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Purchase order financing is a funding solution that helps businesses fulfill large customer orders without upfront capital. This financial option is particularly useful for businesses experiencing rapid growth or dealing with large, one-time orders.

Purchase order funding comes at a relatively high cost, however. Here’s what you need to know about this type of arrangement, how it works, its pros and cons, plus alternatives you might consider.

Purchase Order Financing Definition

Purchase order financing, also known as PO financing, is essentially a cash advance that a company can use to fulfill its purchase orders. With this type of financing, a lender will pay a third-party supplier up to 100% of the cost involved in producing and delivering goods to your customers.

You may qualify for PO financing even if you have a spotty credit history. Purchase order financing companies are typically willing to work with small businesses and startups with bad credit. These lenders tend to be mostly concerned about the creditworthiness of your customers, since the customers will be repaying much of the loan.

How Purchase Order Financing Works

To understand how purchase order funding works, here’s a step-by-step example.

1.   Let’s say you receive a large order from a customer but discover that you don’t have enough inventory on hand to fill it.

2.   After reaching out to your supplier, you determine that you don’t have enough available cash to purchase the goods you’d need to fulfill the order, either.

3.   Rather than turn your customer away, you reach out to a purchase order finance company.

4.   As part of your application for funding, you send the lender your purchase order as well as your supplier’s estimate.

5.   If the lender approves you for PO financing, they will then pay your supplier most or all of the invoiced amount. If, for example, the lender approves you for just 90% of the supplier’s costs, you would need to cover the remaining 10% on your own.

6.   The supplier then fills the order and sends the product to your customer.

7.   Next, you invoice your customer, who sends payment directly to the lender.

8.   The lender then deducts their fees and sends you the balance.

Who Uses Purchase Order Financing?

You might consider PO financing if your business needs to buy goods or supplies from a third party, but you don’t have enough cash reserves to make those purchases or strong enough credit for a traditional small business loan.

Types of companies that may use PO financing include:

•  Startups

•  Business owners with low credit scores

•  Wholesalers

•  Distributors

•  Resellers

•  Importers/exporters of finished goods

•  Outsourcers

•  Government contractors who are fulfilling government orders

•  Companies with seasonal sales

Pros and Cons of Purchase Order Financing

As with all methods of funding a small business, there are advantages and disadvantages to purchase order finance. Here’s a look at how the pros and cons stack up.

Pros

•  Enables you to take customer orders you otherwise could not fulfill. Purchase order financing allows you to serve customers despite seasonal dips in cash flow and/or take on an unusually large order from a customer.

•  Can be easier to get than other types of business loans. While PO financing companies will look at your business’s financials and credit history, they are typically more interested in the creditworthiness of your customers and the reputation of your supplier. As a result, it can be easier for startups and businesses with less-than-stellar credit to qualify for PO financing compared with other types of business funding.

•  You don’t need to make regular loan payments. Since PO financing is more of a cash advance than a loan (similar to invoice financing), you won’t need to pay the money back in regular installments like you would with an ordinary business loan.

Cons

•   Can be costly. PO financing fees may seem relatively low at first glance, often ranging between 1% and 6% of the total supplier’s costs per month. But when that rate is converted into an annual percentage rate (APR), purchase order loan rates are actually fairly high, potentially 20% or significantly more.

•   Final cost depends on your customer. Since fees are charged per month, how much you will end up owing the PO financing company will depend on how long it takes your customer to pay their invoice. This can make it difficult to estimate the total cost upfront.

•   You’re cut out of the process. With this type of financing, the lender and supplier often take over most of what you normally do. In many cases, the lender will pay the supplier, the supplier will ship the product to the customer, and the customer will pay the lender. As a result, you won’t have the usual amount of quality control.

Recommended: 5 Crowdfunding Sites to Help Fund Your Business

Key Considerations Before Choosing PO Financing

When beginning to shop for financing companies, remember that some lenders focus on specific industries. Zeroing in on specialists can help you find a purchase order loan provider that truly understands your business.

Costs and Fees

PO financing providers generally charge fees, interest, or discount rates on a transaction. Business owners should get all those details upfront to figure out whether the revenue margin is large enough to make up for the financing fees.

For context, it may be worth also comparing costs, terms, and approval requirements for PO financing vs. standard small business loan fees.

Supplier and Customer Reliability

It’s prudent for businesses considering PO financing to do their due diligence on their suppliers, customers, and funding company. It’s an even better idea if suppliers and/or customers are based overseas, since commercial regulations can vary widely between countries.

Applying for Purchase Order Financing

Purchase order financing is primarily offered by online financing companies. Some banks offer PO financing, but typically only to large companies or existing clients.

To qualify for PO financing, you usually need to:

•   Have a purchase order of $50,000 or more

•   Sell finished goods (not parts or raw materials) that you don’t make yourself

•   Sell to business-to-business (B2B) or business-to-government (B2G) customers

•   Have profit margins of at least 20%

•   Have creditworthy customers (some lenders will conduct a detailed credit check on your customers)

•   Have reputable and trustworthy suppliers

If you meet the basic criteria for PO financing and want to apply, you’ll typically need to have the following documents:

•   The customer’s PO

•   Your supplier’s invoice

•   Your invoice to your customer

•   Your purchase order to your supplier

•   Information about your business

•   Financial statements (such as your balance sheet, income statement, and cash flow statement)

•   Tax returns

Recommended: What Is EBITDA?

Alternatives to Purchase Order Financing

If PO financing doesn’t sound like the right financing solution for your business, you’re not necessarily out of luck. There are a number of other small business financing options that can smooth out dips in cash flow and help you grow your business. Here are some to consider.

Invoice Factoring

Invoice factoring is a type of invoice financing that involves “selling” some or all of your company’s outstanding invoices to a third party, called an invoice factoring company. The factoring company will typically pay you 80% to 90% of the invoice amounts, then collect payment directly from your customers. Once the factoring company gets paid by your customers, the company will pay you the remaining invoice amount — minus any fees.

Small Business Loans

With a traditional term business loan, you receive a lump sum of capital upfront and then pay it back (plus interest) in regular installments over a set term. While banks typically have strict criteria for business loans, online business lenders tend to have more flexible qualification requirements and are faster to fund. A short-term business loan from an online lender can help solve a short-term cash crisis, but rates and terms are generally higher than bank loans.

Merchant Cash Advances

A merchant cash advance (MCA) might be an option if you do business using credit card transactions. With an MCA, you get a cash advance in exchange for a fixed percentage of future credit card receipts. Typically, the MCA provider automatically deducts a daily (or weekly) percentage of your debit and credit card sales until the advance, plus fees, is repaid in full. While an MCA can be a quick source of cash, overall it’s one of the most expensive ways to finance a small business.

