Disclaimer: At Payability, we do not claim to be experts on everything related to small business financing. There are thousands of different financial institutions, capital providers — and each one is different. This post is intended to introduce some of the most common small business financing options and how they work, but we always recommend that you supplement with your own research before making a decision for your business.
If you’ve ever looked into financing your ecommerce business, you know that there are a lot of options in the market. Understanding how each one works and which one is right for your business can be overwhelming. To make the process easier for you, we put together this guide on all things debt-financing for small business.
You’ll get a better idea of how small business financing works, what qualifications and paperwork might be required, how rates and terms differ, what options are available, and more. So whether you’re looking to fund growth or have other big opportunities in the pipeline, you’ll be able to make a more informed decision for your business. Let’s get started.
How SMB Financing Generally Works
First things first: how does small business financing generally work? As we’ve mentioned, each type and provider of financing has its own way of doing things, but at the end of the day, there is a common three-step process each one follows:
- A business applies for financing;
- The capital provider underwrites the application to assess its risk level and determine a) if it’s approved, b) how much it’s approved for, and c) what the funding amount and repayment terms are (based on its overall risk profile);
- If the business accepts the terms, the capital provider disburses funds to the business’s bank account.
An important component to this process is risk. When a capital provider disburses money, it is assuming it’ll be able to collect in full and on time — but there is always a chance it won’t be able to collect in full or at all. When a capital provider goes through its underwriting process, it is evaluating how risky it will be for them to actually disburse money. The higher the risk, the more expensive the capital will be. The lower the risk, the lower the rate.
In general, capital providers fall into two buckets — those that work quickly and those that don’t. Capital providers with a days-long process inherently charge more interest and/or fees, while those with a weeks- or months-long process charge less. We’ll go over this in more detail in the following sections, but just know that the faster you need money, the more expensive it will likely be.
Understanding Financing Qualifications & Underwriting
How fast you need money isn’t the only indication of risk. Capital providers evaluate a number of other factors and qualifications during their underwriting processes. Here are some of the most common*:
- Credit Score: An evaluation of your creditworthiness (or level of risk) that is based on your credit history. When a capital provider pulls your credit report, they will either do a soft or hard pull. A soft pull does not impact your credit score, while a hard pull does (usually by two points per pull). Always ask a capital provider whether they will do a soft or hard pull, in case that impacts your decision to actually apply. Here are the different credit scores a capital provider could look at:
- Personal Credit Score: FICO is one of the most common tools capital providers use to evaluate risk. Scores range from 350-900 and are generated from the top three credit bureaus: Experian, TransUnion and Equifax. Note that FICO is not a good indication of your business’s creditworthiness — it only says how creditworthy or not you are as an individual, so don’t be surprised if you don’t get approved because you have a low FICO score and opted for a financing option that strongly emphasizes your personal credit (such as a bank).
- Business Credit Score: Dun & Bradstreet (D&B) as well as Paynet provide business credit reports that measure the health of a business and its history with trade credit (i.e. paying on terms to their vendors and suppliers). Experian, TransUnion and Equifax also provide business credit reports and include information such as overall business health, judgements, bankruptcies, liens and credit lines.
- Debt-to-Income Ratio (DTI): In consumer lending, DTI refers to the amount of monthly gross income that goes towards paying debts (including principal, taxes, fees, and insurance premiums). In commercial lending, DTI is used to assess risk level and determine if a business is eligible for lower rates and longer terms.
- Loan-to-Value (LTV): LTV is used when taking a loan to purchase an asset and refers to the ratio of a loan to the value of that asset. For example, if you buy an office building appraised at $1m and make a 20% down payment of $200,000, your LTV ratio would be 80% ($800,000 loan / $1m appraised asset value).
- Personal Financial Statements (PFS): A PFS lists all of your assets and liabilities, allowing capital providers to see your DTI and assess what types of collateral you might be able to pledge. Typically, PFSs are used by government agencies, traditional lenders, or other capital providers that offer the lowest rates or longest terms.
