Small businesses have high risk profile
Although not all small businesses have a high risk profile, most of them actually have high probability of defaulting on their repayment of borrowed money due cash flow constraints. At the early days of your startup, you invest a lot of money in product development on trying to acquire new customers and establish product awareness within the market. This process often take a long time and as you continue to invest in those strategic activities for the long term survival of your business within its industry, your startup rate of generating revenues is often low. Exceptional cases exist, but about 75% of small business will go through this phase of growth when they are spending too much money relative to what they are earning from sales.
The high expenditure is not bad by itself since you need to invest in the most valuable asset your business need; which is your product awareness and brand loyalty. However without regular cash inflows to match the cash outflows, your business is deprived of its life blood and hence it might end up dying at the young age. Balancing the cash outflow and cash inflow therefore becomes a very critical management decision for small business owners at their early stages of development.
In order to access the different types of loans available for your startup at this growth phase you therefore need to generate enough cash flows to make regular principal repayments and interest payment to the lender; as well as have sufficient cash remaining within the business to fund operational activities. With the imbalance explained above, meeting this criterion is difficult for most small businesses, hence raising their risk profiles.
Traditional sources of loans for your small business
With limited personal finances more often than not the founder will be forced to look for external funding to meet the cash demands within the startup. Among the sources of this external funding, debt funding ranks highest. Irrespective of the risky nature of the small businesses described above, borrowing money when in need of external cash injection remains to be a common trend in the startup ecosystem.
1. Family & friends loans
At the seed stage when you are introducing your product to the market for the first time, you will probably have financed your startup from your own personal savings and other personal income sources. In addition, you will most likely get funding from close family members and friends who believe in your business idea; before other external parties appreciate what you are doing and build the trust in you to lend you their money. These borrowed funds from the members are in most cases a soft loan with highly concessional terms and a flexible repayment period. With no cash flows to show yet, most traditional sources of commercial loans are reluctant to lend to small businesses at this stage.
2. Government loans
As your venture transitions into the high growth phase, you become more visible and customers stat flowing in creating a rise in demand for your products or services. With this growth of demand you start experiencing bigger cash needs to finance your increased operations, hire more employees, procure more production inputs and acquire more equipment among other things. To meet your rising financial needs, you can now easily access government loans for small businesses since you already have some traction and proof of ability to pay; although you are still in not yet very stable in terms of regular cash inflows.
3. Commercial bank loans
Commercial banks tend to be risk averse both out of their own precautionary measures to avoid having too much non-performing loans; but also due to the prudential requirement from the banking sector regulators. Accessing debt financing from the banks at the early stages of business growth therefore becomes a little bit tough since you will need to meet a lot of criteria before you are considered for their small business loans. However, after going through the growth stage and getting to the expanding phase for your small business banks are now often a good source funding. At this level you will be in need of huge amounts of money for capital investment and banks can easily give you a loan since you already now have regular cash flows and you have built a trust relationship with them over time.
As a general rule of thumb, you need to always ensure that you do your own calculations before getting a loan in order to ensure that the expected rate of returns is more than the interest rate charged on the borrowed money. Other borrowers tend to factor in premiums to cover other economic factors such inflation when determining their required rate of return before taking a loan. You however, need at the bare minimum to have your cost of debt covered before accepting the loan.