Small business financing options examined

Financing a business is tough. Funding through SBA finance – loans or grants from federal government’s Small Business Administration (SBA) – is common. But it’s not the only way to finance your business.

I’ve written this article to give you an idea of how you might choose to fund your new business venture.

Funding from the government

You might be able to access business loans and grants from federal, state, and local government. There are a range of options available, and each has its own set of lending criteria – the method by which your application is assessed.

The largest source of federal funding for small business is the Small Business Administration. It issues loans directly to new businesses, though most are administered by commercial banks. In effect, the bank lends you the money to start your business, and the federal government guarantees the loan. This means that you’re more likely to be accepted for financing – because the bank’s risk is reduced by the government guarantee.

Usually, only part of the loan is guaranteed. It’s also only available to small businesses that cannot get a loan elsewhere – so you’ll need to apply for a commercial loan before applying for an SBA loan. You’ll also need to meet certain business size and credit history requirements.

Small business loan from a commercial lender

This is the most common way of funding a small business. You’ll need to show the lender – typically a bank – a detailed business plan and financial projections for five years. The bank will use these to assess the viability of your business proposal, and how much risk they might take on when lending to you.

If you’re going to use this source of funding, it’s a good idea to approach several lending institutions (including credit unions). This way you’ll be able to compare the loan offers made to you.

Apply for a microloan

Another route for financing your startup is to apply for a microloan. These are provided by specialist lenders, with the funds provided by the SBA. Interest rates are usually around 8% to 13%, and you may be required to undertake and complete some training before being accepted. The amount you can borrow under a microloan arrangement is up to $50,000, with the average microloan being $13,000.

Tap into your 401(K)

You can access your 401(K) funds early if you want to start a business. It’s relatively easy to do, but there are a bunch of legal pitfalls you could disappear into. If you’ve got a decent 401(K) fund, this may be worth considering, but you should get legal and tax advice before you do so.

Remember, too, that if your business isn’t successful, you will have dipped into – and lost – some of your retirement nest egg. And that means you may have to work longer and harder than you want to before you can afford to retire.

Tap up your friends and family

Borrowing money from friends or family is one of the most common ways to fund a new small business. But this comes with a big warning: if things go wrong, how would you feel about defaulting on a loan from your best pal? Is borrowing the money worth the risk of losing a lifelong friendship, or irrevocably damaging your relationship with your siblings or parent?

If you are considering tapping up your family and friends, here is my advice:

  • Make sure they understand the risks
  • Present to them like you would a bank – with a business plan and financial projections
  • Decide how the loan will be structured (for example, will you offer a share in the business?)
  • Put the agreement in writing (get an attorney to do the paperwork)

These four steps should help your potential lender to make an informed decision, and ensure your personal relationship is kept on an even keel.

Use crowdfunding

You may try to fund your business through a crowdfunding platform. You present your business idea, and ask for funding. In return, you offer a gift for the contribution made. Crowdfunding is becoming more popular among startups that have a product to sell or that wish to produce something creative – the gift the funder receives could be a free item or discounts on products, for example.

Before you crowdfund, you must understand your financial obligations to your funders – and I would definitely recommend that you take legal advice.

Use a credit card

I mention this only because it is an option for business funding, and because I want to tell you not to even consider borrowing money from your credit cards to start a business. The interest rate is ridiculously high, and this will eat into any profits you make.

If you default on any payments, your credit score will get junked, making it harder to get credit in the future. And if you only pay the minimum amount each month, you’ll be in a black hole that could become impossible to climb out of.

So, once more – I do not recommend that you borrow from a credit card to fund your business.

Here’s what I know

Whichever route you select to finance your business, it’s crucial that you borrow the right amount. You’ll need to factor in a bunch of costs – building, equipment, supplies, legal, and so on.

You’ll also need to consider your cashflow. In the first few months, you’re likely to be paying faster than you receive. Even if you’re profitable, negative cashflow could crush your business – no matter how great your business idea is.

Borrowing money always carries an element of risk. But by understanding how much you need to borrow, researching the small business funding, loans and grants that are available to you, and getting professional advice, you’ll be on a much firmer financial footing and reduce the risk of defaulting on your loan.

Let me know how you plan to fund your business venture. Are you going to tap up friends or family? Or do you plan to apply for a traditional small business loan from a bank? Let me know in the comments below, along with any questions you have. I’ll try to address them either directly or in a future article.

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