The success of a small business often comes down to capital – having the funds available to open your doors, pay employees, purchase inventory and equipment, and keep operations running smoothly. For many entrepreneurs, some type of financing is essential in the early days. Understanding the different types of business loans available can help you find the right solution to fuel your venture.
This comprehensive guide examines the most common financing options for small businesses, key factors lenders consider when making decisions, and tips for securing the business funding you need to achieve your goals.
Business Loans
Access to capital is the lifeblood of any business. Without financing, most entrepreneurs struggle to get off the ground, pay for operating expenses, or invest in growth.
Business loans allow companies to bridge the gap between upfront costs and eventual profits. The influx of cashflow gives breathing room to purchase vital equipment, hire talented workers, develop new products or services, market to customers, and scale operations.
With many types of business financing available, it’s important to weigh the pros and cons of each as they relate to your company’s specific needs and stage of development. This guide covers the most popular loan instruments for small business owners and key considerations when applying.
Types of Business Loans
Several loan products cater to startups and small business funding needs across industries. The sections below outline the most common types of financing used by small business owners.
Traditional Bank Loans
Traditional bank loans remain one of the most popular funding sources for small businesses because rates are competitive and banks are easy to find in most locales. Term loans provide a lump sum upfront and allow owners to pay off the balance in installments over time.
SBA Loans
SBA loans are partially guaranteed by the U.S. Small Business Administration and issued by approved lenders. These products help entrepreneurs who may not qualify for traditional financing.
Business Lines of Credit
Business lines of credit (LOC) provide access to revolving credit, similar to a credit card. You can draw against the line as needed up to a set limit.
Equipment Financing
Equipment financing allows businesses to fund necessary purchases with installment payments over time. This specialized financing is secured against the value of the equipment.
Invoice Financing
Invoice financing offers funding against outstanding customer invoices so businesses can bridge gaps in cash flow between providing services and getting paid.
Merchant Cash Advances
A merchant cash advance (MCA) provides an upfront lump sum in exchange for a percentage of future credit card or debit card sales over an agreed timeframe. Payments adjust based on sales volume.
Key Considerations for Business Loans
Many factors influence the loan decision process. Be prepared to provide documents and details related to the items below when applying for business financing.
Credit Score and History
Your personal and business credit scores indicate how reliably you’ve managed debts in the past. Most lenders require good credit to qualify.
Business Plan and Financial Statements
Lenders analyze your business plan to understand your operations, objectives, financial situation, and growth strategies. Historical and projected financial statements allow them to assess business health and repayment abilities.
Collateral
Collateral pledged against a loan provides security for the lender if you default. Not all financing types require collateral, but pledging assets can improve your chances.
Interest Rates and Fees
The interest rate determines how much it costs to borrow money over time. Most loans also incur one-time or recurring fees. Compare total costs across products.
Repayment Terms
Repayment terms dictate loan length (typically 3-10 years), the number of payments, when repayment begins, and whether installments are fixed or variable. These details impact cash flow, so review them closely.
Loan Amount and Purpose
Lenders want assurances that loan proceeds are being used wisely for sound business reasons. Be specific on your loan purpose and tailor the amount to those needs.
Traditional Bank Loans
Traditional term loans extended by banks remain go-to solutions for funding small business growth and expansion.
Explanation
With a traditional bank loan, a business borrows a fixed amount designated for a specific use over a set period of time. Interest accrues on outstanding principal until the loan matures and must be repaid in full.
Borrowers make regular installment payments including both principal and interest elements. The loan term usually ranges from three to ten years. Payments stay the same over the duration or may adjust slightly.
Once approved, the bank deposits the full loan amount upfront so it can be put toward intended business purposes right away. Term loans are one of the simplest and most predictable forms of financing.
Pros
- Competitive interest rates
- Fixed regular payments
- Sum available upfront
- Widely available through banks
Cons
- Strict eligibility and approval criteria
- Risk of default if payments missed
- Collateral often required
- Early repayment penalties may apply
How to Apply
When applying for a small business term loan, come prepared with the following:
- Loan purpose and amount requested
- Business formation documents
- Financial statements and projections
- Business plan and executive summary
- Owner/guarantor personal financial statements
- Personal and business tax returns
- Banking and credit information
Work with a loan officer to submit a strong application positioning your company for approval. Rates vary based on credit, collateral pledged, and market conditions.
