Small business finance is one of the best ways to consolidate or grow your business.
Most small business owners don’t understand the finance jargon or know which business loan is best for them.
In the following guide, we’ll explain in basic terms the most common forms of business finance.
Debt or equity small business finance?
You can easily divide all small business finance options into two categories: debt or equity.
Debt finance
According to Investopedia, Debt financing occurs when a firm raises money for working capital or capital expenditures by selling debt instruments to individuals and/or institutional investors.
A fee is charged in addition to the initial debt and interest.
The most common types include:
- Unsecured loans
- Overdrafts
- Mortgages
- Credit cards
- Equipment leasing
- Hire purchase.
Benefits of debt finance
-ownership stays with you
-current management retains complete control
-interest payments are tax-deductible
-accessible to businesses ( this will depend on a few factors )
What you need to consider for debt finance
- for new small businesses and startups, it may be hard to obtain equity finance because they may not have accurate financial records or projections to allow a lender to decide whether you are creditworthy yet.
- you will have to generate cash to repay these loans every month, and this may be hard if you are starting and building the business.
- startup businesses often experience cash flow shortages that may make regular payments difficult – just adding more pressure for startups ( which they don’t need).
Imagine you have put your house up as security for the loan, and there is a downturn in business. Banks could repossess your home should you be unable to make regular payments. You need to think very carefully about this as a startup.
Equity finance
With equity finance, you sell a portion or share of your business to an external investor in return for the money. If you want to buy back the percentage of your business, you have to pay the investor back.
If you’re a larger business, you can offer investors dividends based on the company’s performance over the year.
Benefits of equity finance
- Far less burden in the short term: with equity financing, you don’t have those monthly repayments at the back of your mind, which is great for startups and small businesses not wanting the stress of set monthly repayments. Equity financing frees up cash flow which you can plough back into your business, such as marketing, equipment etc.
- All your credit history issues will go: if you have a bad credit history or lack the financial statements to obtain debt finance, equity finance is the perfect solution. You no longer have to worry about your past bad credit history.
- You have instant silent partners: once your new equity partners directly invest in the business, they have a share in your business, and you can pick their brain or learn from them. Because they have a stake in your company, they have a vested interest in making sure you succeed. You can use this to your advantage.
Disadvantages of equity finance
- Profit-sharing: you now have partners, and they will expect to receive some percentage of the profit eventually. Equity finance can add a different pressure as your expected to perform for these investors ( and they will be watching). You could justify this by thinking that you also get the added value of their business acumen plus the loan for this profit share. It’s a win-win!
- You lose control: That’s right. You no longer own your own company as you now have investors sitting right next to you. All decisions now need to be run past them, which may annoy some people that don’t enjoy relinquishing control.
- Potential conflicts: If you’re the type of person that’s a bit of a control freak, then having a partner all of a sudden may cause conflicts if you don’t like their management style, their work ethic or business goals. Personality clashes can cause serious conflicts moving forward, which can impact the day-to-day running of the business.
The deciding factor
-if your credit score or recent financial documents may be a problem, equity finance is an option.
-If your a solo operator and like to take the helm, then a loan is the best option over equity as you don’t have to report financial decisions to any other person.
-You have to ask yourself the question; are you happy to repay a lender, or do you prefer having a partner sharing the load by your side?
-if your confident that the business can generate enough money from the get-go to repay the loan, then go for it!
Bank business term loan
Probably the most common type of small business loan; a bank term loan is what comes to most peoples minds. These business term loans are repaid over 3 to 5 years and can be refinanced and extended if the business continues to perform as per the bank’s expectations.
Bank business loans require lots of paperwork ( some banks may even require a business plan ) and can take many months to get approved, so a service like Sparrow Loans is ideal – where we can free up money for you in a couple of days. According to Accountants Daily, more than one in four businesses have been rejected when applying for finance over the past three months, with that figure rising to 37 per cent in regional Australia.
The August Sensis Business Index found nearly four out of 10 business said they believed it was more difficult to secure lending since the start of COVID-19, with the majority saying it was the same, while just 12 per cent said it was easier.
The above figures are pretty staggering when you think about those struggling business owners post JobKeeper that need funding.
Advantages of Bank Loans
-The loans are not strictly repayable at the end of the term and are available for a longer period of time – unless you breach the loan conditions or fail to meet the refinancing parameters.
-Loans can be tied to the lifetime of the assets you have borrowed.
-You might be able to negotiate a holiday period for the interest repayments at the beginning of the loan period, or at some other time.
-You retain complete control of the company or business.
