Financing Your Startup

Once you have determined the initial investment, the amount of money needed to start a business, you need to determine how much you can (or want to) provide personally.  To do this, you need to first calculate the amount of capital you already have in the business. A business’s capital is any and all financial or operations assets of the business, or the total value of the business.  

 

It is critical for you to bootstrap the business early on.  Bootstrapping involves keeping business expenses as low as possible by doing as much work in-house as you can.  For instance, labor (and its ancillary costs- payroll taxes, insurance, etc) is typically a business’s largest expense.  So, when starting a venture, it is wise to keep employment as low as possible until the business has reached a point where it can financially sustain more employees.  It should be noted that, bootstrapping can protect your business from the outside influences of potential investors, but it does place added pressure and financial risk on you, the owner.

 

Every investor wants to know what their return on a potential investment will be.  Return on investment (ROI), the benefit an investor receives from making an investment, is a term that comes up time and again in different parts of running a business.  This is because it is a core concept of financial management. Whatever a business may be investing in, whether it be a marketing campaign or a new employee, that investment should lead to a greater amount of revenue than the cost for that action.  If the cost of an action is greater than the revenue it will generate, then that action should probably not be taken.  

 

ROI is especially important for investors.  Simply put, anyone who is considering investing in a business wants to know that their investment will make them money.  Otherwise, what incentive do they have to invest? It is essential to be able to show potential investors the value of their investment to the business, and how that value will be used to create a return on that investment.  Also, be aware that the greater the investment, the greater the return investors expect. This is why bootstrapping is so important, as it can help to limit the amount of outside investment your business requires.

 

Before you run out into the world asking for money, you need to determine how much money your startup venture needs.  Startup costs include all expenses incurred during the process of creating a new business.  All businesses have different startup costs, but some are universal. For instance, you likely need to purchase office supplies and equipment.  You will definitely need enough money for day-to-day operations until the business reaches the point where revenue can cover its costs. The key is to make sure every expense used to calculate your startup costs is absolutely necessary.  Doing so will help illustrate your financial responsibility to prospective investors.

 

After you have figured out how much of the initial investment you can contribute, it is time to find another route for funding your venture.  The first people to approach should be your friends and family. Dealing with relatives and those closest to you can be a tricky situation. However, if you have a concrete business plan and the trust of someone who is willing to help you out, then friends and family will be your safest route to financing. If possible, negotiate a loan that includes interest in order to incentivize them to aid you without expecting to be involved in the day-to-day aspects of the business.  You may find it is impossible to separate potential investment from operational involvement when it comes to your friends and family, or you may not find an investor through that route.  

 

If you are unable to get the financing you need through your friends and family, then your next step should be to look into crowdfunding.  With the rise of sites like Kickstarter and Indiegogo, crowdfunding has exploded in the past decade.  Crowdfunding is a simple idea in which you share your idea with the world through a campaign on one of these sites and then incentivize a large amount of people to invest a small amount each in your venture.  These sites are free to set up with, but they will take a percentage of the money you raise.  

 

If you reach your fundraising goal, then you must first fulfill whatever incentives you promised your investors.  For example, Broken Lizard, the group behind the popular movie “Super Troopers,” used Indiegogo to fund a sequel when they were unable to get financing from a major studio.  In return for various levels of investment, Broken Lizard offered incentives like t-shirts, posters, and even trips to the red carpet for the premiere of their movie. Now, most campaigns are for smaller amounts and offer incentives that are more like t-shirts than red carpet trips. However, they can be (and often are) just as successful as Broken Lizard’s.  The risk you are taking when crowdfunding, however, is that you are putting your venture out there for anyone to see, and anyone could take your idea and run with it.

 

The next option to consider is seeking an angel investor.  Angel investors typically act as advisors in addition to their investment, rather than becoming directly involved in the operations of the business.  An angel investor will request equity in the business in exchange for funding your venture and may seek to help restructure or reorganize the business.  However, an angel investor will allow your vision for the venture to ultimately prevail. An angel investor is investing in you as much as your idea. Angel investors are looking for strong management, market potential, a window of opportunity, and a good ROI.  They typically have good business connections and experience to help develop your business and maximize its potential. This is largely where angel investors differ from our next type of potential investor: venture capitalists.

 

Venture capitalists are in many ways similar to angel investors.  They invest in a venture in exchange for equity in the business, and they look for many of the same qualities as angel investors in potential investment opportunities.  However, venture capitalists are motivated solely by maximizing their investment. Venture capitalists typically work for large firms that are less interested in helping to build a startup business than they are in finding ventures with the highest possibilities for growth and ROI.  In other words, venture capitalists are typically more cutthroat than angel investors, and are more likely to involve themselves in a business’s operations. (For this reason they are often referred to as “vulture capitalists.”) They will also likely seek more equity (typically in stocks or shares) in a business than an angel investor would.  This cutthroat attitude is nicely (albeit overdramatically) illustrated on the popular TV show “Shark Tank,” where investors compete to acquire equity in small businesses and/or products.  

 

After having investigated all the investment methods listed above, the final route for financing available to a startup venture is a bank loan.  There are many types of loans to consider, including installment loans, balloon loans, bridge loans, and lines of credit.  

 

An installment loan is a fully-amortized loan repaid in scheduled installments (typically monthly), including an interest rate and term determined by the bank.  

 

A balloon loan is a shorter-term loan that does not amortize fully.  In simple terms, a balloon loan is repaid in smaller payments that will not cover the full cost of the loan. So, a larger “balloon” payment is required at the end of the term to pay off the loan.  This is often an attractive option for small businesses due to the shorter term and lower interest rates. However, those benefits are offset by the risk of being unable to make the balloon payment at the end and needing to refinance the loan at a higher interest rate.  

Bridge loans are short-term loans with high interest rates that are used as a “bridge” in-between permanent financing.  Bridge loans require you to put down collateral, which is an asset (or assets) that a business can offer a bank in case they are unable to pay off the loan.  Collateral is essentially a security blanket for the bank against defaulted loans.  Any loan that is backed by collateral is referred to as a secured loan, and a loan not backed by collateral is an unsecured loan.

 

Finally, a line of credit is another option, though they are usually only available for more established businesses.  A line of credit is similar to a credit card, where the borrower will have a maximum balance for the loan and the borrower can use the available credit at any time.  A line of credit will typically have lower interest rates than a credit card, but offers no grace period. Further, interest is charged from the day a purchase is made.  For vendors that do not take credit cards, a line of credit is a great option for payment.  

 

When you are talking to lenders about investments, there are certain things that they will want to know.  First and foremost are your personal credit scores. Having good credit is critical to being able to get a loan, and is especially important for getting a good interest rate.  Lenders also want to know what your qualifications are. How strong is your management team? What schooling do you have? Do you have industry experience? These are all questions you should be prepared to answer.  A lender will also want to know what collateral you have available, and how liquid your assets are. Liquidity is an assessment of how easily a business’s assets can be sold to pay its debts.  It can be difficult for first-time business owners to obtain loans from a bank, so most of the other options we have detailed are easier for someone new to small business.

 

The thought of financing your business venture can be scary.  You open yourself to financial risks, and also risk giving away a portion of your business in order to make it happen.  However, there are lots of options out there, and there is plenty of money to be had. If you have a good idea and take the time to make a solid business plan, then you can absolutely turn your idea into a well-financed startup business.