Expect the process to take 1-3 months from application to funding.
SBA Loans
Backed by government guarantees, SBA-supported financing widens access to capital for qualifying business owners.
Explanation
The U.S Small Business Administration partners with approved lenders to reduce risk and extend credit to entrepreneurs and small business owners not eligible for conventional bank financing.
SBA loans mandated maximum interest rates and fees to ensure affordability. Required paperwork and eligibility standards also limit who can qualify. But these tradeoffs give more entrepreneurs a path to securing startup or growth funding.
Several distinct SBA loan programs serve unique needs:
- 7(a) Loans – The SBA’s primary product for funding a range of general business purposes.
- 504 Loans – Specialty financing for major fixed assets like real estate or equipment.
- Microloans – Small installment loans up to $50k issued by nonprofit lenders.
- Disaster Loans – Fast emergency aid in the wake of declared disasters.
While the government doesn’t directly finance SBA loans, it guarantees 75-90% of the balance if the borrower defaults. This cushion incentivizes private lenders to extend credit to riskier early-stage businesses.
Pros
- Below-market interest rates
- Long repayment terms up to 25 years
- Funding unlikely through traditional lenders
- No balloon payments
- Low down payments on 504 loans
Cons
- Extensive paperwork to apply
- Strict eligibility and use requirements
- Upfront guarantee fees on some products
- Early repayment penalties
How to Apply
SBA loans involve more upfront work gathering documentation and navigating reviews. But approval brings access to rare, affordable financing:
- Determine eligibility based on industry, location, size standards
- Choose appropriate loan product for your situation
- Find an authorized SBA lender to initiate application
- Submit required business and personal financial records
- Provide detailed use of proceeds plan
- Wait for credit analysis and final decision
With many paperwork requirements and fewer eligible lenders, SBA applications take at least 2-3 months to approve after submitting a full application.
Business Lines of Credit
Revolving credit lines offer built-in flexibility to draw against available funds repeatedly over time.
Explanation
A business line of credit (LOC) functions similarly to a credit card, granting access to an approved credit limit. But unlike credit cards, LOCs typically carry lower interest rates.
Companies can tap credit lines to bridge cash shortfalls and fund a range of needs like making payroll, stocking inventory, or financing a new marketing campaign. There’s no requirement to take the full amount right away.
Interest charges apply only to sums borrowed against the line – not the entire limit. Firms draw against available capacity as needed and make monthly interest-only payments on outstanding balances. Principal repayments aren’t required as long as the total debt stays under the limit.
When debts are repaid, that credit becomes usable again for future needs. Revolving access makes LOCs popular short-term financing options when cash flows fluctuate.
Pros
- Access funds anytime as needed
- Pay interest only on what’s borrowed
- Repeated use over time
- Usually lower rates than credit cards
Cons
- Variable interest rates
- Personal guarantee often required
- Strict eligibility requirements
- Bank can reduce or call line
How to Apply
Securing a business line of credit requires good credit and proven ability to handle recurring payments:
- Choose lender and apply for preapproval
- Submit personal/business tax returns and bank statements
- Provide details on purpose and loan amount needed
- Get valuation of any assets offered as collateral
- Await credit check and final decision
Approval times run 1-3 months. Interest rates and terms vary based on qualifications. Draw immediately or as needed against available capacity.
Equipment Financing
Specialized lending helps businesses upgrade vital assets to sustain operations and growth.
Explanation
Investing in core infrastructure and tools allows companies to work efficiently. But major purchases like machinery, heavy equipment, company vehicles, or information technology systems strain budgets.
Equipment financing bridges this gap through installment loans or leasing arrangements tied specifically to acquiring necessary business assets. The equipment itself serves as collateral for the debt rather than unrelated company assets or owner guarantees.
Structured payments tailored to equipment lifespans allow firms to spread costs over time. Businesses conserve working capital for other operational expenses while still securing the production-enabling assets they need.
