Everything You Need to Know (And More) About Business Financing

“Business financing.” Those two words conjure up a thousand and one questions. Why do you need financing? How much? By when? Is your business doing alright? Are you doing alright?

Phew—let’s take a step back for a minute. Finding business financing can be stressful, but it’s also one of the most important parts of starting and running a company. Few get along without finding some sort of external financing at all, and those that manage usually have to make a couple of sacrifices.

That’s why we’ve compiled everything you need to know about business financing—in one handy place. Let’s get started.

Business Financing: What Is It?

The most basic of questions: what, exactly, is business financing?

Whether you call it business financing, funding, or something else, it’s essentially the money you need to help start or run your company. While you could technically pay the upfront costs and cover any cash flow gaps with your own money, out of pocket, it generally doesn’t make much sense to do so.

Instead, most successful business owners turn to outside business financing—whether that means debt, equity, or something else. We’ll explain what each of those paths might hold for you, and what to know about them, in just a minute.

But first, we should take a closer look at some reasons why you might want to get business financing.

(Psst—here’s a fun quiz to test your business financing IQ, too.)

1. Getting Started

Got a great business idea, but no way to start things moving? Business financing can help you get off the ground so you can produce, sell, and be successful.

2. Spend now, earn later

You can’t afford the upfront costs of a purchase, but you know it’ll pay dividends soon enough.

For example, think about a bigger oven or an extra delivery van—you’ve proven that what you have works, and you know that scaling up will lead to more cash, but you just don’t have the money you need on hand right now.

That’s where business financing comes in. It’s perfectly fine to spend beyond your means… As long as you know it’ll be worthwhile to do so.

3. It’s that time of the year

If you own an ice cream truck or a bathing suit emporium, then you’re probably not making the big bucks in your off season. There’s nothing wrong with that—seasonal businesses are a tried-and-true model.

It just so happens that, in your off-season, you might need to extra cash to make payroll, equipment maintenance, or those marketing bills. Since your cash flow is tight, external business financing would be the way to go.

4. Expect the unexpected: The Bad

Whether it’s a major snowstorm ruining your inventory, a burst pipe flooding your office, or a bitter competitor slashing your tires, you’re bound to run into some unexpected—and maybe even debilitating—emergencies as a small business owner.

The cash cushion provided by business financing could help you bounce back quicker… Or at all. Extra capital is just about the best insurance you can have in your back pocket.

5. Expect the unexpected: The Good

On the flipside, you might be surprised by a golden opportunity: some newfangled piece of equipment, a game-changing employee, a chance to expand or purchase a competitor’s business. Whatever it is, these chances don’t come knocking on your door every other day.

But you might not have the cash saved up to spend on that business move. Even if you’re thoughtful and frugal with your capital, you could still need some outside business financing to afford a big expense.

6. Late, but not forgotten

Your customer says they’ll need to pay you back a bit late—again. If your business relies on customer invoices to keep the wheels turning and the lights on, then a series of delayed payments can really put a stop to your activity. Business financing could help you work around those cash flow gaps.

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These are just 5 examples—there are plenty of reasons to pursue business financing. Whether you’re looking to grow, protect yourself, or recover, outside funding is in every successful business owner’s toolbox.

There are also many different kinds of business financing, but we’ll split them up into 3 categories: debt, equity, and other.

Business Financing Through Debt

Let’s start with the fundamentals: debt, or credit, is a system of business financing where you borrow money from a lender—and then pay it back, plus interest, later on.

You’re spending money for the chance to spend money, which might sound like a raw deal… Until you realize that it’s money you wouldn’t have had in the first place. Debt, while a scary word to plenty of people, is actually a good thing: it lets you expand, innovate, and explore. Savvy small business owners know how crucial debt business financing can be.

We’ve categorized debt business financing into 8 major types for you:

1. Short-Term Loans

First things first: what’s a term loan?

When you think of debt financing, you probably imagine a term loan. You get a lump sum of cash and you use it to grow your business, making daily, weekly, or monthly payments back to your lender until the loan is all paid off. It’s a pretty straightforward arrangement—and one that’s easy to plan your business’s financials around.

