How Start-up Capital Works


When funding your business venture, you need to decide between debt capital and equity capital. See more corporation pictures.

­When you start a new business, you need money ­to get it off the ground. You need the money to rent or purchase space for the business, furniture and equipment, supplies, professional fees such as legal and accounting, as well as continuing the research and development of your product or service. You may also need money to pay employees. There are several places where you can get the money that a new business needs, but first you need to think about which type of funding will work best for your company.

In this article, we'll tell you about different sources for funding, explain the differences between the various types of financing, help you decide which is best for your company, and give you tips on how to go about getting the funding you need to get your business off to a running start. First, let's look at the types of capital you have to decide between.

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Your Capital Needs

For each stage of your company's life, there may be financial needs that require outside funding. The funding types for the different stages are called:

  • Seed capital - Seed capital is the money you need to do your initial research and planning for your business.
  • Start-up capital - Start-up, or working capital, is the funding that will help you pay for equipment, rent, supplies, etc., for the first year or so of operation.
  • Mezzanine (expansion) capital - Mezzanine capital is also known as expansion capital, and is funding to help your company grow to the next level, purchase bigger and better equipment, or move to a larger facility.
  • Bridge capital - Bridge funding, as its name implies, bridges the gap between your current financing and the next level of financing.

Each of these plays an important part in your company's growth at various stages. In this article, we'll focus on start-up capital. You're going to need some funds to keep you going while your business cuts its teeth. Where will your money go?

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  • Payroll and its peripheral expenses (for you and any employees)
  • Utilities (phones, electric, Internet/communications, etc.)
  • Rent
  • Marketing and sales-related costs
  • Supplies
  • Maintenance
  • Insurance
  • Taxes

Make sure you allow enough money for the true expenses associated with running your business for the first year of operation. (And don't forget to pay yourself first!) Make sure you've planned for more employees, production increases, more stuff for those new employees, etc. One of the top reasons many new businesses fail is because they don't get enough start-up capital. (The other reason is poor management.) Realistically estimate your financial needs and leave room for the unexpected, or you may unexpectedly be out of business.

So now you know about different financing for different stages of company growth and maybe have an idea of how much capital you need. How does this financing work?

Types of Capital

You have two choices when deciding which type of capital funding you want for your company. You can go for debt capital or equity capital.

With debt capital, you'll be getting a loan that must be paid back over a set period of time, with interest and possibly some other fees. You maintain full control of your company, but you also have a hefty tab to pay at the end of the evening. Equity capital is funding provided by people or firms who want to own a part of your company and reap some of the rewards when your large and successful company goes public or is acquired by another larger and even more successful company. So your real question is, do you want to give away part of your company in exchange for the cash you need to make it happen? Or, do you think you'll be able to make the monthly payments of a loan so you maintain full control and ownership?

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To determine the type of funding you should go after, ask yourself questions like these:

  • Could my company even qualify for debt financing?
  • Am I willing to lose my house if the company goes under?
  • Will I be able to make the monthly payments to pay off the debt?
  • Will the lender give me more money if I need it?

Or, for equity financing:

  • Would investors even be interested in my idea?
  • Am I really the control freak people say I am? Is that a problem?
  • Am I really okay with someone going through my confidential financial information?
  • Am I going to be able to give investors the information they need?
  • Am I going to have a problem sharing my hard-earned profits?

Once you've mulled over those questions, and are totally confused, remember, you can always make use of more than one funding source. Some of your choices for funding your company include:

  • Personal savings
  • Borrowing from friends and family
  • Getting a loan from a bank
  • Getting a loan through the U.S. Small Business Administration
  • Getting a partner and using his or her personal funds
  • Going through a commercial finance company
  • Going the venture-capital route
  • Lease-based financing
  • and many others that we'll talk about as we go

You will probably be able to get more money from investors than from a loan. So if your business requires a lot of cash up front to grow quickly (as in a high-tech industry), then equity capital may be your best route. Let's wade through the various sources for funding, and go over some of the pluses and minuses of each.

Using Personal Funds

Depending on how much cash you need (and how much you have), you may find that using personal funds is the best option. Over 50% of small business start-ups are financed with personal funds. If your business doesn't require producing a product, or hiring employees, or renting an office, then you probably can get along fine without much in the way of financing. But, remember our list of operating expenses from the last session. Your business is going to need some form of sales or marketing, which means advertising, which means spending money. This means you go into your savings account, take out a second mortgage or home equity loan, get a personal loan, or dig up that jar buried in the back yard.

A home equity loan is a low-risk, relatively simple way to secure funding for your business. The bank doesn't really care what you are using the money for, and you'll be financing your business yourself. Often, having a larger financial investment in the business personally will have more weight when you're trying to get a business loan.

