Deciding to borrow money to launch your small business startup is a big decision. It’s the second biggest decision after deciding to start the business. Since it is a big decision, it requires much thought and research before taking the leap. There are multiple ways to fund a small business startup, and it’s important to know and understand all of them before making a final decision. Not only can you borrow money to launch your small business startup, you can also invest your own personal savings or give up a percentage of ownership in the company to investors in return for funding. Before making the final decision to borrow money for your small business startup, here are a few things you should know:
- Types of Financing – There are a number of different ways you kind finance your small business startup. Depending on the amount of revenue the business is generating, how many years the company has been in business, and the business industry, you may or may not qualify for certain types of financing. You can click here to learn more about the different types of financing for startup and established businesses. This will help you understand what your options are and if your small business startup will qualify to borrow money.
- Pay Back & Defaulting – When you borrow money to launch your small business startup, you will be required to make monthly payments. You will also have a set “term” to pay back the loan. The term is the period of time you will have to make monthly payments toward the total loan amount you borrowed. This is important because you need to be comfortable making the monthly payments. It has to be something you can afford. I suggest developing a business plan with at least 3 years of financial projections to estimate what your expenses will be and the amount of revenue the business will generate. This will help you determine if there will be enough money to go around (to cover business expenses and paying back a business loan).
If you default on a loan for any reason it can ruin your personal and business credit. Having a good understanding of how much it will cost you to borrow money to build the business will enable you to plan better and avoid defaulting. It’s good practice to ask a lender what their average interest rates and terms are before you apply so you can estimate what your monthly payments will be. The bottom line is that paying back a loan has to be something you are ready for and capable of handling.
- Maximum Amount of Debt – Your debt to income ratio and the amount of outstanding debt you have on the business is important in the lender’s decision to give you a small business loan. If your company is a small business startup with no revenue, lenders will pay close attention to your debt to income ratio. As a rule of thumb, your outstanding debts should equal no more than 28% of your total income. (Depending on who you talk to, some people will say it should be no more than 32% to 36% of your total income however, 28% is playing it safe). If you have a high debt to income ratio, you may not be able to borrow money to launch your small business startup.
If your small business startup has some revenue, and you’ve already borrowed money for the business, if you apply for additional financing, the lender may also look at outstanding business debt. As a rule of thumb, you usually can’t borrow more than 15% of your total annual revenue. This all depends on the lender, but keep that in mind if you decide to take out multiple business loans from different lending sources for the business.
- How You Will Spend the Money – Some types of financing are restricted to certain business expenses. For example, equipment financing must be spent only on equipment purchases. This includes computers, office furniture, etc. However, financing such as unsecured business lines of credit can be spent on any business expense. This is why it is important to develop a business plan and at least 3 years of financial projections. Financial projections outline what the money will be spent on. Knowing what the money will be spent on will help you determine what type of business financing will work best for you.
Obtaining a small business loan should not be something you dive right into. You need to be in a good position to borrow money before you make that decision. Often times small business owners borrow money when they are in a bind or cash flow is tight (or non-existent). Based on my experience in working with small business owners, that is not always the best time to borrow. If you do decide to borrow money, you need to do it at the right time. If you think you are ready to borrow money for a small business, consider the following:
- Cash Flow – Your business should have a steady and consistent cash flow before you even think about obtaining a small business loan for your business. If you’re revenues are inconsistent and you don’t have a lot of money coming in, how will you be able to pay back what you’ve borrowed? Borrowing money for your business when you don’t have the funds to pay back could cause your business to get into a bind that you can’t get out of.
- Profitability – Your business should be showing signs of profitability if you want to obtain a small business loan. If you’re business is losing money month after month or year after year, do you think a lender will feel comfortable lending to you? Better yet, would you feel comfortable taking a lenders money knowing that there’s a huge chance you won’t be able to pay it back because your company could go out of business? Unless you are 100% sure you can do what it takes to turn the business around so it becomes profitable¸ save yourself the trouble and forgo borrowing money for your small business at this time.
- Debt Servicing – Before a lender will lend to you, you will need to show them proof that you can service the debt. Servicing the debt is your ability to pay them back on time without defaulting. If you feel that you don’t have the business revenue (or personal income) to make timely payments (with ease) then now may not be the time to borrow.
How to Determine if You’re Ready to Borrow Money for Your Small Business
Borrowing money before you are ready and capable of borrowing could cause damage to your personal and business credit history (due to late payments or defaults), or most importantly – cause you to have to close your doors. For example, a past client and I were discussing various funding options that small business owners often utilize for their businesses. One of the types of funding options I mentioned was “merchant cash advances”. In case you don’t know, merchant cash advances are an alternative type of funding that can be obtained based on your daily credit card sales and/or bank deposits. He immediately turned to me and said, “no way, that will ruin a business!” I in turn asked him why he felt that way and he said “an old business associate of mine got a merchant cash advance to help stop his restaurant from going out of business and he ended up having to shut it down anyway.”
I immediately told him that was his business associate’s first mistake! More often than not, you should never get a merchant cash advance to “save your business” from going out of business. Merchant cash advances are an exceptional way to fund a business, when it makes sense for the business. In my experience, they are best for businesses that have a good amount of cash reserves and high daily credit card volume and/or deposits. This is because merchant cash advance lenders often require businesses to pay back a percentage of the advance daily or weekly (until it is paid back in full). That can equal death for a struggling business with little to no cash reserves and few daily customers. However businesses that are in a position to take on this type of debt can often do it with ease. The moral of this story is, don’t take on debt or borrow money when you are not truly ready!
In conclusion, I am not trying to scare you by outlining the things you need to consider before deciding to borrow money for your small business. However, I think it’s important that you properly and effectively analyze your current situation before taking that leap. If you are still unsure of whether or not now is the time for you to obtain a small business loan (after reviewing the information outlined here), you may want to consult with an expert. The best experts will be able to analyze your current situation and give you honest and sound advice on the best route to take.
Need Expert Help? LenCred Can Assist
If you still need helping figuring out if borrowing money will be right for your small business startup, LenCred can assist. LenCred’s team of Advisors will help you analyze your situation to determine whether or not borrowing money to launch your small business startup makes sense. They will also help you figure out what type of financing will work best for you. Contact the LenCred team for more information.