If you’re launching a startup, chances are you need capital to get it off the ground. Some entrepreneurs seek outside financing, including funding from investors, in exchange for equity. Others opt for small business loans to get rolling, but these can feel out of reach for startups that have no revenue or financial history.
Self-funding your business (or “bootstrapping”) is one alternative. About 78% of small business owners rely on personal funds and income from another job for capital, according to one SCORE survey. Here are some helpful tips if you’ve decided to self-finance your startup.
How to self-finance your startup
There are lots of ways to finance a business. If you’re bootstrapping, that might include:
- Personal savings: According to the Federal Reserve’s most recent Survey of Consumer Finances, the median bank account balance in 2019 was $5,300. The average bank account balance was around $42,000. (That includes checking accounts, savings accounts and other transaction accounts.) Depending on your financial health, you may have a pool of cash you can draw on to get your new business going.
- Income from another job: If your schedule allows, you may have time to pick up a part-time job or steady side gig. This could unlock a stream of regular income that you can put toward your new business. Others may opt for freelance work or consulting gigs.
- Home equity: According to Federal Reserve data, 10% of small business owners have used home equity to finance a startup. If you have a mortgage, your equity is the difference between your home’s value and your loan balance. You may be able to tap into that equity and unlock immediate financing. That might be through a home equity loan or home equity line of credit (HELOC).
- Retirement funds: Tapping your nest egg is another way to finance a new business. A Roth IRA, for example, is funded with after-tax dollars. That means you can withdraw your contributions at any time, tax-free and with no penalty. But if you’re under 59½ and have had the account for less than five years, taxes and penalties may apply if you withdraw your earnings.
- A personal loan: Small business loans, especially those backed by the Small Business Administration, are known for their strict qualification requirements. It can be tough for a startup to get approved, but a personal loan could be a good alternative. Like a business loan, it provides a lump sum of cash up front that you can use for whatever business expenses you have. You’ll then repay the loan over time, usually with fixed monthly payments.
5 tips for self-financing your startup
1. Don’t drain your savings
If your bank account balance is going strong, that’s certainly a good thing. Just be sure not to drain your savings completely while starting your new business. The rule of thumb is to keep three to six months’ worth of expenses in your emergency fund. If things don’t pan out the way you expect, that safety net can help you keep up with your financial obligations. You might consider only withdrawing up to a certain amount to fund your business. Once you reach that limit, you can explore other financing options to bridge any gaps.
2. Safeguard your other income
It can be tempting to go all in on your new venture, but going slowly can help shore up your finances. Perhaps that means staying at your 9-to-5 for a while and working on your business on the side. This can provide a steady stream of income — and if you come into a bonus, raise or commission check, you could direct that cash windfall toward your new business. Just be sure whatever you’re working on doesn’t violate any non-compete agreements or other contractual obligations you may have with your other employer.
3. Be careful with home equity
A home equity loan or HELOC could be a great way to fund your business, but there are downsides. Home equity financing comes with fees — and you could lose your home if you default on your payments. As such, you’ll want to tread carefully here and only borrow what you can reasonably afford to pay back.
4. Look at the big picture when tapping retirement funds
With a 401(k) or traditional IRA, you’ll be taxed on any distributions you take — and you’ll likely be hit with a 10% penalty on top of that if you’re younger than 59½. Be aware that using retirement funds to finance a new business could ultimately deplete your nest egg and rob you of future investment returns. If borrowing from your retirement savings, you might consider more tax-efficient accounts, like a Roth IRA or regular brokerage account.
5. Be careful when commingling your personal finances
If you end up self-financing your business with a personal loan, be aware that interest rates can be as high as 36%. And as the name implies, this type of loan is tied to your personal credit. If you’re unable to make your payments, your credit score will likely suffer. That can make it difficult for you to qualify for future financing. With a personal loan, you’ll want to shop around for the best rate and make sure the monthly payment is compatible with your budget.
Pros and cons of self-funding your startup
No matter what your game plan is, you may have to bootstrap your way through the early days of your business. Like anything else, self-financing has benefits and drawbacks.
- You aren’t sacrificing equity: Investors come in all shapes and sizes. That might be a venture capital (VC) firm, an angel investor with deep pockets or a friend or family member who’s willing to provide funding. They’ll likely expect a slice of the company in return. Self-funding allows you to retain your ownership stake and have more control over your business.
- It could improve your odds of getting approved for a business loan later: Using your own money to establish a new business might make you a more attractive borrower if you seek a business loan later on. It could demonstrate to lenders that you’ve got the chops and hustle to get things done.
- You could deplete your savings: If things don’t go according to plan, you run the risk of diminishing your cash reserves or damaging your personal credit score.
- You may stunt your business’s growth: Investors can provide mentorship and guidance that help your business grow in the right direction. They could also be a source of much needed capital, which can help you grow faster.
There are lots of ways to self-fund a new business, and each one has its own pros and cons. The right path for you will depend on your financial situation and risk tolerance. Either way, it’s always a good idea to do your research and go into it with a strong business plan.