There are many sources of debt financing: banks, savings and loans, commercial finance companies and government agencies are most common.
State and local government have developed many programs in recent years to encourage the growth of small businesses. Family members, friends and associates are all potential sources, especially when the capital requirements are small.
Typically, banks have been the major source of small business funding. Their principal role has been as a short-term lender offering demand loans, lines of credit, and single-purpose loans for machinery and equipment.
Banks generally have been reluctant to offer long-term loans to small firms. The SBA guaranteed lending program encourages banks and non-bank lenders to make long-term loans to small firms by reducing their risk and leveraging the funds they have available. In addition to the traditional term loans and revolving lines of credit most often provided by commercial banks, other types of debt financing arrangements, such as asset-based financing from business financing companies, lease and equipment financing and sale and leaseback arrangements, have gained popularity.
Historically, it is extremely difficult to start a business with 100% debt. Private lenders and government loan programs often require 20 to 50% equity participation by the owner. The exact percentage depends on the project, the financial resources of the owners, the type of industry, the use of funds, and the financial institution's general loan policy.
In addition to equity considerations, lenders commonly require the borrower's personal guarantees in case of default. This ensures that the borrower has a sufficient personal interest at stake to give paramount attention to the business.
Most traditional lenders prefer manufacturing or industrial operations where funds will be used to purchase fixed assets, i.e. land, building, or production equipment. These items offer the type of collateral often required to secure the debt.
Before inquiring about debt financing, entrepreneurs should ask themselves a host of important questions.
It's important to consider the state of your industry. Depressed, stable, or growth conditions require different approaches to money needs and sources. Businesses that prosper while others are in decline will often receive better funding terms.
It's also important to consider the nature of the business. Is it seasonal or cyclical? Seasonal needs for financing generally are short term. Loans advanced for cyclical industries such as construction are designed to support a business through depressed periods.
Management is one of the most important elements assessed by money sources. How strong is the management team?
Perhaps most the most important question of all: How does the need for financing mesh with the business plan? If you don't have a business plan, make writing one your first priority. All capital sources will want to see your plan for the startup and growth of your business.
A business consultant at one of our Small Business Development Centers can review the plan and help you determine the amount of financing your projections will likely support.
The consultant can also help you identify potential sources of financing and help you prepare a loan package. You will then need to approach potential lenders to explain your project in detail and apply for the loan.
It may be helpful to contact several lenders prior to preparing loan documents to learn about their lending practices and determine the feasibility of applying for financing.
Regardless of the specific type of loan or credit facility, almost every debt financing instrument will contain specific terms and conditions or "rules" relating to how the borrower uses the funds and conducts its business until the debt is repaid.
These rules are contained in the credit agreement and ancillary documents, primarily in sections referring to "representations and warranties" and "covenants."
The borrower's compliance with these covenants also serves as the means by which the lender monitors the loan and assures itself of a return on its investment.
Compliance with covenants also serves as the means by which lenders demonstrate to federal and state regulators that they are in compliance with the rules and regulations applicable to the types of loans they are permitted to make.
In starting a business, your personal credit history is a key factor in any lender's decision to make a loan. If your credit report shows a history of late payments, judgments or tax liens, it will be very difficult to obtain a loan until the adverse entries are removed from the credit report.
If you have ever declared bankruptcy or defaulted on a student loan or other federal loan, you may be permanently ineligible to obtain a federal loan such as an SBA-guaranteed loan.
