Uncover the Pros and Cons of Secured Financing versus Unsecured Financing

No matter what stage a business is in, the option and necessity for financing can and should be on the table for stability and expansion. In 2012, 5.9 million loans worth $206 billion and 177,000 small farm loans worth about $12.6 billion were written, according to the Federal Financial Institutions Examination Council.

Understanding what types of financing exists and how these options can be applied to one’s business can be helpful when and if it becomes a necessity. Whether it’s secured financing through the U.S. Small Business Administration (backed with personal and business collateral) or unsecured types of financing through venture capital or angel investors, each type has its potential benefits and drawbacks.

Types of Unsecured Financing

Business owners looking to obtain financing without the use of personal or business assets to secure their funding might look to venture capital (VC) or angel investors. Unlike a bank, where repayment is expected to begin within a few months and there is no direct involvement, venture capitalists take an active role to nurture the venture and help make it profitable in the long term. Venture capitalists usually do this by serving on the board of directors, while angel capitalists take a less visible but still important role, such as mentoring the business owners.

Venture capital is distinguished from angel investors by the fact that VCs invest money raised from other entities, while an angel investor uses his own funds. Typically, venture capitalists inject a larger cash investment compared to an angel investor, who may invest as little as $25,000 or $50,000. Instead of paying one’s loan back with interest on a monthly basis, venture capital and angel investors look to cash out years down the road in exchange for their upfront cash infusion and ongoing involvement.

Unsecured Financing Benefits and Drawbacks

As with every form of financing, there are advantages and drawbacks to using venture capital and angel investors. In exchange for venture capital, the investing firm will likely want a seat on the board of directors. This could pose a problem for a business’ founders because the company’s direction might not go as they originally intended. Receiving venture capital also poses original founders with a problem of developing an exit plan for the venture capitalist and finding the right future leader to replace existing members.

Obtaining angel investors may provide more benefits with fewer drawbacks. Angel investors often look for lower profits when the investors leave. Involvement usually takes the form of mentoring or consulting versus mandating influence via the board of directors. Angel investors take into account factors, including socially conscious and community goals, in addition to the potential financial returns a startup might provide. However, angel investors may only focus on narrow industries and give preference to past and in-network business associates and entrepreneurs.

Types of Secured Financing

For entrepreneurs looking to go with traditional forms of financing, secured lending provides startups and established companies with a variety of options. For entrepreneurs who have exhausted all reasonable means, the 7(a) loan program is available. This type of loan guarantees up to 85 percent of small business loans secured through a combination of personal and business assets. The SBA’s CDC/504 Loan Program offers financing for major fixed assets, such as equipment or real estate.

Secured Financing Considerations

Startup entrepreneurs can benefit from the 7(a) loan because it is similar to a home mortgage in terms of amortization. Real estate loans are available for terms up to 25 years, equipment loans (depending on the equipment life) are eligible for up to 10 years, and working capital loans for up to seven years. Be aware that business owners must plan accordingly for the payments and assets if they have a slow quarter or experience a business failure.

CDC/504 loans are intended to finance fixed assets such as real estate or equipment. To qualify for a loan, applicants must have a tangible net worth of less than $15 million and have earned no more than $5 million in net income over the preceding 24 months. This type of loan will not be granted if the owners, or the company itself, is deemed capable of providing all or part of the financing requested. Loans may still need to be personally guaranteed and funds are prohibited to be used for certain circumstances, including purchasing inventory, working capital and debt servicing.

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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