How to Get Money to Start a Business – 8 Startup Financing options
Every year, hundreds of thousands of Americans launch their own businesses. According to the U.S. Small Business Administation (SBA), in 2010, there were 27.9 million small businesses in the U.S. The majority of these – more than 75% – were identified by the government as “non-employer” businesses, meaning that the owner is the only person working at the business.
The odds of success are long. Only about half of new businesses survive for five years, and only a third remain in operation after 10 years. Despite this, a small percentage mature into stable small- to mid-sized businesses, while a microscopic fraction becomes the stuff of legends – like Apple or Hewlett-Packard, companies born in garages that ultimately ascended to the highest ranks of American business.
Before your business can have any hope of becoming a legend (or even just profitable), you need to find a way to finance its birth. The SBA states that in 2009, the Ewing Marion Kauffmann Foundation estimated the average cost of starting a new small business in the U.S. to be about $30,000. To estimate what it will cost to launch your business, check out an online startup cost calculator, such as the one provided by Entrepreneur.com. While the number may seem shockingly high, today’s entrepreneurs have a wide range of options when it comes to financing startups.
While self-financing your startup can be relatively easy, it comes with a big downside: You’re entirely on the hook if the venture doesn’t pan out. Still, it can be an attractive option, and if you’re in the position to get the needed funds from your own reserves, there are a variety of ways you can go about it.
Tap Personal Savings
Tapping your own piggy bank is the eASIest way to finance a small business. Whether the money comes from your checking account, a family inheritance, or funds sitting in an old money market account, using your own cash is not only popular but also demonstrates a business owner’s commitment to other potential investors, which can ultimately help win additional funding from third parties.
Sell Personal Assets
Perhaps you own real estate, stocks, bonds, or valuable family heirlooms that you are willing to sell in order to raise cash to fund your business. Selling assets for cash is a time-tested way to raise money, but there can be tax implications linked to selling certain assets, especially real estate and stocks. Be certain to take that into account before you take the plunge; otherwise, you might find yourself facing an unexpected capital gains tax from the IRS.
Use Credit Cards
Credit cards can provide a quick and easy way to finance the purchase of items needed to launch a business. It is important to remember, though, that credit cards also come with hefty interest rates for balances that remain unpaid at the end of the month. As of April 2015, interest rates on unsecured credit cards range from about 13% to 22% for those with fair to good credit scores. However, if you miss a payment, that rate can zoom as high as 29%.
It may be difficult to keep up with payments in the months before your business generates enough revenue to start paying down the debt. If you do plan to use credit cards to fund your small business startup, it’s best to use cards offering rewards or cash-back programs for business purchases. Also, if you plan to borrow the money for a short period – 18 months or fewer – look for credit cards with a low or 0% introductory annual interest rate (APR).
For example, the Chase Ink Cash Business credit card offers $200 in cash back bonuses, provided you make purchases of $3,000 during the first three months. The Ink Cash Business card also features a 0% introductory rate on purchases and balances transfers during the first year, and specified cash back bonuses on spending at office supply stores and restaurants.
Borrow Against Your Home
If you own a home, you can borrow against the equity in the property. Home equity lines of credit (HELOCs) and home equity loans (HELs) are popular ways to access your home’s value. However, since the financial crisis, lenders have significantly tightened the restrictions on such loans and lines of credit.
Many lenders require borrowers to retain at least a 20% ownership stake in the home – the difference between its value and any mortgages or loans still owed on the property – after the transaction is completed. For instance, say you wanted to take a $30,000 loan against a home valued at $300,000. In order for you to retain at least a 20% equity stake ($60,000) in the home after the new loan, the total post-loan debt on the house would have to be less than $240,000; subtracting the $30,000 loan from $240,000 means the existing mortgage on the house – prior to the loan – could not be more than $210,000.
With a HEL, you borrow a fixed amount with defined repayment terms under fixed or variable interest rates. There are usually closing fees for HELs.
On the other hand, a HELOC allows you to borrow up to a specified sum as needed, paying interest only on the amount actually borrowed. HELOCs usually don’t have closing fees, though interest rates normally remain adjustable during a fixed period after the money is drawn.
Take Out a Bank Loan
If credit card interest rates scare you and you don’t own a house, you can try to persuade the bank to lend you the money to start your business. Personal bank loans come with lower interest rates compared to credit cards – currently between 6% and 13%, depending on your credit history.
However, they can be more difficult to obtain in the absence of collateral (such as real estate or a paid-off automobile) to secure the loan. If you have no collateral, or if your credit score isn’t very high, you can boost your chances of getting a bank loan by finding a co-signer, someone with good credit who agrees to be responsible for the debt if you default.
