Everything You Need to Know About Financing a Business
Types of Debt Financing
- Term Loans
- SBA Loans
- Line of Credit
- Business Credit Cards
- Equipment Financing
- Invoice Financing
- Merchant Cash Advance
Types of Equity Financing
How to Apply
Your Next Steps
Before you dive deep into the process of financing a business, let’s go through the basics. What is business funding?
Put simply, this gives you the money you need to help start or grow your small business. In theory, you could pay the upfront costs and cover the gaps in cash flow out of pocket. Not willing to dish out your own cash to cover those costs? We don’t blame you. Also not willing to toss in a ton of time working through the paperwork? We don’t blame you there, either (and, in that case, no doc business loans might just be the right option for you).
Instead, most successful small business owners will look to outside sources to fund their business. Those sources might be debt, equity, or something else.
In this guide, we’ll give you the know-how on the different types of financing that you might want to consider for your company, from debt, to equity, and other alternatives. After, we’ll walk through some best practices so that your funding process is a success.
How to Finance a Business? For Starters, Follow These Best Practices
If you’ve read about your financing options, you know there are a lot—and if you’ve been through the process of financing a business before, you might find it to be a daunting one.
Good news—we’ve outlined some important things to consider and keep track of when you’re searching for business funding.
Know What You Can Afford Before You Officially Finance Your Business
There’s probably a dollar amount in your mind that you’d love to have in the bank to grow your business. But do you know the dollar amount you need to reach your business goals?
More importantly, do you know the amount of financing that you can actually afford? Figuring out this number is a great first step.
Cash Flow / Loan Payment = Debt Service Coverage Ratio
You can use the debt service coverage ratio (DSCR) to figure out what kind of financing you can afford. Your DSCR is your periodic cash flow, divided by your loan payment for that equivalent period. For a loan with monthly payments, take your current monthly cash flow, and divide that by the loan payment—you’ve got your DSCR.
Lenders look at your DSCR as an indicator that you’ll have the cash to pay off your loan. Most will require a minimum DSCR of 1. But, it’s a good idea to have a little leeway in your cash flow, so most lenders will want to see a DSCR of 1.35. You can also use your DSCR to figure out what you’re comfortable with. A DSCR of 2 is considered a conservative DSCR, and a 1.15 is a little riskier.
Your Credit Score Will Impact Your Financing Options
You’re searching for business financing because you want money for your business—why should your personal credit score matter?
Well, lenders will look at your personal credit score as an indication of how reliable you’ll be with your business finances. Which makes a lot of sense—your personal habits shouldn’t be all that different from your business habits.
It may just be a number, but it’s a pretty important number when it comes to financing a business. If you have a stellar credit score, say, 700 or above, you’ll have lots of options for financing a business. On the other end of the spectrum, a lower credit score of the mid-500 range or lower might limit your financing options. But don’t lose hope, there are a few ways to improve your credit score and get better funding options.
So, before you start your hunt for the perfect way to finance your business, know what your credit score is. Some credit card companies will show you your credit score on your monthly statements or when you log onto your online account. You can also check it here.
Financing a Business With Debt
At the most basic level, debt financing is where you borrow money from lenders. You pay it back, plus interest, down the line.
The word “debt” has a bad rap, but don’t let it scare you. Financing a business through debt can help your company produce, sell, and grow.
There are 7 major business loan types that you’ll want to consider:
Term loans are the easiest types of debt financing to understand. They’re probably what pops into your head first when you think of financing a business. You get a lump sum of cash that you’ll use to grow your business, paying your lender back on a daily, weekly, or monthly basis.
If you’re looking for a quick fix or covering an immediate emergency, you might want to consider applying for a short-term loan, which is a separate type of term loan. These loans range from 3 to 18 months. They can be great if you need cash in a pinch, but be aware that fast cash is also expensive cash. In general, short term loans are faster to apply for, but the interest rate on these smaller loans can be 14% and up (often way up).
Another term loan to know is the traditional term loan, or what we like to call a medium term loan. With these loans, you can expect to get a larger sum of cash at a lower interest rate than short term loans. The downside? They take a lot longer to fund, and are harder to qualify for than financing a business with a short-term loan.
A medium term loan might be a good option if you have an established business and a good credit score.
Who offers these financing options?
Traditionally, banks were the only lending institutions offering term loans. However, online lenders now operate in the space to provide less qualified borrowers medium-term loans, and short-term loans.
While the Small Business Administration isn’t technically a lender, it can help you secure more funding than you’d qualify for otherwise.
The SBA guarantees a large portion of the loan that you receive from your lender. So if you default on your loan, the lender doesn’t lose that much money. In the end, the SBA encourages lenders to take more risks—which means more money for your small business (and a better chance of you qualifying in the first place).
SBA loans are just like bank loans: higher maximum amounts, longer terms, and lower interest rates. Don’t expect a quick time to funding—the processing time for SBA loans is just as long as a traditional term loan from a bank.
You should also be aware that SBA loan applications ask for a lot of documents and will rely heavily on your personal credit score.
If you can stand to wait when it comes to financing a business, and you’re a qualified borrower, it’s hard to beat an SBA loan.