Financing your startup is one of the most challenging tasks that you will have as an entrepreneur. This article helps you with that challenge by discussing eight ways to finance your startup.
In this article you will learn:
- Realistic sources of business financing
- The pros and cons of each source
- How to select the best method or methods to finance your startup
- Two popular funding sources you should avoid, at least for now
After reading the article, you should have a better sense of how to finance your company. For many entrepreneurs, this article provides one or more viable options for financing your company.
1. Your savings
Most small business owners launch their companies by investing their own savings. The reason for that is that entrepreneurs are often the only ones willing to bet on themselves and their potential.
However, using your own funds requires patience and perseverance.
You have to save money, often for years, until you have enough to launch the business.
You also have to live cheaply.
As a matter of fact, this option is how I funded my startup when I launched it over 10 years ago. I used a combination of my own savings – and luck.
I had been saving money for four years when I changed jobs and moved to a company that offered stock options.
The move coincided with the peak of the dot-com boom and allowed me to bank a tidy profit. I reinvested everything to launch my new venture.
2. Your friends and family
Outside of using your savings, asking friends and family is also a common way to launch a business.
However, the path to working with friends – or family – is filled with challenges and you should walk it carefully.
This option is the easiest way to lose friends and alienate family.
You can get an investment from a family member in two ways: they can lend you money, or they can invest money by purchasing equity in your business. Each method has its pros and cons.
A loan does not give ownership to the lender, but you have to make regular payments to them.
In some cases, the family lender may secure their position by filing a lien against your assets.
An equity investment does not have to be paid back, but it gives the buyer ownership. In turn, this ownership gives them a percentage of the profits as long as the company is in operation.
Depending how you structure the agreement, the investor also has a say in how you manage your company.
By the way, don’t fall for the “silent partner” label.
Even the most “silent” partners can become particularly vocal when their money is at stake.
If you decide to finance your business through friends and family, opt for a loan if possible.
A loan has monthly payments, but it also has a definite end. Resort to selling equity only if the person can contribute money as well as work, experience, or valuable contacts – preferably all three.
Regardless of which investment vehicle you use, have an attorney draw up professional loan or equity sales documents. And, above all, honor your agreements to the letter.
3. Your credit
Many entrepreneurs launch their companies by tapping their credit cards and home equity.
Nearly every entrepreneur has used this option at one point or another, but tapping credit has risks.
If you must go this route, try using credit cards instead of your home equity. The repercussions of not paying credit cards are often lower than for not paying a home loan.
If things go wrong, the last thing you want is to put your home in jeopardy.
If you decide to use your home equity – and I suggest you don’t – don’t tap it completely.
Make sure to leave enough to allow you to sell the house with minimal out-of-pocket expenses, in case of emergency.
4. Your future
The press is full of stories of entrepreneurs who bet their retirement savings on their companies and won big.
Good for them.
Unfortunately, the press does not tell the stories of the thousands of people who bet their retirement funds on their businesses and lost it all.
I assure you that the latter greatly outnumber the former.
If you decide to go this route, try to get a loan from your 401K instead of taking a distribution.
Some employers allow loans, though they have restrictions. However, getting a loan helps you avoid the 10% penalty associated with taking a regular distribution.
I also suggest that you speak with a financial planner before tapping your retirement savings.
The repercussions of losing your 401K are fairly significant and can last a lifetime.
5. Regular bank loans
For some reason, a number of writers recommend getting a conventional business loan to start your business. Simply put, banks lend against collateral.
Most startups have little or no collateral.
Unless you are looking to start a franchise or have substantial personal assets that you are willing to pledge, you will not get a conventional business loan.
It’s that simple.
6. SBA guaranteed loans
However, you may be able to get a loan that is guaranteed by the Small Business Administration (SBA). Note that the SBA does not actually make loans, it only provides guarantees.
These guarantees entice regular banks to lend money to entrepreneurs.
The SBA has a microloan program that offers easy-to-get loans for small business owners. Microloan amounts vary, up to a maximum of $50,000, and are available to startups.
Furthermore, they often come bundled with technical advice on how to launch and manage a business. This feature makes SBA microloans a win for many small business owners.
Individuals with more significant financial need can use a 7a loan, though these loans have tougher qualification requirements and take longer to obtain.
This solution is not yet widely known, except in a few niche industries. However, factoring has been gaining popularity as an alternate source of financing for companies that have cash flow problems.
Many small business owners don’t plan for the fact that most commercial sales are paid in net-30 to net-60 days. That is, clients pay invoices one to two months after getting the product or service. This payment delay often creates cash flow problems.
These problems can be solved using any of the previous financing options discussed.
However, a financing tool called invoice factoring can fix them as well. Factoring provides financing for your slow-paying invoices, which helps with cash flow.
One advantage of factoring financing is that it’s relatively easy to get and is often available to startups and self-employed individuals. However, factoring is not cheap.
As a result, factoring should be used only by businesses that have gross margins of 20% or more.
8. Purchase order financing
Purchase order financing is also a niche financing tool that has been gaining popularity recently.
Purchase order financing helps companies that re-sell goods to other companies.
This option provides funding to pay supplier expenses, which allows you to fulfill the order.
One advantage of purchase order financing is that it can help you fulfill large orders – those that exceed your current capitalization.
However, this solution has limitations as well. It can help you only if you use a third-party company to manufacture goods and if your gross profit margins are high.
The eight options discussed here present you with realistic ways to finance your startup.
Choose the one – or ones – that best suit your needs.
You probably noticed that I did not list venture capital and angel investing as options. This omission was intentional because these forms of financing are difficult to get.
Many entrepreneurs spend an inordinate amount of time and resources pursing these options, only to come up empty-handed. Unless your business is unique and has the potential for a quick ramp-up, your time is best spent elsewhere.
However, if you do decide to pursue angel and venture investors, you may be better off spending some time growing your company first.
Nothing gets the attention of a venture capitalist more than a company with revenues, or, better yet, profits.