All great businesses start with a great idea. Turning the idea into action is the hard part. In order to get a small business off the ground, the first steps involve writing a business plan, creating a budget, establishing the legal entity, and what is frequently the most challenging part, finding enough funding to get off the ground.
Many new entrepreneurs start out with a bootstrapper mentality, thinking they will fund their startup entirely out of pocket. But for those without a large savings account, external funding can mean the difference between success and failure.
For established businesses, the challenge is not getting started, but growing through a plateau or making it through a market slump (or a global pandemic).
Regardless of the challenge, there are basically two financing options when you need capital: You can find investors, or you can take out a loan. While shows like Shark Tank have increased the popularity of the former option in recent years, often, taking out a loan can be equally beneficial.
Read on as we dive into the pros and cons of business loans (we’ll leave the pros of the venture capital option for the sharks).
The pros of a small business loan
The most obvious reason to take out a small business loan is that it gives you the working capital you need to acquire the things you need to run your business, whether that includes purchasing equipment, buying inventory or real estate, or hiring staff. Growth can be expensive, and even the most profitable businesses experience tight cash flow at times. A working capital loan can help you get through.
Another pro of taking out a loan is that you can get the financing for your business needs without having to give away equity. If you’re considering investor financing as an alternative to bank loans or another type of financing, remember it comes at a price: You’ll be giving away some control. If you do not want to have partners in your business or want to shop for partners free of monetary concerns, working with a lender may be the best alternative.
If you already have a business partner who wants to exit, a business loan can also help you acquire their equity without bringing in additional partners.
Finally, taking out a business loan can also help you build your business credit. While you shouldn’t take out a loan just to build business credit, it’s one of the perks that come from having your business set up properly. Establishing your credit history early with a small loan and paying it down on time will allow you to have access to more loan options, including loans with lower interest rates and more favorable repayment terms.
The cons of a small business loan
Just because you can get a loan, doesn’t mean you should. There are some cons to taking out a small business loan. For one, taking out a loan for business purposes can be difficult. Loan origination comes with a long list of requirements. Many lenders will look at the business longevity, financial records, and credit history before starting a loan application. The lender may then require a large down payment or upfront personal guarantee. They may also look at the personal credit score of the owner. For loans that are backed by the Small Business Administration (SBA), including the SBA7(a) and SBA Microloans, you need to have a business that has been in operations for at least two years, so during the approval process, you will need to present two years of tax returns.
As another con, loans require time. There is a lot of documentation to gather, and the process can feel like an intrusion. It can also take time to let the lender review the application and get back to you.
The impact on cash flow may be another con to consider before taking out a small business loan. When borrowing money from a financial institution, you will have to make monthly payments. A debt payment usually comprises both interest and principal, although some loan terms allow for interest-only loans for a period. For new businesses, it can be challenging to project cash flow, but whether you’re a startup or an established company, it’s vital that you have enough cash left over after expenses to keep your business operating and growing.
Last, getting a loan may have a negative impact on your personal credit score. Many entrepreneurs believe that a business loan cannot impact them personally, but this is not the case. Some loans require a personal guarantee during the approval process of a business loan, and if you miss payments or your company goes under, that personal guarantee means that if the loan is not repaid according to the terms, you may be personally responsible. Even an established business is not exempt from this, although if you’ve built up a business credit history, you may not be asked to provide a guarantee.
Bootstrapping: Good Idea?
The term bootstrapping refers to getting your business going without any outside financial help. When someone has bootstrapped their own small business, it means that they have gotten off the ground using their personal savings. When people talk about bootstrapping, they often only think of startups. But bootstrapping can also be used to describe entrepreneurs who are using their own personal funds to keep their established businesses going. Starting a business or keeping a business afloat without any outside investors is sustainable long-term for some businesses, while some are only able to rely on their own funds short-term. Interestingly, Coca-Cola, Apple, and Microsoft all began with bootstrapping founders.
Bootstrapping avoids debt. When you use business financing, whether, through business or personal loans, you incur debt. Borrowing money comes at a cost, in the form of interest, which will reduce your net income each month. The payments you make, whether to the principal of the loan or on interest, will also affect your monthly cash flow.
Another benefit to bootstrapping your company, versus using outside investors, is the impact on equity. When you begin a business with your own funding, all equity shares are yours. Having a higher equity share will reflect well on financial statements. Having most of the equity in your company can reduce the likelihood that you may be pressured into selling your business down the line as well. Bootstrapping will also allow you to give stock options to your employees as you choose.
Bootstrapping your business will require a solid business model, which is a benefit to your business. When a company starts off with a more emergent need to quickly turn a profit, it will often succeed long term. Some business models may be built around accepting losses for a certain period. Bootstrapped businesses often start with a model that plans for the business to have a positive cash flow from the beginning.
Control is another positive thing about bootstrapping your business. When you do not have any outside investors, you are free to make decisions about the business without concern for the opinions of others. When starting or running a small business with outside investors, there is often a clash in values. There also may be difficulties in deciding on the proper timelines for business plans.
Bootstrapping a business is hard work and can be stressful. Most often when people are depending on their own financing, they are also depending on themselves more than others. A business is challenging to run by yourself. It is easy to burn out trying to turn a profit fast enough to survive financially.
Another difficulty with bootstrapping your own business is limited growth. When a business is started and being operated all with the founders’ savings, the budget is usually tight. Having no wiggle room in the budget means being able to take fewer risks with expansion opportunities. Often a startup prioritizes growth down the road. However, if the budget allows for it, working on expanding your small business as early as possible is often the best move, which may require more capital than you have on hand.
There are colossal financial risks associated with bootstrapping your own business. The very first notable risk is your personal finances. When considering business decisions, you will already be analyzing how they will impact your business’s bottom line. However, when you have used personal savings or funds considering the impact on how the decision will impact you personally is equally important. The same goes when you make big decisions or have unexpected expenses in your personal life. Before purchasing that new car or hot water heater, you will be forced to weigh the decision against the impact on your home and your business. Having to choose between your business and personal needs may have a negative impact on your good credit.
While some bootstrappers will hold back on buying equipment, services, marketing, and hiring people, others are not as conservative. A new business can be unpredictable. Often startup entrepreneurs find themselves in a situation of not knowing when to stop. New bootstrappers will also push far beyond their personal financial comfort, believing that the big break is right around the corner. Sadly, for some small businesses, the break does not come. If the company does not take off as they planned and they have personally invested more than originally planned, there could be some serious financial consequences at home.
Business loans are a great option for many small business owners, especially with the current interest rates available (SBA loans have even lower interest rates). While there are some risks, if you understand your business needs and have clear goals and a viable path to achieve them with the funding you seek, there’s no need to be apprehensive. With plenty of loan options, you should be able to find something suitable. And if you have questions, talk to an independent accountant or finance professional. You don’t need to reinvent the game; countless others have taken this road before you and successfully leveraged business loans to finance their success.