Before you take out a loan for your business, you have to ask yourself one question: Will this money help my business grow?
If the answer is yes, you’re golden. But if you’re only looking to sustain a sinking operation or slap a band-aid onto a larger financial problem, then getting yourself into further debt is the last thing you need.
From risky investments to financial desperation, here are the four worst reasons to take out a small business loan.
1) You need the money to pay off a previous business loan.
The lure of refinancing or consolidating debt can be hard to resist, especially when you find yourself unable to keep up with your current minimum payments. But keep in mind that you’ll be losing a portion of the new funding to origination fees when you take out a new loan, which means you’re paying a premium in order to stay afloat just a little while longer.
More importantly, you’re just prolonging your indebtedness, rather than making real changes to improve your financial situation.
That’s not to say that taking on new debt to pay off old debt is always a bad idea, but the financial benefit you get from the new capital has to outweigh the cost required to borrow it. Generally, that means waiting until your original loan is at least halfway paid off.
Our advice: Focus on budgeting and cutting expenses as much as possible to afford the debt you already have. And if you really need money to get through a slow period, consider applying for a cash advance instead of a loan. That way, you’ll never have to pay more than a small percentage of what your business actually collects in revenue.
2) You want to take a gamble on a risky opportunity.
Whether you’re building a new location of your popular restaurant or buying inventory in bulk because you forecast a busy season ahead, business ownership is all about taking measured risks.
It’s the longshots that can get you in trouble.
Investing in new business initiatives before thoroughly vetting them is a common pitfall for entrepreneurs, who love to get in on the ground floor of new and exciting opportunities. So when a new business opportunity comes your way — something that might have a lot of upside but is relatively untested — do as much foundational research as you can to determine the following:
- How much additional revenue can you reasonably expect the new investment to bring in for your business?
- What are the ongoing expenses that this initiative will require, beyond the initial launch/purchase?
- Will the resulting income be enough to cover loan payments in the short term?
- If not, will the current revenue from your business be enough to cover the loan payments indefinitely?
If the answer to any of these questions is “I don’t know,” forget about funding. Business loans should be saved for investments with a guaranteed, short-term return — not for rolls of the dice.
3) You need money for anything outside of your business.
We shouldn’t even have to explain this one. If you take out a loan against your business, do not spend it to cover your personal bills. It’s a desperate move that can wreck your business credit and leave you in terrible financial straits.
In fact, many traditional lenders have explicit rules barring you from spending funds from business loans on anything that’s not business-related. These rules are for your protection as well as theirs: If you spend all the capital from a business loan on yourself rather than a business improvement that generates new revenue, the loan payments can quickly overwhelm you, making default more likely.
4) You can’t keep up with your business expenses.
Maybe you’re behind on your rent, utility bills, or taxes. Tough times hit every business now and then, but getting a loan to cover your basic operating costs is something that only makes sense when you’re panicking. The money will run out before you know it, and the loan payments you’re left with will only accelerate your path to financial ruin.
Here are three smarter financing options you can consider if you’ve reached a point where your business revenue isn’t enough to cover your expenses.
Equity financing: Instead of taking on more debt, sell a portion of your business to an investor, who becomes your partner. You’ll give up some control of your business, but joining forces with another entrepreneur could be the solution to turning around your business’s fortunes.
Invoice factoring: If you’ve been having trouble collecting on your invoices and need cash quickly, consider selling your outstanding invoices to a third-party at a discounted rate. (Or if you have a lot of unpaid invoices, hire a collections agency.)