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A trade credit is a business-to-business (B2B) transaction in which one business is able to procure goods or services from the other without immediately paying for them. It’s called a trade credit because when a seller allows a buyer to pay for goods or services at a later date, it is extending credit to the buyer.

Trade credit can be a great tool for a small business: It can free up cash flow and grow a company’s assets. However, there are some drawbacks, including a short financing window and potentially high interest if the borrower needs to extend that window.

Here’s what every small business should know about trade credit.

How Does Trade Credit Work?

If you’ve been wondering what trade credit is, it’s a formal name for an agreement between two companies in which one company is able to purchase goods from the other without paying any cash until an agreed-upon date. You can think of trade credit the same way as 0% financing, but with shorter terms. Sometimes trade credit financing is also referred to as vendor financing.

Sellers that grant their customers trade credit generally give them anywhere between 30 and 120 days to pay for the goods or services they received on credit. The range, however, can be higher or lower depending on the industry and individual seller.

Often, the seller will offer the buyer a discount if it settles its account earlier than the balance due date. If the seller does offer a discount, the terms of the trade credit sale are usually written in specific format that will indicate this option. For example, if the seller offers a 5% discount if the invoice is paid within 20 days but is willing to give the buyer a maximum of 45 days to pay the invoice, that agreement would be written as:

5/20, net 45.

If the buyer is unable to pay its invoice within the set time period (which is 45 days in the above example), the vendor will typically charge interest. If that happens, trade credit is no longer an interest-free form of financing.

Recommended: 15 Types of Business Loans to Consider

Common Terms

Common terms used in trade credit financing include:

•   Net terms: This specifies the number of days the buyer has to pay the invoice, such as “Net 30” or “Net 60,” meaning payment is due within 30 or 60 days, respectively.

•   Discount terms: This refers to a discount for early payment, like “2/10, Net 30,” which means a 2% discount is available if the cost is paid within 10 days.

•   Credit limit: This is the maximum amount a supplier allows a buyer to purchase on credit at one time.

•   Invoice: This means a detailed bill issued by the supplier outlining goods or services provided and the payment due.

•   Grace period: This refers to the extra time the suppliers allow beyond the due date for the buyer to settle the account without incurring penalties.

Typical Payment Periods and Discounts

Both payment periods and discounts can vary depending on factors that include the industry the companies work in, the supplier’s policies, and the buyer’s creditworthiness. But here are some typical numbers.

Payment periods are most often for 30, 60, 90, or 120 days. While discounts may be even more variable, one commonly cited is 2/10 net 30. “Net 30” means, as we’ve discussed, that you have 30 days until your term is up, while “2/10” indicates if you pay within 10 days, you’ll get a 2% discount.

How Trade Credit Affects Cash Flow

Trade credit can be extremely helpful to buyers by allowing them more flexibility in managing their cash flow. With the benefit of trade credit, a company may be able to pay for its goods using the revenue from its sales, rather than needing upfront cash to pay off its products. It could use its available cash for operational needs rather than paying immediately for the seller’s goods.

Types of Trade Credit

The three main types of trade credit include:

1.    Open Account: The most common form, in which the supplier delivers goods or services and the buyer agrees to pay by a specified date. The term is usually 30 to 120 days later.

2.    Promissory Note: A formal written agreement in which the buyer promises to pay the supplier by a certain date. It’s often used when open accounts are not available.

3.    Trade Acceptance: The buyer signs a formal agreement accepting the supplier’s terms and acknowledging its own obligation to pay at a future date. Trade acceptance is sometimes used for larger or international transactions.

Recommended: What Is a Promissory Note?

Who Uses Trade Credit?

Some businesses are more likely to use trade credit than others. Business trade credit is very common in the B2B ecosystem, for example.

Whether trade credit is something that you may be able to use will depend on a number of factors, including the industry you work in and the size and age of your business.

Small and Mid-Sized Businesses

Typically, trade credit is often used by small and mid-sized companies. New businesses especially may find it challenging to access traditional funding, and even more so if they’re in a hurry — trying to deal with an irregular cash flow, for example. Trade credit can provide a way for these businesses to get more flexibility in paying for their needs and help them build positive relationships with their suppliers. Larger companies with more established credentials may find it easier to get the funding they need without using trade credit.

Industries That Commonly Rely on Trade Credit

In certain industries, trade credit is used frequently. These industries include the following:

•   Automotive: Garages, auto dealers, and related businesses

•   Construction: Contractors and construction companies

•   Hospitality: Hotels, bars, restaurants, and event spaces

•   Manufacturing: Factories of all kinds

•   Retail: Businesses that sell goods of all kinds

Pros and Cons of Trade Credit

Like any kind of financing, including loans, lines of credit, and equipment financing, trade credit offers both benefits and drawbacks to both parties involved in the transaction. Here are some of the most notable.

Pros and Cons of Trade Credit for Buyers

Advantages of trade credit for buyers include:

•   Frees up cash: Because payment is not due until later, trade credit improves the cash flow of businesses, enabling them to sell goods they acquired without having to pay for those goods until a future date. Trade credit financing can be a good option for companies expanding into a new market or businesses that have seasonal peaks and dips.

•   Possible discount: Depending on the trade credit agreement, if the buyer pays the invoice within a certain amount of time, it may receive a discount on the goods or services it purchased.

•   0% interest: The cost of capital can be a burden on some small businesses. If the buyer can settle the invoice within the agreed-upon time frame, there is no interest charged on this type of financing.

Disadvantages of using trade credit for buyers include:

•   Short payment period: The length of the trade credit payment term varies, but it’s often 120 days or less, which is shorter than the terms for most types of small business loans. For a growing small business, this may not be enough time. Companies that need a longer repayment period may want to look into other types of debt instruments.

