Introduction

If you were to ask random people on the street where they thought most small businesses got their start-up money, they'd probably answer, "From banks." They'd be wrong. Although banks might be eager to step in after your infant business has started to walk, they're likely to remain notably absent during its labor pains and birth. Most small businesses need to make creative use of personal resources, draw on their credit cards, and get financial help from friends, family, and associates in these early stages. And that's not necessarily a bad thing. This book was written to help you understand why money from people you know is the best financing option for many start-up businesses -- and how to make it work for you.

If you do a little digging into business history, you'll find that borrowing money from family and friends is the stuff of entrepreneurial legend. But these success stories don't mean that you should just start ringing up wealthy relatives, or hitting up neighbors at the block party, without some preparation. Whether your business is at the dream stage, the planning stage, or actually up and running, you essentially won't know what to ask for until you:

• take stock of your options for start-up financing (see Section A, below), and
• understand the fundraising implications of your business's chosen legal structure (see Section B, below).

Small businesses in the United States represent 99.7% of all businesses and generate 60-80% of new jobs each year. (Source: Small Business Profiles for the States and Territories, 2005 Edition, U.S. Small Business Administration (SBA).)

Financing Options for Your Start-Up Business

Money from friends, relatives, and associates is only one of many sources that entrepreneurs like you might use to launch and grow a business. Let's take a closer look at all your possible sources, to see where this particular type of financing fits in.

The first table in this section lists sources of capital -- loans or equity investments (purchases of ownership shares) -- generally available to businesses. The second table matches each source of capital with the stage at which it becomes a realistic option for a growing business. You won't be surprised to see that most entrepreneurs use their personal savings, help from family and friends, and similar informal sources to get their business going.

The reason for this is that, put bluntly, most entrepreneurs don't have any other choice. Even if you're still wary of asking for money from people you know, they may be your most realistic option while your business is young and you have no or very few customers. Until your business begins generating significant revenue, you are only the tiniest dot on the radar screen of banks, venture capitalists, and other institutional investors. Research and common sense reveal that your best bet at this early stage is to seek the money you need from within your own resources, any business assets you've already put in place, and your circle of contacts.

1. Minimizing the Amount You'll Need

Before you start planning to ask your Aunt Millie for a million dollars, think pragmatically about how much money you'll really need to launch your business. Experts recommend you start on a shoestring. Pouring too much money into a business at the beginning can be a mistake -- and it's a mistake that many entrepreneurs make. A fair number of small businesses fail in their first year, so you're only asking for trouble if you raise and spend a lot of money, particularly for an untested business idea.

Starting on a shoestring means making the most of every dollar you have and not incurring costs that aren't absolutely necessary. For example, do you really need that corner office in the newly renovated industrial building downtown? Or can you get your enterprise going from your garage? Do you have to buy a new computer, or can you use the household computer after the kids' homework is done? Can you lease, rather than buy, space and equipment? Some say that a true entrepreneur sees an opportunity where others see a resource shortage. The more you can do with less, the further you'll be able to grow your business, and the better your prospects will look when you begin seeking external money.

Leasing rather than buying expensive equipment is one of the most cost-effective ways to avoid sinking too much money into an untested business. For example, your fine textiles business may depend on that 19th century, $45,000 loom you found; but until you're actually selling the $500 all-natural blankets it can produce, you might be better off leasing it (on a monthly basis) from the owner first. By lowering your monthly outlay, you also save your start-up cash for other items that you have no choice but to purchase with cash, such as printed materials and office supplies.

You may need less total start-up capital than you think. According to an Inc. 500 analysis of America's fastest-growing companies in 2000:

• 16% started with less than $1,000 in capital.
• 42% started with less than $10,000 in capital.
• 58% started with less than $20,000 in capital.

2. Using Your Own Money First

You probably already have first-hand experience digging into your own pocket to get your business going. Typically, at the earliest stages, entrepreneurs rely on personal resources, including savings and credit cards. See "Checking All Your Pockets for Cash," below, for some of the places you might go to scrounge up start-up money of your own.

But do you have to dig into your own pockets? The short answer is "yes." No one else is going to believe in your business if you don't -- and to prove your belief, you'll need to put your own "skin in the game," at least to the extent you can afford it. Some lenders or investors may want to see you exhaust your savings account, max out your credit cards, and borrow against any home equity, 401(k), or other retirement accounts before you begin reaching for their money.

