Before pursuing traditional debt and equity financing options, you may want to consider your own financing options, help from family and bootstrap funding methods.
Most small startup business are initially funded by the personal assets of the entrepreneur. Some funding for your small business is likely to come from your direct contributions of personal savings or assets to the business (e.g., an early retirement incentive payout).
Additional personal funds are often contributed after the entrepreneur borrows money through a personal (consumer) loan and then contributes that money as an equity investment into the business.
The majority of consumer loans will require that you secure the loan with an equity (ownership interest) in an asset that exceeds the amount of the loan. Unless you have an extremely solid personal credit history with a commercial lender, the institution is unlikely to grant an unsecured loan to a startup business.
You can use a great variety of your personal assets as collateral to obtain cash from a lender, but perhaps the most common source is a residence. You can use your home to:
The major disadvantage to using your house as collateral is, of course, that default on the loan can mean forfeiture of your home.
Nearly all commercial banks and residential lending institutions will have options available for home-backed financing. The period and computation of the rate of interest, upfront points, closing costs, administrative costs and burdens, the length of loan, loan conditions and default terms all affect the real cost of a loan. Whether or not the local lender will sell your mortgage to another creditor may also be a consideration for you.
For second mortgages or lines of credit, you should anticipate that lenders will allow a maximum total mortgage debt, including preexisting mortgages, of approximately 70 to 80 percent of the current market value of your residence at best. Gone are the days financing up to 100% of your home's current market value. Interest rates are low now, but they won't remain so indefinitely. The risk of losing your home if your business fails make these loans a last-ditch choice for most budding entrepreneurs.
If your property is currently valued at $180,000 and you have an existing mortgage of $80,000, your equity value in the house is $100,000. If the lender's maximum loan-to-value percentage is 80 percent, your maximum second mortgage would be for $64,000.
The reason for this is that you must continue to maintain at least 20 percent equity in the home ($36,000), leaving $144,000 available to be financed. $144,000 - $80,000 (your existing mortgage) = $64,000.
Also, be aware that second, or even third, mortgages will typically have higher interest rates than first mortgages because the lender is subordinate to a prior mortgagor. (In other words, if you default on the loans, the first-mortgage lender will be paid off first, and the second-mortgage lender may not be paid at all.)
In instances where your interest costs would not be significantly increased, you may be better off refinancing the existing mortgage for an increased loan amount rather than taking a second or third mortgage.
In the event real estate is to be used as collateral, borrowers should be aware that banks and other regulated lenders are now required by law to obtain third-party appraisals on real estate-related transactions of $50,000 or more.
Certified appraisals are required for loans of $250,000 or more. When commercial real estate represents the major piece of collateral for an loan, the SBA will also require a third-party appraisal.
Other than your residence, other commonly used collateral for secured consumer loans include other real estate, life insurance policies, any existing machinery or other business equipment, stock and pension plans.
For instance, you can usually borrow the cash surrender value of an ordinary life insurance policy. You are not obligated to repay the loan principal, only to pay interest on the loan. The rate of interest charged depends upon when the policy was purchased; rates on older policies might be very favorable. Of course, borrowing against your own policy means the eventual death benefit of the policy will be diminished by the amount of the loan, plus the loss of interest.
You may also have other assets in your personal portfolio that permit you to borrow from them or that can be used as collateral in a conventional loan. For example, if you have an employee retirement plan, you may be able to borrow against those savings up to a certain percentage of your total plan value. Marketable securities can also be pledged to a bank as collateral for a loan.
After considering their personal resources, the next place most entrepreneurs look for additional financing is to "insiders" like family, friends or business associates. Borrowing from insiders is attractive because it's private, often informal, usually unsecured, and often includes favorable terms, and because legal default proceedings are seldom invoked. In addition, this kind of financing can often be incorporated into a family's estate plan to assist in minimizing estate and income tax liabilities.
However, financing from family and friends is often a double-edged sword. Counterbalancing the convenience and low cost of insider financing are the misunderstandings, personal conflicts, and other problems that can arise from a lack of business formality or economic success. These dangers can seriously damage both the business and the long-term personal relationship between the parties. If you do seek financing from insiders, keep in mind the following suggestions and cautionary notes.
If a friend or relative is contributing capital as a gift, you should embody that understanding in a written "statement of gift." That the gift may have tax consequences.
The federal Internal Revenue Code allows an individual an annual exemption from gift tax in the amount of $13,000 per recipient. For example, if your parents wanted to give you a tax-free gift, they could each give you $13,000 per year (total gift of $26,000 annually). Gifts in excess of this amount would count against your parents' lifetime estate tax credit and might require the filing of a gift tax return.
If the transfer of funds is not intended to be a gift, an enforceable agreement such as a promissory note should be drafted that reflects the nature and terms of the exchange. The temptation to forego arm's-length formalities must be avoided.
For instance, the absence of interest charges, or below-market rates, may be a red flag for the IRS to question whether the transaction is really a gift, rather than a loan. If the IRS accepts your treatment as a loan, but finds that little or no interest is being charged, it may "impute" interest and tax the lender on the interest that he or she "should" have received.
If the insider does not want to participate in control or ownership of the business, a promissory note stating that the money is a loan, and listing the terms of the loan, should be drafted.
We have designed a promissory note form for you to download and use in our Business Tools section. Once you've downloaded it, the form can be used over and over again.
If you want the insider to become an owner of your business in exchange for financing, documentation of the arrangement is again important, but the paperwork will vary according to the type of ownership interest you are transferring.
For example, if the business is incorporated, a sale of stock ownership can be relatively simple. Attention should be given to ensuring that the value of the capital contribution fairly represents the value of the ownership and control interest being sold. Otherwise, gift tax and director liability issues may arise.
In addition, the issues discussed in equity financing concerning business control and ownership issues (e.g., rights of shareholders, elections of directors, cumulative voting, preferential rights, minority oppression, stock transfer restrictions, and buyout arrangements etc.) may need to be readdressed in the corporation's by-laws.
If the business is not incorporated, equity financing should include a drafting or redrafting of the partnership, limited partnership, limited liability operating agreement, or joint venture arrangement. The rights, liabilities, and responsibilities of the new participants should be defined clearly to avoid later confusion, disagreements, or unanticipated liabilities.
Bootstrapping is a buzzword that basically means generating needed funds by deftly managing your cash inflows and outflows. Improving cash flow should be a daily task, like housekeeping.
Monitoring, forecasting, and analyzing cash flows is essential to liquidity and profitability, even for the Fortune 500 crowd. A basic list of areas of concentration would include:
A little frugality and sensible use of available resources will pay big dividends in the long run. The old cliche "watch the pennies and the dollars will take care of themselves" is the bootstrapper's fight song.