Here Are All the Ways You Can Fund Your Startup
The following is an excerpt from Ed McLaughlin and Wyn Lydecker’s new book The Purpose Is Profit (Greenleaf Book Group Press, 2016), which recounts how, after quitting his high-level corporate job, McLaughlin started a thriving business that was eventually acquired by a Fortune 100 company. A serial entrepreneur, McLaughlin is the founder and CEO of Blue Sunsets, a real estate and investment firm based in Darien, Connecticut.
When I was starting my business, I couldn’t wait to lift off. I had decided to leave my corporate career and was impatient to get started as an entrepreneur. But first I had to decide how to fund my startup. My accountant counseled me to use other people’s money (a.k.a. “OPM”). I’ll never forget his response to my inquiry about startup funding: “OPM, Eddie, OPM.”
Friends and family — equity and debt
Finding outside investors or lenders for a business that is still in the idea stage and has no revenue can be very challenging. That is why the most common route for entrepreneurs seeking OPM is to first approach the people they know best. So I set out to source seed funding from friends and family.
But my discussions came to a screeching halt when I realized three things:
— First, I was very concerned about putting my friends’ and family’s hard-earned money at risk.
— Second, I didn’t want to damage the relationships if the business failed.
— Third, I didn’t want friends and family telling me how to run the business—especially since they lacked experience in the commercial real estate field.
Entering a round of fundraising with friends and family can make sense if the people who invest or lend you money have experience with startups. It can also make sense if they have industry knowledge they can contribute to the business, such as high-value connections and/or technical skills. But none of these factors were present as I thought over my list of friends and family.
I would be remiss not to mention that I did secure a small loan from my mother without any strings attached—other than an interest payment that exceeded the CD rate by one percent.
If you have a long-standing relationship with a bank, you can approach them for a business loan, while recognizing that banks do not normally make loans to startups. If your bank will consider lending you the money, you will be required to complete an extensive loan application, provide a complete set of financials along with a business plan, provide a personal guarantee that the loan will be repaid, and provide collateral for the loan.
If you cannot secure a business loan from a local bank, you can try to secure a Small Business Administration (SBA) loan. The SBA doesn’t actually make the loan, but the SBA does provide a guarantee for the loan if the borrower passes the SBA screening process with an accredited SBA lender.
The SBA does not require fully collateralized loans, as they are willing to take some risk and bet on the promise of the business. Even so, the SBA lender will want to understand the business model, the financial projections, and the economic conditions affecting the business.
Line of credit
If you decide that you want to pursue other forms of business borrowing, you can attempt to establish a line of credit with a bank. A line of credit gives you access to a preapproved amount of borrowing at a variable interest rate. One of the features of a line of credit is that you can draw on and repay the loan on a flexible basis, only paying interest on the amount outstanding until the principal is due.
A line of credit can build your business’s credit rating, get you over rough spots, and provide short-term funding for operations (working capital). Setting up a line of credit is smart, but you need to be aware that a line of credit is structured to be repaid on an annual basis. If your business can generate a greater return with the borrowed money than the interest rate you are paying to use it, then tapping a line of credit probably makes sense.
Using your own money — bootstrapping
As I said earlier, when launching my business, I realized that bootstrapping was my best pathway. As the sole funder, I could maintain ownership control and answer only to myself. I would use my savings as startup capital and forego a salary for the first year. Then, I would bootstrap my company’s growth by reinvesting all of the business’s income.
Deciding to bootstrap is a big step. There are real tradeoffs and opportunity costs to consider.
— Do you have the personal resources to invest in your business without betting the ranch?
— Are you comfortable with putting your own money at risk to fund a brand new enterprise with an unknown outcome?
— Can you accept the fact that the money you invest in your business will no longer be available for personal contingencies or to buy a car, fund education, buy a home, or save for retirement?
— What if the business fails? Can you withstand such an outcome?
When you use your own money, fear of failure becomes your greatest motivator. Besides the business obligations, I had a family with two children under five to support. I had to succeed because there was no Plan B. I was going to do everything I could to ensure that my business would prosper.
If you decide to bootstrap, you can secure capital to fund your startup from the following personal sources:
— Personal savings
— The cash value of a whole life insurance policy
— A home equity loan
— A personal loan
— Credit cards—but only as a last resort
Personal savings are the cheapest source of startup funding. Although you lose the opportunity to invest the cash elsewhere, there is no direct cost for using these funds. Beyond liquid savings, including stocks and bonds, your 401(k) or retirement savings are also sources of funds, but they do have restrictions that need to be considered. Utilizing personal savings enables you to maximize control, but at the same time it forces you to shoulder the lion’s share of the risk.
Whole life insurance loan
If you do not have liquid savings, a whole life policy is the next least expensive source of funds. The cash value is liquid, and you can take it out any time for any reason. With a life insurance loan, you borrow against the cash value in your policy, typically up to 90 percent of the surrender value. The interest rate you pay on the loan will be only slightly above the policy’s internal rate of return.
Home equity loan
Using your home as collateral will minimize your borrowing costs. However, you will need to demonstrate home equity value above the existing mortgage debt. Of course, the best time to borrow is during a low-interest rate environment. When your potential returns are above the cost of capital, using leverage is an intelligent choice.
If you are seeking a personal loan as a source of funds, you should expect to pay a higher interest rate than a mortgage rate. The bank will require the loan to be collateralized by other personal assets, such as your savings. Personal loans can be structured as either a line of credit or as a term loan. A term loan is for a specific amount, at a fixed rate of interest, repaid evenly over a set term.
Credit cards (not recommended)
The most expensive and most risky way to fund your startup is with credit card debt. Since a startup can burn through capital at a significant rate, and credit card interest rates are so dangerously high, funding your startup with a credit card can bury you in personal debt that can take years to pay off. Be advised that the issuer may offer a teaser rate to start, but inevitably, the rate will rise dramatically. Read the fine print on your credit card agreement. Credit cards should only be used as a bridge or as a last resort.
How I Bootstrapped
My wife and I had been saving up to purchase a house. After months of debating the startup and funding decisions, we finally agreed to make the sacrifice and shift our priorities from buying a house to investing our savings in the business.
Once I made the decision to bootstrap, I never looked back. I did not have to struggle with the monthly cash drain of repaying a loan. I didn’t have to worry about losing my relatives’ or friends’ money. But most importantly, I did not have equity investors looking over my shoulder, second-guessing my business decisions. I had complete control over who I hired and where and how I operated. Having control over business strategy and decision-making increased productivity, streamlined operations, and maximized my personal satisfaction. In the long run, bootstrapping enabled USI to enjoy rapid growth, as we kept plowing the profits back into the business.
If you are willing to take the risk, bootstrapping can be a powerful way to fund your startup and maintain control.