Business Lines of Credit

You can also use a business line of credit for short-term financing. Similar to how a credit card works, a line of credit allows you to draw up to a certain limit and only pay interest on the money you borrow. You then repay the funds and can continue to draw on the line. A business line of credit can be used for a variety of immediate needs, such as managing cash flow, buying inventory, or paying employees.

Recommended: Bad Credit Business Loans

The Takeaway

Purchase order financing allows a business to fulfill customer purchases when its cash flow is insufficient. It’s a type of cash advance — similar in some ways to accounts receivable financing — in which a financing company covers supplier costs on the business’s behalf and collects money directly from the customer. The funding company then deducts fees and pays the leftover balance to the business.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

Is PO financing a loan?

Purchase order financing is not a traditional loan, as it doesn’t provide you with a lump sum of capital that you then pay back in installments. Instead, it’s considered a cash advance.

What documents are required for purchase order financing?

To apply for purchase order financing, you’ll need to provide a number of documents. These may include the customer’s purchase order, your supplier’s invoice, information about your business, financial statements (such as your balance sheet, income statement, and cash flow statement), and personal and business tax returns.

Can purchase orders be used as collateral?

Yes, purchase orders can be used as collateral in purchase order financing. Lenders consider the purchase order as a guarantee of future payment from a customer, advancing funds to cover supplier costs. The order itself serves as security, ensuring repayment once the customer fulfills their payment obligations.

What is the difference between purchasing order financing and invoice financing?

Purchase order financing funds suppliers upfront to fulfill customer orders, covering the cost of goods before they’re sold. Invoice financing, on the other hand, provides cash advances based on unpaid customer invoices, helping businesses access cash after a sale is made but before the customer pays the invoice.

What types of businesses benefit most from purchase order financing?

Product-based businesses such as importers, wholesalers, distributors, and manufacturers can all benefit from PO financing. This method of funding can help companies settle up with suppliers sooner, since they don’t have to wait on customer payments. Seasonal businesses, too, may be able to streamline their inventory management using this approach.

Photo credit: iStock/Kerkez

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

SOSMB-Q325-036

If you own a small business that frequently issues invoices to customers and vendors, you may have encountered times when an invoice is late or goes unpaid. It can be frustrating and worrisome when expected income is unavailable, leaving your business short on cash flow for necessary expenses.

There are options like business lines of credit or short-term business loans to provide cash flow. But in this case, you might also consider factoring your invoices to quickly access cash for your immediate needs. This type of financing allows you to leverage your unpaid invoices without applying for an actual loan.

Let’s walk through what invoice factoring is, how it works, and what business cases are a good fit for this type of funding.

Invoice Factoring Explained

Invoice factoring, also known as accounts receivable factoring, is a form of small business financing in which you sell your unpaid invoices to a factoring company. The factoring company gives you a percentage of the invoice value up front and pays you the balance once it’s paid by the customer (minus fees charged by the factoring company).

When financing through invoice factoring, you no longer own the invoices — the factoring company does. As a result, it’s important to choose a reputable company that you can trust to treat your customers with respect.

Recommended: What Is Debt Factoring?

How Does Invoice Factoring Work?

Invoice factoring involves selling your unpaid invoices to a factoring company, which then takes ownership of the invoices. Invoice factoring is technically not a small business loan; instead, you are selling something of value (a share of your accounts receivable) to the company.

Factoring companies will pay you a percentage of the invoice amount up front, which reflects the advance rate. Advance rates are typically based on how risky the transaction is for the factoring company.

Some industries, such as the medical industry, may be seen as higher risk, thus leading to lower advance rates — often ranging from 60% to 80%. Other types of businesses, such as staffing agencies, may receive advance rates of 80% to 90% or even higher.

Once the factoring company receives full payment from your customers, they provide you with the remaining invoice amount minus a factoring fee.

Here’s a quick look at the steps involved in factoring invoices:

1.   Choose a factoring company: It’s a good idea to shop around and pick a reputable company to work with.

2.   Submit invoices: To apply for factoring, you’ll need to provide invoices for approval.

3.   Receive advance: If approved, you’ll get an upfront payment (typically 60% to 90% of invoice value).

4.   Company collects payments: The factoring company collects payments from your customers.

5.   Receive balance: After payments are collected, you receive the remaining amount minus fees.

Recommended: Getting a Cash Flow Loan for Your Small Business

Recourse vs. Non-Recourse Factoring

You might be wondering: What happens if customers don’t pay their invoices?

With recourse factoring, the business is liable for paying the factoring company for any invoices that are left unpaid. This type of invoice factoring is most common because it’s less risky for the factoring companies.

With non-recourse factoring, the factoring company takes on most of the risk associated with unpaid invoices. Since non-recourse factoring causes the company to assume more risk, it may tack on a higher factoring rate or fee. Carefully consider whether the cash advance amount is worth the higher rate and compare factoring companies to see what terms they offer.

The Role of the Customer in Invoice Factoring

The factoring company takes on the task of collecting receivables from customers. That’s why the company looks at your customers’ creditworthiness more closely than yours: Your customers are the ones responsible for repaying the debt. If your customers’ ability to pay isn’t perceived as rock-solid, the factoring company may proffer less upfront cash on those invoices.

When to Consider Invoice Factoring for Your Business

Small businesses that need cash flow right away may benefit from invoice factoring. This is especially true for small companies that may not qualify for loans or may want to keep debt levels lower. Compared to a loan application, factoring invoices involves less paperwork and an easier approval process. There’s also no need for collateral.

Cash Flow Challenges

For small businesses with narrow margins, cash flow problems can loom large. Payroll and overhead aren’t cheap, and planning can be especially challenging for seasonal businesses. If you need to fend off a cash crunch, invoice factoring can often deliver 80% to 90% of the receivables’ value to your account within 24 to 48 hours.

Slow-Paying Customers

Some customers and/or certain industries can take longer to pay outstanding invoices. This may be a reason to offload those collections to a factoring company. At the same time, factoring companies are likely to offer lower advance rates for the invoices of slow-to-pay clients.

For example, transportation companies and staffing agencies pay reliably; their advances typically hover around 90%. Construction subcontractors may be offered around 75% for their invoices. Delays from insurance companies are common, so advance rates on health care–related invoices may dip as low as 65%.

Example of Invoice Factoring

To give you a better understanding of how invoice factoring works, let’s imagine you own a clothing store that sells large quantities of T-shirts to other companies.

1.   Complete sale and issue invoice: You sell $100,000 worth of T-shirts and invoice your customer with a due date in 60 days. If you wait 60 days for repayment, your business could face a cash flow shortage, threatening the well-being of your operation. So, you decide to look into options to help manage cash flow.

2.   Explore your options: You could use an online business loan or a credit card to get cash quickly. Because your customers are reliable and pay invoices in a timely manner, invoice factoring is also a suitable option.

