It takes more than just a great idea to start a small business. You need funds to take it off the ground, and you may be considering incurring debts such as small business loans to fund your venture. While this can be a viable option for securing the capital required to start or expand your business, it’s critical to understand the various types of debt available and how they can impact your business in the short and long term.
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Types of Debt Financing for Startup Businesses
Here are some of the most common options to support your business.
Loans from Financial Institutions
Despite being difficult for small and medium-sized businesses to qualify for, traditional financial institutions, such as banks, remain one of the most common providers of debt financing. Banks are more likely to lend to established businesses with a track record of success and a strong credit history.
Long-term loans are classified into three types:
- Business loans can fund almost any company goal, with or without a specific purpose.
- Equipment loans are used to purchase, replace, or upgrade company assets. The company may be asked to demonstrate that the purchased equipment would produce an immediate return on investment.
- Secured loans require collateral to guarantee repayment; they have a lower interest rate to make repayment easier. Secured creditors will receive more of their claims if the company declares bankruptcy than unsecured creditors.
- Unsecured loans, on the other hand, do not require any collateral. Still, they need a thorough financial assessment, such as requiring a minimum income over a set period to qualify.
Startups with a short operating history or a poor credit history may be unable to obtain a bank loan – and multiple loan rejections may reduce your chances of receiving another from the same institution.
But you still have options. Small businesses have sought debt financing from alternative sources over the years. It is now easier to obtain capital outside of banks, and many companies prefer these other types of debt financing due to their relative flexibility.
Non-bank Lending
When banks evaluate businesses for traditional loans, they consider a wide range of factors such as credit history, assets, investment history, and profit. Banks seek to minimize risk by determining their ability to repay them in the future.
Non-bank cash flow loans operate similarly but are approved based on a much smaller set of criteria. Lenders determine loan viability based on the company’s cash flow rather than its assets. They may evaluate seasonal sales, frequency of transactions, expenses, and even online reviews.
A word of caution, however. Since cash flow loans are deemed riskier, some lenders charge higher interest rates or charge hidden fees. Always choose a reputable lender with a track record of facilitating business success.
Loans from Family and Friends
Many businesses get their start thanks to investments from friends and family members. These loans usually have much softer terms, providing startups with their first investment experience.
However, while family and friend loans may be easier to obtain than bank loans, they carry significant reputational risk. So, first, assess your ability to repay the loan. Would you be able to repay your friends and family if you went bankrupt? Are your friends fully aware of the financial risks of investing in your company? To mitigate the risks of this kind of debt financing, startups should enter it with a detailed repayment plan.
Peer-to-Peer Lending
P2P lending connects borrowers with individual lenders who believe in the company’s services, making it one of the most accessible alternatives to family financing. Sites like GoFundMe, Kickstarter, and Prosper paved the way for P2P lending to be prominent today. This lending option best suits small businesses that are comfortable disclosing financial information publicly. Some online platforms may require revenue projections, detailed financial statements, or assets.
Remember that if a startup cannot produce a return or provide a promised product, P2P lending can harm its reputation.
Credit Cards
Business owners have long used credit cards to help them build their businesses and establish trust with future lending partners. The buyer personally guarantees small business credit cards, so an established business credit is not required. Many have attractive introductory offers, such as 0% APR for the first year. Some credit cards provide cash-back or point rewards that can be applied to travel and other business expenses. The drawback? Credit cards charge high interest rates for late repayment and cash advances.
Final Thoughts
Understanding the various types of debt financing available to small business owners is critical in funding your company’s growth and success. While traditional bank loans may be challenging to obtain, non-bank lending options such as cash flow loans and peer-to-peer lending provide accessible alternatives. However, it is critical to carefully consider the risks and benefits of each option and develop a repayment strategy to ensure the financial stability of your business in the short and long term.