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A personal loan is also a possibility, but make sure you let the bank know that you plan on using the money for your business.

Or, use the Spike Lee method and start taking advantage of some of those pre-approved credit cards you get in the mail every day! Hey, it can work -- just make sure you check out the interest rates, annual fees, and late fee charges.

If yours is a simple business, you could also bootstrap it. This means that, with a very small investment, you get the business going and then use the profits from each sale to grow the business. This approach works well in the service industry, where start-up expenses are sometimes low and you don't need employees initially.

Borrowing from Friends and Family

Before you use up all of your personal savings on advertising your business (which wouldn't take long with today's advertising costs), think about your other options. Have you asked Mom and Dad for a loan? Does Grandma have a few thousand dollars that she might like to invest? Has that college roommate really been as successful as he said he was at the last reunion? Tapping into the pockets of friends and family has some benefits, but it also has some drawbacks.

For one, you have to ask them for the money.

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If you do end up asking friends and family, make sure you present the business to them just like you would pitch it to a venture capitalist (VC). Let them decide whether they want to take the risk (remember, they know you). Make sure you have a written agreement or promissory note that specifies the details of the loan. And don't get upset when they pester you with questions about how their money is doing. This would be another drawback of tapping into this particular money source: constant contact.

Overall, borrowing from friends or family is probably not your best choice, simply because of the strain it may put on relationships. However, it does work for many people and may even strengthen your relationship if your business takes off and is successful.

Getting a Business Loan

If you decide to get a business loan from a bank or other lending institution, there are several things to consider. Start by asking yourself these questions:

  1. For what, exactly, is the loan going to be used?
  2. What length should the loan be?
  3. What assets can you use as collateral?

When answering these questions, especially the first one, be specific. Are you going to buy a building with the loan? Are you going to use it to purchase parts for an order you will fill within six months? You need to think through these things because you want to make sure you get a loan that fits the use of the money. For instance, you don't want to finance supplies for 15 years if you'll be using them up within six months, and you wouldn't want to finance your building or a large piece of equipment with a one-year loan. Make sure your loan type and length fits what you're using the funds for so you're not paying interest on widget parts that are now long gone.

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Next, we'll look at ways to help your chances of landing the loan.

Helping Your Chances

Banks are skeptical about lending money to start-ups. They like to see a couple of years of profitability before they dole out cash. They will require some form of collateral such as vehicles, buildings, real estate, or other hard assets. Occasionally they will loan based on your inventory or accounts receivable, but it's not their preferred relationship. They aren't interested in the potential of your business, only your business's ability to pay off the loan. They call this asset-backed borrowing, and you can actually use many things to back your loan. For example, you can use the equity in your home, or even your children's college fund. (However, you may want to take a moment to consider your kids' athletic prowess and/or scholastic strengths before risking the college fund.)

Another option is to have someone cosign the loan or credit-line for you. You may have a friend or relative that doesn't necessarily have the money to invest in your company, but would feel comfortable enough to cosign. Just make sure that person have a good credit record. You may also be able to find someone who will cosign for a small fee. Check with your legal or financial advisors.

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The Small Business Administration (SBA) can also help you get a loan for your new business. The SBA is a U.S. government agency that backs and guarantees loans made by banks to small businesses. The backing by the SBA gives the local lender a higher level of confidence in the likelihood of collecting on your loan. With less risk, they are more likely to approve the loan. In the event you default on your loan, the SBA has guaranteed the lender that the SBA will pay up to 90% of loan back itself. The guaranteed percentage depends on the type and the amount of the loan The SBA offers many types of loans, including loans for veterans, equipment and facility updates for pollution control, and many other business situations that affect local economies and communities. As a small business owner seeking a loan, you (and anyone else who owns at least 20% of your business) are required to also personally guarantee the loan. Your business must also qualify as a small business. By the SBA's standard, most businesses in the United States are considered small.

With a standard SBA-backed loan (7(a) Loan Guaranty Program), you can borrow up to $2 million; however, the SBA will only guarantee the first $1 million. If your loan is $150,000 or less, the SBA will guarantee 85%. If the loan is for more than $150,000, then they'll guarantee 75% of it.

The drawbacks of going through the SBA are the large amounts of paperwork and time delays that the approval process usually takes. Expect the process to take several months.

The SBA Express is a new option offered by the SBA. It provides a 36-hour approval process for loans up to $150,000. It only guarantees up to 50% of the loan, however. Lenders can also approve unsecured lines of credit for up to $25,000 under this program.

