Finding the Money to Start a Business
Having a great business idea is an important piece of starting a business, but even great ideas are sometimes unable to get the funding they need. Here are a few tips on how to finance a business.
Pledging Personal Assets
Personal assets play a major role in financing a business and are used to either be borrowed against or used as collateral to secure a bank loan. Collateral includes the things you personally own that won’t be used in the business like cars, boats, jewelry, stocks, etc.. The bank can use this collateral as security for a business loan.
One of the tools lenders use to evaluate the value of a borrower’s personal assets is the personal financial statement. This looks at an individual’s assets and liabilities.
Bank loans are a popular source of small business funding, however, they can be difficult to get. There are a few different financing options when it comes to bank loans – conventional and guaranteed.
Conventional small business loans are loans made by the bank and are secured by the collateral and the promise by the borrower to pay the loan back. Banks like to make loans for start-up costs on hard-assets like buildings, equipment, vehicles, etc. It’s a little more difficult to get funding for working capital expenses like wages, advertising and cash flow. Banks look for borrowers with a minimum credit score of 650-680 and full collateral. Entrepreneurs starting a business will also need to invest 15%-25% of personal funds in the total project.
To apply for a loan from a bank, they will need personal tax returns, a business plan, and financial projections.
Read more about conventional bank loans.
Guaranteed loans are loans that are backed by the federal government either through the SBA (Small Business Administration) or to a lesser extent USDA (United States Department of Agriculture). Same as the conventional loan, it’s still the bank’s money however, the SBA or USDA guarantees that a percentage of the loan will be repaid should the business fail and the owner not be able to repay the loan. This reduces the risk for the bank and is helpful in situations where the borrower doesn’t have a sufficient credit score or collateral.
Related: What are SBA loan guarantees?
A loan guarantee may also reduce the amount of personal investment to 10%-15%. The guarantee does come at a price with longer processing time, along with higher fees and interest over the conventional loan.
Related: Do SBA loans affect personal credit?
Revolving Loan Funds
Revolving Loan Funds (RLF) or sometimes known as microloans are shorter-term loans at smaller dollar amounts. Depending on the program, these loans typically range from $500 to $150,000 and requirements are usually not as strict as a bank.
Revolving loan programs are available as an economic development tool to help communities prosper by providing financing for entrepreneurs who are not able to secure sufficient capital from banks. These programs focus more on job creation than credit score, improving access to small business funding and growing communities.
These programs are offered by intermediaries such as cities, local economic development agencies, and not-for-profits. List of revolving loan fund lenders by state.
With access to funding from traditional banks to small businesses being more difficult to receive, fewer businesses are eligible for traditional bank funding. Biz2Credit publishes a lending index and their research showing big banks approved 23% of funding requests while alternative lenders approved over 60. Startups have been hit the hardest unless the owners have excellent credit – and even with excellent credit, it’s harder than in the past.
With the large gap between the number of business loans being requested and approved, alternative lenders have largely filled in the gap. Online lenders even offer SBA guarantees and are a great alternative for startups and small business owners without excellent credit.
Other benefits from alternative lenders include much less paperwork and an easier application process than traditional lenders, the ability to have more flexibility regarding collateral requirements and types of loans offered, and almost instant approval between hours to days. The downside is you will likely pay more in interest and have shorter terms than from a bank, but provide a great opportunity to build credit.
Another way to raise funds for a business if you own a home, are home equity loans. Many people will react by saying, “I don’t want to risk our home” but if you own a home with equity the bank will likely ask for a lien on the property in order to make the loan. In either case, your home is at risk.
Home equity loans for a business are usually used as a down payment or used as collateral to reduce the amount of money the business owner needs to put down. Home equity loans from a business are usually at a lower interest and faster to process than conventional loans.
Peer to Peer Lending
Another non-bank alternative to borrowing for a new business is through peer to peer lending networks. P2P lending bypasses the bank and directly connects borrows with investors through an internet-based marketplace. This arrangement serves a need where financial institutions would not traditionally lend.
These networks bypass the bank and let people who need money to borrow from people who are wanting to make a return. Interest rates are determined by the credit score of the borrower, but a great credit score is not required.
P2P lending provides a win-win for businesses and investors. For businesses, entrepreneurs who either don’t want to deal with the lending requirements of a traditional bank or need to access cash quickly, P2P loans are a popular choice. Investors win since they are able to diversify risk by investing in several projects and get a return on their investment.
Business credit cards are a quick way to fund start-up businesses and sometimes even have introductory 0% financing. Even though the credit card is in the business name, the owner’s personal credit is still going to be a huge factor in getting the card. Any type of business from a freelance sole proprietor to an LLC is eligible to get a business card. While a little riskier than a fixed loan and more expensive after a low introductory rate, one can’t overlook the ease of funding from a credit card.
Depending on what you need the money for, credit cards may provide an easier way to finance the startup or expansion of a business. We know that nobody goes into business to lose money, but have seen several entrepreneurs that leaned heavily on credit cards to get started. Some were very successful, but some were not.
An often overlooked source of funding a business is through personal retirement accounts. Most people are not aware they can use their IRA or 410k to start a business and not pay taxes or penalties on that money. These retirement funds can be an excellent way to start a business without going into debt.
There are two ways to access retirement funds and we strongly encourage utilizing the services of an established firm as there is a considerable risk if you do it wrong. Several rules and regulations apply to use retirement funds for an IRA and the IRS wants to be sure people aren’t using them improperly.
One way to use a retirement account to invest in a business is through a self-directed IRA.
A self-directed IRA is an account held with a company (like Etrade or other investing firm) but instead of investing in stocks or bonds, you invest those funds in a small business.
There are some things to be aware of if you plan to fund a business with an IRA.
