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Getting the right type of financing is one of the most important decisions that can make or break any business. Financing methods are not created equal, and can have dramatic implications on your company’s cash flow, taxes, operations, and overall competitiveness. This is especially true for small and emerging businesses, where access to the right type of capital is essential to growth.
It is often said that the best type of capital is the one you can get from selling to customers. In other words, profits your business earns that you can reinvest into your business. Unfortunately for many small and high growth businesses, past profits are not sufficient to fuel their growth, so they often need to look for external sources of financing.
The following article describes 3 commonly misunderstood financing options for small businesses, their benefits, and when it makes sense to use them. It is meant to help start an important conversation, so please reach out to us to learn more.
Venture Capital & Angel Investors
We’ve all heard about the many technology startups that have raised millions of dollars and have gone on to achieve sky high valuations with each successive round of capital. Despite pervasive media coverage, historically, less than 1% of all businesses have raised capital from VCs. While many entrepreneurs often obsess about the question of how to get VC funding, perhaps a more important question is whether or not VC funding is right for the their business:
|Ideal Businesses||Hyper-growth companies (usually technology) with little or no collateral, unpredictable cash flow, and large capital needs. Company should be looking for a large exit (sale, IPO, etc.) within a 7 year-horizon.|
|Key Benefits||Aside from money, the right VC or angel investors can make connections, provide management expertise, and lend credibility. Unlike debt, which must be repaid with interest, VC and angel investments are a form of equity, so there is more flexibility in terms of cash flow.|
|Important Considerations||Aside from how challenging it is to obtain VC funding, entrepreneurs should be ready for the following:
· Giving up equity – It’s no longer just your company, so you are now sharing on any upside with investors. With subsequent rounds of capital, your ownership of the company will be successively diluted.
· Giving up control – VC’s get to appoint seats to your company’s board of directors. Even if they are not on the board, many investors will want to be actively involved and will expect to have a say in how the company is run. In fact, if enough investors lose faith in you, you can get fired from your own company.
· Constant Pressure to Accelerate Growth – Investors expect massive returns on their investment (think 10X) within a few years. As your company grows in size, maintaining this growth becomes increasingly challenging. With every capital round, investors expect the value of their equity stake to grow, even if other partners are brought along.
· It’s a full time job – Raising equity financing can consume all the time and effort of at least one person in your team (usually the CEO). Furthermore, once you have raised capital, you need to keep raising subsequent rounds at least until you are cash flow positive. Make sure that you are set up and ready for this.
One of the least understood, seldom mentioned, and under utilized ways to finance your business is factoring. In simple terms, factoring involves selling your company’s receivables to a factoring company in exchange for upfront cash, which you can use to pay your bills, make payroll, or reinvest in your business. The factoring company then takes care of collecting payment from your customers, freeing you to focus on running your business. Unlike debt, your company’s credit-worthiness is less important than the credit-worthiness of your customers, so factoring can be a good option for businesses that sell to well-established, stable businesses but might have long payment terms. The table below can be used to understand if factoring might be right for your business:
|Ideal Businesses||Businesses that sell to well-established, credit-worthy organizations, but need to reduce collection time such as:
· Businesses selling to governments & Fortune 500 companies
· Healthy, high-growth businesses
· New businesses without extensive credit history
· Distressed businesses looking to improve cash flow
|Key Benefits||· With factoring, you get to outsource your collections, often making it less expensive for small businesses to collect payment from powerful, bureaucratic, and slow customers
· Factoring is a realistic option for businesses with little credit history or even a checkered credit history
· Speed – businesses can get their cash in as little as 24 hours, depending on circumstances
· When part of a larger financial institution, such as First Business Bank, factoring can lead to an established relationship and open the door to other forms of financing that might have been previously unobtainable, such as Asset Based Lending.
|Important Considerations||· Look for a long-term factoring partner – To get the best rates and service, look for partners that can work with you over an extended period of time, as opposed to “one-off” deals.
· Reputation and regulation matter – Not all factoring companies are created equal, nor do all of them adhere to the same standards. Look for a factoring partner that is backed by a reputable financial institution, such as First Business, as it is likely to be better regulated than a stand-alone factoring company.
