You have the next great business idea that is going to change the world. Your one lightbulb moment is a refrigerator magnet that tells the time, cracks jokes and plays Franz Schubert music. Your other idea is to buy a business and turn it into a laundromat bookshop that serves coffee and doughnuts. Before you start thinking about franchising or filing an initial public offering (IPO), you need to get the company off the ground, and it will require some startup funding.
In the aftermath of the Great Recession, your neighbourhood bank has been apprehensive about lending to startups and smaller companies out of fear that the business loan will not be repaid. Central banks have attempted to quash these concerns by introducing historically low interest rates. But let’s ditch the monetary policy discussion and begin imbibing the meat and potatoes of why you are here: how to get a business loan.
How much capital do you need? How can you qualify for a loan? Are there any alternatives? We’ve compiled a breakdown of everything you wanted to know about business loans but too afraid to ask.
1. Know the Types of Business Loans
When you’re in the market for a business loan, it’s important to understand your options. You never want to go into business blindfolded and unequipped with the knowledge of the basics.
The first thing you need to learn is the types of loans at your disposal. Here are the four most common lending apparatuses for a new business:
- Business term loan: A lump-sum amount that is repaid with interest over a period of time. The length of this loan is usually five years, and the average interest rate ranges between 8% and 24%. You will be approved based on your company’s credit score, monthly or annual revenues and overall financial health.
- Business line of credit: This can be likened to a credit card in the sense that you have a pool of money to access and you only pay interest on what you borrow. The repayment terms are between six months and a year, and the average rate is also between 8% and 24%.
- Merchant cash advance: A lender will provide you with a lump-sum amount in exchange for a fixed percentage of your daily credit card transactions. Instead of a fixed repayment schedule, you keep paying until the advance is repaid – the average repayment term is nine months.
- Invoice factoring: Also known as invoice financing, you sell your unpaid invoices for an advance of 90%. You typically have two options: the company completes the invoice before you pay the remaining percentage, or the firm advances the full amount and you pay a flat weekly fee.
What do you think would suit your business? If you’re a retailer, then a merchant cash advance makes sense. However, if you’re a software development firm, then a business term loan might be sufficient.
2. Calculate the Dollars and Cents
Billionaire Mark Cuban recently said, in no uncertain terms, that only ‘morons‘ borrow money to start a business. While there might be some truth in his remarks (minus the insult), a lot of business ideas do require seed money. In this day and age, when credit is cheap, you may miss out on a lot of opportunities if you refrain from taking out a loan.
Does this mean that you should borrow the maximum amount you are offered when you apply for a loan? That is when you get into dangerous terrain. You should only borrow what you need, even if you meet all the requirements that can raise your borrowing limit. But this is the tricky part: how do you know how much you need or how much you should borrow?
There are a few things to consider when answering these important questions:
Estimate Your Costs
While costs may vary by business and industry, experts say that a home-based startup can require as little as $2,000 and a microbusiness can cost about $3,000. Overall, you can always have a rough estimate of what your costs will be, from supplies to manpower to resources. Your calculations don’t need to be to the decimal, but they should offer you a rough idea which can help you decide how much to borrow. It’s important to be conservative.
Determine the Types of Costs
As you embark upon your entrepreneurial journey, you need to differentiate the many expenses you will encounter - not just the dollars and cents. There are different types of expenses you will have, so let’s explore:
- One-time expenses: These are mostly what you will pay during the initial phase, such as a business registration or a licence.
- Fixed expenses: An ongoing outlay is something that you will pay every month, like utilities or rent.
- Essential expenses: An essential cost relates to anything critical to the growth, development and success of your company.
- Optional expenses: An optional purchase should only be executed if you have enough in your budget and you think it can help the enterprise in some capacity.
- Variable expenses: A variable receipt is an expense that you will pay every few months or so. Think of it like a haircut: you’re not getting a haircut every month, but you will get one perhaps every two or three months.
Identify the Right Lender
If you have come across the right lender that is tailored to your needs and expenses, then you will certainly have a better idea of how much you will spend every month. This lender may have offered you the best terms and conditions of your business loan, whether it is the repayment schedule or the interest rate.
Figure Out Your Long-Term Plan
Even if it’s a short-term cash injection, every borrowing instrument should be added to your long-term sustainable growth plan. This loan might be utilised to buy tote bags and pens that have your name on them, which will be handed out as promotional items. Or you may be hiring a digital marketing firm to help you establish your social media presence. Every microtransaction or large funding mechanism must be inserted into the grand scheme of things.
Crunch the ROI
Finally, and this might be a bit more technical, crunch the return on investment by taking out a business loan. Your ROI may be immense if you’re using the funding to invest in something that will immediately boost productivity or increase sales. That said, calculating the ROI is not always easy, and it can be tempting to think that this new idea of yours will lead to a 23% surge in sales. Be conservative.
3. Gather Your Papers
We live in the era of subprime, but even lenders that specialise in business loans have underwriting standards. One of these requirements is documentation, papers that essentially confirm who you are, what company you own, your credit score, and the list goes on. Without these documents, it can be difficult to borrow from a traditional lender; you may be successful is using an alternative and unconventional lender, but these come with higher costs.
So, what papers are necessary? Here are some that you will need:
- Bank statement: The name of your business on your bank statement, the fees you pay, and the figures inside your bank statement.
- Tax returns: This will give the lender an exact total of how much you have earned either in the last year or in the last few years.
- Business documents: Proof of business registration, licences, permits, employer identification number and business plan.
- Collateral: If you fail to repay the loan, what collateral can you offer the bank? The lender may require real estate or other assets to secure your loan.
These documents should suffice in satisfying the lender.
4. Explore Your Alternatives
Do you think you’re stuck in borrowing from the big banks? Not quite. Many alternatives have popped up in recent years that make taking out business loans a lot easier and more convenient. Indeed, you’re not confined to the system – you have an abundance of options to choose from.
Here are only a handful of the business loan alternatives at your disposal:
- P2P lending: Also known as marketplace lending, borrowers and lenders connect on a third-party online platform that circumvents the banks. The website packages loans from investors and delivers funding to borrowers with commissions and fees.
- Crowdfunding: Whether it’s GoFundMe or Kickstarter, you can generate enough funds for your company by having hundreds of people chip in a few bucks. You can repay them with first access to a new product or a permanent 10% discount on all goods or services.
- Bridge loan: This is a short-term loan that is supposed by an asset instead of a credit report. If you’re a business and you’re relocating offices, then you can use the new property as collateral for the bridge loan.
- Equipment financing: When you need equipment but don’t have the immediate capital to purchase your tools, equipment financing becomes the solution. This is a loan that is specifically tailored to the purchasing of equipment, which is then used as collateral. It is a beneficial loan for small business owners because it usually comes with a lower rate of interest.
More people than ever before are starting their businesses, either for supplementary income or to replace their full-time jobs. The entrepreneurial dream has never been more in reach than it is today, thanks mostly in part to technological developments and the internet. Some businesses may not require too much funding, while others may require a hefty amount of seed money, especially if you’re acquiring a franchise. Now that you’re aware of the plethora of business loans, you can try to get your business off the ground.
Pass the shotgun makeup kit and the electric hammer!
Are you currently shopping around for a business loan to get your idea off the ground? Have you already explored your options and successfully launched your own business? Share your thoughts and experiences with us in the comments section below.