General Question

LostInParadise's avatar

How are start-up businesses financed?

Asked by LostInParadise (26116points) July 7th, 2014

I have been thinking about worker cooperatives as a possible alternative to the capitalist business model. One particular problem that cooperatives have is how they can be financed initially. Given the cooperative ownership, there are particular problems of providing an incentive for a few people to put up a large start-up cost.

In order to understand the problem better, I would like to know what the ways are under capitalism that new businesses are financed. I have zero business knowledge, so please just provide basic information.

Two ways that I can think of are:
1. Venture capital – Someone with lots of money is willing to put up the initial investment in exchange for a share of the profits. This definitely would not apply to worker cooperatives.

2. Incremental growth – Starting small, the business owner invests part of the profit back into the business. At some point the business could be sufficiently large that it would be possible to secure a large loan using the business equity as collateral. This could apply to coops, but I suspect this is not the usual way that businesses start up.

If you wanted to build a moderate sized manufacturing facility, how could you go about getting the initial investment money required?

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16 Answers

Dutchess_III's avatar

Well, I just got a business loan through a bank. I was, however, buying an existing business and using all the inventory (and my house) as collateral, so I suppose this doesn’t help.

jerv's avatar

The usual way is both; someone puts their life savings on the line to start the process, then (hopefully) grows fast enough to pay the bills.

elbanditoroso's avatar

I would be very wary of starting the business as a worker’s cooperative. Why? Because new businesses often need capital infusions in a hurry – for inventory, personnel, operating expenses, etc. – and a workers cooperative is unlikely to be able to come up with sums of money in the time frame and the size necessary.

In my experience, worker cooperatives in the long term almost always fail, especially when the idealists who started the cooperative move on or lost interest. [Yes, there are some that have survived, and continue to, but these are the exceptions, not the rule.]

Even more than the money, I would be worried about governance. Will there be a powerful leader or executive who will have the ability to move the company in aggressive directions? Or will every decision have to be with the consent of the membership? If so, the cooperative will fail precisely because running an operation by committee simply doesn’t work. There has to be a strong leader.

But all that said, you will need to have a credible business plan, a product, and a means of paying back the loan. There are places – credit unions, farm cooperatives, etc., that do this all the time. But a loan – not just contributions from family – is the way to keep things honest.

zenvelo's avatar

@jerv laid it out at a high level.

Essentially, you start off with a small business, often out of your home, and finance it through your own savings.

For instance, suppose you have a killer cookie recipe and people tell you they would gladly pay two dollars a cookie for it. You realize you can make them for 85 cents each worth of ingredients, and it takes you an hour to make 144, so you figure you could be making $165 on hour after ingredients. You start off with all you can afford, sell the cookies, make more the next day, sell them, etc. And you save whatever you can to expand the business.

Eventually, you have enough money to rent a commercial kitchen.

Converting from an entrepreneurial business to a cooperative business means you have to figure out:

1. How the original owner gets paid back;

2.How do the workers earn a piece of the business.

3. What is the dispute/employee discipline process?

The same process applies though on expansion of the business. The co-op agrees to re-investment in the business for expansion and growth.

LostInParadise's avatar

Thanks all. So I basically had the right idea. Thanks for confirming. I will have to do further research to see how cooperatives handle this problem.

@elbanditoroso , I don’t have sufficient knowledge to argue against you. I am in the process of reading literature on cooperatives. That some business cooperatives are successful shows that the basic business model can be viable. If the government provided the same incentives for cooperatives that it provides for corporations, maybe the success rate of cooperatives would increase.

There are some aspects of cooperatives that I find very appealing:

1. There is no separation between workers and owners. In particular, there are no outside stockholders whose only concern is profit. The workers are the owners. They either make decisions directly or elect the people who manage the company.

2. The workers have a strong incentive to turn out a good product and to cooperate with one another, since everyone divides the profits in addition to any base salary.. Note that it is typically not the case that everyone draws the same salary, but in most cases the ratio between highest and lowest salaries is far lower than under strict capitalism.

3. Companies have a strong incentive not to lay people off. If the company hits a rough spot, it is more likely to uniformly cut people’s hours rather than to fire them.

4. Unlike capitalism, a cooperative company can be successful without continuously growing. A corporation’s stockholders want to see the value of their shares increase and that can only happen if profits go up. Cooperatives do not have such pressures on them. Capitalism’s need for constant growth is going to cause it to eventually crumble. Being able to reach a stable equilibrium also makes coops friendlier on the environment.

Dutchess_III's avatar

Good luck. Keep us updated.

elbanditoroso's avatar

@LostInParadise – with regards to #2 – all I can say is “you would hope so”. In my experience in cooperative agricultural enterprises, there is always someone (or more than one) that dont’ feel the same incentive, and do less work, and thereby earn the resentment of others.

So if you can keep people ideologically motivated, more power to you.

funkdaddy's avatar

@LostInParadise – it might be worth noting that what you describe is essentially most privately held small businesses as they operate under capitalism.

