Financing options for small business owners
Depending on a small business owner’s goals, financial situation, circumstances, and funding needs, the appropriate financing options will vary. It is prudent for small business owners to consult with a financial planner who can provide objective advice as this type of decision is made. I provide advice in this area to my small business owner clients if they are looking for financing options and are going through the decision-making process to find the best option available to them. This list is not exhaustive, but I describe financing options below that I believe are best suited for small business owners, which include Small Business Administration (SBA) loans, Traditional bank loans, and Lines of Credit. There are equity financing options available, but for the purpose of this post, I am focusing on debt financing options. There are pros and cons of both equity and debt financing options and the decision to choose one (or both) of these options depends on the specific goals and financial situation of a small business owner. External items such as tax rates and interest rates are also factors that should be considered when making this decision.
Small Business Administration (SBA) loans
Small Business Administration (SBA) loans are designed to support small business owners with their financing needs (e.g., starting up, expanding, recovery) and are backed by the U.S. government. These types of loans are beneficial to small business owners as down payments are lower and terms are more flexible in comparison to conventional loans. Additionally, with SBA loans being guaranteed by the U.S. government, this reduces the risk for available lenders and provides small business owners more opportunities to qualify. Eligibility for loan qualification includes sources of income, location, and credit history. Types of SBA loans include:
7(a) loans: This is the primary loan program of the SBA with a maximum loan amount of $5 million. They can be used by small business owners for items such as working capital, debt refinancing, purchasing, acquiring real estate, and purchasing business equipment.
504 loans: This is a loan program that provides long-term, fixed rate financing to small business owners for major fixed assets with a maximum loan amount of $5.5 million. They are available through Certified Development Companies (CDCs) who promote economic development within their communities.
Microloans: This is a loan program focused on supporting small business owners for startup and expansion with a maximum loan amount of $50,000. They are administered by designated intermediary lenders.
Traditional bank loans
Traditional bank loans are made available to small business owners at banks and credit unions. Qualification for these types of loans generally requires an application showing business plans (e.g., describing how the loan funds will be used to generate revenue), financial statements, a strong credit score and collateral (e.g., real estate, equipment, inventory), which means they are not the easiest loans to qualify for. The purpose of collateral is to secure the loan, which helps mitigate the risk to the lender. These types of loans provide lower interest rates and longer repayment terms to small business owners, which result in cost savings (lower payments) over the term of these loans. In addition to improved cash flow (via cost savings), traditional bank loans can provide a level of stability to small business owners since lenders of these types of loans are well-established financial institutions that have strong reputations and a history of providing reliable services. Even further, these financial institutions are required to follow strict regulations, which benefits small business owners as these regulations are designed to provide consumer protection to borrowers.
Lines of Credit
A line of credit provides small business owners access to a predetermined amount of funds that they draw from when necessary. As long as they stay within the credit limit offered, they can continue repeating this process of borrowing and repaying (note that interest is only paid on the amount that is borrowed). The credit limit made available to a small business owner depends on factors such as credit score and financial strength. Regarding the interest rate, it is typically variable, which is a potential drawback of this type of financing as a variable rate provides a level of uncertainty about costs (and available cash flow). Lines of credit can be renewed by small business owners on an annual basis or after a period that has been agreed upon.
The most important benefit to small business owners when using lines of credit is the flexibility of this type of financing as they can quickly draw on the amounts needed to address items such as emergencies, short-term expenses, cash flow irregularities, and taking advantage of business opportunities. Unlike traditional bank loans where interest is charged on an entire loan amount provided upfront to a small business owner, lines of credit only charge interest on the funds that they decide to use.