Debt has a bad name. From
Shakespeare’s quote “Neither a borrower nor a lender be” to Benjamin Franklin’s
“Rather go to bed supperless than rise in debt,” wise heads through the ages have
reminded us of the dangers of borrowing.
But for many small businesses, borrowing is a powerful way to raise money to finance growth and expansion. Just like any other funding method, it has its own particular pros and cons.
In this tutorial, we’ll look at the different options for borrowing money, and the advantages and disadvantages of each one. Then we’ll look at some practical ways you can secure funding on terms that make sense for your business.
This is part three of our eight-part series on Funding a Business. We’ve already given a rundown of the main funding options, and examined how to fund a business from your own pocket. After this, we’ll look at the various forms of equity investment.
But for today, we’re focusing on debt. By the end, you should be in a good position to decide whether borrowing is a good option for your business, understand the different alternatives available to you, and know how to apply for and secure funding on favorable terms.
1. Different Options
There are lots of different ways in which businesses borrow money. Here are some of the main ones:
The simplest option is to go to your local bank and ask for a business loan. Well, it’s simple in concept, anyway: you borrow a specific amount for a fixed term of, say, five years, and pay it back in monthly installments with interest added.
If you can qualify, this is one of the best ways to borrow, because you get long-term access to funds, at an interest rate that’s often better than those offered by other options like business credit cards. But that “if” is important. It can be very hard to be approved for these loans, and even if you are successful, the bank will often ask for significant personal guarantees or collateral.
If you’re struggling to qualify for bank loans, the U.S. Small Business Administration may be able to help.
With these loans, you’re still borrowing from a bank or other private lender, not directly from the government. But the SBA guarantees the loan, making it easier to convince a private lender to extend credit to you. There are programs for general small business loans, as well as for businesses facing special circumstances like recovering from a natural disaster. You can find out more here.
The SBA programs can make it easier for small businesses to qualify for a loan, but there are still eligibility requirements, and getting funding can be a long process. You’ll often have to offer personal guarantees and collateral. And if you default, the government backing doesn’t mean you’re off the hook. The bank will still try to collect what it can, and then the government will try to recover the rest of what you owe.
This program is specifically for U.S. companies, but some other countries offer similar things. The Bank of England’s Funding for Lending scheme is one example.
Business Credit Cards
Businesses can use credit cards, just like individuals. And the advice on how to use them is much the same, too. While they’re convenient ways of getting short-term access to funds, and much easier to apply for than bank loans, it’s dangerous to let the balance build up too high for too long. Interest rates are often in excess of 20%, so it’s best to keep paying off the balance as much as you can afford to. Only use them for long-term funding as a last resort.
Business Lines of Credit
These work in a similar way to credit cards. Rather than borrowing a fixed amount, you get access to whatever funds you need up to an agreed amount. But the interest rates are often more favorable, especially if your business has assets you can offer as collateral. You only pay interest on the amount of money you access, not on the overall size of the credit line.
Let’s say you’ve sold $10,000 of goods, but haven’t received the money from the customer yet. You could go to a factoring company, which would provide you with $8,500 immediately. Then when the customer pays a month later, the factoring company sends you the remaining $1,500, minus its fee.
Factoring is a good short-term funding solution when you’ve made sales and are waiting for the cash to come in, but you’ll need to look at other options if you want to fund your business for the long term.
2. Advantages of Funding a Business by Borrowing
All of these forms of debt have costs and risks associated with them. But if used right, borrowing can have some powerful advantages for a business. Here are some of them:
Many of the other options we’ll look at in this series involve inviting people to invest in your company, and giving up some control in the process.
With debt, on the other hand, you stay in control. A lender will want to see a business plan and will grill you on your business practices and strategies, but once you’re approved, they won’t try to take the reins from you as venture capital or private equity investors sometimes do. You may have to show financial reports and adhere to “covenants” specifying things like the levels of cash you have to maintain for the health of the business, but as long as your business is healthy and you’re making the repayments, you keep full control.
Retain 100% of Future Profits
The main reason small business owners take out loans is to invest in the future of their company, and it’s logical to expect that investment to yield a profit. When you borrow money, all those profits belong to you (minus the loan repayments, of course). This is different from equity funding, where you give up a share of future profits to someone else in return for the cash upfront.
If you use the money well, debt can actually work out to be a cheaper form of funding than equity. For example, when Facebook was just a few months old, back in 2004, it secured $500,000 in funding from an angel investor, Peter Thiel, who took 10% of the company in return.
The 10% stake that Facebook’s founders gave up was eventually worth more than $1 billion. If they’d taken out a $500,000 loan instead, they’d have paid back only the $500,000 plus interest: a much cheaper option.
Of course this is an extreme example, and in reality it probably wouldn’t have been possible for such a new company to secure such a large loan. But it does illustrate the point that although debt can appear costly at first, it can be worth it in the long run.
