Step 3: Financing Your Business
Financing your start-up business can prove to be one of the most stressful times in actually getting your business off the ground. There are few businesses that can be started with little or no money. The fact is that you must have some sort of financing in place in order to launch your business. This section is designed to outline the different financing options and to discuss the pros and cons of each option.
Many different financing options
Below is a list of the major financing options that most entrepreneurs have to choose from:
• Bootstrapping – Personal savings, credit cards, and other forms of personal funds
• Friends and Family
• Debt Financing
• Angel Investors
• Venture Capital
Let’s dig into each of these areas a little further.
Bootstrapping is one of the most common methods used to finance a new business. This is where an entrepreneur uses his/her own funds to finance their business. These funds can come from a variety of sources, such as personal savings, credit cards, home equity lines of credit, or by selling off other assets to free up needed cash. This is by far the easiest way to get money; however, it can also be the riskiest.
• Nobody will be looking over your shoulder and criticizing your business’s financial decisions.
• You maintain full control of the company because you don’t have to give up partial control in order to receive financing.
• You can get the business up-and-running much quicker since you don’t have to rely on outside funding.
• If the business fails, then 1) you risk losing your personal savings or 2) you risk having to pay back credit card and/or home equity line of credit money on business expenses that you no longer reap any rewards from.
• Oftentimes, using personal funds inhibits a business’s ability to grow since funds are usually limited.
Friends and Family
This funding option can be tricky. Many of us know a friend or family member who has a good amount of money set aside. It’s often very tempting to try and talk friends and family into financing your business. You must walk a tight rope when going this route; you don’t want to exploit the trust these people have in you, but you want to get the financing you need for your business. It can be a slippery slope if the business goes downhill…these people are some of your closest allies, but borrowing funds from them can put a strain on your relationship. Typically you offer to repay these people over a given amount of time or you give them equity in your company.
• No heavy duty contracts to sign. Many times these funds come without a contract at all. You should still draw up a simple contract to make both parties feel more comfortable.
• Flexible loan terms. Your friends and family are usually willing to defer loan payments until you can actually afford them.
• Availability of funds. Usually these types of funds are readily available.
• If you cannot pay back the funds or if the business fails, then this can put a serious strain on your relationship.
• You probably cannot tap this source for more funds if you need them; usually a limited amount of funds available.
This funding option is usually aimed at very specific types of businesses or business owners. Grant money is often set aside for businesses who fill a specific need either through the products or services (e.g., technology or science) or through the demographic of the business owner (e.g., minority, veteran, woman). Grants are usually aimed at furthering existing, specific businesses…not for starting up a new business.
• Free money – Typically no interest or payback terms
• Can be very difficult to get. People are often misled by the ease of getting a grant (usually by someone offering to help them navigate the process for a fee). Generally speaking, getting a grant for a new, start-up business is very difficult if not impossible.
• Tight restrictions on how you can use the money and what the money is to be allotted towards.
• Application process can be very intimidating and competitive.
This type of financing requires a business owner to get loans from an organization or institution in order to launch the business. Getting a loan for a start-up business can prove to be a very difficult and involved process. Banks typically won’t lend money to brand new start-ups, which forces budding entrepreneurs to look towards SBA backed loans. The SBA loan process can be difficult and is best navigated with the help of a professional. It is best to talk with several banks and loan officers in order to compare services and rates.
• Can get favorable or lengthy pay-back terms. This depends upon the source of the loan, but generally speaking you can get a repayment term of 5-10 years.
• Don’t have to give up equity in the business to get a loan, just have to make timely payments.
• Can be difficult to get. Most banks require at least 2-years of operational history in order to approve a loan.
• Loan packages will be scrutinized very closely to determine the business’s ability to repay the loan. You must have a solid business plan and be able to back-up the numbers. Loan officers will look for market analysis, projected sales/profit, and explanations of where you found your research.
• You may have to provide collateral for the loan such as your home or other tangible assets.
• You will have to pay interest on the loan.
An angel investor is typically an affluent individual, or group, who provides financing for a business start-up. This financing is usually exchanged for equity/ownership in the business (equity financing). Angels typically bear a lot of risk when investing in a start-up business; therefore they require a high rate of return. This return is normally given back to the Angels when the business achieves its exit plan (i.e., through an initial public offering or an acquisition by a larger company). Angels are typically not interested in providing small sums of money and prefer to invest sums of $1MM and up. Angels are typically looking for a return on investment (ROI) of 10 times or more when objectives are reached.
• No need to make monthly payments to Angel Investors.
• Angels are typically very experience business men and women who bring more than just money to the table. They offer an invaluable pool of resources, advice, contacts, and experience to the business owner.
• Angels understand the business cycle and they know that it takes years to achieve the stated business’s exit plan.
• Angels only invest in businesses with significant upside.
• Angels will do a very in-depth analysis of your business plan and management team. These items must be up to par or you will find it very difficult to get money from an Angel.
• Angel investors are very hard to find. If you do find them, then it can be difficult to get in front of them to make your pitch. If you get the chance to make your pitch, then it better be good…because you most likely won’t get a second chance.
• You give up equity in your company.
• You will be required to provide financial and business reporting on a regular basis to Angels. This can cause stress and can take time away from other duties.
Venture capital (VC) is a type of private equity aimed at providing businesses with the needed funds for future growth. VC money is typically exchanged for a certain amount of ownership in the company (equity financing). There are venture capitalists who invest their own money into businesses and there are venture capital funds, which are pooled investment funds (from various sources) and are professionally managed.
Many budding entrepreneurs misunderstand VC funding and loosely throw around the term “VC”. In reality, VC funding is VERY hard to get. VC firms only want to invest in large projects that have to potential to be huge (e.g., they want to invest $10MM into a business that can be taken to $100MM++). Also, VCs typically will not invest in a brand new start-up business. VCs prefer that a business has already gotten through the start-up phase and is ready to enter the growth phase. VC firms may look at 1000 deals in a year, but only choose to fund 10. That’s right, about 1% of deals that go in front of VCs get funded. Of this 1%, VCs are looking to hit a home run with 1-2 of them. This home run can be very profitable for the firm and justifies additional expenditures in other deals.
• VCs have the money, expertise, and resources to help take your business to the next level and beyond.
• VCs typically have access to millions of dollars in available funds.
• VCs will typically require that you give up anywhere from 40-60% ownership of your business.
• They may require that you remove key managers and replace them with people of the VC’s choosing.
• They prefer to invest in businesses that are established and well past the start-up phase. They want to invest in a business that is ready for fast growth, not a business that needs two years before it’s ready to sell products.
• VCs will put your business plan under a microscope for the highest level of scrutiny you can imagine. You must have every part of your plan dialed-in and justified. They will want to see an aggressive growth strategy and a clearly defined exit plan.