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Chapter 1

Popular Financing Strategies

It takes a lot to impress the “Sharks” on Shark Tank, the popular television show where entrepreneurs pitch their business ideas to successful millionaires and billionaires in hopes of bringing them on as investors and partners in their businesses. When 35-year-old Julie Busha shared her product line, Slawsa, a unique condiment that is a cross between salsa and coleslaw, the judges not only loved the taste but they were clearly impressed by the fact that she was willing and able to forgo a salary in order to funnel all sales proceeds into the growth of the company.

She was able to do that because she funded the company entirely from personal savings. In fact, when the opportunity came for her to buy Slawsa from her former partner, per his request, she was able to do so without getting a loan. She had set aside a nice nest egg from the decade she spent as a sports marketer, primarily in NASCAR, and says she dug into her savings to finance much of the start-up costs: production, travel to pitch retailers, marketing, legal costs and more. “It’s not cheap to start a company, especially in an industry as highly competitive as the grocery one; it takes a special effort” she says.

Billionaire Shark Tank investor Mark Cuban was extremely supportive of Busha telling her “you’re an example like we rarely have in here and I’ll be a customer for life.” Cuban also expanded after she left the room, “The fact that she scrimped, has no debt, pays off her credit cards, saved up enough money to invest into this company and buy him out is such an amazing example for everybody.” Fellow Shark Robert Herjavec also shared supportive comments about Busha’s work ethic.

When she secured a coveted spot on Shark Tank, Busha had to ramp up production to meet the expected demand the show would generate. She and her husband borrowed equity from their home to fund that. “It is easy?” she says. “No. But I’m not doing this because I think it will be.”

Most Popular Financing Methods

The four most popular ways to finance a business are the ways you would expect: Personal savings, loans from friends and family, home equity loans and personal bank loans.

Let’s review each one.

Personal Savings

Conceptually, it makes perfect sense that using your personal savings to start and finance your business is the first choice for entrepreneurs. There is no interest expense, no creditors wanting to be paid back and no awkwardness or embarrassment in asking others for money. You simply go to the bank and pull out your savings. (Hopefully, you are using a separate corporation or LLC and the money gets deposited into a separate business bank account.)

But in taking this very easy and rational step please ask yourself some equally rational questions:

1. Can I afford to lose all this money?

2. Do I understand that not every business succeeds?

3. How long will it take me to save this amount of money again?

4. How would a loss of this money affect my family?

5. Have I thought enough about alternative ways to finance the business?

In presenting these questions we are not trying to deter you from your goals. Instead, we want you to be realistic with them.

Most businesses need financing along the way. They need it at the start-up phase, the growth phase and all the other phases that occur during the life of an enterprise. If your personal savings can cover every phase, good for you. (You can stop reading now.) For most of us, we need to have alternative financing methods in mind. We need to keep reading this book. And by learning the various financing methods we then have to ask: Should I use up all of my personal savings to get the business going? Should I consider the other alternatives so that not all of my savings are at risk?

We should also clarify what we mean by personal savings. They do not include money in retirement accounts. Your IRA and 401(k) are savings for your sunset years. They are usually protected from creditors and the bankruptcy courts. Pulling these monies out of a protected retirement account (which can incur large penalties and fees if done wrong) may be a very bad move. If your retirement age is nearing and you don’t have enough time to rebuild depleted accounts, it could be disastrous.

Beware of charlatans on the internet claiming you can easily use your retirement money to start a business. These firms tell you that by using a self-directed IRA or a special 401(k) you can easily use your retirement funds to invest in your own business. But what they don’t tell you is that the IRS has strict rules regarding such transactions. We will discuss these issues further in Chapter 6.

The bigger point here is that whether it is your personal savings or retirement savings, you may not want to go all in. You may want to use other proven strategies to finance your business or real estate investment.

Let’s consider the second most popular method.

Friends and Family

Friends and family have always been a great source for boot strap financing. Friends and family want you to succeed and are a lot more likely to take a chance on you than any bank would. That personal belief in you, that personal connection, is a special bond. Be very careful about testing it with a business transaction.

Your relationships are more important than your business. We start with that premise. Accordingly, many seasoned entrepreneurs advise others to never accept money from friends and family. Their take is that if your idea has merit you can find an angel investor and avoid testing a personal relationship altogether. Friends and family members have lost money in the past and will do so in the future. Do you want to be the one to have to confront it every Thanksgiving?

