When you’re starting a small business, there are several funding options you can consider. Many entrepreneurs think about making personal investments in their business. While this can be a good way to acquire the funds your business needs, it’s important to be cautious when investing personal money in your company. Know the risks so you can mitigate them if you make a personal investment in your business.
TL;DR (Too Long; Didn't Read)
Making personal investments toward your small business depends on your financial situation, your business's legal structure and the amount of risk you want to take. Consider speaking with a financial advisor, investment advisor, or registered investment advisor before you make any changes to your finances.
What to Know About Investing In Your Small Business
There are two key ways you can put your personal money into your business: as a loan or as an investment. The path you choose will depend on the financial status of your company, how you plan to use the money, your financial goals and the legal structure of the business. It’s important to understand the risks of each option before you decide which way you want to go.
If you make a personal loan to your business, then it’s important to have a formal lender agreement with clearly outlined loan terms regardless of your business structure. The terms should state how much personal money you are loaning, the interest rate, how the loan will be paid and by when it will be paid back. Outline whether there are any consequences if the loan is not repaid by your business. Keep in mind that the interest you receive is taxable but the principal is not since you’ve already paid taxes on it.
If you’re investing in your company, then the paperwork is more complicated. If your business is a sole proprietorship, you can simply deposit money into your business bank account and write it as owner’s equity on the balance sheet. If you own a partnership, the process is similar, though it’s labelled as a distributive share. However, if your business is a corporation, then you can buy stock in the business.
Weighing the Risks of Lending or Investing in Your Small Business
There are inherent risks for each option, so be sure to keep that in mind when deciding how you want to put money into your business. If you lend money to your business, the business is in debt to you. There is always a chance that your business will not be able to pay back the loan. If you have a formal loan agreement and your business declares bankruptcy, there is a chance that you could get some of your money back.
If you invest in your business and your business fails and has to declare bankruptcy, then it’s unlikely that you will see your money again. When bankruptcy is declared, creditors are paid before investors. Keep in mind that almost half of all small businesses fail in the first five years. While it’s important to have enough working capital to succeed, you also need to make sure you have enough personal assets to take care of yourself and your family if your business does not get off the ground.
How to Lend to or Invest in Your Small Business
There are many ways to put personal funds into your business. Your personal funds account for any money that you have, receive or borrow as an individual, not as a business. The leading way entrepreneurs put money into their businesses is with their personal savings. However, if you don’t have a large amount of savings, there are some other assets that you can leverage to support your business.
Ways to use your personal funds to help support your business include:
- 401(k) savings, ROTH IRA, traditional IRAs or any other retirement plan or retirement account
- Consumer credit cards
- Personal loans
- Exchange-traded funds (ETFs), mutual funds, index fund, individual stocks, and other personal investments and investment products
- Home equity loan or home equity line of credit
- Selling real estate
- Brokerage account
- Fixed income
- Cash from your savings account or a money market account
- Monetary gifts or loans from family and friends
Each method of using personal assets to fund your business comes with its own pros and cons. For example, consumer credit cards have relatively low interest rates, but you have to have a good minimum credit rating in order to qualify for larger amounts. Be sure to mitigate any risks so that your personal assets are secure should your business not find success, and keep your investment objectives in mind.
Keep Your Legal Structure in Mind
The legal structure of your business will affect the way you put money into your small business. It may also affect your decision to loan to your company or to invest in your company. As a sole proprietor or partnership, there is no distinction between your personal assets and liabilities and your business assets and liabilities because the business is not a separate legal entity. As a result, it’s easier to put personal investments toward your small business because there is no legal separation.
In a partnership, a loan toward the business doesn’t change the legal status of the company. The money is just seen as a transfer of funds and is not taxable because there is no legal distinction between the owners and the partnership.
As an LLC or corporation, however, there is legal distinction between the owner and the company so that the entrepreneur is protected from the debts of the company. The advantage of an LLC is that it’s easy to transfer funds into and out of the business while still having legal protection for the owner. Make sure to always account for your personal finances appropriately to keep things separate and legible.
How to Keep Track of Personally Invested Funds
Whether you’re loaning to your business or investing in your business and regardless of your legal business structure, it’s best to keep detailed notes of the personal funds you’re putting into the business. This is important for tax purposes and to ensure you keep track of your funds. Start by making sure you have a separate bank account for your business. This way, you can clearly see how much money is relegated to your personal assets and to your business.
The way you record your transaction will depend on whether you’re lending money or investing money. If you’re investing money as equity in the business, you’ll need to create a journal entry in your personal books or accounting software debiting the amount of money that has been placed in your business account. You’ll then have to credit your business account with that same amount of money to offset the debit entry you made to your personal account.
The capital that you invested in your business will need to appear under owners' equity (if your company does not issue shares) or stockholders' equity (if your company issues shares).
Other Sources of Funding to Consider
There can be significant risks when making personal investments toward your business. If you don’t have the funds available or don’t have the risk tolerance in your investment portfolio, remember that you have other options to fund your company. Be sure to consider your overall investment goals and develop investment strategies before moving forward.
Other sources of funding you can consider for your small business include:
- Traditional lenders such as banks and credit unions
- Online lenders
- Investors such as angel investors, partner financing or venture capitalists
- Community development finance institutions
- Industry-specific grants
The different sources of funding don’t apply to all businesses or work at all stages. You may find that you can’t showcase business growth at the very beginning in order to interest investors, so you may need to self-fund or crowdfund initially. Once your business is off the ground, you can approach investors or lenders for an influx of capital to take your business to the next level.