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Start It Up

Sources of financing and capital for a new business

Matt Whetstone

By Matt Whetstone

Matt Whetstone leads First Bank’s business team. He leverages his lending expertise and understanding of business operations to make great things happen for First Bank clients in Southeastern Illinois and Southwestern Indiana. His team is focused on building relationships, helping clients manage risk and keeping businesses in our communities profitable and thriving.

Unless you’re lucky enough to have all the cash you need to start a business, it’s time to consider all of your options for securing start-up funds. There are several potential funding sources—whether you choose one or a combination depends on what kind of business you’re starting and how much help you need.

All funding sources fall into one of two categories:

  • Debt capital is the most common type of start-up funding. This is borrowed money you obtain from your bank or family and friends. It could be short-term funding, like a line of credit for extra inventory or long-term loans for buying new equipment or real estate.
  • Equity capital is a less common option for start-up funding in which you sell part of your business to raise cash. In effect, you give up some of your equity in the business in order to help it grow. However, you need substantial amounts of capital to make it worthwhile to the investor. This is why debt capital is a more popular route to growth.

In this article we’ll cover the various sources of both debt and equity capital as well as the risks and requirements of each type.

  • Personal savings and investment accounts are the most obvious source of bootstrap funds.
  • The next place to look is your 401(k) or IRA account. Just be sure to consult with your tax advisor before using this option since you will run into tax issues and penalties for early withdrawal. If you have a Roth IRA, you may be able to withdraw contribution funds without penalty.
  • Homeowners may have enough equity to raise funding through a home equity loan, HELOC, or cash-out refinance.
  • Sell personal assets. Many people have recreational vehicles, boats, or other “toys” that could be sold to raise capital. Sometimes the entrepreneur must decide where his priorities are and make tough decisions.
  • As a last resort, you could take out a personal loan or use credit cards to finance your start-up. Just keep in mind that you’ll be personally responsible for making payments whether your business generates income or not.

Borrowing from family and friends

You’ve probably heard the saying “friends and money don’t mix.” That’s why it’s essential to create an agreement, with the loan terms clearly stated, when borrowing capital from friends or family. Both parties should understand and agree on repayment terms and other considerations such as not discussing business at family gatherings.

Hire an attorney to draft your contract so that everything is crystal clear. You want to preserve your relationship with the friends or family members you borrow money from, and the best way to do this is to make sure they understand what they’re getting into.

There are two approaches to personal borrowing:

  • You’re given the money and you pay it back when you can. Are they lending to you personally or to the business? It’s an important stipulation because money received by you personally (to inject into the business) impacts your estate, while money received professionally will affect your business. Make sure you’re clear.
  • Re-pay the loan with interest. The lender gets slightly more than a bank deposit rate; you get a loan with a lower rate than what a bank would typically offer.

In either case, the lender might want some shares in your business. It’s important to be clear about this, and to state it in the lending agreement.3

Venture capital

Venture capital companies are professionally-run businesses that look to invest in companies they anticipate will be sold to the public or to a larger company at a high rate of return. They rarely invest in an untested idea, preferring businesses that can demonstrate rapid, consistent growth and guarantee a worthwhile return. As shareholders, venture capitalists earn a portion of annual revenue – but the real profit isn’t made until the company is sold.

So, to attract venture capital, your business should be in a fast-growing industry and part of a large market, have a solid and up-to-date business plan for continued growth and a proven management team, and be able to bring in investment returns of 20% to 30% each year. Venture capitalists prefer to invest in larger projects, typically in the millions of dollars.

If your business is in a fast-growing industry with a large market potential, the National Venture Capital Association (NVCA) is a good place to look for funding.

Angel investors

When most people talk about venture capital, they actually mean angel investors. An angel investor is often a person who has some experience or knowledge of your industry and is looking to invest in start-up businesses to gain a return.

The best time to approach angels is when you can clearly demonstrate that their investment will help launch your business. So, you need to be ready to discuss your business’s financial projections, its current and potential value, your competitors, any protection you have over your products or services, and how you want to structure a deal with an investor. Make sure you have all your paperwork in order such as your accounts, IP ownership and contracts with staff and suppliers.

Keep Your expectations low

Less than four percent of Angel Investor funding requests get funded, according to the Angel Capital Education Foundation. Venture capital requests that get satisfied are even lower.

For more information, check out the Angel Capital Association and other groups.

Crowdfunding

Described as “democratic financing,” crowdfunding allows a number of people to invest small amounts of money in your business, often in return for the products you’re selling.

It’s particularly useful for entrepreneurs and potential small business owners with ideas that aren’t bankable in the minds of traditional lenders.

Having gained popularity over the last few years, crowdfunding lets you receive donations on the Internet to help get your business idea off the ground. You can offer people incentives, such as bumper stickers and tote bags, to encourage them to support your business.

Kickstarter is a commonly used crowdfunding platform.

Commercial bank loans

While commercial banks are the most likely source of financing for established small businesses, they are not a consistent source of start-up financing. This is because banks are loaning their customers’ personal savings and are required by law to only make loans that are secured and have a defined source of repayment. Many start-up ventures have neither. Therefore, the level of risk and the quality of your management team or your own prior experience in successfully starting a new business can impact the lender’s decisions.5

The more organized you are, the better your chances of success. Prepare the following:

  • The cost of buying or setting up your business, including the stock or equipment you’ll need.
  • How much you think you’ll need to borrow and how much you’re contributing yourself from savings, family assistance, or investors.
  • What you’ll use to secure the loan, if anything. Borrowing against your house is common, but other options are available.
  • How you intend to repay the loan, ideally from the extra profit the business will make after you put extra capital into it.
  • Other personal debts and sources of income you can use to repay the loan.

If you can provide the bank with that information at the start, you’ll be able to reassure them that you’ve thought carefully about the basics.

U.S. Small Business Administration (SBA) Loan Programs

The SBA is a government department aimed at helping small businesses through lending and education. You can apply for an SBA loan from your local bank as long as they are an approved SBA lender. Your bank will help you navigate the SBA process and provide assistance as you prepare your loan application. For start-up businesses, the SBA normally requires the business owner to supply one-third of the total funds required. Additionally, the funds provided by the SBA need to be secured by business assets, and the owner will be required to personally guarantee the loan.

Local government grants and loans

Most local governments have economic development departments that administer grants and loans from various state and local agencies. Generally, the size of these grants and loans is directly tied to the number of jobs the business will create in their community. The availability of these funds varies from state to state and from community to community.

We recommend that you contact the local economic development office to determine what is available in your area.

Summary

If you feel discouraged, keep in mind that there are a number of ways to raise capital. Most business owners work out a combination of options to best suit their needs. For example, if you can obtain government funding assistance, you may decide not to borrow from the bank. Instead, you’ll sell off unused equipment to raise the difference.

Take the next step!

You’ll make the best decision after carefully considering all the options and speaking to a financial advisor about what will work best for you. Now, it’s time to take the next step—check out our article on “9 Tips for Presenting Your Business to Lenders and Outside Investors.

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