First-time entrepreneurs don’t think of themselves as business investors, but they are. And, just like high powered venture capitalists, entrepreneurs can strike it rich if the value of their equity stake in a privately-held business grows to an eye-popping sum.
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Does it matter how you invest your savings in a startup business? Sure it does. Your decisions today will affect your company’s financial statements as well as your future personal income tax obligations.
Here are five things to know about self-funding your startup.
No. 1: You have investment options. You can invest your personal savings in your new company in the form of a loan to your company, equity or a combination of the two.
Investing in the form of equity is the most common way entrepreneurs “capitalize” their new companies. The primary disadvantage of equity is lack of liquidity, meaning you can’t convert your investment to cash when you want to.
Loans can provide entrepreneurs with a little more repayment liquidity, provided that the company is revenue generating and enjoys a healthy cash flow. From a conceptual standpoint, investing in a company through debt is a form of leverage. To the extent that the business is able to steadily pay back the loan, overall investment risk goes down.
To determine the best choice for your personal financial situation, get some help from an accountant who understands the gnarly tax rules associated with “founder’s capital.” Different rules apply to debt and equity investments based on your new company’s business structure --– corporation, Limited Liability Company, partnership, etc.
No. 2: You can invest in tranches. Venture capital funds that invest in startups rarely invest their total allotted capital in a single deal all at the same time. Rather, they prefer to invest in two or more “tranches” based on the company’s need for capital and demonstrated progress. You can too. My general recommendation to startup entrepreneurs is demonstrate restraint and hold back some personal savings until they have adequately tested and tweaked their first products and services.
No. 3: You can do it all by yourself. Married entrepreneurs should think through the pros and cons associated with separate business ownership. If you intend to keep your business investment in your name only, draw investment funds from your personal savings or checking account; not a joint account.
No. 4: Price your shares. At the time of corporate formation, founders get to set the “par value” of their company’s shares. Often the par value is a low number – a penny a share or less. When entrepreneurs make their first cash equity investment in a newly-formed corporation, they may choose to purchase a first amount of shares at the company’s par value or some other “market” value.
I recognize that it is difficult to value privately-held companies that are not yet generating significant revenues, patents or profits. It’s guesswork at best.
Here’s a common gotcha associated with “over-valuing” your shares to outside investors during the first few years of operations. Knowledgeable investors do their homework. During my days of private equity investment due diligence, I would always check out a company’s “statement of shareholder’s equity” and “capitalization table” as a benchmark for upcoming negotiations. Expect a battle if you or your family members pay, for example, just a few pennies per share for your company’s common stock and then ask independent investors to pay $100 a share just a few months later. You’ll need a good reason why your company’s shares have exploded in value in such a short time.
No. 5: You can lose money. It’s no secret that entrepreneurship can pay off handsomely for business founders. However, when entrepreneurs pull money out of personal savings to fund a business, they often forget to treat their small business investments like any other investment.
The most prudent approach is to keep a diversified investment portfolio. This means that you should not invest 100% of your personal savings in any single investment, including your own company -- ever.
Investing personal savings in a business is an important milestone. Holding back some savings for personal rainy day needs should not be perceived as any lack of faith in your business prospects. Rather, look at it as positive confirmation that you can be a shrewd business investor who is out to reduce needless risk at every turn.
Susan Schreter is a 20-year veteran of the venture finance community and entrepreneurship educator. Her work is dedicated to improving startup longevity in rural, urban and suburban America. She is the founder of www.takecommand.org, a community service organization that offers the largest centralized database of startup and small business funding sources in the U.S. Follow Susan on Twitter @TakeCommand.