Just how deeply you dip into your personal well will be used by some private investors as a criterion for getting involved. I've heard it referred to as a "straight-face" test: Can you honestly ask others to put their money at risk if you (and your family) have not done the same? Furthermore, lenders believe that you're less likely to walk away when the going gets rough if a sizable amount of your own money is at risk.

Of course, risking your own skin doesn't mean bleeding yourself dry. You'll need to establish a reasonable limit on the level of your personal investment and then stick to it. If you find yourself in discussion with prospective investors who are pushing you to overextend yourself by borrowing against a retirement plan or taking a second mortgage on your home, step back and reevaluate your plans.

Look before you leap into a new home mortgage to finance your business. This is your home that you're putting on the line -- don't borrow so much that your very ability to make your monthly payments is put at risk. Your payments should remain low enough that even if your business is slow to get going, you'll be able to cover them. Also remember that every new mortgage comes with fees and closing costs. Make sure these don't add up to, say, several thousand dollars if your goal is to borrow only $5,000 to $10,000 for your business.

3. Finding Cash in Existing Business Resources

You may not think you have much in the way of business resources, especially if you're operating on a shoestring out of your home, garage, or barn. But look around again, at the customers, suppliers, and equipment that you've accumulated so far, and you may be pleasantly surprised. A little creativity will lead you to ways to make the most of the business resources -- the assets and the relationships -- that you already have in place. Here are three suggestions.

Make good use of trade credit. Find out whether you can buy the goods or services you need on credit, meaning that the supplier won't require you to pay your bill for 30 or 60 days. This gives you some time to earn the income you'll need to pay back the supplier. If you're on good terms with your supplier, he or she may even allow you to spread your payments out across several months with no finance charges, as long as you keep up. Even if the supplier charges an interest rate, the rate may be considerably lower than you'd have to pay if you used your credit card to finance the purchase. Nearly two-thirds of U.S. small businesses reported in a recent study that they use trade credit as a form of business financing.

Explore the possibility of sale- or lease-backs. If you already own a piece of equipment or real estate, you can sell it to someone else, and then lease it back for your business use. Be cautious with these transactions, however. Make sure the fees are affordable, and look carefully at the fine print -- some overly clever buyers put in a contract clause saying that you can lose the asset if you're late on a payment.

Enter the complex world of factoring your accounts receivable. If you already have customers, you may have accounts receivable -- that is, a paper saying that someone else owes you money for a product or service you sold them. Accounts receivable is a business asset, because it represents money you are owed, and you may be able to sell this piece of paper to a factoring company. The factoring company then advances you 80-90% of the cash and collects on the account when it comes due. If you go this route, shop around for the company that will give you the best rate, and be careful of signing away a business asset as collateral.

4. Asking Family and Friends for Money

Asking family and friends for money -- the main topic of this book -- is often the next stage in your quest for start-up capital. A gift, a loan, or an equity investment from someone you know can fill a critical gap in the growth of your business. It allows you to lean on your friends' and family's trust and support to grow your business to the point where you've amassed the revenue, assets, and credit history usually required before banks or professional investors will invest.

Did you know? Private loans and investments are such a common source of small business financing that MBA students and finance professionals put a name to the practice. They use the phrase "the 4Fs" when referring to money loaned or invested in a new business by "founders, family, friends, and foolhardy strangers."

5. Visiting a Bank or Other Lender

Although banks themselves can be found on virtually every street corner, bank money to launch your business can be harder to come by. Once you're up and running, bank financing is an important resource. But until your business has launched a product and has paying customers, your average bank or other traditional lender will probably view you as too great a risk for a commercial loan. Of course, if you're willing to put your personal credit rating at risk, you can go to a bank for a personal credit card, a personal loan, or a line of credit secured by the equity you have in your home or other collateral. Many entrepreneurs do this to get started, as described previously in Section 2.

If you're applying for a commercial loan with your business as the borrower, the bank will typically want to see that you've figured out how to make a profit and that you have the business assets to protect their loan. Many businesses don't reach that stage until as late as their third year of operation. When you get to this point, you're considered "bankable." It's getting to this point that can be a challenge. See "How Banks Choose Whom to Lend Money To," below, for the five hurdles institutional lenders tend to set for business loans. If you can't fly over the bars, you're out of the race, at least until your numbers improve.

Although traditional bank loans tend to be reserved for established businesses as described above, some banks and other financial institutions do offer small business loan programs, because they can get help from the federal government to lessen the risk you represent. Once you've hung out your shingle, take a trip to the bank (either the neighborhood or the mega-variety, in person or online) and ask whether it has a small business loan program.

