Guide to Business Financing
Most small businesses need to obtain financing at some point, but there can be an overwhelming number of options out there. We know as a business owner you’re busy and don’t have a lot of time to spare. To help you better understand your options, we’ve put together a quick guide to shed some light on financing options so you can make the right choice for your business.
A small business term loan is the most common type of financing. With a term loan, you borrow a specific amount of money and pay it back in fixed payments over a set period of time. The rate you pay is based on your company’s creditworthiness and market conditions at the time you obtain the loan. Many lenders will typically ask for your tax returns and bank statements to assess your ability to repay a loan. They will also want to know how you plan to use the money towards for your business.
A term loan can be secured, which means that the borrower uses collateral to obtain and secure the loan. If you fail to repay the loan, the lender then takes possession of and has the option to sell what you put up as collateral—whether it’s property, equipment or inventory. If a term loan is “unsecured,” then the lender would typically require a personal guarantee. In this case, you agree to be personally responsible for the debt in case the loan goes into default.
Business term loans can be provided by banks or online credit marketplaces. Online credit marketplaces offer web-based online lending services that have less stringent requirements and a faster application process than banks. LendingClub is an online credit marketplace that leverages machine learning and algorithms to weigh factors including personal credit, annual revenue, and time in business to quickly provide a decision.
How to use it: A term loan makes the most sense when you are planning to make a long-term investment to grow your business. You could be buying an asset that costs a large chunk of money upfront but will generate additional profit in the future. Ideally, what you’re investing in will produce a greater rate of return than the interest you’re paying on the loan. For example, a food truck business may could take out a term loan to buy a second truck that will double the company’s sales.
Line of credit
A line of credit (LOC) is a specific amount of money made available to a business to tap as it needed. When you pay back the LOC, the funds become available to you again, giving you ongoing access to cash for a set period of time. When you draw funds from a LOC, you only pay interest on the money your company actually uses, not the total amount of the LOC you were approved for. Lines of credit typically have a variable interest rate, usually often based on the prime interest rate, which can fluctuate with macroeconomic conditions. This means your payments can differ depending on when you request a LOC draw to access the funds. Additionally, many lenders will re-underwrite evaluate the loan every so often to ensure the business’s credit situation hasn’t changed.
How to use it: Due to the use-what-you-need nature of LOCs, they are often a solution for bridging cash-flow crunches and can provide a cushion for seasonal or unexpected fluctuations in revenue. Recognizing how valuable a LOC can be to a small business, LendingClub offers a Line of Credit up to $300,000 for eligible businesses.
Personal loan for business
A personal loan for business is like a business term loan, but the amount and interest rate are based solely upon a business owner’s personal credit history, rather than that of the business. For that reason, they are more popular among startups and new businesses that don’t have a long credit history.
How to use it: A personal loan can be used for just about any business purpose. For example, a retailer can use a personal loan to buy inventory and stabilize cash flow as a business grows. Note that a personal loan is typically capped at a smaller loan amount than a small business loan. For example, LendingClub offers personal loans up to $40,000 but offers business loans up to $300,000.
The U.S. Small Business Administration (SBA) offers a number of loan programs at affordable rates, usually for companies that might not meet conventional lending requirements because of their size, industry, or time in business. The SBA is not the direct lender, but rather guarantees a percentage of traditional loans that are financed through banks and other institutions. This guarantee allows banks to be more flexible with lending criteria, although securing an SBA loan can still be a complex and lengthy process.
How to use it: Of the SBA’s loan programs, the most popular are SBA 7(a) loans, which can be used for general business purposes, and CDC/504 loans, which are typically used for fixed assets such as equipment and real estate. The SBA also offers microloans—shorter-term loans of up to $50,000—and financing for businesses impacted by declared disasters.
Asset-based loan or line of credit
These loans or LOCs are based on the collateral you can put up to secure them, such as equipment, inventory, or accounts receivable. The lender assesses their worth and advances you credit based on a percentage of their value—often 80 to 90% for accounts receivable, and less for inventory or equipment. Asset-based loans often appeal to borrowers who don’t yet have a strong enough financial history to qualify for traditional credit.
How to use it: Asset-based credit is often acquired on shorter notice than traditional loans or LOCs, but used for similar purposes. For example, if you run a restaurant and the refrigeration unit starts to break down, you need to replace it quickly. You could offer up another asset as collateral but keep in mind that if you can’t pay back the loan for whatever reason that you risk losing that collateral.
In this type of lending, a business sells its outstanding invoices to third parties known as factoring companies, which provide the business cash in two installments. For the first installment, the factoring company covers 75%-90% of what the invoices are worth. The business then has immediate cash and now it’s the factoring company that waits to be paid on the customer invoices. Then when the factoring company collects on the invoices, it subtracts fees, and pays the company the remaining balance—this is the second installment. The longer it takes your customers to pay, the less money you will receive from the factoring company and the higher your cost of borrowing becomes.
How to use it: You may want to consider this option only if your company needs fast, short-term capital. For example, a manufacturer whose major clients’ invoices aren’t due for months might struggle to pay its employees in the interim, so it could choose to sell the open invoices to a factoring company for an infusion of cash that helps it make payroll. The factor then collects the clients’ payments as they come due, turning over the remaining percent, minus fees, back to the company. If you choose this option, it’s critical you understand the full cost of borrowing and how it can vary depending on when your customers pay you back. Additionally, you may be able to avoid a situation like this through careful planning and by applying for a term loan or line of credit before your business is caught in a cash crunch.
Merchant cash advance
Finally, businesses could can use merchant cash advances to get a lump sum of cash in exchange for a percentage of their credit card sales, or repay the lender through fixed daily or weekly debits from their bank account through ACH withdrawals.
How to use it: Similar to factoring, this is an option when your company needs cash fast. Note that this is also typically a costly form of borrowing. The effective APR for merchant cash advances can be very high and because you have to repay a fixed amount, there is no interest savings by early repayment—in fact, you may have to pay an early repayment penalty. Merchant cash advances should be considered only if other lower cost options are not available.
Taking the time to understand your financing options can go a long way to ensure that your business finances stay on track and propel you to grow.