Financing a startup is a primary challenge for an entrepreneur or business owner. After all the hard work of generating the idea for a business, an entrepreneur's next hurdle is finding sources of financing in order to get their operation off the ground. While financing a business can be daunting, it is certainly achievable. Learn about the ways you can do so below.
As hard as it sounds, bootstrapping your startup business may be the best way to go. Bootstrapping is when an entrepreneur or business owner starts a business with little capital except their personal wealth and few assets. The beauty of bootstrapping is that you retain total control of the business. You don't owe any money and you have not taken on outside investors. The downside, however, is the financial strain put on the entrepreneur.
Raising funds yourself may involve pledging your own assets. Since the largest asset most people have is their home, you may find yourself in the position of taking out the equity you have built up in your home. Tapping your personal savings or 401(k) are other possibilities.
There are several possible methods of bootstrapping, which are outlined below.
Refinancing your home means applying for and receiving a new mortgage on your home. You might have to pay closing costs and high fees, such as the cost of home appraisal. You also have to go through a credit check. Make sure that you are able to get considerable funds from refinancing your home or it may not be worth it.
Home Equity Loan
Home equity loans are second mortgages. You borrow money against the equity you have built up in your home. The home equity loan is a second-lien loan. If you have enough equity in your home to get a home equity loan, then you have to go through the process of applying and qualifying just like with a first mortgage. If you are approved, you pay back the loan with monthly payments. A home equity loan usually carries a higher interest rate than the first mortgage.
Home Equity Line of Credit (HELOC)
A HELOC is a line of credit granted to you against the equity in your home by your lending institution. It is more flexible than the home equity loan since the interest rate is variable and usually lower than on a home equity loan. The lender sets a maximum amount that you can borrow and you take out as much as you need when it's necessary. Payment terms are better than on home equity loans since you may be able to negotiate an interest-only payment period.
Family and Friends
The advantage of financing your startup business with the help of family and friends is that you can often get fairly lenient repayment terms. That may be important in the initial years of your business. You have to consider that they might want a stake in your firm if you are agreeable.
Personal Credit Cards
Small businesses use credit cards extensively, but typically not for startup costs. Small business owners sometimes use personal credit cards, with high credit limits, to access debt financing. However, according to the Small Business Administration (SBA), less than 10% of entrepreneurs use personal credit cards as a source of capital.
The first thing many business owners think of when launching a new business is getting a bank loan. Often, even the owner's own bank is not interested in an unproven business. Many banks are not willing to loan any of their scarce money to a start-up business that might fail. There are a number of varying types of financial institutions and other lenders that business owners may try for start-up business loans. Here are some types of loans and lenders that may be available to a small business start-up.
SBA 7(a) Loans
SBA 7(a) loans are often given to businesses that are already reasonably capitalized and those in which the owner has invested personal wealth.
SBA 7(a) loans may not be available to all startups due to the strict eligibility requirements, but they are available to some.
Small business startups that need to buy real estate and do meet the eligibility requirements should apply for a 7(a) loan as getting one is not impossible. The SBA guarantees 85% of a 7(a) loan up to $150,000 (and 75% greater than $150,000) with more favorable interest rates and terms than traditional bank loans.
SBA microloans can be helpful to both startup and existing small businesses. If a startup business is not eligible for a traditional bank loan or an SBA 7(a) loan, which can often be the case, it may be eligible for an SBA microloan.
Loan amounts are $50,000 and under with favorable interest rates and terms. Collateral may or may not be required. With microloans, the SBA works with intermediary lenders (called microlenders), which are specially designated, nonprofit community-based organizations that administer the programs in addition to providing training and planning guidance.
Microloans can be used for working capital needs. They can also be used to purchase supplies, equipment, and other business needs. You cannot purchase real estate with a microloan.
Business Credit Cards
If you can't qualify for a microloan, another debt option is a business credit card. You can have the smallest of businesses and still qualify for a business credit card if you have good to excellent credit and an acceptable debt-to-income ratio. Keep in mind that the lower your credit score, the higher the interest rate on the card. You might even be able to qualify for more than one business credit card.
