Companies that are low on cash flow and could benefit from an infusion of working capital have access to a variety of financing options. Many business owners automatically consider applying for a bank loan or line of credit, and for some companies, this is the best course of action.
The current business, economic, and regulatory climate makes it challenging for businesses, especially startups and those with a financial history of difficulty, to qualify for a bank loan. When a company’s owner is denied a loan from a traditional lender, he or she may decide to look elsewhere for funding.
Is that so though? Though bringing in venture capital or so-called “angel” investors could be beneficial to your company, it also comes with a few potential drawbacks. But oftentimes, business owners don’t consider these disadvantages until after they’ve signed a contract with a venture capitalist or angel investor and it’s too late to back out.
Variety of Financial Options
The issue with relying on equity investors to shore up your working capital is that the two are fundamentally distinct forms of financing.
It is appropriate to use a short-term financing instrument to cover the costs of working capital, or the money used to cover expenses incurred by a business before cash from sales (or accounts receivable) is collected. However, equity should typically be used to finance rapid growth, business expansion, acquisitions, or the purchase of long-term assets, which are assets repaid over more than one 12-month business cycle.
On the other hand, the biggest risk when accepting equity investors is losing control of your company. Selling equity (shares) in your company to investors like venture capitalists or angel investors means giving up a portion of your business at what may be a bad time. In most cases, when ownership is split up like this, key players lose sway over crucial business decisions.
As a result, owners are sometimes persuaded to sell equity for little to no cost to themselves. The interest rate on equity financing is typically lower than that on debt financing. Investors in your company’s equity receive their return through the increased value of their stake in the company. However, the “cost” of selling equity over the long term is always much higher than the “cost” of debt over the short term, both in terms of hard cash cost and “soft costs” like the loss of control and stewardship of your company and the potential future value of the ownership shares that are sold.
Diverse Methods of Funding
What if, however, you can’t get a loan or line of credit from a bank, but your company desperately needs working capital? For businesses in need of immediate access to funds, alternative financing options are often the best bet. These businesses typically use one of three alternative financing options:
Providing the Total Package Business owners can take advantage of discounts on their accounts receivable by selling them to a commercial finance (or factoring) firm. Once the receivable is transferred to the factoring company, it is handled by the company until payment is received. As a temporary alternative to traditional bank loans, factoring has proven to be an effective tool for businesses with high customer concentrations and rapid expansion plans.
Finance based on Accounts Receivable (A/R) Businesses that are not yet bankable but have a stable financial condition and a broader customer base can benefit greatly from A/R financing. In this document, the company lists its Accounts Receivable and promises to use those funds to repay any debts. While the finance company figures out how much the business can borrow, it deposits the money it receives from collecting those receivables into a lockbox. Money is advanced to the borrower when it submits an advance request to the finance company, which does so by using a predetermined percentage of the borrower’s accounts receivable.
Asset-based lending (ABL) is a type of business financing in which the loan is backed by the company’s assets, such as accounts receivable, machinery, and stock on hand. In this arrangement, the company is responsible for managing and collecting its own receivables and providing regular collateral reports to the finance company, which will be reviewed and audited on a periodic basis.
The advantages of alternative financing may extend beyond the provision of working capital and the preservation of owner control of the company.
- The exact financing cost can be calculated, and a raise can be obtained without much hassle.
- Dependent on the type of facility and the lender, professional collateral management may be provided.
- Many modern reporting systems allow for real-time, online interaction.
- More money for the company’s operations could be made available.
- The amount of money available for financing can rise and fall depending on the company’s circumstances.
- It’s worth noting that there are scenarios in which equity financing makes sense and even looks good. In particular, debt financing is rarely an appropriate solution when a company needs to expand, acquire other companies, or introduce new products. However, equity is rarely the best way to address a shortfall in working capital or close a cash flow gap.
An Extremely Valuable Item
Always keep in mind that equity in a business is a valuable asset that should be considered carefully and only at the appropriate time. Seeking equity funding is best done when a company has solid growth prospects and a sizable cash need associated with that growth. The company’s founder should retain the majority of shares (and hence, control) in perpetuity (s).
Many cash-strapped businesses that don’t qualify for bank financing can benefit from working capital boosts provided by alternative financing solutions such as factoring, A/R financing, and ABL, without diluting ownership or possibly giving up business control at an inopportune time. After some time has passed and the company has proven itself worthy of traditional bank financing, this type of credit can be easily converted to a more conventional bank loan. If your bank cannot provide you with a satisfactory alternative financing solution, they may be able to put you in touch with a commercial finance company that can.
The best way to make sure you choose the best financing option for your business is to take the time to learn about all of your options and the benefits and drawbacks of each. Alternative financing can help your business expand without watering down your stake in the company. After all, the profits from your enterprise are yours to keep.