[Part three of a series – The Yahoo Smart and Simple Guide to Starting a Business. Part one is here: Is it time to start up that startup business? and Part 1- Goals, Values and Ideas and Resources for Goals, Values and Ideas and Part two is here: Build a winning business right from the start and Part 2: Defining your business concept and Resources for defining your business concept.]
Funding
One of the critical decisions about starting your business and how it will operate both immediately and in the future is around funding.In the past funding was a relatively straightforward decision. Did you have your own source of funds or did you need a loan? But the growth in funding from venture capital, angel investors, other individual investors and now even crowd funding, combined with a dramatic DROP in lending from banks following the recent crash, have all changed the landscape dramatically.
There are also some strongly related issues that can affect your funding options. One is whether you want or need family involvement and another is if you are going into business with partners or essentially by yourself. There are no simple answers here. Every situation is unique. But there are some general principles that make sense. More and more there is a slow move toward bootstrapping – at least initially. Bootstrapping is self-funding – and as cheaply as possible. It gives you an opportunity to take some steps to see where you might have success or failure at minimal risk. However,bootstrapping isn’t possible for all businesses and it also can severely hamper growth so it needs to be undertaken with full knowledge.
Regardless of whether you bootstrap or not, you will still need to carefully look at funding the business yourself. That doesn’t mean going into bankruptcy to fund the business but it does mean looking at your financial and other assets and what you feel you can afford to invest in the business.
How much can you invest?
This is probably the single most important question in determining your funding strategy. There isn’t a right or a wrong answer –just an honest assessment. If you can’t afford to invest anything(except obviously your time and energy) then accept that.
You need to consider the following:
Other financial needs – make a budget and reserve back everything you need for personal financial goals and savings.
Buffer – do you want to reserve some of any surplus as a buffer for the future for either your personal finances or your business as a backup?
Accuracy – do not fudge figures – stay precise.
Cashflow – think about where your money is now and where it will go over time. If your business takes a year to get going can you afford to commit everything you are thinking about to it?
How much can you make do WITHOUT funding?
Next is to take a balance sheet type look at other assets – for example if you own a garage that can be used by the business it doesn’t contribute to funding but it will help cut costs – and you need to be absolutely clear about how much that asset will contribute to the business and how much it will save.
How much of your business operations can be completed without funds? Do you already have a webhosting or email plan that can be repurposed into working for your business?
How much do you NEED?
This is the critical step – without at least an estimate of what you need you cannot accurately assess funding and how much you will need to invest or borrow or acquire.
Make a list of everything you are going to need to do operationally and how much it will cost. Be realistic and also think hard about saving money. Right from the very beginning you will want to keep non-essential costs down. List supplies you will need to purchase and people you will need to pay. Be comprehensive. This is the basis of a preliminary budget – but just a preliminary budget –you will be updating this budget every week at a minimum – quite possibly for the rest of the life of your business.
Now you have an estimate of your costs and some idea of what you can invest yourself you can compare the two and the shortfall is what you need to acquire in external funding.
Sources of funding – pros and cons
Friends and family
Getting funding from friends and family is simultaneously one of the best potential sources and one of the worst. The key is to make it clear that the money and funding relationship is a BUSINESS relationship. That means you treat the issue as you would with any other potential business partner. There is a discussion of all the issues around repayment, interest, equity and ownership. And then there is a contract – the same as there would be for a stranger.
Pros
- If the relationship is a good one and handled professionally terms can be better than from other sources
- Can be easier to obtain than from other sources
- Time to obtain funds can be much shorter
Cons
- Could lead to a break in a personal relationship if things go wrong
- Easier for family member/friend to interfere in business
- Reliability could be lower than from other sources
Bank loan
The biggest challenge is that banks are less willing to lend to small businesses than they were and that terms are more onerous.There is a grain of truth to the saying that ‘banks only lend money to people who don’t need it.’
