Proven Sources of Startup Capital
Get the Cash to Get your Business Off the Ground
“Chase the vision, not the money; the money will end up following you.” –Tony Hsieh, Zappos CEO
After being involved with dozens of baby businesses (mine, friends’, and clients’), I heartily agree with Mr. Hsieh. Starting your own business to get rich is backward thinking. Put yourself behind a product or service that you know, that you like, and that you’re good at. People will notice, and your business will grow.
That said, you can’t buy materials or rent a storefront with hopes and dreams. ‘Spend money to make money’ is a trite but true mantra of any business. So, if this is your first small business or you’re just getting back on your feet from another endeavor, where do you get that money you have yet to earn? Fortunately, there are many sources of startup capital for the eager entrepreneur.
As in ‘pulled herself up by her own bootstraps’, Bootstrapping refers to self-funding a startup. If you’re not swimming in loot, don’t worry. There are several versions of this tactic, all of which are most often combined with other strategies.
1) Personal Savings
Let’s start with the simplest one. Use your own hard-earned bucks as capital in your new business. The PRO is that you’re legally/financially accountable to no-one and you don’t have any interest payments. The CON is that you assume all the financial risk with almost no protection if the business loses money.
2) Retirement Accounts (ROBS)
If you have over $50,000 in an Individual Retirement Account (Roth IRA or traditional IRA) or a 401(k), it is possible to use your retirement savings as startup capital for your new business. This little known, misunderstood, and unfortunately abbreviated program is called a ‘Rollover for Business Startup’ or ROBS. Under other circumstances, taking money out of your retirement savings before retirement age would result in substantial tax penalties and loss of interest, but conducting a ROBS avoids this. A ROBS is not a loan against your investment, and technically it is not a withdrawal from your retirement savings. All this said, using a ROBS is an intricate thing. I always recommend working with financial professionals when using this type of funding strategy.
3) Personal Credit (Credit Cards)
Many aspiring entrepreneurs have better access to credit than cash. While credit cards are a relatively simple and easy way to make capital purchases, there is significant risk to your personal credit. A good strategy is to limit credit card spending to specific revenue-generating projects. That way, when your customer pays you, you can pay off your credit card. This protects your credit score and limits charges from high interest rates.
4) Personal Credit (Home Equity Loans)
This strategy is basically the same as the one above but involves using the equity in your home as collateral. The initial capital flexibility of this is usually pretty high, but the risk is great. I put this on our list of startup capital sources to show one extreme, but I do not necessarily endorse this method.
5) Friends & Family
This is a pretty common strategy because it involves fewer hoops and less financial risk than taking out a loan or charging against your credit. However, this tactic involves mixing your personal life with your business endeavors, which is another breed of complication. If you ask for a loan, you obviously have to repay it. If you sell equity in your business, you have to split profits and potentially involve your friends & family in your business decision-making. Either strategy could get messy.
While this is generally where people’s minds go first, it is not necessarily the best source of startup capital. Banks are generally wary of lending to startups, especially if you don’t already have any commercial assets. For the most part, banks are a much better resource once your business is off the ground or if this is not your first small business. Here are a few targeted areas where the bank may be more willing and able to assist with capital.
6) Term Loans for Machinery
Banks may lend you money, in the form of a term loan, toward the purchase of equipment or machinery. Financial institutions are much more likely to lend you money to buy fixed assets that will have value no matter the outcome of your new endeavor.
7) Term Loans for Working Capital
‘Working Capital’ refers to cost-of-goods (inventory) and providing credit to initial customers of your fledgling business. Banks will typically work off of a business model you provide to assess if their investment will make a return through customer purchases.
8) Loans for Research & Development
Banks may be more interested in loaning capital if your business model involves the development of technology or other patentable items/ideas. Of course, you will be required to adequately demonstrate your capability to create this potentially profitable merchandise or intellectual property.
Customers & Suppliers
This may seem like putting the cart before the horse, but there are a lot of strategies for generating startup capital that involve suppliers and customers for your new business.
9) Product Licensing
Consider this as an ‘alternate strategy’ for starting a new business. This is a common scenario for aspiring entrepreneurs with a great product or service idea: You don’t have the startup capital. You don’t have the capability to produce the product. You don’t know how to produce the product. And even if you got past all that, you don’t have the distribution network to sell the product.
Rather than tackle all of those formidable challenges, consider licensing the idea for the product to a company that has all of this infrastructure already in place. This may feel like a disappointing solution, but it is imminently better than the frustration of sitting on an idea that you have no way of shepherding to fruition. Don’t try this tactic without guidance. Consulting firms like Lambert & Lambert are experts in partnering innovators with the right producers.
