Funding Your Business
You have made the exciting, and somewhat frightening, decision to be your own boss and start your own business. You have a great idea. The question is, how are you going to get your business off the ground and, once you are started, how are you going to keep your business growing? This article discusses different funding strategies.
The First Step: Sweat Equity
Most businesses start with a good idea and a lot of hard work from a dedicated owner. You do research and write a business plan. In many cases, you start making sales or performing services with little or no cash being contributed to the business.
You work hard, and you deserve to be paid for your services. As a business owner it is easy to focus on “profitability” without thinking about how much your time is worth. For example, if your business is making a “profit” of $2,000.00 in a month but you had to spend 160 hours on the business that month, if you paid yourself $12.50 per hour, your profit would be $0. I suggest that you keep track of the number of hours you are spending on your business. That information is very important to have when you are evaluating the success of your business.
The Second Step: Personal Funds
Most businesses require some minimal amount of capital to get started (at least $50 to file for a business name with the State of Oregon). Most business owners use their own funds for these start-up costs. If you are investing your money as well as your time into a business, it is important to be mindful of how you do so. Depending on what entity type you are using for your business and how much money is involved, there are several strategies, including contributing capital to your business, loaning capital to your business, and purchasing assets to be used in your business and leasing them to the business. The decision of how to structure the influx of capital should be discussed both with your accountant and with your legal advisor.
The Third Step: Friends and Family
The “friends and family” round of financing can be simultaneous with sweat equity and personal funds or can come after. Basically, you need additional capital and someone in your life is willing to help you out. Be very careful in the “friends and family” round. It is natural to not want to “negotiate” with a friend or family member who is helping you with your business. It is absolutely essential that these transactions be well negotiated and a written agreement be entered into. There is more at stake than just your business success, including the personal relationship with the person who is providing the financing. There are also many different ways to structure the transaction. Are they loaning the business money? Are they loaning you, personally, the money? Are they buying part of the business? As with the personal funds round, the decision of how to structure should be discussed with your accountant and legal advisor, as well as the accountant and legal advisor of the person(s) who are contributing the funds.
The Fourth Step: Bank Financing
Your business is up and running or you are buying an existing business and you need a bank loan. Bank loans are great for certain types of transactions. As a rule of thumb, in order to get a bank loan you have to be able to demonstrate to the bank that you can make the required payments on time and that, if for some reason you do not make the payments, the loan is backed by security sufficient that the bank would be able to sell the security and receive enough from the sale to pay for its costs, including attorneys fees, plus get their principal and interest back. In all likelihood the bank is going to require that you personally guarantee the debt, which means if the business defaults on the loan, you agree to individually pay the bank back.
The Fifth Step: Angels
You have made it big time. You are up and running and successful. If you just had $1 million, you would be able to expand and be even more successful and make even more profit. In walks an “angel.” Generally an “angel” is a wealthy person who is willing to make an educated gamble on the success of your business in exchange for an equity position. Most frequently, “angels” provide funding to established businesses, but under the right circumstance an angel might provide seed capital for a new business. With angel transactions, everything is negotiable, but you need to take the time to understand your bargaining position. Typically an angel will receive stock, or a note that is convertible into stock, in exchange for the investment. An angel may also require a certain level of control over your business, such as having a seat on the board of directors, restricting the right of the company to issue new shares. Before seeking angel funding, you should evaluate the level of control that you are willing to give up. Depending on your personality, you may be better off selling your business than getting angel funding.
The Sixth Step: Venture Capital
You have successfully completed your expansion and goals as a result of your angel funding and are ready to go to the next level, but you need $1.5 million or more to do it. Venture capital is typically received from a limited partnership. The limited partners tend to be wealthy individuals, and the general partner is responsible for managing the investments of the limited partnership. Venture capital transactions tend to be more structured than angel transactions. The venture capital firm will typically require a seat on your board of directors and preferred stock in your company. As with an angel investment, you will lose some control over your business. As a rule of thumb, the goal of the venture capitalist is typically to grow your company to the stage of an Initial Public Offering or to sell it, and is looking for a 10 to 1 return on the investment.
This document is a summary of some options for funding your business. This document does not create an attorney-client relationship. If you desire more information, I invite you to contact me.
Circular 230 Disclaimer: If any portion of this communication is interpreted as providing federal tax advice, Treasury Regulations require that we inform you that we neither intended nor wrote this communication for you to use in avoiding federal tax penalties that the IRS may attempt to impose and that you may not use it for such purpose.
