Loans

7 Types of Small Business Loans – Pros & Cons

Entrepreneurs and small business owners seeking funds to grow their businesses can either seek equity funds from investors or borrow funds from a lender. Seeking new equity is time-consuming, subject to federal and state regulations, and requires sharing future profits. In some cases, an owner might even lose control of their company if management decisions must be approved by an external board of directors.

On the other hand, warnings against borrowing have circulated in the small business culture for centuries. Stories of aggressive debt collectors, callous bankers, and naive borrowers are passed from generation to generation as evidence of the seemingly inevitable result of taking on business debt. Like other myths and legends, the negative aspects of small business debt are often wildly exaggerated.

Here’s why small business loans might be right for you, as well as a look at your options.

Benefits of Small Business Loans

The prudent use of debt by small business owners is a financial strategy that should be embraced, rather than scorned. The benefits of smart debt financing include:

  • Speed of Funding. In most cases, the period between seeking and receiving funds is considerably shorter for debt than equity. A borrower typically deals with one funding source with established procedures to underwrite and fund the borrowed amount. By contrast, raising equity funds typically requires multiple investors, each of whom may follow different processes to make the investment decision.
  • Administrative Simplicity. Seeking funding from a lender is straightforward and often a matter of completing basic forms and providing financial statements. Equity investors require periodic reports on operations, possible shareholders meetings, and board approval before taking certain actions.
  • Retained Ownership. Unlike equity, a lender does not share in the profits – or losses – of a company. The business owner reaps the consequences of their management and investment without dilution since lenders have no direct claims on future profits.
  • Management Control. A lender does not make management decisions, whether personnel-related, financial, or operational; their sole interest is that the borrower complies with the terms of the loan.
  • Clear Terms. The terms of a loan – such as principal amount, interest rate, repayment terms, and collateral, if any – are unambiguously established at the onset of the loan and do not change during its life.
  • Tax Benefits. The interest paid on a business loan is generally deductible from taxable income, meaning the business owner effectively shares the cost of the loan with the taxing authorities.

Drawbacks of Small Business Loans

While there are a number of benefits of including debt in a business capital structure, the bottom line is that debt must be repaid at some point if the business is to continue. Borrowers should be aware that:

  • Repayment Reduces Future Cash Flows. While borrowing initially provides cash for working capital, the repayment of the debt has the opposite effect, requiring cash that might otherwise be used for investment or dividends to owners.
  • Repayment Terms Are Fixed. The terms of a loan are clearly established at the time debt is extended, and lenders are reluctant to amend terms unless they receive additional benefits, such as higher interest payments, additional security, or authority over future cash expenditures.
  • Lenders Can Be Hard Taskmasters. No matter how cordial and courteous they are during the initial borrowing period, lenders are not partners; they’re vendors. If the business experiences difficulties in the future, the lender’s sole interest is to protect the repayment of the loan, even if repayment results in the business’s bankruptcy.

Popular Small Business Loans

Business loans are available in many forms, each with its own purpose and characteristics. The following are some of the most common.

1. Accounts Receivable (AR) Loans

Uncollected accounts receivable tie up cash and decrease cash flow. Unless a company deals solely in cash, there will always be an accounts receivable balance at the end of the month. For example, if you provide payment terms of 10 days after an invoice’s date, the sales that occur at the end of one month will not be collected until the following month.

Small companies who sell competitive products to bigger customers often have difficulty enforcing credit terms. One of my investments, a Mississippi wood-treating plant, sold products to utilities and railroads across the country, most of whom paid within a 45- to 60-day period after invoicing. While these customers were not credit risks, their slow payments wreaked havoc on our cash flow. A revolving accounts receivable loan solved the problem.

Banks like to lend on accounts receivable because they quickly become cash to repay the loan. For these loans, banks typically agree to advance 70% to 80% of the accounts receivable balance that’s less than 60 days old. Some banks may provide a different percentage of the value based on the age of the accounts, such as 90% of the balance for accounts aged 30 days or less, 75% off the balance for accounts aged 30 to 60 days, and 50% of the balance for accounts aged 60 to 90 days. Few banks will accept accounts receivable aged 90 days or more as collateral, so these accounts have no collateral value.

In a typical AR loan, the company delivers a schedule of the accounts receivable to the bank and receives cash for the calculated values. As the month progresses, old accounts are collected while sales create new accounts. At the end of each month, a new loan balance is calculated.

If the following month’s balance is greater than the previous month’s, the bank advances additional cash equal to the difference, minus interest, to the company. If the following month’s balance is less than the previous month’s, the company repays the difference, plus interest, to the bank. As a result, the loan balance changes each month. In either case, the old loan is repaid and a new loan issued.

