September 21, 2014

Five Myths about Financing Start-ups that Hurt Entrepreneurs

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Most entrepreneurs believe a bunch of myths about financing new companies that hinder their efforts to raise money. Here are a few:

Myth 1: It takes a lot of money to finance a new business. Not true. The typical start-up only requires about $25,000 to get going. The successful entrepreneurs who don’t believe the myth design their businesses to work with little cash. They borrow instead of paying for things. They rent instead of buy. And they turn fixed costs into variable costs by, say, paying people commissions instead of salaries.

Myth 2: Venture capitalists are a good place to go for start-up money. Not unless you start a computer or biotech company. Computer hardware and software, semiconductors, communication, and biotechnology account for 81 percent of all venture capital dollars, and 72 percent of the companies that got VC money over the past 15 or so years. VCs only fund about 3,000 companies per year and only about one quarter of those companies are in the seed or start-up stage. In fact, the odds that a start-up company will get VC money are about 1 in 4,000. That’s worse than the odds that you will die from a fall in the shower.

Myth 3: Most business angels are rich. If rich means being an accredited investor — a person with a net worth of more than $1 million or an annual income of $200,000 per year if single and $300,000 if married — then the answer is “no”. Almost three quarters of the people who provide capital to fund the start-ups of other people who are not friends, neighbors, co-workers, or family don’t meet SEC accreditation requirements. In fact, 32 percent have a household income of $40,000 per year or less and 17 percent have a negative net worth.

Myth 4: Start-ups can’t be financed with debt. Actually, debt is more common than equity. According to the Federal Reserve’s Survey of Small Business Finances, 53 percent of the financing of companies that are two years old or younger comes from debt and only 47 percent comes from equity. So a lot of entrepreneurs out there are using debt rather than equity to fund their companies.

Myth 5: Banks don’t lend money to start-ups. This is another myth. Again, the Federal Reserve data shows that banks account for 16 percent of all the financing provided to companies that are two years old or younger. While 16 percent might not seem that high, it is 3 percent higher than the amount of money provided by the next highest source — trade creditors — and is higher than a bunch of other sources that everyone talks about going to: friends and family, business angels, venture capitalists, strategic investors, and government agencies.

So don’t believe the myths, know the reality.

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About the Author: Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of seven books, the latest of which is Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By. He is also a member of the Northcoast Angel Fund in the Cleveland area and is always interested in hearing about great start-ups. Take the entrepreneurship quiz.

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Scott Shane


Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

33 Reactions

  1. Scott,
    Thank you so much for pointing out those 5 myths. It is not that expensive to start a business, and by renting and leasing what you can, you can really save a lot of upfront money!
    From a fellow Clevelander…
    Joel Libava

  2. Thanks Scott, excellent list. That’s really interesting data on angels. On banks, though, that’s very hard to swallow because banking law doesn’t like banks lending on business plans. I’m guessing that the only way you can connect those dots is by noting that these are loans backed by personal assets, like home equity, and not normal business loans to companies. It has to be mainly betting the house.
    Tim

  3. Tim makes a good point. Most of the money borrowed by entrepreneurs is personal (some of it is guaranteed, while some of it is on credit cards and is not guaranteed). My point was not that banks aren’t lending against business plans, just that there is a way to get money from them. Between the amount that entrepreneurs have to self finance and the personal borrowing that they do, it is a rare entrepreneur who gets financing from another person not involving their personal credit.

    So it might be useful for the experts to discuss how entrepreneurs really get money, instead of talking about VCs, angels, friends and family, and a host of other sources that tend to be much less common than trade creditors and banks (with personal guarantees or not).

    Thanks, Tim, for helping me clarify this point.

  4. Scott, I’ve got a question for you about trade creditors: does that include factoring of accounts receivables? Would that fall under the category of trade creditors?

    The reason I ask is that I have a client which is a factoring company. I’ve noticed an increase in factoring companies serving small businesses — I presume driven by the availability of technology to manage the financial spreads and the Internet to market to small businesses.