10) Customer Orders (Crowdfunding)
If your product is unique or in high demand, customers may be willing to pre-pay for their orders or give you an advance on your production of the product. This sort of arrangement can be hard to negotiate, especially if you are an unknown entity.
Crowdfunding is a more regimented technique that utilizes this same concept. Using the potency of social media, crowdfunding platforms like Kickstarter help you draw the interest of individuals who might pay small amounts to help you get your products off the ground. The reward for them is generally just the first crack at your innovation.
11) Invoice Financing
Invoice Financing (also called ‘Accounts Receivable Financing’) is where a lender will loan you money based on outstanding customer invoices. This can be a bit confusing to wrap your head around, so I’ll break it down with a few simplified steps:
#1 You make a product or deliver a service to a client.
#2 You generate an invoice for this product or service and send it to the client.
#3 You also send a copy of the invoice to the lender, who pays you the amount of the invoice (basically vouching for the client).
#4 The client pays the invoice.
#5 You repay the lender the value of the invoice plus interest.
With Invoice Financing, lenders are much more concerned with your credit (and that of your client) than the nature of your business. These loans are typically fairly easy to obtain in a very short amount of time. However, they generally carry high rates of interest, so I only recommend them for short-term borrowing.
12) Purchase Order Financing
Purchase Order Financing is similar to invoice financing, but with one very important difference: you can apply before you have produced the product or provided the service. This is a crucial advantage if you are lacking the capital for materials (and therefore can’t produce the product, allowing you to generate an invoice). With Purchase Order Financing, a client will send you a Purchase Order signaling their intent to purchase your products or services. You can then take the Purchase Order to the lender for a loan. Once you obtain the capital, manufacture/ship the product, and are paid by the client, you can repay the lender. Qualification for Purchase Order Financing typically has everything to do with the credit and reputation of your customer, so this is a much more effective strategy with a large and well-established client.
13) Supplier Lines of Credit
On the other end of the equation, you may be able to buy yourself some time to pay your own suppliers by negotiating lines of credit. The goal is to be granted ‘terms’ (generally a period of 30 or 60 days) before you are required to pay each invoice. The combination of this strategy and having your own customers prepay for the products can produce a solid chunk of working capital for you. Of course, you have to make sure you deliver!
There are several other niche sources of capital that you can mine if you’re savvy and if your business model meets certain criteria.
Microloans are private loans from non-profit groups that are specifically tailored for certain types of startup businesses. Generally, these loans are for amounts less than $10,000, so they aren’t for substantial capital purchases. Because of the variable interest rate (as high as 22%), I don’t advise that you take one out if you don’t have a high degree of confidence you can repay it quickly. Many microloans are for very specific businesses or business owners such as DBEs (Disenfranchised Business Enterprises). DBEs include businesses owned by women, minorities, or individuals with disabilities.
15) Venture Capital
Many people know this term (possibly because it sounds really cool) but not much about it. Venture Capital groups are investment firms that inject seed money into other businesses. Rather than charge interest for the money (or even expect it back), they buy equity or a minority stake in the business. This means that will you share profits with the Venture Capital firm. Also, because Venture Capital firms have their own investors to report to, they will take a more active role in the managing of your business. While this can be a good source of capital for the right entrepreneur, it can be extremely difficult to obtain. Venture Capital firms target opportunities with high reward potential, typically in specific industries such as medicine or technology.
16) Angel Investors
Angel Investors are similar to Venture Capitalists, but there are a few key differences. First, Angel Investors are more likely to be wealthy individuals or families, rather than corporations. They also tend to make their selections based on their belief in you, the business owner, in addition to your business model. For this reason, aggressive networking and maintaining an unimpeachable reputation in the business world are both very important for attracting the right Angel Investor. Finally, while Angel Investors may be interested in obtaining a higher percentage of your business than Venture Capitalists, they are much less likely to ask for an active role in managing the business.
17) Government & Private Grants
If you have the right sort of business, government grants and private grants can be great avenues for obtaining capital. It’s basically free money. Unfortunately, of all our potential sources, these tend to be the most difficult to secure. Generally, the types of institutions eligible for grant money are very limited (e.g. schools, churches, charities) and you may need to first receive a certain tax designation from the IRS. Obtaining grant money and retaining your eligibility is a complicated process.
The Bottom Line
If you take one thing away from this article, it should be this: don’t let your current financial situation stand in the way of opening your next small business. Do your due diligence to research all the avenues open to you. The opportunities are out there for entrepreneurs with the fortitude and humility to try a few different doors before they find the right source of startup capital for their next great business idea.