One of the most important resources you have as a small business owner is your employees, and therefore, one of the most important expenses you have is your ability to meet payroll. What happens, however, when your business hits a slow period or your cash flow is uneven? You don’t want to find yourself in a position in which you can’t afford to pay your employees – this could cause many of them to quit at once and harm your business’ reputation or keep the business from functioning at all.

There are various financing options available to you to help keep your payroll going during periods when your cash flow is tight or customers are slow to pay their invoices.

Fortunately, there are various financing options available to you to help keep your payroll going during periods when your cash flow is tight or customers are slow to pay their invoices.  These options can assist you in meeting salaries, payroll taxes, commissions, and bonuses until your business is in a position to meet its obligations.

Should Financing be Used to Meet Payroll?

At first, taking out a loan or other type of business financing product to meet your payroll may not seem like a good idea, but there are plenty of situations in which doing so will help your business stay on its feet and even help it grow. Here are some scenarios in which using financing is something to consider:

1. Long-term growth plans. If you are seeking to execute a long-term growth plan and need to hire additional staff as part of that plan, you probably don’t have the immediate funds to pay new employees. Financing most likely would come in handy so you can move your business forward without having to worry about how you’re going to pay your workers.
2. Handling large orders or contracts. When your business suddenly wins a large contract or receives a large order, you may need financing to quickly hire additional staff so that you can fulfill the obligations that came with the new order.
3. Seasonal needs. Many businesses make the bulk of their revenue during certain times of the year. For example, a retail shop may make most of its sales during the holiday season. In this case, financing could be used as a convenient way to maintain payroll during slower periods.
4. When customers are slow to pay. Sometimes customers can be slow to pay their invoices, but you still need cash on hand to pay your employees. Short-term financing can conveniently fill the gap between the time you need to meet payroll and the time the customer finally pays up. 

Sometimes Financing isn’t the Best Option

While financing can be an easy option to cover your payroll, it isn’t an ideal choice in all situations. If you find you can’t meet payroll because your business is struggling, then taking on additional debt to meet it probably isn’t such a good idea as it will only exacerbate the problems your business is facing. 

If your business is struggling to the point in which you can’t meet your payroll, financing will only add to your problems. Your best bet in that situation is to assess why your business is struggling and cut expenses wherever possible. This may even involve the painful step of cutting some of your staff. 

What Types of Payroll Financing Are Available?

There isn’t one specific loan product dedicated to meeting payroll, but there are several convenient financing options available to small business owners who need quick funds to cover their payroll obligations. Some of the most popular of these options with small business owners  include: 

Term Loan 

A term loan is a lump sum of cash that is paid back over time with interest – essentially, it’s a traditional business loan. This is a great option if you are looking to implement long-term growth plans and need to hire new employees. A term loan typically offers a lower interest rate than other types of financing, and the duration of the payback period can, in most cases, be pre-negotiated. 

The potential drawback of considering term loans to cover payroll is that they are the most difficult type of financing to obtain – they often require a good- to excellent credit score, and if you’re applying for one through a traditional bank, you will often face a lengthy, paperwork-heavy application process.  

Business Line of Credit

A business line of credit gives you access to a predetermined amount of revolving credit and is a flexible financing tool if your business is seasonal and you need cash to pay your employees during the slow periods of the year. You are only charged interest on the amount you use, and you don’t have to borrow the full amount when you draw on it.

The potential drawbacks of using a line of credit for payroll is that it typically comes with a higher interest rate than a term loan, and some lenders may require tight repayment terms when compared to a term loan. In many cases, you will likely have to renew the line of credit once at least once a year. Both traditional and alternative lenders offer business lines of credit.

Working Capital Loan 

A working capital loan is a short-term loan from a reputable alternative lender that can be used if you’re facing an unexpected cash crunch and need quick funds to meet your payroll. If your business suffered a slower-than-expected month or quarter or had to deal with an unexpected expense, working capital loans typically have less restrictive requirements than a term loan or line of credit, and the payback period is often 6 months or less. 