Microloans are another option backed by the SBA. These loans are small -- maxing out at $35,000. The average amount of a microloan is about $10,500. The maximum term for the loan is six years. The SBA will forward your loan application to your local SBA-approved lender, and the final credit decision is made by the local lender. In this type of loan program, the lender is required to provide you (the borrower) with business training and technical support. In fact, the lender may even require the training as part of the loan application process. You may have some difficulty finding lenders who participate in microloan programs simply because of the small profit in it for them; but if it meets your needs, it's definitely worth a shot.

The SBA offers many other loan programs that aren't mentioned here. Visit the SBA.gov for more information, as well as a listing of your local SBA-approved lenders. Most local lenders have SBA experts on staff, so you can begin the loan process directly with them.

If you need more than $500,000 and haven't had luck with banks, try commercial finance companies. They will usually take on higher loans than banks. Keep in mind, however, that their interest rates will also be 2% to 5% higher than banks' rates. They are a good choice if you see your loan needs increasing in the future, or if you have a high debt-to-worth ratio.

Our next section has a checklist of important things to remember when applying for a loan.

Some Final Business Loan Tips

Every bank and every banker will have a slightly different idea of what to look for when deciding whether or not to lend you money. They will all, of course, look at your financial projections and credit history, but their perception of your character is also a very critical factor. It may take many visits to many banks and many different bankers to actually find one that will take a chance on your business. So, don't give up too soon!

When you start the process of visiting banks, do the following:

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  1. Call first to make an appointment.
  2. Dress for success.
  3. Have a well-prepared business plan and all financial documents with you.
  4. Be professional.
  5. Be overly prepared to answer questions about anything and everything related to your business, your credit history, and your financial status.
  6. Show extreme confidence.
  7. Be very "matter-of-fact" -- present an air of not being desperate for the money.
  8. Be truthful about everything (they're going to find out anyway).
  9. Don't spend your time "selling" your business idea (they don't care).
  10. Keep in mind that they only want to know how they're going to get their money (and interest) back out of you.
  11. The larger your own financial investment in the company is, the better your chance of getting the loan.

Venture Capitalists and Angels

If your business is in one of those "sexy" industries (high-tech or something very innovative), and you need large amounts of capital to get it going quickly, you should think about finding investors such as angels and venture capitalists (VCs). With this type of capital, you can sometimes obtain large quantities of money, and this money can help businesses with big start-up expenses or businesses that want to grow very quickly. VC firms typically won't invest less than $250,000. Attracting the attention of angels and VCs is pretty difficult. It takes a lot of networking and a lot of plain old hard work.

Angel investors are simply wealthy people who operate in a similar manner as VCs, but independently rather than with a firm. They usually invest less than $200,000 and stick to new businesses within their own geographical region. They are called "angels" because they usually aren't interested in controlling your company, but simply acting as a mentor. It is speculated that angels account for the largest source of start-up capital for new business, but their ventures are more informal and private.

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Venture capitalists fund all sorts of businesses. The classic approach is for a venture-capital firm to open a fund. A fund is a pool of money that the VC firm will invest. The firm gathers money from wealthy individuals and from companies, pension funds, etc., that have money they wish to invest. A VC firm will raise a fixed amount of money in the fund -- for example, $100 million.

The VC firm will then invest the $100 million fund in some number of companies -- for example, 10 to 20 companies. Each firm and fund has an investment profile. For example, a fund might invest in biotech start-ups. Or the fund might invest in dot-coms seeking their second round of financing. Or the fund might try a mix of companies that are all preparing to do an IPO (initial public offering) in the next six months. The profile that the fund chooses has certain risks and rewards that the investors know about when they invest the money.

Typically, the venture-capital firm will invest the fund and then anticipate that all of the investments it made will liquidate in three to seven years. That is, the VC firm expects each of the companies it invested in to either "go public" (meaning that the company sells shares on a stock exchange) or be bought (acquired) by another company within three to seven years. In either case, the cash that flows in from the sale of stock to the public or to an acquirer lets the VC firm cash out and place the proceeds back into the fund. When the whole process is done, the goal is to have made more money than the $100 million originally invested. The fund is then distributed back to the investors based on the percentage each one originally contributed.

Let's say that a VC fund invests $100 million in 10 companies ($10 million each). Some of those companies will fail. Some will not really go anywhere. But some will actually go public. When a company goes public, it is often worth hundreds of millions of dollars. So the VC fund makes a very good return. For one $10 million investment, the fund might receive back $50 million over a five-year period. So the VC fund is playing the law of averages, hoping that the big wins (the companies that make it and go public) overshadow the failures and provide a great return on the $100 million originally collected by the fund. The skill of the firm in picking its investments and timing those investments is a big factor in the fund's return. Investors are typically looking for something like a 20% per year return on investment for the fund.

