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As a small business owner, you are well aware that it takes money to earn money. However, where do the funds you need to either get going or to keep your cash flow positive come from? In this article, we will cover the financing options available to you as a small business owner.
- Traditional Financing Options
- Alternative Options for Funding
- Further Resources
Traditional Financing Options
The options we have listed under traditional financing options are those you would typically think of when it comes to funding businesses: bank loans, government programs design to spur growth in a certain economic area, or grants to help businesses meet an unmet need.
To get a small business loan, you will need to meet minimum criteria related to credit scores, annual revenue, and the number of years in business.
- Many banks offer small business loans, and they are usually term loans. Term loans are those that get you a lump sum that is immediately available. You then repay this loan over a fixed amount of time using a set payment schedule. Each payment that you send to the bank includes interest that you owe on the loan.
- Banks also offer what they call business lines of credit. Such credit lines offer less like a loan and more like a credit card. You get a pool of funds, and these funds are there for you whenever you need the capital. You can use the funds or not, and you are charged interest only on the amount that you draw from your line of credit. When you have repaid what you spent, your line of credit gets “refilled” to its original amount.
- Lesser known are equipment loans, which are like term loans that cover 80% to 100% of the cost of your new equipment.
The Pros and Cons of Bank Loans
Let’s start with the bad news: bank loans are one of the hardest financing products to qualify for — 80% of small business owners are denied a loan. However, a study by Harvard Business School indicates that 48% of small business owners fund their companies via commercial bank loans and 34% do so via regional or community bank loans, so it is not as if absolutely no one is getting a loan.
Now, what is the upside? Bank loans are the best loan option available if you can qualify for one since they cost so little. The average APR for a small business loan from a major national bank ranges from 2.24% to 4.77% average APR on a business loan, with rates from small regional banks only slightly higher at 2.86% to 5.43%. If you get a bank loan, you pretty much know that you are getting some of the cheapest financing available to you. If you get one from a local bank, you might also be getting a better experience working with the bank, since they tend to be more personable and easy to work with.
If you are getting an equipment loan, you might have an easier time qualifying. This is primarily because the equipment that you are purchasing acts as collateral for your loan.
Though bank loans may be the most cost-effective option, they are not an option for a lot of small business owners due to their stringent lending requirements. To help minimize the gap between those who would like financing and the private parties who are offering fewer loans than demanded by the market, the government offers programs that grant financial support to select small businesses.
As part of these programs, banks and other lending institutions provide loans to small business owners. These loans are guaranteed by the government, which makes such lending less risky from the perspective of the bank.
Finding a Government-Backed Loan
- If you run a rural business, you can apply for a loan backed by the U.S. Department of Agriculture’s Rural Development program
- GovLoans allows you to search for loans by type
- The U.S. Department of the Treasury has a map of lending institutions participating in the Small Business Lending Fund program
- The U.S. Small Business Administration offers a variety of loan programs, including those for general small business, disaster recovery, and real estate and equipment
- USA.gov offers a searchable database of state- or territory-specific resources for financing your business.
Currently, the government does not offer any financial grants for the following purposes:
- Starting a business
- Paying off debt
- Covering operational expenses.
However, as always, there are exceptions, such those made for as businesses engaged in things like scientific and medical research and conservation efforts. One such program is the Small Business Innovation Research (SBIR) program, administered by the Small Business Administration.
Because grants are essentially free money, they are hard to find and difficult to get due to the sheer number of competitors for each grant. Furthermore, most grants come with stringent guidelines on what and how you can spend the grant money. However, grants are still a great source of funding if you can obtain them, so if you would like to pursue this path, here are some places you might look:
- Our list of small business grants
- Grants for Veteran businesses
- This list of small business associations, many which offer grants
The Small Business Administration runs the Small Business Investment Capital (SBIC) program, which partners with private equity fund managers and provides these managers access to low-cost, government-guaranteed capital to make investments in U.S. small businesses. The SBA does not provide capital directly to small businesses, but you, as a small business owner, can partner with private investors for business-related funding.
Alternative Options for Funding
The internet is disrupting many industries, and banking is no exception. In addition to the traditional methods of financing a small business we mentioned above, there are many newer options (most based on the digital economy) available to you.
There are online lenders offering loans, or loan products, similar to those you would find offered by a traditional banking institution, such as term loans or lines of credit. There are a few major differences, however:
- Small business loans and lines of credit from traditional banks are hard to get, but if you are able to qualify for one, you are generally getting a well-priced loan. Online lenders, however, are easier to apply for, take less time to be funded, and have less stringent requirements regarding things like your credit score, amount of time in business, and annual revenue.
- The catch is higher interest rates — generally speaking. The average annual interest rate for a loan by an online (or other alternatives) lender is 5.49% – 66.57%. The spread in average rates varies enormously, but even at the low end, you can expect to pay more for your loan than if you’d gotten approved even at a community or regional bank.
You can generally assume that the laxer the requirements for loan approval (especially for those on a very short-term loan), the higher your interest rate will be. However, if you face cash flow issues, which is actually one of the most common problems faced by small businesses, a loan at a high-interest rate might be a better option than shutting your doors.
