The Hazards of Financing Your New Small Business

Recessions come, and recessions go. Each time the economy scales back, thousands of companies cut back by firing employees, reducing production, or filing for bankruptcy. Small businesses are no exception, but with the peculiar world of small business finance, many entrepreneurs are especially vulnerable to financial liabilities in a crisis. This article will examine some of the potential financial "gotchas" small business owners are susceptible to, particularly when starting up a new business, and offer tips on how to avoid them.

The number one killer of businesses, large and small, is debt. Too much debt has caused numerous bankruptcies and has killed off many a company. But business schools teach us that debt is a useful tool. The idea of risking OPM, or "other people's money," is a popular one in the literature and culture of entrepreneurship. It is true that debt allows a business owner to expand more rapidly. A car dealer, for instance, can purchase a larger inventory on debt in order to have more products on hand to sell to prospective buyers. But there is an inherent danger with debt. What happens when the economy turns down, as it has in 2009? Suddenly, many business owners are finding their lines of credit reduced. Credit is crunched and lenders are increasing percentage rates and minimum payments, putting a strain on small businesses that rely too much on debt.

Small business owners may find themselves limited in options for financing, especially in an economic downturn. The first step many new entrepreneurs take is seeking a bank loan. Much to their surprise, banks do not consider new businesses good loan risks. The reasoning a loan officer has for this is, the business is new and has not proven itself to be viable. Also, banks know that many new businesses fail soon after inception.

When banks do offer entrepreneurs loans, the loans are often based on the individual rather than the business. This can be good so long as your credit is okay, however it puts you personally on the hook for paying back the loan. If the business goes under, the bank will still want their loan repaid, and on time.

Many budding entrepreneurs think that by incorporating their business, they can avoid personal liabilities. While it is true a corporation is a legal entity, able to file for a loan much as a real person can, banks still often are unwilling to write a loan for a new business, even an incorporated one. Instead, the loan officer will insist a person (usually the business owner) take on the obligation.

Another source of startup capital many new entrepreneurs are tempted to use is a personal credit card. Again, if your business heads south, you'll be stuck with a large credit card bill. Late fees and penalties accrue quickly, and if you get too far behind, interest rates on credit cards can approach 33 percent in some instances. If business suffers, you may find your personal credit score suffering along with it if you can't keep up with the credit card payments. This can affect many areas of your life, including access to additional credit, and an increased likelihood of higher interest and insurance rates. Also, if your credit cards are racked up with debt for your small business, your ability to use the cards for personal reasons will become limited. For the same reasons, taking out a mortgage on your home to finance a business is among the riskiest measures available to you. If the business suffers, you could easily find yourself without a home.

Finally, many entrepreneurs seek relatives for low interest startup loans. While it seems reasonable at the outset, with the "rich" relative often happy to help out, if the business turns sour you are faced with the prospect of repaying a personal loan with little in the way of cash flow. At this point, many struggling business owners delay repaying personal loans simply because their relatives have little recourse, unlike creditors with their armies of bill collectors. However, while there may be no damage to your credit score, the damage to the relationship may be much worse to live with over the long run. If you must borrow from a relative, be sure and pay them back first, over and above other creditors. Also, all personal loans, even from close family members such as a parent or sibling, should be subject to a paper contract and signed by all parties so that expectations for repayment are in writing.

So, we've taken a look at the dangers surrounding the most common forms of startup capital for new businesses. You might be wondering, is there a safer way to finance my dream? The best answer is to start your business with no debt at all. Scrimp and save until you have enough to get going, then don't buy anything without paying for it up front. Instead of using credit cards for an emergency, build up a savings account as a rainy day fund and dip into it only when needed.

Work out of home to save on office rent. When you do rent out that first office, start cheap. Wait until adequate cash flow justifies moving to a nicer location. Buy used office equipment and furniture. For instance, instead of going into debt for a new computer with all the bells and whistles, grab an older model and outfit it with open source software. There will be time to buy new stuff if and when the money starts flowing. If it doesn't, and your idea doesn't make you rich, then you're not in the hole for a bunch of expenses in a company that has gone out of business.

Sources:

Ramsey, D. (2003). Financial Peace Revisited. New York: Viking Penguin.