Borrowing your Way to Success

Contributed by JJ Richa

There are so many ways to finance a small business.  Most of them rely upon some form of debt, often personally guaranteed by the founder(s).  So we start with the most simple of these methods of debt financing first, since most are simple to execute and non-dilutive – that will help you to retain your ownership intact.

Here is a list of common loan types:

  • Line of Credit – Short Term Working Capital
  • Term Loan – Real Estate, Equipment or Other Long Term Capital Requirements
  • Guarantee Based Programs:
    • Small Business Administration (SBA)
    • CalCap – California Capital Access Program
    • State Loan Guarantee
  • Economic Development Programs such as CEDLI

The Small Business Administration (SBA) is a valuable funding resource for many businesses. However, the SBA itself does not actually make loans. Instead, the SBA guarantees bank loans, allowing commercial lenders to make loans that they may not otherwise. The SBA, through its programs, reimburses lenders for a guaranteed portion of the loan (usually up to 85%), making it less risky for them.

In order to be able to obtain a loan, SBA or conventional, you must meet the basic financial institution risk rating, which is known as the “5 Cs of Lending”:

  1. Character – Responsibilities and Treatment of Employees and Customers
  2. Cash Flow – Debt Handling, Repayment Record, Debt Liquidity and Ratios
  3. Collateral – Hard assets, Real Estate, Capital Equipment, Accounts Receivables
  4. Capitalization – Skin in the Game, Business Resources, Own Risk
  5. Conditions – Economic Conditions, Market Sensitivity, Expense Management

The logical next step is to look at asset-based lending, in which you pledge or assign your short term assets, such as accounts receivable or inventory, to the lender.  Often, the lender then tracks the pledged assets until money is received, or inventory sold, expecting repayment from the proceeds of sale.

Asset-based financing is a specialized method of providing structured working capital and term loans that are secured by accounts receivable, inventory, machinery, equipment and/or real estate. This type of funding is great for startup companies, refinancing existing loans, financing growth, mergers and acquisitions.

One example of asset-based finance would be purchase order financing; this may be attractive to a company that has stretched its credit limits with vendors and has reached its lending capacity at the bank or a possibly a startup company without adequate financing. The inability to finance raw materials to fill all orders would leave a company operating under capacity. The asset-based lender finances the purchase of the raw material, and the purchase orders are then assigned to the lender. After the orders are filled, payment is made to the lender, and the lender then deducts its cost and fees and remits the balance to the company. The disadvantage of this type of financing, however, is the high interest typically charged.

The formalities of such loans often require some amount of dedicated time. Many lenders require that a transaction report be generated along with a batch of purchase orders or invoices pledged as collateral for the loan.  The lender has the right to reject any individual pledged item, then calculates a percentage of the value as the amount to loan.  Ranging from 50% to 80%, you can request an “advance” up to your credit limit, beyond which you must rely entirely upon your own devices to finance further transactions.

Each transaction report also contains a list of money received against pledged items, so that the calculation of available credit remains fresh, and based upon remaining invoices that are not yet overdue.  Government invoices are usually not accepted, and any new invoices from accounts that are more than 60 days old are usually also exempted, as are invoices to concentrated customers who individually account for a significant percentage of the company’s business.

Asset-based financing is not cheap.  Lenders often tack on charges for management of your account, for a “float” of cash to account for the number of days to clear checks received, and for a periodic audit of the company’ accounts.  Adding all of these often adds an additional 3-8% to the stated interest rate of the line of credit, sometimes making it one of the more expensive methods of finance.

Finally, some asset-based lenders are “factors” who actually purchase your invoices, hold back a portion of the proceeds for future bad debts, deduct their fees before remittance, and remit a net amount, with the remaining amount to be remitted upon collection of the money owed.  Factors redirect your customer’s payment to the factor’s postal lock box. You never see the cash collected, since the invoice is owned by the factor, no longer by you

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