Seeds 02: One Essential Rule For Funding A Small Business
How do you start a business if you don’t have any money? In that case, you must raise the money. There are two ways of doing this.
Borrow it (convince someone to lend it to you). This is known as debt financing.
Sell off a piece(s) of your equity in the new company (convince someone to buy into your idea with the promise of a future payday)
There is a lot of great writing about both of these strategies and I don’t have the expertise to write at length about either option, but I do have a general rule of thumb that I give new entrepreneurs to help decide which route to pursue.
One Essential Rule for Traditional Small Businesses:
Don’t Sell Off Equity If You Can Avoid It!
When to raise equity financing:
If you have an idea and plan to scale it into a very large company (aka a startup), then by all means, find investors and sell off equity to raise capital. In this case, you’ll need the money as fuel for growth and having a smaller piece of something that gets very big is better than having 100% of something that never gets off the ground.
When to raise debt financing:
Most new businesses are not startups though. Real life isn’t Shark Tank. If your plan is to take a small idea and turn it into a small business, you might not want or need investors. You just need money.
Most restaurants, shops, and smaller online businesses (think micropreneurs and service providers) aren’t going to turn into nation-wide chains, won’t be as capital intensive, and won’t achieve the economies of scale necessary to provide outsized returns on that capital.
In most cases, small business founders would be better off borrowing and staying as lean as possible to preserve capital until their idea is proven and cash flowing. A first time founder is likely not going to be able to get a bank loan, but they can ask friends, family, and mentors and if that doesn’t work self-fund through credit cards. They will pay a risk premium in higher interest rates, but in most cases, it will be worth it.
Why? Running a small business is hard and relatively thankless. The founder is going to be the one staying late every night, working weekends, and dealing with customer and employee issues, not the investors. Hard days will be even harder if they’ve traded a large percentage of their stake and upside early on. A big piece of a small pie with some debt is better than a small piece of a small pie.
But what if the business fails? Well in either case, the founder is going to disappoint people. All investments will go to zero in the equity example, and they’ll default on their loans in the debt example. An important caveat is that if they are personally borrowing to fund the business, the debt will outlast the company barring a personal bankruptcy. That is why staying as lean as possible is an important factor when borrowing. If your idea requires you to go big or go home, and has a high probability of failure, you probably don’t want to rely solely on debt financing. If both of those things are true, and the potential payoff if it succeeds isn’t sufficiently high, you probably should find another idea. If you’re not sure how to quickly estimate this, read up on Poker Pot Odds, or check out Annie Duke’s Thinking in Bets.
I recently spoke to a friend who was opening his third restaurant, The concept was a super simple, small, wine bar that only required about $75,000 (5-10x less capital than a full restaurant concept). My friend was going to tap his network of investors for his previous projects to come up with the money. I strongly advised him against it. He had a track record of sucessful operation, so I told him to borrow the initial capital, if not from a bank, from friends and family.
Why? Because the restaurant was so small, it was less risky, but it also had much less upside than comparable projects. He projected about $100K in free cash flow annually if it really performed well. To raise the $75,000 in startup capital, he expected he’d need to sell 25-35% of the equity in the restaurant. That means that even if they knocked it out of the park, he’d have a 65-75% stake on $100K in annual earnings. Naturally, the investors would get paid first until their investment was repaid. So after taxes, in a best case scenario, my friend would be looking at something like $50,000-60,000 in incremental income. If that was just extra salary, great, but it wouldn’t be. He would be putting his blood sweat and tears into the business. 90% of the headaches of running a restaurant; dealing with employees, payroll, suppliers, permitting, customer reviews, regulations, and compliance still apply whether your restaurant is 1,000 sqft or 10,000 sqft. It told him he was setting his future self up to resent the deal because his upside to effort ratio would be too small.
Conversely, if he took out a five year loan at 7% interest, he’d be looking at a $1,500 monthly payment added to his expenses. This would reduce his annual profit to $82,000 for the first five years, but he’d own 100% of the equity and upside and, as a bonus, wouldn’t have any investors asking for monthly reports and expecting comps at the bar.
