Capital Gains

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

This story appears in the March 2006 issue of Entrepreneurs StartUps Magazine. Subscribe »

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."

Making the Connections

When Steve Grushcow, CEO, and David Ries, COO, started their web maintenance service,, they deliberately avoided borrowing from friends and family, hoping instead to convey a more serious attitude that would attract professional investors. The two entrepreneurs built on Grushcow's enrollment in Columbia Business School's executive MBA program and links to investor support through the school's Eugene M. Lang Entrepreneurial Initiative Fund for Columbia students. From there, they proceeded with a relentless networking campaign to reach VCs. The proc-ess took about a year of meetings and presentations that mostly paid off in tips and advice--and eventually an introduction to an interested angel investor who decided to support them.

The investment put Grushcow and Ries in an elite group among entrepreneurs. According to the Center for Venture Research, of the 24.7 million small businesses in the U.S., just 48,000 received angel funding in 2004, earning a total of $22.5 billion.

Despite these odds, most angels give businesses a fair chance to at least know if they qualify. The Angel Capital Association lists angel investor groups with links to websites where entrepreneurs can review funding requirements and submit business plans. Generally, angels look for companies with high growth potential, experienced management and unique market advantage, such as proprietary technology or a patent. Some angels may focus on a particular industry or region; others are open to any good idea. Investments run between $100,000 and $1 million. Some angels only look at companies referred to them, so keep working on your business network.

Joyce A. Woodlen, 46, realized the value of relationships when she needed money to start Re-Joyce Medical Billing in Wilmington, Delaware, in 2004. She wanted to use her commercial property as collateral for a loan from PNC Bank, but the bank questioned just how commercial the building was after learning it also had residential tenants. Because of Woodlen's longtime relationship with her bank, Jacinta Panella, PNC's community development business banker, took charge and arranged a site visit that resolved the bank's concerns. "If it wasn't for Jacinta," Woodlen says, "I don't think I would have gotten approved."

If ATM withdrawals define the extent of your banking relationship, start working on establishing more human contacts at your bank. Months before you start your business, visit your local branch manager or business banker, and introduce yourself and your business plan. The description should be brief, but be sure to mention your interest in developing a small-business-friendly banking relationship.

Expanding your network might also turn up some unexpected answers to financing needs while helping you fine-tune your business strategy. Jan Norman, a small-business expert and author of What No One Ever Tells You About Financing Your Own Business, suggests contacting business owners in similar fields to gauge the market for your idea, preferably companies big enough not to feel a competitive threat. If local competitors balk, try reaching out to other geographic areas. While this might not lead to an investment, entrepreneurs often gain useful tips, says Norman, such as the names of equipment leasing agents or suppliers who will give favorable terms to young companies.

Other sources for reaching out to business owners are trade association meetings, local chambers of commerce, rotary clubs, new entrepreneur forums, business breakfasts and business-school lectures open to the public. "Every community has its network," says Thomas C. Kinnear, executive director of the Zell Lurie Institute for Entrepreneurial Studies at the University of Michigan, Ann Arbor's Ross School of Business. "You have to get to know the people who know the people in it."

A less conventional means to funding a business can be business-plan competitions, often sponsored by municipal economic development agencies and universities. Companies with unique ideas and ironclad business plans make the best candidates. Jay and Vicki Perdue, both 51, owners of Amarillo, Texas-based Pedal-Paddle Inc., the eponymous name for the company's land and water bicycle, won $75,000 in the 2004 Amarillo Enterprise Challenge. They credit the competition with helping them revamp their business plan after their first submission failed in 2003. "We had a better idea of the cost, how to make better projections and where our market was," says Vicki.

Each funding source will have its own criteria for judging a business, but David Terry, associate director of West Texas A&M University's Enterprize Network in Amarillo, which administers the Amarillo Enterprise Challenge for the city's economic development corporation, lists some rules for developing a winning business plan, regardless of the potential funder. Your plan should clearly describe:

  • How your business solves a problem
  • How competitors solve the problem
  • Who your potential customers are
  • How your company makes money
  • Your three- to five-year forecast of revenue and expenses

The last bullet gets the most attention from lenders and investors, so the more detail you can provide, the better. This is often the toughest challenge for entrepreneurs. "It's time-consuming," says Jerry Ezell, 33, owner of SFS Fabrication, a metal fabrication and wholesale office-supply company in Tulsa, Oklahoma. "If you're not a Ph.D. in finance, get a counselor to do it the right way."

