When you were eight years old, you launched a highly profitable lemonade stand in your front yard. With nothing but a packet of instant drink mix, a crudely drawn sign and a winning smile, you grossed a whopping $2.35 in just an hour and 15 minutes. If only all new businesses were that easy.
According to the Global Entrepreneurship Monitor, a research group, the average cost of starting a new business in the United States in 2005 was $70,000 [source: Consumer Reports]. In a 2004 survey of failed businesses, 79 percent of respondents said that "starting out with too little money" was a major cause of their collapse [source: Sugars].
But how do you finance a new business? When you were eight, you could borrow the drink mix from mom. But now that you're grown up, will she let you borrow her life savings?
Luckily, you're not the first entrepreneur to start with nothing but a good idea. Keep reading to learn about 10 effective and creative ways to raise start-up capital for your new business.
On average, 68 percent of start-up financing comes directly from the pocket of the business owner [source: Consumer Reports]. Even if you don't have a lot of liquid assets in checking accounts, savings accounts or money market accounts, there are other ways to leverage your assets to finance a new business.
The first way is to sell high-price items that you simply don't need. Auction off grandma's jewelry and antiques, sell the car and lease a new one or downsize to a smaller home.
If you own your home, then consider a home equity loan or a home equity line of credit. Be very careful, though. With a home equity loan, you'll need to make additional monthly payments on top of your mortgage. And if you fail to make those payments, the bank could take your house.
Many people don't realize that they can borrow money from their 401(k) or IRA savings accounts. With a 401(k), you can usually borrow up to $50,000 of your savings as long as it's paid back, with interest, in less than five years [source: Smart Money]. With IRAs, you can borrow a chunk of money, interest free, for a period of 60 days.
Be warned, though, if you don't pay back these loans in time, you'll be charged income tax plus a 10 percent early withdrawal fee [source: Entrepreneur].
If you have a whole life insurance policy, you can also borrow up to 90 percent of the cash value of your account at a relatively low interest rate.
Angel investors are successful businesspeople who dig into their deep pockets to finance new businesses with high growth potential. If you're low on start-up capital, an angel investor can truly seem "heaven sent," but it's important to read the fine print.
First of all, money from an angel investor is not a loan. It's an equity investment. An equity investment buys the investor a share in the ownership of the company [source: FindLaw].
So if you accept money from an angel investor, you're also giving up partial control of your new business. An angel investor will ask for at least a 10 percent stake in your business, but could go as high as 50 percent for a riskier start-up [source: Entrepreneur].
For many small business owners, it's difficult to cede authority to an outside investor, so think hard before attaching strings to your money. On the bright side, since angel investors don't give loans, there are no regular payments with interest to worry about. As partial owners, however, they'll take a chunk of your profits.
How do you find an angel investor? Ask people who do business with the extremely wealthy, like bankers, accountants and lawyers and do research into local venture capitalist clubs. Or you could just hang out at a country club golf course on a Wednesday morning. That works, too.
Friends and Family
Borrowing money from friends and family to finance a new business is a terrific idea -- in theory. Banks and other lenders will demand airtight business plans and financial statements. Your grandma Edna might demand a hug. But be aware of the potential drawbacks of so-called "easy" money.
First of all, if you ask family and friends for money, make sure it's a loan, not an equity investment. If you allow too many friends and family to own a legal stake in your business, then you're setting yourself up for trouble. Legally, you'll have to run every major business decision by them first. And if you don't consider their opinion, they can sue. Talk about an awkward family reunion.
That said, private loans can offer significant advantages over traditional loans. Interest rates -- if interest is even charged -- are generally much lower than those offered by banks. Private loans are also an important show of support (both financial and emotional) in the early stages of a new business [source: Advani].
One crucial rule: Get everything in writing. It will make both sides feel more secure about the transaction and rule out any potential legal problems down the road. You can find free boilerplate loan documents online.
There's something romantic (in an economic sense) about financing a successful small business by maxing out your credit cards. We hear exciting stories about this all the time. What we don't hear are the stories about new business owners who maxed out their credit cards and then failed. So before you turn to plastic for financing, consider the risk.
It's true that credit cards can be a fantastic source for large amounts of capital. A credit card, after all, offers a line of credit with limits as high as $10,000, $20,000 or even $50,000 for a small business card. Since it's a line of credit, you don't need to fill out a loan application or submit a business plan each time you need an infusion of cash. Just swipe away!