With terms between 3 and 18 months, short-term loans are pretty aptly named. They’re made for quick fixes and immediate emergencies—but, unfortunately, they tend to be as expensive as they are speedy.

It’s a reality of the lending industry that fast cash is pricey cash, and short-term loans are no exception. They’re smaller in loan amount than their bigger cousins—the traditional term loan, up next—and generally are faster to apply for, but they can carry interest rates of 14% and up.

Businesses big and small can qualify for short-term loans: they have some of the laxest requirements in business financing, or at least of the term loans. In fact, short term loans are expensive in part because of their accessibility—lenders need to protect themselves against the losses of investing in borrowers with less time in business or lower credit scores by hiking up their rates.

2. Traditional Term Loans

Traditional term loans, sometimes called medium-term loans, are for more established businesses: they’re bigger and slower to fund, with longer term lengths and lower interest rates than short-term loans. They’re the catch-all business financing debt product for business owners with some experience—and good credit scores.

You might be able to score a term loan from your local bank—and if you do, congratulations! Only about 20% of small business owners can qualify for a bank loan, which tends to be the longest and most affordable business financing option out there.

But not to worry. Medium-term loans are still available through online alternative lenders, if that’s the product you’re interested in. Their terms can last between 1 and 5 years, and though they’re not quite as speedy as short-term loans, you can still qualify and receive the funding for a medium-term loan in a few days.

Medium-term loans are great if you’ve got a specific business project in mind—whether that’s a marketing campaign, an expansion, or an experimental new product. Whatever the goal, use your business financing wisely and pay your lender back in full, on time, to keep your credit score strong and your additional fees to a minimum.

3. SBA Loans

The Small Business Administration isn’t a lender—instead, it’s an arm of the government that helps small businesses get bigger loans than they’d qualify for otherwise.

How? Great question. The SBA encourages actual lenders to loan away money to small businesses by guaranteeing large portions of those loans. If your business takes out an SBA loan but defaults, your lender doesn’t lose all that much of their money. They’re incentivized to take more risks, because there’s less danger in doing so.

SBA loans resemble bank loans with their high maximum amounts, long terms, low interest rates, and the processing speed of a particularly drowsy turtle—when compared to that short-term loan, at least. You can expect interest rates between 6 and 13%, terms up to 25 years (though generally less), amounts up to $5 million, and time to funding starting at about 30 days.

You can also expect some pretty extensive documentation requirements and a heavy reliance on your personal credit. Since even the smallest of small businesses can technically qualify for an SBA loan, whereas they might not be eligible for a medium-term loan, the business owner’s personal history and habits matter a great deal.

There are 3 SBA loan programs, each with distinct terms and uses. Let’s dig into them.

7(a) Loan Program

The 7(a) program is the most flexible—and, as you’d expect, the most common. You can score up to $5 million in working capital, for pretty much whatever you’d like.

Doing some remodeling? Hiring new employees? Buying real estate? Refinancing an older, more expensive loan? It’s up to your SBA lender whether that use will help you repay a loan—the SBA doesn’t really care when it comes to the 7(a) program. 9 times out of 10, the 7(a) program is the business financing option to aim for if you’re in the market for a low-cost loan.

CDC/504 Loan Program

The CDC/504 program, on the other hand, is limited to major fixed asset purchases. We’re talkin’ large equipment, real estate, and building purchases or refurbishments.

These loans come highly regulated, with low interest rates and terms of up to 20 years, and are typically only available to small business owners with proven track records and robust credit scores.

Microloan Program

Way on the other end of the spectrum is the SBA’s microloan program—an initiative it started to give credit access to new or especially small businesses whose needs fall below most lenders’ minimums.

Looking for a loan between $500 and $50,000? Got almost no credit history? The microloan program could be the business financing for you. Similar to the 7(a) program, the microloan program isn’t regulated as much by the SBA as it is by the individual lender, so your mileage may vary regarding rates and terms.

4. Business Lines of Credit

A line of credit—if you’re new to the world of debt financing, a fair question might be “What the heck is that?”

