You’ve got to know how to find working capital for your small business if you want it to be a success. Mr Credit Card is going to discuss the type of savings and financing needed to start a business. I think this is an important post because it clarifies the different needs your start-up has and the alternatives that are most appropriate to fund those needs.
How much does it cost to start a small business? How does one finance a start-up? Business loans, venture capital, working capital lines of credit? When does one take on debt? In this post, I will try to highlight three major types of start-up costs and how they should be funded. That is because not all financing is the same.
What is a start-up cost? Start-up costs are simply expenses regarded to get your business started! At the most basic level, registering for your business, getting your IT systems such as computers. If we take setting up a restaurant as an example, start-up costs could include buying kitchen equipment, renovation costs to get the restaurant ready. A car wash would consider rent, building and car wash equipment as their start-up costs. Both would need small business liability insurance.
If you set up an internet business, then your domain purchase, web hosting and designer fees are all start-up costs.
Key Characteristics of Start-up Costs
Start-up costs have key features. First, they are necessary expenses just to get your business “ready” for operations. Spending money on start-up costs isn’t going to guarantee any success at all. In fact, you can take it as the first step.
Second, start-up costs do not produce revenue. They are necessary to begin the business, but that in itself does not generate revenue. For example, paying $10 for a domain is necessary to build a website business, but that $10 generates no revenue.
Types of Financing for Start-up Costs
Given that start-up costs are necessary but do not generate revenue, a new business owner should never take on debt to incur these start-up costs. Because the infrastructure is not in place, banks are very unwilling to give non-resource loans for these, and if you get a loan for such stuff, your personal credit is always tied to it.
Instead of using debt financing, these start-up costs should be financed by equity. These include:
Personal Savings – Personal savings are often a great source of funding for start-up costs.
Investments from Family – This is another common way of getting start-up capital. If you need funds and your business plan is not such that it can attract venture capital, borrowing money from family members is one way to get seed money.
Venture Capital – Venture capital funding is another common source for entrepreneurs who have big ambitions for their start-ups. Funding from venture dilutes your equity stake, but provides you with resources to keep your company started and going for a couple of years. You might also get valuable advice and connections.
Working Capital – Using the strict definition, working capital is the difference between current assets and short-term liabilities. For most businesses, current assets consist of cash on hand (i.e. liquid emergency fund) and accounts receivable (what you creditors owe you). Accounts payable mostly consist of short-term borrowings (like a working capital line of credit).
To put it simply, if you want to know how to make a small business successful, start by having positive working capital. That means that you should sell products profitably (i.e. accounts receivable more than accounts payable) and ideally you want to have “cash on hand” to wholesale products. But if you do not have enough cash on hand to fund a huge order or if the nature of your business is such that it is cash flow-negative for long periods, then you have to consider taking on some form of working capital financing.
Let’s use a couple of examples of when you need working capital funding. You have a business, like say a landscape business. Google gives you a huge contract to make sure their headquarters looks beautiful. And because they are Google, they insist on giving you a year-long contract but only paying you at the end of the year. Yet, when the job starts at the beginning of the year, you have to get equipment and hire workers. Even though you have a profitable contract, the cash flow is negative for most of the year. This is precisely when you need a working capital line of credit.
Another example would be that you suddenly get a huge contract and do not have enough in the bank account to fulfill it. In this instance, having a line of credit really helps.
Working Capital Is Short-term Financing
Because of the nature of this sort of financing, it is always short-term in nature and it is financed by debt and not equity. There are various means of financing a working capital line of credit. Below are some common methods.
Vendor Financing – Very often, you can get vendor financing. The terms that you get (as in interest and length of financing) depend on your history with them. When you just start out, the terms will be “not so good.” But if you develop a good payment record with them, you will be able to negotiate better terms down the road.
Unsecured Working Capital Line of Credit – You can also get a working line of credit from your bank or credit union. Once again, the terms and conditions depend on your history with the bank, the nature of your business and perhaps your credit history (especially if you are applying for one for the first time).
Business Credit Cards – You can also use business credit cards to finance your working capital. Bear in mind that the financing period is short (one month or one billing cycle) – though you can carry a balance for slightly longer (not advised). Some cards like the American Express Plum Card give you 60-day financing at 0% if you pay 10% of your balance. This is a viable way to finance short-term working capital needs as well.
Some businesses would need to invest in capital equipment in order to expand and grow. In this case, there are three ways of financing.
Retained Earnings – The best way is obviously using retained earnings. If you use retained earnings, you incur no debt.
Asset Backed Financing – If you decide to take on debt to finance a capital expenditure, then you could lower the cost of borrowing by taking out an asset-backed financing. Essentially, the equipment is used as collateral in case you default on your loan. This is pretty much like a mortgage or secured credit cards!
Debt – You can obviously take on debt financing for capex spending. The appeal of this is that it is a cheaper form of financing that equity. Taking on a little debt may also moderately lower your company’s cost of capital. But don’t borrow too much. Don’t get in over your head. Refer to your business plan to see if debt makes sense. (Read “Small Business Debt Relief.”)
There are various ways to finance a business. But instead of just how to finance, one should be asking what sort of expenditure it is before deciding on the best method for financing it. To summarize, start-up costs should be funded with equity. Working capital financing is mostly always funded by short-term debt. Capital expenditure when a business is already a going concern can be funded by either equity or debt.
Thanks, Mr Credit Card. I think this is an amazing resource. Remember…be very careful about funding your business with debt. If you don’t have the money to fund your small business, it might be a sign that you should wait or find a new direction. I also believe that you should never, under any circumstances, use credit cards to finance your start-up. There are much better alternatives to credit card debt.
Nunzio Bruno says
This was a really great post for anyone thinking about start ups – even internet ventures. Your break downs were great even though I’ve seen families get pretty intense over not structuring their loans right to loved ones. If it is a loan then it should look like one and read like one – regardless of intent to forgive interest (or repayment as a gift). People should absolutely stay away from personal credit cards – no if’s and’s or but’s about that one.