Pros
- Funding source is rock solid and reliable
- Once accepted as a loan customer, future loans become much easier
- Will not want any equity as part of the arrangement
Cons
- Categorically unshakeable on repayment schedules
- Fees and rates tend to be higher than from other sources
- Can be very hard to qualify in the current economic climate
Angel investor
An angel investor is an individual who likes investing in startups and businesses. They tend to be a particularly good choice if they have expertise or contacts in an area useful to your business operations. They can be prepared to offer pretty significant funding– up to $1 million but will want a significant chunk of equity in return. They are more likely to fund than VC firms and are comfortable with large amounts of risk – which also means they are unlikely to reinvest if the business needs ore money.
Pros
- Can move quickly
- Can provide additional business/startup knowledge
- Could be willing to write off funding as a loss
Cons
- Will want some form of equity in the business
- Will want involvement in business operations
- Won’t reinvest
Venture Capital
Venture Capital can be a source for very large amounts of funding– millions of dollars are common – but in return will want significant involvement and equity in the business. They can also provide resources directly to the business.
Pros
- Can lend very large amounts
- Can be prepared to write off loan as a loss
- Can provide significant business and technical advice and support
- May be prepared to reinvest in order to fund growth(not to rescue a failing business, however!)
Cons
- Will want a significant amount of equity
- Will want a substantial say in the running of the business
- Are looking for a significant return on investment and tends to prefer high risk, high growth approaches over slow but steady growth
SBA-backed Loans
You can get small business loans that are backed by the SBA –meaning that the SBA will cover 85% of the loan against loss, making them a very safe funding source and additionally with SBA-backing banks are far more likely to loan in the first place. One clear disadvantage is that they can take a long time and the amount of paperwork is staggering.
Pros
- Very safe and stable source of funding
- Makes it easier to get a bank loan
Cons
- Very lengthy application and approval process
- Enormous amounts of paperwork to qualify.
Crowdfunding
Crowdfunding is a brand new potential source of funding for small businesses. It was explicitly made a legitimate source at the startof the year but is still very much untested beyond a few early adopters. The idea is that you can get funding from just about anyone in small amounts and in return for a range of possible forms of compensation. A common use is to use it to bootstrap a business by using crowdfunding essentially as a form of pre-ordering. Individuals fund the business and money is held in escrow until a target is reached. At that point typically the funding is released and the business is expected to fulfill its part by creating and delivering the service to the people who crowdfunded it.
Pros
- Very flexible solution with the ability to link funding to volume for example.
- You control the parameters
Cons
- You have no real control over whether you will have success or not
- No way to follow up for additional funds if circumstances change
- Legalities, especially around securities and exchange commission issues are still very vague
The other major consideration around ownership, control and money in your new business is firmly centered in the ownership area – are you going it alone or with partners and what ownership and organizational structure do you want for the business. This question is actually a very pragmatic one – there are specific, legally defined business ownership structures and entities that you will be required to adhere to. These do range across most of the usual possibilities so they are likely to correspond quite well to the ownership structure you may have already been considering.
Ownership does also affect funding. If you have decided to go into business with a partner and they provide most of the funding, it is very hard to argue that they shouldn’t also get most of the ownership.
You may, of course, not be in a position to work with a partner and even for single owner small businesses there are choices to be made.
Ownership Structures
Many business structures can be set up with either single or multiple owners and it is usually easier to think about the structure in terms of complexity rather than strictly by ownership.
Solo Proprietorship
This is a simple, single owner business. It is legally the simplest business and requires the least paperwork and complexity to set up. You may still need local, state and federal business licenses and tax identities but if you do they will be minimal.
Pros
- Simple to set up, simple to dissolve
- Simple to operate
- Minimal overhead
Cons
- No legal separation of personal finances from business finances
- Harder to transfer to another person or ‘grow’ to a more complex business structure
Simple Partnership
This is the multiple owner version of a solo proprietorship. Again there are few documents to file and minimal paperwork. One small legal wrinkle is that BOTH partners are fully liable for all the business debts.