Microloans are small loans, typically around $5,000 to $10,000, that are offered at a low-interest rate. These are usually geared toward businesses looking to get off the ground or newer businesses whose survival past the precarious initial days are dependent on access to capital. Microloans, when launched in the mid-2000s, typically focused on under-represented or disadvantaged groups, such as women-owned or minority-owned businesses or those established in developing countries.
Because the groups targeted by microloans typically have poor (or no) credit history — or lack access to collateral needing to back a loan — microloans serve a population that has historically been ignored by banks.
One new method of lending is peer-to-peer (P2P) lending, where you eliminate the middleman (the bank) and borrow funds from other people. In this model, there is a banking platform or online service of some type that facilitates the matching process between you and those who want to fund you, via an auction or similar.
The upside with these loans is that, by eliminating the bank in the middle, those loaning their money can earn a greater return on their investment, making people more likely to loan.
Keep in mind that those who offer such loans tend to be on the risk-averse side, so if you have a weaker credit history, this might not be an option for you. However, if you are not a candidate for a small business loan from a bank, you might still give this option a shot.
Crowdfunding is the act of raising capital from your peers (or a general group of people on the internet). There are basically four methods of crowdfunding:
- Debt-based: this is essentially P2P lending
- Charity-based: you receive money from your investors, and they are promised nothing in return (though you may send a token of thanks at a later point in time)
- Rewards-based: you “pay back” investors with something other than the money they have invested in your business, such as a product or subscription (a lot of projects backed on Kickstarter fall under this model, especially those where you invest in the future production of a physical good)
- Equity-based: your investors receive a share of your company in return for their money.
There are many platforms for facilitating crowdfunding, and depending on the option you choose, you may have to pay a portion of the funds you raise to the platform you use.
Personal Options (Re-purposed)
If you can’t get a small business loan from a bank, consider getting a personal loan and using the funds for business-related expenses. Your eligibility (as well as the interest rate your receive) for such loans are dependent on your personal credit history, and you can expect to receive a loan amount smaller than what you would get for a specific small business loan — they typically get you at least $1000 (although such small loans are rare) and do not exceed $50,000.
If you need a smaller amount (such as $10,000 or less), you might consider using a personal credit card for your business’ expenses. While the interest rates on your purchases are significantly higher than what you’d see with a personal or small business loan, this is certainly an option if you’re in a pinch and you need to stay cash flow positive.
Invoice factoring is the practice of selling your invoices, at a discount, to factoring companies in exchange for cash up-front. The factoring company, in addition to the gains it gets when the invoices are paid, will hold a reserve of 5% – 30% of the value of the invoices to guard against risk. Any fees (called the discount rate) for factoring, chargebacks from credit cards, or refunds, will come out of this reserve. If you’re a B2B business, you might consider invoice factoring to maintain consistent cash flow.
Obviously, for this option to be viable, you must regularly be working with outstanding invoices. However, if that’s the case, you might be able to source funding, even if you have bad credit. This is because factoring companies are more concerned with your customer’s ability to pay their invoices than your ability to meet your obligations.
Invoice financing is a closely-related alternative to invoice factoring. However, rather than selling off your invoices, you get financing that pays you for your outstanding invoices right away in exchange for some predetermined fee. You’re essentially using your invoices to secure a line of credit.
One alternative to bootstrapping (which is where you fund your business based on incoming revenue streams so that you don’t actually receive infusions of cash from any third-parties) is to use programs like PayPal’s Working Capital, which allows you to repay your loans using a share of your sales (you determine the size of the share) as payments.
The biggest upside to this program is that approval is not dependent on your creditworthiness — it is determined based on your sales history.
Social finance is an option where the lender considers itself to be one that impacts the community in which it is located positively. In addition to effecting change by offering capital to businesses, social finance company strives to improve their communities in some ways — these practices are sometimes referred to as venture philanthropy.
If you have a business that occupies a unique segment of the economy, you might just be a fit for social financing (though more traditional businesses can and do receive loans and such from such companies).
Merchant Cash Advances
You can think of merchant cash advances as the business equivalent of payday loans. The upside to these loans is that you can get the cash you need on very short notice. The downside is that you’ll probably be charged a very high rate of interest and have a short period of time before your loan is due to be repaid.
However, if you’re in a bind and you need a bit of cash to keep you going for a short period of time, this merchant cash advances are certainly an option.
- Learn all the basics in our Definitive Guide to Small Business Financing.
- Browse our list of Popular Small Business Loan Providers.
- If you are a young business owner, check out The Young Entrepreneurs’ Guide to Starting & Growing a Successful Business.
- If you are a veteran, check out our list of Best Small Business Loans for Veterans.
- Check out our guide on Small Business Credit Cards
- If you are a woman who owns a small business, check out our page for Resources For Women-Owned Small Businesses.
- If you have a poor (or nonexistent) credit history, see the SBA’s disclosure of requirements for eligibility where startups may be entited to a small business loan with bad credit.
As a small business owner, you’ll need a steady influx of capital to keep your business going, but raising said capital isn’t the easiest thing to do, especially when you have so many other things you need to do to keep your business going. This article covered many of the options available to you, so hopefully, you’ll be more confident in finding the necessary financial resources for your business.