Beyond having a great idea, product, or service; beyond being able to lead a team; beyond being able to get your message out and generate attention; beyond doing the work… your business needs cash! Funding your new endeavor is a critical component to success. Access to, and the appropriate capitalizing of your business can be the difference between going to the moon or crashing and burning.
Periods of economic challenge tend to generate an influx of new business creation. Fortunately, funding and financing your business has more avenues than ever before – from traditional bank loans; to public and private grants; to boot-strapping; to racking up the credit cards; to bringing in equity “partners”; to raiding your retirement; to tapping your home equity as an ATM; to begging family; or compelling the internet tribe on KickStarter and the like – there is no shortage of options and opportunities for the prepared & disciplined and (or) the ambitious & aggressive.
While we would love to be able to tell you exactly what to do, every situation is different so unfortunately there is “no one size fits all” approach. The following discussion is a brief introduction of financing alternatives to help you orchestrate your perfect plan.
~ The Big Two – Debt & Equity ~
Debt Financing is loans secured from banks, other financial institutions, or an individual. The loan is paid back either from the profits of the business, from new funding (loans or other), or from personal funds if an individual has provided a guarantee for the amount owed. Loans are an attractive method of financing for the borrower since the lender does not receive an ownership or management position in the company.
The lender must be convinced that the cash flow of the business is sufficient to cover the amount of the loan payment, and/ or the value of collateral is sufficient to cover the amount owed if the borrower defaults. Lenders generally have little interest in the future growth possibilities of the business – banks are in the “what have you done for me lately business”, they care about historical results and what can be proven.
To consider approval of a loan application, lenders typically require presentation of credible cash flow projections, a personal financial statement for the owner(s), prior year tax returns (both business and personal) and may look for a detailed business plan.
If you are going the bank route, make sure that your ducks and documents are in order! Your personal credit score and overall financial picture is going to play a large role, particularly for a new endeavor. For a new business, obtaining debt financing from a bank will almost certainly require a component of owner capital ~ your bank may wish to partner with the SBA to relieve some of their risk (banks are incredibly risk adverse), it is ideal to know if this is a possibility in advance so as to better prepare.
Note: The business owner should ascertain chances of loan approval before beginning the process as this process can be lengthy! Know your credit score, your projected debt coverage ratio, your assets and liabilities – have a plan, be prepared to paint the best and most complete picture possible, leave no questions to be asked.
Equity Financing comes from an investor who buys into a company, becoming part owner of the business. The involvement of the investor in the business operations depends on the financing and operating agreements.
Investors take on greater risk than lenders and accordingly demand a higher return. Equity financing can be extremely expensive in comparison to loans. As with lenders, investors generally require presentation of a business plan and place great importance on the management team. Unlike lenders, however, investors are most interest in the likelihood of future growth of the business, rather than current cash flow or the value of fixed assets.
Venture capital. Often backed by professional investment institutions, a venture capital firm usually consists of a group of private investors whose purpose is to gain equity positions in business with unusually high growth potential. Because of the risk involved, venture capital firms require a greater return on their investment than other sources of financing. When applying for financial assistance with a venture capital firm, a comprehensive business plan is usually required. These firms generally consider the management team the most important factor in evaluating whether a company has potential for growth.
Private (Angel) Investor(s). Individual private investors providing financing to start-up businesses are referred to as angels. While the criteria for investment is similar to venture capital firms, the individual investor may be more likely to be influenced by emotional as well as financial factors. For example, an investor might like being associated with an enterprise in a particularly exciting industry, like accounting. The cost of this type of funding is high, but businesses that cannot secure financing from other sources may create interest with an angel and then the angel may end up creating additional interest or enable access to debt financing.
A word to the wise, accepting financing means accepting some form of control over your endeavor; and for many of us, the entrepreneurial itch came from a desire (no, not that itch from that desire) to be our own boss – don’t end up the employee of your own company by giving up too much too early.
~ Alternative Financing Opportunities ~
Crowdfunding is funding a project or venture by raising online contributions from multiple parties. In INFO 2016-0036, the IRS indicated that crowdfunding receipts are generally included in income unless they are loans, capital contributions in exchange for equity interests or gifts. Without endorsement, here is a quick list (as of January 1, 2021): KickStarter; iFundWomen; Wefunder; Fundable; CircleUp – there are more. Be prepared to be very compelling, there is a lot of competition out there!
Your 401(K) / IRA can be a source of funding, and there are a few different ways to accesses these funds.
Loans. Most 401(k) plans have a loan component, generally you can borrow the lesser of 50% of the value of your account or $50,000 – the nice part about borrowing from your 401(k) is that you are paying yourself back, with interest, the bad part is that if you leave your employment, the loan, if not paid back, is converted to a distribution and you’ll incur income tax and maybe penalty.
Distributions. Plain and simple. Give me my money. There’ll be income tax and possibly penalties as well – but you’ll have your funds.
Maybe paying income tax isn’t the worst thing… say what! Imagine that you are leaving your current employer to start out on this adventure, you won’t be making money for a year, paying income tax on a distribution from your retirement funds may not be that expensive if your other forms of income are deflated during the transition. You can plan this and straddle into different years to possibly keep tax rates down.
Self-Directed IRA. Transfer your 401(k) or IRA funds into a new “Self-Directed” IRA account. You’ll be able to use the funds to invest in your business. It will have to be a C-Corp and there are many, many rules at play here – and this can be expensive, but it’s doable, and may be worth exploring in the right circumstance.
Your Home Equity can provide easy access to funds. Easy yes. Risky… hell yeah. You’re literally betting the house your business will succeed. Been there, done that. With the housing market, values, and interest rates where they are this can be an attractive option. You should definitely set-up your home equity line of credit before you leave your current job and go full-bore on your new business.
As you can see, there are a multitude of ways to obtain financing, and there are plenty of even more creative ways out there as well.
It’s not always the worst thing not to have a big initial investment… I know, “it takes money to make money”… but there is a real value in learning your business from the ground up and making your mistakes when the stakes are low and not with other’s people money (OPM) – that way when you are ready for a big investment – whether debt, equity or a combination of – you’ll have a better understanding of how to properly deploy those funds to get the largest return on investment (ROI) which is what we’re after!
~ Parting Thoughts ~
Financial intelligence is key when being funded. Make sure that your business is set up to handle an investment or debt funding – you need your taxes to be right, your financial and accounting structure organized properly, your bylaws and operating agreements tight, basically your t’s crossed and i’s dotted. Ideally, you’ll get all of this right on day one, putting in the work in advance will allow you to avoid many (not all) of the bumps and bruises that come with experience. OPM can also stand for “other’s people mistakes” seek counsel and professional guidance, the investment of putting in the work and getting things right from the start will prove invaluable.
To your massive success.
p.s. did you count how many times we said business plan? In both equity and debt, which basically covers everything except self-funding… you might want to look into that a bit more… hint, hint. We’re here to partner with you to achieve the most efficient path to success!
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