April 2008
How to finance a new business
Entrepreneurs can tap a variety of sources—from their own assets to online peers
You've just been laid off from your job. Or perhaps you've been offered an early-retirement package. In either case, you're
not ready to stop working but don't want to go back on the 9-to-5 treadmill. It's time to start that business you've been
dreaming of for years.
If that's your situation, you have scads of company. According to the U.S. Small Business Administration, nearly 650,000 new businesses were created in 2006. But to get your operation up and running, you'll need money. How much depends on the type of business you are pursuing. Some start-ups need little more than a computer, desk, and telephone; others require much more.
According to the Global Entrepreneurship Monitor, a research group, the average cost to start a business in the U.S. was $70,200 in 2005. While that's not exactly pocket change, it isn't a king's ransom either. And the good news is that there's a variety of potential financing sources.
Your own pocket
The research group reports that 68 percent of start-up financing comes from the business owners themselves. Their sources include personal savings, 401(k) plans, and home equity.
Personal assets. For many people, this is ideal for several reasons. Money held in a bank account, money-market fund, or brokerage account is accessible, and you won't have to pay any interest or fees to get it. But it's not a perfect source. You might put other goals—a college education for your kids, say, or a comfortable retirement—at risk by using money you had saved for those purposes. So set a limit on how much of your assets you're willing to risk and stick to it.
After Jim Stewart was laid off from a telecommunications company in 2001, he spent a year and a half looking for work, with no success. That experience and the desire to have more control over his future prompted him to found JP Stewart Associates, a project-management company in Burlington, Mass. His start-up costs were minimal—around $2,000 in personal savings. Stewart, 53, set a deadline for the venture to become profitable. “I thought I'd look for work if the business wasn't doing well within a year,” he says. It was profitable that first year and still is.
Retirement savings. You might have a substantial amount of money in a 401(k) plan with your employer. If you leave your job, for whatever reason, you can keep the money in the plan if the company allows it, or you can roll it over into an IRA at a financial institution of your choosing. Either type of account could fund a new business. Like savings, these accounts are yours to do with as you wish.
But again, there are downsides. Most important, you shouldn't put your retirement at undue risk by withdrawing more than you can afford to lose. Another pitfall is that you'll have to pay tax on any money you withdraw. If you're younger than 59½, you'll owe an additional 10 percent penalty tax for early withdrawal.
An alternative is to tap into a 401(k) while you're still employed and start a business on the side. You can borrow against your balance if your plan allows it, typically up to $50,000. But you'll have to pay the loan back quickly—usually within 30 days—if you leave your job.
Home equity. Arranging a home-equity loan or line of credit is usually quick and inexpensive for qualified borrowers. A line of credit is flexible; you take the cash only when you need it. A home-equity loan has a fixed schedule for repayment. Both types of home-equity debt generally carry lower interest rates than other forms of borrowing. In early March 2008, a $50,000 home-equity line of credit had an average variable interest rate of 5.18 percent. Interest costs might be tax deductible within certain limits.
But these loans have their drawbacks too. Marcia Layton Turner, author of “The Unofficial Guide to Starting a Small Business” (John Wiley & Sons, 2004), points out that home-equity debt puts your home at risk if your business fails and you can't pay back the loan. And if the value of your home drops, you can go “upside down” on what you borrowed, owing more than your home is worth. With home values slipping, many lenders are tightening the criteria for home-equity loans.
Other sources
If you don't have sufficient assets to draw upon, you'll need to borrow money. Here are some possibilities:
Family and friends. Those closest to you might be happy to lend you money, perhaps at lower interest rates than you might obtain elsewhere. The downside, of course, is the personal risk. “If things go bad and they don't get their money back, you can damage or ruin relationships entirely,” Turner says.
Make sure family and friends are fully aware of the risks. And don't agree to a “pay me back when you can” deal. Formalize your loan with a written agreement stipulating interest rates and a payment schedule. You can hire a lawyer to do this for you, but there are lower-cost options. You can find boilerplate contracts for promissory notes online or at stationery stores for a nominal fee. If you take this route, you might still want to have a lawyer review any documents you draw up.
Credit cards. Your credit cards are a ready source of funding. Once the card is in hand, you can borrow as much as your credit limit allows.
That's what Andy Abramson did when he was laid off from a public relations job in 1992. “American Express and Visa were my investors,” says Abramson, 48, who used the cards to meet payroll and pay expenses as his fledgling public relations agency grew. Some 16 years later, his firm, Comunicano, in Del Mar, Calif., employs 15 people.
But using plastic for seed money can be quite expensive because the interest rates are higher than for other types of borrowing. Recently, the average for fixed-rate standard credit cards was 13.42 percent, according to Bankrate.com. Particularly dicey are teaser cards, which start out at a low rate and spike significantly within six months or so.
Banks. This is the traditional option—an entrepreneur goes to his or her local bank and asks for start-up funding. But banks tend to favor established businesses with a track record and assets. Large banks are not especially eager to lend the relatively small amounts of start-up money most individuals need. “They make a lot more money on one big loan than they do on a lot of small loans,” says Norman Scarborough, who teaches small-business management at Presbyterian College in Clinton, S.C.