From a company's standpoint, here is how the whole transaction looks. The company starts up and needs money to grow. The company seeks venture-capital firms to invest in the company. The founders of the company create a business plan that shows what they plan to do and what they think will happen to the company over time (how fast it will grow, how much money it will make, etc.). The VC firm looks at the plan, and if it likes what it sees, it invests money in the company. The first round of money is called a seed round. Over time, a company will typically receive three or four rounds of funding before going public or being acquired.

In return for the money it receives, the company gives the VC firm stock in the company, as well as some control over the decisions the company makes. The company, for example, might give the VC firm a seat on its board of directors. The company might agree not to spend more than $X without the VC's approval. The VC might also need to approve certain people who are hired, loans, etc.

In many cases, a VC firm offers more than just money. For example, it might have good contacts in the industry or it might have a lot of experience it can provide to the company.

One big negotiating point that is discussed when a VC invests money in a company is, "How much stock should the VC firm get in return for the money it invests?" This question is answered by choosing a valuation for the company. The VC firm and the people in the company have to agree on how much the company is worth. This is the pre-money valuation of the company. Then, the VC firm invests the money, and this creates a post-money valuation. The percentage increase in the value determines how much stock the VC firm receives. A VC firm might typically receive anywhere from 10% to 50% of the company in return for its investment. More or less is possible, but that's a typical range. The original shareholders are diluted in the process. The shareholders own 100% of the company prior to the VC's investment. If the VC firm gets 50% of the company, then the original shareholders own the remaining 50%.

Dot-coms typically use venture capital to start up because they need lots of cash for advertising, equipment, and employees. They need to advertise in order to attract visitors, and they need equipment and employees to create the site. The amount of advertising money needed and the speed of change in the Internet can make bootstrapping impossible. For example, many of the e-commerce dot-coms typically consume $50 million to $100 million to get to the point where they can go public. Up to half of that money can be spent on advertising!

As in many aspects of life, finding a VC is less about your skills or who you are, and more about who you know. Networking has never been more important. To find a VC, you have to use every contact you have. Never miss an opportunity to get a name. You have friends and your friends have friends. Your business associates, attorney, accountant, banker, they all have connections -- use them. Follow up every lead. Go to every function that VCs attend. Work every room. Keep notes, make lists and use them frequently. Find angel and VC organizations and/or associations. Use the Internet. Do whatever it takes to get the names, and then contact them.

Next, how to present your idea.

Selling Your Idea

Venture capitalists review around 100 business plans each week, and eventually invest in about five to 10 businesses per year. That means you have to knock their socks off with your business plan just to get a meeting. One of the primary things they're going to look at is your management team. They will only invest in companies they feel have a management team with the experience to make the business work. Relevant experience is very important for your top players. So you may want to rethink your cousin Louie's token position on your board of directors.

Once you've gotten a VC's attention, how do you present your idea? First, write out a brief presentation of your business idea in terms anyone will understand. Don't think using buzz words and technical language will buy you any points with VCs. Explain the following:

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  1. The product or service
  2. Who your target market is and specifically who your customers will be
  3. What your product is costing you to produce
  4. What price you are selling your product for
  5. How many units you will sell in the first year
  6. When your company will be profitable
  7. What your long-term growth plans are
  8. What your exit strategy is
  9. How much money you need
  10. How you will spend the money

Have a short version (often referred to as the "elevator" version), and a longer 15- to 20-minute version. If possible, have a PowerPoint presentation and a printed version so you'll be prepared for any situation or need. Make your presentation look professional but not showy. Make sure it paints a clear and concise picture of your business and captures the essence of what you are trying to achieve. Be prepared to answer any question they can throw at you. Don't guess your way through it, and don't sound like you're guessing your way through it. Have the facts and figures (especially financial data) to back up what you're saying, and be confident.

Doing Your Research

Just because you've caught the attention of a VC doesn't mean your problems are over. You need to find out if this is the VC for you.

  • Do you know anything about the VC firm?
  • Have you talked to any of the companies it has invested in in the past?
  • Do the homework on the VC just as the VC is doing it on you.
  • Get a list of companies and contacts that it has invested in and find out how the relationship has been working for the other start-ups. Are the companies happy with the relationship? Has the VC been too controlling? Have they gotten what they expected? Have they given good recommendations and had good contacts for other business activities? Have they been accessible and good about returning phone calls? Have the other companies flourished or failed?

