When you’re dreaming about starting a business, one of the biggest hurdles to making that dream a reality is finding affordable financing. Fortunately, there are more business funding options than ever that can fit almost every budget and business plan.
Most business funding methods can be lumped into two categories: debt financing (borrowing capital) or equity financing (reinvesting assets you already own). To help you begin to narrow down your search for the best way to launch your new business, we’ve outlined the most common types of debt and equity financing, as well as the pros and cons of each.
Equity Financing Options for a Small Business
Equity financing has become an increasingly popular option for new entrepreneurs in recent years. The most prominent benefit of equity financing is avoiding debt. Without payments to make to lenders, you’re able to make a profit more quickly. However, because you’re using your own assets to fund your new business, you’re more limited in your project budget.
401(k) Business Financing (Rollovers for Business Start-ups)
One of the most cost-effective forms of equity financing is the Rollover for Business Start-Up (ROBS) arrangement. ROBS allows entrepreneurs to roll money from a 401(k), IRA or other eligible retirement account to start a new business or purchase an existing business or franchise. As a part of the structure, the new corporation sponsors a 401(k) plan, allowing you and your employees to continue to save for retirement.
PROS:
- A quicker path to profitability. Because the ROBS structure is not a loan, no monthly payments or interest rates are involved, allowing you to make money faster.
- Easy to qualify. There are no collateral or minimum credit score requirements, which makes qualifying extremely simple. If you have $50,000 in a rollable retirement account, you’re eligible to use ROBS.
- Control of your retirement funds. Unlike the stock market, ROBS allows you to use your retirement funds to your business’s benefit, and you don’t need to worry about market volatility.
CONS:
- Ongoing requirements. As a part of the ROBS structure, your corporation must sponsor a 401(k) plan. Though this is a competitive benefit for you and your employees, it does require annual filings with the IRS and DOL.
- Risking retirement. Though investing your retirement funds in the stock market is never a sure bet, some entrepreneurs are not comfortable with the idea of alternatively using their retirement funds to start small business. If the business fails, they risk losing part or all of your nest egg.
ELIGIBILITY REQUIREMENTS:
- At least $50,000 in a rollable retirement account
- No minimum credit score requirements
- No down payment needed
Portfolio Loans
If you own stocks, bonds, mutual funds or other eligible non-retirement securities, you can borrow up to 80 percent against the value of your portfolio without having to sell. Portfolio loans, also referred to as stock loans or securities-based lending, work like a revolving line of credit, providing a fast, low-interest business funding option.
PROS:
- Fast funding. Unlike bank loans, stock loans close in an average of 10 days.
- Low interest rates. Portfolio loans have interest rates as low as 3 – 4 percent. Since you don’t incur interest unless you use the funds, you’re not penalized for borrowing more than you need.
- Maintain the value of your portfolio. Because you’re borrowing against the assets in your portfolio rather than liquidating, your assets continue to grow in value.
CONS:
- Limited eligibility. To qualify for a portfolio loan, you need to have at least $85,000 of non-retirement funds in a brokerage account and stocks or other securities which publicly trade at $5/share or more.
ELIGIBILITY REQUIREMENTS:
- At least $85,000 in brokerage accounts
- Stocks or other securities publicly trading at $5/share or more
Home Equity Lines of Credit (HELOC)
Some business owners choose to use the equity in their home to gain capital for their ventures. Home Equity Lines of Credit act like a credit card in which you have access to a revolving balance and pay interest only on what you use. Interest rates usually vary over time based on prime.
PROS:
- Easy to qualify. Given you have equity in your home, acceptable credit and a means to pay back the loan, HELOCs are fairly easy to obtain compared to traditional business loans.
- Affordable debt. Interest rates for HELOCs are usually significantly lower than rates for other loans, and the interest you pay is tax deductible.
- Great for working capital. Since HELOCs offer access to a revolving line of credit at any given time, they’re an affordable option to get over a momentary rough patch in cash flow.
CONS:
- You risk your home. Should you default on repaying your balance in a timely manner, you’re at risk of losing your home.
- Hidden costs and fees. HELOCs usually come with closing costs, attorney fees, loan processing fees, and sometimes inactivity fees and early repayment fees.
ELIGIBILITY REQUIREMENTS:*
- At least 15% equity in home
- 660+ credit score
- Credit utilization below 45%
*These requirements are approximations only. Actual requirements may vary by lender.
Debt Financing Options for a Small Business
SBA Business Loans
Loans from the Small Business Administration (SBA) are one of the most common forms of small business financing. They provide up to $5 million in financing, which can be used for almost any business purpose, including start-up, acquisition and expansion costs. The SBA encourages banks to lend to small businesses, and in exchange they guarantee 75 – 85 percent of loan.
PROS:
- Cost effective. With low interest rates, extended repayment terms and no ballooning costs, SBA loans offer affordable repayment options for business owners at all stages.
- Flexibility. Loan proceeds can be used as working capital, revolving funds, or to purchase real estate, equipment, inventory, etc.
- Grow your business. With budget-friendly monthly payments, you’ll have more money to put back in your business.
CONS:
- Time to fund. The SBA loan process usually takes a minimum of six weeks for approval. Applying for a loan on your own can be even more time consuming as you’ll need to fill out multiple applications and gather a multitude of documents. It’s advisable to work with a financing firm that can help you streamline the process and has relationships with lenders in place.
ELIGIBILITY REQUIREMENTS:
- 20 percent down payment for an existing business purchase or 30 percent for a start-up
- 640+ credit score
- Personal collateral required
- Industry experience preferred
- Secondary income preferred
Unsecured Loans
Unsecured loans provide a fast, alternative method of financing that don’t require any collateral to qualify. You can secure up to $150,000 without risking personal property. These loans are based solely on creditworthiness, so it’s best for those who have a healthy credit history and score.
PROS:
- Quick funding. Guidant clients secure an average of $104,000 using unsecured loans in only a few weeks.
- Freedom. There are no restrictions on what funds from an unsecured loan can be used for.
- Low introductory rates. Interest rates begin at 0-3 percent for the first year, making it a great short term financing option.
CONS:
- Increase in rates. After the first year, the interest rates for unsecured loans will rise, making them a less than ideal option if you won’t have the cash flow to pay it back quickly.
- Requires 690+ credit score. Because unsecured loans aren’t backed with property, they do require excellent credit scores to qualify.
ELIGIBILITY REQUIREMENTS:
- 690+ credit score
- Credit utilization rate below 50%
- Minimal recent credit inquiries
- No recent derogatory comments on your credit report
Combining Debt and Equity Business Financing
If you’re looking to increase your buying power but reduce the amount you need to borrow, there’s an option to combine debt and equity financing methods. For example, you can use your retirement funds as the down payment on an SBA business loan by combining 401(k) business financing with an SBA loan. This both preserves your personal savings for later use and gives lenders the proof they need to know you can afford the financial responsibility of the loan. Learn more in our ebook.
The first step toward financing your business with a loan, equity financing or a combination of the two is learning how much funding you qualify for. Take a few minutes to fill out Guidant’s online pre-qualification tool to get a summary of your funding options, as well as a comparison of each program.
See the original article on equity vs. debt business financing options.
David Nilssen is the CEO & Co-founder of Guidant Financial, which helps individuals secure small business funding to start, buy or grow a business with 401(k) business financing, SBA loans and more. Read more tips about finding and financing your business on the Guidant blog at guidantfinancial.com/blog.