How Do Entrepreneurs Really Finance Their Businesses?

If you crack open most entrepreneurship textbooks, you’ll find that they talk a lot about how entrepreneurs finance their businesses.   Beca
December 23, 2009

If you crack open most entrepreneurship textbooks, you’ll find that they talk a lot about how entrepreneurs finance their businesses.   Because these books are targeted at students in courses that focus on the creation of high potential businesses, they spend a lot of time discussing venture capital, angel investing, and other sources of external equity capital.  As a result, they don’t describe how most entrepreneurs finance their businesses.

In reality four patterns prevail in entrepreneurial finance:

1. Most New Businesses are Lightly Capitalized
Most entrepreneurs don’t need much capital to get started. The Entrepreneurship in the United States Assessment, a survey of a nationally representative sample of people starting businesses in the United States in 2004 found that the typical American start-up only needs $15,000 in initial capital.

2. Much of the Money to Finance New Businesses comes from their Founders
The most common source of that capital is the founder’s own savings, with the majority of businesses only obtaining money from this source. As a result, more people finance their start-ups with their own money than get money from banks and friends and family members combined.

3. External Financing is More Likely to be Debt than Equity
When companies get external capital, it mostly takes the form of debt. A study of young firms in Minnesota, Pennsylvania and Wisconsin found that less than ten percent of the firms had received an external equity investment, but half had borrowed money from an external source.

Even including the equity provided by founders, most of the money used to fund new businesses takes the form of debt. The Federal Reserve’s Survey Small Business Finances shows that approximately half of the funding for businesses less than two years old takes the form of equity (47.9 percent), while the rest (52.1 percent) takes the form of debt.

4. Much of the External Borrowing is Personally Guaranteed
The Federal Reserve’s Survey of Small Business Finances indicates that the owners of between 25.1 and 48.1 percent of small businesses less than five years of age personally guarantee their businesses’ loans, with the exact percentage depending on whether the businesses are sole proprietorships, partnerships, S-corporations, or C-Corporations.

In short, unlike the textbook example of a start-up raising external equity from a venture capitalist or business angel, the typical real world start-up is financed by its founders either from their own savings or from debt personally borrowed or guaranteed.

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About the Author: 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.