Small-Business Financing: What Are Your Options?

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You know what they say: It takes money to make money. All small businesses need some sort of capital, and unless you're independently wealthy, you're probably going to need small-business financing. There are a lot of small-business financing options, but some are more costly than others. From credit cards and bank loans to venture-capitalist funding, you need to go over all your options before you can decide which works best for your business.

Choosing Small-Business Financing

With all the financing options, it can feel overwhelming when trying to pick the right one for your small business. There’s no one-size-fits-all solution, but to narrow it down, you can ask yourself the following questions:

  • How much financing do I need? If you’re a new business, you need to estimate your startup costs to determine how much funding you need. This is a crucial stage because not all funding is created equal. Some small-business owners need millions, while others just need a few grand.

  • Why do I need financing? Are you expanding your business, starting your business or having trouble paying your existing financial obligations? This is a great place to start because most companies don’t need to take out a bank loan to pay off a debt. Sometimes, turning toward a credit card or family member may be the simplest option.

  • How quickly do I need financing? Some options take much, much longer than others.

  • What are my risks? The amount of risks your small business has will affect your ability to get a traditional loan and your interest rates. This includes thinking about the state of your industry. Investors may not want to buy into an industry that’s in a downturn.

  • How far along is business development? Funding is more crucial and costly during transitional phases of your business, like startup and expansion.

  • Does the financing I need go with my business plan? Without a solid business plan, any sort of business-financing options you use could easily be squandered. Make sure you have a solid business plan in place that dictates exactly how your funding will be used so you can make the most out of your money.

  • What is my credit history and collateral? Your personal credit score and the amount of collateral you can offer deeply affects interest rates and whether or not your small business qualifies for a loan at all.

Debt Financing vs. Equity Financing

Though all types of loans have their own repayment terms, financing is usually split into two types: debt financing and equity financing. With debt financing, you’re borrowing money that will be paid back over time, typically with interest. This includes things like bank loans and small-business loans from state and local government programs. The benefit of debt financing is that no one else owns part of your company, but you also need to pay interest and pay back your loan in whatever length of time is outlined in the repayment terms.

Equity financing means you’re raising money in exchange for an ownership share of the business. This type of funding is great because you don’t incur any debt, and you don’t have to repay money within a specific amount of time. However, you’re giving up a share of your company, which can shape your overall end game. Sources of equity financing include friends, employees, relatives, angel investors and venture capitalists.

Long-Term vs. Short-Term Financing

If you’re going the route of debt financing, you have two options: short-term financing and long-term financing. Short-term financing typically lasts less than a year. This includes things like overdraft, a letter of credit or a short-term loan, and it’s a good way to get cash quickly. Unfortunately, it’s not the most economic because short-term financing has high interest rates.

Long-term financing is really your best bet if you have long-term capital investment needs. The term period for this type of financing generally lasts more than a year, and you pay it back periodically. You can typically get more money through long-term financing options — like long-term loans and leasing — than you can with short-term financing, but you may pay more overall in interest because it’s accruing over a greater period of time.

Credit Cards

Small-business owners may wish to open a business line of credit or more personal lines of credit to give themselves some immediate working capital to buy things like equipment and furniture. Unfortunately, you can’t do things like buying real estate or paying certain debts on a credit card, and if you could, it still wouldn’t be the most financially savvy move.

It’s pretty easy to spiral into credit card debt, even if you’re using a business credit card, so be aware of paying off your bill each month. Plus, the more responsible you are with paying it off, the better your credit score and the more likely you’ll be to qualify for a traditional bank loan with a good interest rate.

General Small-Business Loans

The U.S. Small Business Administration has a variety of loan programs, but one of the most popular is the General Small Business Loan Program. The maximum loan amount is $5 million, and you can repay it in seven to 25 years. This is a great option for setting up a new business, expanding an existing business or providing much-needed working capital. You can also negotiate the repayment terms, interest rates and percentage of guarantee with the SBA-approved lender from whom you borrow.

Businesses that are at least 51% owned by socially and economically disadvantaged individuals can also take part in the SBA’s Business Development Program, which is good for up to $4 million for goods and services and $6.5 million for manufacturing. You can apply for either program through the SBA website.

Traditional Bank Loans

If you strike out with the SBA, you may want to consider a traditional bank loan. Sometimes, these are more favorable to people with great credit scores, and those with poor credit get relegated to the “no” pile. However, interest rates tend to be on the lower side compared to other financing options if you’re approved. Repayment terms are generally on the longer side.

To apply for a business loan at a traditional bank, you’re probably going to need to meet the lender in person. Have your business plan handy.