The potential drawback of using a working capital loan for payroll financing is that it comes with high interest rates when compared to a bank loan or line of credit.

Invoice Factoring 

With invoice factoring, small business owners can receive cash upfront from an alternative lender for their unpaid invoices in exchange for a factoring fee, meaning that the lender gets to keep a small percentage of the invoices when they get paid in full. This is a good option for small business owners who are facing a cash crunch due to slow or late invoice payments and will enable them to meet expenses – such as payroll – while waiting for customers to pay. What may make this option even more attractive is that borrowers are not held to the same lending requirements as they would be with a typical bank loan, and they can get the funding they need quickly.  

The potential drawback of invoice factoring for covering payroll is that it is usually significantly more expensive than a bank loan or a line of credit. Additionally, some lenders might want long factoring contracts, so carefully consider the terms of any deal you have on the table before signing on the dotted line.. 

Revenue-Based Financing

In a revenue-based financing deal, small business owners sell a portion of their future sales at a discounted rate in exchange for a lump sum of cash upfront. This can be a good option for small business owners that have a strong sales history, but who are facing a cash crunch due to an unforeseen expense or other extenuating circumstance that is keeping them from meet their payroll deadline. 

The potential drawbacks of such a revenue-based financing arrangement for payroll is that, like invoice factoring, it can be significantly more expensive than a term loan and, in most cases, you will give up a percentage of your daily sales until you have met your obligation to the financing company. 

Before considering any of these financing options, small business owners should carefully consider why they are currently unable to meet payroll.  This will help in selecting the best financing type and borrowing terms for their situation. 

Obtain Financing Before it’s too Late

As a small business owner, your payroll is one of your most important expenses. If you find yourself in a position to have to borrow money to meet your payroll, it’s important to plan to prevent a situation in which your employees are not getting their paychecks. Not paying them may not only cause them to quit, but it can also hurt your business’ reputation among future potential employees and customers. This can be especially harmful if your business operates in a tight-knit community because word can travel fast that you don’t pay your employees.  

If you have to use financing to cover your payroll, carefully evaluate all of your options and choose the financing that best suits your business and its current situation. This includes choosing the payback option that you’re most comfortable with and the fees and interest rates you’re willing to pay.

Which is Best for Your Small Business?

The one ingredient every small business needs is capital – capital to grow, even out cash flow, and meet short-term expenses. The question of where you go to get a business loan, however, can be confusing, especially when it comes to choosing the type of lender. When it comes to financing, small business owners have two main choices for a lender: a traditional bank and an alternative business lender. Both come with pros and cons, different interest rates, different speeds at which funds are delivered, and different loan amounts offered so it’s important to fully know what your needs are and which type of lender is best suited for you. 

What are Alternative Lenders for Small Businesses?

Most business owners know they can walk into a brick-and-mortar bank and apply for a traditional bank loan, but since the 2008 financial crisis, alternatives have become increasingly popular. There are financial institutions that operate outside of the traditional banking sphere that typically offer financing applications entirely online, while giving borrowers the opportunity to speak to lending experts via phone or online channels. They are just as legitimate as banks and offer distinct advantages over them. 

Rise in Popularity 

While alternative lenders have been around since the late 1990s, their popularity began to soar after the 2008 financial crisis when many banks struggled for capital and tightened their requirements for getting loans. 

While alternative lenders were relatively obscure before the 2008 financial crisis hit, alternative business loans rose in popularity during the Great Recession. Before 2008, alternative lenders represented just 7% of the small business lending market, according to a study by the Federal Reserve. That figure rose to 12% after 2008. In 2016, 19% of small business owners turned to online lenders for their financing needs, and by 2019, the number jumped to 32%.

What is a Traditional Bank?

