Posted in Small Business Hacks | by: Mohini Kundu

How to Choose the Right Funding Option for Your Small Business

Starting a business isn’t just about having a great idea—you also need the funds to bring that idea to life.

When picking a small business funding option, you must take into account how each one could impact you and your business across a bunch of dimensions. We spoke with two CPAs, Advisorfi founder Will Lopez and Acuity CEO Kenji Kuramoto, to get the lowdown on what all that business financing gibberish actually means.

‘Intensity’: The cost of funding your small business

There are several ways you can go about getting the dough you need, and they’re mainly divided into two categories: debt or equity. For a quick refresher:

  • Debt financing is when you borrow money that you’ll eventually have to pay back.
  • Equity financing is when you sell partial ownership of your business in exchange for funds.

Lopez and Kuramoto say you can weigh your various financing options by looking at how “intense” they are.

“Intensity measures how much it’s going to cost you tomorrow,” Lopez tells us. Low intensity options, like commercial bank loans, will cost your business less in the long run, while high intensity financing, like credit cards, can have you paying back the funds long after they’re spent.

“In financial terms, they’d call it ‘cost of capital,’” adds Kuramoto. “Certain debts and loans are less intense than others, meaning they’re not as harsh on you as a business owner.”

The intensity of a financing option tells you about two main factors: the difficulty of obtaining the funds and the overall cost to your business. The relationship between the two factors is inverse—when one goes up, the other goes down.

Low intensity financing = difficult to get + low cost.

The funds comes at a lower overall cost, but you may have to jump through a few hoops to get your money. Common features are:

  • Low interest rates, so you’re not spending a lot to borrow a lot.
  • Complex application processes, often involving your tax returns, cash flow details, and so on.
  • More flexible term lengths, aka the amount of time you can take to pay off the debt.

High intensity financing = easy to get + high cost.

The money is easier to get, but the price tag is much heftier down the line. What can you expect?

  • More immediate access to capital through, say, a business credit card or a lending app.
  • A high cost to your business, either in interest rates or in actual equity in your company.

“The more traditional the financing, the less risk you have and the less extra money you’ll pay,” Lopez explains. “The more aggressive, the more it becomes ‘hard’ money lending.”

Which small business funding option is right for you?

Your decision starts with one important date: When you’ll be able to pay back your lenders or provide returns for your investors.

The type of business low intensity financing is good for.

Pretend you own a coffee shop. As the owner, your needs might include some equipment (maybe a few more espresso machines), improvements to your storefront, or a couple more baristas on hand. You could make a good case that with these additions, you’ll quickly earn back the funds you borrowed to get them. If you can prove you’re a low risk with financial records or collateral, you’d be a good candidate for a low intensity financing option, like a bank loan.

The type of business high intensity financing is good for.

For another type of business, like a tech startup, the road to profitability is less concrete. Banks often struggle with borrowers when they can’t see a history of cash flow or a clear vision for how they’ll get their money back in the long term. In these situations, you may have to consider a high intensity financing option, like a credit card. They’re easier to get, but you’ll have to pay for that convenience in higher interest. Or you might consider offering equity to investors, who can support your efforts as you build a product or service they believe in.

Choosing a small business funding option.

To find the intensity that makes sense for your business, first ask yourself a few questions:

When you have a good sense of your needs and the time you’ll take to make good on the money you receive, consider your options. We worked with Lopez and Kuramoto to chart some of the most common funding options by their cost and difficulty—plus a few other factors that’ll help you decide if they’re right for you. Check ‘em out below:

Common small business funding options ranked by intensity large graphic

Family & friends

Intensity Very low
What it is Borrowing money from your network of contacts with semi-formal terms both sides agree upon.
Avg. term length Flexible
Typical amount Flexible
Interest rate range Flexible, although for family loans, there is a minimum interest rate you may want to include for tax purposes.
Who it’s good for Pretty much anyone who needs a loan, so long as your family and friends are comfortable with taking on the risk. You often already have your lender’s trust without worrying about providing collateral or background checks—but both Lopez and Kuramoto recommend formalizing the process with a family loan agreement that includes terms that work for both parties.