Some banks assume collection of the accounts receivable by requiring that invoice payments be made to a bank account established solely for that purpose, thereby ensuring that the bank is aware of all payments the company receives. In other cases, the bank allows the company to continue their existing collection process, relying on the company to present timely reports of collections to the bank and have sufficient cash on hand if a payment on the loan is required.

In addition to the accounts receivable pledged as collateral, the bank might require the personal guarantees of the owners of the company as additional security.

Factoring Alternative

Some business owners prefer to “factor” accounts receivable, rather than borrow against their value. Factoring is the sale of accounts receivable to a third party (the factor) for a discounted face value. Companies like BlueVine give you the chance to turn unpaid invoices into working capital. You can receive approval in just 24 hours with rates as low as 0.25% per week.

Depending on negotiations between the factor and the company, the factor might assume all or a portion of the collection risk and function. In the latter case, the factor may retain the right to return uncollectible accounts to the company for the funds previously paid for the debt. Small business owners should be aware that tax treatments are different for AR loans and factoring arrangements.

2. Inventory Loans

Maintaining a stock of raw materials and finished products, or inventory, is essential for most companies. A manufacturer without raw materials can’t create products to sell, and a retailer without finished goods can’t meet customers’ demands.

Our wood-treating operations invested thousands of dollars in pre-cut timber poles and green wooden railroad ties, which were primarily used to replace weathered and storm-damaged railroad, telephone, and utility lines. Customer demand for these products would peak after each storm, and the ability to deliver our products quickly was essential. If we didn’t have the right-sized pole on hand, our customers would turn to a competitor. As a consequence, the value of our inventory exceeded the book value of the facility.

Like uncollected accounts receivable, inventory represents idle assets, earning nothing and using up cash until it’s sold. There was always green lumber waiting for processing and treated poles and ties waiting to be sold. In order to increase cash flow, we initiated a series of sequential short-term loans using the inventory as collateral.

Unlike accounts receivable, banks and financial institutions are not keen on using inventory as collateral, especially if it requires additional investment before it can be sold as finished products. As a result, banks rarely lend more than 50% to 60% of the value of finished inventory, with lower percentages for work-in-progress inventory and raw materials – if they accept either as security.

An inventory loan works similarly to an accounts receivable loan, with the loan balance fluctuating with changes in collateralized inventory. If the collateral value increases from the previous month’s balance, the loan balance increases and additional cash is advanced. When the collateral value falls below the previous month’s balance, the company must repay the difference, lowering the total loan amount.

For example, our bank agreed to loan the company 50% of the company’s finished product inventory and 40% of the green lumber value. In the first month, we had $250,000 of treated products and $140,000 of green lumber, allowing us to borrow $181,000 (50% of $250,000 plus 40% of $140,000). During the following month of operations, we sold our treated products, converted green lumber to treated, and continued to buy raw materials. At the end of the month, we had $175,000 of finished inventory and $185,000 of green lumber, qualifying for a new loan of $161,500 (50% of $175,000 plus 40% of $185,000). We paid off the old loan of $181,000 and signed a new loan of $161,500, for a net cash outlay of $19,500. We also paid one month’s worth of interest.

Inventory values calculated on a company’s accounting records must be periodically checked and confirmed by regular physical inventory counts, with the lender making adjustments to the loan as needed. Depending on the terms of the loan, the bank may require the company to take physical counts more often than regularly practiced, adding additional administrative costs.

As with AR loans, business owners are usually required to guarantee the value of the inventory securing a bank loan. If you currently have a successful business, OnDeck is a great online lender for inventory loans. However, if you’re a newer business or have a lower credit score, Kabbage might be a good option.

3. Equipment Loans

Equipment loans are usually secured by the physical equipment being purchased with the loan proceeds. Equipment loans terms typically range from three to eight years and are amortized over the life of the loan by a combination of regular interest and principal payments. The lender – whether that’s a bank, finance company, or manufacturer – maintains legal control of the collateral with the right of repossession if the borrower fails to meet the loan terms.

Depending on the lender and the loan value of the collateral, the lender may require personal guarantees by the owners as additional security.

During the loan term, the borrower is legally required to maintain the equipment in good working order and carry liability and property insurance for its use. As the loan progresses, the company’s equity value in the pledged collateral might increase, providing opportunities to refinance the original loan or add a second loan secured by the value. In the latter case, the new lender’s claim on the equipment would be subordinate to the first lender’s claim; in other words, the loan to the first lender must be paid in full before the second lender can claim the collateral. As a consequence, the second, subordinate lender will typically require a higher interest rate on the loan to compensate for the increased risk.

We used equipment loans from truck manufacturers to acquire rolling stock in our treatment facility, typically financing 100% of the purchase price with the vendor and amortizing the debt over three years. Because the market value for heavy trucks and trailers declines much more gradually than automobiles, the market value of our rolling stock was always greater than its book value or loan value as we amortized the loan. This excess value was available as security for other loans if needed.

