What this lesson covers
How to fund a small business beyond personal savings — the types of financing available, how to evaluate them, and how to manage debt once you have it. This lesson covers equity vs. debt, bank loans, SBA programs, lines of credit, and the financial ratios lenders use to assess your business. It also covers when borrowing makes sense and when it doesn’t.
Equity vs. debt
There are two fundamental ways to fund a business: someone gives you money in exchange for ownership (equity), or someone lends you money that you pay back with interest (debt).
| Equity | Debt | |
|---|---|---|
| What you give up | Ownership and control (a percentage of the business) | Nothing — you repay principal + interest |
| Repayment | No fixed repayment; investor earns through distributions or exit | Fixed payments on a set schedule regardless of business performance |
| Risk to you | Diluted ownership; shared decision-making | Personal guarantee may put personal assets at risk |
| Risk to funder | Higher — may lose entire investment | Lower — collateral and guarantees provide protection |
| Cost | No interest, but potentially more expensive long-term (giving away 20% of a successful business) | Interest rate (5–15% for small business loans) |
| When it makes sense | High uncertainty, long runway to profitability, investor adds strategic value | Clear path to repayment from cash flow, owner wants to retain full ownership |
Most small businesses use a combination: the owner’s equity (personal savings, family investment) plus debt (bank loan, SBA loan, equipment financing).
Types of debt financing
Term loans
A fixed amount borrowed, repaid in regular installments over a set period.
| Feature | Typical terms |
|---|---|
| Amount | 500,000 |
| Term | 1–10 years (longer for real estate) |
| Interest rate | 6–13% (varies with creditworthiness, collateral, and market conditions) |
| Payments | Monthly, fixed amount (principal + interest) |
| Collateral | Often required — equipment, inventory, personal assets |
| Best for | One-time purchases (equipment, build-out, working capital at startup) |
SBA loans
The Small Business Administration doesn’t lend directly. It guarantees a portion of loans made by partner banks, reducing the lender’s risk and making loans available to businesses that might not qualify for conventional financing.
SBA 7(a) — General purpose:
- Up to $5 million
- Terms up to 10 years (25 for real estate)
- Rates: prime + 2.25–4.75%
- Can be used for working capital, equipment, build-out, debt refinancing
- Requires good personal credit (680+), business plan, financial projections
- Processing time: 30–90 days
SBA 504 — Real estate and major equipment:
- For purchasing commercial real estate or major fixed assets
- Structure: 50% from a bank, 40% from a Certified Development Company (CDC), 10% owner down payment
- Below-market fixed interest rates on the CDC portion
- Best for buying a building or expensive permanent equipment
SBA Microloan:
- Up to $50,000
- Issued through nonprofit intermediary lenders
- Designed for startups and very small businesses
- More flexible qualification criteria than standard bank loans
Lines of credit
A revolving credit facility — you can borrow up to a limit, repay, and borrow again.
| Feature | Typical terms |
|---|---|
| Amount | 250,000 |
| Interest | Only on the amount drawn (not the full limit) |
| Rate | 7–18% variable |
| Repayment | Minimum monthly payment; principal can be repaid and redrawn |
| Best for | Managing cash flow gaps, seasonal fluctuations, unexpected expenses |
A line of credit is the financial equivalent of a safety net. Establish it when you don’t need it — applying during a cash crisis signals desperation and reduces your negotiating power.
Equipment financing
Loans or leases specifically for purchasing equipment, with the equipment itself as collateral.
| Feature | Typical terms |
|---|---|
| Amount | Cost of equipment |
| Term | Matches useful life of equipment (3–7 years) |
| Rate | 5–15% |
| Down payment | 0–20% |
| Collateral | The equipment itself |
| Best for | Major equipment purchases (ovens, refrigeration, vehicles) when you want to preserve cash |
Business credit cards
High-interest revolving credit. Useful for small, short-term purchases. Dangerous for carrying balances — rates of 18–28% compound quickly.
Use for: Building business credit history, earning cash back on routine purchases, short-term bridge (paid in full monthly).
Don’t use for: Financing operations, covering ongoing cash shortfalls, large purchases that will take months to pay off.