3.   Sell to a factoring company: You sell the $100,000 invoice to a factoring company and agree to pay a factoring fee (sometimes called a factoring rate) of 5% of the invoice value per month. This is the factoring company’s compensation for handling the account receivable. Within 24 hours, the factoring company provides you with 80% of the invoice amount. You now have $80,000 to supplement cash flow and regular business operations.

80% of $100,000 = $80,000

4.   Collection of funds: The customer pays the factoring company within 30 days. Once it receives full repayment, the factoring company pays you the remaining invoice amount ($20,000) minus the factoring fee of 5%.

$20,000 – $5,000 (5% of $100,000) = $15,000 back to you

Keep in mind that this is a hypothetical example to illustrate how invoice factoring may work in a practical situation. Different invoice factoring services may offer various terms and conditions, which can affect how much money you receive up front and the final payment amount.

Invoice Factoring Rates and Fees

Invoice factoring companies generally make money through the factoring rates and fees they charge. Typically, you will see invoice factoring structured with one of the following:

•  Flat rate/fee: You pay a fixed percentage of the invoice to the factoring company. The rate doesn’t usually change — even if the customer pays late. Flat rates are generally less common than tiered or variable rates.

•  Tiered or variable rate/fee: A percentage of the invoice amount is regularly charged until the factoring company receives full repayment. The longer invoices go unpaid, the more you’ll owe in factoring fees.

For example, a factoring company may charge a factoring fee of 1% every 10 days until the invoice is paid; if it takes your customer 60 days to pay, the factoring company would keep roughly 6% of the invoice amount. Some factoring companies may increase the variable rate when the repayment takes longer.

Factoring rates and fees can be affected by:

•  The industry your business is in

•  Your customers’ ability to pay their invoices

•  The number and amounts of the invoices

•  Your business’s stability and creditworthiness

Additional Fees

Some factoring companies may also charge additional fees, including:

•  Application fees. These are charges for processing your application and setting up the account.

•  Invoice processing fees. These fees help cover the cost of things like credit checks and record keeping.

•  Service fees. These are charged in intervals to cover costs related to maintaining a current account with your factoring company.

•  Automated Clearing House (ACH) or bank wire fees. When funds are transferred between banks, there may be fees passed on to you from the factoring company.

•  Early termination fees. Some invoice factoring companies may charge a fee if you cancel your contract before the termination date.

•  Due diligence fees. This covers the cost of verifying the creditworthiness of the customers paying the invoices.

Pros and Cons of Small Business Invoice Factoring

Invoice factoring can be a useful tool for business owners in certain situations. However, it’s important to carefully consider the pros and cons of factoring invoices to avoid unnecessary expenses or added stress for your business.

Pros of Invoice Factoring

•  No collateral: With invoice factoring, your invoices serve in lieu of collateral. In most cases, you do not have to offer additional forms of collateral to be approved.

•  Maintain healthy cash flow: You can receive immediate cash to cover expenses and maintain healthy cash flow for your business between invoice payments.

•  An option for those with lower credit scores: Even if you don’t have good enough credit to get a business loan, invoice factoring may still be an option. Invoice factoring companies generally focus more on the value of the invoices and the credit scores of the businesses that owe those invoices than on the credit score of your business.

•  Outsource invoice collection: For some businesses, it may be helpful to pass the responsibility of collecting invoices to a factoring company so the business staff can focus on other responsibilities.

•  Spend on what you need: Unlike other types of small business loans (e.g., equipment financing), you aren’t restricted to spending the funds you receive on specific business expenses.

Cons of Invoice Factoring

•  Factoring companies have control: After you sell invoices to a factoring company, they may interact with your customers directly. You’ll want to make sure that the company is reputable and behaves ethically in their dealings with customers.

•  It’s typically expensive: With various fees and relatively high rates, invoice factoring can be costly — especially if customers delay payment.

•  Recourse if unpaid: Since there’s no guarantee that an invoice factoring company will be able to collect on all your invoices, the company may expect you to buy back the unpaid invoice or replace it with one of equal value. Additional fees may apply.

•  Approval may depend on customers: Invoice factoring companies want to ensure they will receive payment on the invoices they purchase from you. If your customers have a less-than-perfect repayment history, you may have a more difficult time getting approved.

Recommended: Accounts Payable vs Receivable: How They Compare

How Do Businesses Qualify for Invoice Factoring?

Factoring companies evaluate a few different things to determine if a business is eligible for this type of financing.

•  Invoices: Businesses must have outstanding invoices to sell to a factoring company, and the invoices should be from reputable clients with a history of timely payments.

•  Client creditworthiness: Factoring companies focus on the likelihood of timely payments from your clients rather than the credit history of your business. Therefore, clients that consistently pay their invoices on time are a must.

•  Business bank account: An established business bank account is essential to qualify for invoice factoring. Your business bank account will be used for the factoring company to deposit the advance and the remaining balance once the invoice is paid.

•  Accounts receivable reports: Detailed and accurate accounts receivable reports are necessary to demonstrate your business’s invoicing practices and the payment behavior of your clients. These reports help factoring companies assess the risk involved.

While the primary focus is on the creditworthiness of clients, factoring companies also look for signs of business stability. They consider factors like time in business, industry, and overall financial health. It’s also important for businesses to ensure there are no existing liens on their receivables. Factoring companies need a clear right to collect on the invoices, so any existing liens or claims can disqualify the business.

You can improve your chances of qualifying by maintaining good relationships with your clients, ensuring they are creditworthy and have good payment histories. Keeping financial records organized and accurate is also important, as it makes the evaluation process smoother and faster.

What Is a Factoring Company?

A factoring company is a financial institution that purchases a business’s outstanding invoices at a discount to provide immediate cash flow. The factoring company then takes on the responsibility of collecting payments from the business’s customers.

Factoring companies can be independent firms or divisions within larger financial institutions such as banks or credit unions. They specialize in providing working capital to businesses with long receivables cycles or that need quick cash for operational expenses. By selling your invoices to a factoring company, you can receive up to 90% of the invoice value up front. The company pays you the remaining balance, minus a factoring fee, once the customer settles the invoice.

Factoring companies typically cater to industries with extended payment terms, such as manufacturing, trucking, and staffing agencies. These lenders evaluate the creditworthiness of the business’s customers rather than the business itself, making this an accessible funding option for businesses that have poor or limited credit.

Invoice Factoring vs. Invoice Financing

While they sound similar, invoice factoring and invoice financing are two different financial products.

With invoice financing, your invoices are used as collateral to receive a cash advance rather than sold to a factoring company. You receive access to a percentage of the invoice amount either in the form of a line of credit or loan. Like other types of business loans, you pay interest on the amount you borrow.

Another key difference between invoice factoring and invoice financing: With invoice financing, you and your business are still responsible for collecting payment from your customers. As a result, invoice financing allows you to retain control over your invoices and the collections processes. This may be preferable if you’d rather deal with your customers directly.

