While a micro-business made up of one or two people performing a service might survive indefinitely on its own cash flow, many small businesses require financing to get off the ground, grow to the next level or recover from a downturn event. A borrower with great credit has far more options, whether applying for business credit cards or other types of loans. A business with an established credit file will find the most loan options and the best rates.
Second in line is the business owner who has excellent personal credit and is willing to put it on the line for the sake of the business. Next comes a business owner who can borrow against collateral. The person with just a dream and a business plan stands at the end of the line. That’s not to say that options don’t exist. Quite the contrary.
Although big banks only approve about one-fifth of traditional loan applications (small banks approve about half), alternative sources of funding have exploded in the financial marketplace in response to the needs of small businesses. A wide variety of financing options are now available. Admittedly, the terms presented by some are less than favorable.
Traditional Business Loan
A loan made for business use, typically by a bank and based on the creditworthiness of the business or its owner. This is where the best rates are most often to be found for those who qualify. Sub-categories of traditional loans include equipment loans, similar to consumer auto loans, and commercial real estate loans or lines of credit, similar to home mortgages or HELOCs. The former uses the equipment for collateral and the funds generally can’t be used for anything but the equipment in question. The latter requires good credit and is best suited for owner-occupied commercial business locations.
Available from banks and other lenders, a loan secured with collateral rather than on the good credit of the borrower. Collateral takes many forms, including accounts receivable (also called factoring), equipment and purchase orders.
Purchase Order Financing
An investor funds the manufacture of a company’s actual order from an existing customer. The investor gets a cut of the profits from the sale once the order is delivered.
The Small Business Association offers several loan programs that tend to be more flexible than traditional bank loans. The most popular is the 7(a) small business loan. Borrowers must meet eligibility requirements and present a very organized, professional application that includes a formal business plan and financial statements. Help is available to those who need it.
In the U.S., the Small Business Association provides microloans up to $50,000 (averaging $13,000) to businesses that need working capital, inventory or supplies, furniture or fixtures, or machinery or equipment. These loans are subject to lending and credit requirements, and may require collateral or a personal guarantee.
Midprime Alternative Lenders
A loan from a non-bank alternative lender, like Dealstruck, Fundation and Funding Circle. These loans tend to be reasonable in both terms and payback period. Each company offers a range of loan products. Dealstruck’s interest rates range from 8 to 24%, and the repayment period is up to three years.
Borrowers present basic information about themselves and the need for the loan, often through a company like Lending Club or Prosper. Investors fund small portions of the loans they choose. Once enough investors collectively pitch in the predetermined minimum amount on a loan, it is funded. Borrower rates vary but tend to be lower than credit cards. Investors and borrowers can log on to view loan requests and very transparent terms and conditions.
As the name implies, the business person asks a crowd of people to pitch in to fund the venture. Crowdfunding can be accomplished by any means, including via websites like Indiegogo, GoFundMe and Kickstarter. Investors usually receive no portion of the profit, but may receive a special thank you gift in proportion to the size of the donation.
Merchant Cash Advance
A cash advance from a non-bank lender in exchange for a percentage of future credit card sales. No fixed payments are required. One advantage is that in slower sales times the payment amount is lower. Depending on the length of repayment, effective annual interest rates often reach 75% or higher. (Larry King recently became the spokesperson for one company whose APR is upwards of 100%.)
ACH, or automated clearing house, loans are based on funds the business has available in the bank rather than on credit card sales. The lender might take a fixed percentage of the business’s sales or a fixed amount from the business’s bank account balance every day until the loan is paid. Rates generally fall between 10 and 40% per month.
Although a new business is not likely to qualify for credit cards on its own, the owner may be willing to finance it with personal business credit cards. Check out our pick’s for the Best Credit and Charge Cards for Small Businesses and Startups for 2015.
Friends And Family
Armed with a great idea and a solid business plan, many a successful entrepreneur got started on money invested by friends and family. The money may be given freely, as a loan or in return for a percentage of ownership.
Pitfalls And Warnings
Due diligence is the responsibility of the borrower. Perform thorough research and understand the details of all the financial products under consideration. Business-to-business transactions are not subject to consumer protection laws like the Electronic Funds Transfer Act, the Truth in Lending Act or the Fair Debt Collection Practices Act, although business owners may still file complaints with the FTC when things go sour. Non-traditional financing can be very expensive. Look for upfront fees, high interest rates (that can look low on a short term loan), broker fees and commissions.
On a merchant cash advance, understand the buy rate, which works very differently from APR because (1) the buy rate is added to the principal at the beginning of the loan, and (2) the repayment period can be much shorter, raising the APR.
Match the loan terms to your business. A 6-month repayment period might be fine for someone who needs funds now to purchase inventory and supplies for the selling season that starts next month. But a business that borrows for expansion might need two or three years to repay the loan.
Avoid any deal that is confusing or lacking in clarity. If the terms are difficult to understand or missing key information, you cannot intelligently evaluate the offer. Be wary of any lender or broker who uses excessive jargon or industry slang that you don’t understand.
Anyone considering a merchant cash advance should vet lenders through the North American Merchant Advance Association. (Larry King’s company is not on their list.) Also be sure you are dealing directly with the provider, not a broker (provider details are on the contract but may not be on the application). Cash advances are not subject to lending laws because they are not actually loans, but rather sales of future income.
Free help is out there for people with legitimate business funding needs: