Tired of the 9 to 5 grind? Considering going into business for yourself? You’re not alone. Millions of people have a similar dream. A few brave ones take the next step. Unfortunately, for many, the dream can turn into a nightmare quickly. The U.S. Small Business Administration statistics show that well over half of all new small businesses fail. Bankruptcy professionals can tell you that a disproportionate amount of the debt wiped out in personal bankruptcy cases comes from personal liability on small business debt. These numbers aren’t meant to stop you from pursuing your dream. They are meant as a warning — know the risk up front so you take steps to minimize future financial ruin.
One fundamental question a small business person getting started must answer is, “Where will I get the money to finance my business?” This article suggests some options and the risks involved with each.
First Things First
Before you consider the sources of funds, heed this warning: Don’t make the common mistake of pouring too much money into your business at the outset. Take time to figure out if your business will be viable. Spending borrowed money on an untested business idea can lead to disaster. Most small businesses don’t require a great deal of cash or credit up front. Start small. Funds will become available if you succeed. If you don’t, you can move on, debt-free.
Your Current Salary
“Don’t give up your day job.” That advice is commonly given by nervous parents to their children who decide to become artists or writers. It applies to many entrepreneurs who are just beginning. Start small and you may be able to stay afloat for many months by continuing your full-time job or cutting back to part time. The steady source of income can reduce your need for turning to others for startup funds and can help keep you stay solvent if the business fails.
Putting your own money into your business is the simplest way to get started. You avoid entanglements with others, keep your business affairs private and avoid taking on repayment obligations. The money may come from savings or from a lump sum that comes once, such as an inheritance or severance package from a job you’ve just left. If you’ve sold your house and have bought a less expensive one or will rent, you should have some money to invest in your business.
If you have a retirement savings plan where you work, you may be able to borrow some of that money. Check the plan language to see if loans are allowed for business purposes. If so, you should be able to borrow up to one-half of what you have in the plan, but no more than $50,000. Also check the maximum term allowed for a loan (typically five years), the interest rate and the loan fees. You will have to pay interest on the money you borrow from your plan, but that’s not all bad. Because you are borrowing from yourself, the interest goes back to you.
If you’ve reached the age of 591/2, you can simply take, rather than borrow, money from the tax-deferred plan, without paying a penalty. Before that age, however, you would owe a substantial penalty for early withdrawal.
Equity in Your Home
If you own a home, you may be able to tap into a portion of the equity to raise cash. Equity is the difference between what the home is worth and how much you owe on it. For example, if your house is worth $300,000 and you owe your mortgage lender $140,000, your equity is $160,000.
One way to get to the equity is to get a new mortgage to pay off the existing one, which will leave you with cash for your business. On that $300,000 home, if you obtain a new mortgage for $240,000 — 80 percent of the home’s current value — you’ll have $80,000 to invest in your business after the mortgage is paid off.
Another approach is to apply for a line of credit based on your home equity. In this case the bank will hold a second mortgage on your home. Typically, the bank will give you a checkbook which you can use to write checks against the line of credit. Your monthly payment will depend on how much of the credit line you’ve used.
Whichever method you choose, realize that you are putting your home at risk if you don’t repay the loan. Don’t borrow more than you absolutely need. And figure out how you’ll make the mortgage payments if your business starts out slowly or fails. Consider a loan with a long repayment window — which means lower monthly payments. If your business does well, you can repay it sooner.
The Seller of the Business
If you buy an existing business, try negotiating with the seller for favorable payment terms. This will reduce the amount of cash you have to come up with. First, try to keep the down payment low. Second, ask the seller to agree to below-market interest rates, or even no interest, for the first year or two. Third, try for an extended payment term over many years.
Friends and Relatives
Those close to you will often lend you money or invest in your business. By borrowing money from people you know, you may be charged a relatively low interest rate, may be able to delay paying back money until you get yourself established and may be given flexibility if you get into a jam.
But borrowing money from relatives and friends can have a big downside. If your business does poorly and those close to you lose money, you’ll damage a personal relationship. So in dealing with friends and relatives, be extra careful to clearly establish the terms of the deal and put them in writing and make an extra effort to explain the risks.
Banks and the Small Business Administration
Banks are in the money business, so it’s natural to look to them for start-up funds. But banks are reluctant to lend anything substantial until a business has established a record of profitability.
There is an exception, however. If you present a loan guaranteed by the U.S. Small Business Administration (SBA), a bank may respond more favorably. The SBA is more likely to guarantee a loan for someone expanding a successful business than for someone just starting out, but it never hurts to talk with the SBA about your new business.
You can use your credit cards to help finance your business. Plastic can quickly get you a computer and fax machine — and probably other business equipment and furniture as well. And for expenses such as rent, phone bills or money to pay employees, you can usually get a cash advance.
Credit cards are a convenient way to arrange for short-term financing because they’re so easy to use. Over the long haul, however, they’re a disaster — the interest rate on new purchases averages about 19 percent per year and on cash advances is as high as 25 percent per year. You’re not likely to succeed in business by incurring debt at those rates.
Buying on Credit
The companies from which you’re buying goods or services may let you buy on credit, not requiring payment for 30 or 60 days, to get your business. If they won’t extend you credit, they may let you spread payments over several months with no interest charges, as long as you pay each installment on time.
Even if they do charge interest, it will no doubt be substantially less than your credit card issuer charges.
Typically, the best credit terms go to established businesses; new businesses often must pay up front. But credit decisions can be subjective. You may be able to convince the seller that your new business deserves special consideration. Especially if you need starting inventory, call suppliers and ask for help. Have a copy of your credit history and business plan. If you’re persuasive, you may be able to get a fair amount of your inventory on favorable terms.
If you need equipment, consider leasing it. While leasing doesn’t put money directly in your hands, it does reduce the amount of cash you’d have to come up with if you were to buy equipment. In considering leases, look for ones that include an option to buy the equipment when the lease period is over, as long as the purchase price is reasonable. Over the long term, leasing usually costs more than buying — but if the cash flow from your business will be tight for a few years, leasing can be an effective way to get the equipment you need now.
Equity investors buy a piece of your business. They are co-owners and share the fortunes and misfortunes. Generally, if your business does badly or flops, you’re under no obligation to pay them back their money.
Some equity investors insist on a guarantee of some return on their investment, even if the business does poorly. Unless you’re desperate for the cash, avoid an investor who wants a guarantee. It’s simply too risky a proposition for someone starting a small business.
Corporate shares, limited partnership interests and, in some states, an interest in a limited liability company, are legally considered to be securities, which are regulated by federal and state law. This means that before selling an investor an interest in your business, you’ll need to learn more about the requirements of the securities laws.