Banks are one of the most common sources of funding for small businesses, but are typically not a good source of funding for startups because of the strict loan requirements. Since the recession, the availability of bank financing for businesses has decreased significantly (as has Venture Capital and Angel Investing), but may still be a viable option if you can meet their requirements. Banks offer a variety of business loaning options, all of which have unique characteristics. This post will also explain some of the basic components of the loans that all business owners should know, and break down what lenders look for when considering your loan application.
Types of loans
- Lines of credit: If you receive a line of credit from a bank, the bank makes a specific amount of money available to you, rather than giving you a lump sum of money. This is can be preferable to a traditional loan for two reasons. First, you only have to pay interest on the money you actually borrow, which is generally less than the amount that the bank makes available to you. Also, under the terms of a line of credit, you can usually use your loaned funds for any business purpose, while banks often limit what the money can be used for under the terms of a traditional loan.
- Credit cards: Credit cards are another method of business funding. Like personal credit cards, credit cards for businesses are useful because of their convenience, but have obvious drawbacks. Business credit cards usually have interest rates that are only a slightly lower than personal credit cards. They have an average credit limit of around $15,000, which will not cover the expenses of most businesses.
- Traditional bank loans: these loans are lump sum loans from banks that are usually granted to businesses with a specific use of funds restricted by the bank. Short term loans can be as brief as 90-120 days, intermediate term loans usually have duration of 1-3 years, and long term loans generally last 5-7 years. As the duration of the loan increases, so does the associated risk for the bank, which makes long term loans more difficult for small businesses to get. For each of these loans, the business must almost always provide a source of collateral.
Short term loans are commonly used by businesses that need to cover costs for a short amount of time, this might occur to close the gap between inventory purchase and sale, or between the sale of the business’s produce and payment by customers. Intermediate term loans are often used for a reasonably sized expansion, such as remodeling a store front or purchasing new equipment. Because this loan is made for a specific purpose, once this event happens, the bank expects to be repaid.
The purpose for a long term loan can vary widely, from purchasing large scale equipment or facilities, to acquisition of new business. Loans that last for this duration can be much riskier for banks, so they are often collateralized by the asset that is being purchased (the equipment, facility, or new business).
- SBA Loans: The SBA (Small Business Administration) is a government body that provides a key source for small businesses looking for funding to start or expand. SBA provides a number of financial assistance programs for small businesses that have been specifically designed to meet key financing needs, including debt financing, surety bonds, and equity financing. Rather than loaning the money to businesses themselves, they will guarantee repayment of funds for businesses that meet certain requirements. However, loans from the SBA for startups are also limited.