Traditional banks are the financial institutions in your neighborhood that can be regional or local banks or branches of larger banks such as JPMorgan Chase or Bank of America. They offer you face-to-face service with a loan officer specializing in helping small businesses. Depending on your FICO score, they usually offer slightly better interest rates than alternative lenders. Borrowing requirements, however, tend to be more rigid than alternative lenders, especially now that we’re in a high-interest-rate environment in which lending requirements have significantly tightened. 

Also, the application process is typically more complicated than with alternative lenders and, once approved, there could be a relatively long waiting period to get your funds. Still, if you have an excellent credit score, you most likely will notch a lower interest rate, which could save you significant money when it comes to your total cost of capital. 

Traditional Banks: Pros and Cons

Traditional banks are still the most popular types of lenders for small businesses and offer several advantages over alternative lenders, but there are also significant drawbacks as well. Small business owners should be aware of the pros and cons of using their neighborhood bank for a loan:

 Pros 

• Lower interest rates. While every bank is different, most offer lower interest rates on bank loans than alternative lenders. However, as interest rates are currently high right now, the difference in the interest rates on a small business bank loan between traditional and alternative lenders has tightened. 
• Face-to-face service. Many small business owners like to see a familiar, friendly face when they walk into a bank – a lending expert who is already familiar with their business – and this is a significant advantage traditional lenders have over their alternative counterparts. 
• Direct product offerings. Many traditional banks directly offer a full suite of financing products to small businesses, such as bank loans and equipment financing. Meanwhile, most alternative lenders are usually funded by asset-backed securities, so may not have the capital to directly offer a full suite of financing products, such as business lines of credit. This allows small business owners to directly negotiate the terms of their loans with the lending officer. Many alternative lenders, however, typically partner with several lenders to offer you a marketplace of financing options that they don’t directly offer.
• Offers other financial services. Small business owners can simplify things by having all of their financial needs met under one roof. This includes having a business savings and checking account, as well as a business credit card, all with one institution. Most traditional banks can provide this to you.

Cons

• Stricter lending requirements. While every lender has slightly different requirements, traditional banks generally have strict requirements for small business loans. You’re often going to be turned down if you don’t have an excellent FICO score (700 or higher). Also, to get a bank loan, your business usually needs to have higher annual revenue than what an alternative lender might want. Alternative lenders usually have shorter applications with fewer requirements.
• Longer application process. Traditional banks often require longer application processes than alternative lenders since they are generally more risk-averse.
• Slower funding times. In some cases, if you are approved for a loan from a traditional bank it could take several days or even weeks to get your funds. 

• May be Cumbersome to shop around. If you were shopping for an expensive item such as a new car, you’d probably want to visit several dealerships to get the best possible price. The same holds true for a small business loan. Shopping around for a loan from a traditional bank, however, means you may have to physically visit several local banks to get the best possible deal, and small business owners might not have the time to do that. Many large banks allow you to compare offers online. However, since alternative lenders operate almost entirely online, all you need is your laptop and an internet connection to compare offers. 
• Systemic risk. Systemic risk is essentially the risk that banks may collapse due to declining economic conditions. Banks shut down during the credit crunch of 2008, and recently, as interest rates have gone up, banks such as Silicon Valley Bank and Signature Bank were taken over by the Fed earlier this year in high-profile collapses. While this doesn’t happen very often, it’s still a risk when working with a traditional bank. 

