As part of my entrepreneurship classes, I teach my students to raise capital. When people find this out, they often ask one question: What’s the most important thing I need to know about raising money? For entrepreneurs, four lessons are especially important.
1. For most entrepreneurs, seeking outside financing isn’t worth your time. Only a small fraction of new businesses obtain money from someone who is not a founder of the business. Therefore, unless your business has a lot of hard assets that can be used as collateral for a loan, or one of a handful of startups that has the super-high growth potential and exit plan to attract accredited angel investors and venture capitalists, seeking outside money is unlikely to be fruitful. You are better off developing a less capital-intensive business model and financing the startup yourself than you are spending your time trying to raise money.
2. Your personal credit and personal collateral matter a great deal when financing a startup. Data from the Federal Reserve’s Survey of Small Business Finances shows that the owners of one quarter of corporations less than five years old, and nearly half of sole proprietorships that age, personally guarantee the debts of their businesses. Given that only a minority of businesses borrows externally at all, this means that most of the capital that entrepreneurs borrow is personally borrowed or personally guaranteed.
With personal debt, the lender’s decision depends less on the potential of the business than on the entrepreneur’s credit and collateral. If you don’t have great personal credit and you have few assets to pledge against a loan, you will have a hard time borrowing to finance your new business, no matter how great your business idea is. So if you want to start a business, be careful about your personal credit.
3. You are more likely to get a loan than an equity investment from an outsider. Because venture capital and angel investments are sexier than bank loans and trade credit, the former gets the lion’s share of attention in books and articles about entrepreneurial finance. However, most of the companies that get outside financing obtain debt, not equity.
Only a tiny percentage of startups are financed by selling equity to accredited angels or venture capitalists. The statistics show that around 1 percent of companies get their financing from these two sources combined. Other informal investors – like friends, family and unaccredited angels – add a few percentage points to the share of businesses that get outside equity, but research shows that these sources are actually more likely to lend money than to take an equity stake. Therefore, unless your business is the type that angels and venture capitalists look for, you shouldn’t waste your time seeking equity investors.
4. Tapping trade creditors is where your odds of obtaining financing for the business itself are highest. According to analysis of the Federal Reserve’s Survey of Small Business Finance, next to having a checking account, trade credit is the most common financial tool used by small businesses. Because trade credit is offered by suppliers to help you buy their products, even the newest businesses can obtain it.
In short, unless you have a rare, super-high-growth business with plans to exit through an initial public offering or acquisition within five to seven years, your best bet is to minimize your capital needs and finance your start-up with your own money, money that you borrow personally, and trade credit.
Editor’s Note: This article was previously published at OPENForum.com under the title: “4 Important Lessons About Entrepreneurial Finance.” It is republished here with permission.
Very practical advice Scott. If more entrepreneurs went about their financing with a self-sufficient mentality we would likely see a few less start, but the ones that did start would be more successful.
Thanks Scott. It is always good to see financial advice for entrepreneurs. More people should be doing what they enjoy, even if it is just part time.
Scott Shane, Have you read Reword by Jason Fried? I think that you end paragraph is along the lines with the book.
Good advice…It is kind of a myth that you can walk into a bank with an idea and walk out with a pile of money to start your business. Just doesn’t work that way. The other challenge with financing is that entrepreneurs can often put together enough money to start the business, but struggle with cash flow to operate the business. Therefore the business never can advertise properly for growth and eventually dies out. Financing for entrepreneurs is and probably always will be a struggle.
Well, we do have a business with ridiculously high growth potential. We have patent-pending proprietary technology for commercial scale algae cultivation including continuous harvesting capability. I really don’t understand how it is that finance people can vacate perfectly valid logic so they can foolishly write a check to a savvy liar. We’ve seen many investors get taken, after we told them exactly how to determine if they were being told the truth by their investee. Nobody within the financial industry bothered to listen and many are now flipping burgers at Mac Donald’s. While we have not once, but twice have had people literally “walk in off of the street” and after an embarrassing full-disclosure, insisted we allow them to invest in our company. The public has a clue. The professionals in the financial industry have demonstrated that they are too busy making unwarranted assumptions and trivializing our efforts due to their ignorance of the biofuels industry. Everybody else is demanding a years salary to lift a finger to start a capital raise.
Since our experience is “atypical”, does anybody have any “atypical” advice to help us find the capital that has eluded us for almost a year and half? I would print my own money, but that’s bad form almost everywhere.
Great Article! The only thing I would add is that if you started building “business” credit instead of “personal” credit then as your business grows you can tap into a line of credit that doesn’t have to be personally guaranteed, freeing up your personal assets.
Scott- Excellent article and all true. From my experience everything you have mentioned is accurate. The best entrepreneurial business model today should be something that can be bootstrapped.
I like the trade credit and would add factoring and forfaiting as common sources of small (and large) business financing. Thanks for the article.
raising initial capital for a start- up without seeking for outside funding is herculean task for Africans. About 90% of investee are from very poor background. so what should such entrepreneurs do? can anyone join me to develop a model in order to ameliorate the situation cos it is quite pitiable.But i am not disputing your opinion