Man getting business loan
Your credit score, the age of your company and the goals behind the need for financing all play key roles in determining the best business loan option. — Getty Images/skynesher

For a small business to succeed, it must be adequately funded. At times owners realize that they need more money to keep their company functioning smoothly or to finance expansion. These situations might require taking out a loan.

This guide will:

  1. Help you determine if a loan is your best option.
  2. Prepare you for questions a lender will ask.
  3. Describe the types of loans that are available, and their advantages and disadvantages.
  4. Explain the difference between secured and unsecured loans.
  5. Familiarize you with how Small Business Administration (SBA) loans work.
  6. Caution you against unfair lending practices.

Is a loan your best option?

You need to decide if you really need a loan or if the main issue is related to cash flow. If cash flow is what’s causing the financial difficulties, you may be able to figure out a way to accelerate your receivables, even if that means offering customers a slight reduction in price for paying their bills early.

Decide if a loan will help you achieve the goals in your business plan. If you don’t already have a business plan, write one. [Struggling with writing a business plan? Check out our guide: How to Write a Business Plan] A formal business plan will give you a better idea of what you need to accomplish with a potential loan and how large a loan you need. It’s an important step, because if you decide to pursue a loan, most lenders will require a business plan.

Questions lenders will ask

Since lenders are also business people who need to make a profit, the first question you’ll get is, “Can you repay the loan?”

Lenders will determine this about you themselves, by taking a look at your credit history and financial statements.

The three main criteria lenders use to decide whether to approve you for a loan are

  • your personal credit score,
  • your time in business, and
  • your annual revenue.

Depending on the lender — for example, a traditional bank versus an online lender — some factors will be more important than others.

Young companies may have a harder time securing a loan because they don’t have a track record. To increase the odds of getting a loan, it’s essential that you establish a business credit profile as soon as possible.

Lenders will also question if you have a backup plan, in the event your reason for obtaining the loan is unsuccessful. For example, if the loan is to fund a project designed to increase revenue, and that doesn’t happen, they’ll want to know if you will still be able to make your regular loan payments.

Before you apply for a loan, try and get your credit score in the best shape possible. Also, start gathering the paperwork you’ll likely need, including:

  • Business financial statements, like a current profit and loss statement from the last three fiscal years, a cash flow statement and your balance sheet.
  • Bank statements from the last three months.
  • Personal and business income tax returns for the last three years.
  • Ownership and affiliations, including any other business you have a financial interest in and any partners in your business.

Advantages and disadvantages of various types of loans

Choosing the type of loan that best suits your needs and repayment ability is essential. You should take out a loan with the idea that it will help your business, not saddle you with debt.

Line of credit loan - This short-term loan is considered a useful option for small businesses. With a line of credit, you’re given a certain amount of cash which you can draw from. You only repay the amount you draw and that’s the only amount you pay interest on.

Term loan - This type of loans is the one with which most people are familiar. It comes in both short- and long-term versions, with generally lower interest rates for longer term loans. Borrowers receive a lump sum of cash up front and make monthly repayments of principal and interest. These loans come with some of the lowest interest rates and generally require collateral.

Specialty financing - Specialty financing includes loans for very specific purchases, such as leasing or buying equipment. You usually pay equipment loans over the estimated lifespan of the equipment you’re financing, and the equipment serves as collateral. Specialty financing also includes commercial real estate loans. The main issue with these loans is that sometimes the loan outlasts the life of the equipment.

Invoice financing - With invoice financing, you use unpaid invoices as collateral to secure a cash advance, which is usually equal to a percentage of the invoice. You then repay the advance once the invoice is paid, along with a fee. A similar type of financing is invoice factoring, where you sell your outstanding invoices to a factoring company for it to collect on.

Merchant cash advance - Similar to a payday loan, a merchant cash advance is an expensive form of borrowing where you get a cash advance in exchange for a percentage of your future credit card sales. Because these loans are short, and repayment is taken out daily, they can have the equivalent of a 70-200% APR. The up side is that these loans are very quick and easy to get.

Personal loan - If you have a very strong personal credit score, but have a new business or not much collateral, you might consider taking out a personal loan to use for business expenses. Keep in mind, though, that if you default on the loan, it will impact your personal credit.

Secured and unsecured loans

In order to receive a secured loan, you must provide collateral. The collateral, which can be real estate or inventory, must outlast the loan. Interest rates are usually lower for secured loans.

The advantage of a secured loan is that it usually has a lower interest rate than an unsecured loan.

Unsecured loans generally have a higher interest rate because the borrower does not have collateral to be claimed by the lender if the borrower defaults on the loan. You will only be able to receive this type of loan if the lender considers you to be low risk. That generally means that your company has been profitable and the lender considers your business in sound condition.

To increase the odds of getting a loan, it’s essential that you establish a business credit profile as soon as possible.

How do Small Business Administration loans work?

The governmental body known as the Small Business Administration (SBA) doesn’t directly loan money to small business owners. Instead, it works with partner lenders to make it easier for small businesses to get loans.

The SBA guarantees a portion of the loan, meaning if the borrower defaults, and the lender can’t recoup its costs form the borrower, the SBA will pay that amount. This makes the loans slightly less risky for a lender, which in turn improves the likelihood of approval to a borrower it may not have otherwise approved.

The advantages of SBA-guaranteed loans are long borrowing terms, low interest rates and high borrowing amounts. Another plus is that with some loans the SBA will offer support to help borrowers run their business successfully.

SBA-backed loans range from $500 to $5.5 million dollars and be used for almost any business need. In general, they require lower down payments and collateral isn't always needed.

To qualify for an SBA loan, the business has to be physically located, and operate from, the United States or its territories. It must also be officially registered and a legal entity.

In order to apply for an SBA loan, you must provide a statement of purpose, a business plan and financial statements, including a cash flow statement, income statement, balance sheet and personal financial statement.

Borrower beware

As in any business transaction, you must be sure that you are being treated fairly. Watch out for these lending practices:

  • Lenders who impose unfair terms on borrowers, either by deception or coercion.
  • Interest rates that are significantly higher than those offered by competitors.
  • Fees that are more than 5% of the value of the loan.
  • Being asked to lie on the paperwork.
  • Being told to leave signature boxes blank.
  • Being pressured into taking a loan.

Before finalizing a loan agreement, consult an attorney, financial planner or accountant.

The bottom line

Taking out a loan can be a beneficial way to keep your company on the right track financially. It’s important to decide when you need the money and how much you need. The most crucial factor, though, is being certain that you will be able to make payments on time. You don’t want to ruin your company’s reputation by being deemed a credit risk.

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

Published February 25, 2019