When seeking capital, entrepreneurs and small business owners have two main options: either raise equity capital from investors or secure debt financing. Getting new investors to put up their own money is a time-consuming process that is also subject to federal and state restrictions, and it involves profit sharing in the future.
If the owner is required to get approval from an outside board of directors for all management decisions, the owner may lose any say in the running of the business.
However, cautions against borrowing have been part of the fabric of small businesses for decades. Repeatedly hearing horror stories about ruthless debt collectors, heartless lenders, and ignorant borrowers are presented as an unavoidable consequence of taking on business debt.
The dangers of small business debt are often greatly exaggerated, although this mythology exists with many others. We’ll go through some of the advantages of small business loans and why they could be the best choice for your company.
A Few Advantages of Small Business Loans
Small business owners that use debt to their advantage should be applauded, not criticized. Intelligent debt finance has many advantages.
- The Quickness of Funding. The time it takes to request and receive debt financing is typically far quicker than that for equity financing. In most cases, a borrower will work with a single funding provider that follows standard operating procedures to underwrite and fund the requested amount of financing. In contrast, attracting equity funding often necessitates approaching a number of investors, each of whom may use their own criteria for deciding whether or not to invest.
- Effortless management. Borrowing money is simple; all you need to do is fill out some documents and provide your bank statements. Those who have invested in the company’s equity are entitled to regular updates on the business’s progress, as well as the convening of any necessary shareholder meetings and the board’s stamp of approval.
- There was a retention of ownership. Lenders do not participate in the company’s earnings or losses in the same way that stockholders do. Since lenders have no direct claims on future revenues, the firm owner reaps the benefits of their management and investment without diluting their stake.
- Direction from above. Lenders have no say in matters of employees, finances, or operations, and are instead focused solely on ensuring that the loan is repaid as agreed.
- Terms that are easy to understand. Loan details, such as the principal amount, interest rate, repayment schedule, and collateral (if any), are all laid out in detail at the outset and are not subject to negotiation or amendment.
- Tax breaks. Business interest is usually deductible from taxable income, so the borrower and the government split the expense.
Disadvantages of Small Business Loans
Despite the fact that there are a few positives to incorporating debt into a company’s capital structure, the fact remains that it will need to be returned at some point.
Informed borrowers will recognize that:
- A repayment lowers cash flows in the future. While it’s true that debt financing might help you get started, it ultimately ends up draining resources that could be put toward growth such as capital expenditures or shareholder payouts rather than simply sitting on the books.
- Conditions of repayment are unchanging. Lenders are hesitant to negotiate changes to a loan’s conditions unless they receive extra benefits, such as larger interest payments, additional security, or control over future cash expenditures.
- Moneylenders Often Make Strict Time Requirements. Lenders are not partners; they are vendors, no matter how friendly and helpful they may be at the beginning of the borrowing process. The lender cares only about getting paid back what they loaned, even if that means the business has to file for bankruptcy if it runs into financial trouble in the future.
Popular Loans for Small Businesses
There is a wide variety of loan options available to businesses, each with its own specific features and goals.
The ones below are among the most typical:
1. Loans for accounts receivable (AR)
Accounts receivable that go unpaid have a negative effect on cash flow. There will always be accounts receivable amount at the end of the month unless the business only accepts cash payments.
Payments for transactions that occur at the end of one month may not be received until the beginning of the following month if the terms of payment are 10 days from the date of the invoice.
The ability to enforce credit terms is typically a challenge for small businesses selling competing items to large clients. One of my investments was a wood-treating plant in Mississippi, and it was successful because it was able to sell its wares to utilities and railroads across the country.
These customers typically made payments 45-60 days after being invoiced. While these were not high-risk customers, their payment delays severely impacted our ability to meet our financial obligations. The issue was fixed by obtaining a loan secured by accounts receivable on a revolving basis.
Finance companies favor lending against accounts receivable because the collateral can be converted into cash fast. Lenders are usually willing to advance between 70% and 80% of an AR amount that is less than 60 days old for these types of loans.
Some financial institutions may pay a greater or lesser percentage of the value of an account according to its age, for example, 90% for an account that is 30 days old or less, 75% for an account that is 30 to 60 days old, and 50% for an account that is 60 to 90 days old.
Receivables that are 90 days old or older are of little use as collateral because few banks would take them. A standard AR loan involves the company submitting an AR schedule to the bank in exchange for a cash advance based on the estimated values of the company’s AR.
New accounts are opened as a result of sales, and the outstanding balance of existing loans is adjusted downwards as the month passes. If the account balance in the following month is higher than the previous month’s amount, the bank will make an additional cash advance to the business equal to the difference, less interest.
The business must pay back the bank the difference, plus interest if the account balance is lower the following month than the prior month. The loan balance thus fluctuates on a monthly basis. In both cases, the previous loan is repaid and a new one is established.