Accounts Receivable Financing
Financing your new business is also possible using asset-based lending. There are two ways to use your accounts receivable to raise money for your business:
- Invoice financing: You can use your unpaid invoices, if you have made pre-sales or early sales, as collateral for a line of credit with a financial institution. The requirements for the loan are often not as strict as for other business loan options, and you will be granted a certain amount as a line of credit you can drawdown. You are still responsible for collecting the invoices.
- Invoice factoring: Invoice factoring is the process of selling your outstanding invoices to a third party, or a factoring company. The cost may be higher than for a traditional business loan, but you will receive a quick inflow of cash.
Startups may be able to use equipment financing, the last type of asset-based lending, to buy their initial equipment. Many financial institutions may fund part of a startup's equipment costs since the equipment serves as collateral. You repay the loan over time at a preset interest rate just like with a traditional business loan.
Trade Credit Financing
Trade credit financing, also called vendor financing, is when you work out an agreement with one or more of your suppliers to provide your business with a line of credit to buy your supplies from them. If you are having difficulty getting other types of financing, such as traditional business loans, trade credit financing may be one of your answers.
Small Business Grants
The best source of financing for a small business is free money. There are various small business grants sponsored by the government or corporations. Other grants are available to only specific demographic sectors. Still others are open to specific industries.
Small Business Innovation Research (SBIR) and Small Business Technology Transfer (SBIR/SBTT) grants can be excellent sources of financing for your small business if you can qualify for them. Federal departments and agencies give out considerable funding every year to small business startups that have innovative ideas in line with their missions. Examples of agencies that give out SBIR grants are the Departments of Agriculture, Energy, and Defense.
SBTT grants are harder to obtain and are focused on technology and its transfer from research institutions to small businesses and the wider marketplace. In order to determine whether your business is eligible to apply for either the SBIR or SBTT grant, see the Eligibility Guide.
In order to obtain a government grant, small businesses generally have to meet the requirements set forth by the SBA regarding the number of employees the business can have and how much it can make in profit per year.
Other Government Grants
There are other small business grants you can apply for:
- Corporate small business grants: Large corporations often offer small businesses grant money.
- Targeted small business grants: These grants help different demographic groups that start a business with startup financing.
- State and local grants: State and local governments offer grants to small businesses for business issues specific to a locale. Go to your state or local Chamber of Commerce to find out about these opportunities.
For more possibilities for grants, see the government grants site.
Crowdfunding, a relatively new source of money for small businesses, is the process of making a request to the "crowd" for money to launch your product or service. The request is usually made on the internet through popular crowdfunding platforms like Kickstarter and Indiegogo. Crowdfunding is especially good for startups and their early-stage funding.
Angel investors provide a type of equity financing for startups. Angel investors are typically wealthy individuals who are interested in investing in a company and provide start-up or first-round funding. In return for an individual investing in your company, you give that investor a percentage of ownership in your company. Alternatively, the angel investor may prefer convertible debt.
Angel investors typically don't make really large investments so their percentage of ownership may not be large. Often, angel investors are interested in having input on how the company is operated. You, as a startup founder and owner, can very often benefit from the expertise angel investors have to offer.
Angel investors generally need to be accredited investors. These are investors who are high net worth individuals who have certain qualifications and income.
Small Business Investment Companies (SBICs)
The Small Business Investment Company (SBIC) Program was developed to provide venture capital to small businesses. Those within SBIC are private, profit-seeking investment companies licensed and regulated by the SBA. These companies can be a pivotal source of equity capital for small businesses. The SBIC supplies a list of investment companies that participate in the program to small businesses.
The Bottom Line
Entrepreneurs and aspiring business owners may approach funding their startup business with hesitancy because they have been turned down by a traditional bank, or they have been told that it is difficult. There are many possible funding sources for small business startups, including loans of different shapes and sizes. There are also grants made by government, corporations, and other entities, as well as equity capital from SBICs and angel investors. There isn't a one size fits all, but there is often is a size that will fit you and your small business.