Financing Your Business: Evaluating Sources of Capital
By Frederick Welk, Director of Business Education and Communications, Community Economic Development Fund (CEDF)
Most entrepreneurs use personal savings, or a combination of personal savings and loans from family and friends, to start their businesses. However, if these resources aren’t enough, it can be difficult to understand where and how to get more money. There are many types of lenders, each offering loans and services, and it’s not always easy to compare them. So how can entrepreneurs evaluate different sources of capital and find the best fit?
Frederick Welk, Director of Business Education and Communications for the Community Economic Development Fund (CEDF) in Connecticut, suggests entrepreneurs should consider eligibility, rate, and lender motivation when comparing lenders. He provides his perspectives on each below as well as how to determine the amount of the loan. Later this week, Frederick will discuss “12 Smart Tips to Get a Small Business Loan” in a second guest blog post. CEDF is a nonprofit community development financial institution in Connecticut and a MOBI partner.
Eligibility is the most important consideration for entrepreneurs to evaluate because each lender has its own set of requirements. Commercial banks or credit unions may be the first thought for many entrepreneurs. Banks offer many business loan products such as term loans, SBA guaranteed loans, lines of credit, and credit cards; however, they are regulated by the government and often require the strictest qualifications of any lender. These might include a high credit score, several years of profitable business operations, and sufficient collateral either in business or personal assets. It can be difficult for new entrepreneurs to meet these qualifications. If you are seeking funds from a bank, be sure you have your finances in order and be honest about any issues or problems on your financial record. You may also consider finding a co-applicant if your credit score is below the requirement or if you don’t have sufficient collateral on your own. Non-bank lenders such as community development financial institutions (CDFIs), FinTechs (financial technology organizations), and internet lending companies typically have fewer requirements than banks and credit unions, and so are able to offer loans to new entrepreneurs more easily.
The rate of a loan, fees, and repayment schedule will determine how much it will cost you to borrow the money. As previously mentioned, commercial banks and credit unions are regulated by the government, and therefore provide a standard annual percentage rate or APR. CDFIs also typically provide rates using standardized terminology, usually in annualized rates, so they are easy to calculate and compare. Borrowers should be cautious of lenders who quote in “factor rates” which can be difficult to evaluate or compare. Daily or monthly rates can also be misleading. For example a monthly rate of 1% is actually 12% when annualized. Sites, such as Fundera.com, can help you estimate an annual percentage rate based upon a factor rate. It’s also important to consider the repayment schedule, duration of the loan, and any changes to rates or fees over the life of the loan. Be sure to evaluate and compare all loan offers using the same parameters, such as an annualized rate, and understand any potential changes to rates and fees over time. Banks or credit unions may offer a credit card to a new entrepreneur who does not meet the qualifications for a loan. Credit cards can provide a quick source of capital to help make ends meet or pay for unexpected expenses, and they help establish your credit history. However, interest rates and fees can be quite higher than term loans or lines of credit. Additionally, credit card interest rates may not remain fixed. For example, a financial institution may offer a low initial rate that climbs to 18-29% after an introductory period. Rates (or fees) can also increase due to late payments, exceeding credit limits, etc.
The lender’s motivation can provide valuable insight for new entrepreneurs. As regulated institutions, commercial banks and credit unions abide by standardized terminology and consumer protections. They often require the strictest qualifications, and thereby accept the least risk. This allows them to also offer the lowest rates and also perhaps the most stability. Similarly, CDFIs are mission-driven to support economic development in the communities they serve. While not regulated like banks, they have a unique shared interest in the success of new entrepreneurs. Many CDFIs are nonprofit organizations, and some offer educational components, training, and mentoring as well. The increased demand for small loans and quick capital have given rise to a flurry of non-bank lenders such as FinTechs and other internet lending institutions. These organizations are not regulated and often have the lowest or fewest qualification requirements of other lenders as well as the fastest disbursement of capital. This can make them attractive and accessible to new entrepreneurs. However, it’s important to keep in mind that FinTechs also carry the greatest risk, and they often offset that risk by charging significantly higher rates and fees than other lenders.
Amount of Your Loan
With these considerations in mind, you should also have a solid idea of the amount of money you will need. Regarding the amount of a loan ask yourself the following questions:
- How will your business use the money?
- How will you repay the loan?
- How will the money be used to grow or sustain your business?
- What kind of collateral do you have to support the loan?
One mistake entrepreneurs can make is not raising enough capital, either debt or equity. Another mistake entrepreneurs can make is borrowing too much. Banks and CDFIs will be reluctant to extend credit to a borrower who would be carrying too much debt. However, other kinds of lenders may not evaluate your financial position beyond your revenues. High interest rates and fees can make borrowed money more expensive than anticipated, especially if the business isn’t growing at the predicted rate. Think carefully about the amount of your loan. Prepare your financial statements and include realistic earnings and expenses projections.
There are many resources available when it comes to financing your business. Consider eligibility, rate, and lender motivation when evaluating loans and compare terms using consistent parameters. It’s important that business owners understand the terms and conditions of any loan before signing the documents. Know how much money you need and borrow an adequate amount but never more than you can afford under realistic business conditions. Avoid increasing your debt unless the term and use of funds is properly matched and reasonably necessary. And put profits back into your business rather than using them to pay interest on expensive loans. Instead improve your creditworthiness and work your way toward being “bankable.”
The Community Economic Development Fund (CEDF) is a mission-driven 501(c)(3) economic development organization formed in 1994. Our purpose is to provide resources and assistance to serve the economic needs of the small businesses in low-to-moderate income towns and cities throughout Connecticut. For more information visit https://www.cedf.com/.
Oct 19, 2020
Photo of man considering finance graphic images