Small Business Loans 101: How to Get the Money You Need While Limiting Financial Risk

Starting a small business can be extremely risky, and for some, they may find they’ve bitten off more than they can chew. According to a recent report, about 20% of all new businesses fail within the first year, with 50% failing within five years. There's a lot to juggle, from keeping your employees motivated and productive to creating ideas for new products and marketing strategies.

A more challenging responsibility is ensuring your business has adequate cash flow. One of the most common solutions entrepreneurs facing this predicament use to keep their new business afloat includes taking out small business loans. In this post, we explain how to get the money you need for your small business while limiting financial risk.  

What are small business loans?

Small business loans area means of financing that allows current or prospective entrepreneurs to access the capital they need to keep their business up and running. These loans are geared toward startups that have been operating for anywhere from eighteen months to three years.

Aside from purchasing expensive equipment, a loan could go towards obtaining a more spacious facility, purchasing real estate, or increasing your output. If you're looking to upgrade your business but don't have enough capital, a small business loan could help you achieve such goals.

How small business loans can help

As an entrepreneur, a small business loan might be what you need to break even orget to the next level. Here are a few ways these loans can be of help:

Taking care of startup costs

Starting a business costs money, and depending on the nature of your venture, you may need a considerable sum. New businesses require equipment, office space, insurance, marketing, and more. Getting a small business loan could boost your capital and make it easier for your business to get through the startup phase. 

Running and operational costs

It may take a while for your business to become profitable. Many startups barely break even for a significant period. You may require a small business loan to supplement your company's working capital, pay suppliers, and fulfill larger orders. 

This will take the pressure of paying the bills off your new business, allowing you to reinvest most of your profit into the growth of the company. If you have a good credit score and an solid business plan, you could get a short-term loan from your bank or an alternative lender. 

Acquiring space and real estate

As your business grows, hires more people, and seeks to expand and branch out, you'll need to upgrade your office space. Whether you’re renting a larger workspace or buying new office space, it may cost your business tens or even hundreds of thousands of dollars. Small business loans could help you cover such expenses. You could also use such a loan to renovate your existing office building or pay for a furniture upgrade. 

Types of loans available to small businesses

When looking to finance your business, it's prudent to understand the different options available. To determine the most suitable choice, we recommend considering the size and nature of your business, how much you need, and how soon you need it.

Some of the most common loan options for small businesses include: 

Conventional loans

Conventional loans are typical, standard, and predictable, with fixed interest rates and repayment terms. Such loans are granted mainly by traditional lenders such as banks, credit unions, and other financial institutions. They're often awarded to businesses that have been operating for a while and have proof of concept.

Depending on the loan size, your credit history, and the collateral, the loaning institution determines the amount of the down payment. The terms of such a loan will also vary depending on your agreement with the lender. You could repay the money at a fixed or floating rate, monthly, quarterly, or even annually. 

Small business line of credit

A line of credit is a financing option that allows you to grow your business, meet unexpected costs, or buy new stock by providing access to working capital. A line of credit could also help bridge the gap between when you invoice for products or services and the moment you get paid. 

Nerdwallet reveals that you can borrow as much as 90% against the outstanding payments due with this lending option. You can borrow up to 65% against unsold products or your raw material inventory. An arrangement like this would allow you to address your business needs as they arise. 

SBA 7(a) loans

SBA stands for the Small Business Administration, a government business agency that's the leading resource for business loans backed by the government. The government guarantees a portion of SBA loans, allowing small businesses to borrow capital at lower rates and more flexible terms than a conventional loan. The SBA acts as a guarantor for a percentage of the loan if the borrower defaults on paying it back. 

SBA7(a) loans are the most common SBA loan programs. They're awarded after analyzing your business cash flow and thus will require a smaller down payment than conventional loans. They're long-term loans, paid back within an average of 10 to 25 years. 

SBA 504 loans

This is another loan option from the SBA. However, it's different from the 7(a) loan in that it's mainly geared towards small businesses looking to purchase expensive equipment or commercial real estate to expand their operations. 

504 loans are awarded in conjunction with Certified Development Companies (CDCs). These nonprofit organizations use 504 loans to promote economic development within their communities.

A504 loan could also go towards buying land, constructing new buildings, and renovating existing ones. SBA loans are often structured in a 50-40-10 format, where the bank provides 50% of the total amount, the SBA/CDC provides 40%, and the borrower makes a 10% down payment. 

Determining eligibility for a small business loan

Since many small business loans are offered non-collateral, it may be hard to qualify. For an SBA 7(a)loan, for example, you must've been in business for at least two years, cross a certain threshold of business revenue, and have a healthy credit score. You're also expected to try out all other lending options before applying for this loan. 

