Every small business owner feels that their business needs some money to help with a variety of different expenses. Unfortunately, businesses might not always have the capital on-hand to finance these things. Maybe you’re an aspiring entrepreneur, and although you know it takes money to make money, you don’t know how or where to get funds to get your new business off the ground. Whatever your business experience level, it’s important to know what a small business loan is. To decide if it is the right course of financing for your business, we’ll first explore what a small business loan is and how it works.
What is a small business loan and how can it help?
You might already know what a small business loan is, but in case you don’t, it’s important to define it early on. A small business loan is initiated when a borrower (typically a business owner) borrows a sum of money from a lender based on a set agreement to repay that sum plus interest over some time.
Small Business Loan or Merchant Cash Advance
Some may be torn between a small business loan and a merchant cash advance. Overall, there is little difference between the two. Most of the differences have to do with various state and federal regulations. Nevertheless, it is important to understand these differences. A small business loan is more like a term loan, whereas the funds are lent to the business then paid back based on a payback schedule. A merchant cash advance is where funds are sent to the business as an advance against future projected revenue. The funds are paid back on a suggested schedule, but this could be adjusted based on realized revenue over the payback period. If the payback is scheduled through ACH (automated clearing house) transactions, where the funds are deducted from a bank account, it is very unusual for adjustments to be made to the payback schedule in terms of speeding up the payback.
Some lenders will lower a payment, therefore extending the payback if revenue has slowed dramatically. Some lenders will offer a payback schedule with various set payments based on affordability due to expected seasonality. So overall, both financing methods involve receiving and repaying a sum of money, but with merchant cash advances, the business receives an advance against its future credit card sales, and the provider draws money from the business's future credit card transactions as repayment. Merchant cash advances can be quicker, simpler, and be accessed by businesses with less credit history. That being said, some can cost notably more than business loans, which makes loans preferable for borrowers that have the time and credit to acquire them.
What types of small business loans (or funding) are available?
Small Business Loan (Unsecured)
An unsecured small business loan is a loan which is not collateralized by some specific assets. This is one of the most common types of small business funding. These loans are usually paid back weekly, but there are also daily, monthly or bi-monthly payment options. This type of loan is based on the revenue of the business, as well as other factors. These factors include information like business credit, personal credit (this does not make it a personal loan), industry, time in business, and other factors that predict the risk of repayment to the lender.
Small Business Administration Loans (SBA Loans)
Qualifying for an SBA loan is probably the most difficult out of all the options because of their lofty requirements. Not surprisingly, SBA loans are the cream of the crop of small business loans. The Small Business Administration partially guarantees SBA loans, and because of this, lenders are willing to lend to small businesses more often and with better terms. SBA loans come with exceptionally ideal terms, but they will be the hardest type of business loan to qualify for, despite the partial SBA guarantee that makes it less risky for lenders.
Small Business Revolving Line of Credit
A small business revolving line of credit is great for businesses that have frequent or short-term uses of funds. For example, construction companies often need a line from which to pull funds for payroll and materials then payback when they are paid for their work. If a new job starts before the current job is completed, the company can pull more funds as needed. A line of credit is also great as a supplemental product to a larger loan. By the way, it’s best not to use your business line of credit for personal expenses.
Merchant Cash Advance
We discussed this type of loan a bit earlier, but let’s get cover it more in-depth. A merchant cash advance is where funds are advanced to a business (as advanced revenue) against future projected revenue. This is a very common type of funding. Although this is not a small business loan, this product is a great alternative to a small business loan. A merchant cash advance is paid back as an ACH payment to the funding company (usually either a weekly or daily payment) or through a credit card processing split, the latter of which is less common nowadays.
Invoice financing is an accessible option for most businesses. It works by taking an outstanding invoice that a business is waiting on as a form of collateral. In other words, invoice financing allows businesses to borrow money against the amounts due from its customers. The business lender can advance your company up to 90 percent of an outstanding invoice’s value. The catch is that the lender will not lend you this cash advance for free. For every week that the invoice is outstanding, the lender will charge you interest. This can become more expensive as more days pass since the invoice fulfillment day. On the plus side, invoice financing is a self-secured form of business funding, so the qualifications aren’t rigorous.
Asset-based financing is a small business loan where the merchant pledged some type of asset or group of assets as collateral for obtaining the funding. If the merchant defaults on the funding, the creditor may take the asset as re-payment or freeze the asset until re-payment.
In general, equipment financing is a type of secured loan where the merchant adds equipment to their assets through a loan which is secured by that specific asset. The most common type of equipment funding, on the consumer side, would be a car loan. On the business side of things, these types of loans are used to purchase any new or used equipment that is usual for that business’s industry. If you qualify for equipment financing, you’ll be able to finance up to 100 percent of a piece of an item’s value.
