Joe Ruvacalba, a plumber-turned-entrepreneur from Rancho Cucamonga, California, started his own plumbing company with just $10,000, but soon encountered cash flow problems.
“Your first client check might not arrive for 30 to 60 days. But you still have to pay for labor and material and everything else,” Ruvacalba told a Money.CNN.com reporter in an article weighing the costs of cash advances.
Banks wouldn’t lend to Ruvacalba, so he resorted to a merchant cash advance. The first was for $50,000, and included another $20,000 in fees and other charges. It was paid back within seven months, but Ruvacalba’s challenges weren’t done. He saw the only way to grow his business, keep on top of his payroll expenses and pay back his previous cash advance was by securing more merchant cash advances.
Over four years, Ruvacalba took a total of $700,000 worth of merchant cash advances, which cost roughly $200,000 in fees and finance charges.
“As an owner, you have to ask yourself: ‘Can I handle this payment every day?’ And if you can’t, don’t get it,” said Ruvacalba, who says he doesn’t regret his decision. “I’m not going to badmouth somebody that was willing to help me when the banks weren’t.”
Where to Get Business Financing You Can Afford
Undercapitalization, or “not enough money,” is one of the top reasons businesses fail. Yet in efforts to acquire the capital they need, sometimes the medicine can be worse than the disease. Where can business owners turn for financing where they won’t be bled dry?
Ruvacalba experienced the “good, bad, and ugly“ of merchant cash advances or MCAs. They are often the ‘last resort” for business owners to obtain cash, especially on short notice and/or without business credit. But if you are a business owner, you should try to avoid MCAs if possible. They often come with ugly fees and high costs that can trap business owners in cycles of debt.
So what are some better options? Here are 12, including money from outside sources and ways to use your own assets for business funding.
Other People’s Money:
- Banks and Credit Unions
Major banks offer affordable financing with single-digit interest rates. Options include term loans, lines of credit (secured and unsecured) and equipment loans.
Unfortunately, major banks only approve 25% of loan applications, according to Forbes.com. You’re twice as likely to be approved by a community bank or credit union, though you’ll still need a strong application. You’ve probably heard the saying, “banks only lend money to people who don’t need it.” That’s also true with businesses.
Don’t have excellent credit, cash flow and assets? Just starting a business? Be prepared to look elsewhere.
- SBA Loans
Contrary to popular believe, SBA loans do not come from the government. Rather, they come from various local banks (large and small) and credit unions and are guaranteed by the government. (They are the business equivalent of an FHA housing loan.) According to SBA.gov and Fundera.com, some of its programs include:
- 7(a) Loan Guarantee Program: aimed at helping a business start or expand its services, funding is up to $5 million.
- MicroLoan Program: mostly used for short-term purposes, such as purchase of goods, office furniture, transportation, computers, etc. The maximum amount is fixed at $50,000.
- Community Advantage Loans ($50k-250k) and 504 Fixed Asset Program (up to $5 million) are for applicants whose business model will benefit their community by providing needed jobs or services to an underserved area.
The rates are very reasonable, and even start-ups can apply. But the application process is no picnic. You’ll need a resume, a business plan, a description of how the money will be used, income tax returns, financial statements, and legal documents pertaining to your business. Your credit, your business’s credit (if applicable) and your personal background will also be vetted. SBA business classes may also be required, which new businesses owners may find helpful.
David Waring, co-founder of FitSmallBusiness.com, says you are most likely to obtain an SBA loan if you have “an airtight business plan, a credit score of 700+, a high net worth, and home-equity that the bank can use for collateral.” (Then again, if you have all that, perhaps you don’t need the SBA loan!) But don’t count yourself out too soon—sometimes community lending sources that partner with SBA can be more flexible than you expect.
- Peer to Peer Lending
Peer lending platforms are a cakewalk compared to banks. You can obtain up to $50,000 in a week or so from an online peer lending platform such as LendingClub.com/Business or Bitbond.com. You still need to make your case as to why people should lend to you, your business needs a 12+ month track record, and good credit of 700+ helps. Rates vary from single digits upwards, according to credit and other risk factors.
With crowdfunding platforms such as Kickstarter and Indygogo, the goal is to obtain a small amount of money from a large amount of people. Musicians use crowdfunding to raise money to record and manufacture CDs. Tech gadgets and apparel businesses are also common. Sweatshirt entrepreneur Jake Bronstein raised a million dollars from over 9,200 backers to launch his “Ten-Year Hoodie,” setting a Kickstarter fashion funding record that still stands.
- Online Business Lenders
Fintech companies such as Kabbage.com and OnDeck.com have streamlined the process of obtaining financing for businesses and met needs often unmet by traditional banks. They offer both term loans and lines of credit, which can be funded in a week or less. These sources can be a good fit for people who either can’t qualify or don’t want to wait for bank financing. With starting rates currently ranging from 10-15% for the best borrowers, these lenders are substantially more affordable than a Merchant Cash Advance. However, rates climb quickly for those with lower credit scores and other risk factors, so read the fine print.
- Angel investors and Venture Capitalists
Angel Investors are wealthy individuals and venture capitalists are typically companies or firms. They both have cash and are looking for opportunities for exceptional returns and ownership interest in a fast-growing business. They also bring with them invaluable knowledge and experience. However, be cautious, as they may want more control than you would like to give them.
