Funding a Business with Loans - Explained
How to Use Commercial Loans to Fund a Business
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What are the Loans Available to Fund a Business?
The following are common types of loans used to fund a business?
What are Micro-loans?
These are small seed capital loans (the average is $13,000) made to qualifying businesses by financial institutions or non-profits. Often these loans will be backed or secured by a particular state or federal government program.
What are Small Business Loans?
The US Government via the Small Business Administration (SBA) offers several small business loan programs. Under any SBA loan program, qualified financial institutions under the Small Business Investment Company (SBIC) program make loans to approved businesses. The SBA secures these loans against default, which provides the security necessary for the business to obtain the loan. The SBA will guarantee a certain percentage of the loan (generally 75% or more) against default. The SBA lender will still require a secondary source of repayment (personal credit, collateral assets, etc.) Most SBA loans range from $25,000 to $1 million.The rate on the SBA loan is the prime rate plus 2.75%. There is a closing fee and SBA guarantee fee, which is 1.6 2.6% of the guaranteed loan amount. (These fees can be rolled into the loan.)The lending institution must require that the entrepreneur sign a personal guarantee for the debt as well. The SBA has fairly strict requirements to qualify under each available loan program. SBA Programs include:
- LowDoc Loan Guarantee: Loans up to $150K based primarily on personal credit history.
- 7(a) Program: For amounts up to $750K and covers working capital and refinancing.
- 504 Program: For purchase of hard assets up to $1 Million. This uses financing from a third party bank and a Certified Development Company.
What are Non-SBA Loans?
Private financial institutions may make any form of loan or extend lines of credit to small businesses. There are rash of startups that focus on lending to startup ventures. Banks often make private loans to businesses, but these loans generally requires proof of income history and extensive equity to secure the loan and/or a personal guarantee from the borrowers. The interest rates on non-SBA loans are generally far higher than SBA backed loans, given the higher degree of risk of such loans.
Back to: Business Transactions
How to Obtain a Business Loan
Obtaining a loan from a lender requires an understanding of what the lender is looking for with regard to the loan. The lender provides debt capital for your business. The lender will make a profit on the loan by charging an interest rate on the debt that reflects the level of perceived risk of default. Often, the risk associated with making a loan to a startup venture is too high to undertake in the absence of some form of security in the form of personal guarantees and collateral.
- Collateral - Collateral for a loan is generally assets of the borrower (personal property, equipment, real estate, securities, receivables, etc.). The lender will take a security interest in the collateral to secure the loan. See our Secured Transactions lecture series to further explore security interests in collateral. Without sufficient collateral, most financial institutions will not make loans to startups, unless the loan qualifies for some sort of backing such as a small business administration (SBA) backed loan.
- Funds from Owners - In addition to a personal guarantee by the entrepreneur and posting collateral to secure the loan, financial institutions will require that the entrepreneur invest their own funds in the venture. Lenders like to see some sort of financial commitment by the owner. (Generally, 10% to 20% of startup funds financed by the owner).
- Business Plan - The lender will require a detailed business plan to adequately judge the amount of risk in lending to the business venture. The business plan will outline the assets and debts of the business (Balance Sheet), the income history of the business (income statement), and a statement of cash on hand (cash flow statement). These documents will demonstrate the assets available to secure the loan, the profitability of the venture going forward, and the cash available to service the debt payments.
- Credit History - The bank will review the credit history of the business (generally Dunn & Bradstreet) and the credit rating of the owners. This demonstrates the business and owners commitment to creditworthiness.
- Personal Guarantee - Lastly, the bank will require each owner to sign a personal guarantee for the business loan. This means that, if the business defaults on the loan, the bank may seek to collect the outstanding loan balance from the owners.
- SBA Backing - Remember, SBA backing provides additional security for qualified loans from approved lenders. Approval of SBA backing often allows a business to obtain a loan that otherwise is too risky for the lender. For example, an absence of any of the above-referenced requirements may make a loan too tenuous without SBA backing.
Back to: Entrepreneurship