Lines of credit actually work pretty similarly to a credit card: you’re given access to a pool of funds, and you can draw from that reserve whenever you want or need. You’ll only pay interest on the money you actually take out and use, and once you repay your lender, that pool gets refilled back to its original amount. (That’s why it’s called revolving credit.)

With a business line of credit, you can play the waiting game, sitting on that cash until you absolutely need it, or you can withdraw and repay whenever you like. You’ve got a lot of flexibility with a line of credit that a term loan doesn’t necessarily give you, since they come with fixed repayment terms and schedules—making a line of credit the ideal business financing product for a seasonal business or for a rainy day backup plan.

That said, lines of credit typically have harsher late repayment penalties than term loans do, which is a tradeoff you’ll have to consider. Plus, you could easily “tie up” your credit by withdrawing funds for small things over time—preventing yourself from using a bigger portion of that capital all at once down the road.

We usually break down lines of credit into two categories:

Traditional Line of Credit

Also called a medium-term line of credit, this kind of business financing has similar amounts ($10,000 to over $1 million) and rates (7 to 25%) to a traditional or medium-term loan.

As we explained a minute ago, a line of credit doesn’t exactly have a “term”—you can use and reuse those funds for as long as you want, so long as you prove yourself to be a responsible borrower. We just call this kind of loan “medium-term” so you can compare it with a medium-term loan more easily!

In terms of qualifying, the conditions for a line of credit and a term loan are pretty similar. These business financing structures each have their advantages and disadvantages to consider.

Short-Term Line of Credit

Short-term lines of credit are to medium-term lines of credit as short-term loans are to medium-term loans.

In other words, a short-term line of credit has a lower maximum funding amount, higher interest rates, faster time to funding, and easier qualification criteria than a traditional line of credit. They’re relatively new in the debt business financing space, which is a good thing—some business owners can now secure a line of credit, even an expensive one, whereas before they wouldn’t have been able to.  

5. Business Credit Cards

While the jury’s out on whether or not you should use a credit card to finance your entire business, don’t forget that a business credit card is a kind of business financing—and it’s got some distinct advantages.

Credit cards tend to require less work to qualify for, come with special deals on starting APRs and special bonus categories, have high credit limits, and can get paid through easy repayment portals. Using a business credit card will help you separate your business and personal financials—which is an important part of building business credit—and they’ll offer you flexibility and speed that even a business line of credit might not be able to match.

However, credit cards do usually finance lower amounts than a loan would. Plus, you don’t want to tie up your daily source of business credit by making a big purchase, or incur a big late payment or overdraft penalty by relying too much on one source of business financing.

Check out the best business credit cards and learn more about using them to finance your business here.

6. Equipment Financing

Equipment financing is different from term loans and lines of credit in one very important way: it’s an asset-based loan.

An asset is a thing your business owns—it might be a vehicle, a piece of equipment or machinery, or a selection of inventory. Whereas traditional debt-based business financing uses your borrowing and business history—like your credit score, bank statements, and tax returns—to determine what you qualify for, asset-based loans rely on the value of the asset, which acts as collateral.

In other words, asset-based lenders care more about how much that new piece of equipment will cost than about your credit score… Which is a good thing if you don’t have a stellar track record. You could potentially finance up to 100% of the cost of a piece of equipment and monthly payments with 8 – 30%. Plus, your equipment financing will last for the expected lifetime of that tool or machinery, so you won’t need to pay for longer than you’ll get use out of that new equipment. And after the loan payments end, you own that equipment outright—as opposed to leasing, which is another alternative to consider.

Equipment financing is a good option if you can’t afford the pricetag of a piece of equipment upfront, but you’re confident that the revenue you’ll get outweighs those interest payments.  

7. Invoice Financing

Another type of asset-based loan, invoice financing uses your outstanding invoices as collateral (as opposed to a piece of equipment, like with equipment financing). Also called accounts receivable financing, this kind of loan can usually sync up with your accounting software—making it extra quick and convenient.

