With myriad varieties of loans and financing options available from banks of all sizes, you'll need to know the which is option is best for you.
Much like trying to pick the right loan for a home mortgage, you'll likely be overwhelmed by the many types of small business loans your bank makes available.
And, much like a mortgage, one loan option usually floats to the surface as the best fit for you and your situation. Discerning which loan is the right choice isn't necessarily a matter of one type being better than the other.
Focus on the two of major characteristics that vary among bank loans:
- The term of the loan
- The security or collateral required to obtain the loan
Understanding loan terms
The term of the loan refers to the length of time you have to repay the debt. Debt financing can be either long-term or short-term.
Common applications for long-term and short-term financing
Long-term debt financing is commonly used to purchase, improve or expand fixed assets such as your plant, facilities, major equipment and real estate.
If you are acquiring an asset with the loan proceeds, you (and your lender) will ordinarily want to match the length of the loan with the useful life of the asset. For example, the shelf life of a building to house your operations is much longer than that of a fleet of computers, and the loan terms should reflect that difference.
Short-term debt is often used to raise cash for cyclical inventory needs, accounts payable and working capital.
In the current lending climate, interest rates on long-term financing tend to be higher than on short-term borrowing, and long-term financing usually requires more substantial collateral as security against the extended duration of the lender's risk.
Key differences between secured or unsecured debt
Debt financing can also be secured or unsecured. Unfortunately, these terms don't mean how secure or unsecure the debt is to you, but how secure or unsecure the debt is to the lender.
The price of secured loans
No matter what type of loan you take, you promise to pay it back. With a secured loan, your promise is "secured" by granting the creditor an interest in specific property (collateral) of the debtor (you).
If you default on the loan, the creditor can recoup the money by seizing and liquidating the specific property used for collateral on the debt. For startup small businesses, lenders will usually require that both long- and short-term loans be secured with adequate collateral.
Because the value of pledged collateral is critical to a secured lender, loan conditions and covenants, such as insurance coverage, are always required of a borrower. You can also expect a lender to minimize its risk by conservatively valuing your collateral and by lending only a percentage of its appraised value. The maximum loan amount, compared to the value of the collateral, is known as the loan-to-value ratio.
A lender might be willing to lend only 75 percent of the value of new commercial equipment. If the equipment was valued at $100,000, it could serve as collateral for a loan of approximately $75,000.
Revolving debt and unsecured loans
In contrast with secured loans, your promise to repay an unsecured loan is not supported by granting the creditor an interest in any specific property.
The lender is relying upon your creditworthiness and reputation to repay the obligation. The most ubiquitous form of an unsecured loan is a revolving consumer credit card. Sometimes, working capital lines of credit are also unsecured.
While your property may not be at direct risk, defaulting on a secured loan does carry serious consequences. True, the creditor has no priority claim against any particular property if you default, but the creditor can try to obtain a money judgment against you.
Unfortunately for startups, unsecured loans (at least ones with reasonable interest rates) aren't usually available to small businesses without an established credit history.
An unsecured creditor is often the last in line to collect if the debtor encounters financial difficulties. If a small business debtor files for bankruptcy, an unsecured loan in the bankruptcy estate will usually be "wiped out" by the bankruptcy, but no assets typically remain to pay these low priority creditors.
Types of bank-offered financing
Now that you're familiar with the most important aspects of bank loans, it's important to become familiar with the most common types of loans given by banks to startup and emerging small businesses:
- Working capital lines of credit for the ongoing cash needs of the business
- Credit cards, a form of higher-interest, unsecured revolving credit
- Short-term commercial loans for one to three years
- Longer-term commercial loans generally secured by real estate or other major assets
- Equipment leasing for assets you don't want to purchase outright
- Letters of credit for businesses engaged in international trade
Working lines of credit and credit cards
A line of credit sets a maximum amount of funds available from the bank, to be used when needed, for the ongoing working capital or other cash needs of a business.
Consider a line of credit a loan that functions like a checking account. In most cases you'll receive a checkbook for your line of credit so you can write checks on the fly without dipping into your own cash. Some may offer debit cards, or you can visit the bank to withdrawal cash. It is, of course, still a form of financing that must be repaid with interest.
Common terms for lines of credit
As you consider a line of credit, you'll find most fall within these broad categories:
- Lines are typically offered for renewable periods that range from 90 days to several years.
- Extended periods are usually subject to annual reviews by the lender.
