Small Business Financing & Startup Costs

Before you begin looking for a business loan, you should have a written plan for how much money you need,  how you will use the money, and how long you will take to repay the loan.

It also helps to know your credit score and how that might affect your interest rates and if you have collateral that you are willing to use to guarantee the loan. Credit reports and collateral are discussed further later in this session.

Always assume that things will not go exactly as planned and give yourself some contingency (just in case) funds.

It’s hard to know exactly how much you will need to start your business but many businesses can be started with a small initial investment.

If you don’t yet know what kind of business you want to start, you might want to check out our partial list of businesses you can start with very little cash: Businesses You Can Start for Little or No Money.

A well-thought-out business plan helps you see exactly what your costs are for acquiring new customers and servicing your existing customers. Once you know how much profit you are likely to make once the business is up and running, it is easier to estimate how much you will need to finance until the business becomes profitable.

Your business plan should also include all the startup costs you will incur, like a business license and business website, or inventory purchasing.

If you need help with creating a strong business plan or predicting your future cash needs, refer to The Business Plan session or the Accounting and Cash Flow session and find the cash flow control form.

The amount of money you will need to start your business should cover several months’ worth of expenses unless you already have enough customers lined up to make a profit.

Your expenses include things like:

• Start-up costs
• Buying equipment and fixtures
• Getting a computer
• Building a website
• Licenses and permits
• Inventory
• Operating expenses
• Product or service production
• Delivery
• Taxes
• Rent and utilities
• Payroll
• Owner pay
• Contingencies and emergencies

Startup costs should be minimized and delayed as long as possible and most expenses should wait at least until after you have “proof of concept” - people committed to buying your product or service, not just expressing interest. It’s not a good idea to splurge on nice-to-have items for your business. Instead, be frugal and focus on “must-haves,” the things that are absolutely necessary.

Don’t forget that there is also the invisible “cost” of cash flow: the gap between the money you spend to produce what you sell and depositing the money from the (eventual) sale. Accounts Receivable (money owed to you by customers) and inventory purchases are both examples of a gap between the money spent, money earned, and money actually deposited into your bank. You may have made the sale and “earned” the income, but if you haven’t yet received and deposited the cash you may not have the money you need to cover your expense obligations. When this happens, you may need to borrow cash to bridge the gap.

For example, if your business makes things, you will need to purchase and process your raw materials into finished goods before you can sell the goods. So you can expect to pay out for any goods to be resold along with any shipping and processing costs well before you earn the income.

Even in a service business, if you provide the service and then invoice the customer, it might be weeks between doing the work and getting paid for the work.

And in both cases, your overhead expenses like rent, telephone, marketing, et cetera, still need to be paid.

There are plenty of places to get money, from traditional banks, to community development financial institutions (CDFIs), economic development organizations, microlenders, and crowdfunding to name a few. It’s most important to find the right source or sources for your needs and situation. Different lenders have different areas of lending specialties. For example, you would probably not get a car loan and a real estate loan at the same place. Do your research to find the lender that is most likely to say “Yes” to you!

Examples of lending options for a small business include:

• Personal Savings
• Credit Cards
• Friends and Family
• Banks and Credit Unions
• Alternative Lenders
• Microfinance
• Crowdfunding
• Peer-to-Peer Lending
• Equity Financing
• Venture Capital
• Angel Investment
• Specialized Lenders
• Community development financial institutions (CDFIs)
• Economic development organizations

Borrow From Yourself

The best person to borrow money from is yourself. You don’t risk jeopardizing any personal relationships by borrowing money from family and friends or spending time trying to qualify for a bank loan that you will likely still have to guarantee with personal funds.

Personal savings is the best primary source of funds for starting a business. Begin to set aside cash into a high-interest-rate personal savings account for this purpose. It is helpful to open a new savings account to keep these savings separate from your other savings. This will also give you an idea of exactly how much you can afford to invest into your business each month and still meet your current personal financial obligations.

If your needs are small and your ability to earn is quick, you may consider using credit cards for short-term cash flow help. But, credit cards have steep interest rates and it is important to be able to pay the balance in full each month. If you only pay the minimum payment each month you’ll increase your overall debt and pay high interest rates.

Even if you qualify for a loan, most lenders want to see you have “skin in the game” with your own cash investment and may ask for a personal guarantee for the loan amount.