Most businesses are not publicly traded behemoths, many care about employees, especially long term employees, and profit sharing isn’t that unusual but strangely workers seem to want stability over the opportunity to share in the ups and downs.

Collectives are simpler when you really don’t need everyone, but they can each contribute. Creative ventures are great for collectives because people can contribute when inspired, enthusiastic, and motivated. Once everyone has to show up every single day, then it gets complicated and imbalances develop that aren’t always healthy for any relationship.

I guess I just wanted to point out that there’s nothing magical about collectives and nothing poisonous about corporations. The people still matter more than whatever you call the organization.

LostInParadise's avatar

I appreciate your comments but the value of small businesses is greatly exaggerated

funkdaddy's avatar

I’m not sure I understand the relationship with the link and the value of small businesses in this discussion.

The NYT story seems to be focused on relaying that small* businesses don’t have as many highly compensated employees and aren’t great drivers of growth. Many don’t have to hire constantly to maintain themselves. You’re holding up each of those as advantages for a collective.

Also, if you’ve read that article, why this example?

If you wanted to build a moderate sized manufacturing facility, how could you go about getting the initial investment money required?

Manufacturing is notoriously expensive to start with the hope of a long future with higher profits than hiring someone else to make what you want to sell. The article outlines why that won’t work for small businesses and why it’s outsourced so often. It also outlines that credit markets are tight for small businesses, so businesses with a large initial outlay would be at a disadvantage.

So most US manufacturers are either huge companies, or skilled craftsmen.

I’m not trying to be argumentative, and don’t mind just dropping out of the discussion if that works best, but I’m trying to figure out what you’re really looking for.

Are you looking for sources of initial investments in a manufacturing collective with no outside stakeholders?

Find someone who has a lot of money and doesn’t mind losing it making whatever you want to make because it’s their hobby or passion. Or find a bunch of people who want what you’re going to make and start a crowdfunding effort like kickstarter.

Barring that you start small or take outside money for some sort of compensation (usually they would take equity in the company/collective, not necessarily profits).

Maybe we can tease out whatever piece you feel like you’re missing and maybe we can help with that?

* “small” businesses in the article is under $10M in annual revenue

RealEyesRealizeRealLies's avatar

“If you wanted to build a moderate sized manufacturing facility, how could you go about getting the initial investment money required?”

I wouldn’t. There are alternative methods that you can do for free.

My background… I’ve been self employed for nearly four decades. Never taken a business loan. No credit cards. Never taken a partner until recently. And that partner is a thirty year client that we’ve earned trust over the years. My new partner is for one small side business, not the whole thing. And we trust one another to perform our individual responsibilities without stepping on the toes of the other.

I do not recommend partners unless you’ve done business with them for a very very long time.

My recommendation, with the little knowledge I have of your situation…

Manufacturing? You want to build a manufacturing facility? Now is not the time for that. Perhaps later, once you see that your product is profitable. But not at the beginning.

The proven, and safest business model, especially for startup, is brokering. Whatever your product, be it new, or an existing product, brokering the job (connecting demand to supply) is the way to go.

Whatever you think needs to be manufactured, I assure you, there are thousands of existing manufacturing facilities with vast experience who can provide you with the service. The broker gets 20% or more off normal price. Consider that your startup capital.

jerv's avatar

As a machinist, I can say that the startup costs for manufacturing are non-trivial, but that’s if you do the making yourself.

As @RealEyesRealizeRealLies implies by mentioning brokering, your actual job as a manufacturer isn’t making stuff; rather, it’s seeing that it’s being made to the customer’s specs and delivering ontime. Subcontracting is normal.

Jackofalltraits's avatar

You can always take a loan out from a bank. Some of the bigger banks will provide loans for business start ups.

LostInParadise's avatar

The question was hypothetical. Being highly risk adverse and approaching retirement, I am not planning on building a manufacturing plant. I am trying to determine the difficulty of creating a start-up company under capitalism versus worker cooperatives. The point is that plants for new products do currently get built. It can’t be that the only ones who can manufacture a totally new product are the ones who are already manufacturing something else.

jerv's avatar

No, but I’ve seen both the “slow build” and “rich investor” type. It takes a lot of capital to do the big stuff, so you either start small and slowly build capability, or you come up with an awesome enough idea for someone with deep pockets to feel you’re a wise investment. My former employer (a foundry) started with the President, VP, and one of their brothers doing small castings in their garage. They now have four plants, hundreds of employees, and both pours and machines everything from steel to titanium and Inconel; it took a couple decades, but they now do stuff nobody else in the world can. And it all started with 3 brothers in a garage, just as Apple was just three guys in a garage in the ‘70s.

It can still be done, but if you’re already nearing retirement then you’ll need a billionaire backing you if you want to live long enough to see it take off.

Dutchess_III's avatar

We have an business here called S & Y. I know the S stands for Sandy, one of the founders of the business. They started on their back porch building computer boards. They’re a multimillion dollar industry. My daughter started as a solderer there. She’s now head of Quality Assurance and makes more than my husband makes.
Sandy now also owns other business down town. A boutique and a couple of restaurants and a club.

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