•   It’s easy to overcommit: With discounts and wholesale prices, it can be tempting to buy too much of a particular good. Not only does this create excess inventory, but it also translates to a bigger debt obligation.

•   Possible penalties for late payments: Depending on the trade credit agreement, there may be negative consequences for late payments, such as interest charges or a fine. In addition, the company might report your late payment to the credit bureaus, which could damage your business’s credit score. Of course, this is likely to be true of startup business loans, too.

Recommended: Getting a Cash Flow Loan for Your Small Business

Pros and Cons of Trade Credit for Sellers

Some positive aspects of using trade credit for sellers include:

•   Beat out competitors: Companies offering trade credit may be able to gain an advantage over industry peers that don’t offer trade credit. Because it can be difficult for some small businesses to get a bank loan, they may seek out suppliers offering trade credit.

•   Develop a strong relationship with clients: Offering trade credit often increases customer satisfaction, which can lead to customer loyalty and repeat business.

•   Increase sales: Trade credits are still sales even if payment is delayed. Trade credit can also encourage customers to purchase in higher volumes, since there is no cost to the financing. Therefore, a trade credit can provide the opportunity for growth and expansion.

Negatives of trade credit for sellers include:

•   Delayed revenue: If your business has plenty of cash, this may not be an issue. However, if budgets are tight, delayed revenue could make it difficult to cover your operating costs.

•   Risk of buyer default: Sometimes customers are unable to pay their debts. Depending on the trade credit agreement, there may be little to nothing the seller can do other than sell the debt to a collection agency at a fraction of the cost of the goods provided.

•   Less profit with early payment discounts: If the seller offers a discount for early payment, it will earn less on the sale than it otherwise would.

Recommended: Understanding Business Liabilities

Trade Credit Accounting

Trade credit needs to be accounted for by both buyers and sellers. The process, however, will vary depending on the company’s accounting method — specifically, whether it uses accrual or cash accounting.

With accrual accounting (which is used by all public companies), revenue and expenses are recorded at the moment of transaction, not when money actually changes hands. With cash accounting, in contrast, a business records transactions at the time payments are made.

A seller that offers trade credits and uses accrual accounting can face some complexities if the buyer ends up paying early and getting a discount or defaulting (and never paying). In these cases, the amount received doesn’t match the company’s account receivables and the difference becomes an account receivable write-off, or liability that must get expensed.

Trade Credit Instruments

Typically, the only formal document used for trade credit agreements is the invoice, which is sent with the goods and which the customer signs as evidence that the goods have been received. If the seller doubts the buyer’s ability to pay in the allotted time, however, there are credit instruments it can use to guarantee payment.

Promissory Note

A promissory note, or IOU, is a legal document in which the borrower agrees to pay the lender a certain amount by a set date. While it’s usually used for repaying borrowed money, it can also be used to pay for goods or services.

Commercial Draft

One hitch with a promissory note is that it is typically signed after delivery of the goods. If a seller wants to get a credit commitment from a buyer before the goods are delivered, it may want to use a commercial draft.

A commercial draft typically specifies what amount needs to be paid by what date. It is then sent to the buyer’s bank along with the shipping invoices. The bank then asks the buyer to sign the draft before turning over the invoices. After that, the goods are shipped to the buyer.

Banker’s Acceptance

In some cases, a seller might go even further than a commercial draft and require that the bank pay for the goods and then collect the money from the customer. If the bank agrees to do this, it must put the agreement in writing — which is called a banker’s acceptance. It means that the banker accepts responsibility for payment.

Letter of Credit

Letters of credit are financial instruments frequently used in international transactions,. While they’re not commonly used to guarantee trade credit payment, a seller could ask a buyer to have its bank issue a letter of credit as additional assurance of payment. When you request a letter of credit from your bank, after ensuring that you have sufficient funds, the bank may agree (for a fee) to pay your suppliers for their goods and/or services if you default — as long as specified conditions are met. The letter of credit helps assure the seller that if you can’t pay, it will still be able to get its money from the bank.

Trade Credit Trends

Trade credit is widely used worldwide. In fact, the World Trade Organization estimates that 80% to 90% of all world trade relies on trade credit in some capacity. It’s so widespread that it’s given rise to a type of financing called accounts receivable financing (also known as invoice financing).

With invoice financing, a company that offers trade credit can get a loan based on its outstanding invoices, effectively enabling it to get paid early. When it receives payments from its customers, it gives that money (plus a fee) to the financing company.

Recommended: Understanding Business Liabilities

The Takeaway

Trade credit in business is a common practice that occurs when two companies agree that one will purchase goods or services from the other but won’t pay until a later date.

Essentially an interest-free loan, trade credit can be particularly rewarding for young businesses as well as for seasonal businesses that may find themselves occasionally strapped for cash. A key drawback of trade credit, however, is that the buyer is generally expected to pay the invoice relatively quickly, sometimes within a month or two. For many small businesses, that may not be enough time, and they might be better served by getting a small business loan.

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 is an example of trade credit?

If you’ve been wondering, “What is trade credit?” here’s an example. Let’s say a restaurant offers kobe beef on its menu and gets its beef from a food supplier in Japan. The supplier offers the restaurant a 5/30, net 60 trade. This means that the restaurant has 60 days to pay for a shipment of beef. If it pays the invoice within 30 days, however, it will receive a 5% discount on the purchase price.

Are there any benefits to trade credit?

Yes, benefits of trade credit can include interest-free financing for buyers, improved cash flow for buyers, increased sales volumes for suppliers, and potentially strong relationships and customer loyalty for suppliers.

When do businesses typically use trade credit?

