How To Raise Money For A New Business
By Marc Prosser
July 29, 2013
Fit Small Business
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In today's article we are going to continue our series on how to start a new business with a look at how to fund your new business.
Are you raising money for a new business, an existing business, or to acquire a business?
Depending on your answer, your options to raise money will vary. This article goes into how to raise money for your new business, a brand new idea or a business with less than two years of operating history. Two years is generally the point in time when banks will starting consider a company for lending products, such as lines of credit or term loans.
Most new businesses fail. Twenty percent of new business ventures close down within one year. After 5 years, only one of every two start-ups remain open. (Deeper analysis can be found on iCofounder.com here.) The very high probability that a new business will fail is crucial to understanding who funds startups and under what conditions.
Options For Raising Money For A New Business
This is a two part article part 1 of which will cover:
- Using your savings (including your retirement fund or taking out a HELOC)
- Raising money from friends & family (this could be debt or equity)
In part 2 of this article we will cover:
- Using credit cards as a source of capital
- Raising money from peer to peer sites or crowdfunding sites
- Raising money from angel investors / venture capitalists
How to raise money for a business by being your own bank.
What are you willing to risk to start your own business?
Before you start a new business venture, you and your family should discuss how much of your family's net worth you're willing to put at stake to launch a business. You may also want to include your accountant or financial advisor in the discussion. Once the business starts, there will always be a psychological temptation to put more money in. Establishing a limit up-front will help provide discipline and let your know when its time to shut an unsuccessful business down.
With this in mind, you may have more financial resources that you can put into your business than you realize:
Your Home As A Source Of Capital
If you are home owner with more than 15% equity (home value – mortgage value) / (home value) , you can potentially borrow against the value of your home. Generally speaking, banks will allow existing homeowners to borrow in aggregate between 70 – 85% of the value their home, including the mortgage. If your home is worth $300,000 and your mortgage is $200,000, banks are likely to provide you between $10,000 and $55,000 via a home equity loan (HEL) or home equity line of credit (HELOC).
You can think of HEL as basically a second mortgage, while a HELOC operates like a credit card which uses your home as collateral:
- Advantage: The main benefit of HEL or HELOC is that they can provide you with capital at a MUCH lower interest rate than a credit card or other ways of financing.
- Disadvantage: The downside is that you're potentially creating more risk of losing your home. If you are borrowing against your home, the bankruptcy protections that some states provide against losing your home don't apply to the HEL or HELOC.
Using Your Retirement Accounts As A Source Of Funds
With the right professional help, you can tap into your retirement accounts for starting a new business without incurring any early withdrawal penalties or disbursement taxes. Essentially, you are buying stock in your company with funds from your 401K and holding that stock inside your 401K account.
If your company is successful and starts making payments to shareholders, your 401K would receive a portion of those funds based on its ownership percentage. You could also pay yourself a salary which would not go into the 401K.
Most retirement plans are not designed to facilitate this type of transaction. The two types of retirement plans that facilitate these transactions are known as:
- A Business Owners Retirement Savings Accounts (BORSA)
- Rollover As Business Start Ups (ROBS).
Its also important to note that to make use of these plans your company must be set up as a "C" corporation. Barbara Taylor of Synergy Business Services provides the names of BORSA and ROBS providers in this article.
Raising Money From Friends and Family
Your friends and family want you to succeed and follow your dreams of running your own business. They are primarily investing in you rather than the business, and may not have realistic expectations about the success of the business. Unless your friends and family are sophisticated investors, taking money as a loan might be cleaner than selling them a share of the business for two reasons:
- Even small equity owners believe that they have the right to have a major say in the strategy and operations of the business. You may not want to be constantly getting business advice from your uncle.
- The founders of a new business tend to place unrealistic valuations on the business. To avoid giving friends and family a "bad" deal, a loan that pays a good interest rate might be the fairest approach.
Tips On Taking A Loan From Friends And Family
1) Put The Terms Of The Loan In Writing
You can find a great free loan agreement from Rocket Lawyer here. When you go through the agreement with potential lenders, you have the opportunity to prevent future misunderstandings, like will you pay back the loan if the business fails.
2) Have A Third Party Handle Payments And Notices
ZimpleMoney is great service which will remind you to pay borrowers, calculate interest rate payments, disburse payments to borrowers, and keep track of how much is owed. This is particularly useful if you're borrowing from multiple people, as you only need to make one payment to ZimpleMoney.
3) Interest Free Loans Are Not A Good Idea
If you don't charge a minimum interest rate called the AFR Rate, the IRS may consider the interest that the business "should have paid to the lender" as taxable revenue to the business. Furthermore, if the business is not successful and lenders don't get paid, it will be easier for lenders to record it as an investment loss for tax purposes if they were receiving a reasonable interest rate (and had the loan properly documented). Otherwise, the IRS might consider the money a gift rather than a loan. Joe Kristan has current AFR Rates on his blog here.
That's our article for today. If you have any questions please leave them in the comments section below. Also be sure to stay tuned for tomorrow's article where we will cover part 2, how to raise money using credit cards, P2P sites/crowdfunding sites, and angel/Venture capitalists.