Alternative Lenders: Pros and Cons

Alternative lenders have become a legitimate borrowing choice for small business owners since the Great Recession, especially when small business lending from traditional banks dropped by some 40% in 2009. These lenders offer significant upsides for small businesses, but they also carry some downsides as well. Here are some of the pros and cons of using an alternative lender:

Pros

• Relatively simple application process. Applying for small business financing from an alternative lender typically takes only a few minutes, and it can all be done online. With a traditional bank, there is usually far more paperwork involved and in many cases with regional banks, you need to visit a location as part of the application process. 
• Fewer requirements. Alternative lenders primarily judge you by your FICO score and cash flow history and require minimal paperwork compared to a traditional bank. Alternative lenders also sometimes require fewer years in business and less annual revenue than a traditional bank. Additionally, loan approval rates from alternative lenders remain far higher than traditional banks. If you’ve been turned down for a loan by a traditional bank because of a borderline credit score (let’s say in the 660 to 680 range), then you may still qualify for a business loan with an alternative lender if you have a strong cash flow history.

• Different Financing Products.  In addition to traditional business financing products, such as short-term loans, long-term loans and equipment financing,  alternative lenders offer some financing options that banks do not.  Including:
• Revenue-based financing. Revenue-based financing is when a lender gives your small business a lump sum of cash in exchange for a portion of your future receipts – a practice often referred to as factoring. This type of financing is often used when a small business needs cash for an emergency or to finance an unexpected growth opportunity. Most traditional banks don’t offer this, but many alternative lenders do, giving you another option when it comes to financing.
• Factoring. Factoring is a form of financing offered mainly by alternative lenders. A financing tool such as invoice factoring, for example, can give you cash based on your outstanding invoices. While this can be an expensive way to get quick cash, it is an example of the types of alternative financing that you can get with many online lenders.
• Rapid funding. If you qualify for financing with an alternative lender, you could receive your funds in as little as 24 hours, whereas with many traditional banks it could take several days or even weeks to receive your funds.

Cons

• Higher interest rates. Because alternative lenders are generally willing to take on a bit more risk when giving loans to small businesses, they typically charge a higher rate on those loans compared to traditional banks. However, in the current high-interest rate environment, the difference in the cost of capital charged by traditional banks vs. alternative lenders has dramatically tightened over the past year.
• Fewer direct products. Alternative lenders don’t borrow cash from the Federal Reserve, nor do they offer savings accounts upon which they can lend against. Therefore, many don’t typically don’t have the cash reserves to directly offer certain financing products such as business lines of credit or equipment financing. 

Many alternative lenders, however, do partner with banks and other lending institutions to offer a marketplace to small business owners seeking those products to get them the best possible deal. The potential drawback to this is that borrowers typically can’t negotiate directly with alternative lenders for the terms of certain financing products like they could with traditional banks. 

Key Takeaways

Small business owners in need of capital must make prudent decisions on where to apply for financing. Alternative lending and traditional lending each have pros and cons, so it’s important to be educated on both. Generally speaking:

1. If you have the time and meet the criteria, traditional banks are probably the best bet for financing. 
2. If you need funding fast, or have a borderline FICO score and a strong cash flow history, then an alternative lender might be the best choice for you to obtain capital.
3. While traditional banks generally offer lower interest rates on their loans than alternative lenders, the difference in those rates has tightened as interest rates continue to climb.
4. Traditional banks offer you the opportunity to conveniently have all of your financial services needs – including a business checking and savings account and business credit card – taken care of under one roof.
5. Alternative lenders have made great strides in providing personable customer service. Most offer small business financing specialists available by phone to help educate you and assist you in deciding which financing product is best for you. 
6. Whether you’re applying for a loan with a traditional bank or an alternative lender, make sure to have your paperwork ready. This includes past bank statements, tax returns, and an updated business plan. 

Before you decide how you want to get your business loan, it’s vital that you take the time to closely examine which type of lender best suits your small business needs. Make sure you know what to expect with both alternative lenders and traditional banks in terms of cost of capital and convenience. 

If you’re ready to take on a loan or any other type of financing for your small business, you should give yourself a pat on the back. That usually means that your business has grown to the point where you’re ready to take on additional growth opportunities or you just need funding to keep your operations running smoothly. Before you get that business loan, however, one of the most important questions you need to ask is, ‘what type of financing should I get?’

