Pros and Cons of Outside Financing
Not everyone can find enough cash on their own to start a startup. Outside financing helps you more quickly raise the cash needed to pay for equipment and cover other startup needs.
While there's wide advice by startup advisors to not borrow more money than you need, another concern is running out of money before your startup dream is strong enough to stand on its own. Not having enough cash hampers your efforts to attract investors.
Equity financing means trading equity in the company for cash. You raise money without enormous amounts of debt but also give up some control. Investors expect that their profit will eventually exceed their investment. To get their help may take giving them a say in company decisions. That can mean the right to cap salaries or other benefits.
Rights investors may receive include:
- Electing a board of directors
- Being informed about major business decisions
- Voting on any major business decision
Equity investors can also vote you out of your own company or sue you or your company if they don't feel as though you are granting their rights.
If you bring on equity investors without choosing a business entity, it's likely they will end up your general partners. That gives them a say along with a share of the debt. In comparison, forming a corporation gives them less liability while giving you more say.
We offer guidance for each stage of your business, including which entity to choose. If you bring on a partner to help obtain financing, get terms in writing by having all partners sign a partnership agreement.
Weigh both the benefits and risks before deciding to pursue outside financing.
How to Self-Finance
There are various ways to use your own money, from not quitting your day job to borrowing money from a bank or relying on credit cards.
Bootstrapping is a term you are likely to hear when you consider using your own money. It's starting up a company with little or no outside financing, basically taking whatever resources are easily acquired. It can mean not paying yourself while you pump money back into the company, but it also keeps you in control.
Using your own money doesn't take away the necessity of having a solid business plan in place. A business plan enables you to see your specific needs and determine how much money is needed. It also gives you legitimacy when approaching banks or other lenders. You also want to make sure you can turn your idea into a business before potentially going into debt.
To save money, work with a small group, offer stock options instead of cash and only hire whom you need. Consider interns for a free or low-cost alternative to regular employees, especially if you live near a college. When going this route, make it clear the stipulations of the agreement, including pay, and prepare an independent contractor agreement.
As far as cash, make a list of what you have on hand. Include savings accounts, equity in real estate, retirement accounts, vehicles and any collection that you can barter for cash if needed. Investments may help you get loans. Consider options including a home equity loan or credit cards. If you go this route, get it in writing with a promissory note.
Other routes include borrowing against 401(k) retirement plans or from individual retirement accounts. If you consider borrowing against your IRA, consider the risk of having to pay an early distribution penalty as well as income tax on what you take out.
Pros and Cons of Using Your Own Money
Using your own money can mean taking more time to start your startup but allows you to focus on developing your product or service first. If you do eventually seek outside financing, potential financiers want to see that you are responsible enough to trust with their money. They will be more willing to invest if you do first.
There are downsides, however, including your own sacrifices. Make sure you want to pursue a business before making these sacrifices because it is an investment. It can mean putting vacations on hold, cutting back on expenses or delaying those plans to save for your retirement or your children's college fund.
Borrowing from individual retirement accounts and 401(k) plans also hurts your retirement planning. Building up credit card debt and taking out loans lets you control your company's future while putting the debt all on your shoulders. Setting up a business entity can protect your personal assets from risk. Read our advice on forming a business and, if needed, you can rely on our incorporation specialists.
There are pros and cons to both outside financing and using your own money. Consider the pros and cons of each before deciding whether to fund your business through equity or debt financing. Read our "7 Ways to Bulletproof Your Business" for more advice on safeguarding your interests.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.
