Can You Use a Business Loan as Seed Funding for Your Startup?

You have an exciting idea for a business, but you need seed capital to get started. One of the most critical hurdles that startups and new business owners face is fundraising to get the business off the ground. Seed funding for startups is crucial to helping you develop your product, build your team, and carve out an initial niche in the marketplace.

You may think of venture capitalists, angel investors, and Series A funding rounds when you hear the term seed funding, but you don’t necessarily need to find seed investors or create a pitch deck for venture capital firms to get the initial funding your business needs. Business loans can serve as seed funding for startups. Here, we explore the pros, cons, and crucial considerations of using loans as seed financing.

In this article:

• The advantages and disadvantages of using loans as pre seed funding for startups.
• How to qualify for business loans from traditional lenders and alternative ones, like seed funding companies.
• The best potential business loan options that can be used as seed funding for startups.

Understanding Seed Funding for Startups

Seed funding for startups is the earliest stage of investment a startup receives. In the funding stage, your founding team is likely still doing due diligence to understand a product-market fit, financial modeling for your future, and determining how to use seed money to best get your business off the ground. Startup founders often use seed funding in several ways:

• Market research and validation: Confirming there's a genuine need for your product or service, that the market size is enough to drive a profit, and determine a market strategy.
• Product development: Creating a minimum viable product (MVP) or prototype to attract seed investment during the fundraising process or get your business ready to hit the market quickly.

• Team building: Hiring key personnel to bring your idea to life and start working towards production and customer acquisition.
• Operational infrastructure: Setting up your initial office space, tools, and systems.

• Initial marketing and legal costs: Getting the word out and ensuring you're compliant with regulations.

Many people turn to bootstrapping from their personal savings, but other sources of funding may include friends and family, angel investors, or even accelerators or incubators. When you’re working with an unproven business model, there may be a higher risk of failure, but that doesn’t necessarily mean you can’t still leverage business loans as seed funding for startups.

Advantages of Using a Business Loan as Seed Funding

There are several reasons why a business loan might appeal to you as a source of seed funding for startups:

1. Retain ownership: When you take out a loan, you don’t give up any equity in your company. That means there’s no dilution of your potential profit, and you retain complete control over the business’s direction. For many entrepreneurs, it’s vital to preserve ownership.
2. No outside influence: A secondary benefit of retaining ownership is that you won’t have to deal with the complexity and frustration of creating a board or including venture capitalists in your decision-making. Lenders won’t interfere with your business, allowing you to run it as you see fit.
3. Predictable payments: Business loans typically come with fixed repayment schedules. This allows for clear financial planning and budgeting, as you know exactly how much you owe and when.
4. Building Business Credit: Successfully managing and repaying a business loan can significantly boost your company's credit score if the lender reports to credit bureaus. With better business credit, you may have greater opportunities for more favorable financing in the future.
5. Potentially lower overall cost: Loans cost money, while equity investment doesn’t. But if your startup becomes very successful, you could wind up forfeiting a lot of profit in the long run in the form of equity. Potentially much more than the cost of a loan’s interest and fees.

Disadvantages of Using a Business Loan as Seed Funding

Despite the advantages, using a business loan for seed funding for startups also requires considering some potential drawbacks.

1. Difficulty qualifying: Traditional lenders like banks and credit unions tend to be risk-averse. They typically require a proven track record of revenue, profitability, and time in business – metrics that most early-stage startups can’t show.
2. Personal guarantees and collateral: If you do find a lender partnership, your loan will very likely require a personal guarantee or some form of collateral. This means you are personally responsible for repaying the loan if your business defaults, putting your personal assets like your home or savings at risk. You may also risk losing valuable business assets that you put up as collateral.
3. Cost: Startups tend to receive higher interest rates and shorter repayment terms than more established businesses. You may also have to pay higher origination fees, application fees, and more, which can add to the total borrowing cost.
4. Immediate repayment obligation: Equity investors share in your success or failure, and you’re under no obligation to pay back seed fundraising until you start earning a profit. A business loan, however, has an immediate repayment obligation, which can strain your cash flow out of the gate and stifle your ability to invest in product development, labor, and meet important growth milestones.
5. Limited loan maximums: Seed funding for startups may be much higher with a seed funding round from venture capitalists than with a business loan. Lenders are less interested in your business’s high growth potential and more concerned about your demonstrated ability to repay a loan, making them less willing to approve high loan amounts.

