When people learn that I teach students how to raise money as part of my entrepreneurship classes, many of them ask me the same question: What’s the most important thing to learn about raising money? While I usually answer that there is a lot one can learn, four lessons are particularly important.
1. For most entrepreneurs, seeking outside financing isn’t worth your time. Only a small fraction of new businesses obtain money from someone who is not a founder of the business. Therefore, unless your business has a lot of hard assets that can be used as collateral for a loan, or one of a handful of startups that has the super-high growth potential and exit plan to attract accredited angel investors and venture capitalists, seeking outside money is unlikely to be fruitful. You are better off developing a less capital-intensive business model and financing the startup yourself than you are spending your time trying to raise money.
2. Your personal credit and personal collateral matter a great deal when financing a startup. Data from the Federal Reserve’s Survey of Small Business Finances shows that the owners of one quarter of corporations less than five years old, and nearly half of sole proprietorships that age, personally guarantee the debts of their businesses. Given that only a minority of businesses borrows externally at all, this means that most of the capital that entrepreneurs borrow is personally borrowed or personally guaranteed.
With personal debt, the lender’s decision depends less on the potential of the business than on the entrepreneur’s credit and collateral. If you don’t have great personal credit and you have few assets to pledge against a loan, you will have a hard time borrowing to finance your new business, no matter how great your business idea is. So if you want to start a business, be careful about your personal credit.
3. You are more likely to get a loan than an equity investment from an outsider. Because venture capital and angel investments are sexier than bank loans and trade credit, the former gets the lion’s share of attention in books and articles about entrepreneurial finance. However, most of the companies that get outside financing obtain debt, not equity.
Only a tiny percentage of startups are financed by selling equity to accredited angels or venture capitalists. The statistics show that around 1 percent of companies get their financing from these two sources combined. Other informal investors – like friends, family and unaccredited angels – add a few percentage points to the share of businesses that get outside equity, but research shows that these sources are actually more likely to lend money than to take an equity stake. Therefore, unless your business is the type that angels and venture capitalists look for, you shouldn’t waste your time seeking equity investors.
4. Tapping trade creditors is where your odds of obtaining financing for the business itself are highest. According to analysis of the Federal Reserve’s Survey of Small Business Finance, next to having a checking account, trade credit is the most common financial tool used by small businesses. Because trade credit is offered by suppliers to help you buy their products, even the newest businesses can obtain it.
In short, unless you have a rare, super-high-growth business with plans to exit through an initial public offering or acquisition within five to seven years, your best bet is to minimize your capital needs and finance your start-up with your own money, money that you borrow personally, and trade credit.
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Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool’s Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.