One of the primary goals of starting a business is to make money. However, it takes
an undeniable amount of capital in order to properly launch and sustain a business.
This amount of money for a given venture has to do with the unique goals and needs
of the entrepreneur. It is crucial for a new business to develop resources and additional
means to obtain further capital because without proper financing, a new enterprise
may find it extremely difficult to compete with an already established competition.
In addition, the lack of funding may also lead to a company closing or even worse,
bankruptcy. It is important to consider the pros and cons of different financial
sources that are available in order to make an effective educated decision to fund
a startup.
Bootstrapping
This term refers to a company owner who decides to solely fund their business on
their own without depending on outside sources for financial support. In this type
of funding, the entrepreneur often evaluates all of his/her assets, including personal
savings accounts, credit cards, equity in real estate, retirement accounts, vehicles,
recreational equipment, and even collectables. By assessing their personal assets,
a business owner can easily generate cash if they decide to sell their property.Â
They can also use these possessions as collateral for a future loan. The more money
that an entrepreneur uses on their own for their business, the more likely they
will acquire capital from other sources when they need it in the future.
Pros- When business owners decide to bootstrap their business, they are
able to gain complete independence of their company and avoid having a diluted role
when investors, directors, etc. are introduced.Â
Cons– Unless the business owner is rich, they will have much financial
constraint when using their own finances. Their company may be underfunded, they
may underestimate business costs, and/or do not have the resources and support (financial
advisors, mentors) that the business needs to successfully take off. Bootstrapping
entrepreneurs also have the tendency not to write a business plan, which increases
their chance of failure since the business is less likely to be researched, analyzed,
or have outside feedback. In addition, many people use credit cards to fund the
costs of their startups. Even though this is a quick and easy way to obtain the
money that is needed, they end up spending large amounts on the credit card interest
payments.
Friends, family, business associates
When self-financing is not enough to provide the needed capital for a startup, business
owners usually turn to their families, relatives, friends, and business partners
for further financial support. These people tend to provide much needed support
to the entrepreneur and enjoy the excitement and success of the new venture.
Pros- Loans from family, friends, and partners can be obtained quickly
since they share with the entrepreneur a relationship that is based on a more personal
level. Business owners have the benefit of not paying back interest or providing
a monthly payment as bank loans require.
Cons- One downside of borrowing money from friends, family members, and
associates is the fact that the entrepreneur may give up more ownership of their
company. The more partners involved, the more profit will be divided among all members.Â
Friends and relatives who provide business loans sometimes feel that they have the
right to offer suggestions concerning the management of the business. Their suggestions
may sometimes be contrary to the entrepreneurâs strategy and may even strain
personal relationships. Entrepreneurs should repay the loans as quickly as possible
in order to avoid interpersonal conflicts among family members and friends.
Government funding
While the Small Business Administration (SBA) does not lend money to businesses,
they act as a guarantor through a network of local lending partners to help promote
the startup, growth, and success of small businesses in the United States.
Pros- SBA loans provide a good way to and promote a better interaction
between local lenders and borrowers. These loans will also increase the chances
of an entrepreneur to get a bank loan.
Cons- The guidelines are strict and the network of lending partners may
reject applicants based on income, assets, type of business, past experience, etc.
Commercial bank lending
Unlike SBA loans, commercial bank loans are not guaranteed by the U.S. government.
Obtaining a bank loan may be difficult since banks use different many criteria when
lending money, including the amount and purpose of the loan, company data (management
and operations), the primary and secondary sources of repayment, financial statistics
(balance sheets, cash-flow statements), credit history, etc. First-time entrepreneurs
may face several rejections from different banks before being approved. There are
three different types of financing options available to entrepreneurs so that they
can fund their startups.
Pros- Commercial banks can offer business owners adequate amounts of needed
money and lines of credit quickly. They are much easier to obtain when they are
backed by assets.
Cons- There is always a chance of rejection when applying for any of these
loans, especially if the business owners have poor credit history, little income,
and no assets. The entrepreneur should also be honest and report their companyâs
progress to their banks or if they received capital from other sources. The business
owner will also owe the borrowed money whether their business succeeds or not.
Commercial finance companies
There are non-bank commercial lenders (aka commercial finance companies) that can
also offer money to business owners. Unlike banks, they are willing to look beyond
oneâs credit history and assets in order to provide the needed capital for
startups. Commercial finance companies have emerged in recent years and give opportunities
to companies that banks will not lend money to.
Pros- Non-bank commercial lenders look beyond financial history and possession
of assets and will lend money to companies who have been turned down by banks.