Businesses use trade credit when they do not have the capital on hand to make a purchase or they need to temporarily free up cash for other expenses. Trade credit is also a good option for young businesses that may not qualify for other forms of business financing.

How does trade credit affect business relationships?

Trade credit can help build business relationships. Suppliers may be able to sell more to buyers when they offer trade credit, and buyers may feel loyal to suppliers with whom they have trade credit agreements. If the trade credit obligtations are met, the relationship between the parties will likely be a positive one.

Is trade credit considered a loan?

Essentially trade credit functions like a very short-term no-interest loan between two businesses. However, not all accounting systems treat trade credit in exactly the same way as a loan.

Photo credit: iStock/Hiraman

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.

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.

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.

Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website .

SOSMB-Q425-044

A no-doc business loan is one that borrowers can access without substantial documentation. Rather than relying on income, lenders may approve borrowers based on credit history and collateral.

No-doc small business loans may be ideal for business owners whose revenue is not yet established but who are interested in getting access to cash quickly.

Learn more about no-doc business loans, how to qualify, and the downsides.

What Are No-Doc Business Loans?

Some specialized lenders offer unsecured business lending that requires zero documentation — that’s where “no doc” comes from — or perhaps fewer application requirements than with conventional loans.

Usually, no-doc business loans don’t require collateral. Lack of collateral can sometimes hold some business owners back from being approved for financing from traditional lenders.

An unsecured business loan could help certain business owners get financing fast — even if you don’t currently qualify for other business lending options.

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Types of No-Doc Business Loans

There are a few versions of the no-doc business loan. Some lenders offer lines of credit you can draw from when you need cash, while others offer you a fixed sum all at once.

Unlike many other small business loans, business no-doc loans typically don’t require any documentation. You may be asked to simply state your income or demonstrate your gross sales. Depending on the lender, you may or may not need to provide bank statements or profit and loss reports.

Examples of short-term no-doc business loans or short-term business financing might include:

•   Merchant cash advances

•   Business credit cards

•   Invoice factoring

You may also consider low-doc loans. A low-doc business loan generally requires less paperwork (i.e., bank statements or merchant statements) during the application process.

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Who Offers No-Doc Business Loans?

Small business loans requiring no documents are primarily offered by alternative lenders, including online lending platforms, private sources, and some non-bank financial institutions. These lenders are more flexible than traditional banks and cater to businesses that may not have the extensive financial documentation typically required for traditional loans. They are willing to take on the higher risk associated with no-doc loans in exchange for charging higher interest rates and fees.

Secured vs. Unsecured Lines of Credit

Unsecured lines of credit, unlike secured lines, do not require collateral to guarantee the funds. An unsecured business line of credit for startups can help entrepreneurs get financing without pledging collateral.

Collateral for a secured loan or line of credit may take the form of a business asset, such as real estate or equipment. With secured financing, lenders can seize assets to cover what’s owed if a borrower defaults and fails to pay the lender in full.

If you’re not sure how to secure a business line of credit or loan, but you don’t own any assets a lender would consider valuable, a no-doc business line of credit (BLOC) may be one option. A BLOC is typically unsecured, meaning you generally won’t have to pledge collateral.

Recommended: Equipment Financing

Pros and Cons of a No-Doc Business Loan

When it comes to unsecured business loans, no-doc options have benefits and drawbacks you might want to weigh. Here’s a quick summary:

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How To Get a No-Doc Business Loan

To obtain a no-doc business loan, follow these steps:

1.    Assess your personal credit score: Ensure you have a strong personal credit score, typically above 700. A high credit score is crucial; lenders heavily rely on it in the absence of detailed financial documentation.

2.    Identify collateral: Be prepared to offer substantial collateral, such as real estate, equipment, or other business assets. This collateral secures the loan and mitigates the lender’s risk.

3.    Select the right lender: Research lenders that specialize in no-doc or low-doc loans, including online lenders and alternative financing companies. These funding sources are more likely to offer such loans than traditional banks.

4.    Prepare basic business information: While detailed financials are not required, you should provide basic information about your business, including its legal structure, industry, and length of operation. If you have a [business checking account](https://www.sofi.com/small-business-checking/), you could share past bank statements to show a lender your company’s revenues.

5.    Submit a business plan: If possible, include a concise business plan that outlines your business model, market strategy, and how you intend to use the loan proceeds. This can help build lender confidence in your ability to repay the loan.

6.    Apply for the loan: Complete the loan application process with your chosen lender, providing whatever information and documentation is required.

Recommended: How to Get a Small Business Loan in 6 Steps

Tips for Improving Your Chances of Approval

Here are some pointers for further strengthening your no-doc loan application:

•   Focus on lenders and loan types that fit your business credit score: For unsecured business loans and revolving lines of credit, lenders may want credit scores of 600 or more. Invoice factoring and merchant cash advances don’t rely as much on the borrower’s credit.

•   Maintain high bank balances: You can showcase your company’s steadiness by keeping sizable cash reserves in your business accounts, as shown on your monthly statements.

•   Present clear and consistent bank statements: In dealing with a prospective lender, emphasize cash flow. Be ready to address any unusual transactions upfront.

•   Find other selling points that could build lender confidence: For example, play up your industry experience and previous business successes.

Are No Doc Business Lines of Credit a Good Idea?

Business loans with no documents aren’t necessarily a bad idea, but there are less costly financing options available to those that qualify. To be considered for the most desirable rates, you’ll need a solid credit score, a few years of business history, and consistent annual revenue.

The amount you pay in interest will generally be higher with business no-doc loans than with traditional financing. You might even find a business credit card with a low (or no) introductory APR that could cover the purchases you need. When you’re comparing options, our business loan calculator can help you compute monthly payments, total interest, and overall loan cost.