However, many online and alternative lenders may be more flexible with their requirements. For example, a low credit score may affect your chances of getting a conventional loan, but this may not be the case with invoice financing and other alternative lending options. 

After confirming whether your business meets these requirements, you should evaluate its financial position. This involves checking your personal and business credit scores, updating your balance sheet, and reviewing your books and how your company spends its money. By doing so, you could confirm your business' creditworthiness and how much you can pay back comfortably based on your revenues. 

To qualify for a non-collateral business loan, you may also need to sign a personal guarantee or agree to a Uniform Commercial Code (UCC) lien. This is a formal agreement that you'll be personally responsible for the debt accrued by your business. On the other hand, a UCC lien gives the lender legal grounds to attach your business assets if you fail to repay the loan. 

The pros and cons of traditional lending

Banks are an essential source of loans for many small businesses. Before you settle on a small business bank loan, first understand the following pros and cons involved:

The pros of traditional lending

Many people prefer traditional lenders like banks over other options. Some of the main advantages of conventional lending include:

●     Lower interest rates than other lending options: Although getting these loans takes time, they're worth considering due to the relatively low-interest rates. Traditional lenders may be the safest bet if you're looking for a long-term loan. Invoice financing and other alternative lending options have much higher rates and may cost you a lot more.

●     A fixed interest rate: This lets you know the exact amount you're expected to pay. Other lenders may have hidden fees and costs, making the loan more expensive than a traditional loan.

●     The opportunity to build a good credit score and relationship with the lender: Taking bank loans, using them appropriately, and paying them back on time is an excellent way to show the lender that you're trustworthy. This implies you'll have access to another business loan if needed. 

●     The loan is not repayable on demand: This means that you have the entire agreed duration to pay it back unless you breach the terms and conditions of the loan. As a result, you get more time to focus on running your business. 

●     You keep total equity in your company: A traditional lender gives you money to upgrade and expand your business, expecting you to pay them back with a specific interest rate. They neither get a share of your profits nor buy a stake in your company. 

The cons of traditional lending

Despite all these benefits, traditional lending has some drawbacks. Some of the main disadvantages include:

●     Time-consuming application processes: Banks and other conventional lending institutions have lengthy application processes, quite a bit of paperwork, and a lot of thought going into reviewing your application. This may not be the best way to spend your time as a busy entrepreneur running a business. 

●     A longer turnaround: This means it takes a while for the funds to be deposited in your account. If you need the money urgently, this may be inconvenient. However, considering the low-interest rates you get with such a loan, it may be worth the wait.

●     Hard to get approved: The loan application process that banks have is usually long and convoluted. Such lenders also have many requirements that you and your business must meet to qualify for a small business loan. For example, if you have a low credit score, you may find it hard to get a traditional loan.

●     Collateral is often required: To obtain a conventional business loan, you may be required to declare some collateral. This might be business assets such as vehicles, land, or equipment. If you default on repaying your loan, you risk losing these assets. 

●     Early payment may be penalized: You may be charged an extra fee if you get a fixed-interest loan and want to repay the entire amount before the term expires. 

Pay attention to the terms of the loan

Once your non-collateral small business loan has been approved and the papers are ready to sign, be sure to look over the terms and conditions of the loan carefully. Read everything. If possible, have your business's legal representation go through it. 

Pay special attention to the loan's interest rate, annual percentage rate, stipulated payment schedule, and term length: 

●     Interest rate: the amount the bank charges you for the loan, often calculated as a percentage of the borrowed total

●     Annual percentage rate (APR): the total interest rate for a whole year, the exact sum your loan will cost you per annum 

●     Term Length: the duration you'll be expected to repay your loan in full

Finding the right lender

As mentioned, there are numerous options you could use to get a small business loan. Knowing what the lender is looking for and the type of clients they typically gravitate toward can be incredibly helpful. This will help you understand where your applicationis more likely to be accepted. 

Different lenders also have additional terms and conditions for their loans. Make sure the lender you choose has the loan products that adequately suit your business. Taking out a loan is a significant undertaking, and you should be confident in the loan, its terms, and the lender. 

When to consider alternative business loan lenders

If you don't meet some of the requirements for an SBA 504 or other conventional loans, getting a loan from alternative lenders is still possible, an option prevalent among new businesses. This form of lending isn't new. Alternative lenders played a significant role in helping small and medium-sized business enterprises get funding during The Great Recession. 

Here are some of the circumstances that may require alternative lending: 

●     You need money quickly: Whether you need to urgently pay off suppliers or require funds to fulfill a contract, alternative lending may help you acquire some cash to handle your immediate business needs. 

