The 12 Types of Debt Financing
16 Best Business Financing Options
1. Trade or Vendor Credit
Trade or vendor credit is a form of small business financing that your business may already be using. When the local plumbing supply store gives Joe’s Plumbing $2,000 worth of supplies for a commercial job and sends Joe a bill due within 30 days, Joe is using trade credit to finance his business.
“Net 30” is the most common trade credit term. Less common, but very useful, are revolving vendor credit options that allow you to “revolve” a balance just as you would on a credit card.
- Businesses buying products or materials that will turn over quickly
2. Credit Cards
Credit cards are unsecured lines of credit, and are the most commonly used financing tool for small business owners. According to the National Federation of Independent Business (NFIB), 79%–or roughly 4 out of 5–small business owners use credit cards to finance business operations and growth. Many highly successful companies were started with the founders’ credit cards. However, having looked at thousands of credit reports, my experience is that most small business owners use their credit cards the wrong way.
Six things happen when you use your credit cards the wrong way:
- You don’t separate your business credit from your personal credit. Using personal credit cards or the wrong sort of business cards means your spending will be reported on your personal credit, even though the money is used for business.
- You don’t build your business or personal credit rating. Ideally, payments you make to pay off business debt should help build your business credit profile– but if you use the wrong type of card, that won’t happen. Meanwhile, your personal credit will take a hit.
- You limit your ability to borrow money in the future. When you don’t protect, preserve and improve your personal credit profile as you grow your business, you make it more difficult to obtain additional financing as you grow.
- Your payments are too high. When you don’t choose credit cards carefully or manage them properly, your payments will be too high and your business cash flow will suffer. It’s estimated that as many as 90% of people who select 0% offers on credit cards don’t take proper advantage of those offers.
- You pay exorbitant interest rates. High monthly credit-card interest rates can quickly drain your business’ cash. To keep your interest rates low, be sure to stay under your credit limit and pay your bill on time.
- You get fewer tax benefits. Personal credit-card spending doesn’t usually qualify for the same tax breaks a business loan or business line of credit would, such as the ability to write off interest and fees paid.
If you use credit cards properly to build your business’s credit – by choosing credit cards that report to your business credit report, using them wisely and managing them well – credit cards can be a viable source of financing for a startup or existing business.
- Businesses seeking small amounts of capital
- Businesses with reliable cash flow that can make timely credit card payments
3. Home Equity Line of Credit
A home equity line of credit (HELOC) is secured by the equity in your home. You make no payments and incur no interest until you actually use the money in the credit line. Since the economic downturn of 2008, the popularity of HELOCs as a business financing tool has declined—along with home values.
However, if you have substantial equity in your home and feel confident that you’ll be able to repay the HELOC, this can be a good solution for your business financing needs. Just be aware that borrowing money using your home equity is always risky, because if you can’t make the payments, you could lose your home.
- Businesses with reliable cash flow
- Business owners with substantial home equity
4. Unsecured Business Line of Credit
An unsecured business line of credit (UBL) is similar to a HELOC, with a couple of important differences. First, it’s unsecured, unlike a HELOC, which is secured by the equity in your home. Second, it’s a business loan, while a HELOC is a personal loan. There’s no need to pledge collateral, which is just one of the factors that can make UBLs the ideal debt vehicle for a growing small business.
Rather than fixed monthly payments that stay high even when you’ve paid down most of the principal, a UBL can give you access to up to $100,000 or more—with no need to pay interest until you actually use the money. As you make payments, the available capital is replenished so you can borrow it right back out again. Monthly payments are usually relatively low, which helps your cash flow.
After the “Great Recession,” many banks stopped offering UBLs, and those lenders still offering them are choosy about who they fund. If you’re in a risky industry, such as restaurants, real estate or retail, this type of financing is probably not an option for you. Lenders look for good personal credit–usually a FICO score above 700—and prefer established businesses with at least 2 years of financial history. When seeking a UBL, it pays to have an expert on your side who knows the lenders and their application processes.
- Business owners with excellent personal credit
- Businesses in operation at least 2 years
5. Commercial Bank Loan/SBA Guaranteed Loan
If you have great credit, a relationship with a business bank, and business or personal assets you are willing to pledge as collateral, an SBA-guaranteed bank loan can be a good choice. Be aware, however, that business loan volume has declined and getting a bank loan has become more difficult since the economic downturn of 2008. Applying for an SBA guaranteed loan can help make your business more attractive to banks, as well as lowering your interest rate. (The SBA does not make loans directly; it guarantees a portion of loans made to small businesses by participating banks.)
Keep in mind that most SBA-guaranteed loans require collateral–and that collateral is usually the business owner’s personal residence, especially in the case of startup businesses.
