assets don’t cover the full cost of the loan, the bank can come after your personal assets.

Before approaching any lending institution, it’s also important to be prepared. “You must have not only a solid business plan, but also a good story for the bank that supports profitability in the future,” Worrell points out. “You have to prove to the bank that you’re mature enough to handle your money, your company’s money, and their money.”

Along with gathering all the necessary financial, legal, and tax documents, entrepreneurs must determine the right amount and appropriate structure for their loan. “Your profits will tell you the maximum amount of financing you can afford,” notes Feiman. “You need enough cushion in case of surprises, and there are always surprises.”

“Any money that comes into a company has to have a way out,” says Weiss. “Equity and debt are the same in that there’s a price to be paid for each and each has to be returned at some point.” For those small business owners whose dream it is to nurture their business over many seasons, taking on a manageable level of debt may be just what’s needed to help their business bloom.

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