– Can’t pledge the assets in the IRA as collateral for a loan. If additional funds are needed, the IRA cannot be pledged and the IRA, not the individual) will have to borrow money from other sources. The only loans IRAs are allowed are non-recourse loans, which means there is no personal guarantee for the money being borrowed. As you can probably guess, these funds are very hard to get.
– Self-directed IRAs are intended to be passive investments and the IRA account holder cannot actively manage the business.
– Since the IRA owner cannot actively manage the business, they can’t take a salary.
A second way to invest in retirement accounts and is often a better and more flexible choice is the Rollovers as Business Startups (ROBS). Like the self-directed IRA, you can use retirement funds to fund a business, but unlike the self-directed IRA where the account holder could not actively work in the business, the ROBS must be involved in the business as a bona fide employee.
Some other requirements of the ROBS plan:
– Business owners can pay themselves a salary as compensation for their work – as long as it’s deemed “reasonable.”
– Funds from ROBS can be used as a down payment on a loan. Entrepreneurs are allowed to use other forms of small business financing (i.e. – SBA loans, unsecured credit, etc.)
While self-directed IRAs can be a good option for those who won’t be directly involved in running a business (more common for real estate investors) the rules and regulations make using a self-directed IRA unfeasible. The ROBS plan is more targeted to owners that want to be involved with the business.
Regardless of which one is right for you, be sure to consider that using retirement funds to finance a business comes with significant risk. If the business fails, you are risking having money for retirement.
An often overlooked but creative way to get money to start a business is through preselling to customers. When you have the business close to launch, you can ask customers to pre-order before having the product or service ready to sell.
We worked with a company that rented products to college students moving on campus. Since the customer would not need the product until school started, the company was able to collect deposits to use as a down payment for a loan.
One interesting benefit when preselling to customers is the entrepreneur has the opportunity to see if the market really wants their product or service. We have worked with too many entrepreneurs who had “a great idea that can’t fail” but they never put in front of a customer to see if anyone was interested. Having a great idea is just one part of a successful business.
There are risks to using this approach, so be sure to have a solid plan to deliver on time, otherwise, you may have some upset customers. Some customers may also want a discount in return for fronting the money.
If you are buying an existing business, seller financing can be an effective way to lower the amount of money a buyer needs out of pocket to take over. Instead of the bank providing all of the debt financing, the seller acts as a bank and holds some of the loan. The buyer makes a payment to both the bank and the seller.
Banks like to see seller financing as it demonstrates the seller has enough confidence in the buyer to put their money on the line. There are many ways to structure payments to the seller including; a percentage of sales, monthly payments, a balloon payment, etc.
This does put the buyer at a bit of a disadvantage in trying to negotiate the selling price but may be necessary to get the deal done. Besides being able to sell the business, the seller has the opportunity to possibly lower their tax burden by taking payments over time instead of all upfront and make additional money through interest.
Leasing is an effective way to reduce the amount of money needed to start a business. Leasing allows the business to use machinery, vehicles, or other equipment similar to how one would lease a building. A leasing company owns the asset but the business uses it.
A business may want to lease to get smaller monthly payments or less upfront cost, but leasing also may provide tax advantages over purchasing. Downsides include costing more in the long-term and being contractually obligated to continue paying, even if the equipment isn’t being used.
Selling personal belongings
Sometimes the answer to funding needs is to come up with more personal funds and that is not always a bad thing. Saving more money gives an opportunity to further refine the business idea and have more money in the bank. Many entrepreneurs put all their funds into their start-up and don’t have enough “rainy day funds”. This is a big risk in case the business doesn’t take off as fast as they projected.
Starting a business takes a lot of sacrifice and that may mean selling some beloved items today so you can have a better life in the future.
Friends & Family
Asking friends and family members to invest in your business idea is a great way to finance your startup. You can either ask them for a business loan or offer a percentage of your business.
Even though these people are close personally it’s best to treat the transaction professionally. All too often, borrowing from friends and family is treated casually and could lead to resentment and a loss of friendships. Prepare a business plan, put an agreement in writing and also set up a payment plan.
An angel investor is someone who invests in small business startups. Often, angel investors are colleagues of friends or family. Most angel investors are former entrepreneurs, who can also offer valuable business advice alongside the capital. However, you are going to need a solid business plan to convince an angel investor to finance your startup.
Note that angel investors are not lenders. Money from an angel investor is an investment rather than a loan. As you begin to make a profit, you will need to give part of your profits to the angel investor. Angel investors own part of your business as a result of their investment. They expect a high rate of return on their investments.
When you ask an angel investor for money, make sure to give them a clear exit strategy, as they typically don’t want to be involved with a company for more than five years.
Related: What is the difference between angel investors and venture capital
There are a lot of advertisements for free small-business grant money for businesses and for 99.9% of businesses this is not true! Yes, there are some grants for businesses, but they tend to be for science & technology-related companies through the SBIR (Small Business Innovation Research) or STTR (Small Business Technology Transfer) programs. Sometimes there are grants offered at the state level for a variety of initiatives like technology startups, agriculture, or tourism. Last, there are occasionally a few not-for-profit groups that provide money to minority-owned businesses, woman-owned businesses, and veteran-owned businesses. Those aren’t consistent enough to bank any business funding on, especially for an untested start-up.
Related: List of Small Business Grants
You can find any government grant opportunities at no cost by going to grants.gov and USGrants.org. Don’t pay for information about grants, even those that make guarantees, as you will likely be disappointed.
Depending on the type of business, funding may be a frustrating and discouraging experience. Don’t take a no from a lender or investor personally or that they think the business idea isn’t good. Every funding source is looking for something different in the projects they fund. Many entrepreneurs will spend months or sometimes years trying to find financing for their business.