Ultimately you may decide to hold off on funding and focus on building your credit so that you can try to qualify for more affordable financing options down the line.

Recommended: How Much Funding Can I Get From a Business Loan?

Alternative Financing Options

If you are seeking alternatives to no-doc small business loans, several financing options are available that might better suit your needs, especially if you can provide some form of documentation or collateral. Here are a few options:

1.   Traditional bank loans: These loans generally offer lower interest rates but require detailed financial documentation, including tax returns, financial statements, and proof of revenue. They are suitable for businesses with strong financial histories and good credit scores.

2.   SBA loans: Backed by the Small Business Administration, SBA loans offer favorable terms and lower interest rates. While they require comprehensive documentation, they are accessible to businesses with less-than-perfect credit through SBA’s guarantee.

3.   Business lines of credit: A line of credit provides flexible access to funds up to a certain limit. It usually requires some documentation but offers the advantage of only paying interest on the amount borrowed. It’s ideal for managing cash flow and unexpected expenses.

4.   Equipment financing: This option allows businesses to borrow money specifically to purchase equipment, using the equipment itself as collateral. This reduces the lender’s risk and often makes the loan easier to obtain.

5.   Invoice financing: Businesses can borrow against their outstanding invoices, providing immediate cash flow. This form of financing is especially useful for businesses with long payment cycles.

6.   Crowdfunding and peer-to-peer lending: Online platforms and crowdfunding structures can connect businesses with individual investors willing to lend money. These options may require a compelling business plan and are often used for specific projects or expansions.

Each alternative comes with its own set of requirements, costs, and risks, so it’s important to carefully evaluate which option best aligns with your business’s financial situation and goals.

The Takeaway

No business owner wants to be caught without the capital they need to run day-to-day operations or to take advantage of emerging opportunities for growth. A no-doc small business loan may be useful in such cases. But these loans have some downsides to consider, as well. Proceed only after doing your research.

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 is a no-doc business loan?

A no-doc business loan is an alternative loan product that businesses may get with little or no financial documentation. It can provide businesses with a lump sum of cash and generally carries higher finance charges than traditional business loans.

How hard is it to get a no-doc business loan?

Getting a no-doc business loan is generally more difficult due to the higher risk for lenders and the stringent requirements for borrowers. Those with excellent credit, substantial assets, and the ability to provide a significant down payment or collateral have a better chance of securing such a loan. However, borrowers should carefully consider the higher costs and potential risks associated with no-doc loans.

What do you need to apply for a no-doc business loan?

To apply for a no-doc business loan, you typically need to meet several key criteria, including an excellent credit score, collateral and/or a down payment, a strong business plan, and personal and business identification.

What are the risks of a no-doc business loan?

No-doc business loans, in any format, have their risks. These may include higher interest rates than other loans, short repayment terms (daily or weekly in some cases), hidden fees, or smaller loan amounts. Be sure you understand the APR, repayment terms, and all fees that may apply. If you can, get quotes from multiple lenders; you may find a lower-cost option.

Can startups qualify for no-doc business loans?

Startups and other new businesses that aren’t yet financially established can sometimes qualify for no-doc loans. Lenders will rely on bank statements, revenue history, or collateral. However, these loans generally involve comparatively small amounts, higher interest rates, and short repayment terms. Whatever funding method you choose, be sure your startup can cover the loan payments.

Photo credit: iStock/miniseries

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.

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.

SOSMB-Q425-021

A delayed draw term loan (DDTL) is a type of business term loan that lets you draw funds several times over the term of the loan. This can be helpful if you plan to expand your business by making multiple acquisitions or capital investments over time. It can also help you handle any unforeseen expenses that crop up in the future.

Delayed draw term loans typically come with strict eligibility requirements and complex loan terms. Read on for a closer look at how these loans work, their pros and cons, plus how they compare to revolving business lines of credit.

What Is a Delayed Draw Term Loan?

A delayed draw term loan allows borrowers to withdraw predefined portions of a total approved loan amount over time, rather than receive the full amount upfront. The withdrawal periods are set in advance and may occur every three, six, nine, or 12 months.

This arrangement enables you to get funds periodically to meet your company’s capital needs — a planned purchase, for example — while paying interest only on the amount you draw.

How Does a Delayed Draw Term Loan Work?

A delayed draw term loan is structured so that a business can draw funds only on specific dates. In some cases, the lender will have certain conditions your business must meet — such as reaching defined financial goals — in order to be eligible for draws. By the time the loan reaches maturity, the entire loan amount (including interest) must be paid off.

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Key Features of Delayed Draw Term Loans

Delayed draw term loans don’t work like traditional business loans. They have a number of distinctive features, including restricted access to funds, partial interest charges, and loan covenants.

Draw Schedule and Conditions

Unlike a revolving line of credit, DDTL funds are not fully available to the borrower at will. Many DDTL contracts require the borrower to fulfill stated requirements, such as project milestones or financial ratios, in order to access loan money.

Interest Accrual Timing

A delayed term loan typically allows you to pay less in interest compared to a traditional term loan, since you pay interest only on the amount you draw rather than the full principal.

However, these loans often come with fees, including a “ticking fee.” The ticking fee is based on the undrawn portion of the delayed loan and generally grows over time. Once you draw the entire loan amount (or terminate the loan), you no longer have to pay ticking fees.

Covenant Requirements

Loan contracts for DDTLs often contain provisions known as covenants. The lender sets financial and operational rules that the borrower must follow. These rules are meant to lessen the lender’s risk.

Generally there are two types of covenants.

•   Affirmative: Obligations the borrower must fulfill, such as locking in enough insurance coverage or abiding by regulations. They may take the form of financial metrics (e.g., maintaining a certain debt-to-equity ratio) or reporting requirements.

