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Financing a Small Business Through Loans

You have what you think is a unique startup business idea. You need the capital and financing to turn that idea into a small business. While financing a new business can seem overwhelming for a business owner, it is not impossible.

This FindLaw article explains small business lending and how a small business owner can raise money using different types of loans and small business financing.

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How Do Businesses Generate Financing?

Businesses have two primary ways to raise money. Which one you choose depends on how much money you need and whether you're willing to give up control to other people:

  1. Small Business Loans: Like anyone else, businesses get financing from friends, family members, and banks. Most banks have special divisions that deal with commercial banking (as opposed to personal banking), so an excellent way to familiarize yourself with how bank loans work for businesses is to ask at your bank.
  2. Equity: Businesses also regularly give away a part of themselves, an equity interest, in return for financing. Instead of taking a loan, a business might sell a percentage of its profits to an investor. The entrepreneur's business gets money in return. This can be an effective way to raise funds without incurring massive debts.

There is no right or wrong way to finance a small business. Choosing lender loans or equity investments depends on your business plan and long-term business needs.

Types of Startup Loans

Regardless of which loan you choose for your business startup, there are some things you should gather in advance:

  • Run a credit report on yourself if you are a sole proprietorship (personal credit) or entering into a partnership so you know your creditworthiness
  • Run a business credit report to show your credit history and credit score if you are asking for a loan to expand your existing business
  • Company's financial statements from the last three years
  • Your tax returns from the last three years

There are two types of common loans for a small business: loans from family or friends and loans from banks. To avoid going into unnecessary debt, only take out an amount in proportion to what your business needs.

Loans From Family and Friends

There are a few types of financing for your small business. The easiest, with the least paperwork and no application process, will likely be loans from family and friends. Your brother and sister may offer to loan you $250,000 at 1% interest because they believe in your small business.

Even if you accept loans from family and friends, you should sign a promissory note detailing the loan amount, repayment terms, and interest rate. This will show your family and friends you are serious about your venture. It shows the legal consequences of failing to make your monthly payments.

It's important to keep your personal relationships intact, even if your small business fails. You will still have to repay your loan to your family or friends, who are acting as lenders.

Traditional Small Business Loans

Business loans are like personal loans that most entrepreneurs are familiar with. Before signing an agreement, you, as your business, and the lender agree on the amount of the loan, the interest rate, and the repayment schedule.

Here are financial institutions that offer business loans:

Like any other loan, a bank may need a down payment before issuing the loan. Other times, a bank may ask you to provide collateral, which is often business equipment, inventory, or property.

What Kind of Repayment Options Are There for Business Loans?

Like any other loan, the most common form of repayment is typically a monthly payment. This payment goes toward the principal and the interest on the loan.

Some established businesses structure repayment terms so that they initially have a much lower monthly payment until the business is expected to become profitable. At that point, the monthly payment increases to cover the cost of the initially lower payments. It may end in a balloon payment.

Finally, some businesses structure their repayment to cover the loan's interest before applying payments to the loan's principal.

How Does Selling an Ownership Interest in My Business Differ from a Loan?

When taking out a loan, you borrow and repay that amount over time. This is a debt loan given by a lender.

In contrast, when selling an ownership interest, you get money in exchange for a stake in the business. This is an equity loan or equity interest. There is no repayment due for the amount given to the business. Selling an ownership interest is a business transaction in a contract — you sell a piece of the company and get money in return.

Investors are willing to do this because they generally ask for a percentage of the company's profits as their payment as part owner. To them, it is an investment. They expect the profits generated to exceed the amount they initially paid.

While not having a loan to repay may sound nice, the catch is that someone else now owns a part of your business. This person has rights and can control the company to some extent. This can be good or bad, depending on you, your business, and your chosen investors.

How Do I Sell an Ownership Interest in My Business?

To grant an ownership interest in your business, you'll first have to decide how to organize the business. Suppose you do nothing and execute a contract granting investors a portion of the company. In that case, you'll likely have created a general partnership by default. But general partnerships are usually avoided because the investors (and the founder) are personally liable for the debts and liabilities incurred by the business.

Most businesses prefer to organize as a "limited liability" organization, such as corporations, limited liability companies, or limited partnerships. Each of these organizational structures offers protection for equity holders against business debts and liability.

What Are Other Ways to Get Financing For a Startup?

You have other options if you don't want to engage with lenders for a loan or sell a piece of ownership in your business.

These options are not as common due to the high interest rates, but they are available.

Legal Help With Financing

Knowing where and how to secure financing for your new business is the first step in making your dreams a reality. Speak to a qualified business law attorney today before you choose how to fund your business.

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