The equipment itself functions as collateral for the loan, and thus makes equipment financing less risky for the lender and more affordable for the borrower; however, because equipment financing offers such ideal terms, its minimum requirements are loftier than the loan options mentioned earlier.
How hard is it to get a small business loan?
This is a question we answer in great detail in another article, but we’ll talk about the difficulty of procurement in general. Some loans are going to have more discerning standards. These loans are going to be more affordable, but tougher to attain. On the other hand, the less-discerning loans will have lower qualifications standards, but less-accommodating terms and will likely be more expensive. These will be easier to attain for less-qualified businesses. For comparison, a merchant cash advance is one of the easiest funding options to procure, while an SBA loan is one of the most difficult.
Work on your credit, start banking (responsibly), organize your records, build relationships, and maybe even open a business credit card account. Factors like your business’s age, credit score and revenue will all play big roles when applying to lenders. The most important overall factor for you to consider before you commit to a loan is how stable your finances are. If a business and its owner are on solid financial ground, then the options are expansive.
What does all this mean? Which small business loan is right for your business?
The first thing to think about is the type of loan which best fits the use of funds for your business. The easiest decision is based on if the funds will be used to purchase equipment. (On a side note, the equipment can be new or used, and it can mean items such as software, restaurant tables and furnishings, as well as communication systems, yellow iron and pizza ovens.) If the funds will be used to purchase equipment, that is most likely the best product for your business in terms of small business loans.
If the funds are not used for the purchase of equipment, the consideration is whether the small business loan can be secured with existing assets. This might be able to secure a lower cost of funds for the business; however, if there are assets, including inventory, that can be used to secure the small business loan, it still may not be in the best interest of the business. With the assets pledged, they become encumbered and cannot be sold or transferred. Furthermore, the assets could be seized if the small business loan is in default.
If the business does not have the assets required to collateralize a small business loan, or if it would not be in the best interest of the business to tie up those assets, the situation calls for unsecured funding. There are several types of funding that might meet the needs of the business in terms of a small business loan. The available types of funding include invoice factoring, merchant cash advance, line of credit, and working capital small business loan.
Invoice factoring is an option for a business that is waiting on receivables that are invoiced. Factoring looks at the creditworthiness of the businesses that have been given extended net terms. If the reason for funding is that a net term customer is slow to pay, invoice factoring might not be approved.
A merchant cash advance (MCA) is a possibility. Let’s look at a merchant cash advance paid back through an ACH debit as a small business loan and only consider a merchant cash advance paid back through a credit card split. The first consideration is if the business accepts credit cards. The second consideration is if the business generated enough revenue through credit card sales to offer a large enough approval. In general, MCAs work best for restaurants and retail stores.
An SBA loan is a great choice but is not often acquired, as the process is long and the qualifications are lofty. It is a great product for those businesses that are qualified. Just make sure your business is looking for an SBA loan. If your business has a decent amount of time in business under its belt, great credit and income, then an SBA loan is reasonable and a great option.
Unsecured funding is mainly a mid-range small business loan know as a term loan. These loans generally have payback terms between three and five years. The biggest consideration is the use of funds. Run your debt with your investment. In other words, a three-year payback is not a good idea for purchasing inventory. Many businesses make the common mistake of tying up their ability to leverage themselves by entering into a term loan. If a business is in growth mode, a small business loan that is revolving or renewable in the short-term is a better idea.
In terms of a revolving line of credit, this can be a great product. If the use is to use the funds for a short time and pay the funds back quickly, a line of credit might be the best product; however, a line of credit is usually smaller in terms of the funds available at one time. A line of credit is also a more difficult product for a business to qualify. If the return on the use of funds will not for over six months, or if a larger amount is required, a working capital loan is probably the best option.
An unsecured small business loan, either in the form of a working capital term loan or a merchant cash advance has a shorter-term payback period than most other products. The payback period is usually between six and 18 months. The loan is renewable at some point in the payback, meaning more funds can be taken before the end of the payback period once the loan is paid down by 50 percent. There might be a discount for paying it off early, but what that looks like depends on the structure of the funding. Unsecured small business loans the most common type of unsecured small business loan. These types of loans are based on the revenue and cash flow of the business as well as credit and other risk factors.
The Bottom Line
A small business loan can be a great tool to help unlock new potential for your business. It can help get your startup off the ground, or it can help your long-time business reach new heights. There are various kinds of small business loans, all of which suit a unique set of needs. If your business is in good financial shape and has at least a couple of years of experience, then obtaining a small business loan should not be difficult.
At Crestmont Capital, we can approve 95 percent of our loan applicants. To learn more, click here to review all our small business lending options. Also, please feel free to contact us if you’re interested or have any questions!