Entrepreneurial Desires. Over 6 million people in the United States started a new business in 2015. This was the greatest increase of new business start-ups in over 20 years and this increased pace of new business start-ups has continued in 2016. In a recent Gallup poll that interviewed a diverse group of more than 2,000 Americans, over 50% said they would like to start their own business.
Unless you have saved enough of your own money to get your new business through the first two years of its life or you have a rich relative who will loan you whatever money you need simply because they like you, one of the most important decisions an entrepreneur will make is how to find start-up funding for their new business.
There are many ways to fund a new business and in the relative order of difficulty, from the least difficult to the most difficult, the following is a description of the primary sources of start-up funding:
Personal Sources – Many very successful new businesses have been started with just the personal funds of their founders. Whether from savings or a pension fund or credit cards or the sale of assets or a loan against your home, you may have enough of your own cash, equity or credit to keep your new business going until it starts generating cash flow. Often, entrepreneurs believe the greatest limitation they face is a lack of adequate capital, but it has been shown that poor management is more often the cause of business failure than insufficient start-up capital.
Below is a list showing the amount of money required to fund 85 new start-up businesses that were worth at least $1 million two years after they were started:
Less than $5,000 17.5%
$500,000 and up 1%
Source: Wachovia Bank
We can see from this chart that almost 50% of these start-up businesses had less than $20,000 when they began, so finding enough start-up capital in your personal resources may not be out of reach for someone with a good business idea and the commitment to make their new business successful.
Here are some tips on how best to use each personal funding resource.
Savings/Pension Funds – Before you invest your savings or pension fund money in your business, consult with your accountant to understand how best to structure the investment (loan or purchase of equity) and make sure an attorney creates the appropriate legal documents when your money first goes into the business.
Credit Cards – Credit cards can be a great tool for major purchases of equipment or payment of initial business expenses. Make certain you find the lowest possible introductory interest rate, the best terms and highest cash rebate program. Used properly, credit cards can be an inexpensive way to get your business started, but improperly managed they can end up being a very expensive way to finance your business.
Personal Asset Sale – In some cases the sale of stock, an extra car, artwork, a coin collection or some other personal assets can help to raise start-up funding for a new business. As with the use of savings, make certain you understand the tax consequences of an asset sale and properly document the funding transaction.
Home Loans – Entrepreneurs who own a home may have enough equity to take out a Second Trust Deed to fund their business. As with any business loan, it is important to make sure you have sufficient future cash flow from sources other than the new business for repayment of this type of personal loan.
Friends and Family – If your personal resources are not enough to start your new business, the next easiest source of start-up funding is from your friends and family. Small business funding surveys indicate that more than 50% of all new businesses are partially or totally funded through loans or investment from friends or family. This is because by starting with people who know you, have faith in you and want to see you succeed, it is much easier to tell your story and ask for start-up capital. One serious mistake you should never make is failing to properly document any loan or investment from a friend or family member in the same way you would with a bank or stranger.
There are two primary ways for any outside party to give you start-up business financing: Debt or Equity.
Debt Financing is a loan. This means you will need to pay back the full amount given to you (principal) plus an agreed-upon extra amount (interest) calculated as a percentage of the principal multiplied by the amount of time until you have fully repaid the loan. For example: a two-year loan of $20,000 at 10% simple interest will require repayment of $24,000 ($20,000 principal plus 2 x $2,000 in Interest). With compound interest, you will pay interest on the interest. A lender has limited risk because they will usually want your personal guarantee, but they will only receive back their principal and the amount of interest you have agreed to pay them. A lender of business financing generally does not get involved in how you run your business. The legal agreement used for Debt Financing is a Promissory Note.
Equity Financing is a purchase of an ownership interest in your company. This means the investor becomes your partner and will have a say in how your business is run. An equity investor has a much greater risk than a lender because if the business fails, they can lose their entire investment. However, if your business does well, their ownership interest will become more valuable. If the investor has business experience and you can work well together, their involvement in your business may be a good thing. If the investor has no business experience and is hard to get along with, having them involved in your business can be a very bad thing. The legal document used for Equity Financing is a Stock Purchase Agreement (for a corporation) or a Member Agreement (for a LLC).
