Finding the right sources of funding for your business can be difficult. There are many types of funding available – investors, grants, loans, etc. – and each has its own application process and set of rules.
One of the most common options for small business funding is a business loan. Small business funding sounds like it should be easy to obtain, but borrowing money may not be as straightforward as it seems.
In 2019, prior to the pandemic, the Fed polled small business owners and found that nearly half had difficulty gaining adequate financing. The number of business owners able to secure funding has declined further since the pandemic. As a business owner, you need to know your options so you can tailor your application to the type of loan you’ll actually get. With that in mind, consider these seven types of business loans to figure out which one is right for you.
Friends and family loan
This is typically the first stop for business owners looking to get an enterprise off the ground. It can also be used for cash flow or to chase growth among established businesses. As it implies, you ask your friends and family to lend you money. It’s vital if you go this route to put everything in writing. Otherwise, you open the door to misunderstandings that can chill your relationships. Also, you should have documentation of the loan’s terms in case the IRS decides to audit your business.
Borrowing from friends and families carries risk. Be sure to over-communicate the value you bring to your customers and demonstrate how your friends and family will be part of the business. You should provide a written promissory note stating how much money they can expect you to pay back and at what interest rate. With this note, you’ll also want to specify a repayment schedule in writing.
Money borrowed from friends and family can come with the best repayment plan you’ll ever get. This is one of the best reasons to borrow money from friends and family instead of banks and commercial lenders. You may also expand your sales force 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 your business 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 and outlines of how you’ll use the money; specifications on your friends’ and family’s involvement in your business financing; and suggested loan terms and repayment terms.
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Business line of credit
A business line of credit is a flexible business loan that allows you to pay interest only on the portion of money you borrow. It works similarly to a business credit card in that you may draw funds as needed and repay them as you are able, as long as you do not exceed your credit limit. This is an excellent option for businesses looking for an easy way to manage their cash flow, purchase inventory or pay for a surprise expense.
A business line of credit works like a credit card, allowing you to take out and repay the money on your own terms as long as you stay within your credit limit and make payments on time. Most lenders will allow you to pay off your balance early to keep your interest costs down.
Line of credit limits tend to be lower than business term loan amounts – generally from $1,000 to $250,000 – and are unsecured, so you typically do not need to put up collateral except in the case of a larger line of credit. Fundbox, one of our small business loan best picks, offers lines of credit as high as $150,000. Learn more in our review of Fundbox.
Business lines of credit are a flexible option that allow you to manage your business’s cash flow as you see fit, and you can reuse and repay your credit as often as you need.
How to apply
Similar to business term loans, you can get a business line of credit from either a traditional bank or an online lender. Banks will require your business to have strong revenue and one to three years of positive history to qualify, as well as the following documentation:
- Tax returns (business and personal)
- Bank account information
- Business financial statements
Online lenders generally have fewer restrictions and qualifications than banks, but they tend to charge higher interest rates and have lower credit limits.
To qualify for a business line of credit from an online lender, you’ll need to have been in business for at least six months, make $25,000 or more in annual revenue, and have a credit score of 500 or higher.
Working capital loan
Working capital loans are short-term business loans designed to bring extra cash into the business to use for growth and expansion as well as for day-to-day expenses such as advertising, payroll and inventory purchases. You can also use working capital loans to cover emergency costs or pay down debt.
Working capital loans require you and your business to meet certain thresholds in terms of time in business, monthly or annual sales, and credit score. The qualifications vary from one lender to the next. One top lender, Fora Financial, requires borrowers to be in business for six months; have sales of at least $12,000 per month; and possess a decent credit score. Learn more in our review of Fora Financial.
Working capital loans usually have low interest rates. The better your credit score, the less the cost to borrow will be. When applying, start with the bank you already do business with. Not only will it have access to a lot of your financial information, but it will be able to review your existing banking and credit habits to assess risk. If you get turned down, consider alternative lenders.
Business term loan
A business term loan is a lump sum of capital you pay back in regular payments at a fixed interest rate for a set period of time – which is where the “term” part comes in. The term is generally one to five years.
The purpose of a business term loan is to allow you to finance a large purchase such as equipment or a new facility. There are few restrictions to a business term loan, and most businesses that have sales and good credit will qualify.
With a business term loan, you get a predetermined amount of money and a fixed interest rate to be repaid over a set number of years. The loan amount will depend on your business and its needs, but it’s generally within the range of $25,000 to $500,000, with interest rates from 7% to 30%. SBG Funding, one of the best business loan options, lends small businesses up to $5 million. Terms range from six months to five years. Learn more in our review of SBG Funding.
A business term loan generally has few restrictions and can help you build your business by introducing capital to purchase new office equipment. These loans can also be used to build inventory, cover cash flow gaps or invest in a new opportunity.
Business term loans are suitable for a wide range of businesses, and they generally offer lower monthly payments and longer repayment terms than short-term loans.
