Financing Options for Start-Up Businesses
Being a small business owner comes with its share of challenges. Whether you're in the midst of starting a new business or you're a few decades in, at some point, you may find yourself searching for cheap access to financing. Small businesses have a number of options to consider.
A lot of new business owners start by looking to their own bank accounts or turning to friends and family for a loan, but mixing business and personal that way can backfire. Tapping into your own savings runs the risk of leaving you broke or with bad credit if you don't bring in a profit fast enough, while getting money from friends means giving up a certain amount of control over your business. If Grandma makes a big investment, she may well have her own opinions about how things should be run to ensure you make that money back.Business owners are wise, thereofre, to heed the old adage regarding too many cooks in the kitchen.
In most cases, the best option will be to look into small business financing from a traditional financial institution or alternative lender. But applying for a loan can be intimidating, and figuring out which small business financing option best matches your needs is overwhelming. Our guide to small business financing will help you make sense of your options and figure out how best to execute with costs, flexibility and overall terms in mind.
How to Evaluate Your Financing Needs
Before you start looking for financing, you need to clarify exactly what you're looking for. To do that, ask yourself these important questions.
What do I have now?
Reviewing what assets you have now can help you accomplish two things:
- Getting a clearer picture of what you still need.
- Equipping you with the information lenders will need to determine what kind of financing they're willing to give you.
If you've been in business for a while, the answer to this question will include things like equipment, office space, and any profits you have coming in. If you're just starting out, it will include any money you're already contributing to the business, purchases you've made already, and a clear business plan that demonstrates your aptitude for making the business a success.
In cases where a lender requires collateral, demonstrating the assets you have may be the thing that gets your loan approved. Even when collateral isn't required though, showing evidence of how established your business is and the investment you've already made into it is part of making a strong case to lenders that your business won't be much of a risk.
How much capital do I need?
Before taking out financing, you should have an idea of what the money will be used for. Take some time to think through specifically how you'll spend it. If you've been in business for a while and the money will be going toward types of expenses you're already familiar with, analyze your spending history to create a clear estimate of what you'll need. If your business is new or you're expanding into a new territory you're less familiar with, research the average expenses and profit margins for other businesses in the industry.
It can be tempting to try to ask for too much, but remember that a higher amount of debt will cost you more in the long run. You should try to stick within the lower range of the amount you really need, rather than risk going overboard. Think: What amount do I need, versus what amount do I want. Taking on too much debt can lead businesses to ruin, rather than being the catalyst for growth it's meant to be.
And lenders will be more likely to approve you if you ask for a realistic amount. Normally that will be about 10-15% of your revenue, but of course it varies based on your particular circumstances. Asking for too much is one of the best ways to get denied, so think carefully about how much you need rather than how much you want. On the contrary, when a lender extends a larger amount of funds than you're looking for, but you opt for a lower amount of funds, going back for seconds may be frowned upon. Again, know what amount you need in the near-term. Forecast what amount of debt your business needs to borrow and how it will affect your balance sheet and P&L.
What do I need it for?
This question relates to the last, but it's worth working out specific answers to it. You want a detailed budget that shows what you expect to spend on equipment, salaries, inventory, office space - all the expenses associated with your business. In some cases, the specific answer to this question will affect the kind of financing you'll be approved for. For instance, if you're looking for equipment financing or equipment leasing, lenders know that means your investment will be going directly toward something that will help make you a profit, which puts you in a stronger position. From a lender perspective, it's safer to lend to a merchant looking to finance a truck for their fleet or a CNC lathe for their counter top manufacturing business because the equipment is business-essential. A merchant may slow-pay a vendor, but they're not likley to default on an equipment loan: a tow-truck can't tow cars if his tow-truck has been repoed.
How soon do I need it?
Sometimes small business financing funds long-term goals and plans. If you're thinking ahead to your growth plans for the next year, you won't be in any big rush to get the money. Other times, you'll need that financing fast. If the A/C breaks in your ice-cream store in the middle of a hot summer, waiting weeks to get the money you need to fix it will mean a big hit to your bottom line.