Alternatives to Invoice Factoring

Invoice factoring is one of many options that can help businesses maintain cash flow and address funding needs. Here’s a look at some alternatives.

•   Inventory financing: This type of financing is used to pay for products that will be sold at some time in the future. The inventory acts as collateral for the loan.

•   Equipment financing: This is a type of loan used specifically to buy machinery, vehicles, or other business-related equipment. Here too, the purchased items act as loan collateral.

•   SBA loans: These are small business loans backed by the U.S. Small Business Administration (SBA) and offered by banks and approved SBA lenders.

•   Personal loans: An unsecured personal loan is based on your personal credit history (not business credit). Some, though not all, lenders will allow you to use funds from a personal loan for business expenses.

•   Commercial real estate loans: This type of business loan is specifically designed for purchasing real estate for business use, such as an office space, warehouse, or storefront.

•   Business line of credit: With this flexible form of business financing, you have access to a maximum amount of funding, or credit. You can borrow what you need (up to your credit limit) as you need it, and only pay interest on the amount you borrow.

•   Online business loans: Online lenders offer loan options similar to those from traditional banks but typically have a faster approval process and may have more options for people with lower credit scores.

•   Merchant cash advance: This type of funding allows small businesses (“merchants”) to get a cash advance for business expenses in return for a portion of their future sales or receivables.

The Takeaway

Invoice factoring is a method of financing in which a company gives you cash upfront in exchange for a percentage of your accounts receivable. The factoring company then contacts your customers to collect on unpaid invoices and keeps a small percentage as a fee. It’s a way for business owners to leverage the value of unpaid invoices without applying for a loan or committing to a repayment schedule.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

What are the disadvantages of invoice factoring?

The disadvantages of invoice factoring include high fees, potential impact on customer relationships, loss of control over accounts receivable, and the requirement of having creditworthy clients.

What is the average rate for invoice factoring?

The average rate for invoice factoring ranges from 1% to 5% of the invoice value per month.

Who can use invoice factoring?

Generally, any business with outstanding invoices and creditworthy clients can use invoice factoring. However, this type of financing tends to be more common in industries like manufacturing, trucking, and staffing.

Is invoice factoring considered a loan?

Invoice factoring is not a loan because it does not involve taking on additional debt. This makes factoring a reasonable option for small businesses that want cash immediately but may not qualify for loans or want to increase their debt load.

How quickly can a business get funds through invoice factoring?

Invoice factoring can often deliver 80% to 90% of the receivables’ value to a business bank account within 24 to 48 hours.

Photo credit: iStock/Jirapong

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

SOSMB-Q325-034

When choosing a business structure, you may wonder whether you should form a limited liability company (LLC) or a sole proprietorship. Each has its benefits and drawbacks; the main differences between LLCs and sole proprietorships are in how they are set up and how your personal assets are implicated.

Your specific business needs will determine which works best for you. Learn the details here.

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Key Differences Between an LLC and a Sole Proprietorship

When considering an LLC versus sole proprietorship structure, the most significant differences come down to two things: the setup requirements for each kind of business and the treatment of your personal assets in each structure.

Basically, you don’t have to do anything to set your business up as a sole proprietorship. However, if you want to form an LLC, you must file paperwork, pay a fee, and wait for your state’s Secretary of State to approve your business as an LLC.

As for your personal assets, with a sole proprietorship, they may be claimed to pay business debt. But if you have an LLC, you and the business are considered separate entities, so your personal assets are separate.

💡 Recommended: What Is a PLLC?

Key Comparison Factors

When comparing sole proprietorships vs. LLCs, key factors include:

Liability protection

LLCs limit liability, safeguarding personal assets. Sole proprietors are fully, personally liable for business debts.

Taxation

Both LLCs and sole proprietorships allow pass-through taxation. LLCs have a bit more flexibility, though: They can opt for S-corp (pass-through) or C-corp (corporate) taxation.

Business formation process

Sole proprietorships give owners full control, meaning they have more operational and financial flexibility than LLCs. This business type also involves less administrative paperwork and minimal costs.

LLCs have more legal and administrative requirements; as a result, setup and maintenance costs tend to be higher. At the state level, an LLC is generally expected to maintain a registered agent, file articles of organization, and submit annual (or biennial) reports.

💡 Recommended: Types of Businesses Explained

What Is a Sole Proprietorship?

When you start a business, you can elect a specific business structure, meaning that you formally register it with your state’s Secretary of State and pay a fee. If you don’t do that, your business is automatically considered a sole proprietorship (or a partnership if you have partners).

In a sole proprietorship, you and the business are considered one entity. You file only your personal taxes, and you claim both business income and expenses on them.

Definition and Basic Characteristics of Sole Proprietorships

A sole proprietorship is a business owned and operated by a single individual. It’s the simplest business structure, with no legal separation between the owner and business.

Basic characteristics of a sole proprietorship include:

•   Single ownership: The company is owned and operated by one individual, with no separate business entity.

•   Unlimited liability: The owner is personally responsible for all debts and liabilities of the business.

•   Direct taxation: Business income and expenses are reported on the owner’s personal tax return (Schedule C).

•   Simple setup: Minimal paperwork and low startup costs, with few legal requirements.

•   Full control: The owner has complete decision-making authority over the business operations.

•   No business continuity: The business dissolves if the owner exits, retires, or passes away.

Recommended: Advantages and Disadvantages of Sole Proprietorship

Advantages of a Sole Proprietorship

When it comes to the benefits of a sole proprietorship vs. an LLC, the biggest advantage is the ease of creation. Your business is a sole proprietorship simply by default.

Taxes are also simple, since you file only your personal income taxes and don’t have to file taxes separately for the business.

There are no fees required to be a sole proprietor, either.

Recommended: Small Business Loans for Sole Proprietors

Disadvantages of a Sole Proprietorship

There are, however, some drawbacks to sole proprietorship to consider.

First, because there is no delineation between you and your business, your personal assets could potentially be seized should the business have debts or legal fees that it can’t cover. That could jeopardize not only your business, but also your personal life if, for example, your home or vehicle is taken to cover business debts.

You may have difficulty if you try to get a small business loan through a bank or attract an investor when you are a sole proprietor. You could also struggle to sell your business if you haven’t elected a business structure like an LLC or corporation. Because the LLC is separate from its owner, it may be more appealing to lenders, investors, and potential buyers due to the limited risk.

If you have a sole proprietorship but don’t want to do business under your own name, you’ll usually have to file your DBA (Doing Business As) name. Let’s say your name is Jane Doe but you want your company to be called Dr. Knowhow’s Resume Writing Service. That’s fine, but it will generally require extra paperwork to file that DBA name. The filing fee can cost between $10 and $150, depending on your state and county.