•   Negative: Actions the borrower must avoid. Examples might include changing the company’s ownership structure, selling certain assets, or taking on additional debt.

Pros and Cons of Delayed Draw Term Loans

As with all types of small business loans, delayed term loans come with both benefits and drawbacks. Here’s how they stack up.

Delayed Draw Term Loan vs Revolving Lines of Credit

Both delayed draw term loans and revolving lines of credit are flexible forms of financing. Both allow you to use the funds when you need them and only pay interest on the amount you draw. However, there are some key differences between these loan products.

For one, delayed draw term loans are generally harder to qualify for than business credit lines. In addition, they usually have more complicated loan terms and conditions.

Another distinction is that revolving credit is designed for short-term capital needs like working capital, not for acquisitions. Delayed draw term loans, on the other hand, are considered long-term loans and are often used for acquisitions.

And, while revolving credit allows you to draw funds, repay those funds, and draw them again, delayed draw term loans do not. Once the delayed draw term loan is repaid, the funds are no longer available for use.

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Delayed Draw Term Loan Example Agreement

As an example of a delayed draw term loan, let’s take a computer software company that is looking to borrow money to expand its product line. A lender agrees to give them a $5 million loan with a five-year term. However, since the technology is constantly evolving, the company heads decide they would rather not make a large, one-time acquisition but, rather, several smaller acquisitions over time.

Instead of a traditional term loan, they negotiate a delayed draw term loan that allows them to access $1 million every year, as opposed to $5 million all at once. This allows them to take advantage of purchase opportunities as they come up and pay less total interest over the life of the loan.

Industries That Commonly Use Delayed Draw Term Loans

Businesses that need committed yet flexible financing for long-term, large-scale transactions may want to explore DDTLs.

Industries that frequently use DDTLs include:

•   Construction and real estate. Companies use these loans to manage project financing, drawing funds as different phases of construction conclude.

•   Healthcare and biotech. Some pharmaceutical companies have used DDTLs to back expansion deals.

•   Manufacturing. DDTLs can help these businesses buy capital assets or expand operations.

Applying for Delayed Draw Term Loans

Generally, delayed draw term loans are only offered to businesses with high credit scores that are interested in getting a large term loan to finance future acquisitions or expansion.

If you’re interested and think you might qualify, applying for a delayed draw term loan is similar to applying for any business loan. You’ll likely need to provide basic information about your business, your company’s financial statements, information about yourself and any other owners, and information about collateral, if required.

If you suspect your documentation won’t satisfy a traditional lender, you may want to explore a stated income business loan from online lenders. That process is often more flexible.

What Lenders Evaluate in a DDTL Application

As noted above, the process of getting a DDTL is similar to that for standard business loans. Lenders generally want to see a strong credit history, stable cash flow, and a solid business plan. They will also want documentation like financial statements, market research, financial projections, balance sheets, income statements, and tax returns. They may want collateral in order to lower their risk.

DDTL lenders in particular could focus on the specific ways your business will use the funds, along with appropriate conditions for future draws.

Recommended: How Business Partnership Loans Work

Alternatives to Delayed Draw Term Loans

Delayed draw term loans are one of many types of business loans that can help you grow your business. Here’s a look at some other options.

SBA Loan

Because SBA loans are partially guaranteed by the U.S. Small Business Administration (SBA), they represent less risk to lenders than other types of small business loans. As a result, SBA loans generally offer large loan amounts and attractive rates and terms. With an SBA 7(a) loan, for example, eligible businesses can borrow up to $5 million for a range of business purposes.

Term Loan

A traditional term loan is a small business loan in which you receive a lump sum of capital upfront, then pay it back (plus interest) in regular installments over the term of the loan. Term loans are offered by banks, credit unions, and online lenders. The funds can typically be used for any business purpose. Repayment terms are usually up to 10 years but may be longer.

Short-Term Loan

If you need access to cash quickly, you might consider a short-term business loan. These loans are typically easier to qualify for than traditional term loans and can be used for virtually any business purpose. Repayment periods are often between three and 18 months. With some online lenders, qualifying businesses might be able to access funding in as little as one day.

Business Lines of Credit

A business line of credit is a form of revolving credit. You receive access to a set credit limit and, unlike with a DDTL line, can access the funds you want (up to that limit) whenever you want them. Like with a DDTL line, though, you pay interest only on what you borrow. As you repay the money you owe, you can access that money again throughout the draw period. Once the draw period ends, you can no longer access the credit line. At that point, the repayment period begins.

Recommended: Unsecured Business Line of Credit for Startups

When Are Delayed Draw Term Loans a Good Option?

A delayed draw term loan can be a good option if:

•   Your business has strong credit.

•   You need a large loan to expand your business.

•   You want to make several acquisitions or capital investments over time.

Unlike with a traditional term loan, you won’t have to pay interest on the full loan amount. You’ll only pay interest on the portion that you draw.

The Takeaway

Delayed draw term loans allow borrowers to withdraw preset portions of their approved loan amount over time. Only the withdrawn funds are subject to interest, which can help lower the borrower’s costs. DDTL amounts tend to be large and their rules can be complex, so these loans are typically used by established companies for big moves like expansions or acquisitions.

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 ticking fees on delayed draw term loans?

Ticking fees on delayed draw term loans are fees that accrue on the undrawn amount of the delayed loan. Once you draw the entire loan amount (or terminate the loan), you no longer have to pay ticking fees.

What is delayed drawdown?

A delayed drawdown occurs when a borrower doesn’t receive all the proceeds of a term loan upfront. With a delayed draw term loan, a borrower receives a certain portion of the loan at set intervals, which may be every three, six, nine, or 12 months.

