Non-Traditional Funding

When starting a new business, one must keep in mind that money is already a scarce resource. Thus, an entrepreneur must examine all sources of startup capital that are available and best for his or her business idea. Among the most popular resources are venture capitalists, bank loans, angel investors, small business loans and friends and family. However, each of these sources can be quickly exhausted leaving the entrepreneur with his or her innovative thinking to discover and utilize more non-traditional resources. Depending on the demand of your business idea, non-traditional resources such as home equity debt financing, hiring employees that are willing to share the risk of starting a business, online resources, or gift certificates can all be very beneficial in raising capital for a business and may even attract additional business because of the creativity involved in starting the business. We have discussed such non-traditional resources as well as the advantages and disadvantages of using each of them.

Home Equity Debt Financing

Home equity loans are a viable alternative to traditional bank loans which are available to entrepreneurs that own their home. This section will provide a description of home equity loans and home equity lines of credit, lenders that participate, and advantages and disadvantages.

A home equity loan is a type of second mortgage that is granted for a specific purpose by a lender. The loan may be originated by the holder of one’s mortgage or another institution. The concept behind the home equity loan is that one may borrow against the equity into one’s home. Every payment made on an outstanding mortgage pays principal and interest. The equity buildup is the sum of the principal payments plus the appreciation in the home (if any). These payments vary based on the type of mortgage held but all contribute some figure to principal. Equity can be thought of as the amount of your note that is “paid off”. Lenders are willing to grant second liens for a particular percentage of the portion of one’s home that they own, i.e. their equity.

Home Equity Loans and Home Equity Lines of Credit

Basic descriptions aside, there are two specific types of funding secured by homeowner equity. They are Home Equity Loans and Home Equity Lines of Credit (HELOC). The use of these two debt instruments depends on one’s needs as an entrepreneur.

The traditional home equity loan is granted for a specific one-time expense that is approved by the lender. This would be useful when a set and known amount of money is needed, as in the capital needed to purchase land and building for a business. This option is rather simple. It operates the same as a second mortgage, and generally has a fixed interest rate, term of 5-30 years, and fixed monthly payments. These terms will feel familiar to a homeowner because they mirror a standard fixed rate self-amortizing mortgage. If the home equity loan is secured with the first mortgage holder, then the payment may even be combined. The drawback to the home equity loan is that it only covers a set amount, and the expenses that the set amount must cover have to be accurately forecasted. Home equity loans are ideally suited to startup capital costs.

The problem of the one-time expense is remedied by another home equity instrument, the home equity line of credit. This is exactly what it sounds like, a line of credit that is covered by the equity in one’s home.  The HELOC can be thought of as a credit card that uses your home as collateral for repayment. Money can be withdrawn upon opening and any time afterward, during a set period, until the maximum credit limit is reached. The time in which one may withdraw funds is the “draw period” which can have a variable term (10 years standard). After the draw period expires the payment period begins, which is a set term in which the funds borrowed must be repaid in a manner much like a home equity loan.  Lines of credit are a more complex type of loan. Many have the option to convert between a fixed interest rate and a variable rate at the discretion of the borrower and some have variable rates tied to the prime rate. Lenders will often give the option to make payments on the interest only during the draw period, thereby reducing expenses over a home equity loan. The payments will increase at the conclusion of the draw period to include principal repayment. These terms offer larger flexibility in cash flows that is essential to an entrepreneur. A home equity line of credit is useful as a life line for covering expenses when profits are down and in the event of an unforeseen expense, like litigation or casualty loss.

An important caveat exists in discussing home equity lines of credit. Until several years ago, banks were willing to freely offer HELOCs due to increasing home prices and a stable economy. The large numbers of defaults on mortgages combined with overall slowing of the housing market has caused this willingness to decrease. Interest rates have increased and the maximum credit limits have been reduced. Many holders of these credit lines found their credit either revoked on substantially lessened during the mortgage crisis. Although willingness to lend is on the rise currently, it is not certain to remain so in the future. Thus, entrepreneurs may benefit from other creative resources.