Pros
- Simple to set up, simple to dissolve
- Simple to operate
- Minimal overhead
Cons
- No legal separation of personal finances from business finances
- Harder to transfer to another person or ‘grow’ to a more complex business structure
- If there is an ownership dispute there is little recourse or protection
LLC (Limited Liability Company)
LLCs are the commonest form for small businesses starting out that intend to remain relatively small. Compared to Corporations the documentation and bureaucratic overhead is relatively small and yet they offer the legal protections of a business arrangement(dissociating liability from the people involved and keeping it with the company).
Pros
- Liability remains with the company
- Relatively easy to set up compared to Corporations
- Many states have preferential treatment for LLCs
Cons
- Still do not have the level of ownership and protection that Corporations provide
- Despite relative ease of set up many states still have relatively high associated fees
- Still need to understand legal ramifications around liability since while some protection is provided it doesn’t cover everything.
S-Corporation
An S-Corp is a special subset of a regular (C-Corp) Corporation.The legal definition is that it is taxed under subchapter S of the US tax code. What that really means is that revenue is not taxed as a corporation – instead revenue is passed through to the owners and THEY are taxed on it. This is called pass-through taxation and simplifies the tax code for corporations considerably. There are also limits on ownership in an S-Corp that do not apply to regular corporations. It is worth noting that S-Corps are convertible at al ater date to C-Corps by restructuring. So what’s the point? The answer is simplicity. In many ways S-Corps are a stepping stone between an LLC and a C-Corp. It is a great arrangement for a startup that is starting small but hopes to grow later. There are many savings in corporate filing, fees and accounting.
Pros
- Probably the most flexible corporate structure
- Allows for growth
- Simple ownership structures
Cons
- If you want big growth and investment and VC funding you’ll have to upgrade to a C-Corp
- More complex than even an LLC
C-Corp
A regular corporation that operates exactly like any large business. Can do things like have an IPO. Many more investment and ownership possibilities than any other business form. With the flexibility and power come the equivalent complexity. C-Corp regulations, documentation and filings are far more complex than any other business ownership form.
Pros
- Flexibility
- Ownership options
Cons
- Complexity
Co-operatives
There is one more ownership structure that is even more complicated and made more so by a lack of universal support or agreement on practices, structure and legal requirements. That is the co-operative where typically all those who work on the enterprise are part-owners. If you are interested in a co-op you will have to research the requirements for your locality since they differ so widely.
While these little snapshots should help put you in the ballpark you are going to need far more information than we can provide hereto make a clear and final decision. Take a look at the links and article in our resource list for more information before you make a decision on business structure and bear in mind that the single most important criterion is around ownership, partnership and control of the business.
The Issues around Family and Partners
Partnerships and family involvement in a business can be great blessings and also terrible curses. The upside is obvious – closer ties to friends, better relationships and a mutual source of strength and support. The downside is actually much more than the business –it is the potential destruction of friendships or family.
But at the core there are only really two issues. Should you go into business with these people or not? And if you do – how do you set the boundaries and rules so that it will be successful?
Going into business with friends or family requires a careful discussion around the goals and intentions of all parties. If you are thinking that your friends or family will essentially be employees then they had better know and understand that – and especially so if they are also contributing funding. On the other hand if you are expecting them to step up and be equal partners then they should know THAT – and the ownership structure should reflect it.
The first question to ask yourself is ‘do I really want to go into business with this person?’ In many cases you already know the answer. Do not be distracted by how helpful they might be or how they could provide funding or what they might be able to do. The bottom line is if you don’t really want to be in business with them then soon enough you won’t be – it’s just that getting to that point will be messy - you are better off never starting. But the reverse is just as true: ‘Do THEY want to be in business with you?’The answer is just as important – you shouldn’t try to coerce them – find out if they really WANT to do this. If they do, then great but if not you are better off going some other way.
Finally, after you have talked it through and all parties know their roles then you MUST put it in writing. You should have contracts, agreements, whatever it takes to make it very clear who does what and who owns what. There are two very important reasons.First, doing this is the last step to clarity. Once you have things in writing people will truly understand and believe what they are committing to. The second is that it becomes a legal document. There are a lot of pressures in going into business with friends and family. Things can go wrong. A written contract will protect everyone if that happens.
Read More:
Funding, Fraternity and Family: Turning three potential F’s for your business into A’s