When a Sole Proprietorship Makes Sense

Sole proprietorship is a simple business structure that can be cost-effective for entrepreneurs just starting out. This is especially true for low-risk businesses like consulting or design, where personal liability is less of a concern.

Because sole proprietorship status is automatic, it’s easy to sustain, with no required administrative paperwork. This allows the new business owner to focus on the needs of the business without worrying about submitting reports to state officials.

Recommended: How Much Does It Cost to Start a Business?

What Is an LLC?

LLC stands for limited liability company. To use this business structure, you must elect and apply for it. If a company is an LLC, it’s separate from the business owner (or owners, if there are multiple owners), meaning that the owner or owners aren’t held personally responsible for the business’ liabilities.

Here, a look at the pros and cons of LLCs.

Advantages of an LLC

When it comes to an LLC, your personal assets can’t be taken to cover business debts. You have, as the name indicates, limited liability.

In contrast to another business structure, the corporation, the LLC requires less paperwork to set up and maintain, since a corporation requires annual meetings and annual reports.

LLCs can choose how they’re taxed. They can take advantage of what’s referred to as pass-through taxation, in which the business doesn’t file and pay its own taxes. Instead, its income and expenses are passed through to the owners’ personal tax returns. This equates to the LLC being taxed like a sole proprietor, and may mean it can be referred to as a “disregarded entity.”

Alternately, an LLC can also be taxed like a corporation at a lower corporate rate for the first $75,000.

Another benefit is that an LLC has no limit on the number of members (or shareholders) it can have. An S corporation, by way of comparison, is limited to no more than 100 shareholders.

And finally, you may find it easier to qualify for financing or to sell your business if it’s an LLC.

Recommended: How To Form an LLC in Georgia

Disadvantages of an LLC

So what are the drawbacks of an LLC? First off, to start a limited liability company, you have to apply with your state’s Secretary of State department, which may require a fee and take time for the paperwork to be processed. Where required, filing fees range from $35 to $500.

You may also have to pay an annual or biennial fee to keep your LLC in good standing. As of 2025, those fees (in states that charge them) range from $7 in Pennsylvania to $500 in Massachusetts.

Additionally, you may have to pay unemployment insurance for yourself and any partners, although you wouldn’t have to do so for a sole proprietorship. Costs for unemployment insurance vary by state.

When an LLC Is the Better Choice

An LLC might be the right choice if personal liability protection is an important consideration. Does your business involve meaningful risk? This might mean the physical work of manufacturing or the handling of valuable assets in a retail setting. If this is a concern, you may want to safeguard your personal assets through an LLC.

Also, if your business plan calls for adding partners, setting up operations in multiple states, or expanding in some other way, an LLC (and operating agreement) may be the best way to keep things running smoothly.

Recommended: How to Calculate Cash Flow

How to File an LLC

To file an LLC, start by reviewing the requirements set out by your state’s Secretary of State. Each state has a slightly different process. Some let you apply online, while others may require you to mail in your application.

You will likely be required to file articles of organization, which is a document outlining information about your business and its members. You may also be required to file other forms as well as pay a filing fee, which may range from $35 to $500. Some states may require you to have certain business licenses or permits to qualify as an LLC, too.

Recommended: How To Form an LLC in New Jersey

Working With a Registered Agent

If you think the process of setting up an LLC yourself sounds overwhelming, you have another option. You can employ the services of a registered agent. This is an individual or company who can set up your business structure on your behalf, as well as ensure that you keep up with annual fees and paperwork deadlines. Registered agents charge a fee for their services.

How to Choose a Business Structure for Your Company

When it comes to choosing a business structure for your company, consider how much effort you’re willing to put into setting up your business structure and the fees you’re willing to pay. An LLC does require some effort to prepare, and it may require an annual fee and/or paperwork to be filed.

You may also want to factor in how likely it is that your business might ever be sued. If you run a writing business out of your home, that risk might be minimal. But if you have a fitness training business, you might incur more risk of being sued, if, for example, a customer is injured during training.

Finally, think about how likely you are to want to get investors or some type of business loan. An LLC will likely be more appealing to potential investors or lenders than a sole proprietorship. And it may also be easier to sell an LLC.

Recommended: The Basics on How Umbrella Insurance Works

The Takeaway

When you’re looking at a sole proprietorship vs. an LLC, the most important thing is to carefully consider which will provide the biggest benefit to your business. How you file and pay taxes, whether you separate your personal assets from the business’s assets, and whether you’re willing to go through the process and paperwork of setting up and maintaining a legal business structure should weigh into your decision.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

Can an LLC be a sole proprietorship?

No, an LLC cannot be a sole proprietorship. While a single-member LLC allows one person to own the business, it is legally distinct, providing liability protection not offered by a sole proprietorship. A sole proprietorship is an unincorporated business without separate legal status from its owner.

What are the tax filing differences for LLCs versus sole proprietorships?

A sole proprietorship reports taxes on the owner’s personal tax return via Schedule C of Form 1040. A single-member LLC does the same, but multi-member LLCs must file Form 1065 as a partnership or elect corporate taxation. LLCs offer flexibility to choose between pass-through or corporate tax structures.

Can I change my business structure later?

Yes, you can change your business structure later. Many businesses start as sole proprietorships or partnerships and later transition to LLCs or corporations as they grow. Changing structures involves registering with the state, updating licenses, and notifying the IRS, often for tax benefits, liability protection, or funding opportunities.

Which is better for small businesses, single-member LLC or sole proprietorship?

There is no one-size-fits-all answer to this question. Consider the needs of your business. Entrepreneurs getting their feet wet may find a sole proprietorship to be easier and more cost-effective. A fast-growing company that might need to demonstrate to lenders its stability and active management could be better suited to an LLC.

Does forming an LLC protect personal assets?

Yes, “LLC” stands for limited liability company. This means the owners’ (members’) liability for the business’s debts and lawsuits cannot exceed the amount they have invested in the company, so personal assets such as homes and cars are protected.

Photo Credit: iStock/SolStock

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

SOSMB-Q325-030

Unearned revenue is revenue received from a customer before goods or services have been provided. These advance payments can improve your small business’s cash flow, since your company now has money to use to produce the requested products or perform the required services. However, in order to make the most out of this type of income, it’s important to understand how unearned revenue impacts your company’s books.

Here’s a closer look at what unearned revenue is and how to handle this type of transaction in small business accounting.

Recommended: Pro Forma Income Statements: A Complete Guide

Unearned Revenue, Defined

Simply defined, unearned revenue (also called unearned income) is a prepayment for goods and services your business yet to provide to the customer. This type of revenue provides a business with working capital it can use to fund operations and produce the promised goods or provide the promised services.

Unearned income is typically used in accrual accounting, which is an accounting method in which revenue or expenses are recorded when a transaction occurs as opposed to when payment is received or made. Unearned revenue is not a debit or credit; instead, it’s recorded as a liability (money the business owes) on the business’s balance sheet. The actual revenue is only recognized after the product or service has been delivered. At that time, an adjusting entry needs to be made.