Several equipment financing options exist:
- Loans – Lump sum available upfront to purchase equipment outright
- Leases – Use equipment by making monthly installments toward costs
- Refinancing – Pay off existing equipment debt with better rates or terms
Pros
- Finance essential purchases
- Preserve working capital
- Match payments to asset lifespan
- Potential tax advantages
Cons
- Limited to financing equipment purchases
- Carrying ongoing payment obligations
- Lose equipment if default on loan
How to Apply
Follow these key steps when seeking equipment financing:
- Determine assets needed and costs
- Shop lenders and compare loan vs lease options
- Highlight equipment’s business purpose and ROI
- Authorize inspection of current equipment
- Submit loan application with business & personal financial details
- Allow 1-3 months for review and documentation
Provide as much detail as possible to show the equipment’s necessity and value in supporting business growth.
Invoice Financing
When unpaid customer invoices threaten short-term cash flow, financing against outstanding accounts receivable can provide working capital relief.
Explanation
Delivering goods or services to customers doesn’t always immediately translate to getting paid. Inefficient billing cycles can stretch the gap between outlaying operating expenses and eventual payments for months.
Waiting around for checks to arrive can leave businesses strapped for cash even when profitable work is ongoing. Invoice financing accelerates funds tied up in open customer invoices to liberate working capital caught in limbo.
Rather than directly lending money, invoice financing providers purchase a company’s receivables at a discount. The business receives most of the invoice value upfront, less discounted fees and interest charges. The lender later collects the full invoice amount directly from the customer.
Two main types of invoice financing arrangements exist:
- Factoring – Selling receivables outright to a lender at a discount
- Advances – Using unpaid invoices as collateral for a cash advance
Pros
- Access working capital quickly
- Fund growth/expenses while awaiting customer payments
- Offload collections responsibility
Cons
- Pay discount fees to secure funds early
- No control over client payment problems
- Can be costlier than other financing
How to Apply
Follow these steps when leveraging unpaid business invoices:
- Audit accounts receivable aging reports
- Determine typical customer days sales outstanding (DSOs)
- Shop lending partners and compare rates/fees structures
- Submit recent financial statements and customer details
- Select offer and complete paperwork to sell/borrow against invoices
Closing and funding approved deals usually takes less than a week. Companies receive capital rapidly by pledging slow-to-arrive customer funds.
Merchant Cash Advances
An alternative financing option provides quick funds against a percentage of future credit card or debit card sales.
Explanation
Many retail, restaurant, hospitality, and e-commerce companies conduct a high volume of transactions via credit/debit card payments. When short on cash for growth initiatives or operating expenses, these businesses can leverage expected future sales revenue to secure financing immediately through merchant cash advances (MCAs).
With an MCA, financing companies provide an upfront lump sum payment in exchange for a set percentage of daily card receipts over a fixed period – often less than 12 months. There are no fixed repayment amounts or schedules. Instead, borrowers repay automatically as a percentage of each day’s credit/debit transactions until hitting the agreed total, including fees.
Funds usually arrive within a week after approval. Because payments adjust based on sales activity, MCAs can cost significantly more overall than fixed loans if business volumes trend higher than projected. Nonetheless, the flexibility and speed make them attractive short-term financing options.
Pros
- Fast approval and funding timeline
- Payments scale based on card revenues
- Fewer eligibility requirements than loans
- General use of funds without restrictions
Cons
- Very high equivalent APR
- Costlier if sales volumes are higher
- Daily repayment requirements
- Payback via credit/debit percentage
How to Apply
To secure a business cash advance, potential borrowers provide a few key documents and credentials:
- Contact and profile details about the business
- Bank statements showing recent credit/debit activity
- Total credit/debit volume over the last 6-12 months
- Average monthly card receipts
- Desired upfront advance amount to request
Approval decisions often take less than 24 hours with funds arriving within a week of signing agreements. Then, lenders collect fixed percentages of daily future card transactions until hitting the agreed total value (plus added fees) owed back to them.
Credit Score and History
Your past borrowing track record plays a pivotal role in securing affordable future financing.
Importance for Business Loans
Personal and business credit scores serve as barometers of default risk and loan repayment abilities in lenders’ eyes. Those with high scores and established positive histories have reliably managed debts in the past – signaling lower lending risk profiles currently. By contrast, blemished credit histories raise concerns over whether financing might be repaid on time.
