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 thatfails largely comes down to money. No matter how great the idea orhow high the customer demand, new businesses stumble when theydon't get enough financial support.

Financing may be your greatest source of stress as you startyour business, but the chase for dollars isn't always theordeal some entrepreneurs expect. The simplicity of the processmight even surprise you. Kym A. Nelson, 37, applied for a businessloan from National City Corp. over the phone. "It waseasy," says Nelson, who started The Furry Beastro, a dogbakery, 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 thelending officer, but most new businesses can't match that levelof creditworthiness. Professional investors, such as VCs andangels, are also mostly out of reach. Many entrepreneurs relyinstead on family and friends, personal savings, and credit cardswith hefty credit lines as their greatest sources of early funding.Between the two ends of the spectrum lie less conventionalpossibilities, 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 offinancial support. Axel Bichara, a senior partner with AtlasVenture, an international early stage VC firm in Waltham,Massachusetts, says a software developer may, for example, build onan existing relationship by offering to develop a product tailoredspecifically to that business. The customer gains a competitiveadvantage, and the entrepreneur a real-life test of theproduct's feasibility.

Most likely, though, your first stop for funds will be your ownpocket--a savings account, a home equity loan, stocks and bonds, ormoney from the sale of high-value possessions. Even a whole lifeinsurance policy with a high cash value can be a revenue source, assome insurers will lend up to 90 percent of the policy's cashvalue. Next comes credit cards, a high-priced source of money bestreserved for short-term spending.

Family and friends round out your options for easily accessiblefunding. Like personal savings and credit cards, friendly fundstend to be investments entrepreneurs handle loosely. But unlikesavings and credit cards, personal investments that never show anyreturn can easily wipe out decades-long relationships.

Money from friends also presents a problem for growingbusinesses ready for the next level of investor support. The reasonhas to do with valuation. When a friend invests $10,000 in yourbusiness and you promise a 10 percent share of the stock,that's saying the company is worth $100,000. Professionalinvestors who come onboard later may prompt a more accurateassessment, say $50,000, and suddenly your investor's stock isworth half as much. "Your friends will end up feelinghosed," says David S. Rose, chair of New York Angels, an angelinvestor group in New York City.

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

Making the Connections

When Steve Grushcow, CEO, and David Ries, COO, started their webmaintenance service, Edit.com, they deliberately avoided borrowingfrom friends and family, hoping instead to convey a more seriousattitude that would attract professional investors. The twoentrepreneurs built on Grushcow's enrollment in ColumbiaBusiness School's executive MBA program and links to investorsupport through the school's Eugene M. Lang EntrepreneurialInitiative Fund for Columbia students. From there, they proceededwith a relentless networking campaign to reach VCs. The proc-esstook about a year of meetings and presentations that mostly paidoff in tips and advice--and eventually an introduction to aninterested angel investor who decided to support them.

The investment put Grushcow and Ries in an elite group amongentrepreneurs. According to the Center for Venture Research, of the24.7 million small businesses in the U.S., just 48,000 receivedangel funding in 2004, earning a total of $22.5 billion.

Despite these odds, most angels give businesses a fair chance toat least know if they qualify. The AngelCapital Association lists angel investor groups with links towebsites where entrepreneurs can review funding requirements andsubmit business plans. Generally, angels look for companies withhigh growth potential, experienced management and unique marketadvantage, such as proprietary technology or a patent. Some angelsmay focus on a particular industry or region; others are open toany good idea. Investments run between $100,000 and $1 million.Some angels only look at companies referred to them, so keepworking on your business network.

Joyce A. Woodlen, 46, realized the value of relationships whenshe needed money to start Re-Joyce Medical Billing in Wilmington,Delaware, in 2004. She wanted to use her commercial property ascollateral for a loan from PNC Bank, but the bank questioned justhow commercial the building was after learning it also hadresidential tenants. Because of Woodlen's longtime relationshipwith her bank, Jacinta Panella, PNC's community developmentbusiness banker, took charge and arranged a site visit thatresolved the bank's concerns. "If it wasn't forJacinta," Woodlen says, "I don't think I would havegotten approved."

If ATM withdrawals define the extent of your bankingrelationship, start working on establishing more human contacts atyour bank. Months before you start your business, visit your localbranch manager or business banker, and introduce yourself and yourbusiness plan. The description should be brief, but be sure tomention your interest in developing a small-business-friendlybanking relationship.

Expanding your network might also turn up some unexpectedanswers to financing needs while helping you fine-tune yourbusiness strategy. Jan Norman, a small-business expert and authorof What No One Ever Tells You About Financing Your OwnBusiness, suggests contacting business owners in similar fieldsto gauge the market for your idea, preferably companies big enoughnot to feel a competitive threat. If local competitors balk, tryreaching out to other geographic areas. While this might not leadto an investment, entrepreneurs often gain useful tips, saysNorman, such as the names of equipment leasing agents or supplierswho will give favorable terms to young companies.

