“Do you need to get a business loan for your startup?” No. But many startups will choose to secure a loan to start their business. Why? Primarily because most entrepreneurs don’t have the means to finance 100% of their startup. Also, equity financing is typically only available for high-growth businesses.
Debt vs equity financing for startups
Most startups need financial help from outside sources. These sources of financing fall into two general categories:
- Debt
- Equity
Debt financing
Debt is borrowed money that must be repaid according to an agreed-upon schedule and at an agreed-upon cost (interest rate).
One of the advantages of debt is that you don’t give up any ownership of your business. All the lender is concerned about is receiving regular repayment plus interest.
Once the loan is paid off the relationship with the lender ends.
Additionally, interest is tax-deductible. It is subtracted from operating profit before taxes are calculated.
Finally, debt repayment is predictable. It’s an easy expense to forecast.
That’s also one of the disadvantages, though. Debt is a fixed cost.
If the proceeds from debt aren’t used in a manner that earns a good return on investment (in terms of revenue or reduced costs) then that fixed expense drags the business down. Whether times are good or bad the cost of debt stays the same.
Another downside of debt for startup financing is that you may have to personally guarantee repayment of the loan with your own personal assets.
Equity financing
Equity is ownership of the business. Unless you give someone else equity in your business, you will always have 100% ownership.
If you finance with equity, you give up a certain percentage of ownership of your business. I.e. profits and sales proceeds.
Equity has its advantages.
For starters, you are not obligated to repay equity financing. The outside investor should understand that risk
One disadvantage of equity is that your investors may not agree with your business decisions. Since they are owners, you’ll have to take their opinions on managing the business into consideration.
Investors can be bought out, but that can be expensive.
Types of loans for startup businesses
Not all startup business loans are the same. If you decide to secure a loan to start your business, you have several options.
Equipment financing loans
Loans for startup businesses have strict standards that must be met. If you call the loan by a different name, those standards might loosen.
Equipment financing loans are for buying equipment, machinery, and other fixed assets.
The equipment you purchase serves as collateral for the loan. Repayment is typically made in installments.
Business credit cards
In addition to providing financing, business credit cards can establish credit for your business.
It’s likely that you will have to “cosign” with your business (personally guarantee) before getting a business credit card.
Business credit cards also, often, come with generous rewards programs.
SBA loans
The Small Business Administration doesn’t lend to your business directly. They guarantee the loan to incentivize the lender.
SBA loans are, typically, more “paperwork-intensive” than other options.
SBA loans can also be made for larger amounts than some other alternatives.
Microlender loans
Microlenders are non-profit organizations that provide debt financing to startups who might not qualify with traditional lenders.
These loans are typically “smaller” than those made by a traditional financial institution.
P2P loans or crowdfunding
Peer-to-peer loans, currently, are only made to individuals. Not businesses.
P2P loans are also, typically, small. But, approval and funding are quick.
Loan crowdfunding, unlike other types of crowdfunding (donation, exchange, and equity), requires payback. It’s not dissimilar to P2P loans.
Friends and family loans
Borrowing from a friend or family member might be easier. But, it can come with other complications.
Make sure the terms of the friend/family loan are clear.
Obtaining a startup business loan
If you’ve decided to secure a loan for your startup, these are, more or less, the steps you’ll follow to get funding:
1) Determine how much you’ll need to borrow
This can be determined by creating financial projections for your business.
Keep in mind the fixed assets you’ll need to launch.
Also, money that will need to be spent before operations commence.
Additionally, your small business will need cash-on-hand at launch
Work in an additional amount for unanticipated expenses you might incur before your business becomes self-sufficient.
2) Decide what type(s) of startup business loan you want
Review Types of loans for startup businesses, above, and choose one or more that suits your business’s needs.
3) Compare loan providers
Several different providers should be available for whatever type of loan you seek for your startup.
Compare costs, terms, credit requirements, collateral required, documentation, business requirements, and other variables between providers. A table with the providers in the left column and the variables along the top might help you compare.