Capitol Capital

With help from an SBA Small Business Development Center, Ezell detailed every possible expense, down to the gas used to mow the lawn outside his office. When the tally was done, the Iraq War veteran found his expenses were low enough to make him a good candidate for an SBA Community Express loan-a type of fast-track loan for up to $25,000 available to women, minorities and members of the military through banks and nonprofit or private finance companies.

The loan process is easy. According to Robert Tannenhauser, president and CEO of Business Loan Express, an SBA preferred lender in New York City, Community Express loans typically win approval within three days. Because the loans are unsecured, credit-scored loans, says Tannenhauser, "there's not a lot of paperwork or hassle."

Community Express loans are a companion to the SBA Express lending program, which is open to all qualified candidates. The money comes with a crash course in small-business money management. Every applicant must work with an SBA-approved technical assistance center, often a Small Business Development Center, before and after the loan is approved.

But you don't have to be an SBA borrower to get help from a development center. In fact, many of these centers primarily help lead clients to promising funding sources. Kelly Mizeur, finance director at the Women's Business Development Center in Chicago, says she keeps up with her community's angel investors, nonprofit and government lenders, and small-business-friendly banks to match her clients with the right financing and steer them away from blind alleys. "The top five banks say they are great small-business lenders, but that doesn't mean that's the case," Mizeur says. Midlevel and community banks that don't compete for Fortune 500 customers are a better choice, particularly those that dedicate talented employees to small-business lending.

Excepting SBA's fast-track loans, government loans and grants have limited use for most startups, but may still be worth investigating. The federal government's Small Business Innovation Research Program and Small Business Technology Transfer Program target high-tech innovators. State and local financing available through economic development agencies usually focuses on export-oriented manufacturers who will generate jobs and bring more income to the community. But there are exceptions: If you're lucky enough to do business in North Dakota, for example, the state-owned Bank of North Dakota lends money through its Beginning Entrepreneur Loan Program with few restrictions.

Whatever the source of funds, they probably won't feel like enough as the bills pile up. "Whatever you think your overhead will be," says Ezell, "add 20 percent to 30 percent to cover yourself." But only make room for what's absolutely necessary. "Through all this, entrepreneurs must know the art of bootstrapping," says Bruce Gjovig, director and entrepreneur coach at the University of North Dakota's Center for Innovation in Grand Forks. "Stretch your money as far as it will go."

Friendly Funding
Nothing is as good for the ego as the financial support of family members and friends for your fledgling business. But that feel-good vibe can wither if the business fails and investors feel cheated. How can you avoid the fallout of a business gone bad? Briar L. McNutt, an attorney specializing in business counseling and corporate finance at the Boston office of Eckert Seamans Cherin & Mellott LLC, recommends treating these funders the same as you would professional investors. Make sure everyone involved understands the financial risk by following McNutt's suggestions:

  • Create a mini-business plan listing your business's assets, liabilities, competition and risks.
  • Clearly disclose that investors may receive no return on their investment or lose the full amount of the investment, that there is no market for the securities they receive in exchange for their investment and that shares in the business cannot be sold.
  • Choose investors with a general understanding of business-they're more likely to understand the risk involved.
  • Have each investor sign an agreement acknowledging the disclosures described above.
  • Keep signed documents in a safe place. Give copies to investors. A little paperwork can go a long way toward controlling the damage from business failure and keeping everyone on speaking terms.

How They Did It
If you need more inspiration to help nail financing for your startup, consider the following examples from Jan Norman's What No One Ever Tells You About Financing Your Own Business:

  • Diane Fallon started her Irvine, California, book-publishing firm, Dickens Press, by running an ad for an investor in Publishers Weekly, an industry trade magazine.
  • Amy Frey started import-export business ATC International Inc. in Silver Spring, Maryland, with the settlement money from a traffic accident.
  • Alice Cunningham sold a triplex she owned in Berkeley, California, to finance Olympic Hot Tub Co., a hot-tub retailer in Seattle.
  • Danny Archibald sold his Rolex watch, power tools, guitar and artwork on eBay to raise startup capital for Archibald's Inc., a Kennewick, Washington, seller of expensive pre-owned cars.
  • John Powers won a national business-plan contest sponsored by DiversityInc magazine, Ford Motor Co. and SCORE. He applied the $50,000 award to starting The ReCONNstruction Center, a reseller of used and surplus construction materials in New Britain, Connecticut.
Julie Monahan is a writer in Seattle whose articles on small business and emerging technology have appeared in numerous consumer and trade magazines.

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