It solves a common business problem: you’re waiting on a customer to pay you, but their delays mean a dangerous cash flow gap and potential missed payments on your end. By paying a fee to your lender, you can get most of that cash right away for those outstanding invoices, essentially trading in some of the money you’ve earned for capital now instead of later.  

There are a few different variations of invoice financing, but in most cases you’ll receive around 85% of the cash for those invoices you want to finance upfront—then you’ll receive the remaining 15%, minus fees, when your customer pays. Sometimes a lender will give you 100% of that invoice and a weekly repayment schedule, or other times your lender will “buy” the invoices from you—which means they’ll chase down your customers for payment, so late payments won’t affect your business.

8. Merchant Cash Advances

When it comes to debt business financing, merchant cash advances tend to be a fast but expensive solution to your capital problems. Even if you have bad credit and no collateral to put up, you should be able to qualify.

A merchant cash advance is a lump sum loan that you pay back by offering a slice of your daily credit card sales to the lender until the debt gets cleared. While it’s a quick and easy option—you can often receive that funding within a day or day, and with minimal paperwork—MCAs cut into your daily cash flow. Until you pay back your loan, you just never get a break.

One advantage of this system is that, unlike with a term loan, you’re not punished when you have slower weeks or months. Not as many sales getting made? You just pay less. On the other hand, though, your most successful days are also cut into the most heavily.

Plus, merchant cash advances come attached with some of the highest rates around. While merchant cash advance lenders use “factor rates” instead of interest rates, you can convert their fees. Merchant cash advance APRs range from 15 – 80% APR, which can really affect your business’s financials.

As far as business financing goes, merchant cash advances are a good short-term fix—so long as you’re careful not to get stuck in a long cycle of daily payments.

Some Things to Know About Business Financing With Debt

If you’re considering financing your business with a loan of some sort, keep these 5 things in mind.

1. Your Credit Score Matters… A Lot

We’re talking business and personal credit, with an emphasis on personal if you’re looking for a loan outside of a bank. In fact, it’s the factor most strongly correlated with loan APRs: the better your credit score, the cheaper your loan, generally speaking.

If you’re not too familiar with debt business financing, this might come as a surprise. Why would a lender care about your personal credit score so much?

It boils down to what a credit score actually is. Your credit score measures your reliability as a borrower, based on things like your credit utilization, inquiries, bankruptcies, late payments, tax liens, and a whole host of other factors. Lenders figure that if you take care of your debt when it comes to mortgages, auto loans, student debt, credit cards, and so on, then you’re probably a safe bet when it comes to your business financials.

And since you’re looking to finance a small business, your personal financial habits have a much bigger impact on how you’ll run that business. A Fortune 500 CEO can have terrible spending habits, but that doesn’t mean their company is running into the ground. A late-paying small business owner, though? They’re probably not a great investment, lenders think.

So work on improving your credit score! Make your payments in full, on time, and you’re most of the way there. Keep an eye out for misreporting on your credit reports, too—you never know what might happen.

2. Your Time in Business Also Matters  

For business financing through debt, older is better: a longer time in business means you’ve weathered more storms. 50% of small businesses fail in their first 5 years in the U.S., so outlasting the competition shows your financial chops. The more experienced you are, the more comfortable your lender will feel with loaning you their cash.

Unfortunately, there’s not much advice to give here other than to keep pushing forward. Before you know it, you’ll be eligible for longer and more affordable rates. Keep an eye out for your big transitions—the 2-year mark is especially important to lenders—and avoid getting stuck in cycles of short-term debt. Instead, refinance your expensive loans by taking out better ones to pay for them!

And even if you’re just starting out, there are business financing options for you. Some lenders offer personal loans for business uses or startup loans—both of which rely heavily on your personal credit scores to qualify you—and equipment financing or an SBA loan could also help you out.

3. There’s Plenty Out There

Which brings us to our third point—there’s a whole wide world of business financing through debt for you to explore.

Your choices don’t just run the gamut from small and pricey to big and affordable, as we’ve seen. There are alternative kinds of loans that fit all sorts of different business types and funding needs, from invoice financing to merchant cash advances. And within those 8 categories we explored earlier there are even more variations, like factoring or invoice-based lines of credit.