Recommended: How to Pay Employees as a Small Business

How Unearned Revenue Works

Businesses can benefit from unearned income because customers pay in advance to receive their products or services. This injection of cash can then be invested into the business. For example, a company might use prepayments to purchase more inventory or pay off a small business loan.

White the positive cash flow is nice, it’s important for business owners to remember that unearned income is considered a liability in small business accounting, rather than a revenue. It’s a liability because it’s essentially a debt the company owes the customer. In order to turn unearned revenue into actual revenue, the business must deliver the goods or service to the customer.

Is Unearned Revenue an Asset?

Unearned revenue is not an asset. Revenue becomes an asset once the company has earned it by delivering goods or services. Until then, the revenue is unearned, and it represents an obligation that the business has yet to fulfill.

Is Unearned Revenue a Current Liability?

Unearned revenue is an obligation that the business has yet to fulfill, which makes it a liability. The business has not yet carried out its half of the transaction (providing the merchandise or service that the customer has paid for), so it can’t recognize the payment as actual revenue.

Why Unearned Revenue Matters in Business Accounting

Properly accounting for unearned revenue ensures your business maintains financial accuracy and regulatory compliance. Understanding how unearned revenue shows up in your accounts and how it changes over time can yield insights into performance and emerging opportunities.

Impact on Financial Statements

When you read financial statements in detail, you can see where unearned revenue affects a business’s balance sheet, income statement and cash flow statement. On the balance sheet, unearned revenue increases the company’s current liabilities.

The payment for the purchase appears as operating cash flow on the cash flow statement. Once the business delivers the product or service, the money becomes earned income and is entered on the income statement.

Types of Unearned Revenue

Businesses that have unearned revenue often sell subscription-based products or other services that require advanced payments. Common types of unearned income include:

•   Service contract paid in advance

•   Legal retainer paid in advance

•   Prepaid insurance

•   Advance rent payments

•   Annual newspaper or magazine subscription

•   Annual software subscription

•   Airline tickets

Criteria of Unearned Revenue

The Securities and Exchange Commission (SEC) has established several financial reporting criteria, based on generally accepted accounting principles (GAAP), that public companies must follow in order to recognize revenue.

For unearned revenue to become earned revenue on the income statement, there must be:

•  Evidence of an agreement between the business and the customer

•  Completion of delivery of goods or services

•  A predetermined price

•  Collection probability

Recommended: Retained Earnings: Defined and Explained

Where Unearned Revenue Fits on a Balance Sheet

On a balance sheet, unearned revenue is not an asset; it’s a current liability because it is a debt until the goods or services are delivered to the customer who paid. Generally, it’s assumed that the product or service purchased will be delivered within a year, making it a current (or short-term) liability.

If, for any reason, the company is not able to deliver the goods or services, it would owe the customer the money paid, which is why it’s a debt or liability. If a business entered unearned revenue as an asset rather than a liability on the balance sheet, then its total profit would be overstated for that accounting period. In addition, the accounting period in which the revenue is actually earned will then be understated in terms of profit.

Once the product or service has been delivered, unearned revenue becomes revenue on the income statement.

Unearned Revenue Accounting

In keeping with double-entry bookkeeping, unearned revenue is always recorded in two accounts. It’s originally entered in the books as a debit to the cash account and as a credit to the unearned revenue account. The credit and debit are the same amount.

This journal entry reflects the fact that the business has an influx of cash but that cash has been earned on credit. It is a prepayment on goods to be delivered or services to be provided.

Once the business provides the goods or services, an adjusting entry is made. The unearned revenue account will be debited and the revenues account will be credited the same amount. This means that two journal entries are made for unearned revenue — one when the income is received and and one when the income is earned.

Recommended: Credit Memo vs Debit Memo Explained

Common Industries That Deal With Unearned Revenue

Any business may find itself with unearned income on the books, but some companies are more likely to deal with it on a regular basis. In fact, certain types of companies get most of their annual revenue from unearned income. Examples include subscription-based businesses and companies that offer prepaid service contracts.

Subscription-Based Businesses

Classic subscription businesses are very familiar; think daily newspapers, software licenses or paywalled websites. Amazon Prime and Netflix have thrived as subscription services. Customers pay a set amount at regular intervals (say, monthly) and then, for the upcoming month, have access to all benefits they’ve signed up for. As the paid-up period elapses, the unearned revenue from that month’s subscriptions is recognized as earned income.

Service Contracts and Prepaid Goods

Some businesses that rely on unearned revenue get it in the form of prepaid service contracts or retainers. Equipment maintenance contracts, legal retainers, seasonal lawn care agreements, and similar arrangements generate unearned service revenue when customers pay in advance. The customers can then claim the agreed-upon amount of goods or labor as needed. As the service or merchandise is delivered, the unearned revenue converts to earned income.

Deferred Revenue vs Unearned Revenue

Unearned revenue and deferred revenue are two different ways to describe the same thing — advance payments a company receives for products or services that are to be delivered or performed in the future. Since this revenue is a prepayment, it is not yet “earned.” It won’t be recorded as revenue on the income statement until the goods or services already paid for have been delivered to the customer. Deferred revenue is sometimes also called deferred income.

Example of Unearned Revenue

To illustrate how unearned income works in the business world, here’s an example:

Fictional company XYZ sells a movie streaming service that costs subscribers $60 up front for a full year of the service. When the customer pays $60, the owner of XYZ enters $60 as a debit to cash and $60 as a credit to unearned revenue. The full $60 would need to be recorded as unearned service revenue on the company’s balance sheet. As each month of the annual subscription goes by, the monthly portion of this total ($5) can be deducted and recorded as business revenue.

The Takeaway

Unearned revenue is money received by a company for a service or product that has yet to be provided or delivered. These advance payments are recorded on a company’s balance sheet as a liability because they represent a debt owed to the customer. Once the product or service is delivered, unearned revenue becomes earned revenue on the income statement.

Unearned revenue can benefit your small business because it boosts your company’s cash flow and gives it the cash needed to cover your operational expenses.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

Is unearned revenue a debit or credit?

When a business receives unearned revenue, it records the amount as a credit to its unearned revenue account and a debit to its cash account.

What is an example of unearned revenue?

An example of unearned revenue is when a business sells a subscription-based product or service that requires advanced payments. When the customer prepays for the product or service, that income is considered unearned income because the goods and services have not yet been delivered.

Where does unearned revenue go on a balance sheet?

On a balance sheet, unearned revenue is a current liability.

Is unearned revenue a liability or income?

Unearned revenue is a current liability because it represents an unfulfilled obligation to deliver a product or service to a customer who has already paid.

How is unearned revenue recorded in journal entries?