A credit card allows you to carry a large balance as long as you make timely minimum monthly payments. Conceivably, you can leverage a debt of $50,000 with $50 monthly payments. But the question is, do you really want to?
The huge drawback of credit cards is that they carry very high interest rates. At the time of this writing, the average interest rate for a balance transfer credit card is 13.2 percent [source: Bankrate.com]. So if you choose to use a credit card for start-up capital, make sure you have a plan to pay it back quickly. If not, that interest will add up fast.
Bank loans are one of the most traditional and conservative ways to finance a small business. Unfortunately, they're also some of the hardest loans to get. Small business loans are small beans for banks because they make a lot more money from big loans [source: [Consumer Reports]. But with the right attitude and the right business plan, you might get lucky.
A typical commercial loan from a bank feels a lot like a mortgage. There's a fixed interest rate, fixed monthly or quarterly payments and a maturity date. The specific terms of the loan vary depending on whether it's an intermediate-term loan (less than three years) or a long-term loan (up to 20 years) [source: Entrepreneur].
One reason why bank loans aren't ideal for new businesses is that the bank will often require collateral or other existing business assets that it could seize in the event of a default. New businesses typically don't have a lot of collateral. That's why bank loans are better suited for construction projects, buying new equipment or expanding an existing small business.
Still, don't give up on banks. If you already have a strong working relationship with a local bank, you might be able to convince them to give you a small commercial loan. Remember to bring a solid business plan with realistic financial projections. Of course, it wouldn't hurt if the loan officer were a close family friend, too.
In 1992, the United States Small Business Administration (SBA) launched a micro loan program to help small business secure the financing they couldn't get from traditional lenders like banks.
Under the micro loan program, the SBA doesn't actually lend money directly to small businesses. Instead, it works with 170 non-profit lenders around the country called intermediaries. The intermediaries receive money from the SBA, which they use to make small loans at relatively low interest rates.
A new business can secure a micro loan for as little as $100 and as high as $35,000. The SBA says the average loan size is $13,000. Interest rates vary between 8 percent and 13 percent depending on the size and duration of the loan. The maximum length of an SBA micro loan is six years [source: U.S. Small Business Administration].
To apply for a micro loan, you'll need to be within the local lending area of one of the 170 non-profit intermediaries. Most microlenders also require borrowers to complete business training and business planning seminars before receiving the loan.
Some microlenders specialize in lending to businesses owned by women, minorities, the disabled or other economically marginalized groups [source: Consumer Reports].
Other SBA Financing
In addition to the micro loan program, the U.S. Small Business Administration (SBA) offers a loan guarantee program for new businesses. These so-called 7(a) loans are named after section 7(a) of the Small Business Act.
With a 7(a) loan, the SBA promises to pay back a portion of the loan if the small business borrower defaults. They're designed for borrowers who wouldn't otherwise qualify for a standard commercial loan because of bad credit or little collateral.
Like micro loans, the SBA doesn't lend any money directly to the borrower. Instead, the SBA guarantees a portion of the loan. In exchange for this guarantee, the lender must adhere to rules about interest rates and other loan terms. Interest rates, for example, can't exceed a fixed number of points above the current Prime Rate.
Small Business Investment Centers (SBIC) are another SBA program to help finance small businesses. SBICs are privately held investment companies that adhere to SBA guidelines in exchange for SBA loan guarantees.
There are more than 400 SBICs in the United States, some specializing in start-ups and others focusing on certain industries or geographic areas [source: SBA]. SBICs can offer financing either through loans or as equity investments.
The Internet has added an interesting new wrinkle to the world of new business financing. On so-called social lending Web sites, individuals can apply for loans from other individuals. The two parties set their terms and the Web site acts as the intermediary.
One of the more popular social lending sites is called Prosper.com. The site is designed around the auction model popularized by eBay. As a borrower, you register at the Web site and post a loan request for a fixed amount of money at a maximum interest rate. Interested lenders then bid on your loan. When you find a lender that offers an attractive interest rate, you proceed with the loan.
All loans on social lending sites are three-year unsecured loans. Unsecured simply means that the loan is made without any collateral. A credit card is another form of unsecured loan.
LendingClub.com is another social lending Web site, except it uses a system based on your credit rating. When you register at LendingClub.com, the site assigns you a credit rating (A, B, C, et cetera). Different credit ratings qualify for different interest rates [source: Lindner].
Once the loan is approved, the amount is deposited directly into your bank account. Likewise, fixed monthly payments are automatically deducted from your bank account for the life of the loan.
