IT’S ALWAYS DAUNTING TO RAISE money for a startup. Most entrepreneurs are forced to dive into their own pockets for the cash to start a business, as few lenders or investors want to bet on an unproven startup. Newbie entrepreneurs often cobble together funds by combining their own savings with a few other sources (such as loved ones, credit cards, or home-equity loans) in the early months or years. Those who don’t have enough cash sometimes try crowdfunding sites. It remains difficult or downright impossible for startups to obtain bank loans. That’s because banks and credit unions are risk-averse and don’t want to take a chance on a startup until much later, when the business has a track record and financial statements to prove it.
A small number of startups, often in the technology realm, will try to raise money from investors. This route is only appropriate for businesses that have exit strategies (in other words, they plan to one day go public or sell themselves to a larger company, which is when investors reap profits). If that’s you, starting your capital search with a good business plan will show investors your company’s potential.
Finding and securing startup cash can take careful research, good negotiation skills, and, above all, an unflagging commitment to your new business. Here’s a look at the most common sources of funding for small businesses.
Far and away, the most common source of startup funding is you—meaning your savings, credit cards, retirement savings, or home equity loans. We’ll take a look at each below. Some good news: Entrepreneurs who have started this way—and most have—say having “skin in the game” can teach early lessons in frugality and impresses lenders or investors down the road.
“I started Learnvest out of my savings account. I started paying designers, paying technologists tiny chunks of checks. Because I was actually paying for things myself with my own savings, it sharpened my focus of how to spend money. Quickly you’ll be able to say, we don’t need that.”
ALEXA VON TOBEL, founder of personal-finance website Learnvest, which ultimately raised $69 million in venture capital and was acquired by Northwestern Mutual for a reported $250 million
No matter if the economy is soaring or tanking, this is where you start. Exactly how much you need depends on your business (please see “Calculating Startup Costs,” page 83). And exactly how much you want to risk may depend on your circumstances in life: Are you single? Married with college-bound children? Getting ready to retire? All of this requires some soul searching and (in some cases) discussion with significant others in your life.
Now, a key to investing in your own business is not to put every last penny of your savings into your new, unproven startup. Personal-finance experts recommend keeping enough in an emergency savings account to cover at least three months of personal expenses (like the mortgage, groceries, and utilities). If you’re a newly minted business owner—meaning, you’re not yet drawing a salary—you’ll likely need considerably more, especially if sales take longer than expected to come in. You’ll want to keep extra cash in a reserve, in the event unplanned business expenses arise in your startup’s early years.
Many entrepreneurs use personal credit cards to fund their startups, which can be risky. Fall behind on your payment and your credit score gets whacked. Payjust the minimum each month and you could create a hole you’ll never get out of. That said, if used responsibly, a credit card can get you out of the occasional jam and even extend your accounts payable period to shore up your cash flow. Note: most startups aren’t eligible for business lines of credit until they are more established. Once you have a line of credit, though, you can use it as a short-term bridge loan to cover working capital needs.
If you’re a homeowner, you might consider tapping into home equity to fund a business. In that case, you might consider a home equity loan, which, like a mortgage, usually has a fixed rate and monthly payment. Or you could look into a home equity line of credit or HELOC, which functions more like a credit card, with a variable interest rate. But here’s the thing: If your brilliant idea turns out to be less-than-brilliant, you still have to repay the loan or lose your house. Some experts recommend saving home equity funds as a source of capital for down the road, for when your revenue-generating business has reliable customers.
One of the worst ideas is to dip into retirement savings to fund your startup—although plenty of entrepreneurs do it. If you’ve left a corporate job (or are thinking about it), those funds you’ve accumulated in your 401(k) over the years can look pretty tempting. Technically, if you set up a C corporation and roll your retirement assets into it, you can tap them without penalty. If you’re considering this, make sure to talk with an accountant, as the steps are legally complex. But remember: If things don’t pan out, not only do you lose your business, but your nest egg, too.
“I probably had about twenty grand in the bank when Under Armour started. A lot of money for a college kid. I ended up going to just under $40,000 in credit card debt spread across five cards. In the summer of 1997, I was totally broke—so broke I needed to go to my mom’s house to ask if she minded cooking dinner for me. I needed for her to feed me. Then all of a sudden I started getting my first round of orders.”
KEVIN PLANK, founder of athletic-apparel business Under Armour, now a $5 billion public company
How much money do you need to start a business?
