In their book Start Your Own Business, the staff of Entrepreneur Media Inc. guides you through the critical steps to starting your business, then supports you in surviving the first three years as a business owner. In this edited excerpt, the authors discuss the options you have if you want to fund your startup yourself.
If you're thinking about trying to finance your business yourself, begin by doing a thorough inventory of your assets—you're likely to uncover resources you didn’t know you had. Assets include savings accounts, equity in real estate, retirement accounts, vehicles, recreational equipment, and collections. You may decide to sell some assets for cash or use them as collateral for a loan.
If you have investments, you may be able to use them as a resource. Low-interest-margin loans against stocks and securities can be arranged through your brokerage accounts.
The downside here is that if the market should fall and your securities are your loan collateral, you’ll get a margin call from your broker, requesting you to supply more collateral. If you can’t do that within a certain time, you’ll be asked to sell some of your securities to shore up the collateral. Also take a look at your personal line of credit. Some businesses have successfully been started on credit cards, although this is one of the most expensive ways to finance yourself.
If you own a home, consider getting a home equity loan on the part of the mortgage that you've already paid off. The bank will either provide a lump-sum loan payment or extend a line of credit based on the equity in your home. Depending on the value of your home, a home-equity loan could become a substantial line of credit. If you have $50,000 in equity, you could possibly set up a line of credit of up to $40,000. Home-equity loans carry relatively low interest rates, and all interest paid on a loan of up to $100,000 is tax-deductible. But be sure you can repay the loan—you can lose your home if you do not.
You could also consider borrowing against cash-value life insurance. You can use the value built up in a cash-value life insurance policy as a ready source of cash. The interest rates are reasonable because the insurance companies always get their money back. You don’t even have to make payments if you don't want to. Neither the amount you borrow nor the interest that accrues has to be repaid. The only loss is that if you die and the debt hasn’t been repaid, that money is deducted from the amount your beneficiary will receive.
If you have a 401(k) retirement plan through your employer and are starting a part-time business while you keep your full-time job, consider borrowing against the plan. It’s very common for such plans to allow you to borrow up to 50 percent of your vested account balance up to a maximum of $50,000. The interest rate is usually 1 to 2 percent above the prime rate with a specified repayment schedule. The downside of borrowing from your 401(k) is that if you lose your job, the loan has to be repaid in a short period of time—often 60 days (but occasionally as long as six months) or it's taxed heavily, as if you’ve taken an early withdrawal from the plan. Consult the plan’s documentation to see if this is an option for you.
Another option is to use the funds in your individual retirement account (IRA). Within the laws governing IRAs, you can actually withdraw money from an IRA as long as you replace it within 60 days. This isn't a loan, so you don’t pay interest. This is a withdrawal that you’re allowed to keep for 60 days. It’s possible for a highly organized entrepreneur to juggle funds among several IRAs. But if you’re one day late—for any reason—you’ll be hit with a 10 percent premature-withdrawal fee, and the money you haven’t returned becomes taxable.
If you have a Roth IRA, you’re entitled to withdrawals tax and penalty free, as long as the funds were in the account for at least five years. That’s because a Roth is taxed at the time you put funds into the IRA account—not when you retire and withdraw it. Consider switching your regular IRA to a Roth over a couple of years if you know you plan to finance a business this way. You’ll have to pay the taxes in the year you make the conversion, but the money will then be free to withdraw when you need it, without the big penalties. Make the conversions well before you need the cash.
If you're employed, another way to finance your business is by squirreling away money from your current salary until you have enough to launch the business. If you don’t want to wait, consider moonlighting or cutting your full-time job back to part time. This ensures you’ll have some steady funds rolling in until your business starts to soar.
People generally have more assets than they realize. Use as much of your own money as possible to get started; remember, the larger your own investment, the easier it will be for you to acquire capital from other sources.