    Many of today’s factors cater to businesses that deal with specific types of customers, such as government customers or Fortune 500 customers that you KNOW are going to pay, but just pay in 90 or 120 days. Rather than going for debt financing, these small businesses would rather use their receivables as financing.

    I used to be a banker in my “checkered” past, and I don’t remember factors being as prevalent back then as they are today. But perhaps I just wasn’t paying attention.

    So, back to my question: is factoring part of the trade creditors you are talking about? And does factoring play a significant role in financing small businesses?

    Anita

  5. Anita,
    The trade creditor data doesn’t include factors. They fall into a different category that the Fed measures along with letters of credit and some other things. So trade creditors being important for entrepreneurs is independent of the importance of factors.

    Factors are growing in importance. How important they are depends what you are comparing to. Certainly, far more people get financing for their businesses from factors than from venture capitalists or business angels. But fewer people get money from factors than from trade creditors or banks (but the bank financing is often personally guaranteed or borrowed personally).

    Something related that I need to blog about is the perverse way that entrepreneurs are forced to deal with personal liability when they start their companies. Some entrepreneurs incorporate so they have limited liability and then, to get money from a bank, choose to or have to personally guarantee the loan, undermining the limited liability.

  6. Scott, yes, what you call “the perverse way that entrepreneurs are forced to deal with personal liability” would make a good follow-up to an excellent post. It’s bugged me for years. We get to multi-million-dollar sales and 10+ years of history but we still have to sign a lot of personal guarantees, even with a C-corp, because the lender makes the rules. It’s a heat in the kitchen sort of a thing. You have to get used to it, but from the outside, people don’t realize how common it is.

    Tim

  7. Tim,
    Franchise companies want those wonderful personal guarantees, also, Sometimes the spouse is even asked to sign the agreements, even if he or she is not involved in the least bit with the business.
    Joel Libava

  8. Interesting info Scott. I had no idea that so many Business Angels had such a low income.

    I wonder why they risk investing in start ups, as opposed to starting a business myself. I know that I would certainly feel safer investing in myself if I didn’t have much capital – unless the start up was being launced by experienced entrepreneurs.

  9. Your concept to select ‘myths in financing’ is very much essential to discuss. I truly appreciate your idea and would pass this information to all my well known startups.

    Thanks for your suggestions.

  10. Catherine,

    There are a two reasons why people invest in other people’s start-ups rather than starting businesses themselves. The first is time. Even the most professional, high net worth, angels who are members of organized angel groups average 20 minutes per week per venture in which they invest. No one can run a business with so little involvement.

    The second is diversification. Since most entrepreneurs do poorly (sorry, it’s true) and it is hard to pick winning opportunities, diversification improves my ability to manage my risks. If I have money in ten people’s start-ups rather than one of my own, my chances of hitting a winner are higher.

    The tendency of the non-wealthy to invest in the businesses founded by strangers is on the rise due to these investment matching websites like Prosper.com. A good portion of the borrowers are entrepreneurs trying to raise money for their businesses, and most of the people providing the money are not rich. I think this is a very important trend in how businesses are getting financed that will show up in future statistics.

  11. Steve makes a key point about diversification’s benefits. Many businesses fail and even those that succeed have their sales curve level off quickly. Through a strategy like acquisitions one can continue expanding at 100% or better per annum.

  12. Some other myths:

    1 Start your own company so you can work less hours and do what you want.
    2 “You’re lucky to run your own company” Sometimes I feel cursed.
    3 You have to be super-smart
    4 Your wife will love you for it!

    Thanks, Jason M. Blumer

  13. Scott Shane: Do you have experience from the European market?

  14. Scott,

    I better read your book. I got 40% at the quiz! ;) I have added it to my Amazon wish list.

  15. I just came across this post from OnStartups. Great writeup! I would just add that debt is cheaper than equity because of the interest tax shelter you get with debt.

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