Most small business loan programs are associated with the Small Business Administration (SBA), the federal agency charged with supporting U.S. small businesses. The SBA encourages banks, credit unions, and nonprofit financial intermediaries around the country to lend to small businesses.

One of the most popular ways the SBA does this is the 7(a) loan program. Here's how it works: You can receive up to $750,000 from your local 7(a) lender, with a partial guarantee from the SBA. The SBA doesn't actually lend you any money but provides backup to the bank or lender who does, to reduce the amount of risk that your lender takes on. For a state-by-state listing of the top small business bank lenders, go to the CD-ROM at the back of this book.

Around the country, various nonprofit organizations can also provide you with business capital and sometimes also free business assistance. Many of these organizations serve as financial intermediaries between the entrepreneur and both federal and state small business programs like the SBA. Most have a community improvement mission. But the fact that these are "do-good" nonprofits doesn't mean you should expect a handout. The interest rates they charge for a small business loan can be just as high as banks, and sometimes as high as credit card rates when they take a risk on a business that banks won't touch.

In other words, these organizations provide access to capital for individuals and business who might not otherwise be able to get it. Many serve the smallest businesses, known as "microenterprises" (see "Is Your Business Small Enough to Get Microenterprise Assistance?," below). Others aim to support medium-sized firms that achieve community development goals, like job creation or minority business ownership. Many of these organizations serve a particular region (like an urban neighborhood) or a particular group (like immigrant entrepreneurs). Whatever their mission, they have a common purpose: to "level the playing field" and encourage economic growth among entrepreneurs whom traditional lenders might not consider bankable. The CD-ROM at the back of this book contains a state-by-state listing of some of these nonprofit financial intermediaries.

Get to know a local banker. It's never too early to strike up a relationship with a local loan officer. He or she likely will have a good sense of the financing options available to you and can help you see the larger picture when it comes to the financial structure of your business. Your banker will also probably have experience helping other entrepreneurs in your community launch businesses and can recommend resources you should take advantage of. It's in the banker's interest that you successfully get your business off the ground and grow it until you run through your sources of informal capital -- at which point you will presumably return to your friendly banker for bank capital.

6. Seeking Out Business Angels, Not Venture Capital Investors

If equity capital is what you're after, you've probably heard stories from the once-promised land of professional equity investing: venture capital -- million-dollar investments from high-rolling companies with endlessly deep pockets, and the like. Putting aside the hype, the basic idea is that, after an exhaustive review of your business opportunity, a venture capitalist gives you cash in exchange for shares in your business. If all goes well, the investor eventually exits the company by selling the shares to new investors, at many times the original price he or she paid you. If the ending is not so happy, venture capitalists get lower-than-expected returns (or no returns at all) and disappoint the people who invested in their venture capital firm.

The best part of equity investing from your perspective is that you get all the money up front, you don't have any payments along the way, and your investor gets money back only if your company does so well that all the owners are grinning. Sounds like a great deal, right? Well, hold on a minute. If you're contemplating sending your business plan to a list of venture capital firms you found on the Web, you may want to save your stamps.

The allure of venture capital beckons to most entrepreneurs, but in fact only a small group of companies with rapid growth potential actually get funded. In 2002, just $21 billion in venture capital was invested in about 2,500 companies. Though that may sound like a lot, it's a mere fifth of the $108 billion that gets distributed as informal loans and investments to millions of companies each year. Worse yet, only about 20% of the venture capital invested in 2002 went to start-up and early-stage businesses -- increasingly, venture capitalists direct their investments toward established and expansion-stage companies that are already profitable.

However, this doesn't mean you should write off equity capital as a source of money to start or expand your business. Although venture capitalists are probably an unrealistic target for most start-up businesses, there are other people out there who may want to invest in, rather than lend money to, your young business. You may be lucky and have some wealthy friends and family who can make an equity investment in your business. Even if you're not, you have another excellent option.

"Business angels" are affluent individuals, often successful entrepreneurs themselves, who invest in up-and-coming entrepreneurs like you. The trick is that business angels don't go around advertising free money. These are private individuals, often with other jobs; some operate alone and some as part of a network or a structured group. The challenge is to find these potential equity investors among your friends, family, and other business contacts. (You'll learn how to find these folks and ask them for money in Chapters 3 and 8.)

How Your Business's Legal Structure Can Advance -- or Hold Back -- Your Fundraising

If you're still deciding on a legal structure for your business -- that is, choosing whether to operate as a sole proprietorship, partnership, corporation, or LLC -- you're probably weighing the advantages and disadvantages when it comes to ease of setup, degree of personal liability, tax advantages, and the like. Let me, however, add one more consideration to the mix: your fundraising possibilities.

