Understanding Commercial Loan
Business Loans 101
There are thousands of business lenders offering commercial loan products, but nearly all business loans are a variation of a handful of debt financing products, each with its own individual characteristics. Much of the difference between loan products isn't the type of loan but the way in which the loan is approved, the financing delivered to the business owner, and the way that these loans are paid back. Innovation and technology overall have made leaps and bounds in recent years, and no sector has been transformed more by new innovation than financial technology (fintech). By using new technologies, algorithms, and outside-the-box thinking, lenders are now able to analyze a company's financial situation with great speed, leading to an expedited approval and funding process.
With the loan products and the delivery of new sorts of lending changing on an almost daily basis, trying to keep up with the business financing options can be difficult to understand. On top of that, with the increase in alternative lending and the lack of regulation associated with it, some product descriptions may be downright confusing. In this article, we will take an in-depth look at the most commonly used types of business loans available to all small and medium-sized businesses and enterprises. The look will compare the rates and terms associated with each financing product, as well as provide an explanation of how each product works and what the funding process entails. On top of that, we would like to balance the pros and cons of each product to allow business owners to have a full understanding of each product before starting the application process.
What Is Debt Financing?
Debt financing is another term for "loan." Therefore, when a company is seeking debt financing, they're essentially seeking a business loan from a lender or creditor. The reason loans are considered "debt financing" is because, in exchange for financing, the business promises to repay the principal (the amount owed) plus interest. Therefore, they owe it to the creditor to repay such a debt. This is a much different model than equity financing. Debt financing differs from equity financing in that equity financing is essentially an investment. The investors aren't guaranteed to get paid back. Therefore, they are taking a much bigger risk. But with risk come larger rewards. A debt financing company will have a structured repayment plan and will make a set amount of return based on the interest rate. With equity, the financier is obtaining a percentage of the company's ownership. Therefore, if their investment scales, so will their returns. But they are in no way guaranteed to be repaid.
What Are the Benefits and Downsides of Debt Financing?
- ◼ PROS: Keeping control of your business. While you won't get any strategic help from debt lenders, you also won't lose any of your company's equity in exchange for financing. With equity financing, you may lose a large chunk of your company's ownership, which may be beneficial if the equity investor offers strategic help to assist in scaling the company. But that also means the investor will earn a large percentage of future profits in perpetuity. This can end up making the original amount of financing look miniscule in contrast to their profits. But with debt financing, a business owner can rest assured that they will not have to share any profits with the lending company.
- ◼ CONS: Set repayment schedules. Debt lending has set repayment schedules regardless of profitability. With equity, an investor only expects to share the company's future profits and doesn't see any money if the company isn't pulling a profit. With debt financing, you must repay the loan on a fairly inflexible payment schedule (with exceptions). Another downside is that debt financing is usually collateralized with business and personal assets. If you fail to repay the loan, the lender can seek legal action to seize and liquidate such assets.
Do All Debt Lenders Require Collateral?
No, not all debt financing companies require Collateral. But many, if not most, do, in fact, require some sort of Collateral, business guarantee, or personal guarantee. Lenders will usually place some sort of lien on business or personal property so as to protect themselves and mitigate losses should the borrower default. With that having been said, there are a number of non-collateralized options. There are some lenders who focus almost solely on the value of Collateral for financing, and others will focus almost solely on cash flow (and everything in between).
Secured Business Loans:
Financing that requires collateral Secured business lenders usually require assets used as Collateral to have a net worth equal to or more than the loan amount. This is the most common form of financing among all business lenders. Collateral used usually needs to be worth more (frequently, much more) than the loan amount provided to the business and may require appraisals and regular monitoring of the Collateral. Types of Collateral used for secured lending include business or personal real estate, accounts receivable, machinery, and equipment, along with all other business and personal assets.
Unsecured Business Loans:
Financing that does not require collateral Business lenders offering unsecured financing are generally cash-flow-driven and focus solely on the credit of the business and owner or on future revenue projections. To help mitigate their risks, unsecured lenders may require daily and weekly repayments. While some unsecured lenders don't require general business and personal Collateral, they may purchase current and future business receivables.
