Want to Start a Business – How Should You Finance It?

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Starting a small business is a huge success, but establishing funding on a solid foundation is essential to know whether a business ultimately succeeds or fails.

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As a banker dealing with funding requests on a daily basis, the most common question asked by startup founders is: “Should I finance with equity or debt?” I am here to tell you that there are no easy answers. And worse yet, it can be a life or death decision: More than 500,000 businesses are established in America each year, but half of them fail within five years. The main cause of failure is a bad strategy supported by an excess of optimism, but the second cause of failure is the lack of funding.

Related: When raising capital for your business, big checks aren’t always better

Small businesses attracted nearly $ 1.2 trillion in financing in 2015, according to the Small business management – nearly $ 600 billion in bank loans and $ 593 billion from other sources, such as finance companies, capital of angels and capital risk. However, when it comes to funding startups, only 8% of the capital comes from bank loans.

Priming startups require financial creativity. Personal credit cards are used for 8 percent of financing and 2 percent of business credit cards. Home equity loans provide 3% of capital requirements while other personal assets represent 6% of start-up capital. A quarter of all startups do not use any capital to start up while 57% draw on their personal savings.

Here are some considerations for start-up entrepreneurs looking for capital.

Credit card debt: This type of high interest debt, often costing 13% or more, can meet small capital needs like those required by a service business that needs computers and office equipment to start selling and generating services. cash flow. For larger amounts, the capital should be established on a more permanent basis.

Personal savings and home equity: Business owners should invest their own equity first before going into debt or seeking investments. Savings should be considered first, as no refund is required and you won’t have to split the profits later. Home equity margins can also be a good source of inexpensive capital and are the next obvious personal source, but they need to be established before you need the capital. A key consideration for home equity loans is how you will repay the loan if the business takes longer to make the cash flow positive.

Related: 5 types of start-up investors to avoid

Friends and family: Investments from friends and family often have favorable terms. Family members may be the most patient investors, perhaps not demanding a profit or only looking for a return on their capital if the business is sold. Friends can also offer less onerous terms than other equity investors. This equity constitutes the company’s balance sheet before adding debt.

Angel investors and venture capital: Angel investors are accredited investors with expertise in a particular industry who buy capital from start-ups and can provide invaluable mentorship. The average angel investment is $ 345,000. Only certain types of startups can attract venture capital. VCs are only interested in fast growing companies that they can sell for a large profit, usually within five years, by selling to other investors or by taking the startup to the stock market. Venture capitalists look for companies with low starting valuations, such as technology companies and medical device manufacturers, that can quickly generate higher valuation. These offers are on average around $ 12 million, however, venture capital and angel capital combined account for less than 2% of all small business financing.

Debt: Businesses without cash will find it difficult to go into debt, but Small Business Administration loans, available from SBA-approved lenders, can offer more flexibility than conventional loans. Many small businesses start with a series of several SBA loans before moving on to conventional loans when they have an established track record. When looking for any type of bank debt for a start-up or start-up business, homeowners should be able to demonstrate certainty in their ability to repay the loan.

Related: HHow to bleed your friends dry for your business – and stay friends

Don’t forget the five C.

By the time a company is looking for capital, it should have a solid business plan that will consider the five Cs of credit: what is the capital invested, is there any collateral that will serve as a back-up source for repayment if the business fails, is there historical cash flow to support the loan or an external source of ongoing repayment, how strong is the character of the borrower (as evidenced by their credit rating and its ability to manage debt) and finally, what are the conditions affecting the industry.

Cash flow is the most important consideration so it is very important to be able to demonstrate the ability to repay from historical cash flow. SBA loans allow borrowers to extend the repayment period and qualify for a loan when a shorter conventional repayment structure might not work. Startups and businesses with a shorter track record may be able to secure an SBA loan, but they must demonstrate strong sources of income that will support debt.

Lenders will want a first lien on the assets of the business and will also seek personal collateral, such as home equity, in the event of a shortfall. SBA rules allow lenders to look past collateral issues, but they are required to take out personal real estate if they have valid equity.

When it comes to personality and credit history, lenders are wary of borrowers who have used up a large portion of their available revolving credit, so business owners should reduce this debt before seeking bank financing. If you pay off your credit cards every month, paying off a few days before the due date can dramatically change these ratios. Slow payments, judgments and bankruptcies will also be problematic.

Bankers will also take market conditions into account. A few years ago, for example, the credit markets were inundated with loan applications for yogurt stores – a sure indication of a fad.

Related: 5 reasons why starting your business is the best thing you can do

Watch out for tactical and structural errors.

Before applying for a loan, borrowers must properly set up their accounts. For example, companies that invest to grow quickly may have negative cash flow – a tactical mistake when seeking financing. Instead, cash flows from existing products should be separated from R&D, with those expenses being recorded on the balance sheet and amortized. SBA loans can overcome some problems, but it is almost impossible to overcome a lack of cash.

The structure of the company also informs the financing. A sole proprietorship, for example, cannot sell equity. An S corporation can only have a maximum of 35 owners and must distribute profits in proportion to its equity. For example, a 5% property should bring in 5% profit or loss. However, an LLC can separate profits from losses. For example, an early investor with 5% equity may have a 10% call on profits and only 5% liability for losses until all equity has been paid off, after which it becomes an allocation. equals profits and losses.

The AC company may have many investors, but there are certain characteristics that may help with the initial financing. For example, a C corporation can have a self-directed 401 (k) and the owner can transfer their retirement savings into that plan and then invest those funds in the business. (This is tax-efficient, however, if the business goes bankrupt, that retirement savings may be lost.)

The bottom line is that entrepreneurs need an effective capital strategy to develop and build a business. This strategy can be created with the help of a small business banker, lawyer, or CPA who specializes in setting up small businesses. Free or low-cost counseling is also available at local SBA offices or from mentoring organizations such as the Association of retired executives’ service corps Where Mi Casa, which helps women achieve their business goals.

Getting the business structure and capital right up front is a lot of work, but it can prevent a lot of headaches down the road.

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