Cash in Retirement Accounts
While the funds in your IRA or 401k might look like a tempting source of cash, there can be very steep penalties for early withdrawals. However, some financial advisors promote a plan that claims to permit individuals who are planning to launch a new business to potentially avoid those penalties.
Supposedly, this can be done by rolling over funds in an existing 401k plan into a new 401k plan created by a C corporation. The owner of the new company can then invest the 401k funds in company stock, thus freeing the money to be used to finance the business. Known as ROBS (rollover for business startup), these plans are popularly promoted online, especially by those hawking franchising opportunities.
While the IRS has not declared ROBS plans explicitly illegal under U.S. tax laws, IRS officials say that they often fail to comply with other tax rules, including the Employee Retirement Income Security Act (ERISA). Setting up a fully compliant ROBS plan can be complicated and costly, and can result in significant penalties if the IRS disagrees with its level of compliance. ROBS plans remain very controversial, and many financial professionals consider them extremely risky and likely to provoke an audit.
An alternative to ROBS plans is taking a loan out against the balance of your 401k. Many 401k plans have some form of loan option that permits you to borrow as much as 50% of the balance (usually up to a ceiling of $50,000). 401k loans normally must be repaid within five years.
Note that during the time of the loan, any money borrowed from your 401k is not earning interest along with the remaining the balance. Moreover, if you miss a payment (or if you can’t repay the loan at all), you will be hit with heavy penalties. Retirement accounts should be considered as a source of startup financing only if all other potential sources have already been tried.
If you can’t tap your own piggy bank, or if your credit score isn’t good enough to convince a bank to lend you money, you can always turn to the people who know you best. Family members and friends can be eASIer to persuade than anonymous bank officials. They are also more likely to look past your current account balances and credit score when determining whether you are worth the risk of extending a loan. Moreover, they are less likely to demand stringent repayment terms or high interest rates – and in the case of family members, you may escape interest rates altogether.
Borrowing from a personal friend or family member is a very popular option. In fact, a 2015 survey by Pepperdine University found that 68% of responding small businesses used financing from the owners’ friends and family.
Needless to say, borrowing from friends and family comes with its own set of risks. If the venture fails, or if it takes much longer than anticipated to repay the loan, your relationships can suffer. If you default on a credit card or bank loan, you don’t have to sit down to Thanksgiving dinner with the loan officer or credit card company. If you fail to pay back Aunt Sally, you may never hear the end of it.
Few things can complicate friendly or familial relationships like misunderstandings over money. If you decide to borrow from those close to you, make sure that you have all the terms of the loans clearly written out. That includes how much is to be borrowed, the amount of interest charged, and the timetable for repayment.
Created by Congress in 1953, the SBA doesn’t lend directly to small businesses. Instead, the SBA offers a variety of guaranty programs for loans made by qualifying banks, credit unions, and nonprofit lenders.
Despite the lingering effects of the economic crisis and recession, the SBA says that its loan programs are experiencing “unprecedented growth.” According to the SBA, in fiscal 2014, the number of 7(a) loans extended to small businesses jumped 12% over the prior year, while the dollar value of those loans increased 7.4% over fiscal 2013.
7(a) Loan Program
These loans are a very common means of funding small businesses, and can be used to launch a new business or expand an existing business. There is no minimum 7(a) loan amount, though the SBA states that the program won’t back a loan of more than $5 million.
The SBA says that in 2012, the average 7(a) loan amount was $337,730. For loans up to $150,000, the SBA may guarantee a maximum of 85% of the loan; that falls to 75% for loans above $150,000. The repayment terms state that all owners of the prospective business that have at least a 20% stake in the venture are expected to personally guarantee the loan’s repayment. Furthermore, according to the outline of the use of 7(a) loan proceeds, 7(a) loans cannot be used to repay delinquent taxes, finance a change in business ownership, “refinance existing debt where the lender is in a position to sustain a loss and SBA would take over that loss through refinancing,” or repay equity investments in the business.
Businesses that qualify for a 7(a) loan must comply with SBA standards. If one of partners in the business – with a 20% or greater equity stake – is “incarcerated, on probation, on parole, or has been indicted for a felony or a crime of moral depravity,” the SBA won’t back the loan. Not surprisingly, the SBA also does not back loans to businesses that have previously reneged on any other government loan.
Other restrictions also apply. 7(a) loans are not extended to business that lend money (though pawn shops can sometimes qualify), businesses that are based outside the U.S., entities that generate more than a third of revenue from gambling, businesses that “engaged in teaching, instructing, counseling, or indoctrinating religion or religious beliefs,” and companies “engaged in pyramid sale distribution plans, where a participant’s primary incentive is based on the sales made by an ever-increASIng number of participants.”
There are also specialized loan packages offered under the 7(a) umbrella, including the SBA Express Program, which offers a streamlined approval process for loans of up to $350,000.