When you have longer to wait, you have room to be picky and consider financing options that usually require a slower process. The times when you really need that money right now though, you'll need to prioritize a financing option that gets you the money fast, like an alternative lender.
How will I make it back?
Have an answer prepared for this question before you start filling out applications. For the sake of your own business (and credit score), you need to plan out and be confident you can afford to make payments on any loan you get. But it's also good to have this answer at the ready for the lender as well. They'll want to see some evidence that your business is legitimate and likely to remain profitable enough for them to get back what you owe.
When will I make it back?
How long will you reasonably need to pay off the loan? Some loans have long terms that mean lower monthly payments. Short-term loans mean paying more each month, but knowing that you'll have it paid off faster. Have a timeline in mind and stick to your guns. Afterall, what good is a plan if you don't plan sticking to it!
What can I qualify for?
You'll only be able to get as much money as lenders feel comfortable giving you. Whatever type of lender you go with, they'll be considering a few main things to determine if you're safe to lend to:
- Your personal credit score - Good credit shows you're good at paying off debt, which works in your favor. If you have any delinquencies dragging your credit score down, get them cleared up before you look into small business financing to increase your chances of approval and a good deal.
Here's a link to an Experian article that showcases how consumers can fix tradelines that are incorrectly reported to their credit bureau
- Your business history - Businesses that have been around and can demonstrate profitability are in a strong position when applying for a loan. Lenders look at your history of business loans, how many deposits you have in a normal month (and for how much), and how often you have positive ending bank balance at the end of the month. If your business is new, that doesn't mean you're out of luck, but it makes the other three categories on this list that much more important.
- Other loans you have - Some loans point toward stability and responsibility, especially if you pay them regularly. Home loans, car loans, and student loans look good to lenders and other business loans usually make you look good if you consistently pay on time. But too many loans make you look like a risk. Lenders will look at how your debt compares to what your business makes. If your debt ratio is over 50%, you'll have a harder time getting approved.
- Collateral you can offer - While collateral doesn't come into play in every small business financing scenario, if you have something you're willing to pledge as collateral it may increase your chances of approval and better terms. Of course, if you use something like your own home for collateral, it increases your personal risk as well, so make sure you think through the decision.
Options for Small Business Financing
For most small businesses in need of financing, you have three main types of financing options to consider.
Small Business Loans
Small business loans are a common financing option that work much like personal loans. You borrow a lump sum from a bank to pay back in increments over time with interest. There's a lot of variety in the types of small business loans available and the terms businesses are likely to encounter. Here are some loan types to have on your radar.
Cheap Access to Capital, but don't expect a fast turn around
SBA loans are small business loans backed by the government, which makes them a lower risk for the lender. If your priority is low interest rates or a long term for repayment, this will be the most attractive loan for you. Less risk for them makes it easier to offer lower interest rates, even for loans of a high amount with long payback terms.
There are several types of SBA loans, each designed for specific purposes:
- 7(a) loans - The most common option. These are flexible and can be put toward just about any business expense you need.
- 504 loans - These are for established businesses with a good credit history wanting to put money toward growth. They have some of the best rates and terms you'll find.
- Microloans - These are great for when you just need a little bit (under $50,000), or know you can't qualify for a larger loan.
- CAPLines - These work like lines of credit that businesses can use for short-term working capital needs.
- Disaster loan - For businesses affected by a natural disaster, these can be used to fix damages or make up for economic losses due to the disaster.
- Export loan -These loans are meant to help businesses expand to international markets and cover associated costs.
The main downside of SBA loans is that they're hard get. You have to collect a lot of paperwork - things like personal financial statements (PFS), years of tax returns, and a formal business plan. Even once you have everything gathered and submitted, you can expect to wait weeks or even months for the lender to approve your loan and then it's hurry up and wait to receive the actual funding.
Your chances will be slim if your credit's not spectacular and your collateral doesn't more than offset the risk. SBA loans generally require you putting up personal property as collateral, meaning that you may end up risking your own home or other property if your business fails. Before you throw your hat into the ring, understand the risks of pledging your personal assets.