Pending delivery of your business’s merchandise or service, a journal entry for unearned revenue would appear as a credit to the unearned revenue account and as a debit to the cash account. After delivery, the unearned revenue account is debited and the revenue account is credited.

Photo credit: iStock/pixelfit

SoFi's marketplace is owned and operated by SoFi Lending Corp.
Advertising Disclosures: The preliminary options presented on this site are from lenders and providers that pay SoFi compensation for marketing their products and services. This affects whether a product or service is presented on this site. SoFi does not include all products and services in the market. All rates, terms, and conditions vary by provider. See SoFi Lending Corp. licensing information below.

This content is provided for informational and educational purposes only and should not be construed as financial advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

SOSMB-Q325-029

Debt financing is when you borrow money to finance your business and then pay it back to the lender (plus interest) over time. It differs from equity financing, which involves bringing in investors who provide financing in exchange for an ownership stake in your company.

Examples of debt financing include traditional bank loans, credit cards, government loans, lines of credit, and bond issues. Read on for a closer look at how debt financing works, its pros and cons, and how it compares to equity financing.

What Is Debt Financing?

Debt financing means you’re essentially borrowing money for your business from an external source. In exchange for the borrowed funds, you agree to pay back the principal, the interest, and possibly other fees (like an origination fee) by a future date.

The most common form of debt financing is a small business loan from a bank, credit union, or online lender. The definition of debt financing also includes bond issues. Used mostly by larger companies, a traditional bond certificate includes a principal value, a repayment term, and an interest rate. Individuals or companies that purchase the bond then become creditors by loaning money to your business.

How Businesses Leverage Debt Financing

Debt financing can be divided into two categories based on the type of loan you’re seeking: short-term or long-term.

Short-term Debt Financing

Short-term debt financing is usually used for day-to-day operational expenses, such as purchasing inventory or paying employee wages. These loans typically need to be paid off within a year, though some may extend a bit longer. Common types of short-term debt financing include short-term loans from banks or online lenders, business lines of credit, credit cards, and trade credit (accounts payable).

Short-term debt financing tends to be easier to qualify for than longer-term financing options, which can make them a good option for newer businesses and companies that lack strong credit. However, short-term business loans do tend to come with higher interest rates than other types of debt financing.

Long-term Debt Financing

Long-term debt financing is often used for large purchases (or capital investments) like equipment or real estate. You might also opt for long-term debt financing when expanding your business. Generally, the term to pay off these loans is a year or longer.

For large loan amounts, the longer payoff period can make the payments more affordable. These loans also tend to have lower interest rates than short-term financing. However, you generally need to be an established business with strong revenue in order to qualify for long-term debt financing.

Key Terms and Concepts

Important debt financing definitions include:

•   Principal: The borrowed amount

•   Interest rate: The cost of borrowing

•   Maturity: The repayment timeline

•   Secured loans: Loans that require collateral

•   Unsecured loans: Loans that do not require collateral

•   Debt covenants: Conditions lenders impose to mitigate risk

Effective management of these elements ensures sustainable borrowing and financial health.

How Repayment Schedules Work

A repayment schedule lays out how and when a borrower will pay back a fixed-rate loan over a given period, or term. Business loans are commonly amortizing loans. This form of debt financing means that, with a series of uniform installment payments over the life of the loan, the borrower gradually pays down both the principal and interest — but not at the same pace.

Early on, while most of the principal is still outstanding, a large share of the borrower’s monthly payment is applied to interest. As the principal diminishes little by little, less interest is charged, allowing a larger share of each payment to go toward paying down the principal. The proportion of principal vs. interest will change with each payment.

To show the progress of the repayment, an amortization schedule (usually in table form) sets out:

•   The total number of payments you’ll make on the loan

•   The beginning loan balance for the month

•   The ending loan balance for the month after your payment is applied

•   How much of the payment goes toward interest

•   How much of the payment goes toward fees, if applicable

•   How much of the payment goes toward the loan principal

There are other models of repayment schedules, too. Examples include balloon loans (where most or all of the principal is due in a lump sum at the end of the term) and variable-rate loans.

6 Types of Debt Financing

There are many types of small business loans. Here are some options you may want to consider.

1. Traditional Loans

With a traditional term loan from a bank or credit union, you receive a lump sum of capital up front then repay it (plus interest) in monthly installments over time. Long-term business loans allow you to borrow large amounts for bigger capital projects but tend to come with strict requirements, like a minimum amount of time in business, proof of revenue, and a strong credit history. It can take several weeks (or more) to get your application approved and receive the proceeds of the loan.

2. Online Loans

Online business loans tend to have more flexible qualification requirements and are typically faster to fund than bank loans. This can make them a good option for companies that can’t qualify for a traditional bank loan or need access to funds quickly. Some online business lenders will work with startups or businesses with bad credit.

Applications are typically vetted almost instantaneously and, if approved, you could get a same-day business loan. However, these loan products tend to come with higher interest rates than other types of business loans. If you’re considering an online loan, it can be a good idea to shop around and compare interest rates to make sure you’re getting the best possible deal.

Recommended: What Is Seed Funding?

3. SBA Loans

The Small Business Administration (SBA) guarantees these loans, which are offered by banks and other lenders. Since they’re backed by the government (reducing risk to the lender), SBA loans tend to come with low rates, large loan amounts, and long repayment terms. For the SBA 7(a) loan, for example, you can borrow up to $5 million for 10 to 25 years.

SBA loans, however, can be tough to qualify for. Eligibility requirements vary depending on the lender, but generally businesses must meet SBA size standards, be able to repay, and have a sound business purpose. The application process for SBA loans also tends to be more rigorous than for conventional business loans, and approval can take as long as three months.

4. Short-term Business Loans

Short-term business loan terms typically last for 12 months or less, though in some cases they may extend to as much as 18 months. Common uses for this type of debt financing include working capital, inventory purchases, cash flow, marketing, expansions, improvements, and covering unexpected costs.

Short-term business loans are often offered by online lenders and tend to come with more lenient qualification requirements than long-term, traditional bank loans. They’re also funded quickly (anywhere from one to three business days). These loans may be more accessible for new or small businesses, but tend to come with higher costs.

5. Business Line of Credit

A business line of credit is a type of revolving credit that allows you to borrow money as you need it, up to your credit limit, and only pay interest on what you borrow. In some ways, it works like a credit card. As you use and repay the money you owe, you can access that same credit line again throughout the draw period, which may be 12 to 24 months.

Credit lines can be secured (i.e., require collateral that you own as a guarantee for your loan) or unsecured (no collateral required). Unsecured lines of credit tend to be harder to qualify for and come with higher rates than secured credit lines.

This type of flexible debt financing can be helpful for smoothing out cash flow, covering small expenses, funding projects with undetermined costs, or serving as a backup for emergencies.