- Business Plan: A document laying out your objectives and strategies for growth. Items typically included in a business plan are the addressable market, sales and marketing strategies, financial background, projected profit and loss, management bios/resumes as well as bios/resumes for operational team that will execute the plan.
- Your industry: Certain industries have their own inherent risks, which is why some capital providers have “restricted industries”. These lists are based on a number of factors, but capital providers typically look at an industry’s seasonality, level of regulation, customer payback history, and more.
- Location: Some capital providers only deploy capital within their own states or communities, some nationwide or even internationally. Understanding which geographic areas a capital provider operates in is key to your decision.
- Time in Business (TIB): How long you’ve been in business makes a big difference to capital providers. After all, the more history you can show them (be it sales, profits, credit, etc.), the better. Capital providers consider newer companies to be riskier because there is less data to underwrite, but TIB isn’t always so black and white. In fact, there are several TIB considerations that might help alleviate a capital provider’s concern. For example, has your company been in business 10 years but you just bought it 6 months ago? Have you been in the industry for 20 years, but this new venture is only one year old? Were you a previous employee of a company you bought?
- Annual Revenue: Capital providers consider your annual revenue to be a huge factor in their underwriting processes, but some capital providers ask for revenue metrics in different ways. Any of the following could be required for your application: Gross Revenue, ASR-Annual Sales Revenue, GMV-Gross Merchandise Value or Gross Market Value, or EBITDA (earnings before interest, tax, depreciation, and amortization).
- Collateral: Collateral is an asset that is pledged as security for repayment of capital and which will be forfeited in the event of a default. Capital providers might look at what assets you have available for collateral.
- Bank Statements: Some capital providers look at bank statements to assess financial health and see if there are any red flags. They will look for monthly deposits (including frequency and volume), negative days (i.e. number of days that ended with a negative balance), NSFs (i.e. non-sufficient funds/number of bounced payments), other financing obligations (including payment amounts and where they’re going), and overall cash flow trends and spending habits.
- Profit & Loss Statements: Your P&L or Income Statements give capital providers an idea of the overall health of your business and show them if you have enough cash to simultaneously run your business AND meet the obligations of the funding terms. P&L statements break down sales and expenses and also highlight net profit.
- Balance Sheets: Your balance sheet shows capital providers what you own (assets like cash, property, equipment, accounts receivable, etc.) and what you owe (liabilities like accounts payable and debt). This shows them a detailed picture of your business and what would be available as collateral in the event of a default.
- Tax Returns: Depending on the capital provider, you might have to show both your personal and corporate tax returns — often from the last 2-3 years. They are typically used to verify information on your other financial statements and give capital providers an understanding of the owner’s personal liquidity.
- Marketplace Account Health: For ecommerce sellers specifically, some capital providers will look at your overall account health, including sales performance, claims/returns/chargebacks, customer feedback ratings, etc.
*Note that not all capital providers look at all of these factors and qualifications — this is a collective list from capital providers across the board. Depending on the capital provider you choose, you might be expected to provide some or all of this information.
How Rates and Terms Work
Understanding rates and terms is one of the most important factors in your financing decision. After all, you need to have a clear picture of how much you are funding, how much the capital provider has rights to, and how/when they will be able to collect it. That way, you’ll know if you can even afford to move forward. There are a variety of ways to look at financing cost and other terms/obligations that a capital provider might require. Let’s take a look:
- Financing Cost: Also referred to as total cost, this is the dollar cost of interest and other fees that you will pay for financing. To calculate the amount, deduct the amount of funds you actually receive from the total amount the capital provider is to collect (and factor in any additional charges that were or will be incurred). Breaking out your financing cost will help you measure the ROI of financing and compare financing options. After all, capital with a low interest rate, low monthly payment and long term might actually end up being more expensive than capital with a higher monthly payment, shorter term and higher rate.
- Interest: Often referred to as Simple Interest, this is the financing charge (not including fees) that you pay back at a particular rate and on a fixed schedule.
- APR: The Annual Percentage Rate is the interest rate for an entire year (not the simple interest or a monthly fee/rate). In business financing, APRs can get confusing because not all options are actual loans and not all business loans have amortization schedules or terms of 12-months or longer. In cases like this, APRs can inflate the total financing cost so it’s always a good idea to compare the total cost metrics vs. APRs.
