NFIB

Financing the Business With Your Own Resources
10/ 01/ 2002

Provided by Kiplinger

Traditionally, entrepreneurs have used their own savings and credit (credit cards, home-equity lines of credit, etc.) to finance the prelaunch expenses and initial seed investment for their companies. If you don't have liquidity in your personal or retirement savings, you may be able to borrow against your 401(k) account, pension or life insurance policies.

Only you can dictate what portion of your life savings you're willing to risk, and prudence should dictate some level of conservatism, which may vary depending on your immediate cash needs as well as your short-to-medium-term goals and needs.

An individual with limited savings and two children nearing college age should be very careful with their savings and may want to reconsider whether this is the right time to launch a business venture at all. Conversely, a young couple with toddlers and one working spouse may decide that this is a perfect time to use their savings to launch a business. They know that they have a steady source of income from the working spouse and plenty of time to replenish their savings if the business venture is unsuccessful.

After exhausting that portion of your life savings and available credit lines to finance the start of your business, the next most likely source of capital usually comes from those who love and trust you -- family and friends. Whether it's an equity investment or a formal or informal loan, entrepreneurs often turn to old friends and family members, who typically provide capital on the basis of a relationship rather than on the basis of financial rewards.

The benefits of this inexpensive capital may be outweighed by the costs of the family dynamics and by the complex emotions of guilt, despair and frustration if the business fails and the family investment is lost.

Turning to old friends for money may also be unwise, particularly when the friend is investing in your new business based on trust and can't really afford to lose the money if things go south. Business loans and investments have ruined a lot of longstanding relationships over the years.

The Catch-22, of course, is that if things go very well, then your family and friends wind up arguing with you because you didn't give them a chance to participate. Again, you know your friends and family and their tolerance for risk, and only you can decide whether it will be advisable or appropriate to approach them for seed and early-stage capital.

If you decide to solicit friends and family as a source of capital, you must be very open and honest about the risks and rewards of the enterprise -- and the risks are likely to be much more significant than the rewards in the early stages of the business. Make sure that they know that this is not like investing in the public stock market where public reporting, a track record and the availability of liquidity protect against downside risk. You should also put the terms of the investment arrangements into writing to formalize the transaction and to avoid confusion about the rights and responsibilities of the parties.

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Andrew J. Sherman, a nationally recognized corporate and transactional attorney, has spent over two decades as a legal and strategic adviser to hundreds of entrepreneurs and growing companies. He is a senior partner of the Katten Muchin Zavis law firm in Washington, D.C. and chairs its local corporate and technology department. Sherman is also an adjunct professor at the University of Maryland and Georgetown University, where he teaches entrepreneurship and business planning.

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