Name: Email:

Should You Borrow Money to Start a Business?

Right now a lot of people are either unemployed, underemployed or working in a career or job where promotion opportunities are close to non-existent. In such times, thoughts often turn to cutting a new path by starting a new business. If you do, should you borrow money to start a business?

Many of today’s business models are based on the Wall Street principle of OPM — Other Peoples Money. Whether through the sale of stocks, bonds or by obtaining bank financing, large companies and well publicized start ups seek to open new ventures and expand through leverage.

But what works (sometimes at least) on Wall Street can often be business poison to the would-be small business owner.

Should You Borrow Money to Start a Business?

Should You Borrow Money to Start a Business?

In my accounting career, it was apparent that the most successful and most enduring small businesses were the ones who had no debt. They started small, and grew by self-financing out of their cash flow. While it may seem to defy logic that a business could be started and grow absent an injection of fast cash to finance it, it’s equally true that paying a debt service reduces cash flow.

If you’re starting a business, why should you avoid borrowing for the start-up?

Personal liability. Very few would-be business owners can get financing for an upstart operation without pledging personal assets. Usually, this means taking a loan against your personal residence, borrowing against a 401k or even tapping credit cards. In each case a debt service is created even before the first dollar of income is earned.

Some believe that this type of no-turning-back plunge is necessary for success, but it also creates ongoing expenses and causes stress, both of which can threaten the success of an upstart business, not to mention paying for a venture long after it fails. We may not like to think about that last point but it shouldn’t be ignored.

Survivability. Starting a new business is usually a long term process that will take several years to accomplish. If there’s one thing you can count on it’s that the economy will turn sour sometime during that time frame. One of the major reasons some businesses survive downturns it that they have no debt. No debt means no debt service and no loans to be called in at the worst possible time.

Increased flexibility. If you have debt when you start your business, your primary objective will be to make at least enough money to make your payments. The problem with this approach is that it can limit your ability to move your business in directions you feel are necessary to make it thrive. If it’s one thing you need in a small business, especially a new one, it’s flexibility. You’ll be denied that ability if your cash flow is committed to loan payments.

Profitability. Businesses often leverage not to build profitability, but to increase sales and operations for future take over potential. But for a small business owner, profitability is more important than size. With enough profit, you can grow your business and move it in any direction you choose, creating even more profits that won’t be reduced by debt service.

Complete control. When you borrow money to start a business, you enter into an unofficial partnership with your lender. Product lines and business direction may be compromised in favor of debt service. By operating without debt, you eliminate your “partner” and can take the business in any direction you choose, and isn’t that the reason you would choose to go into business for yourself in the first place?

Stacking the deck in your favor

Talent and the ability to manage money on a shoestring will serve you better than having a big wad of cash from a loan. In fact no amount of money will cover a lack of these abilities. What can you do to start and run your business without taking a loan?

  • Pick a business that you know and have contacts in. Often when a person is determined to start a new business, there’s a tendency to go for one that’s “hot”. Even if we don’t know anything about it, the lure of a “can’t miss” opportunity is strong. But any business venture you attempt will require a learning curve—the longer the curve, the lower the chance of success.Choose a business that you already have at least some knowledge of to speed the process—in business, time really is money and the less of it you spend getting out of the starting gate, the quicker you’ll hit profitability. If nothing else, try working in the business for a future competitor on a part time basis before venturing on your own, that way you’ll learn the business and develop needed contacts while you’re getting paid.
  • Start the venture as a side business. Don’t quit your job to plunge into a new business venture or you may cut you off the steadiest cash flow available. Better to start your business gradually as a side venture, at least until you get a cash flow going, establish a book of business and have some hard numbers to make future projections.Lack of cash flow is the surest way to kill a new business, so it may be better to slow down some and keep the cash flowing from your regular job. Juggling two activities will be stressful and time consuming, but it reduces the risk enormously because it buys you time to get things moving.
  • Master the art of free and nearly free marketing. As a start up, one of your biggest expenses—maybe even the biggest—will be marketing. Though there’s often a temptation to pour money into marketing in the hope of hitting the ground running, it’s important to realize that a good message consistently applied over a long period of time can be more effective than a heavily financed one. Find ways to do this that require little or no money.A web site is one way to do it; offering affiliate participation is another that will enlist sales support completely contingent on revenue generated. Learn all you can about networking and marketing via the social media—Twitter, Facebook, LinkedIn, etc—that you can use for free. Avoid more costly venues like newspapers or TV that can drain your budget in short order.
  • Start the business early in an economic recovery. Time is a crucial element in the starting of a new business, and the more of it you have, particularly in a rising economy, the greater the likelihood of success. Early in a growth phase is the time when markets tend to be the most receptive to new business. This is in part because spending is increasing but also because many competitors were wiped out in the preceding recession. Time your start right, and you can have several years to build your business until it’s strong enough to weather the next down turn.