Before issuing new credit, most institutional lenders review:
- Personal credit reports from the major consumer bureaus
- Business credit reports from commercial reporting agencies
- Public records covering bankruptcies, tax liens, judgements, collection accounts
A few late payments or financial mistakes can torpedo scores, leading to higher borrowing costs or rejected applications. Maintaining pristine personal and business credit should be priorities for any owner planning to seek future financing.
How to Improve Your Credit
Boost the likelihood of securing affordable business financing by taking measures to improve your credit profile long before applying:
- Pay all personal and business bills early or on time
- Lower credit utilization ratios below 30%
- Correct any reporting errors with bureaus
- Only apply for credit when needed to limit hard inquiries on reports
- Build alternative business credit history apart from consumer scores
Give negative information time to fade from reports. The ability to demonstrate responsible management of obligations builds trust with lenders.
Business Plan and Financial Statements
Loan providers analyze business details and money flows to gauge companies’ stability and growth potential.
Importance for Business Loans
Lenders want to see clearly how borrowed funds will be put to work driving enterprise expansion, boosting profits, and facilitating repayment. A well-crafted business plan tells the story of how you’ll deploy capital investment to improve your company’s trajectory.
Accompanying historical and projected financial statements spotlight past performance and assumptions underlying future results. Collectively, these materials help lenders assess situations thoroughly to reach informed credit decisions.
Key components to provide:
- Executive summary
- Company description
- Products and services
- Market analysis
- Competitive assessment
- Management team bios
- Marketing strategy
- Funding request
On the financial side:
- Income statements
- Balance sheets
- Cash flow statements
- Owner personal financial statements
How to Prepare Your Documents
Follow best practices ensuring your presentation aligns with investor expectations:
Business Plan
- Spotlight what makes your business uniquely poised for success
- Emphasize how you’ll use funding to improve products, operations, or reach
- Cover 1-3 years of strategic plans and milestone targets
- Keep executive summary under 3 pages spotlighting key elements
Financial Statements
- Maintain detailed books tracking all business transactions
- Build statements directly from bookkeeping records
- Provide explanations for revenue/cost assumptions used in projections
- Include notes on timing quirks related to revenue recognition, etc.
- Review drafts to confirm accuracy before sharing externally
Getting your ducks in a row demonstrates preparedness and significantly raises credibility during loan reviews.
Collateral
While unsecured loans exist, most lenders reduce risk by tying loans to pledged business or personal assets.
Explanation
Collateral serves as a form of security creditors can seize and sell off if borrowers default on loan agreements. By pledging specific property against financing, business owners provide last-resort guarantees backing repayment even if cash flows come up short.
Assets like real estate, equipment, licensed vehicles, securities accounts, or personal residences all represent potential collateral used in small business lending. Their equity value limits maximum loan sizes.
If borrowers miss payments or default entirely, lenders can seize collateral, sell it off, and apply the proceeds toward recovering outstanding loan balances. This backstop allows creditors to extend more financing at lower rates compared to unsecured alternative lenders.
Common collateral types include:
- Commercial real estate
- Machinery & equipment
- Accounts receivable
- Licensed vehicles
- Inventory & supplies
- Cash savings accounts
- Personal real estate
- Investments
Pledging business assets isn’t always required, but doing so often results in improved loan terms and more favorable rates.
Valuing Collateral
Creditors only lend up to a percentage of appraised market values for assets offered as backing. Accurately assessing collateral worth requires professional valuations from qualified appraisers.
Expect lenders to validate estimates with independent reviews before finalizing financed amounts. Any liens against properties can reduce eligible borrowing capacity.
Provide extensive details on collateral condition, ownership stakes, and purchase timelines when seeking loans.
Interest Rates and Fees
Carefully weighing borrowing costs ensures affordable cash flow for the duration of any financing agreement.
Explanation
In simplest terms, interest rates equate to the ongoing percentage cost of carrying debt – usually expressed as an annual percentage rate (APR). The rate gets applied to unpaid principal loan balances, so actual interest expenses decline gradually as debts are repaid over time.