- Maximum amounts vary greatly, from $10,000 to several million dollars.
- Interest rates usually float, and you pay interest only on the outstanding balance.
Most small business owners typically use their lines for daily operations, such as inventory purchases, and to cover periodic or cyclical business fluctuations. Collateral for the loan is often accounts receivable or inventory.
From a lender's perspective, the adequacy of your cash flow is the most critical consideration. A commitment fee may be assessed by the bank for making a line of credit available to the borrower, even if the full amount is never used. Established businesses with sound credit histories have the best bet of obtaining unsecured revolving lines of credit.
A commercial line of credit can, for better or worse, become an "evergreen" never-ending debt to a small business.
A cautionary tale: The "evergreen credit" trap
Frequently, a small business will open a working line of credit of, for example, $40,000. Because of the immediate cash needs of the business, the credit line is quickly topped out. To make matters worse, the borrower's continuing cash shortage forces it to pay only interest on the loan, and the principal is not reduced.
Commonly, lenders review working capital lines of credit annually, either renewing them or calling them due. While lenders typically want the line of credit to carry a zero balance at some time during the annual period, the competitive banking environment may lead a bank to continually renew a maximized line of credit as long as the institution is receiving timely interest on the loan.
This behavior leads to evergreen lines of credit becoming, in effect, indefinite term loans with a balloon payment of principal that poses risks to both the lender and the borrower.
Lines of credit are a wonderful way to help entrepreneurs build their business. But like any form of revolving credit, they must be used wisely.
Financing through credit cards
Although credit cards are not a financing device exclusive to commercial banks, they are often a part of a bank's lending portfolio. A revolving credit charge card can used by a business as an alternative to a working line of credit.
The competitive banking environment has forced many institutions to seek new sources of income and develop new financial products that meet changing demands. One of the less publicized developments has been the growth of the small business credit card.
The basics of small business credit cards
The largest card issuers—VISA International, American Express and MasterCard International—have adopted small business card programs. As a source for working capital, revolving credit cards offer a quick source for limited funds.
However, their convenience is costly. Cards typically offer an interest rate slightly less than the rate on individual consumer cards and have lending limits that average just over $15,000.
To make the cards more attractive to prospective users, the lenders generally package credit along with additional features such as:
- Discounts for rental cars, hotels and gas
- Travel insurance
- Warranty extensions on purchases
- Variety of different types of insurance
You should be prepared to present both a personal and business credit history when applying for the cards. And, much like lines of credit, be leery of over-reliance on this form of credit.
Short- and long-term commercial loans
Aside from revolving forms of credit, banks can provide commercial loans similar to what you might have experienced getting a mortgage. (Well, hopefully not quite as painful.)
Commercial loans, available in short-term and long-term forms, are similar to traditional consumer loans. And, if you're not interested in purchasing a big-ticket item that would require a loan, you can always consider commercial leasing.
Financing through short-term commercial loans
Although short-term commercial loans are sometimes used to finance the same type of operating costs as a working capital line of credit, they're not interchangeable. A commercial loan is usually taken out for a specific expenditure (for example, to purchase a specific piece of equipment or pay a particular debt), and a fixed amount of money is borrowed for a set time with interest paid on the lump sum. In essence, a commercial loan is close to the loans you're most familiar with, like student loans, home loans, etc.
For nearly all startup businesses—and most existing businesses—a short-term commercial loan from a bank must be:
- Secured by adequate collateral
- Supported by a reasonable cash flow and a regular sales history
A fixed interest rate may be available because the duration of the loan, and therefore the risk of rising rates, is limited. While some short-term loans have terms as brief as 90-120 days, the loans may extend one to three years for certain purposes.
As far as what qualifies for adequate collateral, accounts receivable or inventory, as well as fixed assets, usually qualify.
For startups and relatively new small businesses, most bank loans will be short-term.
Rarely will a conservative lender like a bank extend a commercial loan to this type of borrower for more than a one- to five-year maturity. Exceptions may exist for loans collateralized by real estate or for third-party (e.g., SBA) guaranteed loans.
Financing through longer-term commercial loans
As the name implies, long-term commercial loans are generally repaid over more than one to three years. Because more time for you to repay a loan equals more risk for the bank extending the loan, long-term commercial loans are typically more difficult for smaller businesses to obtain.
With small businesses, a lender may not be willing to assume the risk that the business will be solvent for, say, 10 years. Consequently, banks will require collateral and limit the term of these loans to about five to seven years. Occasionally, exceptions for a longer term may be negotiated, such as loans secured by real estate.
