Finding the right sources of capital in order to start a small business can be confusing. It all sounds so easy on paper: “Get VC funding,” “Self-fund your startup with savings,” or “Ask friends and family to back you.” But when you get down to it, each “obvious” option has a lot of other information behind it that you have to research.
In general, small business owners are hesitant to turn to their friendly neighborhood bank for a business loan. A recent study found that 76% of those surveyed described the process of getting a small business loan from a traditional lender as either “difficult” or “extremely difficult.” Small business lending has loosened a bit this year, but it’s important to know what your options are so that you can perfectly tailor your application to the type of loan you need and to lay out exactly how you plan to use the funds.
Consider these 4 types of business loans to figure out which one is right for you:
1. Working capital loans
Working capital loans are short-term business loans designed to bring extra cash into the business to use for growth and expansion, and for handling current day-to-day expenses such as advertising, payroll, inventory purchases, or renovations. It also covers the cost of dealing with emergencies or handling debt.
Conditions: Like personal loans, working capital loans require that you as the business owner have a sparkling personal credit history. Funding in this way also requires a significant amount of paperwork and processing can take weeks or even a few months to complete.
Benefits: Working capital loans are effective because they finance the everyday operation of your business, and at extremely low interest rates. You’re likely to secure something between 3-7%, provided you have a great credit score.
How to Apply: Working capital loans are typically available through large, national banks as well as smaller regional or statewide banks. You might also consider looking into working capital loans available at your local credit union or through a third party direct lender. For the best chances of securing a working capital loan, trying to first turn to the bank that you already do business with. They’ll not only have access to a lot of your financial information, but they’ll be able to assess their own risk by reviewing your existing banking and credit habits.
2. Small Business Administration (SBA) Loan
SBA loans are government-backed loans available to small businesses from private sector lenders. These are secured, meaning you acquire working capital by using company or personal assets as collateral. There are three different SBA loan programs:
- The 7(a) Loan Program offers financial help for businesses with “special requirements,” such as those that export to foreign countries, operate in rural areas, or qualify as having another qualifying “special purpose.”
- The Microloan Program provides small short-term loans to small business concerns and some non-profit childcare centers.
- The CDC/504 Loan Program offers loans to small businesses with long-term fixed-rate financing for the purposes of expansion or modernization.
Benefits: Depending on your needs, each SBA loan has its own unique benefits. For instance, a 7(a) loan could help you purchase land or buildings, cover new construction, purchase equipment, furniture, and supplies, or acquire an existing business.
Microloans may be used as working capital, to purchase inventory, supplies, furniture, and fixtures, or to buy machinery and equipment.
The 504 Loan program offers you both short-term and long-term benefits, including 90% financing, longer loan amortizations, fixed-rate interest rates; and overall savings.
Conditions: There are a number of conditions under which SBA loans cannot be issued, including a partial change of business ownership, a change that wouldn’t benefit the business, or to repay delinquent state or federal withholding taxes. Loan terms vary depending on the size of the loan, the planned use of the money, and your needs as a small business borrower.
The maximum term allowed for a microloan is six years. Interest rates are usually between 8 and 13 percent.
How to Apply: Each program has specific eligibility criteria and an application process. Visit the SBA.gov site for information on how to apply for an SBA loan and for checklists that help you ensure you have everything you need to put together a successful application.
Accounts receivable factoring is also known as receivable financing. This type of business loan is used to convert sales on credit terms for immediate cash flow. For example, if you provide outsourced marketing services to large enterprise clients, you might sell your existing, uncollected invoices (which you are waiting on payment for) to a third party for an advance payment. This third party, called the factor, provides you with the full or partial amount and then turns around and collects on the sale from your customer. This type of financing is more likely to be used to buy your small business some time while you look for more long-term and sustainable ways of financing.
Conditions: Be aware: this receivable credit line can be costly and, as such, you should exhaust all other efforts of financing before turning to it. Once you factor in a discount fee, interest rates between 10-25%, and other charges, you could end up paying much more over time. Also, your financing is determined by the financial strength of your customer, not you as a seller of goods or services. Most invoices that are over 90 days old will not get financed, and those invoices that are paid out quicker will afford you more beneficial terms.
Benefits: One of the greatest advantages of this type of business loan is that it allows you to cash in immediately on your future sales; you won’t have the majority of your capital tied up in inventory or unpaid invoices. It’s also incredibly beneficial to outsource your accounts receivable management to another company, freeing up your focus for productive work on your business. This funding is also quick financing. You’re not forced to provide a business plan or tax statements.
How to Apply: Most companies that offer accounts receivable financing are commercial lenders, not banks. To apply for accounts receivable financing, you’ll be required to fill out an application and hand over your articles of incorporation paperwork, provide your company’s most recent accounts receivable and payable reports, and supply a master customer list as well as an example of your typical invoice.
4. Friends & Family Loan
We’re all familiar with this option. But there may be things about when and how to do it that surprise you…
First, it’s always a better business practice to put the loan in writing, and to state a specific interest rate and repayment plan. Otherwise, you open the door to unfortunate misunderstandings that can chill your relationship. Also, you want to have documentation of the loan’s terms in case the IRS decides to audit your business.
Conditions: Borrowing from loved ones carries risk. We’ve outlined the benefits and drawbacks of borrowing money for your company from your parents, and a lot of these tips hold true for other family members and close friends who may lend to you. The reality is that many people may not have extra money to part with, or if they do, they may not be comfortable parting with such a large sum on something they have no control over. Be sure to “over communicate” the value you bring to your customers, and indicate if and how your friends and family will be able to participate in your business.
You should initiate the process of providing a written promissory note that states how much money they can expect you to pay back and under what interest rate. With this note, you’ll also want to specify a repayment schedule in writing.
Benefits: Money borrowed from friends and family can come with the best low-interest repayment plan you’ll ever get. This is one of the more significant reasons to borrow money from friends and family vs. banks and commercial lenders. You may also be extending your salesforce or workforce when you borrow money from those you know: when they’re financially invested (in addition to being personally invested as someone who loves you), they may take it upon themselves to help you succeed and reach goals.
How to Apply: To show you’re serious about requesting funding from relatives, you may want to approach the subject formally, armed with your business plan, projections, outlines of how you’ll use the money, specifications on your friends and family’s involvement in your business, and suggested loan terms.
Do you think business loans are the right option for you? What types of business loans have helped you get off the ground?
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