Each of these questions is important in determining whether the VC firm is the right one for your company. Remember, once you've gotten its attention and interest, you're still only half-way there. Also remember to:

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  • Have your company's financials in order (and preferably very solid).
  • Make sure the terms of the deal are equitable and agreeable to everyone.
  • Make sure the VC firm has experience in your industry, and understands your market.
  • Try to find a good match of personality types so you have an enjoyable relationship rather than one that is a chore to maintain.

Using Your Assets

There are many creative ways to get the financing you need to get your business off the ground. Here are just a few to get you thinking.

  • Equipment Leasing - Also known as lease financing, this is an excellent way to finance your start-up if your primary need for the cash is to buy equipment. When you lease equipment, you make a monthly payment, but usually have the option to buy the equipment at a fairly decent price at the end of the lease. Also, by leasing your equipment, you'll be adding no burden to your balance sheet because leases aren't listed. You may also improve your chances of getting other loans because you're building a credit history with the lessor.
  • Factoring - Factoring allows you to collect cash immediately based on your accounts receivable. If you've had problems getting funding from other sources, then this might be an answer for you. With factoring, you are basically selling your receivables at a discount, so you're not collecting as much as you would if you waited until the customer paid, but you get the cash immediately and can put it back into the business. Firms who offer this service may charge from 2% to 10% based on the amount of the total receivables, and then they are responsible for all collections.
  • Convertible Debt - Convertible debt can be good for everyone (as long as you don't mind handing over a piece of the pie). It sets an environment for your lenders that will let them monitor your company's progress, and if your company does well then they have the option of converting their loan into an investment.
  • Asset-sale Lease-backs - This may work for you if you own a lot of expensive equipment, but have little cash. You can sell your equipment to someone who will then lease it back to you. You get a cash inflow for your company and pick up a monthly payment for the equipment lease. In some situations it is ideal.
  • Purchase Order Advances - As a last resort, you can sometimes use customer purchase orders to gain some funding. A lender may advance money for sales based on purchase orders you hold. This type of funding has high rates, so use it wisely.
  • Limited Partnerships - You can form a limited partnership for your company. This sets you up (typically) as the general partner who bears all of the financial risk, while allowing your limited partners to invest funds but not be held liable for losses other than their original contributions. Check with your state's requirements for limited partnerships.
  • Private Placement - You can offer stock in your company privately without having to register your company under federal securities laws. Check with your state's requirements and have your attorney look into it. Typically, you can use private placement for stock offerings of up to $3 million or 35 investors.
  • Employee Ownership - You can also offer ownership to your employees. In order to do this, however, your company has to be set up as a partnership or as a corporation. TIP: Be careful that you've selected your employees wisely.
  • Joint Ventures/Strategic Partnerships - Match your product, assets, and needs with another company's products, assets and needs and pool your resources. Make sure the match is indeed made in heaven by having your attorney check out the deal and have any necessary documents drafted to protect your interests.

Glossary

Asset

Any item owned by an individual or company that could be converted into cash

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This includes stock, vehicles, office equipment, real estate, accounts receivable, etc.

Asset-Backed Borrowing

Secured business loans with assets pledged as collateral

Asset/Equity Ratio

Total assets divided by the shareholder's equity

Collateral

Assets that a borrower pledges in order to secure a loan or other credit. Those assets can then be taken in the event of default on the loan.

Cosigner

Someone other than the borrower who signs a promissory note

In doing so, this person assume equal liability for the loan.

Debt Capital

Capital that is raised via loans, bonds, etc., that must be repaid with interest within a set period of time

Debt Ratio

Debt capital divided by total capital

Dilution of Ownership

The reduction in share value resulting when additional shares of common stock are issued, or convertible securities are converted

This equally reduces each shareholder's ownership of the company.

Equity Capital

Capital raised from a company's owners

Equity financing is done through the selling of common stock or preferred stock to investors.

Fund

A pool of money collected by investment companies from individual investors for purchasing securities in various companies

Personal Guarantee

The guarantee from the owner that in the event that the company cannot pay the loan, he or she will assume personal responsibility for it

Post-Money Valuation

The value of a company right after its latest round of financing

This amount is equal to the number of outstanding shares multiplied by the share price from the latest financing.

Pre-Money Valuation

The agreed upon value of a company right before its latest round of financing

Promissory Note

An IOU, or promise, to pay back money borrowed

It usually takes the form of a signed agreement between to the lender and the borrower and specifies all of the terms of the loan (sample form).

Secured Loan

A loan backed by hard assets as collateral

A creditor may seize the assets used as collateral in the event of an unpaid loan.

Unsecured Loan

A loan not backed by hard assets as collateral, but solely on good credit of the borrower

Valuation

The process of determining a company's (or asset's) current value

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