Steering through fundraising pitfalls can be the life or death of your company. Getting a small business off the ground is a huge achievement, but establishing financing on a solid footing is critical to whether an enterprise ultimately succeeds or fails.
A banking officer dealing with financing requests every day and the most common question we hear from founders of startups is, “Should I finance with equity or debt?”
Bootstrapping startups requires financial creativity. Personal credit cards are used for 8% of funding with another 2% from business credit cards. Home equity loans supply 3% of capital needs while other personal assets made up 6% of startup capital. One-quarter of all startups use no capital to get going while 57% draw on personal savings.
Here are some considerations for startup entrepreneurs seeking capital.
1. Credit card debt: This type of high-interest debt, often costing 13% or more, can work for small capital needs like those required by a services firm that needs some computers and office equipment to start selling its services and generating cash flow. For larger amounts, capital should be established on a more permanent footing.
2. Personal savings and home equity: Business owners should invest their own equity first before taking on debt or seeking investments. Savings should be considered first because there is no required repayment and you won’t have to share the profits later. Home equity lines can also be good sources of inexpensive capital and are the next obvious personal source, but should 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 turn cash positive.
3. Friends and family: Investments from friends and family often have favorable terms. Family members can be the most patient investors, perhaps not demanding profits or only seeking their principal returned if the business is sold. Friends may offer less onerous terms than other equity investors, too. Such equity builds the firm’s balance sheet before adding debt.
4. Angels and venture capital: Angels are accredited investors with expertise in a particular industry who buy equity in early-stage startups and can offer invaluable mentoring. The average angel investment is $345,000. Only certain types of startups can attract venture capital. VCs are only interested in rapid-growing companies that they can sell at a significant profit, typically within five years, by selling to other investors or by taking the startup public. VCs seek out firms with low starting valuations, such as tech companies and medical devices makers that can rapidly build a higher valuation.
5. Debt: Businesses without cash flow will have a hard time securing debt, but Small Business Administration loans, available at SBA-approved lenders, can offer more flexibility than conventional loans. Many small businesses start with a series of several SBA loans before graduating to conventional loans when they have an established track record. When seeking any kind of bank debt for a startup or early stage business, the owners need to be able to demonstrate certainty of their ability to repay the loan.
Don’t Forget The Five C’s.
By the time a company seeks capital, it should have a solid business plan that will address the five Cs of credit how much capital is being invested, is their collateral that will serve as a backup source of repayment if the business fails, is there historic cash flow to support the loan or an ongoing outside source of repayment, how solid is the character of the borrower (as evidenced by his or her credit score and ability to handle debt) and finally, what are the conditions impacting the industry. The five C’s of credit are character, capacity, capital, collateral and conditions.
Getting the structure of the company and the capital set up correctly at the start is a lot of work, but it can save a lot of headaches later.