Other sources for reaching out to business owners are tradeassociation meetings, local chambers of commerce, rotary clubs, newentrepreneur forums, business breakfasts and business-schoollectures open to the public. "Every community has itsnetwork," says Thomas C. Kinnear, executive director of theZell Lurie Institute for Entrepreneurial Studies at the Universityof Michigan, Ann Arbor's Ross School of Business. "Youhave to get to know the people who know the people in it."

A less conventional means to funding a business can bebusiness-plan competitions, often sponsored by municipal economicdevelopment agencies and universities. Companies with unique ideasand ironclad business plans make the best candidates. Jay and VickiPerdue, 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 creditthe competition with helping them revamp their business plan aftertheir first submission failed in 2003. "We had a better ideaof the cost, how to make better projections and where our marketwas," says Vicki.

Each funding source will have its own criteria for judging abusiness, but David Terry, associate director of West Texas A&MUniversity's Enterprize Network in Amarillo, which administersthe Amarillo Enterprise Challenge for the city's economicdevelopment corporation, lists some rules for developing a winningbusiness plan, regardless of the potential funder. Your plan shouldclearly 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 andinvestors, so the more detail you can provide, the better. This isoften the toughest challenge for entrepreneurs. "It'stime-consuming," says Jerry Ezell, 33, owner of SFSFabrication, a metal fabrication and wholesale office-supplycompany in Tulsa, Oklahoma. "If you're not a Ph.D. infinance, get a counselor to do it the right way."

Capitol Capital

With help from an SBA Small Business Development Center, Ezelldetailed every possible expense, down to the gas used to mow thelawn outside his office. When the tally was done, the Iraq Warveteran found his expenses were low enough to make him a goodcandidate for an SBA Community Express loan-a type of fast-trackloan for up to $25,000 available to women, minorities and membersof the military through banks and nonprofit or private financecompanies.

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

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

But you don't have to be an SBA borrower to get help from adevelopment center. In fact, many of these centers primarily helplead clients to promising funding sources. Kelly Mizeur, financedirector 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 banksto match her clients with the right financing and steer them awayfrom blind alleys. "The top five banks say they are greatsmall-business lenders, but that doesn't mean that's thecase," Mizeur says. Midlevel and community banks thatdon't compete for Fortune 500 customers are a better choice,particularly those that dedicate talented employees tosmall-business lending.

Excepting SBA's fast-track loans, government loans andgrants have limited use for most startups, but may still be worthinvestigating. The federal government's Small BusinessInnovation Research Program and Small Business Technology TransferProgram target high-tech innovators. State and local financingavailable through economic development agencies usually focuses onexport-oriented manufacturers who will generate jobs and bring moreincome to the community. But there are exceptions: If you'relucky enough to do business in North Dakota, for example, thestate-owned Bank of North Dakota lends money through its BeginningEntrepreneur Loan Program with few restrictions.

Whatever the source of funds, they probably won't feel likeenough as the bills pile up. "Whatever you think your overheadwill be," says Ezell, "add 20 percent to 30 percent tocover yourself." But only make room for what's absolutelynecessary. "Through all this, entrepreneurs must know the artof bootstrapping," says Bruce Gjovig, director andentrepreneur coach at the University of North Dakota's Centerfor Innovation in Grand Forks. "Stretch your money as far asit will go."

Friendly Funding
Nothing is as good for the ego as the financial support of familymembers and friends for your fledgling business. But that feel-goodvibe 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 andcorporate finance at the Boston office of Eckert Seamans Cherin& Mellott LLC, recommends treating these funders the same asyou would professional investors. Make sure everyone involvedunderstands the financial risk by following McNutt'ssuggestions:

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

How They Did It
If you need more inspiration to help nail financing for yourstartup, consider the following examples from Jan Norman'sWhat No One Ever Tells You About Financing Your OwnBusiness:

• Diane Fallon started her Irvine, California, book-publishingfirm, Dickens Press, by running an ad for an investor inPublishers Weekly, an industry trade magazine.
• Amy Frey started import-export business ATC International Inc.in Silver Spring, Maryland, with the settlement money from atraffic accident.
• Alice Cunningham sold a triplex she owned in Berkeley,California, to finance Olympic Hot Tub Co., a hot-tub retailer inSeattle.
• Danny Archibald sold his Rolex watch, power tools, guitar andartwork 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 byDiversityInc magazine, Ford Motor Co. and SCORE. He appliedthe $50,000 award to starting The ReCONNstruction Center, areseller of used and surplus construction materials in New Britain,Connecticut.