Note that while it is possible to borrow from yourself by tapping into your retirement account or a home equity line of credit, it is not generally recommended.

Finally, in the excitement of launching a new business, it can be easy to lose track of all the start-up costs and how much you have invested in materials, equipment, inventory, and other items. Make a point of keeping your personal cash separate from your business cash so that you will know what your investment is in your new business.

Borrow from Friends and Family

If your funding needs are relatively small, friends and family can be a great source of start-up capital and cash. People can be more willing to simply give you a small amount rather than loan you a larger amount so that they don’t have to worry about your ability to repay them and what they can afford to lose.

If you do borrow from someone you know, treat that loan the same as you would a loan from the bank. Write up an agreement that outlines exactly how much you are borrowing, what interest rate you will be paying, how and when you will make payments, and when the final payment will be due. Having a simple written agreement can help prevent misunderstandings.

Borrow from a Bank or Credit Union

Most people think of going to a bank when they need to borrow money but don’t always think about what makes someone loan-worthy.

A bank's primary concern is your ability to repay your loans fully. Your ability to make payments consistently comes from your cash flow. So, to get a loan at a favorable interest rate, you must be able to create cash flow projections that show your ability to make your loan payments.

Having a good credit score will also increase your chances of getting a loan, and may also help you get a lower interest rate or other favorable terms.

A credit score (“FICO” score) is a prediction of how likely you are to be able to pay a loan back on time, based on information from your creditors, like credit cards.

You may be able to see your FICO score on your monthly credit card statement, your bank statement, or through MyFICO.com, which has a free plan. The site also has a paid plan allowing you to see your score variations as computed with the information from all three major credit bureaus.

It is also important to examine the detail of your credit reports as collected by the three major credit bureaus to look for errors or evidence of potential fraudulent activity.  You can access your credit report annually for free through arrangement with the Federal Trade Commission at: https://www.annualcreditreport.com 

Whatever your credit score is, there are ways to improve it, and you want to give yourself plenty of time to make and see those changes. If you have never had a credit card, it can be a good idea to get one so you can begin to establish your credit. Paying your full balance each month, not just the interest or minimum payment due, will positively impact your credit score. Any other loans you’ve paid off, like a car loan, will also favorably impact your credit score.

Get an SBA Backed Loan

If you live in the US, the US Small Business Administration (SBA) works with certain lending partner banks to offer small business loans. While the SBA does not typically make direct loans, they will guarantee a portion of the loan for some of their products usually offered by banks. These types of loans are designed to decrease the risk to the lender and can allow business owners who might not otherwise be qualified to receive debt financing. SBA microloans come with additional counseling and education to help you run a successful business. Microloans are usually offered by CDFIs. Visit the SBA Funding Programs website for more information about funding and its main website for other small business topics: https://www.sba.gov/.

Borrow from Alternative Sources

Entrepreneurs do not need to think that a traditional bank or credit union is the only option other than borrowing from friends and family, or from themselves. There are now a wide variety of alternative lending options for funding.

Alternative lending is any type of financing that falls outside of traditional lending. This includes microloans, crowdfunding, and private direct lending, among others.

Whatever funding source you decide to pursue, be sure to evaluate each lender and consider the size of the loan, cost of obtaining the loan, interest rate, payback structure, repayment timeline, and monthly payment amounts. Terms may vary considerably from lender to lender even for the same kind of loan. It can be tricky to compare loans because some may quote interest in an annual percentage rate (APR), while others may use a daily or monthly rate, and the fees and term for repayment may vary as well. A good idea is to calculate the equivalent APR for each loan so that you can see the annual interest rate for each one. Also visit the “How to Choose a Microfinance Loan” section in our Microfinancing Basics session to view a sample comparison chart that calculates the cost of different loans.

Below is a partial list of lender types to consider.

Microfinance

Microfinance is the delivery of financial services in small amounts – mainly loans – to entrepreneurs who typically do not have access to traditional financial services like banks.

Organizations like Kiva, Accion Opportunity Fund, and Grameen Foundation are all options, and you can also visit our Microfinancing Basics session to learn more about these types of lenders.

Microfinance’s interest rates are usually considerably higher than those of mainstream banks since the risk to the lender is much higher.

