In a time of high inflation and ever-rising interest rates, having cash on hand is crucial for small business owners. Securing financing can be challenging, and identifying the right type of financing can be critical to the success of your business.
Last week, the Federal Reserve announced a 0.75 basis point hike in its lending rate, indicating more hikes are likely to follow. For companies that need money to cover liquidity bottlenecks or for growth plans, it is important to secure financing at a reasonable cost of capital in good time.
Cash flow is the lifeblood of any small business
Whether you’re an entrepreneur starting a startup or an established business waiting for growth, finding the right funding source can mean the difference between success and disappointment. Even when small businesses aren’t in a growth phase, they should have enough cash to navigate slow phases and absorb increases related to fuel prices, labor costs, and commodities. Bottlenecks in the supply chain also impact the cost of simply meeting demand.
The amount of funding required by a business depends on many factors including how long a company has been in business, current financial position, credit history, type of business and the amount of funding required and how the money will be used. Before you take out a loan, it’s a good idea to calculate the cost of debt so you’re sure of how much you’ll owe in total.
Ways to finance small businesses
Funding a small business can be challenging, but it’s not impossible. Typically, online or alternative lenders can fund your business faster than traditional banks. There are many ways to finance a business:
- Personal Savings – If you want to get into business, don’t expect to do so without putting in some of your own money. Unless you’re already independently wealthy, you’ll likely need seed capital. When you plan to get debt financing, banks and other lenders expect you to “put skin on the line”. Because if you are not willing to invest your money in the company, why should you?
- family and friends – Borrowing money from friends and relatives has many advantages and disadvantages. You don’t have to provide your lenders with three years of tax returns, bank statements, and other documentation required for a small business loan. In all likelihood, the interest rate will be low, if any. But remember that when family is involved, hiring a good-for-nothing nephew and unsolicited suggestions — or, worse, demands — from people who may not understand the business can be part of how the business should be run. Remember that relationships get strained when things go wrong. How persistent will Uncle Ralph be in insisting on repayment if the company goes bankrupt? Joining a family business has the potential to destroy family relationships.
- Traditional bank loans – Securing a bank loan for small business owners is a proven method of raising capital. Large banks tend to offer the lowest interest rates, but tend to be the most cautious when it comes to lending decisions. Currently, just over 15% of business loan applications from major banks are approved, according to the latest Biz2Credit Small Business Lending Index (June 2022 figures). Before the pandemic, the figure was over 28%. In general, the larger banks have the strictest lending criteria. If you have a low credit score or little to no credit history, getting a small business loan from a bank can be very difficult. Also, the process can take weeks or even months.
- Regional and community banks can be a good source SBA 7(a) Loans, and typically smaller banks are more likely to approve loans. According to the Biz2Credit index, they approved 21.1% of the applications received in June. That’s very different from 2019 and early 2020, however, when more than half of loan applications were approved. The good news is that smaller and smaller banks are partnering with fintechs and moving into online lending for small businesses. This advance expands the flow of capital to small business owners. This helps small businesses owned by minorities or located in underserved areas.
- Currently, interest rates on commercial bank loans range from 4.25% to 9%. However, as the Fed continues to raise interest rates to fight inflation, we may see these percentages rise in the near term. Also remember that small business loans are often adjustable rate loans. That means the interest rate on that small business loan that you got at 6.5% this year could be 8% next year.
- Alternate Lenders – Non-bank lenders that offer products such as merchant cash advances provide a quick source of capital, have fewer requirements, and lend to business owners with poor credit ratings. These lenders take on more risk in providing capital, so they naturally get a greater reward in the form of higher interest rates. Often these rates start at 20% and go much higher. But when an owner is in a crisis or has an opportunity to strike a deal on holiday inventory at a spectacular price that can sell at a large premium, it can be worth it. With a merchant cash advance, the company quickly receives an upfront payment — sometimes within 24 hours — which is repaid by a percentage of the day’s credit card earnings. As with any loan, do your research and know what you’re getting into.
- credit cards – There are many stories about startup companies created by the founders to “max out their credit cards”. While this route can be successful and the loan is instant, there are countless stories of would-be entrepreneurs who get into financial trouble by borrowing from their credit cards at interest rates that start at 12-14% or higher. Credit limits on the cards can severely limit the amount one can borrow. As the stories progress, owners will max out multiple cards. Using credit cards to start a business and keep it afloat is risky and potentially financially devastating.
- private equity – Offering ownership interests to investors is a viable financing option. The challenge is to find the right investor. You also give up control when you give up ownership. Anyone who has seen an episode of shark tank will know that well.
- Government grants – The SBA provides limited grants for small businesses and grants for community organizations that promote entrepreneurship, including those that support veteran and disabled veteran-owned businesses and small business development centers.
Whether or not getting small business financing is a challenge depends on your business’s revenue and profitability, the type of financing you are applying for, and the size of the loan. Other factors include your personal and business credit history, time in business, and a solid business plan.
The bottom line: carefully consider your business financing options
Interest rates are not always the most critical factor. The speed of financing is often much more important. When you’ve gotten into trouble and are struggling with payroll, which means high expenses that keep growing, fast funding is needed. Another reason why speed matters: Opportunity costs. Perhaps a vendor has decided to retire or is going out of business. You may have the opportunity to get a great deal on closeouts. In such a case, the opportunity cost of not buying quickly is high. Then a loan from an online lender or a cash advance from retailers makes a lot of sense.