What types of debt are available to small businesses?
In our last blog, we took a deeper dive into the types of equity investment available to small businesses. Now let's talk about the other side of the funding coin: debt financing. As we discussed, the key difference between the debt and equity is that with equity financing you sell off a percentage of ownership of your company, while with debt funding you retain the ownership of the business and instead pay interest on the amount borrowed.
So, what types of debt funding are available to small business owners?
KEEPING IT OLD SCHOOL
The most common type of small business loan is a straight-forward fixed payment loan. What this means is that you borrow a set amount, receive the full principal amount up front, and then pay back the loan (plus interest) in monthly installments. Usually the term is 5-7 years for business loans, but some loans can be shorter or longer, depending on the needs of the borrower and the guidelines of the lender. You get a fixed payment loan from a bank or credit union, or even from an independently wealthy individual, or group of individuals. Some Angel Investors or Angel Groups are known to dabble in private loans.
BLOWING UP A BALLOON
An alternative to the standard fixed payment loan is an interest-only, balloon payment loan. Like a fixed payment loan, you receive the proceeds of the loan upfront, with a fixed interest rate and repayment schedule. The key difference is that your monthly payments will be for the interest-only, and then at the end of the term, your final payment will be for the full remaining amount of the loan. This is also a common way for traditional banks to lend to small businesses, because it ultimately gives the business the best chance of survival. By keeping the payments low during the first 5 years, it enables the business to keep overhead low and hopefully grow into a profitable outfit. The idea is that the business either has enough cash at the end of 5 years to pay the loan off, or will simply refinance the loan to pay off over the next 5 years.
THE REVOLVING DOOR
The next most common type of loan is a revolving line of credit. The most common type of revolving line of credit is a credit card, but they aren't the only type of line of credit available. Essentially lines of credit work by extending a certain amount to a small business owner, and the owner has the option of drawing down from that amount at anytime, for any reason. They only pay interest on the amount that they've used, and only for the amount of time they borrow it. Once you pay back the money, you then have access to that amount to borrow again. The catch is the "revolving" part. What that means is there isn't a fixed number of payments and any debt that is paid off is available to be used again. This type of credit usually comes with a high interest rate.
While small businesses are often issued credit cards, you can also take out a secured line of credit, meaning that the bank is extending you the line of credit based on the value of some piece of property, like real estate or some other valuable. While the mechanics of a secure line of credit are effectively the same as an unsecured line, you'll usually get lower interest rates with the secured line.
Taking out a loan for your business can be a scary and complicated process. If you'd like to know more about your small business' funding options, reach out to us for a free business evaluation.