Home Equity Lenders

Many lenders are willing to grant debt collateralized by home equity. They consider these loans to be relatively safe in that the home can be foreclosed on to cover repayment. Due to this, the prevailing interest rates on these loans are lower than a standard bank loan or line of credit. Even though lenders are willing and interest rates are lower, shopping for the best offer can save one thousands of dollars.

An excellent place to begin shopping is with the holder of one’s first mortgage. They are familiar with your home and in all likelihood the potential borrower. This is not to say that they will offer the best terms. Local institutions are the next step. Often, it is best to use those that are familiar or have superior reputations in the community and with peers. Several types of lenders originate home equity debt, and they include: banks, brokers, and credit unions. None of these are inherently better than the others, but they do provide more opportunities to compare rates. Credit unions have become an increasingly greater force in the home equity loan world as they pick up slack from banks that are risk averse, especially when borrowers have low credit scores. Local offerings should be compared to online offers and advertisements, and online rates can even be used as a bargaining chip to negotiate local lenders down.

Borrowers should be aware that banks make large sums of money from fees, (which is evident to anyone who has ever over drafted). If a borrower has decent credit, they should not expect to have to pay an application, appraisal, or broker fees (if using third party service). Any offer requiring these should be renegotiated or disregarded.

Advantages of Home Equity Debt Financing

  • Prevailing interest rates are lower for this debt due to it being backed by a borrower’s home.
  • Large amounts of money may be borrowed by these transactions, often with an absolute maximum of 80% of the accumulated equity.
  • Interest paid on both home equity loans and lines of credit may be tax deductible.

o   1) Tax breaks are limited to the interest paid on loans of $100,000 and below.

o   2) Expenditures with borrowed money must be able to be itemized.

o   3) Other best left up to local tax and lending professionals

  • These loans are easier to qualify for with bad credit, provided the borrower has sufficient equity buildup.

Disadvantages of Home Equity Debt Financing

  • A default on a home equity debt will result in a foreclosure on the borrower’s home. One must be very careful and know that their family’s home is at stake.
  • Recently, many disreputable lending agencies have offered home equity loans with large maximum amounts and higher interest rates. (Deal only with reputable lenders)

Hire Employees who are Willing to Share the Risk for a Lower Salary

Another way to increase startup capital is for an entrepreneur to hire employees who are willing to “go along for the ride” with him or her. In other words, it may be more beneficial for the entrepreneur to find employees who will share the risk of starting a new business. In doing so, employees may be offered a salary lower than the average market salary. However, the entrepreneur gains value in two areas: qualified individuals who are committed to the business idea and reduced payroll expenses as well as minimizing debt.  When employees are committed to the business, a firm begins to develop a corporate culture leading to a competitive advantage. Competitive advantages are critical in small business, so if an entrepreneur can build a strong committed workforce, he or she is ultimately increasing his or her company’s sustainability. Once the competitive advantage has been established, the entrepreneur then must work to maintain it, and since employees are usually the first to know when a company’s resources are depleting, honesty really is the best policy when utilizing this strategy.

Also, incentivizing employees is an excellent way to ensure a workforce’s security. One way to do this is to design a compensation plan in which employees’ base salaries increase as the company grows and reaches specified milestones. For example, once target profitability has been obtained by the company, an entrepreneur would increase employee salaries from $100,000 to $125,000. With no principal or interest to pay off, such compensation plans ultimately save the entrepreneur money that can be used as additional startup capital.

Advantages of Writing Paychecks that Increase as Business Increases:

  • Entrepreneurs can save money and gain additional startup capital by reducing payroll expenses.
  • Debt is minimized by avoiding loans.
  • A committed workforce is formed with employees who are willing to share the risk with the entrepreneur.
  • A corporate culture is formed.
  • A competitive advantage can be developed.
  • Sustainability is increased due to the competitive advantage.