Still, it might be worth your while to apply for a bank loan. Scarborough suggests trying a small local bank, preferably one you already do business with. And it's essential that you put yourself and your idea in the best possible light to land the loan you need (see First step).
Peer-to-peer lending. Web sites like LendingClub.com and Prosper.com bring individual borrowers and lenders together. LendingClub.com bases loan rates on the borrower's credit profile. At Prosper.com, parties on both sides negotiate the rate, though borrowers can set a maximum they are willing to pay. The companies oversee loan repayment and provide all the necessary paperwork.
Some borrowers have found this is an easier way to get money, at more favorable terms, than through traditional sources. That was the experience of Chuck Staley, 44, and his wife Laura, 37, who wanted to open a wine shop in Modesto, Calif. They took out a $175,000 home-equity loan, which was $25,000 short of what they needed. To borrow the rest, they prepared a business plan and applied for bank financing, but they were rejected at bank after bank because of a past bankruptcy.
Staley turned to Prosper.com, and within a short time 550 lenders had placed bids for his $25,000 loan application. Staley agreed to a three-year loan at 11.45 percent. With the funding in place, he opened Angels' Share Wine Shop last year.
He advises people looking into peer-to-peer borrowing to be straightforward about their financial situation. “I was as detailed as possible in what I gave them, including the reasons for the bankruptcy,” he says. Now that the wine shop is flourishing, “all those people who turned me down want to give me a loan.”
Microloans. These loans, generally for $35,000 or less, are available to minorities, women, the poor, and people with disabilities, who often have trouble obtaining conventional financing. The loans can be privately funded or administered by an organization such as the Small Business Administration's Microloan Program. For more information, check out the Association for Enterprise Opportunity.
Susan Matthews Brown, 53, is founder of Boppy, a $50 million manufacturer and distributor of feeding and support pillows for infants. When Brown tried to find start-up capital 18 years ago, banks were not interested. But she was an ideal candidate for a $25,000 microloan from the Colorado Enterprise Fund, a nonprofit community-development institution. “They go beyond spreadsheets to look at the plan as well as the person,” Brown says.
Small Business Administration. This federal agency offers a variety of loans for small businesses. The basic SBA 7(a) loan provides up to $2 million—sometimes more—through commercial lenders. But a 7(a) loan requires borrowers to first use other funding sources, including personal assets. SBA Express loans are available for up to $350,000 and, because local lenders don't need to complete SBA paperwork, can be made in as few as 36 hours. Patriot Express loans, for veterans and their spouses, carry a $500,000 maximum. For more details on the programs, contact the SBA.
If that's your situation, you have scads of company. According to the U.S. Small Business Administration, nearly 650,000 new businesses were created in 2006. But to get your operation up and running, you'll need money. How much depends on the type of business you are pursuing. Some start-ups need little more than a computer, desk, and telephone; others require much more.
According to the Global Entrepreneurship Monitor, a research group, the average cost to start a business in the U.S. was $70,200 in 2005. While that's not exactly pocket change, it isn't a king's ransom either. And the good news is that there's a variety of potential financing sources.
Your own pocket
The research group reports that 68 percent of start-up financing comes from the business owners themselves. Their sources include personal savings, 401(k) plans, and home equity.
Personal assets. For many people, this is ideal for several reasons. Money held in a bank account, money-market fund, or brokerage account is accessible, and you won't have to pay any interest or fees to get it. But it's not a perfect source. You might put other goals—a college education for your kids, say, or a comfortable retirement—at risk by using money you had saved for those purposes. So set a limit on how much of your assets you're willing to risk and stick to it.
After Jim Stewart was laid off from a telecommunications company in 2001, he spent a year and a half looking for work, with no success. That experience and the desire to have more control over his future prompted him to found JP Stewart Associates, a project-management company in Burlington, Mass. His start-up costs were minimal—around $2,000 in personal savings. Stewart, 53, set a deadline for the venture to become profitable. “I thought I'd look for work if the business wasn't doing well within a year,” he says. It was profitable that first year and still is.
Retirement savings. You might have a substantial amount of money in a 401(k) plan with your employer. If you leave your job, for whatever reason, you can keep the money in the plan if the company allows it, or you can roll it over into an IRA at a financial institution of your choosing. Either type of account could fund a new business. Like savings, these accounts are yours to do with as you wish.
But again, there are downsides. Most important, you shouldn't put your retirement at undue risk by withdrawing more than you can afford to lose. Another pitfall is that you'll have to pay tax on any money you withdraw. If you're younger than 59½, you'll owe an additional 10 percent penalty tax for early withdrawal.
An alternative is to tap into a 401(k) while you're still employed and start a business on the side. You can borrow against your balance if your plan allows it, typically up to $50,000. But you'll have to pay the loan back quickly—usually within 30 days—if you leave your job.