Interest rates on 7(a) loans depend on the lender, the size of the loan, and the borrower’s credit history. However, the SBA sets caps on the maximum spread a lender can add to the loan’s prime rate. For loans greater than $50,000 that mature in seven years or less, the spread is limited to 2.25%; that rises to 2.75% for loans over $50,000 that mature in more than seven years. If the current prime rate is 3.25%, loans above $50,000 that mature in under seven years could come with interest rates as high as 5.5%, while loans greater than $50,000 that mature in less than seven years might features interest rates as high as 6%.
The SBA allows lenders to charge a higher spread for 7(a) loans less than $50,000 – between 3.25% and 4.75%, depending on the size of the loan and its maturity period. With the current prime rate, loans under $25,000 may have interest rates as high as 7.5%, if they mature in less than seven years, and as high as 8%, if they mature in more than seven years. Loans between $25,000 and $50,000 may have interest rates as high as 6.5%, if they mature in less than seven years, and as high as 7%, if they mature in more than seven years.
There are no fees on 7(a) loans less than $150,000. For loans greater than that amount that mature in one year or less, the SBA set a fee of 0.25% of the portion of the loan it guarantees. A fee of 3% is set on the portion guaranteed by the SBA on loans of between $150,000 and $700,000 that mature in more than one year. That rises to 3.5% for similar loans over $700,000. These fees are paid by the lender, but can be included in the borrower’s closing costs.
7(a) loans are repaid in monthly payments that include both principal and interest. Interest-only payments are permissible during a business’s startup and expansion phases, subject to negotiation with the lender.
While SBA-backed 7(a) loans are a popular vehicle for small businesses, lenders are much more likely to offer them to existing businesses that have several years of financial paperwork to demonstrate their viability.
Offered through specified nonprofit community-based intermediary lending organizations, the SBA Microloan Program provides loans of up to $50,000 to fund startup and expansion costs for small businesses. Microloans can be used to finance the purchase of equipment, supplies, and inventory, or as working capital for the business. However, it may not be used to repay existing debt. The SBA says that the average microloan is about $13,000.
The SBA requires all microloans to be repaid within six years. Interest rates on microloans are negotiated between the borrower and the lender, but typically fall between 8% and 13%.
Intermediary lenders typically have specific requirements for Microloans, including personal guarantees from the entrepreneur and some form of collateral. Borrowers are also sometimes required to take business-training courses in order to qualify for the microloan. Microloan lenders in a given area can be identified at SBA District Offices.
Microloans are particularly attractive for potential entrepreneurs who have weak credit scores or few assets and would be otherwise unlikely to secure a traditional bank loan or 7(a) loan. Many microloan lenders are community organizations that offer specialized programs to assist entrepreneurs in certain business categories or demographic groups.
Venture capital firms make direct investments in fledgling companies in exchange for equity stakes in the business. Since most VC firms are partnerships investing firm money, they tend to be highly selective and usually invest only in businesses that are already established and have shown the ability to generate profits. VC firms invest in a business with the hope of cashing out their equity stake if the business eventually holds an initial public offering (IPO) or is sold to a larger existing business.
In “The Small Business Bible,” USA TODAY business columnist Steven D. Strauss notes that competition for VC funding is intense. Individual VC firms “may receive more than 1,000 proposals a year” and are mainly interested in businesses that require an investment of at least $250,000. They will usually only invest in startups that show potential for explosive growth.
If you can’t get enough cash from the bank or your own assets and you don’t have a rich uncle, you can always look for a wealthy non-relative. Some well-off individuals like to invest in startup ventures – often in exchange for an equity stake in the new business. These investors are known as angel investors. Typically, an angel investor has been successful in a particular industry and is looking for new opportunities within that same industry.
Not only can angel investors offer financing to get your business off the ground, but some are willing to provide guidance based on their own experience. They can also leverage their existing contacts within an industry to open doors for your business.
So how do you find these angels? It can take some research. Many angel investors prefer to keep a low profile and can only be identified by asking other business owners or financial advisors. Other angels have joined networks, making it eASIer for potential startups to locate them.
Here are a number of organizations that can put your business in contact with angel investors, both individually and in groups:
There are a variety of ways to approach angel investors, from calling their office to make an appointment, to simply chatting one up at an investment conference. Certain angel organizations hold periodic conferences and networking meetings. However you end up meeting with a potential angel, you have only a limited time to make a strong impression, and every second counts.
In his book “Fail Fast or Win Big,” author Bernhard Schroeder notes that “angel investors typically only do one to three deals per year and average in the $25,000 to $100,000 range.” He says that these angels may meet with between 15 and 20 potential investment candidates per month. So the odds of grabbing an angel’s attention aren’t especially high, but they’re still better than the chances of getting a venture capital firm to invest in your startup business.