Look up and compare reviews for providers, too.
| APR | Loan term | Credit req | Collat needed | Docs needed | Biz req | Reviews | |
|---|---|---|---|---|---|---|---|
| Provider 1 | |||||||
| Provider 2 | |||||||
| Provider 3 |
4) Assemble the needed documentation
Every type of startup business loan will require at least some type of documentation.
Common types include a business plan, historical financial statements, personal & business bank statements, personal & business tax returns, legal documents (leases, contracts, etc). Be prepared to provide more documentation. This should get the ball rolling, though.
5) Complete the application process
Each type of startup business loan will have its own unique application process.
You can apply with more than one provider at a time. This could help you secure a loan quicker. Beware of the effect of multiple inquiries on your credit score, though.
What factors can get your startup business loan application declined?
Not every loan gets approved. In fact, a lot of startup business loan applications get declined. Don’t despair.
If you do get rejected for a loan try to get an authentic reason why. Rejection sucks. But, understanding your shortcomings can help make it clear what you need to work on.
Here are some areas to address, before you apply, to minimize your chances of rejection.
Low credit score
Lenders aren’t visionaries. They rely heavily on the mysterious algorithm known as a credit score.
If your (or your business’s) credit score is too low, you’ll be systematically dismissed. Work to get your credit score to the minimum needed for the type of loan you’re seeking.
Lack of credit history
This can affect your credit score.
If you have no credit history, then, in most lender’s eyes, you have bad credit.
Fortunately, it doesn’t take too long to build a credit history. If you do so with on-time payments, a lot of your credit issues should disappear.
A high-risk industry
Lenders want to minimize risks.
If they deem your industry (or business model) high-risk, they will likely decline your loan application. If they don’t understand your industry (or business model), they’ll probably deem it high-risk and decline your loan application.
If you find yourself in this position more thorough market research might help. Plus, you might search for a lender that specializes in your particular industry.
Character issues
A criminal history and/or a bad reputation can result in a declined loan application.
Conviction of a crime involving “moral turpitude” is likely an instant rejection. If you’re unsure, you can speak with a representative of the lender to gauge their stance on your crime.
Infamy as a particularly immoral person, even if not criminal, isn’t going to help your cause either. In instances like this, you’ll likely have to apply somewhere your reputation doesn’t proceed you.
Lack of collateral
Collateral lowers risk for lenders. If things go bad, they can sell the collateral and recoup some of their losses.
However, if you’re securing a startup loan to pay for things like labor, marketing, or research, then there is nothing tangible for them to sell if you default on the loan. Therefore, they’ll see the loan as riskier and the likelihood of your business getting declined increases.
Capacity to repay
Low margins, a poor location, and many other factors can make your financial projections suspect in a lender’s eyes.
Even if you can show that it is possible for you to pay back the loan, that possibility might be based on so many shaky assumptions that the risk is too high to make a startup loan to your small business.
A poor business plan
A well-researched and thought-out business plan sends a strong message. It shows that you have carefully considered the present and future environment of your startup.
Beyond that, if it’s done right, it also serves as a marketing tool for the funding your startup needs to be successful. Every section of your business plan should make a case for loaning your small business the money it needs.
Lack of quality advice
Business is complicated.
It could be that your business is a good credit risk, but, you’re just not able to convey that to lenders. If that’s the case, check with your local SCORE chapter. There may be volunteers with that organization that can help you put your best foot forward.
Giving up
You’ll get declined for every loan you don’t apply for. Rejection can be discouraging, but try to take a lesson from it and make improvements where needed. Don’t keep banging your head against a wall.
Also, if you’re going to pitch your business, show some enthusiasm. Business revolves around selling and your startup’s potential is the first thing you have to sell. If you’re not pumped about your startup’s potential, then go back to the drawing board and refine it until you are.
Do you need to get a business loan for your startup?
It technically isn’t necessary to secure a loan to start a business. But, if you want to start a business, there’s a pretty high likelihood that you’ll need one.
Understanding your options and the loan process will help you decide what kind of debt financing is right for you. It will also help you to be prepared and increase the chances of your approval.