There are many types of commercial capital loans for small businesses and this article will cover 9 of the most popular types used by business owners. Equipment Financing, Invoice Factoring, Accounts Receivable Financing, Accounts Payable Financing, Business Lines of Credit, Term Loan, SBA Loans, Growth Capital, and Working Capital.
Each is fit for a different business circumstance, and comes with its own pros and cons. The right type of small-business loan for your business will depend on variables like what you qualify for, when you need the money and what you need it for. Exact loan terms, rates and qualifications will vary by lender.
- Businesses that want to own their equipment outright.
- Major equipment purchases.
Equipment loans are a type of small-business loan that is designed to finance equipment, which can include things like semi trucks, other commercial vehicles, commercial fridges or office furniture. Generally, equipment financing can be easier to qualify for than term loans because the equipment itself will serve as collateral to secure the loan; however, your exact rates and terms will still be dependent on your business financials and personal credit history.
- Equipment being purchased also serves as collateral for the loan.
- Equipment lenders may understand nuances of financing large equipment as opposed to traditional small-business lenders.
- Some equipment lenders require a down payment.
- Equipment may depreciate faster than the length of your financing.
- Businesses with unpaid invoices that need fast cash.
- Businesses with reliable customers on long payment terms (30, 60 or 90 days).
Invoice factoring, also known as accounts receivable factoring, is not technically a small-business loan. It allows you to sell unpaid customer invoices in exchange for cash. If approved, a factoring company will give you a certain percentage of the value of an unpaid invoice, and then take over collecting payment from your customer. Once that payment is received, the company will give you the remainder of the value, minus fees.
Invoice factoring can be helpful to cover gaps in cash flow for the purchase of inventory or paying for labor; however, it does require you to relinquish control of your invoices, and factoring companies may be required to probe your customers about their personal credit and business financials. Funding is usually fast, but it can be expensive.
- Fast cash for your business.
- Easier approval than traditional funding options.
- Costly compared with other options.
- You lose control over the collection of your invoices.
Accounts Receivable Financing
Accounts receivable financing, or AR financing, can be a good option if you need fast funding to cover cash flow gaps or pay for short-term expenses. Because AR financing is self-securing, it can also be a good choice if you can’t qualify for other small-business loans.
Here’s what you need to know about how accounts receivable financing works and some of the best options for small businesses.
What is accounts receivable financing?
Accounts receivable financing, also known as invoice financing, allows businesses to borrow capital against the value of their accounts receivable — in other words, their unpaid invoices. A lender advances a portion of the business’s outstanding invoices, in the form of a small- business loan or line of credit, and the invoices serve as collateral on the financing.
How does accounts receivable financing work?
With accounts receivable financing, a lender advances you a percentage of the value of your receivables, potentially as much as 96%. When a customer pays their invoice, you receive the remaining percentage, minus the lender’s fees.
Accounts receivable financing fees are typically charged as a flat percentage of the invoice value, and generally range from 1% to 5%. The amount you pay in fees is based on how long it takes your customer to pay their invoice.
Here’s a breakdown of how the process works:
- You apply for and receive financing. Say you decide to finance a $50,000 invoice with 60-day repayment terms. You apply for accounts receivable financing and the lender approves you for an advance of 80% ($40,000).
- You use the funds and the lender charges fees. After receiving the financing, you use it to pay for business expenses. During this time, the lender charges a 3% fee for each week it takes your customer to pay the invoice.
- You collect payment from your customer. Your customer pays their invoice after three weeks. You owe the lender a $4,500 fee: 3% of the total invoice amount of $50,000 ($1,500) for each week.
- You repay the lender. Now that your customer has paid you, you’ll keep $5,500 of the customer’s payment and repay the rest to the lender (the original advance amount, plus fees for a total of $44,500). You paid a total of $4,500 in fees, which calculates to an approximate annual percentage rate of 65.7%.
Because accounts receivable financing companies don’t charge traditional interest, it’s important to calculate your fees into an APR to understand the true cost of borrowing. APRs on accounts receivable financing can reach as high as 79%.
Accounts Payable Financing
Accounts payable financing, or AP financing, is a funding process initiated by a company purchasing goods. The buyer selects a third-party financing company that pays a vendor for goods the buyer needs. The buyer pays interest to the financing company for the purchase in order to get more time to pay off the debt. The vendor may also pay a service fee to the financing company and/or agree to a discount on the invoice. This process is also called trade credit, vendor financing, reverse factoring, and supply chain finance (SCF).
The buyer creates a predictable cash outflow while maintaining great vendor relationships. From the vendor or seller’s perspective, accounts payable financing is accounts receivable financing with a couple of differences. First, the seller doesn’t initiate financing. Second, the seller receives cash from a financing company (usually lenders) chosen by the buyer. Thus, AP financing involves three parties and works differently.
Parties involved in accounts payable financing
Payables finance involves three parties. These are:
- The buyer: Owes money to the seller
- The seller: Expects cash from the seller for its invoices
- The finance provider: Sits between the buyer and the seller, making payables financing possible.
How AP financing works
Accounts payable financing follows a few simple steps.
- The buyer applies for payables financing and establishes a contract with a financing company.
- The financing company contacts the seller and gives it an option to receive early payment on its invoices at a discount.
- Once the seller agrees, the buyer transfers all invoice data to the financing company.
- The financing company pays the seller at a discount to invoice prices.
- A while later, the buyer pays the full invoice amount to the financing company, helping the latter earn a profit from the arrangement.
Note that the seller can opt out of the early payment option. In this case, the financing company pays the seller the entire invoice amount on the invoice’s due date.
