Small and medium-sized businesses from around the world have always looked up to traditional sources such as banks when in need of financing. However, over the past couple of years, this has become increasingly difficult for SMEs due to several reasons.
For instance, with the rise of new age industries like Software-as-a-Service (SaaS), which do not use the same growth metrics as brick-and-mortar establishments, entrepreneurs are finding it more difficult to get approved.
Although several alternative financing options have grown to bridge this credit gap, as an entrepreneur, it is crucial that you evaluate the pros and cons of both traditional financing solutions vs alternatives before you go ahead and decide.
In today’s post, we will help you do just that.
Types of Financing Offered by Banks
Traditional financial institutions such as banks offer several different types of financing to business owners, and a common starting point for all of them is to have a business account at the institution.
Shared below is a list of the most popular business financing options available to entrepreneurs.
1. Term Loan
A term loan is a standard financing instrument offered by any bank to its business customers. One of the most significant advantages of a term loan is the fact that you are free to use the loan amount for any business expense and are not required shared explicit details about the same in advance. However, on the flip side, to get approved for a term loan, a bank might request you to submit a detailed business plan.
Term loans generally have tenures ranging from 3 to 5 years, and their interest rate can be fixed or variable depending upon your relationship with the bank.
2. Government Guaranteed Loans
Next to term loans, banks across all major economies offer their business customers some variation of a government-guaranteed loan. As the name suggests, one of the most significant benefits of this loan is the fact that it is guaranteed by the government, which arrives with its own distinct set of benefits such as low-interest rates, faster approvals, and longer tenures.
In most cases, these loans are supported by the federal government and are available to businesses from a wide category of industries. However, one downside of this option is that business owners need to ensure that their organization meets all the prerequisites listed by the government for it to act as a guarantor.
3. Line of Credit
This type of financing empowers a business to access cash from a revolving line of credit as and when needed. One of the best aspects of this type of loan is that businesses only need to pay interest on the exact amount they borrowed, making this an economical and flexible proposition for most entrepreneurs. Along with this, as business owners continue to make repayments on time, most banks will increase the credit limit, empowering the business over time to act on potential opportunities.
4. Real Estate and Equipment Financing
Last but not least, is equipment and real estate financing, which, as the name suggests, is for businesses which need to invest regularly in their infrastructure and machinery. In most cases, banks will offer 100% to 120% of the equipment cost as a loan, and in the case of real estate, sanction transactions which empowers the business owner to purchase, refinance or borrow against their existing assets.
However, one downside to both these options is that business owners either need to have a long-term relationship with the bank to get approved or pledge personal collateral.
Pros and Cons of Traditional Financing Options
Now that you have a better understanding of the various types of loans extended by banks to their business customers, let’s explore their pros and cons in detail.
1. Advantages of Bank Loans
Securing approval for a bank loan can be tremendously beneficial for a business of any size. For starters, it allows the business owner to move away from shareholder financing or bootstrapping their enterprise. Along with this, the business can effectively extend their runway without diluting their equity, as most bank loans do not require the founding team to give up their stake in exchange for capital.
Lastly, an underrated advantage of a bank loan is the fact that as you make timely repayments, the bank will reward you with a higher credit limit, meaning you can seize more opportunities in the future.
2. Disadvantages of Bank Loans
Although bank loans empower business owners with certain advantages, there are some obvious downsides to them. For starters, a bank might reject your loan application even if you have a sound business plan and healthy revenue streams simply because your industry is out of their purview. The best examples of these can be found in some gaming industries or tabacco related industries.
In other cases, if you are a new business, meaning you have been operating for under 2 years, you will be unable to meet the eligibility criteria of most banks as they demand a minimum business vintage of 3 years.
Lastly, in upcoming business models such as SaaS, even if you have a sound business plan backed up with healthy growth metrics, the bank might reject your application because their growth metrics are different from yours.
Requirements of a Bank Loan
To get your business approved for a bank loan, you need to meet the wide list of eligibility criteria and requirements set by the bank. Shared below is a glossary of the most significant ones.
Personal credit score
One of the first things the bank will request you is to share is your personal credit score. Irrespective of the fact that you have a sound business plan, and your business has healthy financials; the bank will only approve your loan after you meet their credit score requirement. In some cases, all members of the founding team might be required to share their credit score for a large ticket loan.
Legal and Financial Documents
Second to your credit score, you will need to share both your businesses and your personal bank statements and tax returns to secure approval. At this stage, you might also need to share any financial projections you have created along with your business’s profit and loss statement.
Annual Revenue
In most cases, banks will only lend to revenue-generating businesses, and thus, you will need to share your business’s exact annual revenue to secure approval. Generally, to ensure approval, you will need to have annual revenue of 1.25 times your normal operating expenses.
Business Vintage
Most banks only lend to businesses which have been in operation for 3 or more years, and thus to secure approval, you need to be compliant in this regard.
Collateral and Industry Eligibility
Lastly, you might need to pledge your personal collateral to secure approval and ensure that your business operates in an industry within the bank’s purview.
Conclusion – An Alternate Route to Raising Funds
Although bank loans empower you to turn the tides of your business for the better, they often arrive at a high cost. Starting from strict eligibility criteria to complex and time-consuming application processes, it can be easily said that bank loans are not the best option for every type of business.
An alternate and more business-friendly route to raising funds for your business is to tap into alternative sources such as recurring revenue financing or PayLater direct loans. These financial instruments not only arrive with a sizeable ticket size and favourable terms but are also easier to secure approval.
CrediLinq is a market leader in recurring revenue financing and is a pioneer in helping founders like you effortlessly extend their runway without diluting equity. Contact us today to learn more about how CrediLinq can help your business grow.
