Everyone needs cash to open a new shop. To fund your business, you can beg and borrow from your friends and family. You can apply for a loan from a bank or online lender. Or you can scrimp and scrape until you have enough cash to self-fund your business.
In a perfect world, self-funding your business is generally great advice for startups. However in the real world, many entrepreneurs who launch a new business usually need to borrow money at some point. That may not be for a couple years because banks typically don’t fund startups.
On the other hand, banks generally view new ventures favorably, if the owners initially self-fund the business during the first years. It tells the lender that you believe in yourself and in your vision for your business. Why should anyone else invest in your shop—whether it is a bank, your family, or your friends—if you aren’t willing to put your personal money at risk?
As a business owner, you have to deal with tremendous pressure at work. Taking on a loan can subject you to additional pressure that can affect your physical and mental health. If you have a family, your relationships can also suffer.
To make matters worse, if you fail to make a payment, it can affect your credit score, making it difficult to secure additional funding, not only for your business but also to get loans for a home or car.
Taking out a loan may seem easier and provide more advantages than self-funding. In most cases, you would be wrong. The main disadvantage is that you must pay back the loan with interest.
And failure to repay a loan opens you up to liability. If you have set up your business either as a sole proprietorship or as a partnership, you are personally responsible for failure to repay your business loans. In these cases, lenders can seize your business assets as well as personal assets, such as furniture, cars, and even your home, to cover any debts that your shop accumulates.
Your best financing option is to self-finance. That means that you need to save enough money to get started. What’s more, it also means that you will probably start out small. That’s okay—if you work harder and smarter, your business will probably survive.
By financing your own business, you avoid the additional pressure of making loan payments. It gives you more time to worry about your shop operations and marketing your services instead of worrying about the money you owe someone else.
Types of Business Loans
Lenders provide many different types of business loans to small businesses. Each type has advantages and disadvantages.
Which type of business loan is appropriate for you relies on several factors. Most importantly, the right loan for you depends on what you need it for. Other factors include how quickly you need the money and for what period of time. Some of the types of funding available include business term loans, SBA loans, and a business line of credit.
Business Term Loans. If you are looking to expand your business, a business term loan can provide you with a lump sum of cash to fuel your enterprise. This standard loan covers a fixed “term” or specified period of time, usually between one and five years. The term for buying real estate can be as long as twenty-five years. Over the life or term of the loan, you will make fixed installment payments.
Business term loans are generally used to purchase long-term assets, also called fixed assets, such as real estate, shop equipment, and vehicles. This is not the type of loan that you will use to buy short-term assets, such as inventory.
Getting approval from either a bank or online source is generally easier and faster than other types of loans, if your business is well established and has a good credit rating. When applying for this type of loan, you should have all of your financial statements, tax returns, and bank statements available for the lender.
Prior to applying for a loan, check your personal and business credit rating. Lenders use credit scores as a barometer of the likelihood that you will pay back the loan on time. FICO (Fair Isaac Corporation) is one brand of score. The rating ranges from 300 to 850. The higher the credit score, the better. Banks use this rating in determining whether or not to grant a loan and when deciding the credit limit and interest rate for the loan.
Your business may also have a credit rating, especially if your company has borrowed money in the past or has been issued a business credit card. Your payment history with utility companies or with any vendor or distributor who has extended you credit will likely affect your credit score.
While you can use term loans to obtain larger amounts of financing, you very likely will need collateral, such as real estate or equipment, to secure this type of funding. Loans from online sources are usually faster than getting a loan from a bank, but interest rates are typically higher.
SBA Loans. The SBA or Small Business Administration is not a lender. Instead this government agency works with banks and other lending institutions to help small businesses obtain SBA-guaranteed loans. In the loan approval process, the SBA sets the guidelines, although the lender usually has some of their own credit policies.
There are many different types of SBA loans. However, more than 75 percent of these loans are 7(a) loans. Within the 7(a) category, there are several variations of loans, such as the 7(a) Small Loan and the SBA Express Loan.
You can obtain an SBA 7(a) loan to fund a wide range of business activities. These include purchasing equipment, business expansions, acquisitions, buying real estate, or providing your company with working capital.
What makes these loans attractive are the loan rates, which are some of the lowest rates on the market. These rates range from prime +2.25 percent to prime +4.75 percent.
The repayment terms for 7(a) loans can also be attractive. Repayment terms for equipment is up to ten years. Loans for working capital can be as long as seven years. Down payment for an SBA loan may also be significantly lower than with a conventional loan. In addition, fewer fees, if any, may apply.
The downside of an SBA loan is the qualification process. A standard loan can take as long as six weeks for approval. In some cases, it can take months.
The length of time for the loan approval sometimes depends on whether you are dealing with a preferred lender or not. A preferred lender, which includes most major banks, can make its own credit decisions.
On the other hand, a non-preferred lender acts as a go-between for you and the SBA. For this reason, the qualification process, when using a non-preferred lender, can be quite lengthy.
Your chances of getting a 7(a) loan are about 65 percent, which is typically better than getting a regular bank loan. To qualify for a loan, you will need a good credit score (over 650) and have been in business for a minimum of two years. You will also need to put up collateral for the loan and sign a personal guarantee.
Business Line of Credit. It doesn’t matter how big your shop is—sometimes the spaghetti just hits the fan and you run into a cash flow problem. For that reason, every company should establish a business line of credit with their bank.
The line of credit gives you the flexibility to write checks so you can buy inventory, pay operating expenses, and make payroll. It is not intended to finance the purchase of real estate or shop equipment.
The line of credit is a type of short-term loan that covers your checks when the well temporarily runs dry. To cover the amount needed, the bank charges you an interest fee. Generally this fee is at a much lower interest rate than other types of loans because it is comparatively low risk.
New businesses are generally required to secure a line of credit using personal assets, such as real estate, as collateral. If you have a partner, both of you will most likely need to put up personal assets as collateral.
Not until your shop becomes financially stable will banks extend your company an unsecured line of credit. In most cases, to get a business line of credit without a personal guarantee, your shop needs to have been in business for a couple of years and have strong revenues and an outstanding credit report.
As an alternative to traditional banks, you can also get a business line of credit from online alternative lenders. These institutions have different practices for evaluating your credit worthiness. Alternative lenders will check your banking activity and have different standards for the revenue that your shop generates.
Generally you can get approved for a business line of credit much faster than going to a bank. Make sure that you investigate the repayment terms as well as all of the fees that an alternative lender may charge you (such as an inactivity fee).
Business Credit Card. If you don’t have a business credit card, you should get one. Then make sure that you pay off the balance each month in full. This helps improve your business credit rating. A good rating increases your chances of getting a loan at a good interest rate.
Before applying for a business credit card, compare the advantages of the different cards. Your comparison should include spending limit, interest rate, rewards, and annual fee. Generally business credit cards have higher credit limits and lower interest rates than personal credit cards. Business credit cards also have some great perks, such as memberships in airline lounges.
Now that we’ve gone over these loan process, be sure to check out my article detailing the “Five Cs of Business Credit.”