If you’re looking for an equipment loan and you don’t have stellar credit, Currency is probably the way to go. However, if you’re looking to close on a loan quickly, OnDeck is probably the way to go. They can approve and fund loans in as little as 24 to 48 hours.

4. Real Estate Loans

Real estate loans are secured by real property – land and buildings – identified in the loan document, or mortgage. Real estate loan terms are typically 15 to 30 years, and the loan balance is amortized over the term. Loan amounts typically range from 70% to 90% of the property’s market value at the time the loan is initiated.

Small business owners should be cautious about using real estate loans in their businesses, making sure that the net cost of ownership is less than the costs of renting or leasing facilities. Owning property used for the business can complicate a move when more space is needed, especially if the original facility cannot be sold or rehabilitated for other uses.

5. Working Capital Loans

Companies with significant equity and a history of profitability or owners with a high net worth may be able to borrow funds from a bank or financial institution on an unsecured basis. The loan may be amortized over its term or fully payable at the end of term, depending on negotiations between borrower and lender. Working capital loans are not intended for acquiring tangible or intangible assets, but rather to cover short-term cash flow deficits.

Unsecured loans add an element of risk for lenders since they can’t seize specific property in the event of default. Should the business be liquidated or declare bankruptcy, unsecured debts are subordinate to secured debt – in other words, secured lenders are paid first and fully before unsecured lenders. As a consequence, unsecured debt typically has a higher interest rate.

6.  Letters of Credit

Letters of credit (LC) agreements, in which the financial institution guarantees to fund future amounts, are sometimes used in place of working capital loans. The borrower pays the lender a fee – typically 1% to 5% of the amount of the prospective loan – for the limited-term guarantee, drawing funds if and when they need the money.

Using an LC in lieu of a loan is less expensive since interest isn’t due until the LC is funded. Also, borrowers don’t report contingent loans on balance sheets until they are funded, leaving them a cleaner balance sheet and the appearance of less debt. Typically, the lender’s obligation to fund the borrower up to the amount identified in the LC decreases as the borrower draws down the guaranteed amount. Their obligation terminates when the full guaranteed amount has been lent or at the end of the guarantee period. Funds advanced under an LC are treated as a loan with the previously negotiated payment terms and often documented separately.

7. SBA Loan Program

The federal government, recognizing that banks are often reluctant to lend to small businesses, has established several programs to encourage lenders to serve these borrowers. The most prominent of these programs is the Small Business Administration (SBA) guarantee program, by which the federal government guarantees repayment of 85% of the loaned amount, significantly reducing the lender’s risks.

For borrowers, however, the disadvantages of the program include:

  • Limited Number of SBA Lenders. Only a select number of banks and financial institutions offer these loans.
  • Tedious Application Process. The information required for an SBA guarantee is thorough and extensive, typically more complicated than for a standard bank loan.
  • Limited Use of Loan Funds. Funds advanced under the loan program are restricted to pre-approved purposes, such as for working capital, inventory, and equipment purchases. In some cases, real estate purchases are permitted.
  • Repayment Ability. Applicants must show successful management experience, good credit histories, and minimum equity of 25% (for startups) or 20% (for established businesses) of the sum of the debt and equity when the loan is funded.
  • Personal Guarantees. Any business owner who has a 20% or more ownership in the business – alone or with a spouse – is required to personally guarantee repayment of the debt on a joint and several basis. In other words, each guarantor is liable for the full amount of the loan, not limited to their ownership share.

My experience with SBA loans was more than worth the extra documentation and time required to complete the process. After acquiring the wood-treating facility, we faced extensive modifications to the plant to comply with new EPA regulations. The local bank, an approved SBA lender, gave us $500,000 in the form of a 10-year 7(a) loan to rehabilitate the site. We paid the loan according to the terms and were happy with the process.

Many business owners avoid SBA loans, preferring the more flexible arrangements they might be able to negotiate with a friendly bank. But for companies with poor credit or limited assets to use as collateral, the SBA route may be their only option.


Final Word

Being a good businessperson in today’s competitive environment requires knowledge of various financing options and sources. According to SCORE, more than 80% of small businesses fail due to cash flow problems. Many entrepreneurs fail to recognize that cash is king and neglect the financing options – specifically, debt arrangements – that can be the difference between profitability or bankruptcy.

My experience with managing small businesses suggests that profitability and positive cash flow are the best defenses against complaints from shareholders or lenders. Both equity and debt have a place in a well-run company’s capital structure as both are suited for different purposes. That said, no one should assume a debt without understanding the risks.

Do you use debt in your company? Will you increase or decrease the amount of debt in the next year?

Source: Money Crashers / Featured image by rawpixel.com – freepik

Joseph Tanner

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