Financing Your Business – 1: An Overview

This article is the first in a series that will discuss various aspects of financing your business.  Here is a list of the topics that we will cover:

1. The potential financing sources that are available to you.
2. Understanding the lender’s perspective.
3. What causes the need for financing.
4. How to identify the events that cause the need for financing.
5. Using the proper debt structure.
6. Preparing a financing package.

Let’s begin by taking a look at some of the potential financing sources that are available to you.  Most business owners think that their only option is to get financing from a bank, from savings, or from friends and family.  Actually, there are more sources available to you:

1. Private Investors – This group includes not only your friends and family that are willing to take a chance on you, but also such entities as venture capitalists and angel investors.  Keep in mind that your chances of getting funding from a venture capitalist are very slim; even if you have a product or service that can grow quickly, provide a high return, and offer a quick exit, the venture capitalist may still choose another investment over yours.  You may be better off either borrowing money from friends and family, or creating a Regulation D offering to allow your friends and family to participate in the growth of your company.  A note of caution:  if you do tap relatives and friends for funds, be sure to do an arm’s length transaction, i.e., as if you were total strangers.  Do it right, because you want your friends and family to stay your friends and family, no matter what happens.
   
   
2. Banks – This is a very familiar financing source.  What you want to remember about banks is that they can only lend to your business if your business is established and is generating a profit, has a positive cash flow, and does not already have too much debt.  Even if all of these things are true, and even if your company is incorporated, if you are the sole owner you need to be prepared to personally guarantee whatever debt the bank grants to you.  If your company does not meet the previously mentioned criteria, you might still qualify for a loan guaranteed by the Small Business Administration or, if your personal credit is good, a personal line of credit.
   
3. Factors – A factoring company may seem very similar to a bank, but there are critical differences.  A bank bases its lending decision on the overall cash flow and financial condition of your business, and will take assets such as inventory or machinery as collateral.  A factoring company does evaluate your company’s financial condition to verify that your business is viable, but only provides financing against your accounts receivable.  Technically, a factor does not lend money to you.  Instead, he buys your accounts receivable and assumes the collection risk.  Be aware, though, in many cases, the factor may require you to buy back the accounts receivable if your customer does not pay.  A factor is a good alternative if you do not qualify for bank financing, and can also provide additional credit if you have exceeded the limit of your bank line of credit.  Factoring is a riskier form of lending than bank financing, so be prepared to pay a higher interest rate on factored transactions.
   
   
4. Finance Companies – Finance companies are similar to factoring companies in that finance companies are asset-based lenders.  In other words, they lend to you based on the value of your assets, as opposed to banks, which base their decision more on your overall financial condition and cash flow.  Finance companies establish a “borrowing base”, which is the maximum amount of money that you can borrow.  The borrowing base is based on the value of your receivables and inventory.  This financing is a good alternative if your company’s financial condition is less than stellar, but you have receivables and inventory that have good value.  The finance company is more involved in the management of your credit line and also takes a bigger risk than a commercial bank because the finance company relies only on specific assets for repayment.  Since the lending process is more labor intensive and the risk is higher, the finance company will also charge a higher interest rate than a commercial bank.
   
5. Leasing Companies – Leasing companies are an excellent source of financing if your primary need is to purchase a piece of equipment.  You also have to meet certain credit standards to qualify for lease financing, but a lease transaction is a good way to manage your cash flow.  This is because a good leasing company will try to match your monthly payment to an amount that is within your monthly budget.  Also, the leasing company will factor in any residual value of your equipment at the end of the term of the lease.  For this reason, the leasing company may be able to provide longer terms than a commercial bank.  You may pay a higher rate with a leasing company than you would with a bank, but the leasing company may be more likely to provide a monthly payment you can afford.
   
   
6. Purchase Order Financing – You may find yourself in a situation where you receive a purchase order for a very large amount, yet you do not have the money available to purchase or manufacture the product for your customer.  A purchase order lender will advance money to you so you can buy inventory and manufacture your product to fill the order.  This type of financing is not technically lending.  It is really an equity rental; the purchase order lender “lends” his equity to the transaction.  For this reason, the interest cost is much higher than in other types of short term financing.  Be aware that this type of financing is only viable if you have very high gross margins and the transaction has a short (less than 45 days) time frame.
   
   
7. Suppliers – Finally, do not forget trade credit, which is an excellent source of financing if you can get it.  It is a resource you should strive to obtain and, once you get it, fiercely protect.  Over the long term, a good relationship with your supplier, more so than with any other lender, can make the difference between your company’s survival or failure.

In the next article in this series, we will look at financing your business from the lender’s perspective.

Copyright 2007 Kaufmann Capital Advisors

Comments

[Iris Welch]

As a non-recourse factoring company with no term contracts, I appreciate you pointing out the possible differences in factoring companies. Also in noting that factoring is a means of not incurring debt, but a way to receive funding on services or products already rendered and payment is outstanding. UC Factors is trying to upgrade the image of factoring as an alternative to creating debt by having access to consistent working capital, putting your business on a cash basis, while limiting your credit risk.