Small Business Financing Options Compared

The options, side by side

Option	Best used for	Relative cost	Main risk
Term loan	Equipment, fit-out, acquisition	Low to moderate	Fixed repayment regardless of revenue
Revolving line of credit	Seasonal and timing gaps	Low to moderate	Renewal risk; can be withdrawn
Equipment finance or lease	Vehicles, machinery, technology	Moderate	The asset secures the debt; defaults are severe
Invoice factoring	Fast-growing B2B with slow payers	High	Cost drags margin; customer perception
Merchant cash advance	Short-term emergency only	Very high	Effective rates can be extreme
Revenue-based financing	Predictable recurring revenue	Moderate to high	Repayments scale with revenue, not profit
Trade credit from suppliers	Inventory and materials	Low or free	Relationship damage if abused
Equity investment	High-uncertainty growth	No cash cost, permanent dilution	Loss of control and upside
Bootstrapping (customer prepayment)	Validated demand	Effectively negative cost	Requires trust and delivery capability

Term loans and lines of credit

These two account for most small business borrowing, and they solve different problems.

A term loan hands you a lump sum repaid over a defined schedule. It suits a purchase where the asset produces returns: a delivery van, a fit-out, a machine. Because repayment is fixed, the risk is that revenue disappoints while the schedule does not move.

A revolving line of credit is a limit you draw against and repay. It suits the gap between paying for inventory, labour and materials and collecting from customers. Because it is designed to be repaid and redrawn, it is the natural facility for a seasonal business or one with lumpy receivables.

Two practical points. First, lines of credit are commonly reviewed annually and can be reduced or withdrawn during a downturn, exactly when you need them, so do not treat a facility as permanent capital. Second, most lenders price on a benchmark rate plus a margin, which means your cost changes when rates do. Stress-test your cash flow at a rate two or three points higher before committing.

Asset finance and leasing

Equipment financing uses the asset as collateral, which usually means a lower rate than unsecured borrowing and a longer term matched to the asset's useful life. Leasing may preserve cash and keep the asset off the balance sheet, at a higher total cost over the full term.

Watch two things: whether the asset genuinely holds value if you must sell it, and whether maintenance and insurance obligations are clear. Specialised equipment is a poor asset to hand back, and lenders know it.

Factoring, and the effective rate trap

Factoring sells receivables at a discount for immediate cash. A 2% discount on invoices paid within 30 days does not sound like much, but it annualises to roughly 24% or more once fees are included. Merchant cash advances, which are repaid as a percentage of daily card sales, frequently work out higher still.

These products exist because banks often say no, and they can be the right call to fund a specific, profitable opportunity with a defined return. What they should never do is fund a business running at a loss. If the money is covering a shortfall rather than an opportunity, the shortfall remains, now with a financing cost attached.

Revenue-based financing

Revenue-based financing advances capital in exchange for a percentage of monthly revenue until a repayment cap is reached. Repayments flex with revenue, which makes it forgiving in a slow month and more expensive in a strong one.

The important detail is that repayments track revenue, not profit. A business with a 20% contribution margin repaying 8% of revenue is handing over 40% of its contribution margin each month. Useful for a business with predictable, high-margin recurring revenue; dangerous for a thin-margin one.

Equity: the most expensive money you will ever raise

Equity has no repayment obligation, which makes it the right instrument when the outcome is genuinely uncertain and large. It is also permanent. Investors who own 20% of the business own 20% of every future distribution, so the implied cost of equity is far higher than any interest rate, and the price is control as well as dilution.

Raise equity when there is a real need for speed and scale, or when there is no cash flow to service debt. Do not raise equity to avoid the discipline of a repayment schedule if the model is actually proven. Debt forces focus in a way that a healthy bank balance does not.

Supplier credit and customer prepayment: the cheapest capital

Two sources of financing sit inside your existing relationships and cost nothing.

• Negotiate supplier terms. Moving from payment on delivery to 30 or 45 days is an interest-free loan equal to your monthly purchasing volume.
• Take deposits and prepayments. Subscriptions paid annually in advance, deposits on projects and retainers all shift the working capital burden to the customer. For a business with validated demand, prepayment is the cheapest growth capital available.

Consider the trade-offs. The early payment discount formula tells you what a 2% ten-day discount is worth to you against paying at 30 days, which annualises to a substantial return. Declining such discounts to preserve cash can be a rational decision only if your alternative cost of cash is higher.

Before you borrow, answer four questions

• What exactly will this money do? A specific purchase with a measurable return, not "general working capital".
• What does the repayment do to monthly cash flow at the worst plausible revenue? If that is negative, the structure is too aggressive.
• What is the effective annual cost, including every fee? Ask for it in writing and compare it to your return on invested capital.
• What happens if the forecast is half right? Financing should leave room for being wrong, because you usually will be.

Financing is a tool for acceleration and timing. It is not a fix for weak unit economics or negative contribution margin, and the businesses that learn that distinction early are the ones that survive their own growth.