Many clients have asked me how to begin a business without yet having a sustainable revenue stream. “I want to start something,” they exclaim, “but I don’t have any money. Where do I start?”
This is a very real problem for entrepreneurs which can seriously inhibit the growth of a new enterprise. The ability to fund your business properly in the beginning is sometimes a dispositive factor in whether the business survives at all. Luckily, there are several options available when it comes to funding. Promptly perch yourself upon a boulder facing the sea and ponder the following questions:
- How much funding do I really need? Can I “scrape by” for a few years or do I need to spin things up immediately?
- How do I anticipate using the money? Am I going to put it toward critical milestones like forming an entity, building a legal plan, and writing an operating agreement?
- What stage of the business am I currently in?
- Do I believe that “a penny saved is a penny earned,” or that “you have to spend money to make money”? Which strategy am I going to employ?
- Do I have a safety net, or am I comfortable “betting the farm” on my concept?
There, how did that exercise go? Hopefully, you have a clear vision of how much money you need, how you want to use it, and how aggressive in using it you want to be. When it comes to funding your business, you generally have a few options:
Funding your business using your own money, or bootstrapping, is a common strategy for entrepreneurs. In many cases, people will take income being generated from other sources, such as a spouse, dividend income, real estate income, or a full-time job, and allocate a portion of it to be invested in the business. This strategy mitigates risk because it—usually—does not lead to the founder going into debt to fund the business. However, many founders will opt to turbocharge this strategy by taking additional risk through credit card debt, which can be a dangerous move and is rarely advised. Additionally, bootstrapping lets you maintain equity in the business, assuming you are going alone. This means there aren’t any investors or lien holders of your business, thus freeing you to pursue your own strategy on a timeline that works for you. Keep in mind that before you are earning enough revenue to stay afloat, you are depleting your personal funds. So build a plan and get going!
The Bottom Line: Self-funding your business is relatively low risk but can take longer for your business to get off the ground.
Taking a Loan
In a situation where you need an injection of cash to immediately begin business operations, which is common in startups like manufacturing, restaurant franchising, and other capital-intensive businesses, you may need to take out a loan. The amount of money you are able to secure, as well as the terms of the loan, will depend upon the amount of collateral you are willing to guarantee, and your personal credit (and if you’ve had a business credit account, that too). The chief downside of taking out a loan is an onerous interest rate that can make a loan expensive to service. This can eat into your profits and potentially make your business unprofitable until the loan is paid off. When searching for loan options, a good first step is to see if you qualify for a loan through the United States Small Business Administration (SBA), which often grants loans to first-time business owners as a way to encourage economic growth.
The Bottom Line: Funding your business with a loan is not without risk; research all of the options and determine which type is best for you. Run the numbers for your business through years one to ten to the best of your ability and model your profitability both with and without paying back the loan. This option is not for the faint of heart.
Asking Family and Friends
If you need money but don’t want to turn to a bank for the proceeds, a common strategy business owners employ as a way to raise capital is by turning to trusted family and friends. This option is possible if you have people in your life with whom you are close enough (and comfortable enough) asking for money to fund your enterprise. Depending on whom you are asking for the money, it may come in the form of a loan, or it may be a capital infusion in return for equity. Regardless of the situation, you should be careful to painstakingly spell out the terms of the agreement so that in the future you can resolve any conflict about repayment or corporate ownership that comes up. While we assume you’ve already prepared a business plan which you could show to a banker in order to receive a bank loan, you should not hesitate to share the same business plan with family or friends who are investing in your business. Explain to them why they should invest in your business and how you will achieve a return on their investment. Many entrepreneurs couple this strategy with bootstrapping in order to avoid a bank loan altogether. This type of arrangement still carries risk, but it is a greater social risk for you, as your reputation could be harmed by being unable to pay back a personal loan to your family or friends.
The Bottom Line: Getting funding from family and friends can be a sound strategy so long as the terms and conditions are clearly spelled out; however this strategy is not without risk. Advocate for your cause and show your business plan. Talk details and financials when entering discussions.
Crowdfunding is a relatively new phenomenon that has arisen in the Internet age which allows you to accept micro-loans from hundreds or thousands of different people as investments in your business. In this scenario, you are soliciting funds from the public at large, typically through a handful of websites such as Gofundme.com, Kickstarter.com, and Indegogo.com, which connect people with business ideas to individuals interested in investing in them. Presently, there are four types of crowdfunding: (1) Equity-based, (2) Lending-based, (3) Donation-based, and (4) Reward-based. You can lump #3 and #4 into one category because they operate in much the same way: you are seeking funds from individuals who believe in your cause, product, or service, and want to give you money in exchange for a gift, whether that gift is tangible or goodwill. We will focus on #1 and #2, as they are the primary drivers for new businesses. With regard to equity-based crowdfunding, it involves seeking an investment from people in exchange for ownership of your business. Depending on your needs, there may be unique options available in this regard. One thing you must watch out for is complying with necessary regulations about selling equities (this falls under SEC rules). A lawyer should review the paperwork you are prepared to file with the crowdfunding website to ensure everything is written correctly. Lastly, we will discuss lending-based crowdfunding. This is often used as a way to skip seeking a loan from the bank, family, or friends. It lets you instead go direct to the public and secure a loan from many different investors, usually in return for equity. These transactions are mediated by third-party websites, which will often guide you through the process. Nevertheless, it is important to have a lawyer preside over these transactions to ensure you are getting what you sign up for.
The Bottom Line: Crowdfunding has the potential to expand your pool of investors and let you take money from people you may not know in exchange for equity. If you are certain your business has merit, this may be an effective way to raise funds—just understand that there will be additional fees associated with this method that could eat into your operating margin.
If you don’t want to take out a bank loan, don’t want to turn to family and friends, and need an alternate source of funding, seeking out venture capital investment can be a viable strategy. This discussion will include angel investors for the sake of simplicity. The reason we have included this option last is that it’s usually the most difficult to procure, because VC firms are very selective about what businesses they invest in; the paperwork required to meet their minimum requirements are often lengthy, and it’s rare that a first-time business owner receives their funding. In order to get their attention, it is imperative that you have an ironclad business case that you can pitch which clearly explains the ROI you are proposing to make on their investment. Moreover, VCs are going to overlook “common” businesses like coffee shops, gas stations, and a litany of businesses you may see passing through your local main street. Instead, VCs want to invest in businesses that are scalable—meaning that they are able to provide a very high return on the initial investment. Software is one such business type which attracts the attention of VCs because it often can be scaled to a large user base at a relatively low operating cost. If you are going the route of a VC, it is advised that you work with lawyers and accountants to prepare your business case and develop the presentation needed to “wow” your potential investor. Keep in mind that VCs can also play a very hands-on role in your organization, and they commonly ask for things like board seats and significant amounts of equity. You are also bringing on their expertise and business acumen, which can sometimes justify their added expense.
The Bottom Line: Investors can bring massive amounts of cash into a company as long as it meets certain narrow criteria of viability and scalability; to get the attention of investors you must have a mature and thought-out business plan. If you’re able to secure an investment; however, this could be a major boon to your venture.
That’s All, Folks
As an entrepreneur, you have five ways to fund your business, each of which have different advantages and disadvantages. If you want to understand more about the legal strategies behind them, contact an ESQx attorney today.