Term Business Loans
Term business loans are the standard and most common type of business financing with a maturity date (usually between 1 and 25 years). The loan is repaid on a set schedule (usually monthly, but can be weekly) until the principal is repaid plus interest. Term loan interest rates are usually determined using an APR but may use a factor rate to calculate rates. Fees associated with term loans vary depending upon lenders, with some banks and alternative funding companies charging origination fees, banking fees, and other fees. Uses of a term business loan include purchasing businesses, purchasing commercial real estate, working capital, purchasing business equipment, purchasing inventory, and just about any other business use. Term loans can be secured against business or personal assets or may be unsecured. Approval rates of term lenders vary, with traditional term lenders with strict lending requirements having approval rates as low as 20% and alternative term lenders with approval rates as high as 70%. The process of getting a term loan requires providing documentation showing how your business has performed over the previous few years, as well as projections moving forward that show the business will be able to service the new debt. Such documents include tax returns of the business and of the business owners, as well as financial statements and other business documents.
- ◼ Term loan length: 1–30 years
Pros
- ◼ Best rates of all business loan types
- ◼ interest is tax-deductible
- ◼ Longer payback periods (between 1 and 30 years)
- ◼ Lowest fees of all the business loans
Cons
- ◼ More complex approval process than most business loans
- ◼ Requires an equity injection by the borrower
- ◼ Requires more financial documentation than alternative small business lenders
Asset-Based Lending
Asset-based business loans (ABLs) are specialized commercial financing that provides collateralized business loans to small businesses that may be highly leveraged, have erratic business earnings, or have issues with cash flow. These business loans use business assets as Collateral and are structured to provide financing by monetizing assets on the company's balance sheet. Such assets used in asset-based lending include:
- Commercial real estate.
- Personal real estate.
- Inventory.
- Accounts receivable.
- Equipment and machinery.
- Invoices, as well as any other asset.
Asset-based loans are provided by both conventional and alternative lenders, with the types of facilities varying greatly. AR-based asset-based lenders will purchase future receivables from the company and then forward the company cash minus a discount to the lender.
The process of getting an ABL requires the business to provide extensive documentation on the Collateral (appraisals, title searches, UCC searches, AR and AP aging schedules) as well as supply the company's financial documentation, including tax returns, income statements, balance sheets, and a schedule of liabilities.
- ◼ asset-based loan terms: 1–5 years
Pros
- ◼ Ready cash eliminates the need to wait for the collection of receivables.
- ◼ Focus on the quality of the business collateral rather than the credit rating
- ◼ Less documentation than conventional business lenders
- ◼ Bridge between when money is received and business expenses
- ◼ Flexible, customized business financing
Cons
- ◼ More expensive rates and fees than other types of conventional business loans
- ◼ loss of control (since a third party often gains control of the cash flow of the small business)
- ◼ Associated fees may be substantial
Business Line of Credit
A
line of credit is a pre-approved amount of financing that a company can draw on when it needs it. A LOC functions much like a credit card does in that the lender determines the maximum limit allowed forwarded, and the borrower will have access to instantaneous capital when they need it. The difference between a line of credit and a term loan is that you don't pay interest on the total amount that you are pre-approved for with a line of credit; you only pay interest on the amount you use. The rate and term of a line of credit depend on the business revenue performance and/or assets of the company. Lines of credit are often provided by the company's accounts receivable but may be available to some lenders on an unsecured basis.
The process of getting a line of credit depends on whether it's a lender provided by a conventional lender, an SBA lender, an asset-based lender, or an alternative lender. Most will require business financials and tax returns, as well as asset documentation if secured by AR or other collateral. It includes the following:
- ◼ line of credit terms: 1–3 years
Pros
- ◼ access to business funding when needed without having to wait for approval from the lender
- ◼ access to capital in the increments they need, rather than a lump sum
- ◼ interest is only paid on the funding the small business draws
Cons
- ◼ Can make it more difficult to obtain other forms of commercial financing
- ◼ Lenders require the business to pay upfront and maintenance fees
Alternative Business Financing
Alternative business loans are both plentiful and vary in their characteristics. Generally, when we refer to alternative loans, we refer to loans originated by non-bank lenders with interest rates that fall between bank rates and high-interest cash advances. Alternative lenders tend to be institutional-based, using investor money to provide business financing. Therefore, the investors supplying the money are seeking to make a return on the funding. Therefore, while they have rates that are higher than banks, this is because these investors are willing to take chances on riskier lending opportunities.