· Keep the house in order – Even with factoring, you still need to secure basic documentation from your customers, such as purchase orders and signed statements of work.
· Engage with your factoring partner early and often – Your factoring partner can help you avoid customers that are not credit-worthy and alert you to red flags that can make or break your business.
The Small Business Administration (SBA) is a US government agency that provides support to entrepreneurs and small businesses. One of the most important tools in the SBA’s arsenal is the 7(a) program, in which the federal government guarantees a large portion (typically up to 75%) of the loan. This guarantee helps lenders extend loans to businesses that otherwise may not fit into the bank’s lending policy guidelines (collateral, limited business credit history, longer amortization needed).
|Ideal Businesses||Businesses with healthy, predictable cash flows and a proven management team are good candidates for an SBA loan, even if they have limited collateral assets. Furthermore, SBA loans can be used for a variety of general business purposes, such as:
· Establishing a new business
· Acquiring an existing business
· Long-term working capital for operational expenses, accounts payable, or even purchasing inventory
· Short-term capital needs for seasonal financing, construction financing, and exporting
· Purchasing equipment, machinery, furniture, supplies, and real estate
· Refinancing existing business debt.
The maximum loan amount is $5MM, and the borrower must qualify as a ‘small business’ per the SBA’s guidelines. Because the emphasis is on cash flow, lenders like to see a 2 years history of financials, but projections can be used in the case of startup loans.
|Key Benefits||· Loan can have a collateral shortfall.
· SBA loans have flexible equity requirements. Conventional loans, in contrast, may require 20% down.
· Longer loan amortization (sometimes as long as 25 years for real estate) with no balloon payments.
· As with any loan, you don’t give up ownership in your business.
· As with most business loans, loan interest can be expensed, reducing your potential tax liability.
|Important Considerations||· Owners must be actively involved in running the business.
· For real estate deals, business must occupy +51% of square footage.
· May require personal guarantee and personal real estate assets.
· As with any loan, you must make regular loan payments and adhere to the stipulations in the loan covenant.
· Not all SBA lenders are equal – pick a lender that is an expert in the SBA’s policies and can help you navigate through the process, so you can get the most favorable loan for your business.
You owe it to yourself and your business to understand the benefits and implications of various sources of financing. The right financing vehicle can be a catalyst and an enabler to your company’s growth, just as the wrong one can hold you back. In order to determine the best financing options for your business, you should clearly understand your business model, strategy, and stage of development, but also your business goals and desired trajectory for the next 5-7 years. You should also seek out reputable partners who can provide you with a wide range options, resources, and objective advice to help you get the most favorable terms for your business.
About the Authors:
Gail Heldke has over 30 years experience in banking and financial services with over 20 years in commercial lending and factoring. Her primary responsibilities have included business origination for factoring, asset-based and purchase order programs; credit analysis and portfolio management. Ms. Heldke is actively involved in the Turnaround Management Association, The Commercial Finance Association, Midwest Business Brokers & Intermediaries, IWIRC and the International Factors Association.
Ryan Black has over ten years of banking experience ranging from retail banking to commercial underwriting and now currently focuses on providing lending solutions for commercial customers using the SBA and USDA lending programs. He has conducted financial seminars at the Hmong Wisconsin Chamber of Commerce and has volunteered at Junior Achievement of Wisconsin. Ryan is a sports enthusiast and spends most of his free time chasing his two young children.
Jorge Varela, Jr. has over 15 years’ experience in financial services with over twelve years in the factoring and asset-based lending industry. This includes 2 ½ years with Gibraltar Financial and four years with Working Capital Solutions, Inc. As the primary business contact for First Business Factors, his focus is to consistently provide excellent customer service to clients while remaining primarily focused on protecting the Bank’s assets.
Naydine Lopez has 14 years of banking experience, primarily focused in SBA Lending and Servicing. She brings a strong knowledge of government guaranteed lending and a passion for people and relationship building. Born and raised in Chicago, where she still resides, she is an avid salsa dancer and a diehard Cubs fan. Her young children are amazing, funny and sharp, keeping her on her dancing toes.