You have to ask yourself that same question. It is gut check time. This type of financing is often called the “family, friends and fools” approach. We don’t want you to be the fool for taking money from family and friends that may never be repaid—you may never hear the end of it.

Alright, now that you are sufficiently forewarned and prepared, let’s discuss how to do it the right way. A huge amount of money is raised from friends and family for investments every year and not every Thanksgiving dinner is being ruined. Obviously, some people are doing it right.

Here are four tips to consider.

Understand Their Motivation

A large percentage of friends and family members’ sole motivation is to help you out. They may not tell you this, and you can’t assume it, but they may even consider their money to be a gift. That said, they may also see their extension of money as a reasonable investment. They believe in you and your project, and if a decent return comes with it, all the better. Ask yourself why they are investing, and tailor your approach to meet their needs.

A key in this is knowing when to say “No.” Within your reservoir of goodwill are some people who will help you to their own detriment. If a friend or family member really can’t afford to help you, don’t even ask.

Be Honest and Transparent

Make sure they know the risks of the investment before you take their money. Explain that not only are you not likely to become the next Google but that they may actually lose their entire investment. Make sure that the money they are providing is money they can afford to lose.

While this may not sound like a very positive conversation to have when everyone is charged up to conquer the world, it is a necessary step. Your supporters will appreciate your candor, and may even continue to socialize with you if things don’t go well.

Consider Taking Money As A Loan

You don’t always have to sell equity in your company. It may be appropriate to borrow the money from friends and family. You promise to pay it back, with interest. And then you do so. Most businesses offer no liquidity, meaning it is very difficult to cash out an equity investment. So even if the business survives your friends’ money is stuck in the investment. By borrowing the money and paying it back, your supporters have helped you get started and you are square with them.

Interestingly enough, friends and family may be more pie in the sky about this investment than you are. They may have visions of $1,000 turning into $1,000,000. You have to be the adult. A loan may be the safer course for them and you need to tell them so. If they really want equity in the company they can buy in at a later round when things are hopefully more stable.

Get Everything in Writing

Be sure to put the terms of your agreement in writing. If it is a loan, a promissory note with an interest rate and payment time frames should be drafted. If it is an equity investment the terms must be spelled out with specificity. The assistance of an attorney is strongly suggested. Be sure that all parties agree to all the important terms and details and then sign and save the agreement.

Many people lament the end of the handshake deal. They ask why everything has to be in writing nowadays. And the answer is because our lives have become too over stimulated with computers, smartphones and television. We are constantly bombarded with new information, new things to process and new distractions. As a result, to expect two people to remember exactly the terms of a handshake deal that was agreed to even two months ago is almost quaint. Certainty is found in well-drafted written documents. This rule applies for all financing methods discussed from here on in.

There’s another reason why putting this agreement in writing is so important: the IRS. If your business doesn’t succeed, your lender may be able to deduct the losses from the loan. But if there is nothing in writing and no repayment schedule, fat chance that will happen. And it gets worse: the IRS may treat the money they lent or invested as a gift, which if the amount is large can create gift tax issues.

Next, we’ll talk about another popular method of business financing that will most certainly involve a contract.

Tapping Home Equity

Just a few years ago, home equity loans were one of the easiest ways to finance a business. Home values were high and lender requirements were lax. That changed dramatically when the housing boom turned to bust. With less equity and much more stringent underwriting by lenders it’s harder to turn your equity into start-up capital.

But these loans haven’t gone away entirely. Seventeen percent of businesses with less than $100,000 in sales use home equity lines of credit for business purposes, according to Barlow Research’s Small Office/Home Office Opportunity study.

There are several ways to use home equity to borrow for your business:

• A home equity loan or line of credit

• Refinance your current mortgage for more than you owe, and take cash out for your business

• Pledge home equity as part of an SBA loan or other small business loan

We’ll talk about the latter option—SBA and small business loans—in Chapters 3 and 4. Here we will focus on the first two options.

As mentioned, it is much harder to qualify for mortgages, including home equity loans, than it was prior to the housing downturn. You’ll generally only be able to borrow up to 80% of your home’s appraised value, minus any first mortgage.

Your personal credit score will be a key factor in determining which program you qualify for, and the rate you’ll pay. Make sure you check your credit reports at AnnualCreditReport.com at least six weeks before applying for one of these loans, to give yourself time to fix mistakes. While you’re at it, check your credit score for free at Credit.com to get an understanding of where you stand. Keep in mind, though, that for mortgage applications, lenders use a specific version of the FICO score which they will obtain with your credit reports from each of the three major credit bureaus. The middle of the three scores that are returned will usually be used for qualification purposes. You can learn more about credit scores in the 2012 edition of Garrett Sutton’s The ABC’s Of Getting Out of Debt (We will refer to several of Garrett’s books throughout the text. Of course, not every related topic can be included in just one book. So the idea is to provide you with an easy reference point for more information.)

