What Does It Take to Finance a Startup?

Congratulations — you have an idea for a potentially lucrative small business. All you need is the funding. Several avenues are available, and you should take the time to explore them all before deciding what's best for you.

In case you missed the emphasis, the operative word there is best. With that in mind …

1. When evaluating financing options, remember that it's not always about the interest rate. Terms and conditions matter quite a bit. Even as a C corp, S corp or LLC, you can lose what you've invested, and you may be asked for "personal guarantees" that will entangle you long after a business fails.
2. Match the duration of your financing with the duration of your assets. If you have two-year loans with a big balloon payment at the end and you can't roll your debt in two years because of a major recession, that's a big problem. Ever hear of Lehman Brothers? Yeah, they did that.
3. Don't settle for the quickest or easiest route if it's liable to leave you short of the funds you'll need to get up and running comfortably or sustain your operations in the future. A business that starts out underfunded is a business headed for trouble. And you could be headed for double trouble if you risk your retirement nest egg or rainy-day fund in that scenario. Unrealistic optimism shouldn't blind you to obvious risks. For instance, using $500,000 of your own money to launch a business that requires $1 million to get proper traction is a decision that could have catastrophic consequences.

The key — and this applies to any type of funding you're trying to secure — is to do your due diligence and be sure to provide a thorough business plan that includes a detailed budget. If you haven't done your homework, no one will be eager to lend you money. Also, make sure you and any other owners/partners have things like life insurance, buyout agreements and level of guarantees sorted out ahead of time. Don't try to hammer it out in front of a funding source at the last minute.

With those caveats in mind, let's look at some funding options.

Self-Funding
First of all, a reality check: According to the Small Business Administration (SBA), roughly one in five businesses fail within a year, and half fail within five years. Keep that in mind before investing your hard-earned assets in a startup — particularly if you are older and will have little time to recover any losses before reaching retirement age.

Here are two of the most common self-funding approaches:

• Rollovers as business startups: ROBS is a mechanism that, if done correctly, allows you to use your 401(k) to fund a startup without incurring any early-withdrawal penalties. Effectively, you use your 401(k) to become the sole investor in the stock of a new C corp that you set up. (There are IRS regulations that determine the parameters.) This isn't a great option unless you have a decent-sized pension or some other source of retirement income already set aside.

• Mortgage refinance: This common method is pretty much self-explanatory: You use a second mortgage to finance your business. The interest rate on home equity loans is better than on many business loans, and Uncle Sam may subsidize the rate to a point by offering you a tax deduction. Still, burning up the equity in your house to start a business carries significant risk — including losing personal property if your business fails.

SBA Loans
A bank loan is the tried-and-true way to start a business. However, traditional commercial bank loans can be hard to come by for small businesses, as surveys from firms like biz2credit show that large banks decline over 75% of small business loans and smaller regional banks decline over 50%. That's why many startups now turn to the SBA instead.

The SBA doesn't provide loans directly, but instead works with what it calls "partnering lenders" to reduce their risk by effectively having the federal government back the loan. The hurdle there is that the underwriting standards must conform to some pretty tight terms and conditions. A partnering lender's credit losses are relatively low (SBA guarantees 50-75% of the loan, depending on the program), which means you'll often get a better interest rate than you might have otherwise.

Angel Investors
As the warm-and-fuzzy name suggests, angel investors are people of means who might be willing to help you launch your business. Angel investors can be friends or family members, or they can be wealthy investors previously unknown to the entrepreneur. Angel investors typically have a higher tolerance for risk than banks have but also require a higher rate or return than banks typically do, or equity in the business. Even if the angel investor is a friend or family member, the investment is still a business transaction. It's an investment in your business, and you should expect it to be treated as such. They need to see a sound business plan, return on their investment, and regular reporting of your results.

Venture Capital
In the interest of completeness, I've included this. However, the odds of the average small business getting off the ground via venture capital (VC) are remote. To have even an outside shot at success, you really have to know someone.

Now, you might have a chance if your startup involves a marvelous innovation in a high-tech sector like software or mobile devices. (Presumably, you already have contacts in your chosen sector, or you wouldn't be tempted to launch a startup in the first place.) But pursuing VC funding is an exhaustive (and exhausting) process that amounts to an unpaid full-time job that can last for months.

Operating Leases
This form of financing often has a somewhat undeserved negative reputation. There are unscrupulous lessors out there, so do your homework (read your terms and conditions at end of term closely!). But you might be able to finance the hard assets of your business through leasing rather than having a lot of upfront costs in equipment purchases.

This is a form of financing that works in a business that's equipment-intensive, like a tool-and-die shop, processed food manufacturer or medical outpatient imaging center. Operating leases can be meaningfully better for your business' long-term cash flow because you aren't paying for 100% of the equipment, only a portion of its useful life.

If you're buying brand new equipment, odds are good the original equipment manufacturer (OEM) has a financing partner (a sister company or bank) that can originate a lease. They may also have service/maintenance for the equipment embedded in your lease payments, which can help drive down operational expenses and reduce the total cost of ownership.

If you go this route, always look at the cost of the individual services from other parties and compare to a "bundled" price. Usually, the OEM usually wants a deep relationship with you and is less concerned about maximizing their return on each piece. (Smart businesses know that customer acquisition is more expensive than getting in deeper with existing customers at lower prices.)

If you're taking over an existing business, this approach is predicated on something called a sale and leaseback: You sell your equipment to the bank or finance company, and then they lease it back to you. That means you effectively rent the equipment from them for a portion of its useful life. Depending on your state, there may be sales tax implications; be sure to talk to your CPA before doing this.

You'll get better effective "interest rates" (it's rent, not interest) with this form of financing. The reason? The lender is often giving you money for essential-use equipment, so the odds of you defaulting on the financing are low. In the event of a bankruptcy, you either affirm the lease (continue making payments as scheduled) or give the equipment to the lessor. This is different from a loan, where a bankruptcy might mean the lender is "crammed down" and must reduce the total amount they're going to get back from you or whoever buys out your business in bankruptcy.

The decision to go this route depends largely on the nature of the equipment. It's not such a good approach for equipment that retains its value and isn't going to be replaced because there will be a high buyout price at the end of the term. But in high tech, where equipment becomes obsolete fast, long-term leasing makes a ton of sense because you get to return the equipment and move on to the latest and greatest rather than absorbing the cost of buying it outright.

A couple of good recent examples of this were leasing programs for iPhones/iPads or copier machines. Just make sure you know when the lease is up and that you're upgrading on schedule or renewing at a lower payment, so that you avoid paying a lot of month-to-month rent.

Are You Ready?
After weighing all the risks and considering your financing options, do you still have confidence in your proposed startup? If so, that's great news. Yes, starting a business is a gamble. But it's also one of the most rewarding things you can do.