Financing the Start Up Business
By: Randolph Wright, Esq.
A newly formed or expanding business faces many obstacles, but raising enough financial capital remains one of the highest hurdles a startup will face. Traditional sources of funding have included qualifying for a bank loan or taking out credit on your business or personal credit cards, however the 2008 financial crash and the resulting credit crunch has made this even more difficult for a small business owner. Recent studies have found that 63% of business owners first target banks for funding, but only 27% will actually succeed at getting a business loan.
While bank loans, a private or angel investor, or using your savings remain obvious ways for funding, there are a number of alternative ways for a business owner to raise capital. If your business is looking for funding, you should consider these alternative sources:
1. Crowdfunding — Crowdfunding is a relatively novel alternative financing that began in the 1990s that is generally a way for businesses to raise “many small amounts of money from a large number of people, typically via the Internet” using sites such as Kickstarter, GoFundMe, Indiegogo, RocketHub, and Onevest. A strong crowdfunding campaign reaches the business owner’s friends and family and spreads to their various degrees of social connection and takes advantage of social media, email distribution lists, and local media.
There are five types of crowdfunding: donation model, reward model, debt model, royalties model, and equity model. Each model differs by what investors receive in return for their small investment in the business. For example, in the donation model, the investor does not receive anything in return, whereas, the reward model offers a thank-you reward or perk in return for the investment. The newest type of crowdfunding is the equity model, in which the investor receives a small ownership interest and a portion of the profits in return for their investment. Normally, the sale of such securities must be registered with the SEC, however, Title III of the JOBs Act, which came into effect May 2016, provides an exception from registering securities as required by Section 5 and allow businesses to pursue equity crowdfunding on a national level.
In essence, under the new Rules companies will be able to “crowdfund” up to maximum aggregate of $1 million over a 12-month period from both accredited and unaccredited investors by offering and selling securities through SEC-approved “crowd funding” portals. Each offering must include a business plan for which the underlying purpose must be a bone fide business and not an investment vehicle.
Unaccredited investors whose annual income or net worth are less than $100,000 per year may offer the greater or $2,000 or 5% of the lesser of their annual income or net worth. If their annual income and net worth are equal to or more than $100,000, the investor may offer 10% of the lesser of their annual income or net worth. During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000. Businesses will be able to advertise to potential investors using Facebook, Twitter, email etc., so long as the company hits 100% of their funding target, does not exceed $1 million, and makes their offerings on a SEC-registered funding portal or through broker/dealer.
This model of funding has the potential to reach a significantly larger population and attract attention from a wider variety of investors. Given the array of accessible and oftentimes free social medial and digital platforms, this method of investing is especially promising for small business owners and start-ups. So long as the SEC rules and compliance guidelines are carefully followed, this model has the potential for huge, cost-effective success.
Each model has different tax implications and regulations to follow; therefore it is important to speak to an attorney or advisor before proceeding.
2. SBA Financing — The US Small Business Administration (SBA) provides access to capital by guaranteeing a loan made to a small business by a bank or authorized SBA lender. This guarantee alleviates the lender’s risks associated with the loan because the SBA will pay a portion of the loan back in the event that the small business owner defaults. An advantage of an SBA backed loan is that the bank generally does not take any ownership shares in the company.
There are many types of SBA loans available, and each has specific qualifications. For example, the most popular program is the 7(a) Loan Program. However, among others, there is also a Microloan Program for loans under $50,000, a 504 Loan for expanding or modernizing a small business, and Community Advantage Loan for underserved markets. Generally, to qualify for an SBA backed loan, the business must meet the government’s definition for a small business and must show that the business can’t obtain the necessary funding on its own.
3. IRA or 401k Financing — Generally, an early distribution from your Individual Retirement Account (IRA) or your 401(k) before the age of 59 ½ is subject to an additional 10% early withdrawal tax on top of income taxes, unless an exception applies. However, §408(d)(3) of the Internal Revenue Code allows a person to rollover his or her 401(k) or other retirement account into another new retirement plan tax-free. When a business owner rollovers his or her retirement account into a qualified retirement plan provided by his or her newly incorporated business, this becomes an alternative way for a new business to raise funding, known as Rollovers as Business Startups (ROBS).
ROBS requires significant legal steps and compliance with IRS regulations. Generally, the owner must incorporate the new business as a C corporation, create a corporate retirement account, rollover the outside retirement account into the newly created corporate retirement account, and invest the money in the new company’s stock. The IRS has not authorized this process, but has validated several ROBS with a determination letter. A business owner using ROBS should seek a professionals help because the process raises significant legal and procedural issues.
4. Auction Off Your Future Earnings — Entrepreneurs may have access to an innovative source of funding by auctioning off a percentage of his or her future income. Services such as Upstart, matches up wealthy investors who are looking to invest in entrepreneurs. In return for the investment, entrepreneurs pledge to give up a percentage of their earnings, as reported on the tax return, for a set amount of time. Factors such as credit scores, test scores, schools, and majors will affect the amount that can be raised.
5. Peer-to-peer Lending — Peer-to-peer Lending (P2P) services allows an entrepreneur to pitch his or her business model to potential lenders. Online services such as Prosper or Lending Club help connect entrepreneurs and lenders and provide a platform for entrepreneurs to pitch their business.
6. Family and Friends — Often family and friends are eager to invest because they already know and trust the entrepreneur and may have quicker access to cash. Before entering a loan agreement, it is important to seek out professional help in order to protect the entrepreneur and the investor’s interests.
7. Microloans —For financing smaller amounts between $500 to $50,000, microloans would be a viable option. There are many programs that provide micro-financing, for example the SBA, programs for women-owned businesses, environmentally responsible businesses, veterans, or nonprofits such as Accion USA, Kiva, and Communities at Work Fund.
There are many new ways, in addition to the traditional bank loan and use of credit cards, that an entrepreneur may raise funding for a startup. This article briefly mentions a few of these alternative funding avenues. If you have any questions regarding funding for your new business or implementing any of the above sources of funding, please contact Randolph M. Wright in the firm’s Birmingham office 248-645-9680 ext. 2505 or by e-mail: rwright@berrymoorman.com.
Article last updated November 8, 2016.
