Startup Small Businesses

April 13, 2006

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Startup businesses often begin with only ideas and enthusiasm. One of the many issues that every entrepreneur must address in starting a small business is the financial reality involved in deciding exactly what he or she wants to do, when it can be done, and how it's going to be done.

New small businesses have trouble securing conventional financing because they present a tremendous risk to lenders and investors. The result is that nearly three-quarters of startup businesses are funded through the owner's own resources, such as personal savings, residential mortgages, or consumer loans. Family members, friends, and investments by private contacts or "angels" provide most of the remaining "seed" funds for new small businesses.

Warning

You will find that some small business advisors preach that a "survivalist" mentality is the only way to successfully fund a startup business on a shoestring budget. For example, they may advocate borrowing as much money as you can get, regardless of how much money you think you are going to need for a particular purpose. They assume that it will be easier for your business to manage debt (once you have cash) than it will be for your business to obtain cash when it's really needed. However, while this advice may sound savvy, the reality is that most of your small business debt will also be your personal debt, and any default may mean disaster to your personal finances. Moreover, the more debt you assume, the harder it may be to obtain additional funding, on much better terms, when you are in a better financial position to obtain it. In short, advocating a limitless assumption of risk and debt is easy when it's not your life savings, your house, or your family's assets on the line.

The most common financial problem for startup businesses is a shortage of short-term cash, and cash flow problems during a potentially long initial period can be fatal to the business. Any debt financing (loans) that the business can secure from traditional lenders, e.g., banks, is likely to be expensive because of the high risks assumed by the financier. Moreover, unless the business can boast a significant owner investment and marketable collateral, the availability of conventional debt financing is almost nonexistent.

This "cash crunch" puts a tremendous focus upon inventory turnover, and the need for immediate revenue often becomes a daily crisis that takes priority over financing for sustained growth or development of new products. Perseverance and a willingness to investigate all sources of financing — from angels to government loan programs — are invaluable at this stage.

Warning

The financing pressures of a cash flow shortage has forced many small business owners to take unwise, desperate measures to salvage their business. For example, cash-strapped entrepreneurs may try to "borrow against" payments of quarterly payroll taxes, hoping to repay delinquent amounts as soon as business improves. Unfortunately, the problem is rarely resolved and the entrepreneur not only ends up with a failed business but personal tax liability for failure to withhold payroll taxes.

For a complete discussion of the issues involved in beginning a new enterprise, see our discussion of starting your business.