Types of Business Loans to Consider

Whether you’re unable to get a term sheet from investors or you’re motivated not to dilute your equity in the company, there are several types of loans to consider for seed funding for startups. These include:

• Term loans: Conventional loans provide you with an upfront, lump sum payment that you must repay on a set schedule, usually with monthly payments. Online lenders are more likely to be willing to work with startups than traditional lenders, but you should explore all of your options and get pre-qualified anywhere that’s willing to consider startups.
• SBA loans: The U.S. Small Business Administration (SBA) doesn't directly lend money but partially guarantees loans made by traditional lenders. This reduces the risk for banks, making them more willing to lend to small businesses. The SBA 7(a) loan program is the most popular, but startups may find that Microloans are even more accessible. SBA loans offer favorable terms, but they can have strict eligibility requirements, and you’ll need good personal credit and a strong business plan.

• Business lines of credit: A cross between a loan and a credit card, a business line of credit allows you to draw funds up to a certain limit and only pay interest on the amount borrowed. This offers flexibility as you grow, and these funding options can be among the most accessible for startups.

• Equipment loans: If your startup requires specific equipment like machinery or specialized tech, an equipment loan might make sense. In this type of financing, the equipment serves as collateral, making these loans somewhat easier for businesses that need physical assets. This can support seed financing for businesses that have equipment as a central startup cost.

Steps to Get a Business Loan for Seed Funding for Startups

While the process varies between lenders, generally, this is what you can expect when you apply for a business loan for seed funding for startups:

1. Determine your funding needs: While you may have a wide range of startup costs, it’s important to be as granular as possible with your financial projections. Not only can it help you determine how much funding you need, but it will help you put together a robust business plan that clearly articulates your market opportunity. Any lender will want to see this as it shows you understand your line of business and have a plan to repay what you borrow.
2. Research and compare lenders: Don't just apply to the first bank you see. Look for lenders that explicitly state they offer startup loans or have programs designed for new businesses. Online lenders and community development financial institutions (CDFIs) might be more flexible than large traditional banks. You might even consider alternative options like crowdfunding.
3. Gather documentation: Depending on the lender, you may have to show business and personal tax returns, business bank statements and financial statements, as well as personal financial documents to show that you can provide a personal guarantee for the loan. If your credit isn't stellar or your business is particularly new, a co-signer with strong credit or offering valuable collateral could significantly improve your chances of approval.
4. Apply: You can typically apply for a business loan online with lenders or seed funding companies, but you may have to do it over the phone or in person. If you’re approved, the underwriting and funding process is typically faster with alternative lenders than traditional ones.

Final Thoughts

While it’s certainly possible to use a business loan as seed funding for startups, it comes with a unique set of challenges and risks. But not every business has the luxury of the Y Combinator, pre-seed rounds, and competing for the attention for all types of investors. For many new entrepreneurs, it can be very difficult to qualify for business loans, but by showcasing a firm understanding of your business model and a strong personal financial situation, you may raise your chances of getting approved for a business loan. That way, you can get the seed funding you need without diluting your ownership or control.

FAQs About Seed Funding for Startups

What is the primary difference between a business loan and traditional seed funding for startups?

A business loan is debt; you are obligated to repay the borrowed amount with interest, and you retain full ownership of your company. Traditional seed funding for startups, like angel investors or VCs, is typically equity-based, meaning investors receive a share of ownership in your company and only profit if your company succeeds.

Is it easier to get a business loan or equity seed funding for a brand-new startup with no revenue?

It’s generally difficult for a startup with no revenue to secure a traditional bank loan. However, it’s also very difficult to get equity seed funding. Ultimately, lenders and investors weigh different criteria. Lenders value security and stability, while investors are more interested in growth potential.

What credit score do I need to get a business loan for seed funding?

It depends on the lender. However, since your startup likely won’t have its own business credit history, the higher your personal credit score is, the better chance you may have of getting a loan approval.

Can I use an SBA loan for seed funding for my startup?

SBA loans can be an option for seed funding for startups. However, you'll still need a strong business plan, good personal credit, and often a personal guarantee. The application process for SBA loans can also be more extensive and take longer than some other funding options.

What are some alternative ways to secure seed funding?

If you can’t get a business loan, consider bootstrapping with personal savings, seeking investments from friends and family, exploring crowdfunding campaigns, applying for business grants, or participating in startup accelerators or incubators that often provide initial capital and mentorship in exchange for equity.

Frequent searches leading to this page