Where’s the Money?

By Trishan Arul    August 27, 2009

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Among the many things needed to start a business, the one most often cited as a roadblock is money. Especially for young people who have the energy, passion, ideas, and other key ingredients to become entrepreneurs, money is scarce. Some businesses, notably personal services such as consulting, require very little money to start but others such as a retail store require significant upfront investment before any money comes in the door. Below I’ll discuss various common funding options for entrepreneurs.

Personal Funds: This is the most common source of startup funds for businesses. Many people who have worked for years have significant retirement and regular savings. I don’t recommend tapping your retirement funds to start a business no matter how good you think the idea is – you’ll not only pay penalties in most scenarios but you’re jeopardizing your future financial security. If you’ve planned to become an entrepreneur for some time, then you can live frugally and save money for a few years to fund your dream. While it may seem like a long time to wait, you can use the time wisely by planning, researching, and laying the groundwork to make your business a success in the long run.

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Friends & Family: More than just a cell phone plan feature, this is the second most common source of funds for new businesses. You can draw from a larger pool of people who can each can invest less money to reach your overall funding target. People with self directed IRA’s can even tap into some of those funds to invest in your business. The good thing is that these people are investing primarily in you & your idea. The bad thing is that they are then relying on you to execute well, work hard, and make the business a success. Be aware that there is a non-monetary cost to taking this type of investment – the dynamic of your friendship could change and many relationships have been ruined because of money. If you go this route, ensure you set expectations properly, that no one is investing money they can’t afford to lose, and that you comply with any relevant securities laws (consult an attorney).

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Loans: The recent stimulus package includes incentives for small business lending and many people believe this is a ready source of capital for starting a new business. Programs through the Small Business Administration do help many small businesses however they are administered through traditional banks and geared towards operating businesses with a financial history. If you don’t think a bank would loan you money based on the 5 C’s (Character or Credit History, Capacity or Cash Flow, Collateral, Capitalization, Conditions), then the SBA guarantee won’t change that situation. If you plan to invest a significant amount of money in the business (20-50% of total capital required), will have assets that can serve as collateral, and can personally guarantee the loan then this is a viable source of additional funding.

Angel Investors: Angels are professional investors, often former entrepreneurs and other wealthy individuals who invest in new businesses. Many do it to help entrepreneurs get off the ground but they are also seeking a financial return. They will thoroughly vet you, your team, and business so you need to be prepared for that level of scrutiny.  Some want to get involved in the business (i.e. a Board seat) but most are happy to invest in the background and let the team run with the business. But in either case, having a professional investor WILL change what you have to do. You will have to manage the business more formally, produce timely & accurate financial statements, and regularly report to the investors. Unfortunately, angel investment has become harder to find in the current economic environment.

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Venture Capital: Being in Silicon Valley, this is the first thing everyone thinks of when raising money for a business. The truth is very few companies are appropriate for venture financing. Venture capitalists are looking for “home runs”, they don’t want to earn a 10% return, they shoot for a 10X or 100X or more return with each investment. They need a few stellar investments to compensate for all the investments that don’t make any money. VC’s  have large pools of capital which need to be invested and limited time/resources to invest that capital. A company that needs $1M and will never need any more money, isn’t as compelling as a company raising $20M which will eventually need $50M in funding before a liquidity event. That’s just how the business models of large funds work. As an entrepreneur, you will also give up a significant portion of your company (at least 20%) along with some control. Entrepreneur stories & complaints about dealing with VC’s are common and sometimes fodder for comic relief. That said, there are very good VC’s and this source of funding is quite valuable to many startups however unless you need a large amount of capital, VC’s are normally not the best funding option for a new business. If you do want to seek professional investment, reading Joe Beninato’s Raising Capital presentation is a great start.

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Bootstrapping: Bootstrapping entails raising funds through operating a business with paying customers. In my opinion, this is the best path of funding for businesses which can use this approach since it minimizes the upfront investment while providing additional business benefits. Software and services businesses are the best candidates for growth through bootstrapping. A good example is a software company that starts out doing consulting. The company generates revenue while it gains expertise in understanding the customer’s problems, tailoring a solution, and creating code that will eventually become a piece of software that can be sold on its own. This also increases the company’s chances of success since it has learned firsthand from people who would eventually become its customers.

Every aspect of starting a business is hard work but finding the right sources of funding is something that should be done upfront with a lot of careful thought. Every business is different so you should determine the best combination of funding that works for your business. And don’t be afraid to get creative by bartering, giving equity or a percentage of future revenue, or anything else you can think of – one local couple even used their wedding registry!