-You can lock in interest rates for a period of the loan so that you can manage cash flow effectively.
Disadvantages of Bank Loans
–Large bank loans may come with ongoing requirements, and specific reporting and paperwork restrictions such as quarterly reporting. These can become quite onerous and may leave you feeling like you are not in control of the loan term in case you may fail to meet the ongoing requirements.
-If there is a downturn in the economy and business is not good, cashflow issues will arise ( especially if customers are not paying you), leading to loan repayment defaults and actions against you by the bank.
-If you have a secured loan against your home, this adds pressure as you have to keep repaying the bank. Not ideal if your a nervous trader or business owner.
-Banks charge exit fees for early repayment of the loan (especially if you have a fixed-term loan).
Business overdraft
Business overdrafts are extremely common, and they are a line of credit attached to your bank’s transaction account that you can draw upon when you need extra cash. Overdrafts are popular with small to medium-sized business who want the security of knowing they can have additional funds available if they need it. These are usually at a higher interest rate.
For example, you negotiate an overdraft limit with the bank of, say, $50,000, which means you can let your bank account go into the negative by $50,000. And, you only pay the interest on the amount you borrow – if you borrow $20,000 of the $50,000, you only pay interest on the $20K.
Overdrafts are relatively easy to get, especially if you have a decent trading history and a good relationship with the bank. They require less paperwork than other loans and can be approved within a shorter period.
There are two types of overdrafts; secured and unsecured, with the former loan offering cheaper repayments because they are less risky. The huge downside is they are secured against your house, which adds pressure, especially if the business is slow. Plus, banks can rescind this loan at their discretion, meaning you have to pay it back regardless of your current economic situation.
A business line of credit
A business line of credit is similar to a business overdraft; however, it’s not automatically attached to your daily bank account.
With a line of credit, you get access to an agreed amount of money and only pay interest on what you draw plus bank fees. Most business lines of credit are for more significant amounts than an overdraft. Some Australian banks may say the minimum business overdraft amount is $10,000, while others say that a minimum line of credit amount is $150,000.
Business overdrafts & lines of credit are outstanding for helping SME’s get through tough times when cash flow is tight.
A business loan from family and friends
A common way for small businesses to get startup funding or the cash needed to help buy equipment, pay staff, super or pay rental bonds. Whatever you need money for, friends and family are reliable options that won’t come with the same strings attached as banks. You are lending money from close relatives, loved ones or friends, which you have to consider carefully if things in business head south and money is tight. Just imagine your business goes under and you are unable to repay the loan? Loan defaults can and will likely affect close relationships. An absolute disaster!
Equipment finance
Equipment finance is a small business loan for a particular asset or piece of equipment. Most loans are between 2 to 5 years, secured against the equipment. Because it’s guaranteed, the interest rates can be fairly competitive.
Buy now, pay later as business finance
Buy now, pay later; finance has grown in popularity among Aussie consumers. It’s a great way for SME’s to get unsecured loans quickly. For example, you can buy some equipment for your business now and have three months to repay it without interest being charged. After this period is up, you have nine months to repay the loan. According to the RBA; the buy now, pay later (BNPL) sector is growing rapidly, and new providers and business models are emerging.
Unsecured business loans as small business finance
This form of small business finance is super popular with Australian businesses as they can get cash within 48 hours from non-bank lenders, which helps with working capital in tough times. These are usually expensive and limited to the amount of cash that your business turns over in a month.
Other property-backed business loans
Advanced technology means that online lenders like us at Sparrow Loans can assess a businesses financial situation quickly and make a speedy lending decision. For example, a business can apply online with us and get a response very fast.
Businesses that struggle to get a loan with a bank can look to the non-bank lending arena for financial solutions.
Based on the information provided, the potential borrower will receive an answer within 48 hours. As a short-term loan, the length of the loan can be 12 months or less, helping you in a sticky spot so you can rebuild your business and head back to the bank for a cheaper rate.
Deciding on your small business finance
Small business is stressful enough without having to go through the loans process. Unfortunately, many SME’s need extra funding to stay afloat, but these come with conditions as there’s no such thing as a free lunch. Don’t rush into these loans without fully understanding all the implications. Remember, you might lose your property if the business goes bust. It is good to go into a business with your eyes wide open given that UTS has found that one in three new small businesses in Australia fails in their first year of operation, two out of four by the end of the second year, and three out of four by the fifth year.
Bear this in mind when you are about to sign on the dotted line. Even better, why not speak to us at Sparrow Loans for honest and trustworthy advice about your business loan options.