SBA loans aren't for everybody, but if you have the time to wait and good enough credit to qualify, then they're your most affordable option for financing.
Signature Loans or Other Term Loans
While SBA loans are appealing, they aren't available to everyone. For those who don't qualify or can't wait that long, banks offer small business term loans with a fixed payback term. These will have higher interest rates than SBA loans, but lower ones than most other types of small business financing. These are usually only available for relatively small amounts of money - less than $100,000 - so if you need more than that, this isn't your best option. But because the amounts are small and the risk isn't too high for the bank, they're not that hard to qualify for.
Short-term loans, also called working capital loans, are much like term loans, but with a shorter payback term. For a business that needs money right away or doesn't have good enough credit to be approved for a term loan, these work fast and are easy to qualify for. These loans have higher interest rates than longer-term loans and the shorter payback period means high monthly payments. But they're fast, they're easy, and they're flexible, which makes them a good fit for many businesses.
If you need money specifically for business equipment, then an equipment financing loan or equipment leasing is a smart choice to consider. These are attractive to lenders because they know the money's going straight toward something that helps you make money, increasing the chances that they'll get that money back. And the loan has built-in collateral. If you have trouble making payments, they can sell the equipment to recoup losses. For those reasons, these loans normally offer attractive terms and are easy to get approved for.
Invoice Financing AKA Factoring
Invoice financing, sometimes called invoice factoring, is another type of loan that's a solid bet for lenders. If you find yourself short on cash while waiting on clients to pay outstanding invoices, you can get a lender to give you the amount of money owed on those invoices and pay them back with a fee once your clients come through. Since the lender knows that money's coming, these usually offer pretty good terms and are easy to get approved for.
Merchant Cash Advance
A merchant cash advance provides you with a lump sum like a loan does, but instead of making fixed payments each month for a set amount of time, you pay back a percentage of your credit card sales each day or each time you batch your credit card receipts. That makes it harder to predict how long it will take to pay off the loan, but you know you won't be stuck paying more than you can afford in a particular month since it's tied to your earnings. They're pretty easy to apply and qualify for and a good option for businesses with inconsistent earnings.
Lines of Credit
A line of credit works a lot like a business credit card, but with lower interest rates and a longer period for repayment. A lender will pre-approve a certain amount of money, but instead of giving it to you in a lump sum as with a loan, you can take out the amount you need as you need it. You'll only pay interest on the amount you use and since you're pre-approved up to a certain amount, getting the money quickly when you need it is easy.
Lines of credit are a good option if you want the flexibility of knowing you can get credit when you need it, without committing to a large loan. Where with loans you'd want a clear idea in advance of what you'd be spending it on, lines of credit are useful for the various and sometimes unpredictable ongoing expenses of running a business.
Business Credit Cards
Business credit cards work a lot like personal ones. The main differences are that they usually offer higher credit limits and they affect your business credit instead of just your personal credit (although sometimes they affect both). They're very easy to get approved for, but have high interest rates on any money you don't pay back within a month. If you're going to carry debt for any length of time, then this is a more expensive option than the others on the list.
How to Evaluate Your Small Business Financing Options
When choosing between your different financing options, there are a few important criteria to consider and compare.
What's my Interest Rate?
You want to think about both how high the interest rate is and whether or not it's fixed or variable. A fixed rate means you know what you're getting, while a variable rate could change to become higher or lower during the time you pay off the loan. How high your interest rate for different financing options will be depends on a lot of factors, but it plays a huge role in how much your financing ultimately costs you so it's worth comparing a few options.
What Fees will I pay?
Interest is the main way financing will cost you, but some financing options include additional fees as well. Look out for things like an application fee, origination fee, processing fees and late fees to make sure you know the full cost of the financing you're considering.
Average Length of a Small Business Loan
Loans that have a longer term will be easier to pay off, since you get lower monthly payments. But short-term loans are often easier and faster to get, and the interest won't have as long to build up before it's paid off.