- Businesses with a track record of success and good credit
- Business owners willing to put up collateral, including their homes
- Business owners seeking over $300,000 in financing
6. Cashing Out or Borrowing from Retirement Funds
Do you have a retirement fund, such as a 401(k)? It’s possible to tap that money for startup financing by cashing out or borrowing from your retirement fund using a Rollover as Business Startup (ROB). ROBs work like this: You incorporate your business and create a 401(k) plan for the startup. Then you transfer funds from your existing retirement account to the new company’s retirement plan. Finally, you borrow the money from your new company’s retirement plan to spend on business growth – tax free.
ROBs are a great option for the right people; for example, they are extremely popular in the franchising space. However, they are perhaps the riskiest of all business financing strategies. According to Michael Gerber, the author of The E-Myth, 40% of businesses fail in the first year. Additionally, 80% of businesses fail within 5 years. When you use your retirement funds to build your business, you’re risking the nest egg that you worked hard to grow—so you’d better have confidence that your business is a sure thing.
- People with alternative sources of retirement income
7. Equipment Financing
If you need financing to purchase business equipment such as a company fleet, specialized equipment lenders can help. Rates for an equipment loan can range from bank rate to high cost, depending on your credit and the type of equipment you’re financing.
Few banks offer equipment financing; those that do often require down payments and don’t offer a leasing option. Rather than taking on long-term debt to finance the purchase of equipment, I often recommend small business owners lease equipment instead.
Leasing preserves your cash flow, as it requires no down payment and little or no money out of pocket. There are tax advantages to leasing, too: You can write off the payments as a business expense. Also, a bank loan shows up as debt on your credit rating; a properly structured business lease doesn’t. There are many types of equipment leases; an experienced financing professional can help you determine the best option for your business.
- Business owners who need equipment, but want to conserve cash
8. Merchant Cash Advance (MCA) or Merchant Financing
A Merchant Cash Advance (MCA), also called merchant financing, is a lump sum advance of cash against your business’s future income In May 2011, more than onequarter of Americans homes were “underwater” — that is, the owners owed more on their mortgage than their home was currently worth. 10 | 16 best business financing options (typically, future credit card sales). You can typically borrow between 100% and 300% of your business’s monthly credit card sales. There is no fixed payment amount or repayment time frame; instead, the lender collects a set percentage of your credit card sales every day via ACH payments until they recover the advance and their premium – usually in under 12 months.
There are many benefits of MCA financing:
It’s normally non-recourse, meaning that if your business fails while you have the advance out, you don’t have to pay it back.
Payments are based on sales volume, so they vary with your cash flow. If sales volume grows, you pay more – but if sales volume slows down, you pay less. Nice, huh?
No collateral is required. Instead, underwriting is based on your business’s credit card sales history, bank account and checking account balances.
Even business owners with low credit ratings or in high risk industries such as restaurants can qualify, although they will pay higher rates.
- Short-term financing
- Seasonal businesses
- Businesses where majority of sales are from credit cards
- Business owners with poor credit ratings or in high risk industries
Factoring, or accounts receivable financing, allows businesses to turn their accounts receivables into cash. Factoring works for startups and existing businesses, and solves a common cash flow problem: Often a business gets paid net 30, 60 or even 90 days or more from the time they invoice. Meanwhile, the business has expenses that can’t wait 30, 60 or 90 days.
Factoring is not a loan. A factoring firm purchases a client’s accounts receivable invoices at a discount in exchange for cash; title to the accounts passes to the factoring company. You’ll typically pay the factor a flat fee ranging from 2% to 4% of the receivable’s face value.
Suppose you factor a $100,000 receivable. After doing due diligence on the account debtor, the factor typically advances up to 90% of that receivable, or $90,000, and takes title to the invoice. Suppose the receivable is normally paid in 45 days and the factor charges a 3% discount fee per 30 days outstanding and an additional 1% per 15 days outstanding (a total of 4%). When the debtor pays the factor (45 days), the factor advances you the remaining $10,000, minus their 4% discount fee ($4,000). This cycle can go on and on with every invoice your business generates. Since this is not a loan, there is no interest.
There are two types of factoring lenders: recourse and non-recourse. Recourse factoring lenders may offer lower discount rates, but if the debtor doesn’t pay the receivable you sold, you must buy the invoice back. Nonrecourse factors charge higher discount rates, but once the receivable is purchased, the factor, not your business, assumes the bad debt risk.
Factoring has many benefits:
- You receive immediate working capital on invoices, often within 24 to 48 hours.
- You reduce bad debt by screening customers upfront using the factor’s credit risk analysis.