Beyond regular charges, most loans also incur one-time or recurring ancillary fees:
- Origination fees when opening new credit
- Application/processing fees to file paperwork
- Prepayment penalties if paying off early
- Annual account maintenance charges
Weighing true all-in costs goes beyond just the headline interest rate. Savvy small business owners compare provisions across prospective lenders to optimize both affordability and flexibility.
Aim for the most competitive borrowing expenses feasible given your situation. Reducing rates even by a few percentage points generates substantial savings over multi-year loans.
How to Compare Options
Follow these best practices when evaluating and comparing business loan offers:
- Clarify rates tied to prime vs fixed benchmarks
- Standardize comparisons using APR estimates
- Calculate overall costs including one-time & recurring fees
- Review terms governing prepayment options
- Assess rate variability and adjustment triggers
- Discuss temporarily discounted promotional pricing
- Verify no hidden fees or surprise charges beyond agreed estimates
The lowest rates require meeting strict eligibility standards and ideal financial credentials. But shopping across several providers can help find the most suitable terms at competitive costs.
Repayment Terms
Loan conditions significantly impact cash flow. Understand all details before committing.
Explanation
Beyond headline interest rates, the fine print governing required repayments constitutes critical considerations when selecting financing.
Key elements defining repayment terms include:
- Loan duration length
- Fixed vs variable installments
- Grace periods before payments begin
- Frequency of payment schedules
- Balloon payment requirements
- Allowances for early repayment
Weighing options like 5-year amortizations with even installments offers predictable planning versus variable instruments tied to revenue flows. Consider both upfront flexibility in borrowing as well as ongoing implications for reliable cash flow management.
Craft terms aligning with realistic business growth projections and capacity to take on recurring financial obligations – not just momentary needs for capital.
Loan Duration and Amortization Schedules
Amortization refers to the process of incrementally paying off debts through installments over time. Loan duration sets the overall length of scheduled principal and interest payments until balances reach zero. Consider aligning terms with functional lifespans of assets purchased.
Typical small business loan durations fall between:
- Short-Term = Less than 12 months
- Intermediate = 1-5 years
- Long-Term = Greater than 5 years
Amortization structures include:
- Straight-Line Payment = Equal installments
- Variable/Seasonal = Fluctuating periodic amounts
- Interest-Only = Pay interest first, principal later
- Balloon Payment = Large fixed principal payment due at end
Weigh cash flow consistency needs against revenue seasonality patterns when assessing options.
Loan Amount and Purpose
Tailoring financing specifics directly to near-term business plans ensures money gets used effectively.
Explanation
Rather than maxing out lending capacity based on approved thresholds, smart business owners specifically align loan purpose and amount to immediate capital needs. Consider targeting injections to bridge the gap to next growth phases – not long-term financing for all possibilities.
Clearly convey explicit plans for investing proceeds if approved:
- Expanding current facilities
- Opening secondary locations
- Developing new products/services
- Marketing to new customer segments
- Hiring key team members
- Implementing productivity infrastructure
Demonstrating prudent financial stewardship improves the chances lenders will approve reasonable requests aligned to strategic roadmaps.
How Much to Borrow
Consider balancing loan amounts between minimum funding required to fuel growth plans and maximums based on realistic repayment capacities.
Assess if it makes sense to pay some expenses from existing cash reserves first before taking on debts. And always build cushions to cover unforeseen disruptions to sales.
Run loan amount scenarios projecting cash flows and risks if revenue slows. No entrepreneur can perfectly predict the future. Stress testing assumptions at different funding levels builds fiscal prudence.
Conclusion
Access to capital empowers entrepreneurs to turn ambitions into reality. Understanding available funding options positions small business owners to pursue strategic growth securely backed by financial resources.
This guide examined popular instruments like traditional loans, SBA products, lines of credit, equipment financing, invoice factoring, and merchant cash advances. We also covered best practices for managing personal credit, calculating costs, aligning terms to business cycles, and defining loan purpose and amounts.
While securing financing brings pressing responsibilities, the fuel obtained from borrowing allows visionaries to reach heights otherwise unattainable bootstrapping alone. Do the legwork upfront to find the right solutions at affordable rates for your enterprise. Then get ready to execute on the plans and strategies that motivated you to launch out on your own in the first place.