It is common practice for some financial institutions to handle the collection of accounts receivable on their client’s behalf by mandating that any payments for outstanding invoices be made to a special bank account dedicated to that purpose.
The bank may also opt to let the business keep using its current method of loan repayment, in which case it would rely on the business to report collection activity to it on a timely basis and maintain adequate cash reserves to cover any eventual loan repayment obligations.
It’s possible that the bank will want personal guarantees from the company’s proprietors in addition to the accounts receivable pledged as collateral.
Instead of borrowing money based on the value of their accounts receivable, some business owners choose to factor in their invoices. Accounts receivable are factored when sold to a third party, the factor, at a reduction from their face value.
Companies like Blueline provide a means to convert accounts receivable into immediate cash flow. Within 24 hours of applying, you could find yourself approved at rates as little as 0.25% each week.
Negotiations between the factor and the company will determine whether or not the factor takes on any collection risk or responsibility.
If the latter is the case, the factor may keep the option to return the uncollectible accounts and the associated monies to the company. It’s important for entrepreneurs to understand that factoring agreements and AR loans are viewed by the IRS in a different light.
2. Inventory Loans
Most businesses can’t function without some sort of inventory system to store their supplies and finished goods. Both producers and retailers would be unable to meet consumer demand in the absence of necessary inputs (raw materials) and outputs (finished items).
Our wood-processing facilities spent thousands of dollars on green wooden railroad ties and pre-cut timber poles, which were generally utilized to repair or replace railroad, telephone, and utility lines that had been damaged by weather or a natural disaster.
After each storm, there would be a surge in demand for these goods, therefore speedy shipping was crucial. Customers would go elsewhere if we didn’t stock the appropriate pole length. Since then, the worth of our stock has grown to the point that it has eclipsed the building’s book value.
In the same way, as unpaid receivables drain funds until they are collected, unsold inventory does the same. Untreated poles and ties and green lumber were constantly on hand. We started a sequence of short-term loans using the stock as security to boost cash flow.
Banks and other lenders are less interested in utilizing inventory as security than accounts receivable, especially if the inventory needs to be invested in further to be sold as finished goods.
Therefore, banks often only lend between 50% and 60% of the value of finished inventory, and even less for WIP and raw materials assuming they accept either as collateral at all.
Like with accounts receivable, the balance of an inventory loan varies in accordance with the value of the goods pledged as collateral. With an increase in collateral value from one month to the next, the loan balance rises and more money is issued.
When the collateral value is less than the outstanding loan sum at the end of a given month, the company is required to pay down the difference.
Our bank, for instance, is providing us with a loan for 50% of the value of our finished goods and 40% of the value of our green timber. With $250,000 in treated products and $140,000 in green lumber in the bank at the end of the first month, we were able to borrow $181,000 (50% of $250,000 plus 40% of $140,000).
We continued to purchase raw materials, treat green lumber, and sell treated goods during the following month of business. Because we had $175,000 in finished goods and $185,000 in raw materials at the end of the month, we were able to get a fresh loan for $161,500 (50% of $175,000 plus 40% of $185,000).
We took out a new loan for $161,500 after paying off the previous one for $181,000. We also caught up on the interest by one month’s payment.
Lenders typically require periodic physical counts of inventory in addition to accounting record valuations to ensure accuracy and make loan adjustments as necessary.
The bank may demand more frequent physical counts than is customary in order to make loan payments, which would increase the company’s administrative burden.
The value of the inventory used as collateral for a bank loan is typically guaranteed by the business owner, just as it is for accounts receivable loans. OnDeck is a wonderful online lender for inventory loans if you already have a thriving business.
Kabbage, on the other hand, could be an excellent choice if you run a small business or have a bad credit score.
3. Loans for equipment
Typically, the collateral for an equipment loan will be the very piece of machinery that the money will be used to buy. Most loans for purchasing equipment have periods between three and eight years and are amortized through equal monthly payments of interest and principal.
A lender a bank, financing business, or manufacturer will have the legal right to seize the collateral if the borrower defaults on the loan. The lender’s need for personal guarantees from the owners is contingent on the lender’s risk assessment of the loan value of the collateral.
The borrower is obligated to ensure the machinery is in proper operating order and insured against any potential damage or loss during the loan term. The equity value of the pledged collateral may improve over the life of the loan, allowing the company to either refinance the existing loan or take out a new loan against the collateral.
Rather, the second lender would have to wait until the first one is repaid in full before taking title to the machinery that serves as collateral for both loans. Therefore, the secondary, subordinate lender would often demand a higher interest rate to compensate for the added risk associated with the loan.
Our treatment facility acquired rolling stock through vendor financing of typically 100% of the purchase price, amortized over a three-year period, with the help of equipment loans from truck manufacturers.