A real benefit of alternative lending for the borrower is the easy approval process (which can be completed in hours, if not minutes), as well as fast funding. In fact, a small business that is approved for alternative lending can be funded as soon as a week. Alternative lenders rely heavily on future earnings and cash flow and are not necessarily credit-driven, so they'll analyze your recent cash flow and project how much debt you'll be able to service moving forward.
- ◼ Midprime alternative loan terms: 1–5 years
Pros
- ◼ Lower credit requirements than traditional bank loans
- ◼ Fast approval process (within two days)
- ◼ Faster funding process (2–7 days) than traditional small business lenders
- ◼ Less documentation required than traditional small business loans
- ◼ Better rates than Merchant Cash Advance Loans
Cons
- ◼ Higher interest rates than those offered by traditional small business lenders
- ◼ Shorter terms than traditional bank business loans
- ◼ May have expensive fees
Bridge Financing
Bridge financing is a short-term business loan that is usually used for capital purposes until a small business secures longer-term financing from a commercial lender or payment from a customer. Bridge loans are usually used for commercial real estate financing or for working capital purposes. A commercial real estate bridge lender will generally use their facilities to finance commercial real estate while the borrower works on finalizing permanent financing. Working capital bridge lenders generally provide financing to help a company keep operations going while they complete longer-term financing or until a business payment is received by the client or vendor.
Since bridge loans vary in type and use, the process for obtaining them varies among lenders. What they all have in common is an expedited funding process. Commercial bridge loans may require appraisals of commercial real estate, which can slow down the process. A working capital bridge lender may be able to provide financing in as little as a day while only needing an application and a company's bank statements.
- ◼ Bridge loan terms: 1 month – 2 years
Pros
- ◼ access to business funding when needed without having to wait for approval from the lender
- ◼ access to capital in the increments they need, rather than a lump sum
- ◼ interest is only paid on the funding the small business draws
Cons
- ◼ Bridge loans have higher interest rates than traditional types of business loans.
- ◼ Shorter terms than other loans
- ◼ May require property as Collateral
Factoring and AR Financing
Factoring (or AR financing) is not a business loan but instead the sale of accounts receivable to third-party small business lenders at a discount.
- ◼ Factoring terms: 4 months – 2 years
Pros
- ◼ factoring is not a business loan, so you're not incurring any debt with a business lender.
- ◼ Using a factoring company can immediately help a small business meet its present and immediate cash needs when traditional business loans are not a viable financing option.
Cons
- ◼ Requires fees that other lenders don't require
- ◼ Only a fraction of the receivable amount is advanced.
Equipment PURCHASE OR LEAsE FINANCING
Equipment financing relates to any and all forms of financing for the purchase and/or leasing of business equipment. There is a wide range of commercial finance options, including term loans, advances, and equipment leasing. With equipment leasing, a commercial lender will purchase the equipment for the purpose of leasing it to a small business for a fixed number of months or years, with the option for the business to purchase the equipment at the end of the term.
- ◼ Equipment Leasing Terms: 1–7 years
Pros
- ◼ Leasing equipment allows a small business to get equipment financing without having to pay the full cost of the business equipment upfront.
- ◼ By leasing your business equipment, you will incur fewer initial costs than if you were to make full purchases.
- ◼ An option to purchase the equipment at the end of the equipment leasing agreement gives the small business the right (but not the obligation) to do so.
Cons
- ◼ Leasing equipment can often cost more in the long run than purchasing business equipment with a traditional business loan.
- ◼ When leasing business equipment, you can often pay up to 25% more than the business equipment is worth after the deposit, monthly payments, and equipment leasing fees.
Merchant Cash Advance
Merchant Cash Advance business loans are lump-sum payments in return for a percentage of future small business sales. Unlike most other types of business loans, repayments are usually made through ACH (Automated Clearing House) in the form of a fixed daily payment taken directly from the small business's bank account during business days. Other forms of business advances include a payback to the commercial lender using a percentage of daily deposits instead of a fixed daily payment.
- ◼ Merchant cash advance terms: 4–24 months
Pros
- ◼ Fastest approval process for all types of business loans
- ◼ Bad credit is accepted with most business advances
- ◼ Faster funding than loans from traditional small business lenders (1–5 days)
- ◼ Little documentation required
Cons
- ◼ Bridge loans have higher interest rates than traditional types of business loans.
- ◼ Shorter terms than other loans
- ◼ May require property as Collateral
Learn the basics of business lending with us. Have questions? Call us at (801) 532-1763.