Various types of small business lenders offer an array of loan options and other financing products for different purposes, and it’s crucial that you determine which product best suits your needs as a small business owner. While nobody really wants to pay interest, each financing option will offer a different cost of capital. There are also those that offer different repayment terms, while there are still others that are designed to fund specific business needs. 

What types of loans are there and which one is best for you? You have an array of options, and which one you choose should depend on how you plan to use the funds, your business and personal credit scores, as well as the loan amount you’re seeking. 

Types of Business Loans

Here are the different types of small business loans you can seek for your small business and how they can help you the most:

Term loans.

Term loans are offered by both traditional banks and alternative lenders. It is a large chunk of money that you receive all at once and agree to pay back over time with interest. The proceeds of a term loan (also called a bank loan) typically must be used for a specific purpose, such as expanding your business, developing and marketing a new product, or consolidating debt. 

Traditional banks usually offer slightly lower interest rates than alternative lenders, but often demand that you have a good to excellent personal FICO and business credit score. The application process tends to be longer and more complicated than alternative lenders, and the funds may take days or weeks to be delivered to you. Alternative lenders typically charge higher interest rates but offer a simpler application process, typically have less stringent qualification requirements, and can deliver funds to you in as little as a day.

Small Business Administration (SBA) 7(a) loan

SBA 7(a) loans are essentially term loans given out by both traditional and alternative lenders, while the US Small Business Administration guarantees a large portion of them and sets the general borrowing requirements for small business owners. These loans typically offer the best interest rates when it comes to term loans, but come with a long list of requirements such as an excellent FICO (680 and above) and a business (80 or above) credit score. Also, it may take weeks to actually obtain the funds. 

Working capital loan

These loans are typically offered by online lenders and typically don’t require a personal FICO or business credit score as high as a term loan. They are usually meant for small businesses with seasonal or uneven cash flows throughout the year that need to keep operations going during the offseason or when there’s a downturn in the economy. Depending on the borrower’s credit score, the interest rate can be very high.

Non-Recourse Loan

Non-recourse loans are often used in commercial transactions in which the real estate itself acts as collateral. In a non-recourse loan, the lender may only seize the collateral in the event of default or bankruptcy, even if the collateral does not equal the full value of the loan. A non-recourse loan, in rare cases, can also be applied to a secured term loan. 

Lenders usually offer this type of loan with strict requirements, such as a very high credit score or performance guarantees. The SBA also offers some non-recourse loans through intermediary lenders, which also usually carry exceptionally strict requirements.

Commercial Real estate loan

If you’re a small real estate company seeking to invest in a property or a small business owner who’s decided that it’s in your best interest to purchase the property from which your business operates, a commercial real estate loan is your best option. It is essentially a commercial mortgage from a traditional bank in which the property being acquired becomes the collateral, so your credit score may not matter as much as your business plan. 

SBA Microloan

An SBA microloan is offered through intermediaries, many of which are not-for-profit and are geared towards young small businesses (at least 6 months in operation) and carry fewer requirements and lower interest rates than bank loans. In some communities, these loans are offered exclusively to women- and minority-owned businesses, or small businesses operating in underserved communities. The maximum loan amount is $50,000 with the average amount in 2022 being slightly less than $17,000. 

SBA CDC/504 loan 

Like the SBA Microloan, these loans are typically offered through not-for-profit intermediaries and are typically granted to small businesses for the purpose of enhancing their communities through storefront renovation and increasing local hiring. They can also be used for land acquisitions and equipment purchases, and carry less strict requirements than bank loans. Unlike the SBA Microloan, they do offer larger amounts, with the maximum being $5 million.

Equipment loan

An equipment loan, commonly referred to as equipment financing, is just that: a loan that pays for the entirety of a piece of revenue-producing machinery (such as a business vehicle, tractor or manufacturing equipment) for your business. This is offered directly by traditional banks and alternative lenders. This type of loan usually offers an interest rate that is less than a bank loan, depending on the credit score of the borrower, since the machinery purchased acts as collateral for the loan. The catch is that the interest rate on this loan will usually be higher than if you went directly to a dealer and financed that equipment. However, if you buy directly from a dealer, you usually have to make a large down payment. 

