This project is called “Startup Roadmap” and outlines every step in starting a business.
This is the second in my series of columns on funding your small business. This information is covered in depth in one of SCORE’s projects that was developed with the help of and in partnership with FedEx. This project is called “Startup Roadmap” and outlines every step in starting a business. I will focus on this column topic and build on and incorporate content from the Startup Roadmap project. I encourage CEOs to ask their SCORE mentor how to access this free course. In this and the following columns, I will present a closer look at the various types of financing a small business can use.
- Description: You can finance your business by using business credit cards to pay for inventory, materials, and equipment. (Using personal credit cards for business is not advisable since it can negatively affect your personal credit score without building your business credit score.)
- Advantages: It’s easy to get credit card financing; you can generally get a business credit card even before your business is up and running. Using a business credit card and managing your payments wisely will help build your business credit rating if you choose a card that reports to the business credit bureaus. Many business credit cards offer low introductory rates and benefits such as discounts on products and services, rewards points or cash back. Credit cards are revolving credit, so as soon as you pay off your balance, that money is available to borrow again without having to re-apply.
- Disadvantages: Interest rates on credit cards are higher than many other types of financing. If you’re late with a payment, you face fines, your interest rate may go up and your business and/or personal credit rating will suffer.
- When used: Best for purchases you know you’ll be able to pay off on time.
- Examples: An e-commerce entrepreneur uses a credit card to buy initial inventory, knowing he can pay off the credit card with the proceeds when the products sell.
Borrowing Against Your Personal Assets
There are several ways to use your personal assets to finance a business, including:
Home equity line of credit/Home equity loan
- Description: Homeowners can borrow against their home by taking out a home equity line of credit (HELOC) or a home equity loan (HEL, also called a second mortgage). A HELOC offers revolving credit similar to a credit card for the period of the loan, usually about 10 years. A HEL is a term loan. HELs and HELOCs can have either fixed or variable interest rates.
- Advantage: With a HELOC, you only pay interest once you draw on the line of credit. Because it’s revolving credit, so you don’t have to reapply for approval once you’ve repaid the loan. Because your home is collateral, the interest rates are lower than for unsecured loans.
- Disadvantages: HELs and HELOCs are limited by the amount of equity in your home. You risk losing your home if you can’t make payments. You typically need equity equal to at least 15%-20% of the value of your home and cannot borrow more than 85% of the value of the home. HELs require a lot of paperwork, incur closing costs and can take a long time to approve and fund. Interest rates for variable-rate loans or lines of credit can rise quickly.
- When used: Best as a last resort for those who need a relatively small amount of capital and are confident that they can repay the loan.
- Examples: An entrepreneur gets a HELOC for $25,000 to purchase inventory for his startup, knowing that his wife’s income can help repay the loan if necessary.
Borrowing From Your Retirement Account
- Description: Using a Rollover for Business Startups (ROBS), you can withdraw $50,000 or more from an eligible retirement account, create a 401(k) plan for your new business, and roll over the money into that 401(k) without taxes or penalties for withdrawing the funds early. You then issue shares for your corporation and the new 401(k) purchases shares, funding the business.
- Advantages: Since you’re using your own money, you don’t have to pitch your business, convince a lender or investor, or show anyone your business plan. You aren’t taking on debt so you don’t have to rush to pay back a loan. By creating a retirement plan for your new business, you can continue to build savings for retirement.
- Disadvantages: You need at least $50,000 in your retirement plan to use ROBS. You could lose your retirement funds, putting your nest egg at risk. The process is complex and can be costly: You must form a C corporation, hire a company specializing in ROBS to manage the transaction, and incur setup and ongoing administration costs. You’ll also need to comply with IRS and Department of Labor reporting requirements and make contributions to the new retirement plan.
- When used: Best for entrepreneurs who have time to rebuild their nest eggs. ROBS are often used by entrepreneurs buying franchises.
- Examples: A young, single professional withdraws $200,000 from her 401(k) to buy a franchise.
In my next Column, I will discuss other sources for funding your business.