The purposes for longer commercial loans vary greatly, from purchases of major equipment and plant facilities to business expansion or acquisition costs. These loans are usually secured by the asset being acquired. Additionally, financial loan covenants are regularly required.
Some small business advisers discourage the use of debt financing for fixed assets, particularly long-term assets such as equipment, office space or fixtures. They suggest that the cash-flow problems of small businesses require that borrowed money be directed to generating immediate revenue through expenditures relating to inventory and marketing.
Buying a new expensive piece of machinery may take many years to pay for itself. Instead, you should aim to obtain a high rate of short-term return on every cash investment, and do whatever you can to minimize the costs of fixed assets by leasing, buying used equipment, sharing equipment, etc.
Financing through equipment leasing
From a bank's perspective, the leasing business can take the form of either:
- A loan that the borrower uses to lease equipment from an independent source
- A direct lease from a bank subsidiary company that owns the equipment
The duration of the loan is tied to the lease term.
Assets commonly leased by small businesses include equipment, vehicles, real estate or facilities. Most banks require a solid operating history before engaging in leasing agreements with small businesses.
Letters of credit
As with many aspects of international business, the game changes. And that sentiment holds true for financing a company with international ties. When you're business deals wit issues abroad, you'll likely need letters of credit.
Letters of credit are not the most common means of small business financing, but they are an important financing tool for companies that engage in international trade.
A letter of credit (LC) is simply a guarantee of payment upon proof that contract terms between a buyer and seller have been completed. LCs are just fancy, two-way IOUs often used to facilitate international credit purchases.
How letters of credit work
In their most basic forms, obtaining letters of credit involves three steps:
- You, the buyer, go to your bank to request a letter of credit.
- The bank will grant your letter of credit only if you have an adequate line of credit established their.
- On your behalf (and for a fee), your bank promises (via the LC) to pay the purchase price to a seller (or his or her appointed bank) if stipulated and highly detailed conditions are met.
These conditions might include any or all of the following:
- Complete, on-board, ocean bills of lading
- Commercial invoice, original, six copies
- Packing slip, original, six copies
- Insurance certificates
- Inspection certificates
- Strict date limitations
- Precise name, and address of the beneficiary (seller)
- References to mode of transport
- Dozens of other conditions covered by the "Rules"
What are these "Rules" we speak of? They were drafted by the International Chamber of Commerce (ICC) in 1933 and revised as recently as 2007. They govern a standard letter of credit format accepted internationally and are known as the "Uniform Customs and Practice for Commercial Documentary Credits (UCP)."
Your bank's role in making your purchase
Your bank works as a kind of transfer agent, usually with the seller's bank, to exchange the purchase price for title or claim to goods. The parties thereby use their banks as intermediaries to limit the risks of doing business with foreign trading partners. These risks include foreign currency exchange rate fluctuations as well as frequent shipping delays, not to mention the perils inherent in international trade.
Letters of credit are available in a variety of forms, including:
- Confirmed irrevocable letters of credit
- Confirmed letters of credit
- Acceptance letters of credit
- Back-to-back letters of credit
Each demands differing degrees of bank commitment, but, generally speaking, you will only be dealing with irrevocable LCs.
If you are the importer, for example, you need to be assured that the proper goods will be delivered to you intact, on a date certain, in good condition and at the agreed-upon cost. The sellers (exporters) need to know that when they comply with all the terms you've set forth in the letter of credit, they'll be paid the amount due in a timely manner. And everything must be thoroughly documented at both ends.
Keep in mind that banks deal with documents, not goods, and if the documents are incorrect—even if the goods arrive as promised—the letter of credit can be worthless if any party to the agreement has made a mistake in the paperwork. The converse, of course, is that the paperwork can be perfection personified and the LC therefore honored , but the wrong goods might be delivered. That's why you need to have an inspector (a customs broker, freight forwarder, etc.) certify what you ordered is what was shipped and that it arrived in good shape.
The importance of detail
The key point to remember about LCs is the need for precision. Attention to detail and nit-picking legalese are mandatory. If an error is made or adjustments are needed subsequent to the issuance of an LC, amendments can be made to accommodate all parties to the transaction. But banks will follow these instruments to the letter so you need to be as concise and accurate as possible when specifying terms.
The devil, as usual, is in the details, but the security an LC provides to both buyer and seller is well worth the effort involved.