Cons- These lenders often require a business plan, personal financial statements,
cash-flow predictions, and the borrower to provide 20-25% of the needed capital
themselves.
Personal loans
Another good way to obtain needed capital is by getting a personal loan rather than
a loan under the business name. There are two common types- a home equity loan and
a home equity line of credit.
Pros– Both types of loans are widely available through many financial institutions.
The business ownersâ home is the collateral and interest is tax deductible.
Cons– One disadvantage for home equity loans is that they are comparable
to an additional mortgage on your home; if the borrower cannot make repay the amount,
their home may be at risk for foreclosure. These loans are also risky in the sense
that if the business fails and the entrepreneur is not able to make payments, their
home will be at risk. In addition, if a borrowerâs house value drops, they
may end up owing more on their property than it’s worth, especially if they plan
to sell their home in the near future.
Personal installment loans
This type of loan is an unsecured installment loan that does not require any collateral
for approval. It can be used in combination with other types or sources of capital-generating
practices. These loans are required to be repaid within five years since it provides
only a modest amount of money to the borrower.
Pros– This type of loan is easier to obtain than a standard small business
loan with a fixed interest. Since the product is unsecured, it is ideal for business
owners who are homeowners, or who have a one-time borrowing need.
Cons– A disadvantage is that these loans have high interest rates, limited
borrowing availability, and a non-deductible interest.
Insurance policy loans
A policy loan is a loan that is issued by an insurance company to an individual
that uses the cash value of a person’s life insurance policy as collateral.Â
The individual can borrow up to 80% of the surrender value of his/her life insurance
policy.
Pros- There is flexible repayment options where the borrower can repay
the loan in whole or in part at anytime.
Cons- Traditionally, these were loans issued at very low interest rates;
however, this is no longer true. In addition, if the borrower (the entrepreneur)
fails to repay the loan, the money is automatically withdrawn from the insurance
death benefit.
Angel financing
Angel investors are wealthy individuals who like to invest in small start-up enterprises.
When they invest their money into a business, it is not considered a loan. Instead,
they desire an agreeable percentage of stock or share in a company for their own
financial gain.
Pros- Most angels have experience in the industry of their investment and
most likely have been successful business owners themselves. They can act as effective,
obliging advisors and mentors to entrepreneurs on how to make their business thrive.
In addition, they offer a large sum of money that may not be available from other
sources.
Cons- Angels often require a percentage of stock or shares in their invested
companies. This means that entrepreneurs may have to give up some control of their
businesses.
To read more about the Pros and Cons of Angel Investing, please refer to our related
articles.
Venture capitalist financing
Venture capitalists usually prefer to invest in companies that are in their later
stages of development. They typically invest anywhere from $500,000 to more than
$5 million. Like angel funding, venture capital dollars are invested in exchange
for equity (an ownership share) in a company. VCs obtain their money out only when
the business is acquired by another company or “goes public,” that is,
when its company shares become publicly traded on a stock exchange.
Pros- Venture capital can help business owners expand their companies and
obtain market share.
Cons- By obtaining venture capital, the business owner will no longer be
the sole owner of your company and may lose control. Moreover, a VC may move their
invested company towards an Initial Public Offering (IPO) of publicly traded shares
faster than might be best for the long-term health of the business.
State and federal grants
Federal funds can be granted to startups, especially if they are minority-related
or defense-related non-profit organizations. On a state level, a company seeking
grants to fund their business is encouraged to enroll in an Individual Development
Account (IDA) that requires classroom participation and training on financial management
and budgeting. The program is run with a âmatchedâ savings program in
which participants make monthly savings deposits to an account. For every dollar
that is saved, the participant received at least a dollar added in their account
that can be used towards their business.
Pros- State and federal governments may offer tax benefits to companies
that hire minorities or disadvantaged individuals. The IDA matched savings account
can serve as an invaluable financial management training that enables low-income
American families to save, build assets, and enter the financial mainstream for
their businesses. The money also does not need to be paid back.
Cons- Both state and federal grants provide very limited opportunities
and are available only in small amounts. This type of funding cannot be relied upon
to fund a startup company. In addition, the process to obtain state or federal grants
may take months.
Young companies often face the daunting task of finding an adequate amount of capital
during its early stages of development. There are many types of funding options
available to business owners, including personal financing and loans from banks,
the government, family and friends. In addition, there is angel and venture capital
and state and federal grants to choose from. While there are different funding sources
available, it is important for entrepreneurs to weigh all of their options in order
to find the right type of financing for their new company.