The answer, of course, is unique to your startup, which will have its own specific cash needs at various stages in its developmental cycle. For example, a service-based business with no inventory (think Uber, a transportation company that doesn’t actually own any vehicles) can be started on a small budget. Other startups—a restaurant, for example—will need to invest a substantial amount in inventory or equipment.
While there’s no universal method for estimating startup costs, the Small Business Administration provides a few helpful tips at its website, www.sba.gov.
First, figure out how much seed money you’ll need by estimating the costs of being in business for the first months. “Some of these expenses will be one-time costs such as the fee for incorporating your business or the price of a sign for your building,” according to the SBA. “Some will be ongoing costs, such as the cost of utilities, inventory, insurance, etc.”
When you’re analyzing those costs, decide which are essential and which are optional. “A realistic startup budget should only include those things that are necessary to start a business,” the SBA says.
Next, divide essential expenses into two categories: fixed or variable. Fixed expenses might include monthly costs, such as rent, utilities, payroll, and insurance. Variable expenses might include inventory, shipping and packaging costs, and sales commissions. “The most effective way to calculate your startup costs is to use a worksheet that lists both one-time and ongoing costs,” the SBA says.
Nothing is scarcer than cash (except maybe sleep) when you’re starting out. That’s why the term “bootstrap”—i.e., doing more with less—is a buzzword in startup circles. The more you can bootstrap in the beginning to validate your business idea, the easier you are going to find your path to raising capital.
Tom Walker, an investor with Rev1 Ventures and author of The Entrepreneur’s Path: A Handbook for High-Growth Companies, provides bootstrapping tips. Hold fixed costs to a minimum by doing the following:
Share office services and equipment
Co-locate with another company or move to a business incubator
Use the computers and servers you already have
Delay capital purchases
Lease instead of purchase
Negotiate fees and terms with all service providers and suppliers
Treat variable costs like you’re spending your own money (which you are) by doing this:
Seek trade credit terms with key suppliers
Save thousands on travel by using smart scheduling or teleconferencing
Hire interns from local business and/or design schools
If anything puts family members’ love to the test, it’s asking them for money. Yet it happens every day. In fact, family and friends pour some $60 billion a year into startups, far more than professional investors. While Mom or Uncle Gene may be an excellent source of seed, the money almost always comes with strings attached. “It’s the highest risk money you’ll ever get,” says David Deeds, who has taught entrepreneurship at Case Western Reserve University in Cleveland. “The venture may succeed or fail, but either way, you still have to go to Thanksgiving dinner.”
Fortunately, there are ways to increase the odds that your relationships remain harmonious. A classic mistake is hitting up friends and family too early, before a formal business plan is in place, says Stephen Spinelli, who has served as director of the Arthur M. Blank Center for Entrepreneurship at Babson College.
No matter how excited you are about your idea, you need to be as rigorous as you would be if you were wooing the most jaded banker. That means supplying formal financial projections, as well as an evidence-based assessment of when your loved ones will see their money again. Why? For one thing, it lets your investors know that you think of their funds as something more than Monopoly money. And for another, it reduces the likelihood of unpleasant surprises.
On that note, we can’t stress this enough: Make sure that your friends or family understand the real risks of investing in your startup. For that reason, avoid approaching people with little business knowledge, who may simply want to invest in your startup out of a sense of loyalty or altruism. Make sure your investors can afford to lose the money; it’s not appropriate, for instance, for an older family member to sink their retirement savings into your startup.
Before you make the ask, think about how you want to structure the arrangement. Are you willing to give up equity? Or would you rather pay interest on a loan? The answers to these questions have major implications for both your business and your personal relationships.
Many entrepreneurs prefer debt, because it’s cheaper over the long haul and involves no loss of control. Plus, you can deduct the interest as a business expense. On the other hand, if your business expects low cash flow for several years, or if you want to make your balance sheet look stronger because you’re planning to borrow more money from an independent third party, a deal that involves equity could be preferable.
Some entrepreneurs have a relationship with friends and family where they can keep the terms fairly loose, categorizing the investment as an informal loan that will be paid back when the business has stable cash flow (which could take several years).
Whatever the terms, keep in mind that the investor usually comes attached to the cash. For instance, you may be peppered with questions every time you see your loved one. That’s why you need to be careful, warns Deeds. “You want to get the right people onboard,” he says. “The wrong investors can suck up an amazing amount of your time and force you to divert resources away from building the business.”