But even the best business idea cannot succeed without a solid financing plan. Options abound for financing a startup, from traditional routes such as personal assets and bank loans to newer methods like microloans and crowd sourcing.
The following summarizes some of the most common options for financing your small business.
Using personal assets is the most common way people finance startups, says Dorothy Browning, Director of the Kansas Women’s Business Center, which helps women develop and execute business plans.
That can include home equity loans, personal savings or even credit cards. Each has advantages and drawbacks.
Home equity loans are based in the equity potential borrowers have in their home. They come with low interest rates and flexibility, which makes them an attractive option.
“The risk is you are putting your home on the line,” Browning says. “If things go south, you could lose your home.”
Some turn to personal savings or 401K plans, which experts say is a sound option if those accounts are healthy. But they warn people should not drain their entire accounts.
Credit cards also are a popular option, but business experts urge borrowers to practice extreme caution. Roughly 44 percent of small businesses surveyed by the U.S. Small Business Administration say they used credit cards to finance their ventures.
“Credit cards are so easy. It’s like an invisible line of credit,” Browning says. “Some people can rack up a lot more debt than they plan to. But frankly, for a lot of people, it’s their only option to start a small business.”
Friends and family
Next to personal assets, loans from friends and family are the most common method for funding a startup. These loans tend to be informal with no business plan, but Browning still recommends drawing up a contract.
“If you think you can show up and face everyone on Thanksgiving, friend and family loans are great,” she says. “Just make sure everyone is aware that most businesses do not turn profits for the first year or two.”
Traditional bank loans are a long shot for most startups, says Whitney Peake, an Assistant Professor of Business Management at the University of North Texas in Denton. Banks typically require collateral for loans, she says, pushing them out of reach for most new business owners.
“Startups are too risky for the majority of banks,” Peake says.
The Small Business Administration does offer banks and private institutions some loan guarantees, which means the agency will cover defaults in case of business failure.
New businesses can try to secure a micro loan, which is run by the Small Business Administration.
Under this program, the SBA works with intermediaries, or nonprofit lenders around the country. The intermediaries receive money from the SBA. They use it to make small loans, no larger than $50,000, to businesses in their geographic area.
The average loan size is $13,000, according to the SBA, and interest rates vary between eight and 13 percent.
Crowd funding, or social lending, is one of the newest and most creative ways to fund a startup, and business experts say the practice could help redefine small business financing.
Websites like http://www.kickstarter.com, http://www.prosper.com and http://www.lendingclub.com allow entrepreneurs to list loan requests and details about their business plan. Investors can lend as little as $25.
Projects posted on Kickstarter range from a musician’s first full-length album to technology inventions. One recent client received $15,000 from lenders for her high-end cookie baking company, Browning says, and she sent investors samples of her product.
“This is the newest innovation and a great, low-risk way for entrepreneurs to secure funding,” Browning says.
Funding a small business can be challenging, so many people take a “layered” approach, which means money is brought in from several sources, Peake says.
“Perhaps a small business owner needing $100,000 would use $50,000 in personal savings, $20,000 in loans from a local lender and $30,000 from family and friends.”