Sources of Financing for Small Business

Approximately 80 percent of the estimated 27.5 million U.S. small businesses – defined as those with fewer than 500 employees – use some form of credit to help finance their operations. That financing includes bank loans, credit cards and lines of credit.

Before the financial meltdown of 2007 and 2008, it was easy for many businesses that relied on their credit lines – and repaid them regularly and on time – to renew or extend those credit lines. All it took was a quick call to their lenders.

Then the economy went south, and the effect on small businesses was direct. Millions of small businesses had their lines of credit reduced or revoked, with many loans being called in before their due dates. In the first six months of 2009, 38 percent of small businesses reported a decrease in their lines of credit or credit card limits, according to the National Small Business Association.

A small business line of credit allows a firm to borrow money up to a pre-specified amount. These lines of credit can provide a business with cash reserves to meet day-to-day expenses and do not require collateral as long as the business is deemed credit-worthy by a lender. Lenders make money on the credit lines though fees and interest that accrue on any balance.

And although banks could always lower credit limits or call in loans if economic conditions compelled them to do so, this only happened occasionally – usually when a business was delinquent in its payments or had other problems that increased its credit risk.

As the country works through a sluggish recovery, small businesses must access whatever forms of money and credit are available to them. Here are some alternative sources and methods of financing to consider.

1. Community Banks

More than 8,000 community banks operate across the county. Many stayed clear of the mortgage meltdown, have money to lend, and aren’t subject to the same strict underwriting standards to which the large national and regional banks must adhere. These banks are issuing lines of credit to local borrowers who can convince them of their ability to remain profitable and repay loans. Since 2007, small-business loan volume at small banks has grown by $17 billion to $302 billion, as of June 2011.

2. Credit Unions

During the banking crisis, many of the country’s 7,800 credit unions amassed billions of dollars from their members’ savings and from interest on home and car loans. Approximately 2,000 of them already make business loans to their members, and others are increasing their small-business lending capacity. Because credit unions are nonprofit organizations, they can generally offer better terms to their borrowers than commercial banks, and their membership rules have relaxed considerably over time.

3. Finance Companies

Hundreds of alternative finance companies provide short-term cash loans to small businesses. However, these loans often carry high fees and interest rates. In addition, they are loosely regulated, and standards tend to be low. Small-business owners are advised to be extremely careful before signing a contract with one of these groups.

4. Borrowing against Receivables

Another method of obtaining financing for a small business is using accounts receivable — i.e. customers’ credit accounts — as collateral for a short-term loan from a bank, commercial finance company or other financial institution. The small-business owner is still responsible for the collection of debts, while the lender will generally advance 75-80 percent of the value of all receivables it deems acceptable. If the small business defaults on the loan, the lender can take over the company’s accounts receivables and collect on the debts itself. Interest rates for receivable financing can be are high – upward of 36 percent a year.

A variation of receivable financing is known as factoring: A lender will actually buy up a small business’s receivables at a discount and get reimbursed when the customer pays up. Factoring frees a business from having to collect its own debts, but will cause it to lose some of the value of its total receivables.

5. Purchase Order Financing

Purchase order financing is similar to the practice of factoring, but in this case, a lender is acquiring a company’s purchase order from a buyer who is committed to buying the product that the small business is selling. The lender might then pay for the costs of fulfilling the order, including the manufacturing process and shipping. After the lender is paid by the buyer, it will take its cut and then give the rest of the money to the small-business owner. Again, interest rates for this type of financing can be high, ranging from 1 to 5 percent per month.

6. Merchant Cash Advance

A merchant cash advance is another type of receivables financing wherein a lump sum of money is given to a company against its future credit card sales. The lender collects a set percentage of a company’s daily credit card receipts until it recovers the advanced amount plus a premium. The advantages to a small business for a merchant cash advance include: no actual date for the loan to be repaid, no collateral, and since the money collected by the lender is a percentage of monthly credit card sales, a slow month for the business can lower the amount of payment, with no penalty. Also, there is no interest rate attached to a merchant cash advance because it is not considered a loan.

7. Inventory Financing

There are several forms of financing that utilize a firm’s inventory as collateral for a loan. Inventory financing can provide a valuable source of capital for businesses that sell high-priced items that don’t move quickly, such as luxury items, or for businesses that need to display large amounts of merchandise and thus must carry a substantial inventory on their sales floor or in the warehouse. Lenders are repaid as inventory is sold off.

8. Unsecured Lines of Credit

Small-business owners may be able to secure lines of credit even if their businesses are currently losing money, as long as their personal credit scores are high – generally above 700. Several companies arrange business credit lines for low-risk borrowers through a network of financial institutions, but the price is high – an additional 10 percent of the line’s value on top of the bank’s 5 to 9 percent cut.

9. Borrowing from an Individual Retirement Account (IRA)

For a fee, a handful of companies will help a small business owner invest part or all of a 401(k) or other Individual Retirement Account (IRA) into the business, turning retirement savings into working capital. This type of financing incurs no debt or interest payments, but does deplete a business owner’s retirement account, while also putting it at risk. It is only advisable for business owners who are sure that their businesses are sound and that the money will grow safely.

10. Cash

For small-business owners who cannot get credit, whose credit lines have been reduced or revoked, or who just don’t want the hassle or high interest rates attached to other forms of financing, a business savings account can provide a ready source of cash that can be tapped into when necessary. This is essentially an emergency fund to be used only to offset temporary cash-flow problems and not for capital improvements or other purchases. Such a fund can help keep a small business out of debt and forgo the need to borrow.

Effect of Credit Line Shutdown Can Differ

The National Federation of Independent Business reported that approximately 40 percent of small business owners who requested extensions of their credit lines in 2009 were turned down, and many of those who received extensions were required to provide or increase collateral, pay higher interest rates or agree to other more stringent terms.

While the credit crunch has eased somewhat from the darkest days of the recession, the picture for small business continues to be precarious. Bank of America Corp. in January 2012 began severing lines of credit to some small-business owners who had been using them to remain solvent.

The bank demanded that a number of its 3.5 million small business customers pay off credit line balances immediately. If they couldn’t pay in full, they were offered new repayment plans with significantly higher interest rates.

For some firms, losing a line of credit may amount to little more than a minor annoyance. For others, it can be devastating.