There are generally two kinds of people who start their own business.

The first loves the art of building a company. They want the challenge of creating an organization out of nothing, and when money is tight they jump out of bed ready to chase down every lead. This personality type usually moves on once the business is successful, because for them the fun part is over.

The second type of person wants to do the business' work. Creating this organization is a means to an end, and its day-to-day operations are the price of independence. For them, solving an operational problem and securing financing is usually the worst part of the day. They would just rather get back to glass blowing, practicing law or whatever other professional skill they've organized their business around.

If you're reading this article, you probably identify with the latter. Getting a business loan is probably a necessary first step to take your craft beer from hobby to paycheck, but it doesn't have to be stressful. Here's what you need to know.

(Note, this article will discuss lending for small businesses. While the principles of lending apply to businesses of all sizes, in practice large companies will have a different experience from small ones.)

What Is a Small-Business Loan?

Small businesses have access to several different types of lending. The most common are business credit cards, small-business lines of credit and lump-sum lending (also known as installment or term loans).

The term "small-business loan" refers to a lump sum loan.

In a small-business loan the lender, typically a bank, will advance the business a specific amount of cash in an up-front, lump-sum amount. The business will then repay that amount on a set schedule with a specified amount of interest.

The repayment terms of a small-business loan can vary. A few common repayment variables will include:

  • Commencement of Payment - Not every small-business loan will come due immediately. Sometimes the lender gives the business a grace period to turn the loan into revenue.
  • Payment Schedule - On what schedule the business will have to repay the loan. Most lenders will require monthly payment.
  • Interest Rate - Whether the interest rate is fixed or variable, on what basis it is variable, and what this interest rate is.
  • Interest Compounding Rate - At what rate interest for this loan compounds. Most lenders will compound interest monthly or annually.
  • Amortization of Payment - Whether the loan payment is amortized to ensure that the payments are of equal amounts.

Why Get a Small-Business Loan?

A small business might take out a loan for many different situations, but there are three most common circumstances:

1. Starting Up a Business

The most common reason to take out a small-business loan is simply to open your doors and turn the lights on.

Starting a business takes much more money than the average entrepreneur has on hand. Signing a commercial lease alone will cost more than most individuals can afford, not to mention hiring staff, buying products, paying for insurance and all the other associated costs of doing business.

A small business loan can give you access to the capital you need for all of these expenses.

2. Expanding Your Business

Expansion is a risk for any business. More important, it can be enormously expensive for many of the same reasons as starting a business from scratch.

As a result, most businesses prefer to expand with borrowed money. Even if it has the cash on hand a business generally takes out a loan to spread the expense out over a series of years, turning a massive up-front expense into a manageable cash flow.

For companies which don't have the cash on hand, a loan to expand can mean the difference between taking advantage of an opportunity and watching it pass by.

3. Smoothing Out a Cash Flow Problem

Finally, a business might take out a small-business loan to stabilize a downturn.

If the owner is confident that they just have a cash flow issue rather than a fundamental problem with their business model or market, a loan can be a sensible way to make payroll while waiting for business to improve.

This is, of course, potentially dangerous. If business does not improve, or does not improve quickly enough, you will have added a new (potentially expensive) obligation on top of all the existing ones.

What Will You Need to Get a Small-Business Loan?

To get a small-business loan you will need to present the lender with a few critical facts about you and your company.

Credit Score

The lender will want to know your personal credit score and, if applicable, your business' credit score.

Anticipate their requirements to change based on the kind of loan you are looking for. Larger loans will require a better score, as will a loan for unsecured spending.

Business History

How long has your business been in continuous operation? Has business ever been suspended for any reason?

The longer you've been around, the more likely it is that the lender will work with you. Unfortunately this means that businesses just starting up have the hardest time securing a loan. It's not impossible, just expect to need more…

Collateral

Will you use anything to secure this loan? How much of your own money are you staking in this venture?

In particular, for someone just starting out, the lender may want more collateral to back the loan. Unfortunately, this often can mean putting personal assets at stake, such as your home or car. Any segments of the loan being used for capital purchases, such as real estate or vehicles, can be secured with that asset, making it easier to get the loan.

And every lender prefers to see an entrepreneur with "skin in the game." Just as a mortgage will come more easily with a bigger down payment, the more of your own money you are sinking in to this new business the more likely it is that the lender will stake some of its own.

Cash Flow

What kind of cash flow do you and your business have? This includes not only revenue and income but also existing expenses. It does no good for your company to make $200,000 a year in revenue if it already has $199,000 in expenses.

This is key information for the lender to assess whether you can repay the loan.

Business Model

Finally, for businesses just starting out, the lender will probably want to take a good look at your professional background and business model.

This information tells the lender how seriously to take you. In this regard they will act much like an investor, trying to decide if you have a good idea and the ability to execute it. For an existing business this isn't as necessary, because your results will speak for themselves. For a business that's still just an idea on paper… Well, the lender will really care about what you have on that piece of paper.

Types of Loans

As noted above, this article only refers to lump-sum loans. We aren't discussing lines of credit or business credit cards (nor some of the less common options like invoice financing or merchant financing). Even within this specific field, though, you have a range of options.

A small-business term loan, or simply a small-business loan, is the classic product. This is a lump-sum loan extended to you or your business for general expenses.

Small Business Administration secured loans are sometimes available to qualifying businesses. These are low-rate loans secured by the SBA. While they are often excellent products for those who can get one, the process of getting an SBA secured loan can be lengthy and difficult. You can find more information about getting an SBA secured loan here.

Then there is an equipment loan or real estate loan. This is a loan taken out to buy capital assets such as vehicles, land and buildings. In this case you will typically have to stake a down payment, but the loan itself will be secured against the asset that you buy. As a result it will usually be easier to secure and come with better financing.

Finally, there is microlending. This is a product that focuses on very small transactions, typically below $30,000 in value. Microlending is usually easier to secure than a traditional loan, but also usually has a significantly higher interest rate.

Types of Lenders

Banks provide most small-business lending, including both traditional small-business loans and SBA secured lending.

If available, a local community bank is often a better place to go for startup small-business lending. These institutions are often far more motivated lenders due to their connection to the community, and the individual banker will typically have more discretion to lend based on personal and professional history.

Government and non-profit grants are also available to entrepreneurs. These programs are run sometimes by the state but more often by local communities and can provide startup funds for community businesses. These will typically have limited funds available, so they are best used to supplement other sources.

Finally, online lenders have grown as an option for small-business lending in recent years. Both centralized and peer-to-peer institutions provide funding for entrepreneurs. Borrowers should take care, however, as the terms through these lenders can often be unfavorable.

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