- Factors assess the strength of your business’s debtors, not your business itself. Even businesses with poor credit or weak financials can use factoring.
- You obtain cash without debt and maintain leverage to take on debt in the future.
- Business-to-business companies
- Companies that need quick cash to enhance cash flow
- Companies with poor credit or weak financials
10. Purchase Order Financing
Purchase order financing is often confused with factoring, but it’s really the opposite. In factoring, you sell receivables for merchandise you’ve sold or a service you’ve provided. In P.O. financing, money is advanced to you so you can pay for goods for which you have a firm purchase order from a major customer–usually a big retailer or government agency.
Suppose a value-added manufacturer in Missouri who sells shirts to Bible bookstores uses P.O. financing to pay the shirt manufacturer in China for the shirt stock to be shipped to the U.S. Once the shirts arrive in Missouri, they are imprinted for the end retailers, shipped, and then the retailers are invoiced for the shirts.
The risk for P.O. financing lenders is even 12 | 16 best business financing options higher than in factoring, since they are funding materials that aren’t ready for sale and haven’t been delivered. As a result, interest rates are higher than in factoring.
P.O. financing does involve a factoring component. The P.O. lender wants to be paid back as soon as your product is delivered to the customer. That means you need a factoring line available to pay off the P.O. lender and provide working capital for your operations.
With this dual financing program, your margins need to be very good or there will be little or no remaining profit in the order after the P.O. lender and factor take their cut. However, if you have high profit margins, need to preserve or establish an important client relationship and don’t have the money you need to fill the client’s big order, P.O. financing can be a lifesaver.
- Short-term financing
- Wholesalers or manufacturers
- Companies with high profit margins
11. Import/Export Loan
If you need capital to expand your business into foreign markets, consider specialized import/export loans available from nonbank lenders. The National Export Initiative earmarks funding to help startups and small businesses start selling overseas. Import/export loans through nonbank lenders are essentially P.O. loans involving a product that crosses borders. They enable you to finance the purchase of goods to be sold overseas. Import/export loans are used for products or goods only; they cannot be used to finance service-based goods.
- Companies new to exporting/importing
- B2B transactions in other countries
12. Peer Loan
You’ve probably heard of websites such as Prosper.com and LendingClub.com, which help individuals get unsecured loans. This fundraising method is known as peer-topeer (P2P) lending. You post your story online in hopes of attracting lots of individual lenders willing to put up small amounts towards your loan total—usually just $50 or so apiece.
If enough people buy in, your loan will be funded at an interest rate determined by your credit rating and what the crowd is willing to accept. (If you don’t get enough people to buy in, your loan won’t get funded.) On most peer lending sites, the amount you can borrow tops out at around $25,000 to $35,000.
However, this isn’t magic money from the Internet. As with a traditional bank loan, you’ll need to make payments on time or it will hurt your credit report. In addition, the P2P loans available from most websites are personal loans, so even if you request the loan for business purposes, it will be reported on your personal credit report—which is less than ideal. (There are a few sites, such as Funding Circle, Daric and Funding Club, that offer P2P business loans.)
P2P loans are not a sure thing, either. The site reviews your credit application and may not approve it. In my experience, 10% to 15% of applications get approved. In other words, peer sites aren’t much more flexible than banks. But if you have good credit, need a small amount of capital and can pitch your story in an appealing way, P2P loans could be the answer you’re looking for.
- Businesses seeking small amounts of capital
- Business owners with good personal credit
- Business owners who are good at “selling” their story
Bonus Idea: Gift Funding Sites
Crowdfunding sites such as Indiegogo and Kickstarter work on a crowdsourcing model similar to peer loan sites, but with a twist: The money you raise is a gift to you, not a loan. You launch a campaign on the crowdfunding site, set a specific deadline to raise your chosen amount, than persuade individuals to donate money to your business to help further a cause or develop a product that they’re passionate about.
Crowdfunding isn’t free, since you typically reward donors with discounted merchandise or premiums. However, the bottom line is you end up with no loan payments and no debt.
Crowdfunding sites can help you raise anywhere from a few thousand to a few hundred thousand dollars. In fact, one of the best-known crowdfunding success stories, the Pebble watch, raised over $10 million using Kickstarter. Overall, an estimated $5.1 billion was raised via crowdfunding in 2013, according to research firm Massolution – an 81% increase from 2012.
There are some limitations to crowdfunding. For instance, typically you cannot raise money for general working capital needs, but only for a specific project. If you don’t hit your goal by the deadline, you don’t get funded. You’re more likely to succeed if you have an “artsy” business, such as graphic design, filmmaking or apparel, or a consumer technology business such as videogame devices and smartphone accessories.
- Consumer-oriented technology products or “artsy” businesses
- New product development