Is it Ever OK to Finance a Startup with Home Equity?

Who are the big idea innovators in the startup world these days? Is it the fearless 20-year olds? Not so much.

Actually, the majority of new business owners are innovators who are over the age of 40.

According to the Kauffman Foundation, during the last 16 years, entrepreneurship among 55 to 64-year-olds increased by an astounding 64%. For 45 to 54-year-olds, new business formation increased by 10%. Yet during the same period, entrepreneurs aged 20 to 34 dropped by 24%.

Given the recent recovery of home valuations and advancing age of new business founders, it makes sense that I’m getting more questions to my FOXBusiness inbox about funding a startup with home equity funds.

Is it a good idea or bad idea?

Different types of businesses, at different stages of business development, call for different funding solutions. Drawing down funds from a home equity loan to invest in a startup is a riskier investment move than using home equity funds as an emergency source of capital for businesses that generate revenues from a reliable customer base.

Here are the factors every entrepreneurial homeowner should think about before turning to a home to fund a new business.

Real funding requirements. A common mistake of startup entrepreneurs and first-time business buyers is to estimate the funding requirements to start a business, not succeed in business. The difference is subtle but meaningful.

If the amount of funding required to complete product development, secure a first customer, or achieve positive cash flow far exceeds your family’s resources, don’t start your business with a home equity loan. Funding your new business with equity from investors rather than debt may be the smarter, risk-adverse way to go.

Your monthly payment. It’s easy to find free online tools that will help you calculate a monthly payment from a new mortgage or home equity loan. Can your family afford the increased monthly bill? For how long?

Of course, the real problem with funding a new business with a home equity loan is bad timing. Just at the time when the total home financing bill goes up, the family’s household income often goes down because one family member usually left another paying gig. If the new business is not able to pay any salary to the entrepreneur for some period of time, then the family’s finances can easily spiral out of control.

Impact of rising interest rates. Most second mortgages and home equity loans are issued with variable interest rates. Can your family finances afford a sudden rate increase of one percent or more? Work the numbers, don’t just guess the numbers!

Budget for delays and unexpected problems. If you are pursuing a business that is outside your primary area of expertise, (for example an advertising executive starting a restaurant), budget some extra funds for beginner's mistakes and routine trial and error.

A good exercise is to double your company’s projected startup expenses and delay the introduction of new products or services by a good six months or more. It also usually takes longer for startups to secure their first customers and get paid by their first customers, too.

Reliance on investors to pay back loans. It’s quite common for older entrepreneurs to draw down funds from a home equity loan or personal savings and then “invest” the funds in the form of debt into the new business entity.  Their big hope—and deadly miscalculation—is that they will get paid back quickly by angel investors or venture capital funds.

The real deal is investors in young companies prefer to fund new product development, aggressive sales and marketing plans, patent filings and other initiatives that will boost a company’s revenue and profit generation. Paying off debt to founders or their family members is simply not a priority.  In these situations, expect investors to insist that any debt to founders or their family members will be rolled into equity as a condition of investment.  So, when will entrepreneurs get their money back? Usually when the company is sold, which can be years down the road. Yikes!

In general, debt is not a good funding option for startups especially if it adds strain to a family’s finances. Many banks understand this too and turn down home equity loan requests if it is revealed that the funds will be used for new business purposes.

Tapping a home equity loan, however, can be a reasonable solution for households that are not dependent on the new business for fast debt repayment or to pay other household bills. It also helps if the new business is not capital intensive and may start with one or more commitments from first customers or clients.

Susan Schreter is a veteran of the venture finance community and entrepreneurship educator.  For more information and actions steps on strategic planning, raising capital and building a lucrative business, read Susan’s book, Start on Purpose. Follow Susan @StartonPurpose