How Long Will it take to Get Approved for a Loan
Your options are different if you need money fast versus if you can take your time. Short-term loans and lines of credit will give you access to money faster, while term and SBA loans have much slower processes.
Risks with Taking Out a Business Loan
Taking on debt always comes with risk, but the degree of risk varies. SBA loans offer great terms, but sometimes require you to risk your home as collateral. Even if you keep your home out of it, if you take on more debt than you can handle you risk the failure of your business and your own credit. The risk is often worth it if you're thoughtful about it, but make sure you know what you're taking on.
Types of Small Business Financing Providers
Most small business financing comes from one of two types of lenders.
For a long time, banks were the go-to source for small business financing and while they're still a popular option, they no longer have a monopoly on lending. Because they have access endless amounts of capital, banks can afford to provide small business owners with low interest rates and long terms, particularly for SBA loans, which afford them extra protections. In most cases, banks only take on 10% of the risk of each business loan, which is how the SBA encourages banks to lend. Considering the amount of collateral that business owners must pledge, it's a win-win for banks, even if the merchant defaults.
The main downsides to going with a bank are that they have high standards for approval and a markedly slower process for getting money to you. It's common for small businesses to get rejected for a bank loan and, even if you're approved, you could wait weeks to actually get the money. In the event you're approved, prepare to have your bank account and quarterly financials scruntinized on an ongoing basis. Especially nowadays, banks keep close watch on their borrowers.
Alternative lenders are a great alternative to banks for small business owners that have trouble getting approved, or that need the money faster. They usually offer easy online applications and a quick approval process. The easier approval does come at the cost of higher interest rates, and loans from alternative lenders usually have shorter term length, so you can expect higher daily or weekly payments. Don't expect an alernative lender like a working capital loan funder to offer monthly payments. They want constant communication with their debtors and that means a more frequent payment schedule.
One thing to be aware of with alternative lenders is that they have fewer regulations to follow than banks. That means you need to be more careful in evaluating which one to work with. Many are legitimate, trustworthy businesses, but some aren't and you'll need to do some work to tell the difference.
How to Evaluate Small Business Financing Providers
You're going to be working with your financing provider for at least the time it takes to pay off your debt, so you want to pick a company that's reputable, easy to work with, and provides you the best experience possible. Here are a few things to look for.
Word of Mouth
You can often learn more about working with a business from their other customers than from anything they tell you themselves. Ask around to learn what financing providers other small business owners you know have worked with and what their experience was like. Look at customer reviews and see what people are saying about the lender on social media. If other borrowers have been happy, the company's reputation will bear that out. Keep in mind, a few 1-star reviews usually aren't exactly indicative of what it will be like to work with a company. Be sure to look at the average rating of the firm before making a decision to apply with a lender.
Age of Business
As a business owner, you know how harmful bad word of mouth can be to a business. If a business treats their customers badly or isn't run well, they won't last. The lending companies that manage to stick around for a while are usually those you can count on to be trustworthy and provide a good experience. Start by looking up the lender on Secretary of State's website of where they're business is located. Make sure that their license to operate is active and in good standing. If their status shows as revoked, then you can easily rule them out as a potential lender. Be as persnickety with choosing a lender as they would be when reviewing your file for consideration.
The reviews and testimonials you researched can tell you something about the long-term customer service you can expect from a company, but you can also tell a lot about how they treat you in your early interactions. If a lender is pushy and tries to pitch you on a loan you can't afford, they don't have your best interests at heart. If they're unresponsive to your questions or evasive before you commit, you can expect the same after you sign the dotted line.
Look for a financing provider who takes care to help you understand the products they're offering, tailors their offers to your particular needs and situation, and makes you feel like they're there to take care of you.
Small business financing is a big part of keeping most businesses afloat year after year. Make sure you find the right financing option from the right provider to keep your business running smoothly and be careful not to overdo it. Responsible financing is a way to grow and improve your business, but too much debt can bring it all falling down. A good lender will help you avoid that.