What is a startup business loan? How does it work?
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Key takeaways
- The majority of new businesses need financing to cover operating expenses or expansion.
- Getting a loan for a new company can be difficult as lenders consider new businesses higher risk.
- Because of this, many lenders will examine your personal credit and require a personal guarantee.
A startup business loan is any loan that helps get a new business off the ground. According to the Federal Reserve Banks’ 2022 Small Business Credit Survey, 70 percent of companies under two years old used loans to fund operating expenses, and 67 percent used loans to pay for expansion in 2022.
Given the risks of financing new companies, startup loans require lenders to assume greater risk. But you can still find both traditional banks and online lenders that are willing to take a chance.
The best startup business loans will fund projects for companies with little time in business and limited credit histories. In return, you can expect additional requirements like significant collateral or a higher interest rate.
How a startup business loan works
Startup loans ultimately work like any other business loan: You apply for funding, a lender assesses your creditworthiness, and if your loan is approved, you repay the funds with interest.
Here is a more in-depth look at how a startup business loan works:
Requirements
Startup business loans may offer more lenient requirements in some respects, such as accepting borrowers with low revenue streams. You’ll want to review the requirements for revenue, credit score and other requirements before applying. That way, you ensure you’re applying with a lender that will approve financing for a startup.
Because many new small businesses fail, you may have to meet other requirements to offset lenders’ increased risks. You may have to provide greater collateral for approval, sign a personal guarantee or pay a higher interest rate.
Getting a startup business loan is often easier if you launch your business before you apply for funding. Showing lenders your business has an operating history is a big help when seeking financing.
You should also limit your debt service coverage ratio. That is, try not to take on too much other debt before you apply for your startup loan.
Applying
Once you know the requirements, you’ll need to gather the correct documents and apply for the startup loan. These documents include basic information about yourself and your company, such as ID, Social Security number and business formation documents. You also want to gather business bank account statements, licenses and other information that show details about your company’s operations.
In addition, putting together a business plan shows how you’ll use the funds and how you can repay the loan. Lenders may use the business plan to gauge the strength of your business operations and ability to repay the loan, important for getting approved as a startup.
Once you’ve gathered all the documents, fill out the lender’s application and send in all the paperwork as required. The lender will contact you if they need additional documents or details about your business.
Application review
Once you’ve turned in the application, lenders can take anywhere from a few days to several weeks to review the application. The lender will assess your creditworthiness and ability to repay the startup business loan, approving you only if it deems your business a credible risk.
The lender may not approve your loan if you don’t have the finances to support repayment or if you work in an industry with a high risk of failure. In some cases, the lender may partially approve the funding you requested.
If you did not receive the funding you need or were denied a business loan, you can improve your loan application and apply for a loan with a different lender. Online lenders may offer more lenient requirements and may be more willing to take on risk than a traditional bank lender.
Repayment
Once you’re approved for the startup loan, review your business budget to see if you can manage the repayments before signing the loan agreement. You can estimate the loan repayments ahead of time by using a business loan calculator.
Then, after finalizing paperwork, you receive the funding and repayments begin at the agreed-upon date and repayment schedule. If you apply for a term loan, you’ll receive the funding as a lump sum given by the lender. If you apply for a business line of credit, you’ll get approved for a specific amount that you can draw from as needed.
During the course of the loan, be sure to make all payments on time. Communicate with your lender if your revenue drops, and you think you might miss a loan repayment. The lender may be willing to work with your business over time to ensure the business loan is repaid.
