Money will be one of your biggest challenges when you start a small business, and it will continue being a major concern as you try to sustain and grow your company.
As a small business owner, it pays to know and even master the ins and outs of small business loans or financing.
Traditional banks used to be the only viable financing option for any small business. But that’s no longer the case today.
Small business owners now have more choices, whether you’re searching for funds to address cash flow gaps, or to expand your business.
But it’s important to understand your choices in order to make the smartest decisions for your business.
In most cases, your decision will be based on why and how soon you need the financing. Here are 3 business scenarios and the top financing options to consider.
Small Business Financing for Startups
Raising capital to launch a new business is challenging. Banks and other major lenders typically don’t offer startup financing. So your choices are limited. Here are some of the best and most popular options:
Personal Savings, Family & Friends
Many entrepreneurs start a business with their personal savings or with the help of family and friends. There is one clear advantage to this: With your own savings and financial support from people you know, you probably wouldn’t have to worry too much about your personal credit history or your balance sheet.
However, unless you have very wealthy friends and relatives, the funds available to you would probably be limited. Plus, if things go wrong with your business, you risk straining or even ending some important personal ties.
Business Credit Cards
Credit cards are also a popular and practical way of launching a business. But this is a very expensive form of financing. You should use credit cards only for minor business expenses. It’s also smart to pay off balances as soon as possible.
Crowdfunding has become an increasingly popular way of raising capital. There are two basic types:
Rewards Crowdfunding – You offer gifts, usually the product or the service you are planning to sell, in exchange for contributions solicited through such platforms as GoFundMe and Kickstarter.
Equity Crowdfunding – You offer equity or minority ownership in the business in exchange for funding.
There are also a number of grants available to first-time business owners. An excellent resource is the U.S. Small Business Administration which runs Small Business Development Centers throughout the country. SBDCs offer free business consulting and low-cost services for different business needs, including crafting and developing business plans and securing financing.
Small Business Financing for Emergencies
You just launched your business and things are progressing smoothly. But then you run into unexpected hurdles and emergencies. It could be a piece of equipment that suddenly broke down or an unforeseen shortage.
This is a dilemma for many business owners for whom quick and convenient access to financing is important. Having plenty of cash in your business bank account would certainly help. But for many businesses, especially those that are just getting started, money is usually tight.
Credit cards are certainly an option for dealing with everyday business funding needs and emergencies. But again, this type of financing is expensive. You definitely should avoid using credit cards for major expenses.
Instead, you should consider 3 other types of lower-cost financing that may make more sense for emergencies and other short-term needs:
A term loan is a loan that you repay over a set period of time. The repayment terms vary depending on the lender. The loan may be based on a fixed or variable interest rate. The repayment period could range from 6 months to 30 years.
SBA loans are the most popular type of business term loan. Since they are guaranteed by the federal agency, SBA loans are less expensive than other forms of business financing.
The downside of using a term loan for day-to-day business needs is that you end up borrowing and paying interest on funds that you may not need all at once. Two other types of financing offer more flexibility.
Business Line of Credit
A business line of credit gives you access to a set amount of funds based on a financing arrangement with a traditional bank or an online lender. Unlike a term loan, you withdraw only the funds you need up to your credit limit. You also pay interest only on the amounts you use, which makes a business line of credit both flexible and practical.
With invoice financing, which is also referred to as accounts receivable financing or invoice factoring, you get cash advances on unpaid invoices that are due in 30, 60 or even 90 days. This can be a smart financing option for businesses that sell products or services to other businesses. Instead of waiting weeks or months to get paid, you’re able to get access to funds your business already earned.
Small Business Financing for Growth
As business improves, you’ll probably start looking to expand by opening a new location, hiring more people or buying new equipment.
Financing once again will be key in this stage of your business. For big ticket expenses, long-term loans are usually more cost-effective and practical.
Term loans, particularly SBA Loans, are the most ideal type of financing for these major expenses.
Equipment financing is also available for major equipment purchases. While many small businesses rely on traditional banks for equipment financing, online lenders have begun to play a critical role in addressing this need.
A business line of credit is another good option for small businesses looking to grow. This type of small business financing can give you access to the capital you need, and you’ll only have to pay for what you use. Business lines of credit are a great alternative to small business loans if you’ll need ongoing access to financing instead of one-time access to a lump sum.
Pros and Cons of Business Financing Options
Let’s take a quick look at some of the different financing options for small businesses, and the advantages and disadvantages for each.
Term loan advantages and disadvantages
- Come in short-term or long-term repayment periods
- Predictable payment schedule
- Typically quick approvals
- Lump sum
- Build business credit with on-time repayments
- Regular payments with interest
- Might need to wait to access funds
- Potential prepayment penalties
- Risk collateral (for secured loans)
- Rates are much higher if you have poor/no credit
SBA loan advantages and disadvantages
- Low interest rates
- Accessible to younger businesses
- Favorable repayment terms
- May take months to process
Business line of credit advantages and disadvantages
- Improves your cash flow when you need it
- Flexible usage of funds
- Accessible to younger businesses
- Find out if you’re approved quickly
- Predictable payment schedule for each draw
- Build business credit with on-time repayments
- Draw fees
- Not a lump sum
Invoice factoring advantages and disadvantages
- Improves cash flow ties up in outstanding invoices
- Debt-free alternative to traditional loan
- Fee, which means you won’t receive full sum of unpaid invoice
- Fees increase if customer takes long time to pay
What are the steps to get a small business loan?
The five steps to get a loan for your small business are listed below.
1. Understand why you need a small business loan
Do you need to improve your cash flow to stay ahead of expenses? Are you covering for an emergency? Or will this loan serve as a way to upgrade your equipment and/or grow your business?
2. Determine if you’re qualified for funding
Know your business and personal credit history, as well as your cash flow situation. Lenders will want to know that you’re able to pay back the money you borrow before they approve your business for a loan. Also, be prepared to provide collateral if your credit isn’t up to par.
3. Compare small business loan options
Be sure to research and discuss whether your business needs would be better suited for a term loan, SBA loan, or business line of credit.
4. Evaluate different lenders
Once you’ve figured out what type of small business financing best fits your needs, you can compare lenders to make sure you choose the one with the most favorable terms and benefits. Options can include traditional banks, online lenders, the SBA, and non-profit lenders.
5. Prepare your documents and apply
Finally, you can get your documents together and submit a loan application. Here’s a quick list of what you’ll likely need to apply for a small business loan:
- Incorporation papers – make sure you’re properly registered with your Secretary of State
- Bank statements for last 3–12 months
- Tax filings for last 1–3 years
- Updated balance sheet
- Profit and loss report
Fast and convenient access to working capital for small businesses.
This article was first published on August 30, 2017. It was updated on August 21, 2018.