Nearly every small business needs financing at some point, whether it comes from a loan or is received in exchange for a piece of your company. If your small business is new, or you’re thinking about starting a business and wondering how to fund it, there are several common financing options you should know about so you can choose what’s best for you.
Here are three basic loan-based financing options for your small business, along with descriptions of what requirements and expectations each entails.
1. Small Business Loans
In the U.S., the Small Business Administration (SBA) has a guaranteed loan program. The program works by allowing traditional banks to provide loans that are guaranteed by the federal government through the auspices of the SBA. These SBA-guaranteed loans usually offer more favorable lending terms and longer line-of-credit repayment periods for small businesses.
Banks participate because the loans are backed by the federal government. So, if SBA-guaranteed loans are so great, why wouldn’t every small business have them? Well, there are some things to consider.
First, applying for these loans generally requires more information than a standard commercial loan. This is because, again, it’s the government backing you, and they want to know more about your ability to repay. Because of this increased paperwork, there is often a much longer timeframe for approval. Secondly, if time is of the essence, you might need to look elsewhere. This program likely won’t be fast enough to get you the right financing in time.
Finally, according to the Journal of Accountancy, “to qualify as a small business under current law, a business must demonstrate that it has less than $15 million in tangible net worth and two years’ net income after taxes of less than $5 million.” These are specific terms you’ll need to ensure your business meets before you apply. For some larger businesses, this may not be doable. But if your business does meet the requirements and you have the time, an SBA-guaranteed loan could be a great financing option.
2. Lines of Credit
Small business lines of credit work much like a credit card. You apply for credit with a commercial lender, they extend you a secured or unsecured credit line up to a certain amount and then you are able to draw operating capital from that line as your business requires it.
Rob Leary, Senior Vice President of Commercial Lending at Dedham Savings, explains that the advantages of a line of credit include building your business’ credit history and also having the flexibility of cash on demand when you need it. That’s in contrast to borrowing a lump sum loan and then paying back interest on unused capital. He warns, however, that lines of credit carry up-front application fees, penalties for late payments and overdrawing. He also cautions potential borrowers to be aware of annual administrative fees charged regardless of your use of the line of credit.
Carrie Gallagher, writing for the small business site The Self Employed, states that you’ll also want to be aware of the documentation required, as most financial institutions will only offer unsecured lines of credit to established businesses with years of operating income and extensive financial records. If you can properly manage your draws on a line of credit, however, this can be a great, flexible option for your small business’ financing needs.
3. Private Investors
You may think your only private investment options are your family and friends, but there are a host of ways to get private investors in your small business. One avenue is through peer-to-peer lending sites like Prosper and Lending Club, which are alternative lending platforms. Once thought of as “fringe” or “risky,” they’ve grown in popularity over the past several years as businesses have benefited from an alternative short-term financing option that isn’t a bank. Private investors that have lent through these sites have seen favorable returns.
But peer-to-peer lending isn’t without caveats. First, these loans are going to be tied to your credit or your business operating history, so you’ll need to have one or the other to be an attractive financing option to private investors using these platforms.
Finance site Nerd Wallet warns that sites like Lending Club, for example, “prefers borrowers who have been in business for at least two years with annual sales of at least $75,000.” They also “prefer that [the loan recipient] own at least 20% of the business.” You’ll also need to make timely payments, or risk hurting your credit score, just like any other loan.
Finally, consider how long you’ll need the loan, as most peer-to-peer loans carry terms of less than five years. If you want to keep control of your small business, but need an alternative to bank issued business loans, look into peer-to-peer loans as a potential option.
To learn more about acquiring the right funding for your small business, continue to our next article to see if a line of credit or a traditional loan would make more sense for your business.
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