From the October 2003 issue of Startups

When physical therapist Jodi Medell opened a running store in Santa Fe, New Mexico, she had time on her side. Her home had sold, and as a result, Medell had a critical ingredient in any start-up financing plan: collateral to secure a loan, the lack of which can ground even the most inspired idea.

She also found a supporter in a local banker, a fellow runner who thought Medell's vision was well-suited to the Southwestern town; the nearest such store was an hour away. "Everything fell into place," recalls Medell, 33. "My house was on the market for a while. Right before I desperately needed money for collateral, it sold."

Getting collateral was only half the battle. Although it took just three months from the time she drafted a business plan until she received an SBA loan from a local bank, in that short period, Medell learned the harsh reality of start-up financing. To begin with, she qualified for only two-thirds of her loan request, despite putting up the money from her home, her car and life insurance for collateral. She also had the daunting task of developing a three-year financial plan. Lacking a business background, Medell struggled with the estimates. "It was phenomenal how much paperwork I had to go through," she says. "You spend so much energy trying to get funding that you're wasted before you even open."

The rigors of the credit process didn't end with the launch of her store, The Running Hub. The $98,000 loan was mainly for inventory, and she needed approval before accessing funds. "I had to copy my invoices and send them to the bank so they had proof it was going back into the inventory," says Medell.

Despite the strings attached to her financing, Medell is one of the lucky ones. While there may seem to be a boundless supply of business credit, little is flowing to start-ups. Even SBA dollars generally fund existing companies, not start-ups like Medell's. And other programs for unbankable entrepreneurs have such strict requirements that many people don't qualify.

Complicating the credit search are misconceptions about start-up financing. One of the most common myths is that the strength of a business idea can secure a bank loan when assets are scarce. "My first question is, 'How much do you have [available] to put in?' I make it clear that I will not be their venture capital partner," says John Milbauer, chair of Minnesota's Lino Lakes State Bank, which requires an owner's equity investment of 25 percent of project costs.

Jumping the Gun

Unfortunately, entrepreneurs are so obsessed with financing, they often neglect details like critiquing the business plan. Even a banker may not uncover flaws in the strategy, particularly when the borrower is a strong contender in terms of credit history and collateral. "If people have good credit and are willing to put up their house, they will get the loan," says Therese Flaherty, director of the Wharton Small Business Development Centerin Philadelphia, "but they may not be able to generate the payback."

There was no danger of Jamila Payne, 26, falling into that trap. Payne was a recent college graduate when she launched a mail order clothing business, Milla by Mail Direct. Without collateral, traditional credit sources were out of reach. But instead of plunging headfirst into a frustrating credit search, she planned her business to the smallest detail. By the time Payne needed a loan, she had incorporated her company, drafted a business plan and saved $8,000. Impressed with her initiative, a nonprofit lending group accepted her in its program for entrepreneurs 30 and younger. Payne got $15,000 and completed a 10-week training program, an invaluable experience for the young business owner.


How Low Can You Go?
Entrepreneurs tend to overlook an obvious way to reduce their debt dependence: trimming the fat from their business plans. "One of the biggest sources of financing is not needing to spend the money," says Therese Flaherty, director of the Wharton Small Business Development Center in Philadelphia. "If they can buy used equipment and furniture and not need the money, they're taking much less risk. They should look at their whole operations plan and see if they can minimize the amount of investment they need. It's better not to take out the loan if they don't need it."

It's not uncommon for start-up entrepreneurs to seek credit simply because they believe it lends validity to a brand-new business. "I've seen people who just want a line of credit because they think it makes them look more legitimate," says Flaherty.

She urges start-ups to think of alternatives to credit, especially to fund short-term spending. For instance, a painting business could finance certain operating expenses, such as paint and other supplies, by asking customers for a portion of the payment upfront. "If you can get staged payments, you can avoid the line of credit."

Expand the Search

For every thoroughly prepared entrepreneur like Payne, another fails to fully explore their options. "The only idea a lot of people have is that they need to go to the bank," says Michael Mykris, director of the Santa Fe Small Business Development Centerin New Mexico. "We plant the seed that there are other sources of funding."

Some start-ups may actually fare better because of their inability to access mainstream credit. Family members, for instance, are more forgiving than banks and provide flexible terms at a time when entrepreneurs need it most. You should consider a family loan not only an important first step in business ownership, but also a critical component of your credit history. Like other types of credit, family loans demonstrate that your business has handled credit responsibly, often a precursor to future funding from a bank or investor. In addition to hiring an attorney to authenticate a family loan, you should also document the payment history, including an amortization record.