Obtaining Microloans

Microloans are loans of less than $50,000 that help a small business with startup or expansion costs. You can use this cash for working capital, inventory, furniture or equipment financing, but you can’t use it to pay existing debt or to purchase real estate.

To get a microloan, apply through the SBA Microloan Program or another organization like Accion USA or Kiva. Lenders are usually nonprofit community-based organizations, and the maximum repayment term is six years with an interest rate between 8% and 13%.

Community Development Finance Institutions

Nonprofit community development finance institutions generally provide capital to small businesses with reasonable terms. There are thousands of these types of lenders across the country, and it’s a pretty solid alternative financing option for someone who doesn’t qualify for traditional bank loans.

CDFIs don’t look at credit scores in the same way as traditional lenders. For example, they examine the reason behind an unfavorable credit score, like family medical issues or job loss, and they don’t require as much collateral as a bank.

Venture Capitalists

Venture capitalists pretty much run Silicon Valley. These types of investors use equity funding and generally exchange cash for shares of a company. As a result, they help shape the company’s trajectory and may even hold a spot on the board of directors. The terms and percentages are highly negotiable and are generally based on a company’s valuation.

Venture capitalists usually only work with businesses that have a high growth potential, such as trendy tech startups or groundbreaking innovations within a chosen industry. In other words, you probably won’t see a venture capitalist inject money into a hair salon or HVAC business, but when venture capitalists do invest, they can provide millions as well as crucial mentorship.

Angel Investors

Angel investors are like venture capitalists except they’re individuals instead of companies. It could be a wealthy person with knowledge of your industry (like the sharks on "Shark Tank"), or it can be family and friends. This person generally gets equity or royalties with the investment, and the terms are negotiated based on the company’s current valuation.

Partner Financing

Partner financing is another form of equity financing. With this, you find a strategic partner within your industry who can help your business grow in exchange for things like products, staff, distribution rights and more. It’s like venture capital except you’re working with a company in your industry rather than a company that solely lends.

To make the most out of partner financing, the larger company should have customers who are already in your demographic, and you should be able to hit the ground running with their resources.

Invoice Financing

Most small businesses have been in the difficult position where they have plenty of contracts, but they’re waiting for customer money to come in. Invoice financing (or invoice factoring/invoice advances) front this money as you wait for your customers to pay their outstanding invoices. This is a direct-cash injection, and a number of companies provide this service. Be sure to shop around for the best rates.

Crowdfunding Platforms

Instead of turning toward financial institutions for small-business financing, you may wish to turn directly toward your customers through crowdfunding. Platforms like Kickstarter and Indiegogo allow entrepreneurs to raise small investments, typically a few thousand dollars, directly from consumers. Many businesses use crowdfunding as a preorder for goods that they have yet to manufacture because it helps front the manufacturing costs.

Keep in mind that there are various processing and postage fees that eat into the profits, so choose your crowdfunding platform wisely. This is not simple fundraising, as most crowdfunding isn't just asking for donations. Consumers typically receive something for their efforts, and in a small number of cases, they may even receive equity.

Small-Business Grants

The SBA offers a number of grants to small businesses through its Small Business Innovation Research Program and Small Business Technology Transfer Program. Other sources of grants include various nonprofits and government organizations; however, they mostly all require a lengthy application process and only give money to nonprofits or educational organizations. Your business must align with the overall mission of the organization providing the grant, and you may have to meet federal research and development goals.

If you qualify, the time and effort it takes is worth the reward. You don’t have to pay back grant money. It’s essentially free money.

Merchant Cash Advances

Merchant cash advances are a quick way to get a lump sum of working capital, but they should only be used as a last resort because they’re extremely expensive. With this type of advance, a financial company will give you money in exchange for some of your credit or debit card sales.

This means each time you process a transaction, the company will take a percentage of the sale until you pay back the advance. Only use this type of financing if you don’t qualify for a small-business loan and cannot get funding any other way.

Reverse Mortgages and Home-Equity Loans

If you’re over the age of 62, you can get a reverse mortgage. Essentially, this means you are converting equity in your house directly into cash. You only need to pay this type of loan back if you move or die. Home equity loans are similar but don’t have any specific age requirements. You’ll need to make regular loan payments on this type of financing option.

Convertible Debt

Convertible debt is a great financing option for a startup because it’s flexible. Basically, the premise is that this type of debt starts out as traditional debt funding — like a loan with a standard repayment plan — but can be converted into equity in the future. You’ll have to ultimately give up some control of your business when it converts into equity, but you won’t end up drowning in interest payments.