When starting a business there are many funding options to research. However, you may be surprised to find out that most funding options don’t open up to small business owners until you’ve been in business for 2 years or more. This includes bank lending, SBA loans, and outside investor options. Before you decide on a funding source you’ll need to know how much funding your seeking, as certain types of funding are only appropriate when you’re seeking larger amounts of money. Prior to year two, you’re going to have to rely on your own funds, or those of people close to you such as friends and family. The following chart lays out funding sources from smallest levels of funding to the largest levels of funding. It also shows some of the tradeoffs (less control of the business, more expensive financing terms) when using outside investor sources.
Now that you have a broad overview let’s address some of the myths.
Myth One: I’m going to get investors
While it’s a noble goal to proclaim that you’re looking for investors before you’re up and running, it’s probably not going to work. The reason is very few businesses are successfully able to raise money. Outside investor money such as venture capital and angel funding isn’t as plentiful as it seems. For instance, less than 1% of all startups raise venture capital (VC).
Being an unproven entity with zero or very few customers makes it far less likely you’ll be able to get outside investors.
In order to get outside investor funding through VC or angel sources you need to prove you have a profitable business on your hands, and they want to see that you’ve risked your own capital on the endeavor in the early years.
Investors are seeking significant long-term returns (5x returns or more on their money) from businesses. This requires more than just a plan on paper. Funding sources like this don’t open up until your business has a history of success in a growing and profitable industry. Most of the time this sort of profit/progress doesn’t happen until at least 2-3 years into business.
Another downside of taking on investors is that you lose some financial ownership and management control over your business. Outside investors want large portions of ownership in return for providing you capital. Working with them can eventually take up as much time and energy as your customers. Before you go down this path, be sure that you’re ready to give up decision making power of managing the day-to-day of your business and you’re willing to share the financial wins (and losses) with other individuals/groups. It’s important to prevent your investors from becoming a distraction for serving your customers. Finally, you should also expect to sell the business at some point if you’re taking on outside investors, as selling the business tends to be when the investors get the returns they’re looking for.
The alternatives: You must seek other funding sources to get started in the early years. Self-funding is very important. You may be able to seek funds from friends and family or crowdfunding sources, but those also require you to have a real business with real growth and profits, not a business on paper. I would advise you not to put all your eggs in the basket of “friends and family,” for obvious reasons. The bottom line is, you’re going to have to fund some of your initial startup costs yourself.
Myth Two: I’m going to get bank funding
Banks don’t lend money to unproven business. You have to be in business for at least two years showing progressive revenue growth before you can get any kind of bank funding for a business. Even then, banks will heavily weigh your personal credit score as a measure for approving funding. There is no difference if you’re seeking Small Business Administration (SBA) loans. The SBA sets some initial guidelines for the loans and provides a guarantee, but it’s ultimately the bank that’s approving the loan and providing funding. Banks require the business to have at least two, if not three, years of financial and credit history to review. Once you’ve hit the 2 year mark, meticulously prepare your documentation and shop around for loan products taking time to consider the interest rates carefully.
The alternatives: Since business bank loans are out, you must self-fund your business or use personal loans or business credit cards for the first 1-2 years of business.
If you go the bank loan route, the very first loan you’ll get won’t be a business loan at all, but a personal line of credit. That means your personal credit needs to be in tip top shape (score of 680 or more). It also means that you’ll probably pay a slightly higher interest rate than offered to more established businesses through the SBA program since you won’t have any specific assets to back your loan. Expect interest rates of at least 7-8%.
PRO TIP: The cheapest option may be getting a business credit card. If you just need short-term funding for a few months to get things set up before your first revenue comes in, you can apply for a credit card with a lender that specializes in providing credit to businesses. Assuming you have a plan to pay off the balance quickly, this helps you in two ways: providing seed money at a low or 0% interest rate for 6-12 months and helps you build a credit profile for your business. This funding source will be reported on your business credit report, not your personal credit report. If you need loan funding later, this credit history for your business is going to be very important. Read more about getting a business credit card and establishing a credit profile for your business here.
Myth Three: Self-Funding is Impossible
With enough planning self-funding a business is well within reach. Most of the successful businesses I know have navigated this process well. In essence, it means you’ll need to save up cash and plan to launch your business thoughtfully instead of making reactionary decisions (like quitting a job with no plan). The biggest downfall I see in starting off with friends and family money or crowdfunding is that you’re not focusing on the elephant in the room:
How are you going to manage your living expenses until you’re able to pay yourself for the work that you’re doing?
While you may be able to get them to chip in for business costs, it’s not realistic to also assume that your friends and family are willing to pay your rent while you get going. Here are some other reasons why you should self-fund:
- If startup capital requirements are small, bootstrapping is smartest way to go
- Your business truly is your business, you retain 100% equity
- You are able to make split-second decisions without requiring board/investor approval
- You’re able to support your personal and business expenses in the early stages before you’re able to pay yourself
- You won’t have to beg for business because you need to get more customers to appease the investors. You can take on the customers you want to take on.
The alternatives: Aside from saving up cold hard cash well in advance of starting your business, here’s a summary of other recommended bootstrapping sources to look into.
One area I didn’t mention was grant funding. This source often gets mentioned when I speak to people thinking of starting a business. I know why — grants seem so enticing because it’s free money! The reality is grants come with a lot of strings too and they aren’t always free money. They are not a common source of funding for new businesses. Many require you to have seed money in the form of loans or other types of financing that the grant will match dollar for dollar. The types of grants and funding amounts vary wildly. With significant competition for these sources, the chances of you getting a grant for a for-profit endeavor are very slim since the majority go to charitable or nonprofit causes. Don’t turn down an opportunity to apply, by all means, but please don’t bet on getting a grant to fund your business. You’ll likely be disappointed.
As you start your business endeavor I hope that you spend a lot of time researching the cost side of your business and not just the revenue side. You’ll need to know what your run rates (monthly expenditures) are going to be and how many customers you need to break even. But you’re also going to need to get a handle on your personal expenses.
Have you estimated how long you’re going to have to float your personal expenses? What if it takes more months than expected?
We’ll talk more about contingency planning for both business and personal expenses in future blog posts. It should go without saying, but you shouldn’t spend a dime until you’re sure your business has a chance to succeed.
What do you think? Were you surprised by the availability of any of the business funding sources mentioned? Have you had success getting funding through one of the sources mentioned? Drop me a line and share your experience.