Large companies use the steps above to pay their smaller vendors. Thus, small businesses are often recipients of funds from payables financing programs. If you’re dealing with a company roughly the same size as yours, you can use a modified form of payables financing.
For example, let’s assume your customer owes you cash on invoices you’ve sent. You can offer trade or supplier financing with the following steps:
- Collect cash on a negotiated percentage of the invoice. For instance, your customer can pay 70% of the invoice’s value.
- You collect the remaining amount monthly at a fixed interest rate.
Thus, as a small business owner, you can opt for payables financing to quickly receive cash from large customers or use it to boost cash flow by financing a small or similarly-sized customer. In essence you can create something resembling Buy Now, Pay Later programs.
Business Lines of Credit
- Short-term financing needs, managing cash flow or handling unexpected expenses.
- Seasonal businesses.
A business line of credit is a revolving source of funding that provides your business access to funds up to a predetermined amount. Similar to a credit card, you pay interest only on the money you’ve drawn. Once you’ve repaid your funds, you can draw on your line again.
Lines of credit are offered by banks, online lenders and other alternative lenders. Qualification requirements are similar to those for business term loans – banks have more stringent qualifications and lower rates, while online lenders may be more lenient, but offer higher rates.
Business lines of credit can provide more flexibility than term loans. They are typically unsecured, but can require strong credit and business financials to qualify.
- Flexible way to borrow.
- Revolving access to funds.
- Typically unsecured, so no collateral required.
- May carry additional costs, such as maintenance fees and draw fees.
- Strong revenue and credit required.
- Businesses looking to expand.
- Business owners who have been operating for at least six months.
A business term loan is one of the most common types of business financing. You get a lump sum of cash upfront, which you then repay with interest over a predetermined period of time. Payments are fixed, usually on a monthly basis. A variety of lenders offer small-business term loans, including banks, online lenders and other types of alternative lenders, like nonprofits.
Term loans can be one of the most inexpensive types of small-business loans; however, qualifying for the best rates and terms can be difficult. Banks, which usually offer the lowest rates, usually require at least two years in business, for example, and a good credit score (between 690-719). Online lenders are typically more lenient with their qualifications, but often offer higher rates than banks.
- Get cash upfront to invest in your business.
- Fixed monthly payments offer stability to help you improve cash flow and grow your business over time.
- May allow you to borrow a higher amount than other types of small-business loans.
- If you want the lowest rates and longest terms, term loans may be difficult to qualify for.
- May require a personal guarantee or other collateral.
- Costs can vary; term loans from online lenders typically carry higher costs than those from traditional banks.
- Businesses looking to expand or refinance existing debts.
- Strong-credit borrowers who can wait a long time for funding.
An SBA loan is a type of small-business loan that is partly guaranteed by the Small Business Administration and offered by banks and other lenders.
There are several types of SBA loans but the most popular offering is the SBA 7(a) loan. SBA loans can be used for working capital, business expansion, equipment or commercial real estate purchases and more, and can range from below $15,000 for SBA microloans up to $5.5 million for 504 loans.
SBA loan rates are among the lowest available, and repayment terms can go up to 10 or 25 years, depending on loan usage. However, the SBA loan application process can be long and rigorous, and a personal guarantee is required for everyone who owns 20% or more of the business.
- Low rates.
- Loan amounts up to $5.5 million.
- Long repayment terms.
- Hard to qualify.
- Long and rigorous application process.
Growth capital, sometimes called growth equity, is a form of financing which gives late-stage companies the funding they need to grow their business. Growth capital could be used to:
- grow customer acquisition
- launch into new markets
- invest in growing your team or in upskilling your existing team with new skills such as management or team leader training
- invest in your technology
- fund acquisitions
- offer liquidity to shareholders
It’s usually taken on by more mature companies that have already established themselves in their market, demonstrated profitability (or a clear route to profitability), and have spotted that there’s an even bigger opportunity for them out there.
Who is growth capital for?
Late-stage businesses might need an injection of capital to enter a new market or take on a larger, better-resourced competitor. That’s where growth capital comes in.
Growth capital funds usually offer between $5-50m of capital to be spent on major projects to drive growth such as product development, customer acquisition or to acquire competitors.
Once a business has met its growth targets, that’s when growth equity funds look for their exit. The two most popular forms of exit are an IPO or via sale to another business.
How growth capital works
Businesses that take on growth equity are usually already profitable, but struggle to build up the cash that they need in order to:
- fund expansion,
- invest in technology
- develop new products
- buy other companies
They could take on debt to do this but the cost of repayments would put too much pressure on their cash flow. Instead, these entrepreneurs sacrifice shareholding in their company to a growth equity fund in exchange for funding.
Entrepreneurs approach organizations like PE firms, mezzanine funds, hedge funds, sovereign wealth funds, startup advisors and family offices, among others for this capital.
With most growth capital deals, investors will want to take a majority shareholding in the business and play a big part in strategy.
Investors will probably want one or more seats on the board to help the company quickly grow revenue, profitability, and market share with the goal of floating on the stock market or selling the company in 5 years.
A working capital loan is a loan that is taken to finance a company’s everyday operations. These loans are not used to buy long-term assets or investments and are, instead, used to provide the working capital that covers a company’s short-term operational needs.
Those needs can include costs such as payroll, rent, and debt payments. In this way, working capital loans are simply corporate debt borrowings that are used by a company to finance its daily operations.
- A working capital loan is a loan taken to finance a company’s everyday operations.
- Working capital loans are not used to buy long-term assets or investments; they are used to provide working capital to covers a company’s short-term operational needs.
- Companies with high seasonality or cyclical sales may rely on working capital loans to help with periods of reduced business activity.
- Working capital loans are often tied to a business owner’s personal credit, so missed payments or defaults may hurt their credit score.