It's no secret that the most popular source of startup financing is the personal savings of the business's founder. But while almost everyone will tell you that you must use your personal savings when starting a business, very few people will advise you on the more important question: What percentage of your personal savings should you use? Should you pour all your savings into your budding business? Should you use 50 percent less? I'm going to offer some tips on how to use your personal savings effectively to get your business off the ground.
To help illustrate just how much you should use, let's assume your business needs $25,000 to get off the ground. That's how much it will take to reach a point when it's financially self-sufficient or when you have sufficient proof of concept--a functional website, a prototyped product, your first clients, etc.--that will allow you to raise scale-up capital. Let's also assume you have $10,000 in the bank and about $30,000 in retirement savings (in a 401k) and that your annual earning potential is $50,000 per year (the salary you were paid for your last job).
Under this scenario, you have two options. One is to decide to take a big bet on your business by using all your personal savings and borrowing from your 401k. Your other option is to use considerably less of your savings and find a way to make up the difference. I'd recommend taking the less risky approach--no matter how confident you are in your business. Here's what I'd suggest:
1. Keep $5,000 in the bank. A good rule of thumb is to have at least $5,000 in the bank at all times. This is not only good for you; it's good for your business. Because no matter how great your business concept is, there's a decent chance that you'll need a sudden infusion of cash at some point in the first 24 months of opening your doors. This could be to deal with a problem, such as unexpected bills or legal work, or to fund an opportunity, such as a new client who won't pay you up-front. Dealing with time-sensitive cash needs without having some money in the bank could put your business at risk and lead you to make counter-productive decisions.
2. Borrow from your 401k in a limited manner. Borrowing from your retirement savings isn't really such a bad idea. Most plans allow you to borrow up to $50,000, or 50 percent of the value of the account, whichever is less. This is penalty-free, unless of course you don't pay the money back. Then the usual early withdrawal penalties apply.Because you're borrowing the money, you'll need to pay back interest to your own 401k account at a competitive rate set by your plan administrator (usually prime plus 2 percent) so you can replenish the loan without losing the capital gain. Most plans also require you to repay the loan within five years, and definitely before you change employers. If you're self-employed or unemployed, this restriction would not apply.
In fact, this kind of borrowing isn't at all uncommon and may be a smart solution in your case. These 401k loans are typically documented carefully, so this is the type of entrepreneur-to-business loan that usually gets repaid by the business, rather than typical entrepreneur-to-business loans that often get forgotten or forgiven. I highly recommend documenting all funds you loan to your business to ensure a proper paper trail. In my experience (personally and via my work with CircleLending), I would estimate that more than 75 percent of all entrepreneur-to-business loans are never repaid in a formal manner.
But by keeping $5,000 in the bank and using $15,000 from your retirement assets (assuming you have $30,000 or more in total retirement savings), you're still $5,000 short of the $25,000 budget described in the scenario above. So how should you raise the remaining funds? You have several options:
3. Leverage your personal savings. You can borrow against your $5,000. In my experience, it's better to have a low-interest loan from a close friend or relative than to use all your personal savings. That's because it's better to borrow money in a position of strength rather than weakness. The alternative would be to wait until you've run out of all your money, then turn to relatives and friends to bail you out. But this really isn't a financially responsible decision.
In fact, depending on your situation, it may be better to reduce the amount you borrow from your 401k and increase the amount you borrow from people you know. This spreads the risk of the business to more people. And remember: If necessary, you can always tap your 401k later to pay back those private loans. But doing that at a later date gives you the financial control to make those decisions when you have more information about the likelihood of the success or failure of your business.
4. Use a low-interest credit card and defer your expenditures. If you can stagger your $25,000 in expenses so you don't need the full amount up front, you should be able to use a credit card effectively. As long as you can avoid building up a balance on your card and paying exorbitant interest rates, there's nothing wrong with relying on credit cards to finance your business expenses.
5. Get a job. Don't forget, you can always get money the old-fashioned way--by earning it! What I mean, is that you can get a part-time job while you're in the startup phase. Even if you've already quit your day job, that doesn't mean you can't still roll up your sleeves and find a job to earn the remaining funds you need.
Using your personal savings is part of the entrepreneurial process, but be careful not to be swayed by the legends of entrepreneurs who leveraged all their personal assets to start their businesses. Many of those tall tales were invented by entrepreneurs who had money in the bank all the time!
Asheesh Advani is CEO of Covestor, an online marketplace for investors. He founded CircleLending, which was acquired by Virgin.