Disadvantages to Writing Paychecks that Increase as Business Increases:

  • Entrepreneurs may sometimes have to exaggerate potential growth opportunities.
  • Employees may not stay with the firm if profits do not increase.
  • Unforeseen changes in the business environment may cause increasing paychecks to be delayed.

Kickstarter.com

Kickstarter.com is one of the largest funding platforms for small businesses in the world. This website offers entrepreneurs a place to post their business ideas online as well as a place for those interested in aiding the funding process to donate money. Kickstarter is a great source for additional funding if one’s business idea pertains to music, film, art, technology, design, food, or publishing; however the business idea in question must be “creative.” In order to use Kickstarter.com, one must abide by two sets of guidelines: the project guidelines and the community guidelines. Such rules as listed on the website are as follow:

Project Guidelines:

  • No Charity Projects or Causes
  • Fundraising for Projects Only
  • No Fundraising to Hire Web Developers

Community Guidelines:

  • Spread the word but do not spam.
  • Do not promote a project on other projects’ pages.
  • Be courteous and respectful.
  • Do not post obscene, hateful, or objectionable content.
  • Do not post copyrighted content without permission.
  • If you do not like a project, do not back it.

Should one choose to utilize Kickerstarter.com’s services, a time limit, set by the entrepreneur, of 1 to 90 days is then started. Once a business idea or project has been posted on the website, donors can then pledge as much money as they should choose in order to support the entrepreneur. However, a project cannot be launched until its goal amount has been achieved. This “all-or-nothing” approach is set in place for three reasons:

1.     It is less risk for everyone involved.

2.     It allows people to test concepts without risk.

3.     It motivates.

Less risk is incurred when using Kickstarter.com because one cannot fulfill the needs of a business with a necessary startup cost of $10,000 with only $7,000. Therefore, if the goal amount is not reached by the specified deadline, no money transfer takes place and no one experiences a loss. Kickstarter.com also enables entrepreneurs to gain perspective on their ideas by testing their business idea. For example, an entrepreneur can gauge how sustainable his or her idea is by how much interest is displayed through pledges. If a substantial amount of interest is gained and the target amount is reached, the entrepreneur is then able to proceed with his or her business plan. If no interest is gained, donors do not experience a loss and the entrepreneur may have gained more and valuable  insight as to how to modify his or her idea.  The time limit also plays a critical role in motivating the entrepreneur as well as the donors. An expiration date motivates entrepreneurs to spread the word about their idea or project to as many donors as possible, thus, raising as much startup capital as possible.

One may wonder why anyone would donate money to support a business idea or project posted on Kickstarter.com. The answer is that not only does the entrepreneur potentially benefit, but the donor does as well. Entrepreneurs must offer “tangible rewards.” Rewards can range from anything as small as low dollar amount downloads to anything elaborate such as weekend get-aways. Ultimately, it is up to the entrepreneur to determine price and the fulfillment of their rewards. The concept is like that of incentivizing employees. In this case, the entrepreneurs incentivize the donors to support their idea.

Once the deadline is reached, one of two results can occur. In the event of successful fundraising in which the goal amount or more has been reached, all donors will be charged and all funds will go directly to the entrepreneur via an Amazon Payments account that was setup prior to launching their first business idea. The entrepreneur is then responsible to continue with their idea or project and ultimately deliver the tangible rewards. In the event that the funding goal has not been met by the specified deadline, all pledges are canceled and no one experiences a loss.

Advantages of using Kickstarter.com

  • All entrepreneurs maintain 100% ownership and control over their business idea or project.
  • Donors receive tangible rewards.
  • Little risk is involved.
  • Entrepreneurs can gauge interest in their idea.
  • Because it is entirely donation based, there is no principal or interest to repay.
  • Entrepreneurs can raise more than goal amount if inclined/able to do so.

