This article was written by Mike Capsuto, SCORE Orange County Business Mentor
If you can count your money, you don’t have a billion dollars. J. Paul Getty
Home businesses vary in size and scope, making financing needs different. Some home businesses may only require a few thousand of dollars to start. Others may require investments of $100,000 or more.
Information in this article is provided for general educational use only. No responsibility is assumed for any problems associated with the use of its content. One should seek the advice of their financial and legal counsel in every step of purchasing a business.
Self funding sometimes called “bootstrapping” is using resources under your own control to finance a business without having to use outside sources for funding. It basically says you are willing to take the risk. If you don’t have cash readily available, you may consider selling an asset such a stamp or coin collection and using those funds towards your business.
• Owner has not diluted ownership by having investors wanting a payback.
• Substantial personal risk.
• Tight personal living expense budget.
• Loss of your personal financial safety net.
Other sources of self funding are:
Credit cards should be a last resort because of the unpredictability in using them to finance a business. The interest rates are high, credit limits can be reduced without warning, and there are fees if you use a credit card for a cash advance. However, a large percentage of small businesses use credit cards to finance their business in some way.
• Quick cash.
• High double digit interest rates.
• Minimum repayment schedule.
• It is a personal loan not subject to the protection of the business LLC or corporate structure.
Many buyers have built up sizable amounts in their 401(k) plan. There two basic ways to obtain money from your 401(k) – the money can be obtained either by withdrawing funds or may be borrowed as a loan. If the money is withdrawn, it is subject to state and Federal income taxes. 401(k) loans are both penalty free and tax deferred, provided that a loan remains in good standing. While early withdrawals cannot be later totally replaced, the paying back of 401(k) loans can effectively replenish your account.
• Minimal paperwork is required.
• No credit check as it is your own money.
• If you declare bankruptcy, your retirement plan assets are protected from creditors. If you withdraw money from your 401(k) to buy a business, that withdrawal is no longer protected.
• The maximum term for 401(k) loans is five years and repayment schedules usually start immediately after a loan is taken out.
• If you quit your job, your entire 401(k) loan balance is due within 60 days. If you can't repay it, the money is treated as a withdrawal. You will owe all Federal and state income taxes on it, plus an additional 10% penalty tax if you are under the age of 59.5 years old. You could be left with 50¢ to 60¢ on the dollar after taxes.
• Some 401(K) plans prohibit loans or early withdrawals except for certain situations. Consult with your plan administrator for the plan's terms and conditions.
Life Insurance Policies
Term life insurance policies typically do not have a cash value. If you have a Whole Life or Universal Life policy that has cash value built up in it, you can choose to surrender your policy and cash it out. Once that is done, you will no longer have life insurance coverage. If you want to take the cash out of your policy and keep your life insurance policy intact, you can borrow from the cash value or do a partial surrender. It's also important to keep in mind any tax ramifications that cause your surrender to become a taxable event.
Advantages of Taking a Loan Instead of Cashing Out:
• You can take out a loan against the cash value.
• A loan against your life insurance policy can almost be granted for any reason, without a credit check.
• The interest rate is usually lower than a traditional loan.
• A loan does not have to be paid back. You can pay back the loan on your own terms, but will not incur a penalty if you decide not to make repayments, however interest may continue to be charged.
• If the loan is fully paid back, the policy is in effect at the original value in the event of death.
• If the loan is not paid back, the death benefit will be reduced by the amount borrowed, plus accrued interest if any.
Cash Out Advantages:
• You can cash out your policy and use the proceeds to fund the purchase.
• Survivors do not have to pay back after your death.
• A portion of the cashed out value may be considered taxable income.
• Surrendering the policy relinquishes the right to the death-benefit protection afforded by the insurance.
• It might be difficult and more expensive to get the same coverage at a later date.
• If the policy is surrendered during the early years of ownership, fees may be charged by the company, reducing your cash value. These charges vary depending on how long you've had the policy.
Please contact your insurance agent or financial adviser to assist you with that decision.
Bottom line: Whether you decide to invest 100% of your own money, seek funding from outside sources, or do both, make sure you review all the options available to you before making a decision.