What Is A Small Business Loan? | How Small Business Loans Work
Almost all ideas for starting or expanding your small business have one thing in common: They need money to become a reality.
Unless you already have the workspace, equipment, technology, licenses, staff, marketing budget, and office furniture your business would need, you will need to pay for some of this stuff.
When they need capital, many new and existing businesses turn to small business loans. Borrowed cash can help transform a business or expansion idea into a profitable reality.
How Do Small Business Loans Work?
Traditional small business loans resemble a home mortgage. You borrow a large sum of money and repay the loan, over time, with interest.
Other loans work more like a credit card: You can access a line of credit to use when needed, repaying your balance in installments with interest.
A business can also find loans matching specific needs, such as buying new equipment or solving a cash flow problem.
New start-ups have the hardest time securing business loans. Most start-ups have to find alternative funding sources such as microloans, grants, crowdfunding, or personally financing the new business.
Why Is It So Hard To Get A Business Loan?
The odds of creating a successful business aren’t very good. About 1 in 4 new businesses fail within the first year. About 2 in 5 never see their second anniversary.
No matter how optimistic you feel about your business idea and its chances of success, small business loan lenders will still pay attention to the numbers. They typically do not grant business loans for brand new companies.
If you can find another source of funding and succeed for a year or two in business, you’ll have a much better chance of getting small business financing at that point.
I’ll list some ideas for alternative start-up funding below. For now, let’s stick to the topic: small business loans.
What Do You Need to Qualify for a Business Loan?
Different banks have different qualifications for small business lending, but your lender will almost always consider these criteria:
- Your Personal Credit Score.
Why does the bank check your credit instead of considering your business’s financial history? Because your personal financial tendencies will likely reflect how you’ll run your business. If you have a 660 or higher credit score, your business will have better chances of borrowing.
- Your Business’s Annual Revenue.
Understandably, your bank will be very interested in your business’s ability to repay your loan. If your business generates $100,000 or more in annual revenue, your chances of borrowing will be higher. Revenue of $250,000 annually increases your borrowing power significantly.
- Your Business’s Age.
I referenced this earlier. If your idea for a business is just an idea, don’t expect a bank to finance your business investment. A year in business will get a lender’s attention. Two years in business will open even more doors.
- Your Collateral:
If you can’t make the cut with the previous three criteria, putting up collateral will help. Whether it’s a life insurance policy or personal property, collateral will tell the lender you mean business.
For most kinds of business borrowing, expect to share your business records, checking accounts, and payroll numbers with your lender. This is especially true for term loans and SBA financing.
Types of Business Loans
Business loans come in many forms. Online lending has opened up new opportunities for borrowers, but we’ll start with the basics:
Business Term Loans
If you’re familiar with home mortgages, you already know a lot about business term loans. They give your business a boost of capital in exchange for regular payments over a specified period of time.
Typically, you get a fixed interest rate, which leads to predictable payments for your business. Expect to put up some form of collateral and to go through a rigorous application process.
It’s not uncommon for these loans to exceed $1 million. You can understand why a lender would want to make sure your business has a proven track record for at least a year before extending this kind of credit.
Because term loans are so hard to secure, the U.S. government runs the Small Business Administration, which can help your business get better lending terms.
Small Business Administration Loans (SBA loans) work especially well if your business needs to buy real estate, but the application process can take months. And like traditional term loans, SBA loans won’t be available to new businesses.
Equipment loans make a lot of sense for existing businesses in need of new equipment. You can use the new equipment itself as collateral — much like you would with a home or auto loan.
Companies in fast-changing sectors should be careful to avoid loan terms that exceed the life expectancy of the equipment. For example, if the software system you’re buying will be obsolete in two years, don’t finance it for four years.
Additional Borrowing Options for Small Businesses
Not every business needs to borrow hundreds of thousands of dollars for a major investment. If your business has cash flow issues — either seasonal trends or just a slow period — these next loan types could help.
Business Line of Credit
Rather than providing a large infusion of cash, a business line of credit works more like a credit card.