Startup loan vs. conventional loan
Startup loans are often offered by the same lenders as conventional loans. They may be marketed as startup loans or simply small business loans with relaxed minimum requirements for credit or time in business.
| Startup business loans | Conventional business loans | |
|---|---|---|
| Who offers them | SBA, banks, online lenders, nonprofits | SBA, banks, online lenders |
| Time in business requirement | As little as 0 to 6 months | Typically at least 2 years |
| Personal credit score requirement | Minimum score as low as 500 to 560 for some loans | Minimum score of 600 or higher for most loans |
| Business credit score requirement | 155 on the SBSS scale is recommended; lenders may not require this | 155 on the SBSS scale is recommended |
| Amounts | Most lenders cap loans at $1 million or less | Most lenders cap loans at $5 million or less |
| Interest rates | Typically higher | Typically lower |
| Collateral required | Usually, plus a personal guarantee in most cases | Depends on the lender |
However, based on the difficulty that startups have securing funding, businesses aged zero to five years were almost twice as likely to use personal savings or funds from family and friends compared to businesses over 20 years old.
Types of startup loans
There are many different types of loans startups can apply for, each suited to a different purpose. For example, a startup valuing flexibility may prefer a line of credit, while one needing to make a one-time large purchase may feel a term loan is a better fit.
Understanding the different types of startup loans and when to use each is key to getting the right financing for your company.
- SBA loans: These loans are backed by the government and offer easier approvals and large loan limits. Through the SBA 7(a) program, borrowers can get loans up to $5 million.
- Microloans: These are small loans, often available from SBA lenders. The maximum loan amount from the SBA is $50,000.
- Term loans: Term loans disburse funds all at once, making them useful for one-time purchases. You can get short-term or long-term business loans.
- Lines of credit: Lines of credit give you a source of funds that you can draw from up to a certain limit as needed. Most are revolving, which means that you repeatedly borrow from the credit line as you pay back past loans.
- Equipment financing: These loans are used to buy expensive equipment and have long repayment terms. The equipment serves as collateral, which can help make qualifying easier.
- Invoice factoring and financing: Invoice factoring and financing allow you to sell the value of unpaid invoices to a third party to access funds quickly.
- Private loans.You may also be able to get a direct loan from an investor, peer-to-peer lending or family and friends.
Alternatives to startup business loans
Startup loans are a useful source of funding for new companies. But like any form of financing, they have pros and cons. It’s important to consider all of your options when looking to fund a business. Some alternatives to startup business loans include:
- Grants: A grant can provide funds to help start or expand a company without requiring repayment. Grants may target specific industries or groups, but the application process is long and competitive. That said, it’s a great option to consider if you want to avoid debt financing.
- Business credit card. Credit cards are a flexible option to assist startups with operational expenses. Some of the best business cards offer introductory interest rates and rewards that can help you save money. Additionally, if you pay the balance back in full each month, you won’t be charged interest.
- Merchant cash advance: If your startup needs quick funding, a merchant cash advance is a good option that many businesses qualify for. Merchant cash advances use your company’s future debt and credit card sales to repay the loan. But losing a percentage of future revenue to repay the loan can make it easy to get trapped in a cycle of debt.
The bottom line
You’ll have the best chance of getting approved for a startup loan if you have at least six months in business and an established business credit score or strong personal credit score. You’ll want to apply with lenders that approve business loans for startups and apply with buttoned-up documentation, including your business financial statements and a business plan showing how you plan to repay the loan.
The lender will approve you based on your ability to repay the loan, and then you will start loan repayments. You can compare multiple lenders and loan offers to see which lender will approve your business with the best loan offer.
Frequently asked questions
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The amount a startup can borrow depends on many factors, including its current debt, revenue and its owner’s credit. SBA Community Advantage loans have a limit of $350,000, but 7(a) loans have a limit of $5 million, so it’s possible to borrow a large amount.
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Getting a business loan to start a company can be tricky. Most lenders prefer to lend to companies with at least six months to two years of operating history. If you have strong personal credit and sign a personal guarantee, that could help you qualify.
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If you have a good business plan and a path toward profitability, borrowing money is still a risk, but that doesn’t mean it’s a bad idea. The majority of startups borrow money to help cover operating expenses or buy equipment or other assets that help them grow. Just make sure you understand the risk, especially if you sign a personal guarantee, and don’t borrow more than you can afford to repay.
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