●     You're looking for a simple, uncomplicated process: Applying for and getting a bank loan is quite rigorous. Conversely, many alternative lenders make it easy to apply for loans online in only a couple of hours, sometimes minutes. 

●     You don't meet bank qualifications: Banks only lend money to businesses that satisfy specific requirements, including having a good credit score, a certain revenue threshold, or a minimum duration of operation. If you don't meet these requirements, alternative lending might be suitable. You should, however, ensure the loan you're getting doesn't cripple your business and that you can comfortably pay it back on time.

●     You need a relatively small loan: Banks and other traditional lenders usually gravitate toward larger loans since they're the ones that will make them the most money in the long run. Therefore, they're unlikely to grant your request for a smaller loan. That isn't the case with alternative lenders who are more flexible and can offer loans as low as $2,500. This option may make sense if you don't need that much money. 

Examples of alternative lending

The alternative lending market is full of diverse options to choose from. These lenders are typically very flexible and engage with businesses on a case-by-case basis. As such, you'll quickly find a suitable loan for your business and its needs. 

●     Invoice financing: When seeking these loans, the lender usually offers you upfront cash for an unpaid invoice. They give you a percentage of the invoice amount and then pay the rest (minus fees and costs) when the client clears the invoice. 

●     Equipment financing: The lender provides funds to purchase equipment like vehicles, telephone equipment, computers, or machinery for your business. This allows your business to grow without putting too much strain on your cashflow. 

●     Short-term loans: Here, the lender provides a cash loan with a 3 to 18-month term length at an interest rate of about 10%. It's possible to get any amount from $2,500 to $250,000, depending on the lender. 

In the past, alternative lending was regarded as a last resort for entrepreneurs looking for small business loans. That's not the case anymore. Today, depending on your business and its needs, alternative lending may be the option that makes the most sense. Just make sure you aren't taking on too much risk by getting a loan that will be difficult to pay back. 

Types of alternative financing

As you can see, alternative lending options have proven effective in dealing with urgent business expenditure needs. There are many types of popular alternative lending options, including: 

Venture capitalists (VCs)

Venture capitalists are a group of individuals who establish an organization they can use to invest in other businesses. VCs often chip in to help already-running companies increase their output, generate more sales, and ultimately become more profitable.

Angel investors

Angel investors are groups of people or individuals who provide businesses with capital to run their day-to-day affairs. These investors get this capital from their assets, allowing the recipient to start and run their business comfortably.

Crowdfunding

Crowdfunding entails raising funds from the public via the internet. You'll need to create a reasonable goal and offer the people some reward for contributing, which could be anything from small equity in your newly-formed business to first dibs on your products or services. 

Government grants

You may qualify for a government grant if you have a research-related business. The government, in conjunction with the SBA, provides certain small businesses with some funds to boost their operations. You wouldn't have to repay this grant, making it an effective supplement to your company's capital. 

Credit cards

Many entrepreneurs use business and personal credit cards to make essential purchases for the company when they don't have upfront cash. However, you should be careful with this financing option. Failing to make your monthly payments may tarnish your credit score, making it hard for you to access loan products in the future. 

The pros and cons of alternative lending

If you're wondering whether alternative lending will work for your business, this quick breakdown of the pros and cons will give you more insight: 

The pros of alternative lending

●     A more straightforward application process: Getting a loan from conventional lending institutions like banks requires a lot of paperwork. Alternative borrowing options take less time and have less stringent requirements. This may be your best option if you're looking for a quick and hassle-free borrowing process.

●     A faster turnaround: Alternative lenders often review and accept applications quickly and deposit the funds as soon as 24 hours after your request. This enables you to handle your urgent business needs or take advantage of a short-lived business opportunity. 

●     Multiple loan options to choose from: Banks and other conventional lenders can't compete with alternative lenders' diverse loan options. From asset-based financing to loans granted against future receivables, alternative lending may give your business the exact support it needs. Further, the borrower can typically spend loans obtained from these lenders any way they see fit for their business. 

The cons of alternative lending

●     Higher interest rates and fees: Since alternative financing options come with less strict terms, they also tend to have higher rates and fees than traditional loans. Although these lenders provide you with financing in a shorter time frame, it would be best first to determine whether your business can afford the higher rates. 

●     Shorter terms: Small business loans obtained from alternative lenders have shorter terms. Since you have a shorter period to pay the money back, your installment payments may be pretty high. That said, this shouldn't be a problem if the loan is a reasonable amount.

