The Entrepreneur’s Guide to Small Business Finance – Part 1
Most small business financing advice falls into two schools of thought.
One encourages you to bootstrap your business: put your head down, unload your personal savings, invest all the cash from your first sales, and with a bit of hard work, you’ll make it.
The other school is more traditional: go to a big bank, sign your house away, and if you have a good credit history, you’ll get a nice loan with a hefty interest rate.
Both strategies are reasonable, but there are other ways small business funding works.
In this article, we’ll discuss business loans and financial management. First, we’ll talk about your funding options. Then, we’ll look at how to manage small business finances once you’ve got money in the bank. If you’re here for small business finance basics, see our section on how to manage your finances.
Understanding small business loans and funding options
Funding is one of the first things to think about when it comes to your business. It’s also the most important financial choice you’ll make in your journey. How you fund your business can impact how you run it.
Types of small business financing options
Let’s look at a few common ways to fund a business:
- Term loans
- Merchant cash advances
- Equipment financing
- Lines of credit
- SBA loans
Term loans
A term loan is a bank loan for a specific amount that is repaid at regular intervals over a set period of time. Term loans are set at either a fixed or a floating interest rate. These loans may require a big down payment to lower the loan payments and total loan costs.
Established small businesses, typically with two years in operation, opt for term loans. They use term loans to buy assets (such as equipment) or growth investments, versus using them to cover day-to-day expenses.
Terms loans have a few things that set them apart from other financing options:
- Lower interest rates
- Fund usage flexibility
- Predictable payment schedule
They also come in three different loan options, each serving a different purpose for your business:
- Short term (repaid within a year). Businesses choose these loans over merchant cash advances because they have lower interest rates and are easier to get. You could use a short-term loan to purchase inventory for the holidays, take advantage of an inventory deal, or cover payroll if you are experiencing a lack of funds.
- Intermediate term (repaid between one and five years). These loans are good for larger scale projects, like equipment purchases, or refinancing old business debt. You’ll want to use these loans for projects that may take a few months or years to earn a return on your investment.
- Long term (repaid between six and 20 years). Long-term loans are geared toward growth opportunities, like a new building or heavy equipment purchase for manufacturing. They’re supported by your company’s collateral or existing assets. These loans usually come with strict rules as to what you can and cannot do with the money.
Merchant cash advances
A merchant cash advance is a lump sum of money that you can receive for a fixed fee. In this model, the funder buys a percentage of your future sales, then collects a percentage of sales each day by holding back a portion of your credit or debit card sales. Because sales can be high some days and low on others, there is no set term length.
Equipment financing
At some point in your business, you’ll need to buy, upgrade, or replace different pieces of equipment. This is where equipment loans come in.
Equipment financing is a type of small business loan designed to help you buy equipment for your business. These loans cover any number of things, including office furniture, commercial ovens, medical equipment, computers, heavy-duty manufacturing equipment, and more.
Each lender will have different terms. But in general, you can finance around 80% of the total purchase price of an item. A down payment of 20% is usually required for a small business equipment loan. You own the equipment from day one.
Lines of credit
Adapting to change is a regular part of owning a small business. Sometimes, if there’s a growth opportunity you want to take, you may need cash fast, with flexible monthly payment terms. An unsecured line of credit can be a solution.
Think of a small business line of credit as a credit card more than a loan. It offers you access to money you can use to meet any business need that comes up. There’s no lump sum (meaning, you receive all the cash at once) disbursement made when you open the line of credit.
Similar to a credit card, once you take cash from your line of credit, interest begins to accrue. The amount you can spend depends on the available credit you have left. As you repay the drawn funds, your credit increases. Lenders will set a limit on the amount you can borrow.
SBA loans
The Small Business Association (SBA) partners with lenders to give loans to small business owners. The SBA doesn’t lend money directly to the borrower. It sets the guidelines for loans made by its partners. The SBA helps small business owners who struggle to get approved for other loan programs.
For example, if a bank thinks your business is too risky to lend money to because you have bad credit, the SBA can guarantee the loan. The bank then has less risk and is more willing to provide the business loan. SBA loans can be used for most business needs and vary in amount. Some programs have limitations and requirements to qualify.
Interested in getting an SBA loan? Learn more about the eligibility requirements on the US Small Business Administration website.