Do delayed draw term loans amortize?

Some delayed draw term loans amortize, but it depends on the lender and the terms of the loan.

Are delayed draw term loans considered secured or unsecured?

Delayed draw term loans are often secured by collateral such as the borrower’s real estate or business assets.

Can startups qualify for a delayed draw term loan?

Startups can qualify for DDTLs but could face headwinds if they’re still evolving. Lenders generally look for strong credit history, stable cash flow, a solid business plan, and many financial documents including balance sheets, income statements, and tax returns.

Photo credit: iStock/Tero Vesalainen

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.

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.

This article is not intended to be legal advice. Please consult an attorney for advice.

SOSMB-Q425-012

GAAP, an acronym for generally accepted accounting principles, is a set of rules and principles that public companies in the U.S. must follow when preparing their annual financial statements.

Without GAAP, it would be much more difficult for lenders, investors, and other interested parties to know how a business is performing.

Read on to learn more about what GAAP is, how it works, pros and cons of GAAP, the differences between GAAP and non-GAAP, and more.

What Is GAAP?

GAAP, or generally accepted accounting principles, is a commonly recognized set of rules and procedures designed to govern corporate accounting and financial reporting in the U.S.

GAAP was established to provide consistency in how financial statements are created, eliminate the potential for fraudulent or misleading financial reports, and make it easier for investors and creditors to evaluate companies and compare them apples-to-apples.

All publicly traded businesses in the U.S. must use GAAP in their financial statements. While small businesses that don’t get audited aren’t required to use GAAP, doing so can still be helpful, particularly if your business may be interested in attracting an investor or exploring small business loans at some point.

Recommended: What Is Funds From Operations?

How GAAP Works

Three nonprofit organizations — the Financial Accounting Foundation (FAF), the Financial Accounting Standards Board (FASB), and the Governmental Accounting Standards Board (GASB) — play a role in setting GAAP standards as follows:

•   The FAF oversees the FASB and GASB organizations

•   The FASB issues GAAP rules for businesses and nonprofits

•   The GASB issues GAAP standards for state and local governments

For businesses filing periodic reports with the U.S. Securities and Exchange Commission (SEC), GAAP dictates how a company can recognize revenue and expenses and how information must be presented to shareholders in an audited report. It also standardizes the financial reporting process so that third parties can easily compare and contrast two GAAP-compliant companies or entities.

GAAP incorporates three components to help eliminate misleading accounting and financial reporting practices:

•   10 GAAP accounting principles

•   Rules and standards issued by the FASB or GASB

•   Generally accepted industry practices

Why Is GAAP Important?

GAAP is crucial because it provides a standardized framework for financial reporting, ensuring consistency, accuracy, and transparency across businesses. This allows investors, regulators, and stakeholders to compare financial statements and make informed decisions. GAAP also helps maintain trust in the financial system by reducing the risk of fraud and misrepresentation.

Recommended: Guide to EBITDAR: What You Should Know

Who Must Follow GAAP?

The SEC requires that publicly traded companies in the U.S. follow GAAP in the financial statements they file. While businesses that are not publicly traded aren’t subject to this rule, most financial institutions require annual GAAP-compliant statements as part of their debt covenants, which results in many businesses following GAAP even if the SEC requirement doesn’t apply to them. However, GAAP is not always used for small-business accounting.

In addition, many government entities also use GAAP. That includes all 50 states and many smaller jurisdictions, like counties and municipalities. Many federal agencies follow the guidance of the Federal Accounting Standards Advisory Board (FASAB), but some do use GAAP. such as the U.S. Postal Service, federal government corporations, and some entities of the Department of the Treasury, among others.

Recommended: NOI vs. EBITDA

Pros and Cons of GAAP

GAAP offers a number of benefits. It guides companies in preparing accurate and clear financial data, reduces fraudulent financial reporting, and provides consistency in the financial statements of one GAAP-compliant company compared to another.

However, GAAP also has some limitations. Its “one-size-fits-all” approach to financial reporting, for example, doesn’t always address issues faced by specific industries. GAAP can also be overly complex, as well as costly to implement, for smaller businesses. And, it’s not a globally used standard, which can make it challenging for international organizations and for investors who want to compare companies operating in different countries.

Pros of GAAP

Here are some of the pros of GAAP:

•   Fosters honesty and transparency in financial reporting

•   Makes it easy to compare one GAAP-compliant company to another GAAP-compliant company

•   Ensures that compliant businesses follow the same accounting principles for all reporting periods

•   Enables businesses to compare their performance with that of their competitors

Cons of GAAP

Here are some of the cons of GAAP:

•   Strict accounting model does not address many industry-specific situations

•   Can be costly for smaller companies to become GAAP-compliant

•   Overshadows non-U.S. GAAP financial performance metrics, such as adjusted EBITDA

•   Not a global standard

Recommended: What Is the Difference Between EBIT and EBITDA?

10 Important GAAP Principles

GAAP has 10 fundamental principles that companies must follow:

1. Principle of Regularity

Accountants must adhere to the rules and regulations of GAAP accounting. This principle keeps accountants from making up their own methods. With GAAP, any accountant can understand the work of another accountant. This is extremely important when comparing businesses and analyzing their worth.

2. Principle of Consistency

Accountants must apply the same standards and techniques for all accounting periods. This ensures financial comparability between periods. Any changes or updated standards must be explained in the footnotes to the financial statements.

3. Principle of Sincerity

Accountants must be as honest, impartial, and accurate as possible in their reporting of a company’s financial performance. They cannot lie or fudge numbers to make a company seem more profitable.

