Finance Your New Business: It's Not as Complicated as You Think

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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These are tough economic times, but despite that (in some cases because of it) people are trying to find money to start a new business. If you're one of those people, and you've never done it before, the process can seem impossibly hard — but fundamentally, finding money really isn't complicated.

There are only three ways to finance your dreams if you don't have enough money to start it yourself:

• You can ask someone to write you a check, with the understanding that you'll have to pay the money back. You also have to accept that you'll have to give them a bit extra, too. Think of the interest on a loan as rent you pay to use their money. In financial language, that's called debt financing.
   
• You can ask someone to write you a check, with the understanding that you're trading the money for part of your company. You also have to accept that you will have to give them some control because now they're an owner too. In financial language, that's called equity financing.
   
• You can do both.

However, you can't just march into a bank, ask for money, and walk out with it. You also can't just stick out your palm and expect someone with a lot of money to peel off hundred-dollar bills. It would be nice if it were that easy, but people who give you money first want to know if you can do what you say you will.

So, what about borrowing from someone who already knows you, likes you, or loves you? Turns out they are the most common source of startup money after the owner's own.  Borrowing from someone you know can be intimidating, though, because we all know at least one person with a strained relationship because combining family and business didn't work out. Still, consider this option carefully because it is the way many people finance a new business...just keep in mind it could make Thanksgiving dinner a bit awkward.

Debt Pros and Cons

The good news when it comes to lending institutions (banks, credit bureaus, finance companies) is that you don't have to marry them. The bank has no say in how you run your company, and when you pay the money back, the relationship is over. You can get short term and long term loans, and you know how much you have to pay each month, allowing you to plan and budget — plus you can deduct the interest you pay from your taxes.

The bad news is you have to pay the money back in a certain length of time, and you can't miss a payment regardless of how your business is doing. Bad weather, flu epidemic, and "my dog ate my homework" are not acceptable excuses. Plus, if you have too much debt, investors will consider you a risk and that will make it hard to raise equity capital, even if business is good. Yes, you will have to pledge your first-born or at least your house as collateral. If you aren't willing to stand behind the deal, why should they?

Equity Pros and Cons

Investors are in for the long haul. They won't expect monthly payments or a financial return in the short run, and you don't have to pay investors back, even if things go sour. What's more, investors can add credibility to your business, especially if you manage to find some that bring connections or expertise you don't have.

The bad news is your dream company isn't just your dream any more. Your investors have a stake in its success, and they will take steps to protect their investment. We're not talking Guido from New Jersey (usually), but we are talking some heavy-duty "discussions" if you and your investors don't agree on the direction the company is going. In fact, you could actually lose your company if investors don't like what you're doing and collaborate to force you out. We said debt financing doesn't require that you get married. Equity financing does — until death or bankruptcy do you part.

Reality

Let's get serious here. If you're looking for equity capital from investors, you better have a track record, a dynamite team, and a marketing plan that kicks butt...or a rich uncle. Notice we didn't say anything about a great product. A clear understanding of your market and how to sell in it with a foggy product idea is much more important than an exquisitely defined product without a market.

Professional investors and angels are offered more deals than they can afford. What's more, only about 15 percent of startup businesses are financed with professional equity capital. Your business has to be very, very special.

If you're looking for debt capital, you'd better have a great credit record and property you can pledge as collateral. But only about 20 percent of startups are started with bank loans, er...debt financing, and only 20 percent more are started with loans from friends, family, or business associates.

So how do you find money to start a business?

Most new businesses start with less than $10,000, and four out of five are self-financed. Sell your toys, get a second mortgage, tap your life insurance, raid your IRA, take a part-time job, rent a room, borrow against your credit cards, sign up for medical tests, sell your blood, and sweet talk your friends and family.

The road to success is to build a nest egg, start small, and stay lean. You don't need a fancy office, business cards, and letterhead — you need customers. Don't burden yourself with debt, plan ahead, and focus on cash flow. As your business grows, you'll have the proof you need for people who don't know you: You can do what you say you will.

Research shows that people who have to wait in line to see a movie enjoy it more than people who walk right in to the same movie. I'll wager the same is true for people who pull themselves up by the bootstraps and build a successful company by making it happen on their own.

You can do it.