With a multitude of business financing options available, how do you know which is right for you? If you have a new business or are in the planning stages, getting your hands on cash can feel like mission impossible.
This dynamic has led to an influx of nontraditional lenders hoping to meet the demand. While having so many funding avenues to explore can be a good thing, it’s not easy to figure out which path to take. Many businesses have failed because they got stuck paying for a loan they couldn’t afford.
While most business owners are familiar with traditional business loans, crowdfunding is growing in popularity as a funding option. We’ll outline essential information about business loans and crowdfunding – along with some other options – to help you figure out what’s right for your business.
According to CB Insights, the top reason startups fail is poor cash flow management, such as running out of cash and failing to raise new capital.
What is a business loan?
A business loan provides companies with borrowed capital. The business can use the borrowed capital to pay expenses it previously couldn’t afford. You can use a business loan to pay employees or contractors, stock inventory, pursue business growth, and purchase office supplies. Business loans are available from traditional banks, online lenders and microlenders.
For more information, read our reviews of the best business loan and financing options so you can compare lender offerings.
Editor’s note: Looking for the right loan for your business? Fill out the below questionnaire to have our vendor partners contact you about your needs.
Types of business loans
There are myriad business loan types. We’ll outline some of the most popular.
Business credit cards
Similar to personal credit cards, business credit cards have a revolving line of credit that’s available to you as long as you make the minimum monthly payments and don’t exceed the credit limit. A business credit card is a popular option for ongoing expenses.
Business line of credit
A business line of credit is flexible because you pay interest only on the money you use. A line of credit is a valid option for seasonal businesses and short-term financial needs.
A business equipment loan is used exclusively for purchasing equipment. The loan term falls in line with the expected life span of the desired equipment. Interest rates are based on how well the equipment holds its value and the financial health of your business.
Invoice factoring is a way to get paid more quickly for outstanding customer invoices. It involves selling invoices to a factoring company, which is then responsible for collecting the money when the invoice comes due.
A factoring service offers several benefits over a bank loan, including less paperwork, quicker cash, and a third party invested in your clients paying their bills.
If you’d rather not use an invoice factoring company, you can get a cash advance by using your invoices as collateral.
Merchant cash advance
A merchant cash advance offers fast cash, but it comes at a price. Borrowing costs can rise more than 300%, and you must make payments weekly or via daily withdrawals from your credit and debit card sales.
Nonprofits and mission-based lenders extend microloans to startups, newly established businesses and disadvantaged communities. Microloans are $50,000 or less and can also include consulting or training.
If you have a short business history, personal loans may be your only option. To qualify, you’ll need an excellent personal credit score. However, if you fail to make a payment, it can affect your credit.
Small Business Administration loans, including the popular SBA 7(a) business loans, are guaranteed by the SBA through banks and other financial institutions. However, the SBA application process is extensive, and it can be hard to qualify. Repayment plans on SBA loans can range from seven to 25 years.
If you’ve been turned down for an SBA loan, you can seek an alternative funding source, explore unemployment benefits, or take out a business credit card.
Term loans are a common loan type with a predetermined length and interest rate. A term loan will quickly provide you with a lump sum of funding upfront, and it often offers a higher amount than other loan types.
If you’re deciding between a line of credit and a term loan, consider a term loan for large, one-time purchases and a line of credit if everyday expenses are your concern.
How does a business loan work?
When applying for a business loan, you’ll have to explain to the lender in detail how you will use the loan. Other factors include your business’s size and financial health.
The lender makes the final decision on whether to lend to your company, the amount and the interest rate. You can then approve or deny the loan terms. Depending on the loan terms, the monthly payment obligation will include principal and interest payments.
If you miss a payment on your business loan, you could face consequences such as late fees, penalties, and the loss of any assets you used to secure the loan.
What is crowdfunding?
Crowdfunding is a way to fund a project or business venture through a series of small donations or pledges from multiple individuals or investors. In return, you usually promise to provide one of your products or equity in your business.
You may consider crowdfunding a newer financing source, but it’s actually existed for a long time. Authors and publishers have used it for decades, funding new books via readers who pledge to buy them before they’re released.
Types of crowdfunding
There are four types of crowdfunding. All can help a startup or entrepreneur raise money to grow their business.
- Donation-based crowdfunding: Donation-based crowdfunding is used mainly by nonprofits to collect financial donations for their causes. Donors do not receive anything in return; they’re supporting causes to which they feel a personal connection.
- Equity-based crowdfunding: Instead of offering product-based incentives, equity crowdfunding allows investors to receive a financial stake in the company. Although startups can receive a quick financial boost from this method, they could lose majority equity if they don’t handle it correctly.