4. Principle of Permanence of Methods

All GAAP-compliant companies must be consistent with their methods and procedures. This way, all GAAP-compliant companies can be compared regardless of their industry.

5. Principle of Non-Compensation

Businesses must report all aspects of their performance, both good and bad, and do so without the expectation of debt compensation.

6. Principle of Prudence

Accountants should never speculate or give their opinion in a financial report. All records must include only expenses and provisions for spending that have taken or will certainly take place.

7. Principle of Continuity

When valuing assets, accountants must assume the business will continue to operate in the foreseeable future. Any potential buyouts or foreclosures should not be considered.

8. Principle of Periodicity

Accountants must report all revenue and expenses in the appropriate accounting period, such as fiscal quarters or fiscal years.

9. Principle of Materiality

Accountants must strive to fully disclose all financial data and accounting information in financial reports.

10. Principle of Utmost Good Faith

All parties that contribute to a company’s financial report are assumed to be honest and reputable.

Recommended: Debt-to-EBITDA Ratio Explained

Alternatives to GAAP

IFRS

The International Financial Reporting Standards, or IFRS, are another set of accounting standards, but these are used at the international level. IFRS is standard in the European Union and many countries in Asia and South America, but not in the United States. IFRS was established so that companies could be comparable from country to country.

The main difference between GAAP vs. IFRS is that GAAP prioritizes rules and detailed guidelines, whereas IFRS only provides general principles to follow. Accountants have more leeway when following IFRS, but often need to include explanatory documents. On the other hand, businesses that use GAAP may feel confined by the lengthy rules.

Recommended: How to Calculate Cash Flow

Tax-Basis Accounting

Tax-basis accounting follows the accounting that a company is required to use for filing its federal tax return. If allowed by creditors, investors, and other financial statement users, tax-basis accounting can make sense for a privately held company, since it means less work when preparing the company’s tax return. When comparing tax-basis vs. GAAP accounting, tax-basis accounting is less complex and often leads to less footnote disclosures in financial statements.

GAAS

Generally accepted auditing standards, or GAAS, is the framework that guides auditors. GAAS standards help auditors prepare a transparent and reliable audit report on companies. Following these standards also ensures that auditors don’t miss any important information. When comparing them, it’s important to remember that GAAP is used by accountants, whereas GAAS is used by auditors. Therefore, an auditor following GAAS may see how well a company is following GAAP.

Recommended: Explaining GAAS vs GAAP

OCBOA (Other Comprehensive Basis of Accounting)

Other comprehensive basis of accounting (OCBOA) refers to systems that are not GAAP or IFRS. These can include tax-basis accounting, but also cash-basis accounting. To understand that approach, imagine your company’s business checking account. You would only count revenue when you actually had gotten the cash deposited in the account and expenses only after you’d paid the cash out, so your statement would reflect exactly what was in the account, Cash-basis accounting extends this approach to all your company’s financials Accrual accounting, by way of contrast, counts revenue when it’s earned, even if it hasn’t been received yet, and expenses when they’re incurred, not when you actually pay them.

Other systems that fall under OCBOA include modified cash-basis accounting (a hybrid form of cash-basis and accrual accounting) and regulatory-basis accounting, in which you’re following rules set by a government or industry regulatory agency. Methods like these can make financial reporting easier and help keep results clear, but aren’t always useful for cross-industry comparisons, investors, or compliance purposes.

The Takeaway

GAAP accounting principles are what public U.S. companies must follow when putting together financial statements. The goal of GAAP is to hold publicly traded companies accountable and ensure their financial statements are complete, consistent, and comparable.

For small business accounting, you aren’t required to follow GAAP regulations. However, doing so can make it easier for outsiders to evaluate your business and compare it with other companies in your industry. Publishing GAAP-compliant financial statements could make it easier for your business to attract an investor or get approved for certain types of business loans.

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

How many GAAP principles are there?

The generally accepted accounting principles, or GAAP, has 10 principles. They are the principle of regularity, the principle of consistency, the principle of sincerity, the principle of permanence of methods, the principle of non-compensation, the principle of prudence, the principle of continuity, the principle of periodicity, the principle of materiality, and the principle of utmost good faith.

Is GAAP the same in every country?

No, only publicly traded companies in the U.S. must use GAAP (generally accepted accounting principles). IFRS (International Financial Reporting Standards) is a framework used in the European Union and many countries in Asia and South America.

Why is GAAP important?

GAAP (generally accepted accounting principles) is important because it ensures honesty, transparency, and uniformity in financial reporting. Without GAAP standards, businesses could report their earnings differently, which could make it difficult for investors and creditors to evaluate and compare companies, and the absence of GAAP could also provide opportunities for fraud.

What does GAAP stand for?

As an acronym, GAAP’s meaning is “generally accepted accounting principles.” It’s a comprehensive framework of accounting rules. GAAP is primarily used in corporate accounting and financial reporting in the United States.

Who oversees GAAP?

Three nonprofit organizations — the Financial Accounting Foundation (FAF), Financial Accounting Standards Board (FASB), and Governmental Accounting Standards Board (GASB) — each play a role in setting GAAP standards. FAF oversees the FASB and GASB organizations, while FASB issues GAAP rules for businesses and nonprofits and GASB issues GAAP standards for state and local governments. The U.S. Securities and Exchange Commission (SEC) can establish GAAP via government regulations, but it typically allows the private sector to establish the standards.

Photo credit: iStock/AndreyPopov

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.

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.

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-Q425-028

One important way to attract top talent is with an enticing compensation package. For many companies, these include stock options. A 409A valuation is an independent appraisal of a company’s common stock, and is a tool to determine fair market value when issuing equity to employees.

This guide will cover what a 409A valuation is, why companies need a 409A valuation, how they affect stock options, and more.