Crowdfunding. A start-up business can raise operating capital through a “crowdfunding” campaign. The campaign is based on a creative presentation video and information about the business, posted on a crowdfunding website (ie. www.kickstarter) asking people to either donate or invest small amounts of their money in the business. Successful crowdfunding campaigns all have the following elements: (1) a product or service that appeals to a large percentage of the buying public; (2) an organized marketing campaign designed to reach thousands of people and create subscription momentum at the beginning of the campaign and (3) an offer that will entice people to buy the item offered or fund the new business.
A start-up business can choose from two basic types of crowdfunding campaigns: “Rewards” crowdfunding is when business owners presell their primary product or service to launch a business concept without incurring debt or sacrificing equity/shares and “Equity” crowndunding is when the subscriber receives shares of a company in exchange for the money pledged. Although each “investment” in a crowdfunding campaign may be small (ie. $100), by using a carefully promoted Internet marketing campaign to appeal to thousands of strangers, a business can raise anywhere from $10,000 to multiple millions. In 2015, over $34 Billion was raised worldwide through crowdfunding.
Bank Financing. Another common way to obtain start-up funding for your new business is to get a Bank Loan. Getting a start-up business loan from a large national bank may be difficult; and entrepreneurs may find it easier to work with a smaller, local bank with a better understanding of your particular business environment. The US Small Business Administration (SBA) is specifically designed to provide loan guarantees for the start-up or expansion of small businesses. The way this works is a national or community bank is qualified by the SBA to issue loans and you apply for a SBA guaranteed loan through a branch of that bank. Your loan is funded by the bank and you make repayment to the bank, but if you default on the loan the SBA will replace the funds lost by the bank. As with non-SBA loans, you generally will be required to give a personal guarantee and pledge all your personal assets as security for repayment of a Bank Loan. Since the banking meltdown of 2008, the regulations imposed on banks have made it much more difficult for a small business to get any form of bank financing.
Asset Based Lending. In general terms, asset-based lending is type of business finance where a loan, line of credit or other form of funding is secured by specific business collateral (“the assets”). An asset-based loan or line of credit can be secured by accounts receivable, inventory, contract rights, intellectual property and/or other types of balance-sheet assets.
Asset-Based Lending programs can convert current accounts receivable and non-performing assets of a business into cash. Some examples of non-performing business assets that can be used for Asset-Based Lending are (1) Accounts receivable that are being slow-paid, (2) Inventory that is not selling quickly, (3) Intellectual Property rights that are not currently generating income or (4) excess manufacturing raw materials.
Asset-Based Lending Compared to Bank Loans. Asset-Based Lending programs offer many benefits when compared to traditional bank loans.
- Easier to Get Approved – Because the pledged asset provides the lender with the security they need, an asset-based loan can be approved much easier and much quicker than for the typical bank loan.
- Provides Immediate Funding – When an asset-based lending program has been established and the pledged asset has been valued, funding can be immediately provided. Same-Day Funding is available for Factoring transactions and draws on an asset-based Line of Credit.
- Much More Flexible – An asset-based loan can be specifically tailored to the urgent cash needs of a business. For example: the factoring of an invoice can provide immediate cash for payroll or an asset-based line of credit can be designed to meet fluctuating cash flow requirements of a business with fixed expenses and variable income.
- Your Credit is Not an Issue – When an asset of known value is pledged as repayment security, business credit or personal credit is not an issue for approval of an asset-based funding program.
- Can Help Improve Credit Ratings – When business cash flow is effectively managed, bills get paid on time and credit ratings are improved.
Alternative Funding Methods. In addition to the traditional methods of obtaining business financing listed above, there are numerous alternative methods of raising business start-up or development funding that include the following:
Leasing – For larger purchases (vehicles, multiple computers, expensive software programs, etc.) it can make good economic sense to lease rather than buy. Especially in the case of rapidly changing technology or vehicles that have high depreciation and expensive maintenance and/or repair costs, for a small down payment and a monthly payment often lower than a loan payment you can enter into a business lease. Additionally, because the leasing company continues to own the subject of the lease, leases often will not require the same level of financial qualification or collateral as a purchase loan. Managed properly, a sensible lease plan will conserve precious capital your business will need for other purposes.
Third Party Loan Guarantees – In this form of loan transaction, a relative or friend will use their assets and their credit history to cosign a bank credit-line agreement when your credit history or the credit history of your company would not otherwise qualify. In this type of loan, your company is the borrower and makes the payments on the loan, but the third-party puts up the collateral for the loan and is on the hook in the event of a default. One advantage to this type of loan is that it often frees whatever assets and other collateral the company has for other forms of financing.
