Obtaining capital is one of the biggest challenges for startup businesses. Many entrepreneurs struggle in finding the right financing method and securing the loan needed for their initial growth. This is despite the wide range of small business loan options available. While there are some low-cost options, they are not often accessible to business owners without strong credits, good revenues, and several years of business under their belts.
A startup loan is financing intended to support the financial needs of a new business. Proceeds can be allocated to purchasing equipment and machinery, supplies, and inventory. It may also be used as working capital, or for the acquisition of real estate. Banks are the usual first choice for a startup loan, but due to the strict lending standards of these institutions, businesses may be better off with other alternatives.
1. Personal funding
While using personal funds or loans is a risk, it is still a viable option to access capital for small business owners. It takes a shrewd mind to be able to balance funds and not run out of money before the business can support itself. There are different options when it comes to personal funding. One way is to use personal credit cards with a relatively high limit. Entrepreneurs who have quite a large amount set aside may also dip into their savings.
Another way of personal funding is by borrowing against your home equity. Equity is the difference between your home’s market value and the mortgage you owe. There are two types – the fixed-rate and the home equity line of credit (HELOC). HELOC is a revolving source fund that works just like a credit card. You can access it as you choose. While this is a gamble, this type of loan has several advantages.
With HELOC, there is a preapproved amount that a borrower may access anytime. Repayment usually involved an interest-only fee during the draw period. There will be no interest paid on the money you will not use. Interest rates are also generally adjustable and less than those for credit cards or other loans. Since HELOC is flexible, it works best with businesses that need to draw on credit lines on demand. For more information about home equity loans, click here.
Many startup owners have also received capital from family and friends. In fact, this is one of the biggest sources of funds for early-stage businesses. Families can be a great, positive support for your new venture, but you still have to exercise caution. Once they are involved, the potential cost of your failure has become personal. It is best to approach those who understand your plans and are comfortable with taking risks.
2. SBA loans and microloans
SBA loans are those that are sponsored by the Small Business Administration (SBA), a federal program that grants support to small business owners, either through mentorship or funds. When applying for an SBA loan, you need to present a list of documents to your lending institution. This includes your personal background documents (e.g. educational background, previous addresses, and criminal records, if any) and professional resume.
You will also need to submit a detailed business plan, a business credit report, personal/ business tax returns, and legal documents, which include your business licenses and registrations, franchise agreements, and commercial real estate or business equipment leases. Lenders will also look for your personal credit report to determine whether you are a good bet for lending and see if how you will be able to handle money within your startup.
There are different types of SBA loans. The most popular is the 7(a) program. In 2020, about 17% of the money lent through the 7(a) loan program in the United States went to startups. Through this, business owners can receive around $5 million of the loan amount. However, 7(a) SBA loans are quite difficult to secure. They are mostly granted to established businesses that can provide collateral in case of default. Processing may also take several months.
Meanwhile, SBA microloans are made by approved middle persons, usually community development financial institutions and other nonprofit organizations. They are often utilized for working capital and supply purchases. The longest loan term is 72 months and the average is about 40 months. Meanwhile, the maximum loan can reach $50,000, while the average amount is about $13,000. For this reason, some startups may find SBA microloans to be insufficient.
There are other microlending options aside from SBA. Nonprofit organizations also offer startup businesses opportunities to acquire financing in smaller amounts. Usually, these lenders target disadvantaged and struggling small business owners. If you have shaky finances, securing loans from lending institutions tends to be difficult. However, both the lender and the borrower can now use a tool to customize the amortization schedule in order to make things easier. Nonprofit microlenders offer an easier route for those with money management problems.
3. Crowdfunding
Crowdfunding involves soliciting funds through online campaigns. It has become a popular method for startups to raise money. With crowdfunding, you will present your pitch to a large group of people and get them to agree to finance your business in exchange for equity ownership. New security regulations have also allowed entrepreneurs to reach out to mom-and-pop investors, making crowdfunding a broader option.
Crowdfunding is also the perfect financing option for businesses looking to raise up to $5 million. While campaigns can take a lot of marketing effort for business owners, the funds raised and business validation from potential customers you will receive make it worth it. This is why this method is particularly good for startups who have products and want to test the market, no credit necessary.
4. Equipment Financing
Equipment loans are purposely designed for the purchase of vehicles, machinery, and furniture. While business owners can use their operating cash flow and pay for large equipment in lump sums, this can be costly. Equipment financing will allow them to extend the payment terms over time rather than paying all at once. This way, entrepreneurs can increase their working capital and cover other operating expenses.
Equipment financing is structurally similar to conventional loans, with monthly repayment terms covering a specific period of time. It tends to have less strict standards, as your equipment will be used as collateral for the loan. During default, lenders have the right to seize your equipment to cover the cost of their lost money. Utilizing this financing option can also free up other credit lines, so if you want to apply for a business term loan later, you can.
Pros and Cons of Loans for Business Start-Ups
A startup loan is used by business owners when they need to raise money right away for their operations since it has many advantages over other types of loans. But, a loan for a company has benefits and drawbacks, just like practically other credit products.
Here are the top pros and cons of a loan taken for a startup:
Pros
1. Immediate Capital
Startup business owners require ongoing funding to expand their enterprises and secure their viability in the face of fierce competition. Such business owners can quickly and easily get the necessary funds by taking out loans for their startups. After acceptance, the loan amount is credited within 48 hours into the bank account.
2. Better Control
Entrepreneurs can raise money in two ways: through venture capital funding or business loans. In the event of VC funding, the startup owners have to sell their company’s equity, which causes them to have reduced control. On the other hand, small business loans simply demand the loan amount to be repaid over time, providing the borrower better control over the company.
3. Nominal Interest Rates
Startup-focused business loans provide attractive and reasonable interest rates that are free of extra fees or hidden costs. The nominal interest rates on such business loans ensure that startup entrepreneurs can pay the money without creating a future financial strain. Also, borrowers have multiple alternatives for loan repayment.
4. Personal Wealth Protection
The capacity of business loans for startups to protect the personal wealth of the firm owner is one of their most advantageous qualities. Business owners can avoid using their own money to invest in the company, which can be risky for startups, by using a startup loan. So, these loans can help business owners who are just starting out grow their enterprises without having to invest their own money at great risk.
Cons
1. Eligibility Criteria
Similar to other forms of loans, obtaining a business loan for a startup requires meeting the established eligibility requirements. The minimum business turnover, credit score, business history, type of business activity, etc., may be included. Small business entrepreneurs frequently struggle to meet the requirements for these loans because they think they are onerous.
2. Cash Flow Restrictions
With startup loans, the business owner must make monthly EMI payments covering both the principal and interest. If the loan received is short-term or has a large EMI amount, it can put financial stress on the firm to fulfill the monthly EMI liability towards the lender. In such a circumstance, the startup may encounter cash flow difficulties.
3. Personal Guarantee
No collateral is necessary for a startup loan in some countries, although some lenders may still want the firm owners to provide a personal guarantee in case the company fails or fails to make interest payments. In such a circumstance, the financial institution may require you to clear all the outstanding loan amounts from your wealth, leading to large losses.
4. Burning Cash
Startups frequently spend the money they make from giving discounts or freebies to draw in clients. But, if it is increased to the loan amount, it can significantly negatively impact the startup’s cash flow and, ultimately, viability.