Some years ago, my wife and I wanted to start a business together. My wife was an expert in her field, we had completed all of the necessary research, and we had most of the money required to start the business.
I prepared the business plan, and we submitted it to our bank.
We applied for an unsecured loan to supplement our existing business assets. Notwithstanding our good personal credit, our bank would not grant a loan to our business. They would happily loan money to my wife and me, but not our new business. We were shocked. After the work we put in during the business planning phase, we felt almost entitled to the loan. Nonetheless, while we were certain of business success, our bank was not. The bank wanted to see actual success before they put their money at risk.
Most businesses need money at start-up, and possibly for several months after that until the business can earn revenue for itself. An expectation of ready financing may not seem unreasonable, but, in reality, it often is.
Business financing is normally divided into two categories: Debt and Equity Financing.
Debt financing: For most small businesses, debt financing involves the taking of a loan that must be repaid over a defined period and at a set or variable rate of interest. Irrespective of your business’ success, any debt financing you receive must be repaid.
Equity financing: Equity financing involves the selling of an ownership interest in your business to an investor. Investors put cash in your company hoping to share in its profits and/or to sell their ownership interest, at a future date, and realize a profit. Unlike a loan, you are not required to repay an investment if your company fails.
Let’s take a look at several funding options available to business startups.
For the majority of my clients, I advise that they should fund their business start-up expenses from their own resources. This, of course, is no small issue for most people. The thought of raising maybe tens of thousands of dollars organically can seem daunting. But it is possible, and there are solutions.
Starting a new business does not mean that you quit your day job. If you balance your spending and savings properly, your current income can be a source for future start-up capital. A night job or consulting work can also act as a funding source. Some people balk at these ideas because of the time it will take to raise funds or the embarrassment of working a second job. Well, I did entitle this section ‘sweat equity’!
The beauty of raising money organically is that once you reach your goal, you are free to focus all of your attention on the business of growing your business. If you raise money in any other way, outside of receiving an outright gift, you will serve two masters: (1) your new business; and (2) your creditors/investors.
Friends and Family
I am somewhat torn on the friends and family strategy for raising capital. In my experience, the main reason most friends and family will invest or provide loans to your business is to ‘help you out.’ The fact that your business idea will make them money is rarely the driving force behind their decision to give. If for some reason the business fails, or you are unable to repay a family/friend loan, relationships can be irreparably ruined. The cost of a lost relationship may not be worth the start-up expenses your business needs.
If you are going to do business with family members and friends, treat it like any other business transaction. Develop a business plan, create enforceable legal agreements, and keep your family and/or friends regularly updated concerning the status of your business and their investment.
Using credit cards as a form of business finance is very tricky. A credit card is a short-term loan at a high rate of interest. Credit cards can be great tools for cash flow management. For example, if your company invoices are paid on the 15th of the month and your expenses are due on the 5th, you can use your credit card to pay your expenses and your invoice revenue to pay the credit card. The interest accrued on your two-week loan will be either be zero or nominal.
At no time, however, should you use a credit card(s) for long-term business financing or family maintenance while you work to make your business financially self-sufficient.
Imagine, after months of hard work you have attracted your first client. The bank loan you obtained six months ago has been a lifesaver as the development of your product has taken longer than expected. Unfortunately, development has proven more costly as well. You have spent all of your loan money, and your bank requires repayment now. Your client has agreed to take delivery in three months. You will not be paid for three months!
The problem with debt equity is that you have to pay it back irrespective of how well your business does. The pressure to meet loan repayments can alter the natural development of your business. Maybe a potential client is on the fence concerning your product or service. Your overdue loan may compel you to unduly pressure your potential client into a quick sale. Such tactics may cause you to lose your client.
Angel investors & Venture Capitalists
Venture capitalists and angel investors seek to invest in companies with high growth potential, interesting products and/or services, and a proven management team. However, the investment strategies of venture capitalists and angel investors are different.
Venture Capital: Venture capitalists are professionally managed companies that tend to invest in promising businesses with a track record of success. Unless there is a compelling reason, they tend not to invest in start-up businesses, and they are rarely interested in companies with funding needs of less than a million dollars.
Angel Investors: Angel investors tend to be high wealth individuals willing to provide start-up money to new, typically local, businesses. Investment amounts range between $25,000 and $100,000. A group of business angels may be willing to invest more.
The Challenge You Face.
Raising capital from angel investors and venture capitalists is difficult. The process is time-consuming. The time spent pitching your business ideas to potential investors reduces the time you spend doing the actual work of building your business.
Maybe if the chance of obtaining equity funding were higher, the time spent trying to get it would be worth it. Your average venture capitalist or angel investor may look at dozens of business plans per year and may only invest in one or two. One thing, however, is certain, if you do get funded, your equity investor will demand a significant ownership share in your business and a high financial return on their investment.
If you believe equity funding is worth the effort, try to delay your capital raise until you can build brand recognition and demand a high business valuation from your investors. Remember, you are selling a significant portion of your business to a person/entity who may not share your business vision. You should only seek investment from angels and/or venture capitalists if your business will fail without them.