Microfinance is available around the world, and while the interest rates are typically higher than banks (about 40 percent on average globally), they are lower than informal money lenders or “loan sharks” (whose interest rates can be 70 percent or more). Also, in some countries like China and Vietnam, governments have enforced interest rate caps on microloans of no more than 30 percent.

Crowdfunding

Generally speaking, crowdfunding is a way of raising money through the contributions of many people, typically online via the internet. Crowdsourcing is another word for crowdfunding. There are several different kinds of crowdfunding so do your research before starting. Depending on what platform you use, like Kickstarter or GoFundMe, and what you offer, crowdfunding income is usually considered taxable income since the money won’t be repaid to your supporters. With a traditional loan, the money isn’t considered income since it will need to be repaid. Some platforms are “all or nothing” - either you reach your funding goal and get the money, or you don’t, and the people who contributed get refunds. Be sure that you aren’t inadvertently selling equity (ownership) in your company.

Peer-to-Peer Funding

Peer-to-peer lending connects borrowers directly with individual lenders instead of to a financial institution like a bank via online platforms like Prosper or Lending Club. When using peer-to-peer funding, it is important to ensure that the platform is licensed and certified by the state.

Equity Financing

Equity financing uses an investor, not a lender. If you were to close the business or end up in bankruptcy, you would not owe anything to the investor, who, as a part-owner of the business, simply loses their investment. It is important to realize that investors own a part of your business and may expect to be involved in decision-making. Equity financing is fairly rare for very small businesses including solopreneurs, and more appropriate for larger companies.

Angel Investors

Angel investors are individuals or groups who invest their own money in someone else’s business. Most often, they like to help build out a single product or project rather than a whole business from the ground up. Their great benefit is that they usually don’t require monthly payments because they recoup their investment when the company goes public or is sold. Angel investors move fast and want simple terms. Note that the goal of angel investors is to eventually sell the company, which may or may not be your goal.

Venture Capitalists

Venture capitalists are professional investors who use funds raised from limited partners to invest in new ventures. Like angel investors, venture capitalists expect a high return and often equity in the company, meaning you would have to give up a percentage of your ownership. Venture capital firms often deal in significant investments of multiple millions of dollars, so the process can be slow and the terms of the deal are often complex.

Specialized Lenders

There are other specialized lenders that serve their communities by assisting small business development. It can be a good idea to inquire at your local city offices or chambers of commerce about the organizations in your area or search on the internet using your favorite search engine.

Community Development Financial Institutions (CDFIs)

CDFIs are U.S Treasury-certified organizations, often nonprofit, that support economic development in their communities. These organizations often provide funding and opportunities for funding for businesses that are not able to meet the minimum requirements of traditional banks. These organizations often provide educational services, advising, and other programs that can support small business development as well. An example of a CDFI is the Community Economic Development Fund (CEDF), a MOBI partner serving Connecticut.

Economic Development Organizations

Like CDFIs, economic development organizations are often nonprofit and are focused on promoting small business development within their communities. Many are state or local government entities. They can be a great source of information, education, and funding opportunities for new businesses. An example of a federal economic development organization is the Minority Business Development Agency (MBDA), which has centers around the US to provide business assistance services. One center, MBDA/ASIAN Inc., is a MOBI partner located in Silicon Valley.

Loans

A loan is a debt, an amount of money borrowed that gets repaid with interest over a fixed amount of time. The person receiving the loan is often personally responsible for its full repayment, even if the business fails.

Secured Loans

A secured loan is a loan that is guaranteed, or secured, by collateral (something of value) that could be repossessed or sold in the event you cannot pay. For many small business loans, this collateral is the business itself, the income and assets. Other examples of secured loans where the lender would repose (take ownership) or sell the collateral include:

• Pawn shops
• Home Mortgage
• Car loans or leases
• Small Business Administration (SBA) backed loans
• Equipment leases/loans (for example, car or equipment loans or leases that you are paying off, and which could get repossessed if you fail to pay)

Most small business loans are secured by your business income and assets, personal income and assets, or both.

Collateral

Lenders are likely to ask for some collateral to secure the loan. Common types of collateral are your home equity, the accounts receivable of the business, inventory that the business may own, and equipment. The idea with collateral is that if you are unable to repay the loan, the collateral will be forfeited and sold to meet your obligations, so be very careful about loans that are secured with unrelated collateral. For example, if you are taking out a car loan, the car is the collateral. If you can’t make your car payment, your car will be repossessed - but you will no longer owe. This is the right kind of secured loan. You don’t want to use that car as collateral for a different loan if it isn’t fully paid off because you might lose the car and still owe the loan you took out to buy it.