Disadvantages of using Kickstarter.com

  • Entrepreneurs only have a maximum of 90 days to reach goal amount.
  • Kickstarter.com applies a 5% fee if funding is successful.
  • Amazon applies credit card processing fees if funding is successful.
  • Entrepreneurs must be based in the United States due to the use of Amazon Payments.
  • Entrepreneurs have shown the world their idea and it may be stolen by another.

Gift Certificates

When raising startup capital for businesses that are interested in expanding, gift certificates are an efficient way to reach new clients while maintaining the original client base. Gift certificates provide entrepreneurs with advertising in multiple ways. The most effective advertising, of course, is word-of-mouth advertising. Gift certificates provide just that. For example, a restaurant owner wants to expand and open a new location. As the owner, the Entrepreneur is able to determine the amount of the gift certificate, and by selling gift certificates, he benefits is several ways. Customers purchase the gift certificate at the same time they purchase their meal, essentially paying a marked up price for just one visit. Another benefit is that customers may give their gift certificate away, ultimately bringing in new customers and increasing the owner’s client base. Repeat customers are also inclined to purchase a gift certificate to a new location because they know they are already pleased with the service and will return in the future.

Gift certificates enable entrepreneurs to advertise their products or service and increase their clientele simultaneously. Entrepreneurs are able to do this without incurring the liabilities of repaying a principal and interest.

Advantages of Gift Certificates:

  • Entrepreneurs expand their clientele through word-of-mouth advertising.
  • Entrepreneurs are able to raise money fast due to a marked up price in one visit.
  • There is no principal or interest to repay.
  • Entrepreneurs can determine the discount of the gift certificate.

Disadvantages of Gift Certificates:

  • Customers/clients may lose their gift certificates and choose not to return.
  • Gift certificates may expire without a customer/client realizing it and may be denied.
  • Gift certificates may not reach as many people as the entrepreneur would like.

 

Sources

“5 Tips for Wisely Tapping Your Home Equity – MSN Money.” Commentary Index – MSN Money. Web. 20 Oct. 2010. <http://articles.moneycentral.msn.com/Banking/HomeFinancing/5TipsForWiselyTappingYourHomeEquity.aspx&gt;.

Advani, Asheesh. “3 Honest Ways to Raise Startup Money – Raising Startup Money – Entrepreneur.com.” Business & Small Business. Web. 20 Oct. 2010. <http://www.entrepreneur.com/money/financing/startupfinancingcolumnistasheeshadvani/article197224.html&gt;.

Detamore-Rodman, Crystal. “Business – Out on a Limb.” Business & Small Business. Mar. 2003. Web. 20 Oct. 2010. <http://www.entrepreneur.com/article/59712-1&gt;.

“Home Equity Loan.” Wells Fargo. Web. 20 Oct. 2010. <https://www.wellsfargo.com/equity/solutions/he_loan/&gt;.

Kickstarter. Web. 20 Oct. 2010. <http://www.kickstarter.com/&gt;.

Pritchard, By Justin. “Home Equity Loans – How Home Equity Loans Work – Tips for Borrowers.” Banking and Loans at About.com – Best Ways to Bank – Tips for Borrowers. Web. 27 Oct. 2010. <http://banking.about.com/od/loans/a/homeequityloans.htm&gt;.

Pritchard, By Justin. “Line of Credit – How a Line of Credit Works.” Banking and Loans at About.com – Best Ways to Bank – Tips for Borrowers. Web. 20 Oct. 2010. <http://banking.about.com/od/loans/p/lineofcredit.htm&gt;.

Smithstein, Kevin. “Start Up Capital – Funding Without Business Loan.” EzineArticles Submission – Submit Your Best Quality Original Articles For Massive Exposure, Ezine Publishers Get 25 Free Article Reprints. Web. 20 Oct. 2010. <http://ezinearticles.com/?Start-Up-Capital—Funding-Without-Business-Loan&id=4893308&gt;.


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