This kind of product can help if your business experiences slow seasons and needs to survive a few months before the busy season brings in more revenue.
One significant advantage: Unless you use the credit line, you don’t have to pay interest, unlike a term or SBA loan.
Invoice factoring can also help your business during a slow period. This kind of borrowing turns your upcoming invoices from clients into immediate cash.
Your lender will extend your business credit and then collect your upcoming invoices as payment on the loan. The lender charges fees rather than interest for this service.
Invoice financing resembles invoice factoring, but you’d be using upcoming invoices from your clients as collateral on an actual loan with interest.
This strategy has one notable advantage: Your clients won’t know you’ve financed their invoices because you (and not your lender) will be collecting payments.
Merchant Cash Advances
If you have a retail business, you could take out a cash advance and repay it gradually through a percentage of your incoming credit or debit card transactions.
The upside is you get cash immediately without even applying for a loan. The downside is an erosion of your sales until you get the debt paid off.
If this sounds like something helpful, try to find a service that lets you pay off the loan early.
Is a Business Loan a Good Idea?
Just like with personal borrowing, you have to weigh the pros and cons when borrowing for your business:
When an infusion of cash would help you break into a new business stratosphere, a business loan’s fees, interest, and headaches will be worth the cost. This is true if you’re expanding into a new market or adding a new product. If all goes as planned and the money starts coming in, you could pay off the loan early.
When money’s not coming in, and you need the cash from a business loan to stay afloat, give your borrowing idea some more thought. Chances are, if you’re already struggling to keep your business going, the added expense of paying back your loan could make your problems worse.
Rather than borrowing money to survive, take a real close look at why you’re struggling.
If borrowing money can help you solve your business’s underlying problems, it’s worth a shot. If not, you may be just delaying the inevitable (and making the inevitable more expensive).
Startup Business Funding Ideas
As you noticed, just about all business borrowing requires having a successful business in operation for at least a year. It’s an age-old problem: You need money to succeed, but you need success to get money.
So how do you crack this code? If I had a one-size-fits-all solution, I’d share it. But there’s no easy answer.
The Internet offers a few rays of hope, but ultimately you’ll need to depend on yourself, your own ability to innovate, and your determination to thrive.
Here are some alternative funding ideas to consider:
Sites like Lending Club and Funding Circle let you appeal personally to investors who have the cash your business needs.
With Equity Crowdfunding, your investors would be buying ownership in your idea.
Rewards Crowdfunding is less official. You could offer your investors discounts or free products in exchange for their initial support of your idea.
Either way, you have to sell investors on your idea.
Since microloans extend smaller amounts of credit — $15,000 to $40,000, for example — the benchmarks for borrowing aren’t nearly as high as a traditional term or SBA loan.
These loans aren’t always easy to get, though. Often they’re administered by non-profits who have their own agendas such as developing a specific sector of the economy.
In some cities, you can find business grant programs. Ask your local Chamber of Commerce about programs in your area.
If you have good credit and you believe wholeheartedly in your business idea, you could consider a personal loan to help get things rolling.
Many banks and credit unions let you borrow $5,000 or $10,000 unsecured. If you have collateral to post, you may get better terms.
This strategy is risky. You’re putting your personal financial freedom at stake.
Asking Family & Friends
It’s not always a comfortable conversation, but you could ask friends and relatives to invest in your business idea.
If you do this, keep your investors in the loop about your progress. Be upfront about their risk of loss. Put the details in writing, so everybody understands the expectations.
Business Loans Should Match Your Needs
Starting a business from scratch takes a lot of grit and self-confidence.
If you’ve already done it, you know the deal: You’ll work around the clock, pouring your energy into the business, hoping it’ll all pay off in the form of more security and financial independence.
But your dedication and determination won’t always generate the money you need to get your business off the ground.
When you’re ready to turn to business borrowing, look for a loan that will enhance your hard work, and not create another problem for your business brain to solve.
Finding the right terms and loan type will make this possible.