As we amortized our loan, the market value of our rolling stock remained higher than its book value or loan value since the value of big trucks and trailers falls considerably more slowly than that of autos. This surplus may have been used to guarantee additional loans.
Currency is the best option if you need an equipment loan but don’t have perfect credit. But OnDeck is the best option if you need to close your loan soon. When it comes to loan approval and funding, they can do it in as short as 24 to 48 hours.
4. Loans for Real Estate
Loans on land and buildings real estate are backed by the physical assets listed as collateral in the mortgage. The loan balance on real estate is amortized during the loan’s tenure, which is normally between 15 and 30 years.
A typical loan amount is between 70% and 90% of the property’s worth as determined by the market at the time the loan is closed. Before committing to a real estate loan for their company, entrepreneurs should carefully compare the total cost of ownership to the monthly rental or lease payment for comparable space.
If the original building cannot be sold or renovated for other purposes, then relocating the business could be more difficult if the owner also owns the site on which the business currently operates.
5. Loans for Working Capital
Some businesses may qualify for an unsecured loan from a bank or other financial institution if they have substantial equity, a track record of profitability, or wealthy proprietors. Borrower and lender might negotiate for the loan to be paid back in full at the end of the term or to be amortized during its term.
Loans for working capital are not meant to be used for the purchase of fixed or variable assets, but rather to bridge temporary cash flow gaps. Lenders take on more risk with unsecured loans since they have no concrete collateral to confiscate in case of default.
In the event of a business liquidation or bankruptcy, secured creditors have priority over unsecured creditors and are paid in full before unsecured creditors receive any of the remaining funds. Therefore, a higher interest rate is associated with unsecured debt.
6. Credit Letters
Financial institutions guaranteeing to fund future sums through letters of credit (LC) agreements are occasionally utilized as an alternative to working capital loans.
With a short-term guarantee, a borrower pays a charge to a lender usually between 1 and 5 percent of the total loan amount, and then takes out a loan only if and when the money is needed.
Interest on an LC is not owed until the LC is financed, making it a cheaper alternative to a loan. Additionally, until the loan is funded, the borrower does not have to include it in their balance sheet, giving the impression of lower debt.
As the LC guarantee amount is drawn down, the lender’s responsibility to fund the borrower up to that level often declines.
Their responsibility will end once the guaranteed amount has been fully borrowed, or when the guarantee period has expired, whichever comes first. An LC advance is a loan, subject to the repayment terms already agreed upon and typically recorded separately.
7. The SBA Loan Program
In light of widespread reluctance among financial institutions to provide loans to small enterprises, the federal government has launched a number of initiatives to change this.
The Small Business Administration’s (SBA) guarantee program is the most well-known of these initiatives; it guarantees repayment of up to 85 percent of the lent amount, greatly decreasing the risks to the lender.
The downsides of the program, from the perspective of the borrowers, are:
- There is a Shortage of SBA Lenders. Few financial organizations and banks provide this type of credit.
- It’s a pain to fill out applications. For a regular bank loan, the paperwork involved is much simpler than what is needed for an SBA guarantee.
- There Should Be Restriction on Borrowing Money. The lending scheme only allows the money to be used for certain things, including buying inventory or machinery. Purchases of real estate may be legal in some jurisdictions.
- Capacity to Make Repayments. Successful managerial experience, strong credit, and a minimum equity contribution of 25% (for startups) or 20% (for existing firms) of the total debt and equity at the time of funding are all requirements for obtaining a loan.
- In the form of Personal Guarantees. Any individual or couple owning 20% or more of a company is required to personally guarantee repayment of the debt on a joint and several bases. Therefore, each guarantor is responsible for the entire loan amount regardless of their percentage of ownership.
In my opinion, applying for and receiving an SBA loan is well worth the additional effort and paperwork involved. Once we had acquired the wood-treating plant, we were confronted with making significant changes to the plant to make it in line with new EPA requirements.
We were able to secure a 7(a) loan for $500,000 from a local bank that is an SBA-approved lender. The loan term is ten years. We fulfilled our part of the loan agreement by making timely payments.
SBA loans have stricter requirements than what many business owners would like, therefore they often opt for more lenient terms with a more cooperative financial institution instead. The Small Business Administration approach, however, may be the sole choice for businesses with bad credit or little assets to utilize as collateral.
Understanding the many avenues available for securing financial backing is crucial for success in today’s business world. Cash flow issues are cited as the primary cause of failure for over 80% of small firms, per SCORE.
Many business owners overlook the importance of cash flow and put off exploring financing possibilities, such as debt agreements, that could be the difference between success and failure.
Profitability and a steady flow of cash are, in my experience as a small business manager, the best deterrents against shareholder or lender concerns.
A well-managed company will use a mix of debt and equity financing, as each has its place. Nevertheless, no one should take on debt without first fully appreciating the implications.