Capital Gains

The truth about startup financing: Know your options and do your homework to get the funding you need for your business.

The difference between a startup that succeeds and one that fails largely comes down to money. No matter how great the idea or how high the customer demand, new businesses stumble when they don't get enough financial support.

Financing may be your greatest source of stress as you start your business, but the chase for dollars isn't always the ordeal some entrepreneurs expect. The simplicity of the process might even surprise you. Kym A. Nelson, 37, applied for a business loan from National City Corp. over the phone. "It was easy," says Nelson, who started The Furry Beastro, a dog bakery, grooming and pet-accessories shop in Chicago, in 2003.

Nelson was lucky. Her management experience at MTV Networks, stellar credit score and debt-free lifestyle helped win over the lending officer, but most new businesses can't match that level of creditworthiness. Professional investors, such as VCs and angels, are also mostly out of reach. Many entrepreneurs rely instead on family and friends, personal savings, and credit cards with hefty credit lines as their greatest sources of early funding. Between the two ends of the spectrum lie less conventional possibilities, including economic development corporations, business-plan contests, and public and private microlenders.

First Look
In limited cases, even a potential customer can be a source of financial support. Axel Bichara, a senior partner with Atlas Venture, an international early stage VC firm in Waltham, Massachusetts, says a software developer may, for example, build on an existing relationship by offering to develop a product tailored specifically to that business. The customer gains a competitive advantage, and the entrepreneur a real-life test of the product's feasibility.

Most likely, though, your first stop for funds will be your own pocket--a savings account, a home equity loan, stocks and bonds, or money from the sale of high-value possessions. Even a whole life insurance policy with a high cash value can be a revenue source, as some insurers will lend up to 90 percent of the policy's cash value. Next comes credit cards, a high-priced source of money best reserved for short-term spending.

Family and friends round out your options for easily accessible funding. Like personal savings and credit cards, friendly funds tend to be investments entrepreneurs handle loosely. But unlike savings and credit cards, personal investments that never show any return can easily wipe out decades-long relationships.

Money from friends also presents a problem for growing businesses ready for the next level of investor support. The reason has to do with valuation. When a friend invests $10,000 in your business and you promise a 10 percent share of the stock, that's saying the company is worth $100,000. Professional investors who come onboard later may prompt a more accurate assessment, say $50,000, and suddenly your investor's stock is worth half as much. "Your friends will end up feeling hosed," says David S. Rose, chair of New York Angels, an angel investor group in New York City.

A better approach, Rose says, is to treat money from family and friends as a loan instead of equity. When your business attracts professional investors, convert the loan value to preferred stock priced the same as that offered to new investors, or at a slight discount. But use this approach with care. Treating early investors as lenders may give them the impression they'll be paid back even if the company fails. If the company does fail, Rose says, "it's important for family and friends to understand they won't be paid back. Their return depends on the success of your company."

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This article was originally published in the March 2006 print edition of Entrepreneur's StartUps with the headline: Capital Gains.

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