Business Loan vs. Crowdfunding: Which Is Best for You?

What is a business loan?

A business loan is a loan designed specifically to provide businesses with capital. The business can use the borrowed capital to pay expenses it previously couldn’t afford. For example, 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. 

Types of business loans

There are many types of business loans. Some of the most popular include the following:

• Business credit cards: Similar to personal credit cards, business credit cards offer a revolving line of credit 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 a flexible business loan for which you pay interest only on the money you use. It is a valid option for seasonal businesses and short-term financial needs.
• Equipment loan: A business equipment loan is used exclusively for purchasing equipment. The loan term aligns with the desired equipment’s expected life span. Interest rates are based on how well the equipment holds its value and the financial health of your business.
• Invoice factoring: Invoice factoring is a way to get paid faster 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 typically requires little paperwork and provides quick cash. 

• Invoice financing: If you’d rather not use an invoice factoring company, you can get a cash advance using your invoices as collateral.
• Merchant cash advance (MCA): An MCA offers fast cash — but it comes at a price. Borrowing costs can rise more than 300 percent and you must make payments weekly or via daily withdrawals from your credit and debit card sales.
• Microloan: 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.
• Personal loan: If you have minimal 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 (SBA) loan: The SBA guarantees loans, including the popular SBA 7(a) business loans, 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. 
• Term loan: Term loans are a standard loan type with a predetermined length and interest rate. They provide you with a lump sum of funding upfront quickly and often offer a higher amount than other loan types.

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.

After submitting your application, the lender decides whether to lend to your company, how much it will lend and the interest rate it will charge. 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 existed for a long time. Authors and publishers have used it for decades to fund new books via readers who pledge to buy them before they’re released.

Types of crowdfunding

There are four primary types of crowdfunding. All can help a startup or entrepreneur raise money to grow their business:

1. Donation-based crowdfunding: Donation-based crowdfunding is used primarily 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.
2. 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.
3. 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.
4. 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, the business must deliver on promised rewards to prevent distrust among supporters.

How does crowdfunding work?

Crowdfunding can be especially useful for financing a new project or idea. It allows you to validate market interest before sinking money into the project and avoid dreary fundraising work. Here’s how it works: 

• Decide on a crowdfunding type: First, you must decide what kind of crowdfunding you want to pursue. This choice will guide the crowdfunding platform you select. You’ll also have to determine what rewards you’ll give funders, such as equity, a repayable debt or free products.
• Evaluate crowdfunding platforms: Some platforms are more general while others have a narrower focus. For example, Kickstarter, Indiegogo and Fundable are general crowdfunding platforms for startups and new projects. In contrast, Crowd Supply specializes in electronics, Experiment focuses on scientific research and Patreon helps musicians, artists and other creative people establish fan memberships.
• Create a crowdfunding strategy: After choosing a platform and creating an account, you’ll devise a strategy to drive funder interest, which typically will include posting content about your business or project on the platform. As people become funders, you’ll communicate with them to keep them engaged and updated on your progress. You can withdraw and use the money raised minus the platform fee. Most crowdfunding sites take a 3 percent to 5 percent share of the money you raise on their platforms, although some have a monthly fee.

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. 

Bank loan pros

• There’s no delay in using your funding: The cash is yours once you’ve been approved for a bank loan.
• Bank loans can help improve your credit: Making on-time payments can help build your business credit.
• You maintain company ownership: 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.
• Bank loans carry more upfront risk: If you default, you could lose any assets you pledged as collateral. And if you’ve given a personal guarantee, your financial assets are at stake.

Crowdfunding pros

• Crowdfunding lets you test the waters: Since crowdfunding success depends on enticing individual investors or investment groups to rally around your idea, it enables you to 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.

Crowdfunding cons

• Crowdfunding is a lot of work: Crowdfunding requires significant upfront effort, and your campaign may not succeed, meaning your efforts will have been in vain. 
• You’ll need a marketing campaign: To attract pledges, you must create a robust and multifaceted investor marketing strategy. 
• Crowdfunding requires follow-up: You’ll need to keep up on administrative work, such as correspondence and investor communications.

Is a business loan or crowdfunding best for you?

• Business loans: A business loan may be right for you if you have an established business with steady revenue and a good business credit score. Business loans allow you to obtain a larger amount of funding in a lump sum, which can be helpful if you need the money to buy equipment, real estate or inventory.
• Crowdfunding: Crowdfunding may be best for you if you’re a startup, have poor credit or have been unable to get a business loan. Since crowdfunding amounts are typically smaller, this option helps finance prototypes and startup costs. It’s also a great way to test the viability of your idea.

The following chart provides an overview of business loans vs. crowdfunding to help you decide on the best funding option for your venture:   

Alternatives to business loans and crowdfunding

While business loans and crowdfunding can generate cash for your company, some alternatives are worth considering.

• Grants: Business loans and business grants differ significantly because you don’t have to repay grants. By applying for grants, you can access money awarded by federal, state and local governments. However, business grants are competitive and can take longer to receive than loans.
• Venture capital: 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.

Jennifer Dublino contributed to this article.