- Friends and Family
This is an area where you must proceed very cautiously! The positive side is that you may have friends and family who believe in you and are willing to help. On the negative side, friendship and kinship don’t always mix well with money. You should definitely have a business plan and write out a promissory note so that both parties understand the expectation and obligation.
- Credit Cards
As you can imagine, this is not the best or cheapest source of business financing! We wouldn’t suggest that it be a major source of business financing, however, it can work well to use credit cards that you pay off monthly for convenience and for added perks such as travel benefits.
According to Brian Tracy, 37% of business owners use credit cards (personal or business credit cards) to cover costs in their businesses. As with a line of credit, you’ll want to line up the credit before you need it.
Your Own Savings or Investments:
- Home Equity Line of Credit
A HELOC can be an excellent funding source, as it is secured against your home and therefore the interest rate is low. According to FitSmallBusiness.com, HELOCs are used by 25% of business owners.
There are catches, though. You will typically need more than 20% equity in your home to benefit from a HELOC, and a minimum credit score of 620. And you will definitely want to set up the line of credit while you have a reliable and verifiable income source. And keep in mind, if the housing market declines or you make payments late, the bank can lower or freeze your credit line.
- ROBS: Rollover as a Business Start-up
In theory, this little-known way to fund a business is a great idea: use the money in your own retirement plan to fund your business start-up, without paying the onerous taxes and fees that would be required if you cashed out. In fact, however, it is complicated, unwieldy, and full of rules and costs. (Just what you would expect from government-sanctioned business funding from a government-sanctioned account.)
With a ROBS, you cannot use the money as you wish, nor can you remove it from your retirement account. Rather, you set up a C corporation for your business, and your retirement account buys shares in your business. (That’s the short story, it’s actually more complicated than that, and you’ll pay about $5000 to set it up, plus monthly maintenance fees, none of which can come from the rollover.)
On the plus side, there’s no interest charge or debt to repay.
- Liquid Investments
You may have savings accounts or brokerage accounts (outside of retirement accounts) that can be used. These are good sources to tap when you need to put some of your own skin in the game, which more traditional lenders often require.
- Whole Life Insurance Cash Value
Whole life cash value is the savings portion of a whole life policy. We like high cash value whole life as a funding source for several reasons.
- You can borrow or withdraw for any reason. There’s no credit check or confirmation of income. We recommend borrowing so that you continue to build your asset and replenish your funding source.
- You can borrow against an asset that continues to grow—even while being used as collateral. Unlike your shoe box (or most savings accounts paying virtually nothing these days), the growth of your cash value can outpace inflation.
- Low interest. You can probably borrow against your policy for 5-8%, depending on how your policy was set up and whether it’s fixed or variable. But another great option is using your policy as collateral to borrow from a bank, often at prime lending rates. (Prime is 3.75% today.)
Can you see the potential of borrowing at a cost of 3.75—7% against an asset earning perhaps 4%? While it shouldn’t be seen as “free money,” the growth of the collateral offsets the cost of your business funding when you use whole life insurance. It pays to “be your own bank!”
Find out more: “Collateral Assignment: Banking on your Life Insurance Policy” or skip straight to bank lending sources.
Four Rules of Thumb of Business Financing
As we compiled the resources above, we couldn’t help but notice, there seem to be some common themes or “rules of thumb.”
Rule #1: Your credit matters. Whether you’re applying for a loan, a line of credit, or peer lending, good credit makes funding a business cheaper and easier. It’s a good idea to bolster your credit before starting a business, and try to keep your score high.
(There are exceptions. No one asks crowd funders what their credit score is—that’s all about persuasion and networking. And your score does not matter is when borrowing against your life insurance policy. Your policy determines the rate.)
Rule #2: It pays to plan ahead. More affordable business financing options typically have longer time frames. The faster you need the cash, the more expensive it will be.
The best option is to line up money before it’s needed. Shark Tank’s Barbara Corcoran advised an entrepreneur that it is better to use a credit line then giveaway equity in your business. However, to do this, you must establish the credit line while you still have plenty of cash. “They’re not your friends – the banks, and they won’t be there when you need them if you don’t move early.”
Rule #3: Savings saves businesses! Those who save or build equity first have more options later. There is not only an advantage to having money, but entrepreneurs who have skin in the game tend to be more successful in business.
Notice that savings are not the same as investments. You may have noticed, there’s a catch to some of “your” assets. Even if you have money or equity in a retirement plan or home-equity, you will still have to either qualify to get it or jump through some expensive and complicated hoops to get it.
The least restrictive sources of funding will be highly liquid, such as savings accounts, brokerage accounts outside of retirement plans, or whole life cash value.
Rule #4: THINK from a prosperous mindset. We’ll end these four rules with the first of our 7 Principles of Prosperity™. If you lack savings, assets, or good credit, don’t despair. Your mindset matters, and if you think you can fund your business, you will find a way. Ultimately, there’s no lack of money in the world, only a lack of ideas.
How Can We Help?
Partners for Prosperity is a registered investment advisor that business owners and entrepreneurial thinkers with their personal finances. We work with clients from all 50 states, specializing in alternative investments and life insurance.
Find out more about what we do and how we might help you by downloading our Prosperity Accelerator Pack. You’ll receive our Financial Planning Has Failed ebook, plus a video and audio that show you why Prosperity Economics is a better alternative to typical financial planning and advice.