So, if you want to go the angel investor route, practice your pitch until you’ve honed it to an art. As quickly as possible, you need to make clear why your service or product will be a hit with consumers, why your business will stand out in the market, why you are the right person to run the business, and how much of a return on investment the angel can expect. This is sometimes called the “elevator pitch” because the amount of time it should take is not more than an elevator ride – about two minutes or less.
Businesses have been using the Internet to market and sell things since the 1990s. However, over the last decade, the web has become a new source of financing as well.
Using crowdfunding websites such as Kickstarter, entrepreneurs, artists, charities, and individuals have been able to post online appeals for cash. For example, in 2013, Hollywood screenwriter and producer Rob Thomas used Kickstarter to raise $5.7 million to finance a movie project based on the cult TV series “Veronica Mars.” More than 90,000 people pledged small sums of money to realize Thomas’s goal. By 2015, Kickstarter had drawn pledges totaling more than $1.6 billion for more than 200,000 separate projects, of which more than 81,000 were successfully funded.
Prospective entrepreneurs who seek funding on a crowdfunding platform need to understand the rules of the game. Some crowdfunding platforms hold funds collected until a specified goal has been raised. If the goal isn’t met, the funds may be returned to the donors. The platforms also take a cut of the money raised – that’s how they fund their own operations.
Many crowdfunding efforts are not successful. ArsTechnica reports that a 2013 effort by Canonical to raise $32 million to develop a high-end super-smartphone running both AndROId and Ubuntu Touch failed after raising just $12.8 million on Indiegogo, a popular crowdfunding website. As a result, Canonical did not receive any funds from the effort.
In order to attract the attention – and cash – of individual donors, you need to have a good story to accompany the pitch. Also, the business will likely have to promise donors something in exchange for their money – a free perk such as a t-shirt or sample product to generate enthusiasm. It’s a good idea to emphASIze your own personal commitment to the startup in your pitch, stressing the time, effort, and cash you have invested yourself. Adding a video appeal often helps as well.
Other popular crowdfunding platforms include the following:
Simply put, peer-to-peer (often denoted as P2P) lending means borrowing money without going through a traditional bank or investment company. Under P2P, a borrower posts a loan request on a P2P platform – such as Lending Club or Prosper – stating the amount desired and reason for the loan. Potential investors review the request and agree to loan various amounts of money to the borrower up to the desired amount. Once a loan has been funded, the borrower receives the total amount lent and then pays the loan back through fixed monthly payments made to the platform, which then repays the investors based on the amount each one lent.
Online lenders, including P2P platforms, are becoming a major source of small business funding. A study from the Federal Reserve Banks of New York, Atlanta, Cleveland and Philadelphia found that 20% of small businesses surveyed had borrowed from an online lender during the first six months of 2014. Approval rates for such loans were higher among online lenders compared to traditional banks.
While P2P lending has advantages over traditional bank loans – including lower interest rates, fewer fees, and greater flexibility – the bASIcs of lending still apply. Borrowers have to fill out an application and provide financial information that will be assessed by the P2P platform. So, you need to have a decent credit score to obtain a loan, and your credit will be damaged if you default on it.
If you have a good idea for a business, but need a lot of help (both money and guidance) in getting it up and running, a business incubator could be the way to go – if you can get your business into one.
Business incubators are exactly what the name suggests: an organization dedicated to providing services and support to fledgling companies. Business incubators are run by venture capital firms, government agencies, and universities with the goal of nurturing new business through their earliest stages by providing marketing, networking, infrastructure, and financing assistance.
Idealab is a good example of a business incubator. Founded in 1995 by legendary Pacific Investment Management Company (PIMCO) co-founder Bill Gross, IdeaLab says it has helped launch 125 companies, 40 of which have gone on to hold an IPO or be acquired by a larger company.
To become involved in an incubator program, a prospective business owner has to complete a lengthy application process. Requirements differ among various incubators, but the entrepreneur must demonstrate a strong likelihood of success for the business.
Competition for a spot in an incubator can be very difficult. A listing of business incubators in the U.S. can be obtained through the National Business Incubator Association.
Unless you’re already a millionaire, putting together the financing to launch a new business takes serious planning and effort. The diligent entrepreneur must weigh the benefits and downsides of available funding options and determine which sources of cash provide the greatest flexibility at the least cost.
But you don’t have to limit those options. Many small businesses are started with money obtained from a mix of different sources. Even if you land a significant bank or SBA loan, you may still need additional cash from friends and family, or yourself, to make your startup dream come true. And there will always be unanticipated events and expenses. Fortunately, the rise of new financing sources like crowdfunding and peer-to-peer lending means that prospective small business owners now have a greater range of financing options at their disposal than ever before.
How will you finance your small business startup?
Categories: Small Business
How to Get Money to Start a Business – 8 Startup Financing options