Make sure to explore all your options! There’s bound to be one that suits your goals.

4. Manage Your Money Smartly

But, of course, debt financing does involve debt. Like we said, your credit score is an important part of getting business financing through debt—and making delinquent payments is a great way to hurt your credit score and incur late fees on your loan.

The moral of the story? Be a responsible business owner. Make your loan payments in full, on time, every time. Plan out your financial situation before you take on any debt, make sure thee debt you’re considering is worth the cost, and never get careless with your business cash. While debt financing can help you grow and expand beyond your means, it can also come back to haunt you if you’re not thoughtful about your financial decisions.  

5. Prepayment Penalties

Finally, some kinds of loans come with prepayment penalties—which are more or less exactly what they sound like. Simply put, lenders give out money to make even more, so letting you make off with all those interest payments they were expecting is bad business for them.

Sometimes a prepayment penalty comes in the form of a flat fee, or other times it’s that you’re only forgiven a certain amount of interest by paying early. Regardless of your lender’s system, make sure you fully understand the consequences of paying your debt off early, whether it’s because you solved your problem or you’re aiming to refinance. The pros and cons of taking a prepayment penalty aren’t too hard to sit down and calculate—just don’t forget about them!

Business Financing Through Equity

Compared to debt, equity is a whole different ballgame.

Instead of borrowing money and paying it back, plus interest, equity financing is when you trade a bit of your business away—in exchange for some cash, and maybe guidance from an investor.

Business financing through equity generally takes longer than through debt, and it often happens early on in your business’s lifecycle—or at regular intervals throughout. It also tends to offer more capital. Whereas you might take out a small loan of $15,000, investors typically think in terms of millions—and in being partners for the span of your business, not just a few years.

In return for that money, you’re offering investors a percentage of your business—which is usually accompanied by some decision-making influence. On the one hand, it might not be a great feeling to give up some control over your business. On the other, plenty of investors want to offer their wisdom, experience, guidance, and connections to up-and-coming entrepreneurs. Just make sure you’re comfortable with outside investors having partial control over your business: the human aspect of business financing comes into play much more with equity than it does with debt.

Let’s take a look at 3 of the major sources of equity business financing:

1. Angel Investors

Angel investors are individual investors who happen to have the time, money, and inclination to invest in small businesses and entrepreneurial startups by themselves.

Why? What motivates an angel investor?

First, there’s the financial incentive—investors get monetary returns if your business takes off and performs well. By offering you a bit of funding in your early stages, or giving your business cash at regular intervals to accelerate growth, an angel investor can multiply their money by quite a lot… As long as they bet on the right horses. If you’ve got an angel investor knocking on your door, that means they think your idea could make them richer.

Second, some angel investors might just like the authority they gain over a business or the experience of working to build startups from the ground up. Successful angel investors usually have a lot of good advice and they tend to understand their market’s challenges and weak points pretty well.

If you partner up with the right investor, your business could improve a lot just by having the right guidance at your back. (Not to mention the right connections! Angel investors are well-networked individuals: that’s never a bad thing for your business.)

Third and finally, maybe investing is just a fun way for an investor to spend their money! If they’re experienced or bored, working with new talent could simply be a way to keep things interesting.

An angel investor might offer you a whole lot of money before your business is making any at all, but remember, equity means sharing your decision-making power. Unlike business financing with debt, equity involves long-term partnerships. If an investor’s vision for the business is radically different from yours—or if you just plain don’t get along—then that business financing might not be worth the cost.

With equity, you’re receiving experience, expertise, resources, connections, time, energy, and attention… Not just money. But you’re giving more, too.

2. Venture Capital

A venture capital firm is like an angel investor—but multiplied. Instead of an individual with the means, motivate, and opportunity to invest, a venture capital firm is an entire company dedicated to swapping capital for equity in new ideas and growing businesses.

Venture capital is a more competitive form of business financing, too. You usually decide how much money you’re looking for and how much equity you’re willing to part with, then shop around. Venture capital is generally distributed in “rounds,” with companies and firms matching up for more money in return for more equity. Startups move from their seed round through their Series A, B, and C rounds, maturing as a business until they’re ready to IPO (or offer stocks to the general public).

