Funding a Business: Weighing Cash, Debt, and Outside Investors

When starting a business, one of the first—and toughest—decisions is how to fund it: should you use your own money, borrow, or seek outside investors? That was the dilemma one investor brought to us. He dreamed of becoming a business owner and opening a retail shop. He had $1.4 million in investments and about $250,000 in cash; however, he estimated it would take $500,000 to launch the business. His quandary was where the additional $250,000 should come from.

If you know finance, you know our answer was: “It depends.”

The first step is to assess the financial risk—with the most significant being that the investor could lose all the personal money invested if the business fails. Cashing out a large portion of investments can also put many entrepreneurs at risk of losing the benefits of a diversified portfolio. As most small-business owners know, the bulk of their wealth is often tied up in the business, making its success critical.

Starting with an emergency fund, we wanted to ensure that the $250,000 in cash was not the investor’s cash reserve. We generally recommend at least three to six months of funds to cover personal expenses. Factors to consider include a spouse’s contributions to household cash flow, how quickly one could find work if the start-up takes longer than expected, dependents and obligations such as tuition, childcare, or elder care, and access to other lines of credit or liquidity.

We would also look at the investor’s cash flow projection over the next 10 years. Are the investments earmarked for retirement, or are they after-tax savings? What changes might be necessary if the investments used for the business were lost? One factor to weigh here is the tax impact. Selling stocks, bonds, or real estate at a profit will likely trigger capital gains tax, which could require selling even more investments to cover the tax bill.

If the funds come from a retirement account such as a 401(k) or IRA, withdrawals before age 59½ can trigger a 10% penalty in addition to ordinary income tax. While there is a complex strategy called a Rollover for Business Startups that allows an investor to tap retirement funds, we generally view retirement money as a last resort.

If the entrepreneur doesn’t want to touch investments, they could consider raising funds through friends and family, crowdfunding, business partners, angel investors, or venture capitalists. Engaging with partners or outside investors often means forfeiting complete control of the business, sharing profits, and working under greater pressure to succeed. It can also complicate the legal structure and limit options for exiting the business.

Borrowing money is another option, whether through small-business loans, business credit cards, or a home equity line of credit. However, borrowing not only incurs interest and repayment obligations, but it also often requires collateral, meaning a home or investments may be on the line. If the entrepreneur is buying an existing business, seller financing may also be an alternative.

Overall, there is no single answer that works for every business venture. Every avenue involves risk. And while it may sound pessimistic, it’s best to evaluate financing decisions through the lens of the worst-case scenario. What are the consequences of failure? Is the risk affordable? New business owners may face increased stress and anxiety knowing their personal savings are in jeopardy—something that can affect both their personal lives and their decision-making.

If you have questions on how to raise capital for your business, the experts at Henssler Financial will be glad to help: