Avoid These Common Financing Mistakes
Plenty of traps await the neophyte business owner seeking funding for the first time. To get your new venture off to a good start, here's a list of common mistakes to avoid.
Whether you're bootstrapping a new business from your basement or thinking big and trying to raise thousands of dollars from investors, making certain funding mistakes can be fatal.
A classic problem is overestimating revenues your new business will generate and underestimating expenses, says Joel Shulman, an entrepreneurship professor at Babson College in Wellesley, Mass.
"Entrepreneurs are the proverbial optimists," he says. "They don't see the difficulty involved with bringing in those hard dollars, and they underestimate their business expenses and the cost of their living expenses when they are trying to start up."
Dr. Shulman says committing this error is the primary reason most new businesses fail in their first five years. "They run out of working capital," he says.
Plenty of other funding traps await the neophyte business owner. To get your new venture off to a good start, here's a list of common mistakes to avoid when seeking financing.
Not raising enough capital. Some companies may not require a huge investment up-front--think eBay seller, for instance--but don't stint on startup funds for new technology ventures or those requiring expensive equipment. Without sufficient operating funds, a capital-intensive business is doomed to a smaller existence than its owner might envision.
In 1989, Massachusetts entrepreneur William Herp started his first company, Event Cellular Communications, with $5,000 borrowed from his in-laws. The business was among the first to rent portable phones, but because it was under-funded, it was destined from the beginning to be a small player and operate only in Boston, he says. With insufficient capital to expand, Mr. Herp sold it three years later to a larger telecommunications company.
"The lesson learned was that in a business which is capital intensive, where you need to acquire assets to generate revenues, more capital is important," he says. "If we had more money to begin with, it could have been bigger."
Mr. Herp, 41, took the lesson to heart. For the two companies he has started since then, including his current venture, Linear Air, a Newton, Mass.-based air-taxi service, he's attracted ample investor funding.
Risking everything you own. Don't invest all your savings or put up all your assets as collateral for the sake of your new venture. It's better to have some cash in reserve and be able to keep the family home if your new idea doesn't work out.
"The biggest mistake that people make is to use all their savings or re-mortgage their house to borrow large sums," says Paul Holstein, senior vice president of CableOrganizer.com, a Fort Lauderdale, Fla., cable-management company. "If you fail, you lose everything."
Mr. Holstein, 40, speaks from experience. In 1995, he jumped on the Internet wave to start an Internet-service provider. He spent his entire savings of $20,000 to buy computers, routers and other equipment to serve customers in Florida's Broward County. But a company he partnered with to secure customers in Dade County filed for bankruptcy protection, leaving Mr. Holstein with all the expenses and no revenues. He shuttered his company, absorbing the loss. "It was a lesson learned and probably a smart investment, because I learned not to take big risks like that," he says.
His new company, which he founded in 2002 with his wife, required very little capital to start. The couple spent $30 for a domain name and Web site and small sums to buy materials for the first products--Velcro straps and tubing. The company is now generating $4 million annually and employs 16 people.
Borrowing from friends and family. When seeking loans, many entrepreneurs turn first to relatives and friends, says Mark Neath, a financial planner and business-valuation specialist with JK Harris & Co. LLC in Charleston, S.C. But if you can't repay the debt as quickly as you promised, it can sour the relationship--sometimes permanently, he says.
"You need to be aware of what happens if the business doesn't succeed," says Mr. Neath. "A loan can ruin the relationship."
Mr. Neath says one of his clients, a doctor, borrowed about $70,000 from a patient to set up a medical practice. The loan ruined the relationship because the doctor has been in business for about seven years and still owes about one-third of the initial sum. "People view this type of loan as their first option, but maybe it should be their last option," says the planner.
Failing to keep good records. Many entrepreneurs are too busy or lack the skills to keep accurate and timely financial records. When tax time comes around, it's nearly impossible to reconstruct their income and expenses, says Mr. Neath. Faced with the hurdle of trying to remember what they did, many entrepreneurs fail to file returns. "We see a lot of non-filers because they don't keep good books, and they're no longer getting W-2" earnings statements from employers, he says.
Entrepreneurs who don't keep records also may incur the wrath of the Internal Revenue Service by failing to pay quarterly taxes once their businesses begin to earn profits. The idea of paying taxes in advance is often a surprise to owners who were previously employees and had their employers deduct taxes, says Mr. Neath. Their quarterly tax bill includes not only estimated income taxes, but also such self-employment taxes as Social Security and Medicare, which employers deduct from gross pay.
For a small startup, coming up with $1,000 to $2,000 every three months for Uncle Sam can be painful. Tricia Keener Blaha founded Green House Creative in Boise, Idaho, with two partners in the early 1990s. The founders worked out of their houses and had the equipment they needed to provide clients with graphic design and marketing materials, so they never invested their own capital or secured loans to get started.
Ms. Blaha has since bought out her partners but without a line of credit or a stash of capital. She recalls lean times when she would go without a paycheck to cover expenses. She also vividly remembers taking funds earmarked to pay printers or other vendors and using it to cover quarterly tax bills. "You remember you need to make payroll, but you forget about the extra $3,000 you need at tax time," she says. "So you rob from Peter to pay Paul, and that's when you run into trouble."
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