- Unsecured: If capital is unsecured, it means the capital provider did not require collateral. In most cases, unsecured capital has little to no restrictions, meaning you can use the funds for whatever you need.
- UCC: The Uniform Commercial Code is a legal filing (typically referred to as UCC-1) that a creditor files to give notice that it has (or may have) interest in the property of the debtor. It is also used for liquidations or bankruptcies to tell the courts who is owed what, and in what order.
- Amortization: This is the process of spreading out a loan into a series of fixed payments over time. You’ll be paying off the loan’s interest and principal in different amounts each month, but the total payment amount is always the same.
- Personal Guarantee: An agreement that you make with a capital provider to be held personally liable for the capital’s repayment.
- Performance Guarantee: An agreement you make with a capital provider to NOT prevent them from collecting payments, either through diversion or changing your bank account.
How much you pay for capital, over how long, and whether or not it’s personally guaranteed or collateralized all depend on your risk profile. That said, there are important considerations to make when it comes to your funding terms and rates. Remember earlier when we explained that capital providers typically fall into two buckets — those that work quickly and charge more vs. those that take a long time and charge less?
At the end of the day, if you need fast cash, you’re going to have to pay more for it. Capital providers that underwrite and fund quickly (like online business lenders and MCAs) hold more risk than those that don’t because they don’t have a lot of time to actually evaluate your business. Not only that, you’re paying for a premium service (i.e. getting money when you actually need it). So the trade-off for quick financing typically comes in the form of higher rates, shorter terms (often less than 12 months), and frequent payments (sometimes daily auto-debits).
On the other hand, if you want lower rates and longer terms so that your actual payment amounts are small, the trade-off is time. For example, banks are known to offer favorable terms, but their processes can take weeks or months and they require a lot of paperwork. They are looking at your business from all sides and want to be as thorough as possible. Not only that, their processes are mostly manual, which is why it takes so long.
More on your financing options in the next section.
SMB Financing Options & When to Use Them
Now that we’ve broken down how financing, qualifications and rates typically work, let’s look at what your actual options are and when to use what funds. After all, not all financing is created equal — if you need to invest in a rush inventory order, you’re likely not going to use the same financing option as someone who needs to buy office property or a major piece of equipment. Here’s how your options and their use cases break down.
- If you need funds ASAP: unsecured working capital, unsecured term loans, merchant cash advances, unsecured line of credit (or LOC), app-only equipment leasing, online business loans, unsecured consumer loan or existing financing you already have (like a bank LOC or credit card).
- If you want to spread your payments out over a long period of time, so the payback amount is small: SBA loans, USDA loans, bank loans, or equipment financing.
- If you want the lowest interest rate: SBA loans, USDA loans, traditional bank loans, traditional bank LOC, equipment financing, or secured LOC.
- If you’re purchasing equipment: equipment financing, equipment leasing, unsecured term loan, merchant cash advance, unsecured LOC, app-only equipment leasing, online business loans, unsecured consumer loans, bank loans.
- If you’re purchasing a building: SBA loan, USDA loan, bank loan, hard money or project financing (note that these last two are recommended if the property you’re purchasing is going to be used as an investment property).
- If you’re purchasing inventory: purchase order financing, inventory financing, merchant cash advances, unsecured LOC, online business loans, unsecured consumer loans, bank loans, bank LOC.
If you’ve made it this far, you hopefully have a better understanding of the SMB financing landscape and what to expect from the financing process. As you can see, there are so many financing options for ecommerce sellers — it just depends what you need funds for, when you need them, and how much you can afford.
As you assess your options, don’t forget to check out Payability. With cash flow solutions for every ecommerce need (including daily working capital and inventory financing options), Payability can help you grow your business fast. In fact, sellers that use Payability grow their businesses 2.5x faster than sellers that don’t. Not only that, there’s no paperwork required and no credit checks — just a simple online application process that looks at your account health and sales performance, funding in as fast as 24 hours, and a small flat fee.