Types of Small Business Loans
Business owners have the widest possible variety of needs and loan amounts, ranging from a few thousand dollars to cover a week’s payroll to millions over several decades for heavy equipment and perhaps real estate. Accommodating those needs falls to a broad spectrum of different types of lenders. Here are 15 popular types of small business financing and their uses.
Top Tier Loans
These can be secured or unsecured, short-term (less than one year) or long-term (one-to-seven years). Lenders may grant business credit without the need for a personal or business credit check and they rarely require a personal guarantee. Interest rates vary widely.
These are backed by the Small Business Administration and can be used to start or buy a business. There is no minimum loan amount, and businesses can borrow up to $5 million. Interest rates are in the five-to-nine-percent range in 2014. Terms range from less than one year to 20 years.
Accounts Receivable Factoring
This isn’t strictly a loan. Instead of borrowing against accounts receivable, businesses sell them at a discount to factors — companies that purchase receivables at a discount and then collect them. The discount typically translates to a 10-to-15 percent interest charge.
Merchant Cash Advance
Similar to accounts receivable factoring, the cash advance isn’t really a loan; it is the sale of future receipts at discount to a buyer. Usually the sellers are businesses that can’t get traditional lines of credit. They generally operate with a lot of credit card receipts but not a lot of cash flow. interest rates range from 18 – 22 percent.
Startup loans cover the costs of creating a business. These can be SBA loans, private loans, large commercial packages and alternative loans like crowd funding ormicroloans. Startup loans from traditional sources like banks require detailed business plans and often collateral and / or a personal guarantee. This can be risky — a restaurant owner who gets a startup loan could lose the restaurant if he or she defaults, and perhaps personal assets as well.
Franchise loans are like startup loans for franchisees. They require significant participation; ten to 30 percent of the startup costs must be injected by the owner, with 70 to 90 percent coming from the lender. The SBA also backs franchise loans. That guarantee is called a 7(a) loan.
Business Acquisition Loans
These loans finance the purchase of an existing business. They are considered safer by lenders because the enterprise’s income producing ability has been established. Buyers can acquire their businesses with seller financing, or with a bank loan (easiest for an established business), or they may just borrow against the assets of the business, using them as collateral — for example, a mortgage on an office building.
Lines of Credit
This is short-term revolving (reusable) financing designed to smooth out cash flow — for instance to fund the purchase of inventory and be repaid when that inventory is sold. Lines of credit can be unsecured or secured by anything from business assets to the personal property of the owner.
These are designed to meet the needs of traditional professionals — doctors, law offices, accounting firms, etc. It’s short-term credit, payable in two-to-six months, with interest rates of five to ten percent.
These loans are used to finance major equipment and large vehicle purchases and they are secured by the equipment itself. Interest rates range from eight to 25 percent.
Equipment Cash-out Refinancing
Business owners refinance their heavy equipment and vehicles to get larger sums of cash, using their equipment as collateral. Typically they can get about 40 percent of the value of the equipment in cash. They then repay the loan in installments over time. This scheme is also known as a “sale-leaseback,” and is set up so that the business sells its equipment to the lender (getting a lump sum) and then leases back the equipment from the lender (making monthly payments).
This is for the construction of commercial buildings. Lenders evaluate the loan application based on the projected costs, value and potential income of the building — information compiled on a real estate pro forma. Once the building is complete, the construction loan is paid off with a permanent loan, a real estate loan with a repayment period of ten to 25 years.
Hard Money Equity Loan
Hard money, as the name implies, is high-interest short-term financing for those who either can’t qualify for better deals or those who need financing too quickly to go through more orthodox channels. They are not based on the borrower’s credit rating, just the value of the asset the lender can repossess if not repaid. These secured loans carry interest rates ranging from 15 to 30 percent.
Working Capital Loans
Working capital is defined as the difference between a business’s current assets (cash, investments and other liquid resources) and current liabilities (obligations that are due within one year). It’s available to fund the daily activities of the enterprise. Working capital fluctuates as expenses and income rise and fall independently, so working capital loans help business maintain enough cash to meet their operating needs. These loans are short-term and can be secured or unsecured. Rates range between three and seven percent.
Accounts Receivable Financing
Also called purchase order financing, these loans have very short terms (one to two months). Borrowers receive cash advances of payments due from their customers, typically within 30, 60 or 90 days, providing needed capital to meet operational overhead.
Peer to Peer Loans
This alternative financing category allows business to apply for loans in amounts ranging from $1,000 to $35,000 at rates between six and 36 percent. Most have fairly short terms, from one to three years. The loans are facilitated through P2P sites and obtained from individuals rather than institutions. They may be secured or unsecured.
Small business financing exists to meet many needs and takes many forms. The process of applying for a business loan and receiving the money can take anywhere from a few days (for hard money) to months (up to nine months for a complicated startup or acquisition).
Starting a small business or expanding your existing one can be an exciting opportunity. Of course, a key component of any small business plan is financing. But just what do lenders consider when deciding whether to approve a small business loan?
When looking for a small business loan, you’ll need to prepare a written proposal that will do the following:
- introduce yourself and your business
- specify how much you wish to borrow
- describe what you will use the money to finance
- indicate how you plan to pay it back
Here are the major factors lenders consider when they assess your request:
Your business plan
If you’re starting a new business, it’s essential to show that you’ve got a workable strategy. There are many books, seminars and consultants that can help you prepare a solid business plan, which should demonstrate your knowledge and experience as well your projected revenues. If you’re borrowing to expand an existing business, provide financial statements for at least the past three years, major legal documents (lease contracts, articles of incorporation, etc.), and describe how you plan to grow your business with the money you’re borrowing.
Your ability to repay
A lender will want to know how long you will need to pay back the loan and will ask you to demonstrate your means of doing so. This will be the major factor in determining the amount you’re approved to borrow. If you already have a business, you’ll be asked for an income statement that shows your past performance. A new or expanding business will need to provide realistic income estimates for at least two years. Lenders will also want to know your backup plan if those projections fail to be accurate.
Backup plans can fail too, so lenders will want to know how you can secure the loan. For an established business, you can provide a recent balance sheet that lists all assets and liabilities. If you’re the sole proprietor of a new business, however, you may be expected to secure the loan with your personal assets. Make sure you understand the risk this involves, especially if you are securing the loan with your home.
Your credit history
As with a personal loan, lenders will look at your credit history to see if you have reliably paid back what you’ve borrowed in the past. Before shopping for a small business loan, it’s a good idea to check your credit report to make sure the information they have on file is accurate.
Your personal stake
Lenders will want to know how much of your own equity you have put into your venture. Investing your money in a small business shows that you’re committed to its success. As a rule of thumb, the ratio of debt to equity in your small business should not be more than four to one. In other words, if you want to borrow $40,000, you should already have $10,000 of your own money invested in the business.