Crowdfunding

Intensity Very low
What it is Using sites like Kickstarter or Indiegogo to give donors a chance to support your business.
Avg. term length N/A
Typical amount Varies, and less than 40 percent of fundraisers tend to reach their goals.
Interest rate range N/A
Who it’s good for If your business provides a product or service that holds appeal for the masses, set up a way for them to contribute to bringing it to life! Rewards-based crowdfunding—where donors get a sample of your product or service—can also double as an effective marketing tactic.

Commercial banks

Intensity Low
What it is You know this one. Similar to personal bank loans, business loans are when the bank provides you cash on the condition you will pay it back with an interest rate that is determined by your credit track record.
Avg. term length 3–10 years
Typical amount $50,000+ (Average loan size is $500,000.)
Interest rate range 4–13%
Who it’s good for Business loans are a good option for borrowers who have strong credit and need lump-sum financing to start a business. Also, you don’t need collateral—such as a house or a car—to qualify.

SBA loans

Intensity Low
What it is Government-sponsored SBA loans are subsidized and designed to get small businesses off the ground.
Avg. term length 5–25 years
Typical amount $10,000+ (Average loan size is $350,000.)
Interest rate range 6.5–9%
Who it’s good for These loans are good for large one-time and longer-term investments, purchasing real estate or equipment, buying existing businesses, and refinancing debt. Applicants should have good personal credit (690 or higher), strong business finances, and no immediate need for the funds (the application process can take 60 to 90 days).

Equipment loans

Intensity High
What it is Loans to buy equipment for your business that use the equipment itself as collateral, or in other words, security in case the loan doesn’t get paid back.
Avg. term length 2–10 years
Typical amount $100,000–$2,000,000+
Interest rate range 10–20%
Who it’s good for Equipment financing is great for businesses that rely on big, costly machinery—like restaurants or construction companies. It’s a good option if you’re trying to buy something for your business that you can’t personally fund—usually purchases of $5,000 or more.

Alternative lending

Intensity High
What it is This category includes any lenders that fall out of the scope of “traditional lending,” including apps.
Avg. term length 13–16 weeks
Typical amount $50,000–$80,000
Interest rate range 13–30+%
Who it’s good for If you need cash quickly and don’t want to jump through hoops, alternative lenders like Kabbage, OnDeck, and more make the process easy. But be prepared—in exchange for the convenience and quick funds they provide, their interest rates tend to be higher and vary depending on your business’ finances and history. A service like Fundera can be helpful if you want to apply to a variety of alternative lenders all at once.

Credit cards

Intensity High
What it is Business credit cards or lines of credit allow you to spend up to a certain limit with the promise of paying back the amount with interest.
Avg. term length Ongoing
Typical amount Up to $50,000
Interest rate range 12–22%
Who it’s good for Someone with strong credit who needs quick access to cash for emergencies and ongoing expenses.

Investors

Intensity Very high
What it is When you get money from investors, you’re engaging in equity financing. This means that you receive funds in exchange for stakes of ownership in your business.
Avg. term length N/A
Typical amount Varies
Interest rate range N/A
Who it’s good for Equity financing is for entrepreneurs who are comfortable sharing ownership of their company and want to start their business or finance an expansion of their product or service that takes their company to the next level. But entrepreneurs who go this route should be ready to share their decision-making powers with their investors.

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Do your homework. Then talk to a financial professional to find out which option makes the most sense for your situation. By understanding the obvious and not-so-obvious costs of business funding, you can avoid paying extra on the money you need for months and years to come.

 

This article contains general information but is not intended to be construed as financial advice. Please consult a financial professional to help you make the most informed choices for your situation.

About Mohini Kundu

Mohini Kundu is a news editor on the Gusto content team. She studied journalism at Northwestern University and started her career at The Huffington Post before embracing the #startuplife.