To Finance or Not to Finance - Is Getting a Loan the Right Decision for Your Small Business?
June 11, 2021
As you get your small business off the ground, you have dozens of decisions to make. One of the most crucial of these decisions surrounds the question of financing. Should you get a loan to jumpstart your business?
It's more than just a practical question. The decision can open up an existential debate about your new venture.
After all, startups are, in part, about achieving freedom. You want to rid yourself of the stifling attention of a boss. At the same time, you founded your business as a way of tramping your own distinctive path through the professional landscape.
However, you also want your venture to be successful. That takes cash. Most people don't have the resources to start a business on their own. Without the proper funding level, you won’t be able to sustain your startup. Pretty soon, you'll be back to working for someone else.
All this puts a lot of weight on the financing question. There are pros and cons to getting a small business loan. As such, it's vital to understand all the implications. That way, you can determine if debt financing is right for your startup.
There are pros and cons to getting a small business loan. As such, it's vital to understand all the implications. That way, you can determine if debt financing is right for your startup.
Why Would You Need a Small Business Loan?
You've probably heard that debt is bad for you. It's a central piece of advice for many personal finance gurus. These arguments have merit, but the guideline doesn't always apply in the business world.
In fact, debt is quite common for small businesses. Stats compiled by the Small Business Association show that 70% of small employer firms carry some form of debt.
Are all these companies making a mistake?
Hardly. There are very defensible reasons to seek out a small business loan. Generally, they fall into two main categories:
The survival part is rather self-explanatory. If you can't keep your business going without additional funds, you should strongly consider a loan.
Be careful, though. Taking on debt to sustain a failing business could pose long-term issues. Consider the specific terms of the loan. Don't rush into a desperate move without thinking about the implications.
Beyond just keeping the doors open, you can use financing to spur expansion. This situation offers the definition of "good" debt - debt that accelerates your growth and becomes easier to manage as your revenues increase.
These arrangements let you add to your war chest so you can pay for healthy growth.
Advantages and Disadvantages of Taking Out a Bank Loan
Banks represent the benchmark when it comes to applying for a business loan. As such, we'll lay out some of the pros and cons of pursuing this type of funding.
Remember, there are two fundamental considerations at play here:
- Whether to pursue funding at all
- How to obtain funding
First, you need to determine whether you want to seek out additional financing at all. Many businesses attempt what's known as "bootstrapping." This approach involves using the company's revenue to pay for ongoing growth. All the additional cash needed is generated by the business. As a result, you won't require outside financing.
That form of building a business has its appeal. However, it isn't always practical. It often lengthens the amount of time needed to build your business. At the same time, you could miss out on opportunities simply because of a lack of ready cash.
Your second consideration when it comes to funding relates to the method. If you determine to raise additional funds, you need to consider your potential options.
Bank loans are a prevalent choice. However, you can seek out other possibilities. We'll touch on some of these in the next section, but they include a wide variety of alternatives, from selling equity to using your personal credit cards.
Here are some of the pros and cons of a bank loan:
- No Partners: Unlike selling equity, you don't have to deal with additional partners.
- Relatively Low Rates: Bank loans offer low, predictable interest rates, compared to options like a credit card.
- Strengthen Your Business Credit: A loan will help you build your business credit, opening the door to other options down the road.
- Detailed Approval Process: Most banks require long, paperwork-intensive loan processes.
- Credit Check: You'll need to meet minimum credit requirements. This can exclude many small-business owners.
Factors to Consider When Taking Out a Loan
As we've noted already, loans don't make sense for every situation. But how do you know if it's the right choice for you? Here are some factors to consider when determining whether you should pursue this particular funding option:
Type of Business
Some ventures don't require significant startup capital. You might just need a computer and a kitchen table to start making progress. These circumstances might make the bootstrapping option the right choice.
Other businesses require a higher level of startup capital. You might need to rent factory space or purchase heavy machinery. Here, just getting your operations going might require an injection of cash.
Your Ability to Fund the Business on Your Own
At the same time, review your personal financial resources. Do you have what it takes to launch your business on your own? If so, you might not need to turn to a loan at the outset.
However, be careful to not cripple your personal finances to chase your startup dream. If you can spread the risk around, you can save yourself hardship in the future.
Terms of the Loan
Not every loan comes with the same terms. Shop around and see what's available. You might find a situation that amounts to free money. Or you might discover that even the most lenient terms would severely burden your fledgling startup.
Your Other Options
Loans represent only one option when it comes to financing your small business. Yes, they represent the most popular option (along with lines of credit). This fact is supported by the Small Business Association data we quoted before, which shows that loans and lines of credit make up 55% of external financing.
Loans and lines of credit make up 55% of external financing [for small businesses].
However, there are other potential ways to obtain funds. Here are a few other options you can use:
- Credit Card: The interest rates here are high, but you cut down on the paperwork compared to a bank loan. Also, as a short-term financing option, credit cards have significant advantages. If you pay your balance each month, you essentially avoid paying any interest.
- Trade Credit: Here, you negotiate a "buy now, pay later" deal with your suppliers. Essentially, you buy your supplies on credit, which allows you to start your operations and pay your bills when the revenue comes in.
- Equity: You don't need to borrow money to fund a business. You can also turn to investors for financing. By selling equity, you avoid taking on debt. Of course, now you have partners to worry about.
Choosing the Right Financing Option for You
Loans can provide the launchpad you need to rocket to startup success. Or they can hamper you with a weight constantly holding you back. The result largely depends on your specific situation.
If your back is up against a wall, or if you're ready to scale up, getting a loan may be the right option. It's important to review your circumstances and judge what makes sense for you.