An entrepreneur running a solo, unincorporated Web design shop out of his or her barn will have different fundraising options from the founders of an incorporated Web design company. The solo entrepreneur can't, for example, raise equity capital, because selling equity shares means dividing up ownership, and it's impossible to have more than one owner in a so-called "sole" proprietorship.

Even if the solo entrepreneur brought in a second person and started a partnership, he or she would have trouble raising equity capital, because as co-owners, the investors would be just as liable for the company's debts and liabilities as the owner would. These limitations on fundraising by sole proprietorships and partnerships are perhaps the most important issues to understand, but there are other layers to the analysis, as covered below.

Your main choices of business structure are:

• sole proprietorship (see Section 1, below)
• partnership (see Section 2, below)
• C corporation (see Section 3, below)
• S corporation (see Section 4, below), and
• limited liability company or "LLC" (see Section 5, below).

Picking the right legal structure can be a complicated decision, because you need to be able to look into your crystal ball and project how big you want to get and what type of capital you'll need in order to get there. The subsections below give you a primer on balancing fundraising and other considerations. Also see "Ways to Organize Your Business," below, summarizing the key advantages and drawbacks to these five legal structures.

Your legal structure is not set in stone. Make the most informed choice possible now, to save on setup costs and paperwork. But remember that you can always change the legal structure later, to fit the needs of your growing business.

1. Sole Proprietorship

Most small businesses are organized as sole proprietorships, at least at the beginning. This is by far the cheapest and easiest way to set up a business -- with a single owner, who receives and reports all the profits and is responsible for any debts or liabilities. Establishing a sole proprietorship requires almost no formalities, and you'll personally own your business assets.

The main drawback to sole proprietorships is that personal liability means personal risk -- the owner could literally lose his or her shirt because of unexpected losses or lawsuits. Even if the situation doesn't become so dire, one slow month may be all it takes to eat up your family's vacation savings, for example, in paying your employees' salaries.

In addition, as mentioned earlier in this section, a sole proprietorship can have, by definition, only one owner. So if you want to raise capital by selling shares in your business, you'll need to find a legal structure that can accommodate multiple owners.

EXAMPLE: Jamie, who has always loved kayaking, starts a small one-person business renting three kayaks for either personal use or guided tours. After a glowing write-up in a popular sporting magazine, he is flooded with customers. Jamie decides to raise capital to grow Jamie's Kayaks into Jamie's Outdoor Play, a year-round multisport expedition and outdoor gear company.

Jamie's first loan, of $10,000, is from his friend Josh, a fellow boating enthusiast. Jamie knows that, as the sole owner, he will be personally liable for that loan. Jamie next approaches his father-in-law -- who is interested in the business but turns out to be a business angel who would rather make a $50,000 investment and become a co-owner. If Jamie wants this investment, he will need to change the legal structure to one that offers his father-in-law both a share of the company in exchange for his investment and protection from the company's liabilities (a protection nearly all investors expect).

2. Partnership

A partnership is a relatively simple and inexpensive way to organize a business that has more than one owner. In a general partnership, you and your partners jointly own your business's assets and liabilities, usually based on how much each partner brings to the table. Small groups of people who want to pool some resources for a business or real estate project tend to use the partnership structure to do it. Again, however, personal liability is an issue -- both you and your partners will be personally liable for the debts of the partnership.

One way to get around the liability problem of a general partnership is to invite certain partners -- in particular, your investors -- to join as "limited partners." As long as these new partners remain "passive investors," meaning they take no role in running the business, they are protected by "limited personal liability." That means they are liable only up to the amount that they contributed to the business. Another advantage to limited partnerships is that they allow you to invite investors in without dealing with the complexities of selling ownership shares and managing equity investors. (Limited partnerships are most often used in real estate, so that one or more general partners can buy and sell properties while the limited partners provide the capital.)

Jamie, in the kayak example above, could invite his father-in-law to invest as a limited partner. If his father-in-law agreed to this, he'd have the semi-comfort of knowing that limited partners are liable only to the extent of the investment they made in the business, and not for any business debts or liabilities that arise out of the negligence of another partner or manager. For example, if a customer drowned on a business-led outing and the customer's family sued the business for $5 million, a limited partner would not be liable.

However, if Jamie achieves the growth he projects in his business plan, Jamie's Outdoor Play will be on track to being a very profitable business, and his father-in-law might prefer to have an actual ownership stake through a corporate or LLC structure. As a limited partner in the growing business, Jamie's father-in-law would be entitled only to those profits that are passed through to the limited partners as designated by the partnership agreement.