Whereas wooing potential equity investors is a lengthy process, some of the borrowing options are much quicker. You’ll need to go through an application process and provide evidence of your business’s financial viability, but still you can generally expect a quicker decision, especially with things like factoring, credit cards and lines of credit. Some online services cut the time down even more. Kabbage, for example, pledges to provide funds (if you’re approved) within seven minutes.
3. Disadvantages of Funding a Business by Borrowing
Debt also has its downsides, of course. Here are three of the big ones.
Difficulty of Acquiring
This is the biggest disadvantage for many businesses, they’re simply unable to qualify for a loan. Banks and other lenders have become more cautious in the wake of the 2008 financial crisis, and the requirements are often very strict. SBA backing helps, but even that program has eligibility restrictions.
The result is that more than half of all small businesses have been rejected for much-needed loans in the past four years, according to a survey by the National Small Business Association. In addition, 29% of small businesses reported having their existing loans or lines of credit reduced.
Cost of Repayment
Every form of funding has its own costs, but with debt, those costs are more real and immediate.
With the various “equity” forms of funding that we’ll look at in future tutorials, for example, you give up a stake in your business and a portion of future profits. As we saw in the Facebook example, there is a cost to that, but it’s more intangible.
When you take out a loan, on the other hand, you commit to start repaying the money every month, with interest, whether your business is making any profits or not. The same NSBA survey found that the average interest rate on a business credit card was 15.6%, and many businesses were paying 20% or more. Other forms of debt usually have lower rates, but you’re still locked into a repayment plan that will eat into your profits.
Often, banks will ask business owners to put up their houses or other personal assets as collateral for business loans, or to give a personal guarantee. This is especially common for small businesses with limited trading histories. If you do that, the risks are substantial. If your business fails and you can’t pay back the loan, you could lose not only your business but also your home. We’ll look more at the question of collateral and guarantees in the next section.
4. Tips for Successful Funding
As those survey statistics show, borrowing money is not easy, especially on terms that you can agree to. But it’s not impossible. Here are some strategies you can use.
Cast a Wide Net
Michael McKean of hospitality company The Knowland Group approached a dozen different banks before he found an acceptable loan. Some rejected him outright, while others came back with onerous terms. He kept going, and eventually secured a loan from M&T Bank. His approach to M&T was exactly the same as to the other banks, but this time it worked. Persistence sometimes pays off.
So don’t assume that because you’ve been rejected by one or two banks, you’ll be rejected by all of them. Keep making proposals, targeting 10 or more different lenders, to maximize your chances of success. And don’t forget to see if you’re eligible for any of the SBA programs.
If you keep getting rejected for loans, try asking for a smaller amount. It may be that the lenders don’t think your company can handle the sum you originally asked for, but would be prepared to lend less.
It’s also worth going small in terms of the institutions you approach. Many of the large, national banks are wary of making loans to smaller companies, because they still have to bear the administration and underwriting costs, but make less profit than they would on larger loans.
So go beyond the household names, and approach small local banks, community banks and credit unions as well.
Be Careful What You Commit To
With many types of loans, some kind of collateral or personal guarantee will be needed. If you’re desperate for the funds, it can be tempting to sign anything you’re asked to sign, but it’s worth at least trying to negotiate, and even walking away if you’re not comfortable with what’s in the fine print.
The first step is to offer as many business assets for collateral as possible. The more security you can provide from your business, the less you’ll have to provide from your personal funds. So make a full inventory of anything you can include in your proposal, and try to give the lender as much security as possible.
If it’s not possible to avoid making a personal guarantee, at least try to put limits on it, protecting your family home if you can. Going into business is enough of a risk already, without literally “betting the farm.”
It may seem as if you’re in no position to negotiate, but don’t forget that lenders are not doing you any favors. It’s a business transaction, and they may be willing to make some concessions to conclude it successfully. If they won’t, it might be better to walk away than to commit to terms that aren’t in your interests.
You’ve already taken the first step by reading this tutorial, but if you’d like to go into more depth on any of the options, help is out there. The non-profit group SCORE runs workshops for small business owners both online and locally, as well as providing mentoring and advice. The SBA also operates about 900 Small Business Development Centers nationwide, providing help not only with SBA loans but also other aspects of funding and running your business. And there are Women’s Business Centers aimed specifically at helping female entrepreneurs.
5. Other Options
So now you know some of the options for borrowing money for your business, and the advantages and disadvantages of each approach. Plus, you’ve got some strategies you can use to secure funding.
After reading this and exploring each alternative, you may find yourself siding with Shakespeare and Franklin after all, and deciding that debt is not for you. If that’s the case, don’t worry. For the next five weeks we’re going to explore a range of different options for Funding a Business, starting next week with a tutorial on crowdfunding.