Financing the Opportunities

Entrepreneurs who dream of owning large, successful companies should also consider how those dreams will be funded.

October 01, 2001

Entrepreneurs who dream of owning large, successful companies should also consider how those dreams will be funded. Using the capital of others, such as when a builder uses a customer’s funds to build a custom home, is psychologically and practically simpler than using your own (especially if yours is limited), but do so only after thoroughly examining the type of business you want to grow into. Only after that step should you explore the numerous venues available to chase dollars to fund dreams of growth.

Discretionary Cash

Custom home builders can grow their companies with capital derived from their success. Profits left in the business can be used to expand existing activities or diversify into new ones. A couple of items, however, should be considered.

First, is cash truly discretionary? More than a few builders have confused money that should have been targeted for future payables with their own capital. While this might generate short-term excitement, it ultimately leads to long-term disappointment, especially when suppliers and subcontractors find that their money is sitting in the builder’s new mag-wheeled truck. Only when cash has been set aside for all accrued expenses, and all salary checks have been cashed, can the remaining funds be considered truly discretionary.

Second, cash that has accrued in a business account probably will be taxed, resulting in the need to take some of the cash as a bonus just to pay the owner’s income taxes. Thus, while good accountants might be very creative in their work, recognizing discretionary cash before it becomes taxable is an important consideration to any business owner.

Personal Assets

For most homeowners, the home is their largest asset. For an entrepreneur, it’s the asset that can easily be targeted for cash to start a new business or expand an existing one. But beware the pitfalls.

If a home has value in excess of its debt, some percentage of the difference is subject to access through a home-equity line of credit or second mortgage. A home-equity line of credit is akin to a checkbook-in-waiting; no debt is incurred until you write a check. At that point, additional debt on the home has been incurred.

Similarly, the stock market boom of the ’90s greatly increased brokerage accounts for many families. Short of selling stock to raise cash, brokerage houses allow account holders to borrow a percentage of their portfolio value. Once again, similar to a home-equity line of credit, using margin places debt on your brokerage account.

If business owners have insulated themselves from lawsuit with the correct corporate structure, potential business losses will be limited to the sum invested in the company. But if a business is funded or expanded through the use of capital from a home-equity line of credit or margin account, those debts remain even if the company closes. Thus, a future nest egg or a family’s lifestyle can be jeopardized.

Perhaps the most damaging consequence from the use of personal funds is the toll it can take on a marriage. Most people in the construction business can probably tell a story about someone they know who lost a business and then a marriage. The events are not coincidental. Before asking your partner to put half of his or her home or kids’ college accounts at risk, consider the impact of failure.

Third Parties

Bank financing is the most obvious source of funds for owners of most any type of business. In simple terms, once a bank is satisfied that the collateral offered exceeds the value of the loan, it will advance funds.

The thrift crisis that cost tens of billions to resolve resulted in tightened lending practices by many banks. To succeed with a loan application, a builder probably has to present a written plan detailing how the bank’s funds will be used, cash flow projections to satisfy how the loan will be repaid and a balance sheet detailing collateral that can be seized if repayment does not occur. (Interestingly, business owners often have to use their homes as collateral for bank loans. Many could save fees and some interest by using a home-equity line of credit and, essentially, loaning the money to themselves.)

A builder also might find an equity partner to provide funding in return for a share of profits. While this might be the only opportunity for a cash-strapped or collateral-starved builder, caution is key.

First, will the equity partner be silent in fact or in name? In other words, is this party really agreeable to handing over checks for tens or hundreds of thousands of dollars with no interest in decision-making, even if the project starts to sour? Or after fees, expenses and profit sharing, is the project still as attractive as it looked when profits were not to be shared? When another party will become part of the equation, it might be necessary to stop and remember why you became an entrepreneur: sole responsibility for decision-making, ultimately answering only to yourself and enjoying (at least) most profits from risk-taking.

Land Partners

Construction is often about land, and builders are an industrious lot. Rather than accrue all the debt for a potentially lucrative project, opportunities can be found to share the load.

Rosenthal Lumber & Fuel Co. of Crystal Lake, Ill., is a $3 million to $5 million diversified company that has been out of the lumber and fuel businesses since 1976. While the parent name still exists, revenue is generated only through its three divisions: Rosenthal Company Inc., a residential and commercial land development company; William Thomas Homes Inc., a custom and semi-custom home builder; and Custom Construction Concepts Inc., a consulting company.

When it came time for Rosenthal to start its first subdivision, Tom Stephani, president of the three divisions, decided to try land partnering. Rather than tying up land until approvals were completed, Stephani tied up the land, without interest charges, through the entire project.

To purchase land for Dole Crossing, a 23-home subdivision in Crystal Lake, Stephani set a pre-construction price with the landowners that slightly exceeded market value. Of more interest to them was the opportunity for profits at the end of the job that would significantly add to their land sales value.

In this instance, Stephani pays the land company (a joint venture between the former landowners and Rosenthal) $60,000 per house. Deductions from the retail cost per site become management fees by Rosenthal, real estate commissions for the retail price of each lot when homes are sold, legal costs for land approvals, etc.

When the entire project is completed and all 23 lots are sold, the original landowners will recoup the previously agreed-upon lump-sum price (approximately $255,000) for the land. Rosenthal will repay the infrastructure debt it incurred to improve the lots (approximately $750,000), and the joint-venture partners will split the remaining profits approximately 25/75. Thus, the land partners will get a substantially higher percentage than they would have received by selling undeveloped land, and Rosenthal locked up costs and reduced cash outlay. "It’s the only way to do land development," Stephani says.

Developer Partners

While the concept of joint ventures might not be new to entrepreneurial home builders, scale can vary considerably. An example at the higher end of the spectrum is The Bozzuto Group, a 500-plus-employee company based in Greenbelt, Md. Aside from closing some 998 apartment and custom home units in 2000, the company also includes a commercial construction division, a commercial landscape company, an apartment management division and a mortgage company.

But the mainstay of the company is its residential apartment business. Rather than just securing equity partners, The Bozzuto Group recently created a joint venture with a large pension company that will allow for better project control from the start.

"A typical equity partner contributes 90% of the capital," explains Tom Bozzuto, president of The Bozzuto Group. The builder contributes 10% and then receives a development fee, a building fee and a fee to manage the property. Upon completion of the project, however, the builder/developer owns 30% to 50% of the project, while the developer partner owns 50% to 70%. A buy/sell provision allows either party to sell its share to the other party.

According to Bozzuto, the downside of this arrangement is "we own less than 100%." The upside? Builders can develop multiple projects at the same time. How else can a 13-year-old company have revenue of $118 million?

 

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