Is a Small Business Loan Right for You?

Small business loans are funds given to a small business that must be repaid with interest. There are many types of loans. Here are their pros and cons.

Banks

Bank loans are the best source of funding if you qualify. They are the second most popular source of loans for small businesses, after retained earnings. They have the lowest interest rates since they use depositors' funds to make the loans. Your local community bank or credit union offer the best rates. 

But banks require a business to show signs of success before lending money. The bank wants to make sure it gets a return on its investment.

This makes it difficult for small businesses that are just starting out. Banks also want to see that you've put some of your own money into the company. Also, they require some hard collateral, like real estate, equipment or inventory. You must provide a detailed business plan to show you've thought your idea through. There are many other small business loan qualifications you must pass.

SBA Loans

If you can't get a bank loan, you may qualify for a Small Business Administration loan guarantee. There are many different types of loan guarantees. The smallest is micro-lending, which are loans less than $50,000. A larger business should apply to the 7a program for loans up to $5 million. 

SBA loans are very paper-intensive and time-consuming. It may take a long time to get your loan. That time could be better spent simply improving your business.

Micro-Loans

Microloans are from $1,000 to $50,000 loans with a wide range of terms. They're designed for start-ups, so they don't require a demonstrated history of profitability.

The Small Business Administration's Microloan program works through local non-profits. It funds start-up, expansion, and child-care centers. It requires collateral and personal loan guarantees. 

Accion is a website that connects small businesses with lenders from around the world. It lends anywhere from $5,000 to $100,000.

Kiva allows lenders to contribute just a portion of the borrowers' loan. It is a non-profit designed to help entrepreneurs in under-served parts of the world, but U.S. small businesses can and do apply. Kiva provides interest-free loans if you're business providing a social good, such as organic food, an urban mushroom farm, or gluten-free vegan granola. 

"Boot-Strap" Loans

Boot-strap loans are the most common source of funds because loan applications are difficult and time-consuming. Most businesses that are just starting out use their own funds, loans from friends and family, or credit card debt. The advantage is that you can get any of these loans pretty quickly. 

The disadvantage is that loans from friends and family are emotionally risky. That's because they can permanently ruin your relationships with them. Once friends and family become lenders, they may meddle with your business, causing distractions. If your business fails, they may take it personally or think you took them for granted. You might be forced to give them your car, home or anything else you put up for collateral. There could be hard feelings from all sides.

Less than 10% of all small businesses use credit cards for financing, according to the SBA. That's because a credit card loan could wind up costing a small fortune, thanks to the high-interest rates. 

The home equity loan has the advantage that you can write off your interest payments. However, you might lose your home.

One other alternative is an unsecured personal loan. It doesn't require collateral and may be easier for new businesses to get because the lender looks at your personal credit history, rather than the business's finances.

Other Forms of Small Business Funding

Crowdsourcing is when a group of people provides funds for a business via a website. You must get them excited about your company's purpose. 

Angel investors are wealthy individuals who provide their own funds. In return, they expect part-ownership and a percent of future profits. They are looking for a high rate of return, and so tolerate high risk.

Venture capitalists are companies who use investors' funds instead of their own. They want a share of future profits and a controlling share of ownership. They offer more money than angel investors but tolerate less risk. 

A self-liquidating loan may also be a good way to finance your business, especially if it's a seasonal one. The loan helps you buy assets or inventory that you can then sell. You repay the loan with the money you earn from the sale of those assets, and then you get to keep whatever is left over.

Private equity is when a group of investors buys a controlling share of a company. They usually have a five to 10-year time horizon. They look for a $2.50 return for every dollar invested. 

Small business grants don't require repayment. But your business must serve a particular purpose as outlined by the government. The application process is detailed and may require too much time.

Supply-chain financing is like a pay-day loan for businesses. Suppliers use the invoice for a shipment as collateral to get a low-interest loan from a bank. Banks know that they will get paid due to the credit-worthiness of the business receiving the goods. This helps small suppliers get better financing terms. Even banks that are reluctant to lend to each other are willing to lend against approved purchase orders and invoices with companies that have a good shipping record.

Another source of funds is becoming more efficient in your operations. This frees up cash to invest in your company's growth. For example, reduce foreign exchange and interest rate risk. 

How Small Business Loans Affect the Economy

Small businesses gained 9.1 million jobs between March 2019 and March 2020 and lost 8.7 million, for a net increase of 466,607 jobs. For this reason, loans to these entrepreneurs keep the economy functioning.

Almost three-fourths of all small businesses need financing each year, according to the SBA. The amount borrowed totaled $1.2 trillion in 2015, the latest statistics available. Of that, $600 billion was bank loans and $422 billion was credit from finance companies on receivables. The rest was buyouts and venture capital.

Most new companies need $10,000 each in startup capital. Hi-tech firms need eight times that amount. Once they become established, small companies need loans to purchase inventory, expand or strengthen their operations.