Non-Loan Business Financing Options

While there are a lot of different types of business loans, there are also financing products that are not technically considered loans, even though they involve lenders giving money to businesses in exchange for the principal and an interest rate or “factor” fees. These types of financing products can come in handy for specific purposes and sometimes can be more convenient than traditional loans.

Business Line of Credit (BLoC)

A business line of credit, offered by traditional banks and alternative lenders, gives your small business a predetermined amount of debt to draw upon for any business need. While conceptually similar to a credit card in that way, there are many differences. A BLoC often offers a lower interest rate than a business credit card but doesn’t offer rewards of any kind. Additionally, a BLOC has to be renewed, sometimes on an annual basis. It often has minimum withdrawal amounts; penalties for non-use and repayment terms that include full payment at various intervals. 

BLoCs, however, are very flexible financing tools for a small business owner – the money can be used for any purpose at any time, including meeting payroll during the offseason or for purchasing additional inventory when customer demand unexpectedly swells. 

Revenue Based financing (RBF) 

RBF is a contract-based financing tool typically offered by alternative lenders. A lender will give a lump sum of money to a small business owner in exchange for a predetermined percentage of the business’ future receipts. The contract is based on a factoring model, which means that the portion of each receipt will be factored as a percentage to give to the lender or factoring company. 

While this is usually a more expensive form of financing than a loan, RBF can be very useful if a small business owner comes across an unexpected growth opportunity or an emergency business expense. One positive is that factoring companies usually don’t consider your credit score as the most important qualifier when deciding to do business with you.

Invoice Financing 

Often referred to as invoice factoring, this is a financing tool in which an alternative lender gives you money upfront for your unpaid invoices. The money upfront will be slightly less than the combined value of the invoices, but this type of financing enables small business owners to unburden themselves of the risk of slow-to-pay customers never paying. The potential drawback is that the small business owner may be forced into a longer contract than desired, and depending on the terms of the contract, may be on the hook for a portion of the money if the customers never pay their invoices.

Purchase Order Financing 

Let’s say your small business receives a large order from a major retailer.  However, the cost to produce this order is beyond your reach right now or you’re just not comfortable using up that much of your available cash flow to fulfill the order.  This is where purchase order financing, another type of factoring product, can be incredibly useful. 

With purchase order financing – usually done through an alternative lender – the lender will pay your suppliers upfront for inventory in exchange for a small percentage of the purchases being made, which are referred to as factoring fees. While this can be a bit expensive compared to other types of loan products, the cost of purchase order financing is covered by the amount you would be paid when fulfilling the order. While it may eat into your profit a bit, that is profit you wouldn’t have had if you had to turn down the order due to a lack of inventory.  Additionally, high credit scores on your end will not be a requirement for this type of financing because the credit that is taken into account is the credit of your customer that made the purchase order. 

Consider a Checklist to Help You Select the Right Business Loan for You

Choosing from the different small business loans available to grow your small business, meet unexpected expenses, or keep your business running smoothly is one of the most important decisions you need to make as a small business owner. Before applying, you should go down a fundamental checklist of questions you should answer before seeking financing:

• Why do I need financing/what will the money be used for?
• How much am I willing to pay for business financing?
• Which types of financing are most convenient for me in terms of how I can use the money and how quickly will I receive it? 
• Which financing products am I most qualified for? 
• Do I have a realistic plan for making loan payments or paying the factoring fees? 
• Does my current cash flow justify taking on financing?

Answering these questions beforehand will help you make the wisest decision possible on what type of financing you need, what financing you’re able to afford,  and will – ultimately – help your small business flourish in the long run.