Have you ever lost a lot of money on a failed business venture? Can you think of other ways to get a business going without borrowing?

( Photo by Images_of_Money )


19 Responses to Should You Borrow Money to Start a Business?

  1. John D. Buerger, CFP® says:

    The number one reason most businesses fail is that they start with far less capital than they need. This includes making the mistake of borrowing that capital. The new biz owners believe (mistakenly) that their new venture will be profitable inside a few months when in reality it takes even the best idea years to be proven profitable.

    Starting small is a great idea, but “small” is relative to the resources you have to back up your efforts. If you happen to have a $200,000 in bank roll, you can be start “bigger” than if you only have $20,000 … or worse yet, $2,000.

    Kevin is right on when it comes to doing what you know, not what’s hot. A successful entrepreneur is the one who is both talented at and passionate the business they are in. If you’re not, don’t waste the time and effort. The public will see right through your efforts and go support your competitor who IS true to their passions and talents.

  2. Kevin M says:

    Good points John, but I tend to think that even if you have a big bankroll to start, the goal should always be to use as little of it as possible in the business. For one thing, the cash may be needed to pay living expenses during the start up, for another, the sooner you’re able to run the business out of cash flow the better. That’s the real talent of the entrepreneur.

    Investing money in the business can be an illusion, especially if this is the first time for you. You can either “buy business” or create it, and the ability to create it should be something you have going in. We all hear of the success stories where people sunk a lot of money into a business, but I’ve seen the opposite from the inside. A lot of people sink money into businesses and never get any back. They end up paying for it for years if they borrowed it.

  3. I agree with you 100%. This is why I am launching my business while keeping my full-time job. Some days I feel overwhelmed and wish that I could do what I love full-time, but since I’m still working my way out of personal debt that needs to be my main goal.

  4. Kevin M says:

    Khaleef – Paying off your personal debt will ultimately help you in moving your business forward, so keeping your full time job to pay it off is the way to go. Businesses often fail for poor money management in their personal finances, so you’re showing great discipline.

  5. Michelle says:

    Capital is the number one thing that people who want to start businesses should think about, which is why all business plans include it. Business is a risk, the capital that you invest in it, either will or will not come back. It would be much safer to stay away from borrowing money as capital, saving up for capital may be the best option. But if you are totally sure that your business will earn back its capital in a year or maybe a few years…then I guess loans could be a fine option.

  6. What do Walgreens, Cisco, Microsoft, and Harley Davidson have in common?

    They operate debt free. I think borrowing to start a business is just too risky.

  7. Kevin M says:

    FB – When it comes to borrowing, all of the good news is up front when you get the initial check. After that it’s mostly down hill–debt service and the pressure to meet it, etc. If you don’t have a way to expand your business without a bunch of capital you may be in the wrong business.

  8. Aury (Thunderdrake) says:

    While I’m against tapping credit cards for the ridiculous, even usurious rates, I’m not against tapping into one’s 401k. Primarily because that gets taxed like regular income when pulled out, and a notably painful lack of control over the assets within.

    of course, another thing to consider is using debt to finance a business idea. I’m not against the idea. There’s the whole good debt bad debt dichotomy, but I stress a low interest rate more than anything else. That coupon payments every month should be easy. It’s a risky move, but the right business model, especially when wrapped around nonpersonal business entities, can aid some pretty intense growth.

