Sooner or later most small businesses find they need financing for one reason or another. This means, as a small business owner, you should know your options.
Small Business Financing Options
There are many different avenues you can take toward financing:
- Loans from friends and family
- Credit cards
- Government Loans
- Alternative or online loans
- Conventional business loans
- Lines of credit or working capital loans
- Equipment loans
While all of these are possible choices, the first four are the main financing options that can be obtained without using a traditional bank loan.
Loans from Friends and Family
A popular avenue for obtaining funds is to get a loan from your family and close friends who may want to invest in your new venture. This is a common choice since only 39 percent of small businesses are approved for traditional bank loans, leaving advances from loved ones as the main way that small business owners are able to finance. Before accepting loans from friends and family consider the pros and cons.
Low Interest Rates
Because of the risk involved with starting a new business, most financial institutions will charge a higher interest rate for business owners to access the funds they need. This is one of the benefits of borrowing money from friends and family; they can offer a lower interest rate than a conventional bank. This option allows you to re-invest more money into your business and give it a chance to succeed.
According to a study by U.S. Bank, more than 80 percent of small businesses that fail do so because of cash-flow issues. Not only does cash flow take into account money coming in and going out, but it also requires an understanding of timing. The amount of debt a business has is also a huge factor in cash flow, which helps make the case for accepting loans from friends and family. Loved ones are often more open to delaying a payment by a few days without charging you a late fee, something a traditional bank won’t allow.
Another great advantage to getting loans from friends and family is that your loved ones will not assess your credit score like a bank will. You won’t have to jump through the same financial hoops to be approved for funding. Your loved ones want to help achieve your goals and see your business succeed, thus they will often lend you money in cases when banks have denied you.
One of the main problems with accepting loans from friends and family is that mixing money with loved ones can be the cause of stress around the dinner table. You may be unknowingly opening up your personal finances to the scrutiny of your loved ones as they judge your spending habits. A conventional financial institution does not have an emotional stake in your company, but your friends and family will and they may use this to question your decisions.
Going outside of a financial intuition for business funding can complicate your tax situation. If not properly handled, accepting a loan from friends and family may be classified as a gift for tax purposes, versus being categorized as an investment. To protect everyone’s interest it’s important to follow the same procedure that traditional banks and credit unions take when setting up a business loan of any kind.
In addition to tax issues that may occur with a “friends and family” loan, there may be confusion around the clarity of the investment. Your loved ones may assume they have more rights to interject their opinion about how the funds should be spent or how the daily operations should function. To avoid further lack of clarity, work with a business attorney to write up the legal paperwork that outlines the terms and conditions of the loan.
Credit cards tend to have a bad reputation as a means to finance a business, but they can do a lot of good when used responsibly. Before determining whether you should use credit cards to help fund your business, consider the pros and cons.
In many cases, larger banks such as Capital One and Bank of America will opt to give small business owners large lines of credit with a credit card, versus a business loan. This makes the case that credit cards offer a better chance of getting approved for funding so you can expand and grow your business. In short, credit cards usually offer higher approval rates for small business owners compared to other funding options.
In the event your business is brand new and doesn’t have a credit history of its own, you can use your personal credit score to obtain a credit card to use for business purposes. Most financial institutions don’t make a distinction between the business and the business owner, so this gives you the chance to further build your personal credit while establishing a credit history for your business.
An excellent advantage to using credit cards to fund your business is the freedom to purchase equipment, inventory and office supplies as needed. There are no limitations in terms of how you must use the line of credit, making credit cards an easy vehicle for purchasing inventory, balancing out the slow and busy seasons, as well as investing in much-needed equipment.
High Interest Rates
According to information from the Federal Reserve, current business credit card interest rates sit around 15.37 percent on average. This is nearly three times the interest rate you’ll pay with an SBA loan. Because of this, using a credit card to pay for large purchases that can not be paid off within the 30-day grace period make it an exorbitantly expensive loan.
When applying for a credit card, most financial institutions will issue cards under both the business owner and company names. This can put your personal credit history at risk since you and the business are commingling credit. If your business credit card is paid late it can have a negative effect on your personal credit. Likewise, carrying too high of a credit card balance can cause your personal credit score to drop.
When not managed successfully, there’s a high chance of going into major debt when using credit cards to launch a business. The cost of credit card debt, and the interest associated with it, can eat away at a company’s profits. There are strategies to help business owners manage credit wisely. The smart thing is to keep spending to a minimum and pay down your balance in full.
Two types of rates associated with credit cards
- Introductory Interest Rate — To help business owners get a jumpstart on inventory and equipment needed for the business, credit card companies will offer an introductory interest rate of 0 percent for a period of 12 to 18 months. This means you can purchase a new $10,000 piece of equipment for your new bakery and won’t have to pay any interest for a year or more. The downside to this is you may be hit with the entirety of the accumulated interest if you’re unable to pay the full balance within this promotional time frame.
- Cash Advance Rate — A cash advance from a credit card allows you to get quick access to much-needed funds. You can use this to pay your employees or put cash in the till to help cover an extremely busy day. The major drawback to a credit card advance is that you’ll have to pay a cash advance fee as well as upward of 24 percent interest on the amount borrowed. And there isn’t a 30-day grace period on these advances like there is with regular credit card purchases.