Most small businesses don’t really qualify as targets for venture capital business financing: these firms usually aim for technology-centric “disruptors” with much higher funding needs and faster-moving business plans. But it’s a worthwhile option to investigate if equity-based business financing is what you’re after!   

3. Family & Friends  

Reaching out to friends and family is a pretty common source of equity funding—and business financing in general—for small businesses.

And it makes perfect sense: you come into contact with your friends and family more than anyone else, they know your character best, and they get to watch the evolution of your business from up close. So if you’ve clearly got a successful endeavor in your hands, then why wouldn’t a friend or relative invest?

Our caution here is over the potential cost: friendships, and even family relationships, have been ruined by far less than fights over business financing. If you’re following this path, tread lightly—make sure all terms, conditions, and expectations are absolutely clear, agreed upon, and written down with no ambiguity.

This holds true for loans from friends and family too, of course! Treat this kind of business financing like a professional transaction and don’t assume you can make a late payment or push advice aside because you’re dealing with a friend or relative.   

Other Kinds of Business Financing

Debt and equity are the 2 main categories of business financing, but there are a few other options you might want to consider, too:

1. Crowdfunding

For new endeavors, you might think about using sites like Kickstarter and IndieGoGo to fund your wild, crazy, innovative moonshot projects. By letting others decide whether your business is worth their money, you forgo the obligations of debt and equity business financing in exchange for the kindness of strangers.

And, of course, those strangers’ expectations—crowdfunding usually promises some sort of deal, like early access or special packages, to a business’s supporters. Plus, if no money comes your way, then you can rest easy knowing maybe your idea just wasn’t meant to be.

2. 401(k) Financing

If you’ve got some work experience under your belt, you might be able to dip into your 401(k) retirement savings in order to help finance a business. You can actually also accept 401(k) payments from friends and family if they’re willing to donate, too.

While the benefit of avoiding taxes is hard to beat, the costs of this kind of business financing run high: if your business fails, much or all of your retirement nest egg goes down with it. Think carefully about the pros and cons, hire a tax attorney to help you navigate the legalese, and make the most informed decision you can.

3. Grants

Small business grants do exist, although they’re few, far between, and usually pretty specific.

If your business is involved in scientific or technological research and development, urban restoration, or health advocacy, you might be surprised at how much you qualify for. If not, there’s still no harm in checking out a list of grant opportunities anyway!

4. Competitions

Finally, some large companies hold competitions—think Shark Tank—that entrepreneurs can take advantage of to get business financing or attract the public. If your business idea revolves around an especially inventive or exciting product, consider applying for contests and competitions in your area. You might be the lucky one to win it big!

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Whew—talk about “everything you need to know.”

We’ve given you a lot of information on business financing, but it’s up to you to figure out which type of financing works best for your business. Different businesses and situations match with different kinds of business financing—it’s just a matter of understanding your needs.

Does your well-established restaurant need some financing to open a second location? An SBA loan might be the way to go. Do you have a wild idea to disrupt the coat hanger industry? You probably want to look for angel investors or crowdfunders.

Here are some questions to ask yourself when you’re trying to figure out the right sort of business financing:

• How much money do you need?
• Do you need that business financing now, soon, or just in the near future?
• Are you alright with sharing your business equity?
• How will your business fare with daily, weekly, or monthly loan repayments?
• Does your product have that crowd-pleasing pizzaz?
• Who are your customers?
• Where do you see your business going and growing?
• What’s your competition like?
• Do you prefer the expertise of an investor or the freedom of a loan?
• What’s your credit history like?
• Can you successfully navigate the venture capital world?
• Finally, what kind of business do you want to own?

Some of these are just calculations or easy decisions, but others deserve long, considered answers. Think carefully: the business financing you look for will shape the company you run. Good luck!

The post Everything You Need to Know (And More) About Business Financing appeared first on Fundera Ledger.

from Fundera Ledger https://www.fundera.com/blog/2016/04/19/business-financing-2/