Don’t quit your day job just yet! If you are still working a full-time job, apply for a home equity loan or line of credit while you can still show steady employment. Lenders want to see two years of documented income, and it’s become more challenging for those who are self-employed to get these loans. Unless your spouse can qualify for the loan on his or her income and credit score alone, it’s best to get a loan nailed down before go out on your own.

Home equity loans or lines of credit, as well as “cash-out refi’s” may be available from your local bank or credit union, a megabank, online lender or mortgage broker. Shop around by contacting several lenders or using an online portal, or by hiring a mortgage broker to shop for you. Just try to limit applications to a two-week period to avoid possible damage to your credit score that can result from multiple inquiries. (Mortgage-related inquiries within a 14 or 45 day stretch will usually be counted as one, depending on which credit scoring model is used.)

What’s the downside of using home equity to start your venture? The loan will be reported on your personal credit reports and can affect your credit scores. If you pay those loans on time, however, it shouldn’t create too much of a problem. But if you fall behind on a payment on any mortgage loan—home equity or otherwise—your credit scores will likely plummet, at least in the short term.

Another consideration to keep in mind is the fact that home equity lines of credit typically offer interest-only payments for an initial period, called the “draw” period, which usually lasts for ten years, though sometimes it is shorter or longer. After that period, the borrower can no longer borrow against the line of credit, and must pay the entire loan back—interest plus principal—over a set period of time, which may be 10, 15 or 25 years, depending on the terms of the loan. During this latter period, the monthly payment will likely be substantially higher than during the draw period. So it is crucial to understand the term of the loan and what kinds of payments will be required during that time or you may find yourself in default, or forced to sell your home to pay back the loan.

If you’re thinking of taking out one of these loans, one of the hardest things to do it so put your optimism aside for a moment. Most entrepreneurs are risk-takers; if they weren’t, they’d never venture out on their own. But you need to think about what will happen if it takes longer to get off the ground than you planned. Will you be able to repay the loan? What happens if you can’t?

How Long Is Your Runway?

Emily Chase Smith is an attorney and coach who works with entrepreneurs. She says: “Every business takes twice as much time and twice as much money as you think it will, and we call that your runway. You want to extend your runway as far as you possibly can. Sometimes as small business owners, we just see the vision so clearly, so we go for the big vision and we don’t have a plan for how we’re going to get there. So we might go out and rent a giant office because that’s our vision. We’re going to have this fantastic law firm or we’re going to have this great retail space, to satisfy our vision as opposed to taking the realistic steps to get there. But then we run out of runway. We run out of money and run out of time. Perhaps (if we took it more slowly) we could have had a fantastic business.”

Reverse Mortgages

If you are 62 years or older and you have equity in your home, you may want to consider a reverse mortgage (officially known as a home equity conversion mortgage) instead of a home equity loan.

A reverse mortgage is a federally-insured mortgage, only available to homeowners 62 years or older. You get the proceeds of the loan in one of three ways; as a lump sum, in monthly installments or as you need it (a line of credit). You don’t make mortgage payments, but you are required to pay your taxes and homeowners insurance. And if you get a reverse mortgage on a property that already has a mortgage, the existing loan will be paid off and a new loan put in place.

When you sell your home, or if you die before then, the reverse mortgage is paid off—including interest and fees that have accrued on the loan—and any equity left in the home goes to your heirs or estate. If your home’s value has dropped, however, and there is not enough equity to pay off the reverse mortgage, then the lender takes the loss regardless of other assets you may leave behind.

The advantage of this type of mortgage for an entrepreneur is clear: If it takes you longer to generate cash flow than expected, you won’t be scrambling to make payments on your mortgage or a home equity loan.

In the past, lenders didn’t even look at borrower’s credit reports, making these loans especially attractive to those with past credit problems. But due to losses by the FHA, a “financial review” that includes a credit check is required as of March 2015. That doesn’t mean you can’t get a reverse mortgage if you have bad credit, but it does mean you may need to provide an explanation for how you plan to use funds to pay back currently delinquent debts. Still, a reverse mortgage isn’t reported on traditional credit reports, so taking one out won’t hurt the business owner’s credit history.