Home equity. Arranging a home-equity loan or line of credit is usually quick and inexpensive for qualified borrowers. A line of credit is flexible; you take the cash only when you need it. A home-equity loan has a fixed schedule for repayment. Both types of home-equity debt generally carry lower interest rates than other forms of borrowing. In early March 2008, a $50,000 home-equity line of credit had an average variable interest rate of 5.18 percent. Interest costs might be tax deductible within certain limits.
But these loans have their drawbacks too. Marcia Layton Turner, author of “The Unofficial Guide to Starting a Small Business” (John Wiley & Sons, 2004), points out that home-equity debt puts your home at risk if your business fails and you can't pay back the loan. And if the value of your home drops, you can go “upside down” on what you borrowed, owing more than your home is worth. With home values slipping, many lenders are tightening the criteria for home-equity loans.
Other sources
If you don't have sufficient assets to draw upon, you'll need to borrow money. Here are some possibilities:
Family and friends. Those closest to you might be happy to lend you money, perhaps at lower interest rates than you might obtain elsewhere. The downside, of course, is the personal risk. “If things go bad and they don't get their money back, you can damage or ruin relationships entirely,” Turner says.
Make sure family and friends are fully aware of the risks. And don't agree to a “pay me back when you can” deal. Formalize your loan with a written agreement stipulating interest rates and a payment schedule. You can hire a lawyer to do this for you, but there are lower-cost options. You can find boilerplate contracts for promissory notes online or at stationery stores for a nominal fee. If you take this route, you might still want to have a lawyer review any documents you draw up.
Credit cards. Your credit cards are a ready source of funding. Once the card is in hand, you can borrow as much as your credit limit allows.
That's what Andy Abramson did when he was laid off from a public relations job in 1992. “American Express and Visa were my investors,” says Abramson, 48, who used the cards to meet payroll and pay expenses as his fledgling public relations agency grew. Some 16 years later, his firm, Comunicano, in Del Mar, Calif., employs 15 people.
But using plastic for seed money can be quite expensive because the interest rates are higher than for other types of borrowing. Recently, the average for fixed-rate standard credit cards was 13.42 percent, according to Bankrate.com. Particularly dicey are teaser cards, which start out at a low rate and spike significantly within six months or so.
Banks. This is the traditional option—an entrepreneur goes to his or her local bank and asks for start-up funding. But banks tend to favor established businesses with a track record and assets. Large banks are not especially eager to lend the relatively small amounts of start-up money most individuals need. “They make a lot more money on one big loan than they do on a lot of small loans,” says Norman Scarborough, who teaches small-business management at Presbyterian College in Clinton, S.C.
Still, it might be worth your while to apply for a bank loan. Scarborough suggests trying a small local bank, preferably one you already do business with. And it's essential that you put yourself and your idea in the best possible light to land the loan you need (see First step).
Peer-to-peer lending. Web sites like LendingClub.com and Prosper.com bring individual borrowers and lenders together. LendingClub.com bases loan rates on the borrower's credit profile. At Prosper.com, parties on both sides negotiate the rate, though borrowers can set a maximum they are willing to pay. The companies oversee loan repayment and provide all the necessary paperwork.
Some borrowers have found this is an easier way to get money, at more favorable terms, than through traditional sources. That was the experience of Chuck Staley, 44, and his wife Laura, 37, who wanted to open a wine shop in Modesto, Calif. They took out a $175,000 home-equity loan, which was $25,000 short of what they needed. To borrow the rest, they prepared a business plan and applied for bank financing, but they were rejected at bank after bank because of a past bankruptcy.
Staley turned to Prosper.com, and within a short time 550 lenders had placed bids for his $25,000 loan application. Staley agreed to a three-year loan at 11.45 percent. With the funding in place, he opened Angels' Share Wine Shop last year.
He advises people looking into peer-to-peer borrowing to be straightforward about their financial situation. “I was as detailed as possible in what I gave them, including the reasons for the bankruptcy,” he says. Now that the wine shop is flourishing, “all those people who turned me down want to give me a loan.”
Microloans. These loans, generally for $35,000 or less, are available to minorities, women, the poor, and people with disabilities, who often have trouble obtaining conventional financing. The loans can be privately funded or administered by an organization such as the Small Business Administration's Microloan Program. For more information, check out the Association for Enterprise Opportunity.
Susan Matthews Brown, 53, is founder of Boppy, a $50 million manufacturer and distributor of feeding and support pillows for infants. When Brown tried to find start-up capital 18 years ago, banks were not interested. But she was an ideal candidate for a $25,000 microloan from the Colorado Enterprise Fund, a nonprofit community-development institution. “They go beyond spreadsheets to look at the plan as well as the person,” Brown says.
Small Business Administration. This federal agency offers a variety of loans for small businesses. The basic SBA 7(a) loan provides up to $2 million—sometimes more—through commercial lenders. But a 7(a) loan requires borrowers to first use other funding sources, including personal assets. SBA Express loans are available for up to $350,000 and, because local lenders don't need to complete SBA paperwork, can be made in as few as 36 hours. Patriot Express loans, for veterans and their spouses, carry a $500,000 maximum. For more details on the programs, contact the SBA.
This article was also published in Consumer Reports Money Adviser.
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