There are many options for financing a startup business, but they generally fall into two main categories: debt and equity. Which is better for you depends on a number of factors.
I started my first company, Mindwire Interactive, in December of 1999, although it was under a different name then. At first I bootstrapped, or used my own funds. All I needed to get started was a computer and an internet connection, both of which I already had, so there wasn’t much outlay of cash to be made.
Nine months later I incorporated and brought on partners and employees, so the cash needs became a different issue. We didn’t have the cash we needed so we turned to friends and family and raised $41,000. That money paid for salaries, computers, and furniture and although it didn’t last long it gave us enough to get started.
At MWI I went and got a $100,000 loan from Zions Bank and the SBA. Starting MWI has been more complicated than Mindwire (in part due to events related to selling Mindwire) and so additional funds were needed. I also used personal credit cards, loans from family, and essentially loans from employees, vendors, and the IRS.
And right now I’m attempting to start a retail chain of stores using equity financing.
Here are some of the basic pros and cons of equity and debt funding.
1. If you go out of business you don’t have to pay it back.
2. You don’t have to make monthly payments.
1. If you go out of business you feel worse because you lost someone’s money.
2. You give up a chunk of your company that you could have retained ownership of had you been funded with debt.
1. You keep ownership of your company.
2. You keep personal relationships out of it (assuming you’re borrowing from a bank). It’s easier on you emotionally to owe money to an institution rather than a person.
1. You have to make monthly payments.
2. If you go out of business you will probably still have to pay off the loan.
Now those are pros and cons when you keep it simple, but things are rarely, if ever, simple.
For example, what do you do when your business is short of money and you can’t pay a bill? If you don’t pay that bill and the vendor allows you to not pay it that month, then you are, in effect, funding your company on debt. The debt is the money you owe that vendor.
What are the consequences of not paying that vendor? If they provide a critical service then they might pull the plug on you.
What if that vendor happens to be someone you know personally? A friend, a business acquaintance, a family member? They probably won’t pull the plug on you unless they have to, but then what happens to your relationship with them when you owe them $20K?
Did you know that you can borrow money from the IRS? Yep, you can by not paying your taxes. This is tempting for small businesses to do, but beware the consequences. The IRS will often work with you, and if you’re lucky you’ll get a good officer to work with, but working with you does not mean there aren’t some serious consequences.
When you go and get a bank loan you might pay 10% per year in interest. The IRS will charge you 20% per month in interest and penalties. When I say “they’ll work with you” I mean if you do certain things they won’t levy your bank account to force you to pay. But they’re not going to waive the interest, and they’ll only waive the penalties after you’ve paid them in full and only if you have some good reasons for why you didn’t pay the taxes in the first place.
Credit cards are another type of debt with their own consequences. They can be easy to get if you’ve got decent credit and a good debt to equity ratio. Once your debt to equity ratio gets out of whack, however, it’s impossible to get more no matter how good your credit is or how good you are at keeping up on payments, so credit cards will only take you so far and there is a point where you can’t get any more.
Credit cards carry high interest rates, even if they start out with the 0% deal. You might think you’re going to pay them off before you start paying the interest, but chances are you won’t. But even though credit cards have high interest rates, those rates are pleasant compared to what the IRS charges you.
What about borrowing money from family or friends? You risk precious relationships when you do this. Money changes people. It might change you, and it might change them. Do you want to risk losing your friend? Do you want to risk causing a rift in your family? How are other family members going to feel when they find out so and so loaned you money but didn’t loan it to them when they asked for it?
You can also borrow from your employees. It’s called not paying them. Sometimes you just don’t have the money and there’s nothing you can do about it because you’ve already maxed out credit cards, taken out bank loans, borrowed from friends and family, borrowed from vendors, and borrowed from the IRS, and you still have no money. My experience is that it is sometimes better to let employees go then to borrow from them by not paying them.
There is one more way to fund your business that I didn’t mention and it involves neither equity nor debt. It’s called revenue. I highly recommend it.