The different types of startup financing

December 05, 2018

Consider these pros, cons and tips before you decide how to fund your small business.

 

Starting a business comes with a wide range of challenges, but how to fund it is often a major one. Getting a business off the ground costs $30,000 on average1, and records show 50 percent fail within the first five years.2 Many banks don’t offer small business loans until a business is established — in business at least two years — with a credit history and record of income. Until you qualify, you might be considering other sources of money. Explore the four most common below, including their pros, cons, what to consider and tips from Eric Tunbridge, senior product manager at U.S. Bank.

 

Fintech 

Fintech — short for financial technology — is growing in popularity. These startups tend to lend to businesses that might not qualify for a more traditional small business loan. To do this, they often use less traditional metrics for underwriting. For instance, one company looks at the number of UPS packages shipped and received.

"They're causing banks to re-evaluate how we do business lending. That innovation and change is good for the industry," says Tunbridge.

Pros: 

  • Nontraditional: If your business is unique, and traditional metrics that banks look for are hard to produce, Fintech can be a great way to access funds.
  • Convenient: Often, you can apply for and access this money digitally. The process can feel streamlined compared to other loan applications.
     

Cons:

  • Terms: Many of these loans come with high interest rates or other fine print. Keep a lookout for amortization schedules, prepayment penalties and high premiums. 
  • Less regulation: These companies might not have the same oversight and government compliance programs as more established lenders.
     

Tips: Read the fine print. Make sure you know the annual rate, the amortization schedule, prepayment penalties and more. These details can help you evaluate whether you can really afford the terms.

 

Crowdsourcing

Global investment through crowdfunding is expected to reach $96 billion by 2025, according to the World Bank.4 Fundraising is often done via a third–party website, and investors often expect sample products, recognition or equity in exchange for their donation.

While this type of fundraising is used for more than just business ventures, many of the most popular fundraising campaigns have been for new products or businesses.

Pros: 

  • Wide net: Crowdfunding platforms put you in touch with a vast pool of would-be donors. 
  • Lower bar: Donors on a crowdfunding site are unlikely to apply the same scrutiny to your business that a traditional lender would.
     

Cons: 

  • Regulation and fees: If you use a third–party platform to fundraise, chances are there are fees involved. Plus, these sites aren’t subject to the same regulation as more traditional capital sources. 
  • Idea theft: If you haven’t trademarked your idea, there’s a chance someone with more resources could see it on a public site and steal it.
     

Tips: Read the fine print to understand what protections and liabilities you have before using these sites. While they can be a great and innovative source of funding, Tunbridge says, "There’s a lot of unknown risk. I would use it as a last resort."

 

Friends and family

It can be tempting to take money from people you know instead of pursuing more formal channels. But there can be strings attached. Beyond any potential damage to personal relationships, "It gets super complicated on the tax implications and the legal risks," says Tunbridge.

Pros: 

  • Less red tape: Your friends and family are unlikely to run a credit check or ask for revenue projections. 
  • Encouragement: It can be nice to feel like those close to you support you with more than words.
     

Cons: 

  • Taxes: Gifts above a certain amount are taxable. If the money is viewed as a loan and there is no interest rate charged, the IRS may calculate interest retroactively. 
  • Equity trap: Friends or family may ask for a share of the business, which could potentially limit future funding options.
     

Tips: Have a frank conversation about terms and expectations before you borrow from friends or family. Be sure to discuss the amount, payment schedule and interest rate, then document what you decide.

 

Self-funding

Nearly 6 in 10 entrepreneurs use their personal savings to start their businesses.3 If you factor in personal credit cards, home equity loans and other personal funding, that number jumps even higher.

Pros: 

  • Autonomy: You maintain control over strategy and operations. 
  • Motivation: Placing your personal savings on the line might give you added incentive to succeed.
     

Cons: 

  • Personal risk: If you used your own money, failing could mean personal debt or bankruptcy. 
     

Tips: Legally registering your business with your state — as an LLC, simple partnership, S Corp or C Corp — can help limit some of your personal liability.

Create bank accounts and credit cards in your business’s name, even if you use personal savings to fund them. “Business lenders look for a credit history for the business itself, in the business’s name,” says Tunbridge.

 

Next steps

If you’re ready for a small business loan, Tunbridge says there are a few criteria that lenders are sure to look for.

  1. Time in business: Most banks require a business to be at least two years old. 
  2. Credit history: If you use one of the methods of funding discussed here to get off the ground, you can still build a credit history by using those funds to open a bank account and credit card for your business. If your business has no credit history, whether you qualify will be based completely on your personal credit history. 
  3. Performance: Lenders are likely to look at your balance sheet, with a focus on overall profitability. 
     

For details on obtaining a Small Business Administration loan, read this article.

 

1“6 Tips for Borrowing Startup Funds from Friends or Family,” U.S. Small Business Association, September 2016.
2 “Entrepreneurship and the U.S. Economy,” U.S. Dept of Labor, Bureau of Labor Statistics, April 2016.
3 “Top Sources of Business Startup Financing,” Small Biz Daily, July 2016.
4“Crowdfunding in Emerging Markets: Lessons from East African Startups,” World Bank Group, 2015.

Learn about U.S. Bank

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