The Personal Cost of Financing a Business
Have you ever wanted to start a business? Or maybe you’ve already started one. Whether you pictured yourself as the next Jeff Bezos, or just wanted to freelance and join the gig economy, you’re not alone. There are millions of businesses in the United States, and they all started somewhere.
There are 5 popular ways to initially fund a business:
1. Personal Savings: the safest way to fund a business is to save up over time and invest that money. Some entrepreneurs chose riskier forms of self-funding, like cashing out retirement accounts or re-mortgaging their homes.
2. Friends and Family: if entrepreneurs are not able to save up enough capital to start the business, it is natural for them to turn to those who know and love them. Business owners need to tread lightly here because now personal relationships are tied up in a business venture.
3. Credit Cards: these cards are tied to the business owner’s personal credit score. Although credit cards can be useful for smoothing out cash flow crunches when a business is up-and-running, using credit cards for initial funding is not wise due to the high interest rates.
4. Small Business Loan: getting a loan for a new business without a track record for success can be difficult, however, the Small Business Association has some options for fledgling businesses.
5. Angel Investors: these investors pool their money and invest in businesses, with the expectation that the business will grow and they will be able to exit with a great return.
If an entrepreneur chooses personal savings to fund a business, they’ve already placed at least a portion of their personal financial well-being on the line. Mortgaging a home, using a credit card, or guaranteeing a small business loan all increase personal financial ties to the business. If an entrepreneur accepts investment from friends, family, or angel investors, they are now accountable for the financial well-being of others. Of course, an entrepreneur accepts these risks when they start a business and aims to minimize risk with a well-thought-out business plan.
According to Entrepreneur, there are 5 stages of the business life cycle. We’ve just described #1: Seed and Development. Each stage has its own set of challenges, and for Stage 1, funding is the main challenge. The second stage is referred to as Startup. The biggest financial focus of Stage 2 on sales, trusting that cash and profits will follow. Stage 3 is called Growth and Establishment, and at this point, the entrepreneur begins to focus on cash flow. Note that most startups fail within 5 years, often because they run out of cash. When the business is established and running it becomes more routine, entrepreneurs enter Stage 4: Expansion, and the goal is to increase profits by expanding into new areas, although there is risk of entering the wrong markets. The last stage is Maturity and Possible Exit, and at that point, profits are stable. The business owner has to decide whether to run the business as-is with some top line growth, attempt more growth and expansion, or exit the business.
Each stage has its own challenges, and the business will face many points of potential failure. Businesses need cash and profits to operate and owners need to keep a close eye on the financials at every business stage. Although there can be periods where businesses do not generate cash or turn a profit, these periods must be few and far between. Business owners need to understand when these situations are temporary and can be worked through with strategies that will secure short-term funding, increase sales, decrease expenses, manage assets more effectively, bring in new leadership, etc. They also need to understand when there is no viable solution to their cash crunches and losses, and it’s time to close the business.
Entrepreneurs go into business with a great idea, and a plan to execute on that idea. They must have a positive outlook on the business to gain investors and motivate employees. It is not typically in their nature to think of the business failing, however, every entrepreneur should have a clear understanding of what their personal financial impact – and the financial impact on their investors – will be if the business fails.
Recall the five ways to fund new businesses: personal savings, friends and family, credit cards, small business loans, and angel investors. With a significant amount of money and a number of stakeholders involved, it can seem like the business owner must save the business at any cost, even if there are no viable strategies to save the business by generating more cash or profits.
A friend of mine is an accountant specializing in tax strategies and he told me he sees so many business owners react emotionally to a failing business, using personal money and investments to keep the business afloat. This is a costly mistake because it can keep the business owners from every being able to retire.
Here’s what not to do if your business begins to fail, so that you can still retire:
1. Max out personal credit cards: With interest rates in the double digits, business owners may never be able to pay these off.
2. Re-finance or take out a home equity line of credit on the house: If the business owner’s retirement plan does not have enough passive income to make this payment (outside of the business), they should not leverage the house.
3. Personally guarantee a loan for the business: If/when the business goes under, the business owner would be on the hook for the remaining principal and interest payments on the loan.
4. Cash out retirement accounts: Tax implications and additional penalties are two really good reasons to leave retirement accounts alone. Another is that the plan was to use this money during the business owner’s golden years. Lastly, most retirement accounts are protected in bankruptcy.
This advice is meant as a friendly warning, based on my accountant friend’s many encounters with indebted business owners. Although many businesses fail, yours certainly may succeed. As your business progresses through each stage, keep a watchful eye on the finances and change course when necessary, then you’ll probably never need to heed this advice. If, however, you do find yourself the owner of an unprofitable business with a need for cash, fight the emotional urge to max out credit cards, re-finance the house, personally guarantee a loan, or cash out retirement accounts. Losing a business does not have to mean losing out on retirement.