6. Equipment Financing

Heavy equipment financing helps businesses purchase or lease machinery without having to pay in full upfront. Generally these are secured loans, using the machinery itself as collateral. You may need to make a down payment as well.

There are various forms of equipment financing, such as loans, leasing, lines of credit, and sale-leaseback arrangements. The option you choose should depend in part on whether you want to own the equipment at the end of your payment period or return it after leasing.

Advantages of Debt Financing

One of the biggest benefits of debt financing is that you get to retain full ownership and control of your company. Unlike equity financing, you don’t need to give up an ownership share of your business to obtain the capital. The financial obligation is temporary and your relationship with the lender ends after you pay off the loan.

Another perk is that the payments you make on interest generally qualify as a tax-deductible business expense. This interest tax deduction is typically available as long as you’re borrowing money from an actual lender (not friends or family) and using the loan for business purposes. Other loan costs, such as origination fees, may also be tax-deductible.

In the case of long-term financing, the repayment period can be extended over many years, reducing the monthly expense. Assuming the loan does not have a variable rate, the interest expense is a known quantity for budgeting and business planning purposes.

If you make all of your payments on time, debt financing can help you build business credit. This can help you qualify for other debt financing options in the future, potentially with better rates and terms.

Disadvantages of Debt Financing

You’ll need to make consistent payments on your loan, regardless of your revenue, which could be challenging if you have seasonal business or inconsistent cash flow. (If uneven cash flow is a concern for you, it might be worth looking into revenue-based business loans.)

Also, if your business is new or doesn’t have strong credit, interest rates may be high, making this a potentially expensive form of financing. And, if you are late or miss payments, it could negatively impact your business’s credit score.

Business lenders often require business collateral or a personal guarantee (or both) to secure loans. If you default on the loan, any business assets you pledge could be repossessed by the lender. If you sign a personal guarantee, you could potentially lose your personal savings or home. These are significant risks to take, so it’s important to understand the terms of your debt financing and feel confident in your ability to repay the borrowed funds.

When Does Debt Financing Make Sense?

Deciding on debt financing is a big decision that can impact the future of your business. Here are some reasons why you might consider debt financing as a way to raise capital for your business.

•  You’re past the startup phase. It can be difficult to qualify for loans with attractive rates and terms as a brand new business. In addition, many startups lose money before they start turning a profit, which can make committing to a regular repayment schedule risky. Should you default on the loan, you can lose any business or personal assets you used to secure the loan, plus damage your business credit, which could make it harder to get loans with competitive rates in the future.

•  You need capital quickly. There are various forms of debt financing that deposit funds in a business bank account much faster than equity financing or most other alternatives. You’ll want to focus on online options if you’re truly strapped for time.

•  You want to maintain full ownership of your business. Lenders don’t want an ownership stake in your business, only the certainty that you can repay that debt. While taking on debt means making a payment with interest each month (compared to no payments with equity financing), it may be worth it if you’re not prepared to give away a percentage of your company and/or do not want to share future profits.

•  You anticipate a positive return. While debt financing comes with costs, you may be able to recoup those costs (and more) if the money you borrow leads to an investment that can bring in a significant increase in revenues — a concept known as leverage. For example, if you take out a $150,000 loan with an 8% annual percentage rate (APR) but can get a 15% return on that money, debt financing can be a smart business move.

•  You’re comfortable with risk. If you put up collateral or sign a personal guarantee for a business loan, failing to repay the loan could cost you important business or personal assets. Even if you get an unsecured loan, your company’s credit score will be on the line. These are risks you have to be willing to take if you choose debt financing.

Recommended: What Is Unearned Revenue?

Alternatives to Debt Financing

The main alternative to debt financing is equity financing, which involves selling a portion of your company’s equity in return for capital. This means the investor will own a certain percentage of the company and have a say in business decisions going forward.

The advantage of equity financing is that there is no obligation to repay the money you acquire through it. Investors also often provide operational expertise and valuable business contacts along with an infusion of capital.

On the downside, you’ll have to share control and profits with the investors. Also, the only way to remove investors is to buy them out (which could cost more than the amount of money they originally gave you).

Some sources of equity financing are:

•  Angel investors

•  Crowdfunding

•  Venture capital firms

•  Corporate investors

•  Listing your company on an exchange with an initial public offering (IPO)

Equity Financing vs Debt Financing

Here’s a closer look at how equity and debt financing compare.

Similarities

Both debt and equity financing allow you to raise capital for your business. You can use those funds for a variety of business expenses, including day-to-day operations, inventory, equipment, real estate, expansion, or hiring staff.

Differences

Debt financing involves borrowing funds from a person or other entity that you must pay back with interest by a certain date, whereas equity financing involves securing capital in exchange for a percentage of ownership in the business.

With debt financing, the lender doesn’t have any say in your business decisions, and your relationship ends once you’ve paid off the loan. With equity financing, on the other hand, investors will often want to have a say in business decisions and the relationship is ongoing.

Another key difference: Investors can often provide valuable industry knowledge and connections, which you would not get from a lender.

These financing options also differ in terms of risk involved. Equity financing tends to be less risky than debt financing because you don’t have a loan to repay or collateral at stake.

The Takeaway

Debt financing is when you borrow money to fund your business and pay it back with interest over time. Small business loans are one of the most common types of debt financing.

If you’re thinking about financing your business with debt, you’ll want to consider how much capital you need, your business’s qualifications (including your personal credit score, time in business, and annual revenue), how quickly you need to access funding, and how much debt you can afford.

If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.

FAQ

What are some examples of debt financing?

Examples of debt financing include traditional bank loans, online loans, Small Business Administration (SBA) loans, business lines of credit, credit cards, equipment financing, invoice financing, peer-to-peer loans (crowdlending), and real estate loans.

What are the advantages of debt financing?

One key advantage of debt financing is that it can allow a business to grow more rapidly than might otherwise be possible. Another is that the interest payments on the debt are generally tax-deductible. Also, with debt financing, the company does not have to give up any ownership control in return for the capital, as would be the case with equity financing.

Are debt financing and business loans the same thing?

Not exactly. Debt financing is a broad term that means borrowing money for the benefit of your business. Loans are one of the most common types of debt financing. However, debt financing in business also includes selling fixed-income products, such as bonds or bills, to individuals or institutional investors.

What’s the difference between secured and unsecured debt financing?

Secured debt financing uses collateral to help guarantee repayment of a business loan. Collateral reduces risk for lenders, meaning they should be able to offer the borrower lower interest rates or other favorable terms. Unsecured loans don’t involve collateral and are approved based on the borrower’s credit history and ability to repay the debt. They also pose more risk to the lender, so they tend to have higher interest rates.

How does debt financing affect business ownership?

Debt financing does not affect business ownership in any way. It is simply a contractual arrangement to borrow money for a set period of time and repay the money with interest before the end of the loan term. No ownership or equity stake is involved.

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