  9. Kevin M says:

    Aury, while borrowing against a 401k might make some sense once a business is established and a predictable cash flow exists, I’d recommend against it for an upstart. If the upstart fails, having the 401k would be one of your aces in the hole. If you borrowed against it and the venture doesn’t make it, you’ll have a debt to remind you of the failure.

  10. Some businesses can be started with very little money. For example, a lawn mowing business. Buy one $130 mower, get some clients, and start cutting grass. Then bootstrap the business… use profits (cash) to buy more mowers or equipment… and expand as your cash flow allows it. No debt required.

    Two main reasons most businesses fail?

    1. Lack of Sales (cash flow)
    2. Lack of Marketing….

  11. Kevin M says:

    Good point. Of course, lack of sales and lack of marketing are closely related. Sometimes people go with expensive marketing plans, run out of money, then they’re done. They key is sustainable marketing–finding ways to reach prospects that costs little or nothing so that multiple contacts can be made over a long period of time.

  12. Professor Budget says:

    lack of marketing and lack of sales often creates a vicious circle. The best example I can think of is private schools. While public schools are being overcrowded with teachers being laid off, this would be the ideal opportunity for private and parochial schools to market themselves to these public school children parents. But the lack of knowledge in marketing along with lack of money keeps these private schools from reaching their “sales” potential. just an example.

  13. Kevin M says:

    PB – I agree, marketing and sales are the key. It would be best for any new business to develop a low cost marketing plan and a reliable cash flow before investing any real money in the business. Cash flow is the business, and until that’s established, there is no business.

  14. Judy Caroll says:

    There are things we need to consider when planning to borrow for our business. We need to realize the implications. Borrowing comes with a cost. It can cause us to be in a long term debt. If you’re experiencing a financial trouble, I suggest you figure out where you gone wrong and also begin generating more sales so you will not put yourself further in debt.

  15. Kevin M says:

    Hi Judy–What you’re recommending is becoming “self-financing”, which is excellent advice. A lot of businesses get into trouble because they borrow money during good times in order to expand, but when the economy sinks, the growth goes away and all their left with is old debt. It’s a double whammy.

  16. bill says:

    I am doing the self finance thing but i feel that i am hitting a wall, i have a roofing business on the side but work full time for another contractor, while i am making his projects look good with my crew i feel i should be doing this for my own business, i work every weekend for my self and have everything from website to all my tools to a C corp structure all nessasry insurances and everything is paid for by the money i make i have no debt..but i need more money to get me away from my contractors and do my own thing but i dont like the idea of burning bridges.

  17. Kevin M says:

    Hi Bill–People I know in the trades confirm that you can’t make money as a sub, especially not one with employees. Can you try building your own business clientele while working for the contractor? Also, could you find someone who knows how to use the web to generate business? As a local tradesman you should be able to do some things with Yahoo Local and Google Adwords to generate some of your own clients. How about talking to other roofers in your area to see how they’re getting their business–though I suspect no many of them will be truthful.

    Also, check into any neighborhood associations you have in your area. They often have monthly or quarterly news letters that go out to their residents, and people do read those. If you could get a couple of jobs in a neighborhood, word of mouth could do the rest. If you can get into a few neighborhoods that way, you’ll have plenty of referral business. Ads in those newsletters are pretty inexpensive, and you’ll want to have them in each month or quarter so people get familiar with your name. Hope this helps!

  18. Jim says:

    Kevin, love the analogy of a partnership when you borrow money. As a lender, they now have a fiduciary interest in that business being profitable. With a SBA Loan can the lender audit the business in order to protect their interest? If that is the case, can they then dictate how its run? Not sure if there are laws protecting against this?

  19. Hi Jim – As far as I know, it depends on the requirements of the loan. In my accounting career we sometimes prepared required audited financial statements for the lender. I don’t think they can dictate how you run your business, but if the bottom line gets shaky they will make demands for improvement. Since the loans tend to be short/intermediate term, often with variable rates, the threat is real. They can move you into a higher rate classification, or decide not to roll over your loan. However, I’m not an expert on that outcome, as I’ve never worked in business lending.

Leave a reply