How to apply
You have a couple of options when applying for a business term loan. They are traditionally available through banks, though they often have a long and arduous application process. Several banks offer expedited online applications, though. These are some of the documents you’ll need:
- Driver’s license
- Voided business check
- Bank statements
- Balance sheet
- Credit score
- Tax returns (personal and business)
- Profit and loss statements
Small Business Administration (SBA) loans
SBA loans are government-backed loans that are available to small businesses from private-sector lenders. These are secured loans, meaning you must pledge your company or personal assets as collateral. There are three different SBA loan programs:
- The 7(a) loan program is the SBA’s primary program for providing assistance to small businesses. The terms and conditions vary by loan, and loan amounts range from $350,000 to $5 million.
- The microloan program provides the smallest loan amounts available from the SBA, ranging from $10,000 to $50,000. Microloans are ideal for small startups, borrowers with limited collateral or companies that just need a small financial boost.
- The CDC/504 loan program offers loans to small businesses with long-term fixed-rate financing for the purposes of expansion or modernization – such as large equipment or real estate purchases. These are typically larger loans, “generally capped at $5 million.” Terms are 10, 20 or 25 years, depending on the purpose of the loan.
Unless you are applying for a microloan from the SBA, make sure you don’t need the funding fast. The SBA loan application and funding process can take weeks, which may not be an option for some small business borrowers.
There are multiple conditions under which SBA loans cannot be issued, including if a business is operating as a nonprofit or is not based in the United States. SBA loans cannot be used to repay delinquent state or federal withholding taxes.
Terms vary by 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 8% to 13%.
Each SBA loan has its own unique benefits. For instance, a 7(a) loan is extremely versatile and can be used to purchase land or buildings, cover new construction, finance equipment or other supplies, or acquire an existing business.
Microloans may be available to businesses that otherwise wouldn’t qualify for a loan. They can also be used in multiple ways: working capital; purchasing inventory, supplies, furniture and fixtures; or buying machinery and equipment.
A 504 loan, which borrowers typically use to buy commercial real estate or heavy equipment, offers short-term and long-term benefits, including 90% financing, longer loan amortizations, fixed interest rates and overall savings.
How to apply
Each program has specific eligibility criteria and an application process. Visit the SBA website for information on how to apply for an SBA loan and for checklists to ensure you have everything you need to complete your application.
Accounts receivable factoring
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 collects on the sale from your customer. This type of financing is generally used to buy your small business some time while you look for more long-term, sustainable funding sources.
This receivable credit line can be costly, so you should exhaust all other financing efforts before turning to it. Once you factor in a discount fee, interest rates of 10% to 25% and other charges, you could end up paying much more over time than you would with other financing options. Also, your financing is determined by the financial strength of your customer, not you as a seller of goods or services. Most invoices over 90 days old will not get financed, and invoices that are paid out quicker will afford you more beneficial terms.
One of the greatest advantages of this type of business loan is that it allows you to cash in immediately on your future receivables; you won’t have the majority of your capital tied up in inventory or unpaid invoices. It may also be beneficial to outsource your accounts receivable management to another company, freeing up your focus for productive work on your business. This funding is also faster than many options, as you don’t have to provide a business plan or tax statements. When reviewing factoring companies for our best picks, we found BlueVine to be among the fastest to fund.
How to apply
Most companies that offer accounts receivable financing are commercial lenders, not banks. To apply for accounts receivable financing, you’ll have to fill out an application and hand over your articles of incorporation, your company’s most recent accounts receivable and payable reports, a master customer list, and an example of your typical invoice.
Merchant cash advance
A merchant cash advance isn’t technically a loan, but rather a cash advance based on the credit card sales deposited into your merchant account.
Merchant cash advances are quick; the funds are often deposited 24 hours after approval. Historically, merchant cash advances have been used by businesses that primarily subsist on credit and debit card sales, such as restaurants and retailers, but they have become available to other businesses that do not rely on card payments alone.
With a merchant cash advance, you receive an upfront sum of cash in exchange for a portion of your future credit and debit card sales or by remitting fixed daily or weekly debits directly from your bank account.
Merchant loan advances provide you with fast money but carry high annual percentage rates that consist of the total cost of the loan plus all fees. They can run your business into debt quickly if you are not careful.
Your fee amount is determined by your ability to repay the merchant cash advance. The provider will determine a factor rate of 1.2 to 1.5 based on a risk assessment. The higher the factor rate, the higher your fees. Your total repayment amount is the factor rate times the cash advance.
The main draw of merchant cash advances is that they are fast; you could have cash in hand less than a week after submission, with little to no paperwork. Merchant cash advances are also unsecured, which means you do not have to put up collateral, and repayments will adjust to how well your business is doing.
How to apply
Applying for a merchant cash advance is simple. Start by looking at online business lenders and filling out their online applications. Expect to provide three months’ worth of financial statements.
Kiely Kuligowski contributed to the writing and research in this article.