Evaluating a loan offer
The numbers that matter
APR (Annual Percentage Rate): The true annual cost of borrowing, including interest and fees. Compare APR, not just the stated interest rate — a 7% loan with a 2% origination fee costs more than a 7.5% loan with no fees.
Monthly payment: Can the business afford this payment from operating cash flow? Check against your cash flow forecast.
Total cost of borrowing: Monthly payment × number of payments − principal. A 10,800 in total interest. At 12% over the same term, it costs approximately $16,700.
Prepayment penalty: Can you pay the loan off early without penalty? Some lenders charge a fee for early repayment (because they lose future interest). Avoid loans with prepayment penalties if possible.
Personal guarantee: Does the lender require you personally to guarantee the loan? This means if the business can’t pay, you pay from personal assets — regardless of your corporate structure. Negotiate to limit or eliminate personal guarantees, especially as the business builds its own credit.
Debt service coverage ratio (DSCR)
Lenders use DSCR to determine whether the business can afford the loan:
DSCR = Net operating income ÷ Total annual debt service
If the business generates 48,000/year:
DSCR = 48,000 = 1.5
A DSCR of 1.0 means the business earns exactly enough to cover debt payments — no margin for error. Lenders typically require 1.25 or higher. A DSCR below 1.0 means the business cannot cover its debt from operations — it will need to draw on reserves or equity to make payments.
Check the DSCR using your financial projections — not just at steady state, but during the ramp-up period. If DSCR drops below 1.0 in months 2–4 (common for new businesses), you need enough working capital to cover the gap.
When borrowing makes sense
Debt is a tool. Like any tool, it’s useful when applied correctly and harmful when misused.
Borrow for:
- Revenue-generating assets: Equipment that enables production (an oven for a bakery, a truck for a food truck). The asset generates the revenue that repays the loan.
- Build-out and improvements: Leasehold improvements that are necessary to operate. The build-out enables the business — without it, there’s no revenue.
- Working capital during a defined ramp-up: If projections show the business reaching profitability in month 4, borrowing to cover months 1–3 is rational — if the projections are credible.
- Opportunity with a clear return: A catering contract that requires a 20,000 in revenue over six months.
Don’t borrow for:
- Operating losses with no end in sight: If the business is losing money and there’s no credible plan to reach profitability, borrowing extends the problem rather than solving it.
- Lifestyle expenses: The owner’s salary during pre-revenue should come from equity (owner’s investment), not from loans that the business must repay.
- Speculative growth: Opening a second location before the first is profitable is using debt to amplify risk.
- Covering other debt: Borrowing to make loan payments is a death spiral. If the business can’t service existing debt, the problem is operational — not financial.
Managing debt
Track all obligations
Maintain a debt schedule — a list of every loan, line of credit, and credit card balance:
| Lender | Balance | Rate | Monthly payment | Maturity | Collateral |
|---|---|---|---|---|---|
| First National (SBA 7a) | $42,000 | 7.5% | $842 | 2031 | Equipment |
| Equipment Finance Co | $12,400 | 9.0% | $258 | 2028 | Oven, refrigeration |
| Business credit card | $2,800 | 22.0% | $280 (min) | Revolving | None |
| Total | $57,200 | $1,380 |
Prioritize high-interest debt
Pay minimums on low-rate loans and direct extra cash to the highest-rate balance first (the credit card at 22%). The interest cost difference is dramatic: 2,200/year in interest; the same amount at 7.5% costs $750.
Build toward refinancing
As the business establishes a track record (profitable operations, on-time payments, growing revenue), you may qualify for better rates. After 2–3 years of clean financials, approach lenders about refinancing high-rate debt at lower rates.
Know when to stop borrowing
Total debt service (all loan payments combined) should not exceed 25–30% of gross revenue for a small business. Beyond this, debt payments consume so much cash flow that the business has no margin for error or investment.
Guidance
- Calculate your total startup funding need from your use of funds and financial projections. What portion can you fund from equity (personal savings, investor)? What portion requires debt?
- For the debt portion, compare three options: a conventional term loan, an SBA 7(a) loan, and equipment financing for the equipment portion. Calculate the total cost of borrowing for each.
- Calculate the DSCR for your projected business at month 6 and month 12. Is it above 1.25? If not, your projections either need more equity or less debt.