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Aug 30, 2022

Everything you need to know about raising capital

Portions of this Read were originally published in the DBusiness blog in 2020.

It’s no secret that in order to grow, small business entrepreneurs need access to cash. You may be inundated with offers of fast financing and easy applications, but before making a move, it pays to understand the risks and opportunities.

A Quick Primer on Shopping for Money

When shopping for money, it’s important to know that the interest rate equals price. But interest rates may not capture the total cost, so it’s important to calculate a loan’s Annual Percentage Rate (APR). The APR includes the underlying interest rate plus any other costs associated with the loan. The APR can underestimate the impact of upfront costs if a loan is repaid early, but generally it’s the best way to compare the financing costs of different loans.

Like the price of anything, interest rates are impacted by supply and demand. When lots of people are shopping for money or supply of lenders offering loans is limited, expect rates to rise. A lender’s risk also impacts the interest rate. A risky borrower has a higher potential for default and therefore a higher interest rate is charged.

One of the ways lenders manage risk is by working with the Small Business Administration (SBA) which provides loan guarantees to the lenders. Borrowers are able to access SBA loans through their commercial lender (more on SBA loans below). Lenders also manage risk with collateral commitments or personal guarantees.

Know Before You Go

Financing options differ with a range of turnaround times from application to payout, as well as qualifications on who is eligible and what the money may be used to fund. Before seeking financing options, a small-business owner should know:

  • How soon they need financing
  • How much they need
  • How they’ll use the financing
  • How long they need it

Even if lenders don’t require it, a small business owner should have their books in order and know both their business and personal credit score. While personal credit reports are free from each of the major reporting agencies, it’s more difficult to get direct access to a small business credit report. Yet it’s worth it to know what lenders and vendors will see when making financial decisions that impact a business. 

The Most Common Financing Options

Traditional Lenders – Banks and credit unions typically offer the best rates compared to other financing options. They cater to larger, more established companies and offer the benefit of a professional banker relationship.

On the downside, a small business usually needs a strong business and personal credit score to get a loan or line of credit. The application process is also longer and more arduous. Traditional lenders prefer to make larger loans so even a $250,000 loan may be too small. A small business may have a better chance of getting a loan through a traditional lender by utilizing the SBA program.

SBA Loans – Aside from disaster loans, SBA loans are like regular loans in that the borrower never deals with the government. The bank lends out its own money, and the loan is serviced by the bank. Behind the scenes, the government helps guarantee the loan, improving a small business’ odds of qualifying.

An inside scoop: just because a small business is not approved by one lender doesn’t mean it won’t be approved by another. SBA loans are great options for patient borrowers who have their records in order and are willing to go through the process. These programs are designed for start-ups and small businesses and generally offer more attractive rates, better terms, and less collateral than online lenders.

SBA loans take longer, require good credit, and can have complex program rules. But a small business owner can find a variety of programs available, including micro loans and an express version of a standard loan term. The SBA offers Lender Match, a free service that prepares borrowers and connects them with SBA-approved lenders based on funding needs.

Alternative Lenders – Primarily available online, these lenders fall into two types: direct finance companies that operate without a middleman, and peer to peer (P2P) platforms that connect the small business with a lender.

A small business will find many of the same financial products as traditional lenders, but with less paperwork and often much quicker turnaround. One of the most highly touted features of alternative lenders is speed from application to payout. However, this convenience comes at a cost with much higher interest rates than traditional and SBA backed options.

Additionally, with online lenders borrowers can expect little or no mentorship. Online lenders can also have sticky penalties for prepayment or collateral. While alternative lenders are not the cheapest option, they provide expanded access to capital for riskier businesses not well served by traditional lenders.

Merchant Cash Advance (MCAs) – This form of small business financing enables companies to borrow money against future credit card sales by advancing a lump sum of cash that is automatically paid back from their daily credit card transactions.

MCAs sidestep the typical traditional underwriting process by focusing on the merchant’s credit and debit card sales data. This is great for a small business with a high volume of credit card transactions and needs cash in a hurry but may be new, lacks assets, or has poor credit history necessary to obtain a traditional loan.

On the downside, MCAs are probably the most expensive form of funding with APRs upward to 200 percent.

MCAs are not long-term loans, and payments are made from every transaction, so the merchant can experience a real cash crunch. Additionally, these arrangements may put limitations on the business, like binding them to their merchant processor or restricting the merchant from encouraging cash transactions.

Funding For All

As a small business owner, it’s beneficial to be aware of the various ways that you can raise capital for your business. In addition to the options discussed here, you can also explore grants, crowdfunding opportunities, or working with investors. Regardless of your business stage, when it comes to financing, there is no shortage of choices for funding and growth.


AUTHOR

author photo

Roy Lamphier

Small biz owner, mentor, and economics geek.