Third Party Asset Sales – In this financing transaction, relatives or friends can help you create a relatively simple alternative to either loans or equity deals. Your company sells hard assets it owns of whatever age (computer equipment, office equipment, furnishings, etc) to a friend or family member you know and trust; he or she then leases those assets back to your company at a lease payment that is commercially reasonable and seems fair to both of you. Your friend receives a tax deduction for the purchase of business equipment and they also receive income in the form of monthly lease payments while your company gets an injection of cash and, hopefully, better leasing terms than it would have received from an equipment leasing company. The only problem with this type of financing transaction is leaving your friend or family member stuck with equipment they don’t need with little value if your business does not succeed.
Preferred Stock – The typical equity investment deal gives an investor common stock in your company in exchange for funding. One of the risks these equity investors face is a complete lack of cash necessary to redeem their stock after payment of all other company debts if the company fails. One method of giving an investor greater security is to issue them Preferred Stock, granting them preferential liquidation rights over the common stock shareholders. Additionally, holders of Preferred Stock may be given greater rights (ie. two for one share conversion) if the company goes public. One concern about issuing Preferred Stock is the need to balance the preferential rights given to holders of Preferred Stock against the rights of Bank Loans, Angel Investors, Venture Capital and other secured creditors of the business (ie. landlords).
Warrants and Options – A Warrant is an investment agreement between the warrant holder and the company granting the holder of the warrant the right to purchase stock in the company upon the occurrence of some event (stock price, going public, passage of time) at a stated price. Warrants are not stock until they are exercised, but often they can be sold for cash by the original warrant holder to another person. The term of Warrants is often years. An Option is an agreement often entered into between the company and its employees, shareholders or Directors granting the owner of the Option a right to purchase stock in the company on certain dates at stated prices. The term of Options is often months and Options are generally not transferable to third parties without the prior approval of the company.
Investment Agreements with Buyback Provisions – Sometimes owners of start-up companies are willing to give an early stage lender or investor controlling interest in the stock of the company until much or all of the investor’s principal investment has been repaid. As principal is repaid and the risk of the investor declines, the company founders earn the right to buy back some of the investor’s stock in the company, often reducing the investor’s ownership to well below a 51% controlling interest. In this way, company founders who are confident in the potential success of their business can receive a larger amount of start-up capital while still preserving their right to regain a controlling interest in their company.
Strategic Business Partnerships – Often a start-up business will provide a product or service in a particular niche area that is not heavily populated. If other companies (buyers, vendors, consultants) recognize the value of the product or service being provided, it may make sense to form a strategic business partnership for the creation of new products, pursuit of additional markets or development of ideas. When this occurs, some part of the growth or development plan of the start-up company can be allocated to the strategic partnership with the partner funding its share of that activity. If the allocation of project control and intellectual property ownership can be worked out in a fair way, this type of partnership can preserve precious capital while increasing the speed and efficiency of an important development area of the company.
Advance License Fees – For start-up technology or software companies, one strategy for raising early stage capital is to charge a customer an advance against royalties or License fees. Under this scenario, a significant percentage (20% to 25%) of the total cost of a Software Development Agreement or Technology License Agreement can be paid by the customer as an advance against future fees. Several valid reasons for requesting such an advance are: increased allocation of resources, hiring of additional personnel, suspension of other projects, etc. One issue to watch, it is important not to spend all of the advance on expenses completely unrelated to the contracted for project or the company may risk delayed performance or non-performance of the services for which the advance was paid.
Government Grants – With very little research, it is possible you will discover that your company can qualify for one of the thousands of US government grants that give away or loan millions of dollars of capital to start-up businesses. Although most of these grants will take several months to get approved and funded, the sooner you start, the sooner you will receive government money you either don’t have to repay at all or can repay over a long period of time at favorable interest rates. A note of caution, writing grant applications is an art and you may want to hire someone who has a successful track record of getting grants funded in your business area.
Conclusion. Owners of a start-up business have many options for raising the capital their new business will require. Entrepreneurs who have started a business before know it can take 24 months for a new business to become profitable, so they also know that the funding plan they create may need to make arrangements for more than one form of funding and they take that into consideration as move forward with the funding of their business.