Trade credit is the lifeblood of most established businesses. It works very simply. When you buy parts from a supplier, the supplier delivers those parts with an invoice for the amount due. Because you have an established relationship with the supplier, he doesn't ask you for cash on delivery (COD). Instead, you have a period of time to pay him back without incurring any interest or penalties. That's called trade credit.
Trade credit is based on trust. As a new business, you're at a disadvantage, because you don't have an established track record of paying invoices on time. If you want to win the confidence of suppliers, you'll need to present them with the same credentials you might give a bank: a business plan, collateral, financial statements and other proof that you have your act together [source: Entrepreneur].
One of the greatest advantages of trade credit is that it's interest-free for a fixed period of time, perhaps 30 or 60 days. Even better, some businesses offer discounts if you pay the invoice within a very short period of time, maybe a week or 10 days. As a new business, it might take a lot of legwork and a little luck to secure trade credit, but it's worth it.
Now, this one might seem illogical at first. How can customers help finance your new business if it isn't even a business yet?
The trick is to use your business plan and your charm to convince people to become your customer even before your business is off the ground. Let's say, for example, that you want to start a company that builds custom computers for videogame enthusiasts. You build a prototype of your computer, bring it to a videogame convention and a large computer retailer wants to buy 1,000 units.
You don't have supplies to build 1,000 units and no bank is going to give you a loan to cover the costs since you're working out of your parents' basement. You can have the retailer sign a letter of credit saying it will pay for the 1,000 units upon delivery [source: Entrepreneur]. With that letter of credit, you can convince suppliers to offer trade credit until the computers are delivered.
Here's another customer-based technique. Let's say you're a hairdresser with a loyal clientele. If you decide to start your own beauty salon, you might want to ask your long-time clients to become investors. Throw in free haircuts for life, and you may have yourself a deal.
For lots more information about starting a new business, follow the links on the next page.
Starting a bank requires a good business plan, raising capital and going through a complex regulatory process.
Related HowStuffWorks Articles
More Great Links
- Advani, Asheesh. "Private Loans & Investments: Raising Money from Family and Friends." FindLaw. (April 23, 2009)http://smallbusiness.findlaw.com/starting-business/starting-business-financing/money-from-family-and-friends.html
- Bankrate.com. "Credit Card Averages." April 20, 2009.http://www.bankrate.com
- Consumer Reports. "How to finance a new business." April 2008. (April 20, 2009)http://www.consumerreports.org/cro/money/credit-loan/how-to-finance-a-new-business/overview/how-to-finance-a-new-business-ov.htm
- Entrepreneur. "6 Sources of Bootstrap Financing." April 20, 2009http://www.entrepreneur.com/money/financing/selffinancingandbootstrapping/article80204.html
- Entrepreneur. "Angel Investors." (April 20, 2009)http://www.entrepreneur.com/money/howtoguide/article52742.html
- Entrepreneur. "Bank-Term Loans." (April 20, 2009)http://www.entrepreneur.com/money/howtoguide/article52728.html
- Entrepreneur. "Trade Credit." (April 20, 2009)http://www.entrepreneur.com/encyclopedia/term/82538.html
- FindLaw. "Raising Money for Your Small Business: Loans vs. Equity Investments." (April 20, 2009)http://smallbusiness.findlaw.com/starting-business/starting-business-financing/starting-business-financing-loans-equity-compared.html
- Lindner, Melanie. "Where Credit Still Flows." Forbes. March 24, 2009. (April 20, 2009)http://www.forbes.com/2009/03/24/social-lending-credit-entrepreneurs-finance-credit.html
- Smart Money. "Should you borrow from your 401(k) or 403(b)?" Dec. 14, 2000. (April 20, 2009)http://www.smartmoney.com/personal-finance/debt/should-you-borrow-from-your-401k-or-403b-9657/
- Sugars, Brad. "The 6 Biggest Mistakes in Raising Startup Capital." Entrepreneur. Sept. 20, 2007. (April 20, 2009) http://www.entrepreneur.com/startingabusiness/startupbasics/startupbasicscolumnistbradsugars/article184350.html
- U.S. Small Business Administration. "Entrepreneurs Seeking Financing." (April 20, 2009)http://www.sba.gov/aboutsba/sbaprograms/inv/esf/inv_sbic_financing.html
- U.S. Small Business Administration. "Micro-Loans." (April 20, 2009)http://www.sba.gov/services/financialassistance/sbaloantopics/microloans/index.html