Angel investors also offer advantages beyond funding, serving as mentors to the entrepreneur. Even so, many start-ups fail to include them in their funding search because they assume investors target only technology start-ups with vast growth potential. Not so, says veteran investor Hans Severiens, founder of the Band of Angelsin Silicon Valley. "The businesses we're interested in tend to be technology-based businesses that make a better widget or better software," he explains. "But that's only a small portion of the overall angel activities. The angel that invests in a restaurant is happy to put his money in and, in two or three years, get two or three times his money back. He's not looking for a restaurant to become the new McDonald's."

That's the good news. The bad news is that a start-up may need several angels because investments are typically $10,000 to $20,000 per angel. Says Severiens, "If you need to raise a million dollars, you have to talk to 50 people."

Persistence is paramount, not only because start-ups have to network extensively, but also because they should make repeated appeals to individual investors, says start-up manufacturer Edward Tucker. "I would strongly encourage people trying to raise money not to accept 'no' for an answer," he maintains. Tucker, 42, didn't veer from that advice when lining up funding for his company, Philadelphia-based Plasticoncentrates Inc., which manufactures components for coloring plastic. When he encountered resistance because of the technical nature of his presentation, he rewrote his business plan to make it more palatable. During meetings with socially conscious investors, he stressed that his manufacturing plant was located in a low-income area.

Tucker got additional dollars by highlighting his company's location and social objectives, which include $100,000 in "opportunity grants" from the state of Pennsylvania. Other states and localities offer programs to help new businesses, and some offer lower loan rates to start-ups in certain urban and rural areas.

A few entrepreneurs, however, find these government programs and local loan funds too restrictive. "A lot of times, they're for a specific purpose," says Vandell Hampton Jr., executive director of the Enterprise Center Capital Corp., a Philadelphia company that recruits, trains and grows start-ups in urban communities. His group funded Payne's business through its young entrepreneur program.

Before obtaining her SBA loan, Medell, who is part Chocktaw Indian, investigated a Bureau of Indian Affairs program. "The restrictions were so stringent," she recollects, "that you had to be on a pueblo or on native land."

Also, loan funds like Hampton's generally link training to financing. If a start-up needs credit quickly, it may have to forgo a business opportunity because of the funding delay. The loans are also more expensive, with interest rates as high as 14 percent. However, they still aren't as costly as many credit cards, which are not suitable for long-term financing, such as equipment purchases. "These assets are not going to produce significant revenue anytime soon, but the credit card bill comes in every month," Hampton emphasizes. "You need a term loan for longer-term working capital needs."

More Misunderstandings

The SBA 7(a) loan program, in contrast, is tailored specifically to long-term capital needs, offering borrowers lower monthly payments due to an extended repayment term; the funds can be used for most business purposes, including real estate, construction, inventory and working capital. But while the federal program has been around for 50 years, it's one of the most misunderstood financing resources. Despite what many entrepreneurs think, their credit history is critical because SBA loans are less collateralized than conventional credit. Many view SBA loans as a bailout program for distressed companies, and lots of start-ups consider the SBA a likely funding source. Neither belief is really accurate. "Most banks have credit policies that require two to three years in business, even for their SBA program," says Heather Endresen, director of SBA lending for Citibank's Western division.

Citibank has bucked the trend by offering up to $50,000 in SBA financing to qualified start-ups. Borrowers must have a three-year financial plan and a net worth equivalent to the amount they want to borrow. However, the bank doesn't take personal assets as collateral, only business property. "Maybe they'll use the equity in the house for another source of borrowing," Endresen says. "In most cases, $50,000 is not enough to do the whole start-up. We're generally dealing with companies that have some other source of capital."

While Medell's SBA loan helped her get started, she has relied on credit lines with several vendors to keep store shelves stocked. Most are limited to $5,000, which restricts the amount of merchandise she can buy.

Her ongoing financial challenges underscore a truth of start-up financing: Seed money can take a new company only so far. Nearly two years after her launch, Medell isn't living large. But she's still in business. "If you start a business without having deep pockets, even after you've gotten your loan, they really sock it to you," says Medell. "It's not easy at all. You have to be cautious."


Paving the Way
How one entrepreneur braced herself financially when launching a new business

Before launching a mail order clothing business, Jamila Payne was paying off credit card debt and scaling back living expenses in anticipation of her entrepreneurial plunge. The 26-year-old even sold an expensive car to purchase a cheaper one. "I think that's something the loan officers and venture capitalists evaluate. 'How are you living? You just bought a new car but don't have any money to put in your business?'" says the founder of Milla by Mail Direct. "People underestimate how much [investors] look at your personal spending habits."

Along with wanting to send the right message to potential financiers, Payne knew being able to skip a salary was crucial to her survival. "I've talked to other entrepreneurs who have to go back to work because they don't have enough money for their personal expenses," she says. "It's important not just to save for start-up capital for your business, but to save so you can sustain yourself until the business is generating revenue."


Crystal Detamore-Rodman is a Charlottesville, Virginia, writer who covers the small-business finance market.