These loans can get expensive, and some older people have been sold loans that weren’t appropriate for them. Of course, there is always the risk of sinking your home equity into a business venture that might fail. You can lose your equity and have nothing to show for it. As a result of past abuses in this industry, you are required to get mandatory counseling from a HUD-approved counselor before you can get one of these loans.

On the other hand, unlike a home equity loan, you won’t be kicked out of your house because you can’t make your loan payments. You must keep up with your property taxes and required assessments such as homeowner association dues, though, or you could lose your home. The lender will also require you to keep a minimum amount of homeowner insurance in force to protect the lender in case of a fire or other catastrophe. You will have to be able to document that you can afford to continue to make your insurance and tax payments in order to get one of these loans.

Personal Bank Loans

In the Inc. 500 survey, 13% of respondents said they used personal bank loans to fund their businesses. That makes sense, as it can be hard to get a business loan for a brand-new venture. However, personal loans also carry a tremendous about of risk.

Getting a personal loan will require a personal credit score strong enough to help you qualify for the loan, and a large and steady enough income to support the payments. If you are considering a personal loan for business financing, ask potential lenders the following questions:

Do you have a minimum credit score requirement? If the lender will tell you what the minimum credit score needed is in order to qualify, you’ll at least know whether you are in the ballpark. Understand, though, that you don’t have a single credit score; you have many. There is a good chance that if you checked your credit scores, you won’t have seen the same exact credit score the lender is using. That’s true even if you order your credit score from the same bureau the lender uses. Lenders may use custom scores, or scores that aren’t generally available to consumers.

If you are turned down for a personal loan, the lender is required to disclose your actual credit score, based on the credit scoring model they used, and give you information about how to order a free copy of your credit report from the reporting agency that supplied your report. Take advantage of this opportunity to learn more about your credit score for free.

Is there a maximum debt-to-income ratio you’ll accept? A debt-to-income ratio typically compares the borrower’s gross (before tax) monthly income to monthly debt payments. A typical requirement for many lenders is that debt payments excluding any mortgage payment don’t exceed 28 – 30% of gross income, and that total debt payments including a mortgage total no more than 38 – 40% of gross income. Be sure to count the new loan when calculating your debt-to-income ratio.

What are my payment options? Will you have a fixed monthly payment, or will you be able to make minimum monthly payments if cash flow is tight?

Is this a revolving or installment loan? With a revolving loan, you can borrow up to a certain limit (your credit line), while an installment loan will allow you to borrow a specific amount of money and pay it back over a specific period of time. These two types of loans are very different in terms of how they affect your personal credit scores.

Let’s say you need a $10,000 loan to start your business. If you get a revolving line of credit and use $8000 right away, you are using 80% of your available credit. In credit scoring terms, that ratio of available credit to balance is called the “utilization” or “debt usage” ratio. And when it comes to your credit scores, that high utilization ratio is likely to hurt your credit scores. There’s no ideal utilization ratio, but consumers with the highest credit scores tend to use about 10% of their available credit.

But if you get that same loan as an installment loan, then it will be viewed differently. If your loan is reported as “installment” rather than “revolving” credit, the amount of debt is part of the credit score calculation, but utilization is less likely to be a problem. You can shop for a personal loan to start your business by finding out what your current bank or credit union has to offer. One type of personal loan that is growing in popularity is the peer to peer, or P2P loan.

Peer to Peer Loans

The original premise behind peer to peer or “P2P” loans was to cut out the middleman—banks—and to match individuals who have money to lend (lenders/investors) with individuals who need to borrow money. The premise was that lender/investors can earn a better return on their money by lending directly. In addition, these companies sold lenders on the idea that they could spread out their risk by lending small amounts of money to many different borrowers. LendingClub.com and Prosper.com are two of the earliest major players in this space, and they have both been very successful with this model. So successful in fact, that it’s no longer just individual lenders providing the funds for these loans. Large investors such as pension funds and institutional investors are major lenders for these platforms now, too.

Borrowers who qualify typically get a loan with a fixed interest rate and fixed monthly payments. Often these loans are used by individuals who are starting, or growing a business. If you are looking for a personal loan and have a good credit score, you may want to check out a P2P lender. It is expected that more lenders will get into this business as it grows in popularity. For more information on these lenders visit the Resource Section. We will talk a bit more about these companies in Chapter 15, Crowdfunding.

But in chapter 2, let’s investigate business plastic…