Accessing capital is a challenge for many small business owners—particularly for startups. Of course there are options, but some of them are potentially more risky than others.
While I have seen successful small business owners use one or two of these financing approaches, the need for capital, the long-term financial risk involved, and the potential value the financing might provide should be thoroughly evaluated before taking one of these steps.
Accessing Home Equity
Many small business owners turn to a home equity loan to get things off the ground. Growing up in the family business I know that’s how my dad got the seed capital he needed to start his business and years later, when I started my first business, that’s what I did to get my own off the ground.
With a reasonably good personal credit history and a fair amount of equity in your home, adding a second mortgage or refinancing your home is a pretty straightforward proposition. In fact, it’s fairly simple. There are however, a couple things to carefully consider before you tap into your home equity.
1. You’re putting your home at risk: Entrepreneurs as a group are a fairly optimistic bunch. With confidence in a new business idea, it might not feel like borrowing home equity to get things started is very risky, but it is. Of the businesses that start today, roughly half of them will survive the first five years. What’s more, many of these failed businesses are piloted by smart, hardworking entrepreneurs just like you. And, like you, they were confident their business idea would be a success. If, for some reason, you are continually late on your second mortgage payment or default altogether, you run the risk of losing your home.
2. You increase your need for personal income: For many small business owners, the first few years can be financially challenging as they try to keep personal expenses low so business income can be reinvested to help the business grow. The burden of an increased mortgage payment can make that difficult for new business owners who don’t have a good second source of income. If you decide to use home equity to seed your business, it may be a good idea to make sure you have an additional source of income to ensure the mortgage payment is made on time every month.
3. Using your personal credit just isn’t a good idea: While using personal credit, like your home equity might be expedient in some circumstances, it puts your personal credit score at risk and doesn’t do anything to build your business credit, which can make small business financing more challenging down the road.
These cautions aren’t to suggest that a disciplined business owner can successfully leverage their home equity into successful startup capital, but rather to point out there are some serious risks that should be considered first.
Leveraging Your Retirement Savings
Some business owners dip into their 401k or other retirement savings to find capital. There are even companies that will help a business owner roll some of their retirement funds into a business loan—maybe even avoiding the penalties typically associated with accessing retirement funds early. Although this may be a legal use of retirement funds, consulting your tax advisor before borrowing from your 401k is important.
While borrowing from your retirement savings is a source of capital accessed by some business owners, it puts your retirement funds at risk and the long-term consequences of pushing back the money your retirement account could otherwise be earning should be considered before taking this option.
Using Personal Credit Cards
Many business owners use their personal credit cards to access capital for their businesses. Any time you use your personal credit to pay for business expenses you should consider it meeting a short-term need with long-term consequences. While it may be convenient, the higher balances typically associated with business expenses can hurt your personal score even if you pay off the balance every time a payment is due. And, that’s assuming you have the discipline to regularly pay off the balance on time. If you don’t, your personal credit will take additional beating.
What’s more, like leveraging your home equity, using a personal credit card doesn’t do anything to help you build a strong business credit profile, which can make it more difficult to access business credit down the road. Building a strong business credit profile, especially in the early years of your business, is very important.
Do You Really Need the Extra Capital?
Having been there myself, I understand how access to extra capital can make running a small business a lot easier. However, in a recent conversation I had with John Sperry, CEO of InMoment, he suggested, “You have to find creative ways to work on the cheap without the need for a lot of cash.”
Now a very successful 13-year old tech company, he added, “We did a lot of things … to make it less expensive for us to do business. Some of those things even helped improve our ability to build the best product in the end. We had to do a lot of outside-the-box thinking, which was very good for us.”
Choosing the right type of financing for your business requires the ability to look objectively at the risks compared to the potential rewards to determine if it makes sense. After weighing both, you may even decide that waiting is the best option. In the end, it’s really creative problem solving, not money that builds the most successful businesses.