Module 6: Financing Options
Owners have many financing options for their business, from using personal savings to getting a bank loan. In between, there are more creative ways to fund a business. Each has its own set of risks, fees, interest rates, and payment terms. It’s important to remember that you never want to overextend yourself. You need to make sure you aren’t getting over your head. There’s no such thing as free money; you will need to pay the debt at some point.
Self-Financing, Gifts and Informal Loans
Self-funding is the most common way to fund a new business. Most entrepreneurs use their personal savings, receive monetary gifts or get informal loans or investments from friends, family and other individuals to realize their dream of owning a small business.
Getting a loan from a financial institution or an outside investor is hard at the start, primarily because of the risk of lending to a new business with no track record of success and no collateral to put against the loan.
If you receive informal loans from others, make sure that they become part of your cash flow calculations on your balance and cash flow spreadsheets and keep them there until they are either forgiven or paid off. If you receive a cash gift, you can place it in your business accounting program or app as business capital. As always, it’s wise to check with an account when these types of loans or gifts are presented to you.
Business Installment Loans
While lines of credit are used to meet short-term cash flow requirements, business installment term loans can be used to purchase vehicles, equipment or real estate. In contrast to a line of credit, which you draw money out of as needed, an installment loan is disbursed upfront. You then make payments on the loan and interest for a fixed amount of time. A good example is the state’s Small Business Flex Fund, which loans up to $150,000 to established small businesses.
Installment loans are usually secured by some type of collateral, such as equipment, vehicles or real estate. If you fail to pay off the loan as promised, the lender can sell off these assets. Term loans mean predictable payments for the business each month, but unlike a line of credit, you may have to submit a new application if you need additional funds.
For equipment and vehicle loans, the length of financing is tied to its useful life. For commercial real estate loans, the terms are typically longer. In some cases, borrowers may wish to pay off their loans early, so be sure to ask about any prepayment penalties when you are loan shopping.
Business Line of Credit
A business line of credit can be used to cover operational expenses as they arise. These are usually short-term funding needs, such as buying inventory, filling a gap in cash flow because a customer’s payment is overdue and other unexpected expenses.
Credit lines are usually secured with business assets, such as equipment, company-owned real estate or accounts receivable. Smaller lines of credit can serve as overdraft protection on a business checking account.
With a line of credit, you must make monthly payments on the outstanding balance. Most credit lines have a variable interest rate tied to an index, such as the prime lending rate. Unlike a business loan, a line of credit can remain open as long as the borrower is in good standing with the lender. It is not disbursed in a lump sum, like a business loan. You can withdraw funds from your credit line as required, and you pay interest on the outstanding balance, not the total line of credit available.
Business Credit Cards
A business credit card is very much like a line of credit. Based on your needs and credit history, the bank will offer you a credit card with a maximum limit, similar to a personal credit card. These cards often have a grace period in which no interest is charged if you pay the card in full before the due date. A business credit card can help you build your company’s credit history while avoiding costly interest on purchases.
You will want to choose a credit card after doing thorough research. You want to compare fees, terms, interest rates and any rewards or benefits.
Additional credit cards can be issued to authorized users, but you want to consider the risk of doing so as you are responsible for any debts incurred, not the user. Before requesting additional cards, speak with your banker to discuss options and potential risks.
Special Purpose Loans and Loan Guarantee Programs
In addition to the traditional financing options listed above, their loan programs for specific industries, eventualities and business owners:
- Agricultural loans for crops, livestock, or farm machinery
- Manufacturing loans for the equipment needs of manufacturing companies
- Veteran and military member loan guarantee programs
- Exporter loan guarantee programs
- Disaster loans for small businesses affected by natural disasters
Government programs for small businesses
- SBA – guarantees repayment for a specific portion of the lines of credit and term loans that participating lenders make and service, allowing them to approve loans they otherwise would not. In addition, the SBA Microloan Program provides direct loans and grants to eligible nonprofit microlenders so that they may provide loans of up to $50,000, business training and technical assistance to newly established and growing small businesses. Finally, certain borrowers may be eligible for special SBA loan programs, such as veterans or victims of disasters.
- U.S. Department of Agriculture Rural Development – provides grants, loans and loan guarantees designed to help creditworthy rural businesses and agricultural producers obtain needed credit. These programs are designed to save and create jobs.
- U.S. Department of Commerce’s Minority Business Development Agency – has a national network of Minority Business Development Centers and domestic and international partners that provide minority entrepreneurs with technical assistance and access to capital, contracts and new market opportunities.
- State and local governments – operate their own programs to foster entrepreneurship in underserved communities. Some state and local agencies offer loans directly to small businesses as part of their economic development mandates, in addition to operating loan guarantee programs that are implemented by participating private-sector lenders.
- Office of Small and Disadvantaged Business Utilization – (within local and federal government agencies) support for getting government contracts.