- Debt-based crowdfunding: Companies like Prosper and Lending Club have created debt-based crowdfunding platforms as an alternative to asking family and friends to fund your next business venture. Peer-to-peer (P2P) lending sites can be helpful for businesses unable to get a loan through traditional financial institutions. P2P loans also generally have lower interest rates. However, there is no insurance or government protection for P2P loans, which creates a higher risk for the lender than other crowdfunding methods.
- Reward-based crowdfunding: Made popular by Kickstarter, reward-based crowdfunding gives incentives to people who pledge money to startup projects and products. For example, a company may provide the donor with one of the final products for a $100 donation. Reward-based crowdfunding can quickly grow a company’s following. However, it’s important that the business delivers on promised rewards to prevent distrust among supporters.
How does crowdfunding work?
Crowdfunding can be especially useful if you’re financing a new project or idea. You’ll validate market interest before sinking money into the project and avoid dreary fundraising work.
This chart should give you a better idea of whether crowdfunding is right for you.
|Financing originator||The bank or online lender where you apply for the loan is the originator.||Funds are issued by the crowdfunding platform that hosts your campaign, but the money comes in the form of pledges from several individuals or groups.|
|Application and approval process||Banks will typically review your credit score, tax returns, financial statements and business plan before approving the loan.|
Approval can be difficult. On average, you can expect the entire process to take 60 to 90 days for a bank loan.
|Campaign requirements and guidelines vary by platform, but the process is typically faster than it is for bank loans.|
However, the end of the application process does not mean access to funds. It merely means that you can start raising funds.
|Credit requirements||Typically, business loans require good personal and business credit scores.||There are no credit score requirements associated with crowdfunding campaigns.|
|Repayment terms||Loan repayment comes in the form of monthly installments (principal and interest) until the loan is paid in full.|
Penalties and fees are assessed for delinquent payment or loan default.
|You are not required to repay the funds raised for your crowdfunding campaign.|
However, you are typically required to fulfill any promises you made in exchange for a pledge, including product distribution or equity shares.
|Interest and fees||You pay interest on the total amount of the loan. Interest is based on various factors, including your personal and business credit scores.||Crowdfunding platforms typically charge a one-time, percentage-based fee upon the disbursement of funds.|
|Guidance||Banks issuing business loans often provide business owners with guidance or mentorship resources.||Some crowdfunding platforms give you access to investors and any advice or mentoring they can offer.|
Pros and cons of bank loans vs. crowdfunding
If you’re debating the merits of business loans vs. crowdfunding, consider the pros and cons of each. Only you will know which option better aligns with your situation and goals.
Research your funding options, and consult a small business advisor or mentor. Many advisor programs, like local Small Business Development Centers, are free to use.
Bank loan pros
- There’s no delay in using your funding. The cash is yours once you’ve been approved.
- It offers a chance to improve your credit. Making on-time payments can help build your business credit.
- Ownership of the company is entirely yours. This is in contrast to equity crowdfunding, which requires you to provide investors with equity in your company once a business loan is paid in full.
Bank loan cons
- You may not qualify. Traditional bank loans have strict application and approval requirements. There’s no guarantee you’ll be approved.
- They carry more risk upfront. For example, you could lose the asset you pledged as collateral if you default.
- You can test the waters. Since crowdfunding success depends on enticing individual investors or investment groups to rally around your idea, it lets you tap into your potential market base before starting your business.
- You can abandon a bad idea. You’ll know there’s little interest before investing additional time and money. If there isn’t enough appeal, your campaign won’t take off, you won’t have access to funds, and you can go back to the drawing board.
- It’s a lot of work. Crowdfunding requires a lot of upfront effort on your part, and it’s always possible your campaign won’t succeed and your efforts will have been in vain.
- You’ll need a marketing campaign. To draw in pledges, you’ll need to create a strong, multifaceted marketing plan.
- You have to do a lot of follow-up. You’ll need to keep up on administrative work, such as correspondence and investor follow-up.
Alternatives to business loans and crowdfunding
While business loans and crowdfunding can generate cash for your company, there are some alternatives worth considering.
By applying for grants, you could gain access to money awarded by federal, state and local governments that you don’t have to repay. However, business grants are competitive and can take longer to receive than loans.
Venture capitalists are individuals or firms with money earmarked for startups in industries such as tech, medicine and e-commerce. If you seek venture capital, you’ll need a strong business plan and pitch deck.
Jared Proctor contributed to the writing and research in this article.