●     More regular payments: You may have to make more regular payments to pay off the loan in the shortest time agreed upon. Remember, alternative lenders offer loan terms as short as three months, meaning that you may have to make payments weekly or bi-weekly. 

Tips for paying off a small business loan

Many things will help you limit financial risk when taking a small business loan, including finding the perfect lender, understanding what your business needs and can comfortably repay, and ensuring the terms of your loan are reasonable. 

However, another crucial element to limiting financial risk is paying back the money you receive within the stipulated period. That’s why it’s absolutely crucial you stay on top of your loan repayment, and you can do this in the following ways: 

●     Understand the terms of the business loan: Know how much you're expected to pay monthly and how long you'll be servicing the loan. This way, you're less likely to forget a payment.

●     Contact your lender immediately when you miss or delay payments: Communicating makes it easier for the lender to understand your situation and helps you come across as a responsible debtor.

●     Set up a standing order or choose a specific payment date: This will also help you remember to make your payments. 

●     Refinance your loan: If your loan rates are too high, you can refinance it with another. This will allow you to secure better rates and prevent you from tarnishing your credit score. 

●     Spend all the money you receive wisely: Follow a budget and monitor your business’s financial health closely. Ensure all the money you make and spend is accounted for. If you misuse the loan or allocate the funds in a way that isn't profitable in the long run, you may have difficulty paying it back.

●     Increase the equated monthly installment by a particular figure each month: This implies that you'll finish paying off the loan sooner than planned. 

●     Direct extra income toward repaying the loan: This will help chip away at the loan quicker. 

What if I fail to repay my business loan?

Whether you receive your money from a bank or an alternative lender, you must be sure beforehand that you can afford to repay it. Defaulting on a small business loan will damage your credit score, making it harder for you or your business to get another loan in the future. Vendors and suppliers, doubting your creditworthiness, may also be wary of offering you credit lines for fear that you may not pay them back. 

Under the most severe circumstances, lenders seek legal intervention when businesses fail to repay their money. This is especially true when your home, real estate, or other personal and business assets are collateral for the loan.

If the business still has assets that can go toward repaying the loan, the lender will take them to court to ensure this happens. These court cases often take a long time and end with the business losing everything and filing for bankruptcy. 

It's your responsibility to protect your business from such possibilities. Paying off your business loan on time will limit the risk a loan would otherwise pose.

Financial challenges that most businesses face

A loan is a great idea if you intend to use it to upgrade your business. However, it may be time to reevaluate your business if you're consistently caught up in a web of debt.

Here are some of the most common financial mistakes that keep new businesses in this rut:

Inconsistent cash flow and a small cash reserve

Many startups struggle with maintaining a consistent flow of cash in the business, making it hard to address the business’s needs as soon as they arise. To avoid this problem, invoice effectively and encourage customers to pay quickly, preferably in full. Make sure you understand how to accumulate cash and reinvest it in your business expansion and growth. Liquidity is essential. 

Failure to use a budget

Following a budget is crucial when running a business. This is the best way to ensure all your money is planned and accounted for. Track your expenses to know how much the business spends in a month, and then let this sum inform your budget. Failing to use a budget may cause you to spend more money than you make, a sure way of getting into financial trouble. 

Failure to prepare for a rainy day

Unexpected expenses derail many businesses. Since most small businesses and startups don't have a cash reserve for such situations, they're forced to use part of their working capital to cover these costs. Over time, this adversely affects business operations and makes it difficult for the business to grow. A significant cash reserve is crucial to help bail your business out when unforeseen expenses arise. 

Taking on too much debt

When you use your loan to buy production equipment and effectively increase your output, sales, and profits, that's a good thing. However, you should be wary of taking on too much debt. 

Unpaid debt collects interest. As these fees continue to pile up, the financial obligation may become unbearable. As a result, this may force you to refinance and get trapped in a never-ending cycle of debt. 

Contact Smith.ai today to help with your small business loan

Whether you need to lease or purchase equipment, commercial real estate, or even land, a small business loan could be helpful. Once you've done some evaluation and know your company's financial position, you can determine the kind of financial support you need.

At Smith.ai, we provide the tools your small business needs to keep your business running. We have 24/7 payment collection answering services that make sure you get paid on time so you can keep the company going, and our appointment booking services allow you to focus on retaining and getting clients, instead of trying to schedule everything yourself. In addition to these andother services, we have 24/7 call answering, bilingual virtual receptionists, and after-hours answering, so you never miss a lead or a chance to help your customers.

If you’re not sure whether Smith.ai is right for your small business, we offer a 14-day, money-back guarantee so you can decide for yourself. Schedule a free 30-minute consultation today to learn more.