What is Equity?
One of the most heartbreaking realizations that most first time entrepreneurs come to, is that you won’t be able to get all of the financing you need to get started. For some, this realization comes the when they visit a commercial lender or investor and are told two things: a) You need a business plan and b) You need X% equity or down payment before we will look at giving you any money.
Lets face it…the saving rate in this country (the good old U.S. of A.) is below average and many people are living paycheck to paycheck. So where do most people find the money they need to get started. We'll get to that in a minute…for now just understand that you will need some cold hard cash of your own, to get you venture started.
But cash is not the only form of equity. Many times a person can “place assets into service” in a company and, so long as those assets or not borrowed against their value can be used toward your equity requirement. A common example occurs with auto mechanics who typically have thousands of dollars worth of tools and specialty equipment that can be transferred into the business. Given a combination of some (lesser) amount of cash and the value of their assets, the equity requirement would be met without having to search the couch for loose change. Other common examples of assets placed into service include: vehicles, office equipment, and minor production equipment.
So How Much?
As mentioned in our commercial financing guide a minimum equity position is considered 10%. Typically lenders will not get comfortable until you investment level reaches 15%-20% of the total start-up costs. This means that if you need $200,000 to get started you can expect to need at least $20,000 cash coming from your own pocket and probably more realistically $30,000-$40,000 of cash and assets available to use in the business (and available for collateral).
Speaking of collateral, start-up businesses that are week in that area, typically have a higher equity requirement. Because there are less assets available to secure a loan the bank will reduce it’s exposure by requiring more investment from the entrepreneur. This is why starting a liquor store in a leased space will have a 35%-40% equity requirement (not to mention the need for additional cash to buy the liquor license, inventory, etc...) and a manufacturing start-up in a building that is purchased will have a 10%-15% equity requirement.
There are other factors that affect the amount of equity required including your personal credit score, the source of the financing and the quality of your business plan/market research.
Why do they require equity?
There are two main reasons why lenders require equity. Number one is to reduce their exposure. On the whole, a typical start-up business will have about 70%-80% of their total start-up costs wrapped up in assets with collateral value. It is no surprise that then that lenders have 20% equity as a rule of thumb. Banks do not like to lend money for working capital (cash on hand) purposes so they require the entrepreneur to fund that portion of the project.
The second reason is commitment...you have to have some "skin in the game". If a bank did lend you 100% of what you needed you would have no “skin in the game” and therefore no reason to stick around if things start heading south. The fact that your credit score could get damaged is a small penalty and is usually not enough to keep business owners going when their new venture is hemorrhaging cash on a daily basis. Knowing that your life savings is wrapped up in a project has a way of motivating people to be smarter with their money leading to a higher chance of success.
Where do I get it from?
Contrary to what lenders may want you to believe, few projects exceed 20%-25% equity investment. So on the plus side; most lenders have come to the realization that only a small number of clients have a pile of cash lying around to invest. That said, you will be required to make some investment.
Aside from the obvious places entrepreneurs obtain cash for investment in their project (savings, partners, and assets placed into service) there are some additional places you can look to cobble together enough to satisfy your lender’ and their underwriter:
· Home Equity Loans / Second Mortgages
· Cashing Out or Borrowing Against Life Insurance
· Cashing Our or Borrowing Against a Retirement Account
· Selling of Other Investments in Land, Rental Property or Lake Homes
· Starting a Pyramid Scheme (Just Kidding)
Realistically, none of these are optimal places to go for funding as most entrepreneurs wish they could fund their business on their own. However, we understand the determination and drive behind entrepreneurs who will do most anything to get started. There are downsides to each of these: Love Money can create hard feeling between important people in your life if things don’t go as planned for repayment which is why we reccomend Virgin Money. Home equity loans have to be approved based on your personal income, before they will loan you the money, and many people don’t have the extra income to get approved for the extra debt. Silent Partners can become awfully vocal or even take control of your business if things start going awry. Cashing out assets can have major tax consequences among other lifelong repercussions – Like dying with no life insurance, retiring with no money and working 80 hour weeks instead of enjoying your lake cabin.
So what is the answer? Save as much and as often as you can. Pay yourself first, ensuing you have saving for emergencies (we should all have six months worth of salary socked away in a bank account – why do I hear laughing), long term savings for retirement and finally a stash of cash for when the next great business idea or investment comes knocking on your door.