Plan on repaying your debts, no matter what business structure you choose. I'm not counseling you to find a structure that allows you to wriggle out of your obligations. I assume that your intentions are to make responsible use of your family's and friends' money -- and that you'll try to repay them regardless of whether your corporate structure allows otherwise.

3. C Corporation

If you set up your business as a C corporation (the standard, most commonly used corporate structure), it becomes its own legal entity. The corporation, not its owners, will own your business's assets and liabilities. This ingenious structure acts as a buffer, since neither you nor your investors are personally liable for unpaid debts of the business. In fact, if you plan on selling any shares in your business to investors (in the form of stock), or if you dream of one day "going public," forming a corporation (or an LLC, as described in the next section) is an obvious choice for you.

If, in the earlier example, Jamie's friend Josh had made his $10,000 loan to "Jamie's Outdoor Play, Inc.," rather than to Jamie himself, he'd have to sue the corporate entity if Jamie failed to repay -- and would have no recourse against Jamie himself (unless Josh had gotten Jamie to personally guarantee the loan, which many lenders understandably do). If Jamie's corporation went bankrupt before repaying, Josh, as a lender, would be among the first in line for repayment -- but he would have to hope that the company had enough assets to repay him, because he couldn't get the money directly from Jamie (again, unless he'd had Jamie personally guarantee the loan).

During your efforts to raise loan capital, you may well find that, especially in the early days, lenders want reassurance that someone will be responsible for the corporation's debts. That someone will most likely be you. You may well be asked to personally guarantee loans, meaning you pledge your personal assets as a backup if the business's assets are insufficient to pay off the debt. In fact, the SBA requires that all owners with more than 20% equity in a business provide a personal guaranty before they receive an SBA-backed loan, so that if the business fails, the lender has recourse against you personally. Still, this doesn't cancel out the benefits of incorporating -- it's the unexpected liabilities you should be most worried about.

4. S Corporation

More and more entrepreneurs are taking advantage of an IRS tax status for corporations called "subchapter S tax status." While regular, C corporations pay corporate federal income tax, an S corporation does not. Instead, the S corporation's tax obligations are passed through to and paid by its owners, on their personal tax returns. This avoids the problem of "double taxation," the bane of investors in C corporations.

It's called double taxation because the C corporation must pay taxes on any profits it makes before it distributes profits to shareholders, yet the shareholders must also pay taxes after they receive these distributions (in the form of dividends or other gains). The net result to shareholders in a C corporation is that there's less money to be shared after the IRS has taken its cut, making an S corporation structure tempting to potential investors.

Also, even if your S corporation loses money, there's some good news for your equity investors. An S corporation passes both gains and losses through to its shareholders, who must then report both on their personal income taxes. They can use these pass-through losses to offset their other sources of personal income, potentially lowering their overall tax bill.

Before you leap at S corporation status, however, realize that it's really designed for smaller companies sharing ownership between the founder and a few investors. In fact, to be eligible for subchapter S tax status, your corporation must have 75 or fewer stockholders, all of whom are resident aliens or citizens, and you must issue only one class of stock. In addition, no other corporations may be investors in your company, only individuals.

5. Limited Liability Company (LLC)

The LLC structure is a relatively new and increasingly popular legal structure for growing small businesses. It is distinct from any of the three structures listed previously yet offers a combination of their advantages. Structuring your business as an LLC offers you (and your equity investors) both the limited personal liability of a corporation and the pass-through tax advantages of a partnership or S corporation. For example, LLCs usually have a clause in their operating agreement detailing the formula used to determine the annual profits each member will receive. The most common formula is the member's share of profits times his or her tax rate.

Even better, LLCs are fairly simple to set up. Given the choice between an LLC and a corporation, experts agree that most small business owners would be better off forming an LLC.

Want more detailed information on setting up your LLC? Take a look at Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo), which provides forms, step-by-step instructions, and guidance on when you do and don't need an attorney.

Want more information on choosing an appropriate business structure? See the following resources:

Legal Guide for Starting & Running a Small Business, by Fred S. Steingold (Nolo), which includes detailed analysis of the tax burdens, personal liability, ease of setup, and other features of each small business structure, and

The Small Business Start-Up Kit for California by Peri Pakroo, (Nolo), particularly Chapter 2, "Choosing a Legal Structure." Pakroo discusses each of the six options described in Section B, above, and includes material that is relevant across all 50 states.