Unsecured Loans

Unsecured means that there is no collateral securing the loan. However, they may still be personally guaranteed. Examples of unsecured loans include:

• Credit cards
• Some lines of credit
• Friends or relatives

Line of Credit

A line of credit is an amount of money available to you if you need it. You only pay interest on the amount you borrow, even if you have access to a larger amount. There is usually an annual fee and the line of credit is subject to annual renewal by the bank- meaning you may need to continue to prove your creditworthiness or lose access to the funds.

Term Loan

A term loan is a fixed amount of money loaned and payable monthly over a predetermined number of years. You get all the money at once and pay interest on the full amount, whether or not you use it.

Repayment Plans

Whichever kind of loan you prefer to get, be prepared to tell lenders how you plan to use the money and when you plan to be able to repay the loan. Give them details in a well-thought-out business plan.

When you create your loan packet, consider including a repayment plan. While there are usually different lengths of repayment available, it shows potential lenders that you have put real thought into what you need to borrow and how long you think it will take to repay it - instead of just focusing on getting the money.

Once again, you can visit “How to Choose a Microfinance Loan” in the Microfinance for Entrepreneurs session to see a chart comparing loans with different repayment schedules and how that impacts the total cost of the loan.

Investments

Investments are purchases of an asset (by angel investors, venture capitalists, etc. as mentioned above), like a business or stocks, that will produce income over time. The repayment is generally based on how the asset performs. Investments are risky for the investor because if the business fails, the investor will not be repaid. Investors usually want some equity, meaning a percentage of ownership in the company, so investment funding is also known as equity investment. This makes investment funding risky for the business owner as well. If you aren’t ready to share ownership decisions, be wary of taking on investors too soon.

Some companies issue stock to raise money and the people who buy the stock are considered shareholders. This is generally only for large companies so we will not be discussing that in this course. Your lawyer and accountant would be better prepared to give you appropriate guidance.

Equity investment has the advantage of not needing to be paid back on a monthly schedule because the investors are part-owners in your business. Most investors understand that it takes time to build a business and are willing to wait to see a return. However, you need to be honest with yourself about how you feel about having someone else in your company to whom you have to answer and to whom you will have to pay a portion of your profits and share decision-making - indefinitely.

Grants

Unlike a loan, which you have to repay, or an investment, where you are giving up some ownership in your company, grants are not to be paid back. Grants may be available to your business through a variety of sources. Typically, you will have to go through a grant application process to show that you meet the grant criteria and may be required to show that you have spent the money as specified by the grantor. If you meet the requirements set forth by the grant, you don’t have to repay grant money.  A similar concept is a “forgivable loan.”

Grants are most often given to specific kinds of operating small businesses like veteran-owned, women-owned, or minority-owned businesses, but you can check with your local chamber of commerce, small business nonprofits, the federal grants.gov website, and your favorite internet search engine to see some of the grants available and whether you might qualify to apply. Some cities may have special programs that are funded by grants. For example, if you plan to open a retail store your city may have grant funds available for site improvement if the city is hoping to encourage updates and renovations of storefronts. During the pandemic there were also specific grants that helped small businesses pay their employees, their rent, or other expenses that were difficult to meet when operations were closed.

You should evaluate lenders as carefully as they evaluate you. Consider how much money you need and whether the repayment terms fit within your plan. Making sure you understand and can comply with all the terms of a loan. The terms include the length of time you have to repay, whether or not you have a fixed or variable interest rate, if there is a pre-payment penalty, and if collateral is needed.

When comparing lenders, look at how much money each lender is offering and the cost of the loan. The interest rate is a percentage of your principal loan balance and is included in your monthly payment amount. The APR represents the true cost of your loan, because it includes your interest rate plus any additional fees charged by your lender.

Look for lenders with good ratings from previous customers to get a sense of how a lender operates and supports its customers.

You may also want to give preference to lenders with experience with lending in your industry, as they are more likely to be understanding of unusual circumstances and creative solutions.

