Finding Money for a Startup

By Tom Harnish on 22 May 2010 (Updated 23 June 2010) 0 comments
Photo: adventtr

You don't need a lot of money to start a company, sometimes none at all.

The first company I started, while still in college, didn't require a dime of up-front money. I worked for a data processing training school as a teacher. They had a computer that was busy from 8 a.m. to 10 p.m., but it sat idle the rest of the time. I proposed to pay the school a percentage of my income in exchange for use of their system. The deal was done when I pointed out that there would be negligible cost for them, and the machine wasn't helping their bottom line at all during the period I wanted to use it. They said "yes" and Business Computer Systems was born. We were profitable the first month with no debt on the books and no money out of my pocket.

But when you do need money to start a business, where should you look? Venture capital, private investors, or a bank?

Maybe none of the above. Here's why.

Research shows that over 90% of new ventures start with whatever money entrepreneurs can scrounge from personal resources. The other 10% relied on external sources with family members (parents and spouse) as the most common (5.0%). Private investors fund less than 3% of startups. Venture capitalists are involved in less than 1%.

Venture Capital

Why aren't VCs involved in more startups? Because they're looking for 30-50% return on investment and want to cash out in three to seven years. There aren't very many startup companies that can present a strong enough management team and good enough marketing strategy to convince a venture capitalist they can do that. (Notice I didn't mention anything about a wizbang product. Product ideas are a dime a dozen. VCs invest in people and markets.)

But your business is unique, you say, and you think it could be one of 0.6% of new business that is able to attract venture capital. You'll be looking for money in the wrong place if you aren't in biotech, medical, software, energy and located in Silicon Valley, New York, or New England. In 2009, that's where almost two-thirds of all VC investments went. In any case, only 9% of VC dollars and only 11% of the deals went to startup businesses. Your team and your market will have to be very special to attract venture capital. A proposal to fund the development of a chain of Midwest environmental services companies (septic tank cleaners) just won't interest a venture firm, although they might get a chuckle from your proposal if your slogan is "We want your stinkin' business" or "Your Poo Is Our Bread and Butter." (Both are tag lines for real companies.)

So why do people always think of VCs as a source of startup funding? I suspect it's because they have the mistaken impression that it's free money. But, of course, it isn't; you exchange part of your ownership in the company (and some control) for their investment.

I tried to interest a venture firm in an electronic publishing business I'd started. We'd created some innovative software by bootstrapping (using our own time and money), managed to get the product out the door with excellent reviews, and had some impressive names on our customer list. But we needed money to grab an early share in what we knew would be a rapidly growing segment we'd proven existed. I was thrilled when, after careful consideration, they offered the money we need with a 95/5 split. Thrilled, that is, until I realized I was the one who would own 5% of the business. I should have paid closer attention to their mascot in the lobby — a stuffed vulture.

Private Investors

Knowing we weren't destined for explosive growth, when I needed money to start an aviation-related software company I didn't look to VCs. I talked to local angel investors, bought a lot of dinners, made a lot of pitches, kissed a lot of frogs, and finally found a lead investor. He was an entrepreneur who'd built an electronics manufacturing business himself. As a pilot, he understood our market. He thought he could convince some people who had invested in his business into investing in mine if I would give up 51% ownership. He did, they did, and I did. Ya do what ya gotta do. The company is still in business, although I have no financial interest in it now.

Seven out of ten private investments are made within 50 miles of an investor's home or office. Nine out of ten Angels, as they're called, put money into small companies with fewer than 20 employees. They're older, have higher incomes, and are better educated than the average citizen, yet they usually aren't millionaires. Private investors expect about 25% annual return, but in 2009 their investments produced only a 15% yield.

You'll be looking for money in the wrong place with private investors if you don't have sufficient growth potential, reasonably priced equity, management talent, and an impressive team of key people. But you'll be happy to know that there's plenty of informal capital available. Investors say they would invest almost 35% more if acceptable opportunities are available.

Banks

If VCs or private investors aren't an option, what about a loan? If you need one, SBA lenders are your best choice for startup loans. Uncle Sam — who prints the money, after all — guarantees up to 90% of your loan so banks are more willing to lend to chancy startups.

In 2009, startup loans guaranteed by the SBA teetered near record lows, down 40 percent from 2007. In any event, 15,000 new companies did manage to get a bank to say yes with the help of an SBA guarantee. Thanks to American Reinvestment and Recovery Act (ARRA) initiatives, the first quarter of 2010 shows SBA loan volume up 90% over 2009.

So, what does it take to qualify for an SBA loan? Most lenders will want you collateral with a value at least equal the amount of the loan; and if you own real estate, they'll want it pledged on the loan. Don't go looking for loans if you (and your spouse) aren't willing to personally guarantee the loan. They'll also want to see projected cash flow (from the business or a secondary source) that comfortably covers the loan payments. Don't quit your day job!

MDFF

Which leads us back to The Bank of MDFF (Mom, Dad, Friends, and Family). People who know you, like you, or love you will be your most likely source of startup financing. With conventional investment returns in the low single digits, you might just find MDFF eager to lend you money at Prime-plus.

Just keep in mind that taking money from friends is a good way to make them ex-friends. We even know someone who has an ex-brother — the result of a business squabble. As with all things financial, proceed with caution. Finding money is an art, but it is an art you can learn.

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