How a 409A Valuation Works

When a company is public, shares of its stock trade on the open market. Value is determined by what buyers are willing to pay for each share. However, when a company is private, setting stock value — and ensuring it aligns with Internal Revenue Service (IRS) rules — is a bit harder. This is where a 409A valuation comes in, and they can be important to understand when starting a small business.

A 409A valuation is conducted by a third-party to determine the fair market value of common stock. The main purpose is to set an exercise, or strike price, the price at which employees with stock options may buy company stock at a future date.

Recommended: Small Business Loans

Why Companies Need a 409A Valuation

The IRS requires a 409A valuation for legal and tax compliance. The rules emerged after events in the early 2000s, including the Enron scandal in which executives were manipulating options to enrich themselves. The 409A regulation prevents companies from issuing artificially low stock options by requiring that strike prices are set at or above fair market value.

When companies set strike prices, the IRS will compare this price against the 409A valuation, and if there are any differences, it may levy severe restrictions or penalties.

How a 409A Valuation Affects Employee Stock Options

Employee stock options are typically offered as part of a compensation package. Startups often use them to attract top talent when they may not have enough capital to offer competitive salaries in cash alone.

Stock options give employees the chance to buy company stock at a later date at a pre-set fixed price. This is known as the strike price. Companies must set the strike at or above the fair market value set by the 409A valuation. Ideally, the value of the stock will continue to increase from this price, and by the time the employee purchases shares, they can then sell them at a profit.

409A Valuation Methods

There are several ways used to determine valuation, including:

•   Income approach: This method is suitable for startups that are generating revenue and have a relatively stable cash flow. It accounts for company assets and liabilities to determine fair market value.

•   Asset approach: For startup companies that haven’t yet begun to generate income, the asset approach looks at net assets alone to determine value.

•   Market approach: Another method used for startups that have yet to generate profit, the market approach compares the company to other similar companies to determine value.

Recommended: Small Business Checking

How Often 409A Valuations Are Required

Startups need to carry out 409A valuations at least once a year, and sometimes more often. Valuations are required if there is an event that causes material change to the value of a company. Such events might include:

•   Hitting or missing a milestone, such as the launch of a new product.

•   Achieving a new round of funding from investors that might affect the stock price.

•   Before an initial public offering or a merger and acquisition.

•   During a recapitalization event where a company might alter the mix of equity and debt financing.

409A Valuation Compliance and IRS Rules

When setting fair market value for common stock, you must get a 409A valuation in order to comply with IRS rules. This includes getting an independent appraisal from a qualified third party who does not have a conflict of interest with your company.

Failure to obtain a 409A valuation can lead to IRS penalties. For instance, options might be deemed underpriced and could be subject to an immediate tax of 20% in addition to other federal and state monetary penalties. Employees hit with unexpected tax liabilities could file lawsuits against the company.

A certified 409A valuation from an independent third party provides what is known as a “safe harbor.” This means that in the case of an IRS audit, your company will have some legal protection that a valuation was made in good faith.

409A Valuation for Startups

As mentioned previously, startup companies often offer stock options as a way to stay competitive with more highly capitalized companies when attracting talent. As a result, 409A valuations can be an important — and ongoing — part of business operations for new private companies.

Recommended: Microloans for Startups

Common Mistakes to Avoid with 409A Valuations

In order to ensure IRS compliance, watch out for these common pitfalls when carrying out 409A valuations:

•   Using inaccurate data. Be sure that figures used to calculate value are up-to-date and as realistic as possible.

•   Missing recent business developments. Material events must be accounted for, as well as any new risks or liabilities.

•   Choosing an incorrect method. Choosing a valuation method that’s inappropriate for your business can lead to distorted valuations.

How Much Does a 409A Valuation Cost?

The cost of 409A valuations varies widely depending largely on what stage a company is in. Early-stage startups might expect to pay up to $5,000 for a valuation. As companies grow, their finances tend to get more complex, and the price of valuation goes up. More mature private companies might expect to pay significantly more.

Recommended:Business Line of Credit

How to Get a 409A Valuation

To secure a 409A valuation, you will need to engage a third-party provider. Look for companies who have certified appraisers, a strong reputation, and a track record of proven results. You may also wish to engage a company with a support team that can grow with the company. Finally, it may be worth considering whether the valuation company offers audit support.

To pay for the 409A valuation, you can use money from your small business checking account, take out a small business loan, or put the expense on a small business credit card.

The Takeaway

A 409A valuation is a critical step as startups seek to set a fair market value for their shares. It ensures that equity compensation is priced fairly and protects the company from compliance risks from the IRS. Choosing the right partner to perform the valuation can help ensure accuracy, defensibility, and confidence in the outcome.

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 is the purpose of a 409A valuation?

A 409A valuation helps set fair market value for a company’s common stock. It is required by the IRS, and is especially important when offering employee stock options.

Who performs a 409A valuation?

Experienced third-party appraisers offer 409A valuation services.

How long is a 409A valuation valid?

Companies must go through the 409A valuation process every 12 months. In some cases, they may need to perform a valuation sooner if there has been a material event that has an impact on the value of the company, such as a new round of funding or if the business is acquired by another company.

How does a 409A valuation affect stock option pricing?

The 409A valuation sets the fair market value for common stock. The strike price, the price at which stock options may be bought, must be equal or greater to this amount.

What happens if a company doesn’t get a 409A valuation?

The IRS requires 409A valuations. Companies that don’t comply can face stiff penalties — and their employees who purchase stock can, as well. For instance, if the IRS considers stock options to be priced below fair market value, it will trigger immediate income tax for employees when the options vest.

Photo credit: iStock/Ridofranz

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.

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-Q425-033