The 5 “C”s of Lending

There are five categories all lenders use to evaluate potential borrowers:

1. Capacity: The ability of the business to repay the loan. Your business plan should show you are planning to generate enough money from normal operations to easily cover loan repayments.
2. Capital: The amount of money and/or equity the borrower already has and the ability to fund the business if things don’t go according to plan.
3. Collateral: The resources outside of the business, ideally liquid assets like cash, that can be repossessed or sold to get the loan repaid in the event that the business defaults.
4. Conditions: The timing and economic conditions that impact the potential business and whether it is a good idea right now.
5. Character: The variety of other factors that make a potential borrower an attractive or unattractive risk like personal credit score, industry, or other relevant work experience.

Each lender will have a different lens through which to evaluate the individual differences between borrowers so just because one lender says no, that doesn’t mean all lenders will say no. Start by familiarizing yourself with these common requirements and then ask your preferred lender directly for guidance on which “C” they put the most value on.

It helps to have your basic information, like a business plan, that clearly shows your path to profitability, as well as basic financial reports and tax returns ready for review. Get guidance from an advisor such as your personal banker or accountant, to make sure your materials are clear and complete.

For a business loan, the most common documents needed are

• Business financial statements
• Business and personal tax returns
• Business plan with budget or projection

If you don’t have any business tax returns, you may still qualify for a loan using your personal financial statements and tax returns.

A good advisor can also help you to prepare a Letter of Explanation that highlights your “character” - your fiscal responsibility and financial performance and how that applies to your new business venture. For example, if you have excellent credit, you could highlight your ability to use debt responsibly and pay it back on time. Or, you may be able to talk about business success from your research and development phase referencing happy clients, success stories, pre-orders or re-order rates, the size of your mailing list, and other non-financial factors for success. You could also mention your entrepreneurship education and include your MOBI Certificate of Completion for your course.

Be ready to answer questions about your business and be able to back your plans up with research you’ve conducted about your business and the market, evidence of past success in other areas, or proof-of-concept information you’ve gathered.

Getting the money is only the first step. Make sure you understand the requirements of your loan and do your best to meet or exceed expectations. If you have an opportunity to pay off your loan early, be aware that some loans have an early payment penalty. Be sure you calculate the overall cost of an early payment versus maintaining the loan through the entire term.

Some lenders ask for regular financial statements, which you should produce regularly and before the deadline. Creditworthiness is more than just making timely payments, and your credit rating is something you will continue to build throughout your life.

Be sure to stay in touch with regular updates, even if it doesn’t feel like there is anything new to report. Most lenders will appreciate the attention you give to the relationship.

If there is ever a problem, be proactive and communicate with the lenders to see if it is possible to get a temporary pause on payments.

• Find a lender that fits your needs. The best access to a lender is through a referral from a business contact: your banker, your tax preparer, your lawyer, or a friend.
• Don’t expect anyone to loan you money just because you want a loan. You have to show the lender that you are highly likely to succeed.
• Take the time to be prepared and confident with your presentation. If you feel rushed or desperate, you aren’t going to present as a good risk.
• If you haven’t filed taxes in a few years, get up to date.
• Improve your credit score as much as you can before applying for credit. Be prepared to discuss and explain any negative marks on your credit report.
• Have a well-thought-out, realistic, and researched business plan.
• Be upfront with your lenders - highlight the good but don’t try to hide the bad. Lenders are looking for a realistic plan, not the ‘best-case’ scenario.
• Keep your lenders informed of any changes to your business or your business plan, even after you get the loan.
• If you see that you are unable to make a scheduled loan payment, be proactive and call your lender in advance to explain the situation and talk openly about options.
• Control your costs. Only spend money on things that will bring in new income in the next 90 days. Delay any costs that are not directly related to producing income.
• Avoid putting everything on credit cards! Only charge what you can afford, and negotiate for a lower interest rate if possible. Aim to pay the full balance each month, not just the minimum payment.

For more information, visit our MOBI blog entitled, “12 Smart Tips for Getting a Small Business Loan” to learn more.

If you are writing your business plan while reviewing this material, take a moment now to include any information about your business related to this session. MOBI’s free Business Plan Template and other worksheets, checklists, and templates are available for you to download. Just visit the list of MOBI Resource Documents on the Resources & Tools page of our website.

Here are some key terms and definitions used in this session or related to this session: