Types of Financing

I. Debt Financing – Commercial Bank Loans: Debt financing does not give the lender ownership control, but the principal must be repaid with interest. Length of the loan, interest rates, security and other terms depend upon for what the loan is being used.

  • Short-term: Loans for short periods (30-180 days) usually made to cover temporary or seasonal needs for inventory or personnel. These are common for established businesses, but may be hard for a new business to obtain. The key to getting a short-term loan is to always have an identified primary and secondary source of repayment. A short-term loan will probably be either a time loan or a line of credit, both with maturities of one year or less. These types of loans often possess the following characteristics:
  1. Time loans are made for a specified period when there is an identified source of repayment that will be available within a specified period of time. Prime candidates for these loans are seasonal businesses, with the source of repayment being the conversion of inventory to receivables and then into cash.
  2. Lines of credit are annually renewable pre-approved vehicles allowing the borrower access to credit whenever needed within predetermined terms. The business owner can borrow and repay as the business cash flow dictates. A line of credit is usually documented by a loan agreement, a contractual document that details the specific terms and covenants which must be observed. Self-liquidating purchases of inventory or the bridging of expenses pending the collection of accounts receivable are examples of uses for a line of credit.
  • Medium to long term: These loans may be repaid over anywhere form 1 to 5 to even 20 years depending on how the funds are used. The source of repayment is the cashflow of the business. Typical uses are for equipment, fixed assets, etc. Most loans to start a small business will be of this type. Often referred to as term loans or installment loans, these usually cost more than short-term credit. The most common uses for long-term loans are to provide working capital, to purchase equipment, or to buy or improve land and/or buildings.
  1. Working capital loans represent funding for all purposes that are not fixed assets or a line of credit. Examples could be general and administrative funds for expanding the business, a percentage of the purchase of permanent assets, the costs of building out leased space or for purchasing furniture, fixtures, or computer and automotive equipment. Banks usually require 20-30 percent as a down payment and will finance the balance for a period of three to seven years.
  2. Loans for equipment generally will be extended for a term consistent with the depreciable value of the assets.
  • Real estate financing: Real estate is typically financed over a fairly long term, 10 to 30 years. Expect a down payment of about 20%.

II. Non-Bank Options: Asset-Based Lending Summarized, the term asset-based lending came into vogue in the 1970s to describe an industry that included specialized lending departments of banks, non-bank commercial finance firms, and factoring organizations. Today, asset-based lenders provide a variety of financial services to small, medium, and large businesses through:

  • secured lending against the assets of a corporation,
  • loans for machinery and equipment, real estate, leasing, import-export financing, acquisitions, and
  • factoring accounts receivable.

This area of financing should be part of the working knowledge of every small business owner. Combined with the commercial lending services of a firm’s bank, and a working knowledge of state and federal loan programs, asset-based lending (or the broader category of non-bank commercial finance) rounds out the available sources of debt financing available to the growing small enterprise.

Today’s small business owner must be knowledgeable about all forms of financing, what they can do, why one method may be better than another, and where sufficient funds can be found. Given the highly regulated credit markets faced by banking institutions it only makes sense to maximize knowledge of lending options for your business.

The small business owner familiar with bank lending will find an asset-based lender capable of structuring similar loans and lending agreements with a willingness to take slightly more risk. Virtually any type of loan a bank can make will have a corresponding asset-based lending option.

Significant Differences

The difference between a bank and an asset-based lender can be significant. Asset-based lenders are not regulated and this makes conventional financial ratios secondary in the credit analysis. While banks are virtually confined these days to strict reliance on balance sheet figures, an asset-based lender can look behind the figures at the business strategy, management, market potential, products, etc. Make no mistake, these lenders are as interested in getting repaid as banks and government programs, but they will have a tendency to see if they believe the funds can be put to profitable use.

Assuming these parameters are met, asset-based lenders may allow a higher borrowing capacity. They will certainly establish the limit on a loan based on the client’s collateral and not its net worth. In the best asset-based lending arrangements, as business grows, the borrower becomes self-financing. For example, if a firm has a line of credit with an asset-based lender, as receivables grow, the ability of the firm to borrow grows.

Asset-based lenders will generally not require compensating balances; interest is paid only on the funds borrowed. This type of secured lending revolving loan pool is not impossible with banks, but has become much more problematic for small businesses to obtain in the 1990s. An asset-based lender will require significantly more of the borrower’s record keeping systems. Reporting requirements can be extensive and include invoices, remittance reports, sales assignments, accounts receivable aging reports, etc., perhaps on a daily basis. The nominal rates charged by asset-based lenders will therefore be higher, sometimes significantly higher, than conventional borrowing from banks and government loan programs. But the small business owner of the 1990s should avoid undue emphasis on rate, and also take into account the terms of loan agreements, the availability and flexibility of the funding source, and the profit potential of what the borrowed money can accomplish.

Equity financing

In its most basic form, equity financing results in the repayment of principal and/or return only if the venture produces sufficient funds/revenues for that purpose; hence the term risk capital. Due to the risk(s), the possible capital sources could be anyone, anywhere, anytime depending on the amount, purpose, and stage of business at issue.

Equity financing will always require consideration of ownership, profit, benefit sharing, operational control, valuation, and exit strategies as important issues to be carefully evaluated.

Although equity financing can cover a wide array of capital source types, there are, in general, several overall categories. The following summaries may help you in the equity search.

Venture Capital/SBICs/Investment Banking

Approximately 500 institutional firms represent sources of equity financing involving investment approaches which are typically characterized by specific, often demanding investment criteria for their financing interest, result in substantial due diligence investigations, and can require significant ownership sharing. The bulk of this capital source is focused to more developed enterprises with few start-up or early stage opportunities. Of the entire equity market for small businesses, venture funds represent less than 5 percent or approximately $35 billion. Pratts Guide to Venture Capital Sources is a comprehensive guide to these organizations.

Friends & Relatives

For most start-up situations or early stage enterprises, capital is typically generated by persuading available friends or relatives to bankroll the venture. Although requiring less in the way of written business materials and perhaps more accessible, there are substantial risks beyond economic considerations which should be seriously evaluated, not the least of which may be disrupted relationships should the business not perform as expected. Since the funding primarily results from the personal relationships involved, complete business plans, a professional support team, and significant due diligence investigations are not characteristic of this funding mechanism. Ownership sharing may or may not be required. Many family members will enter into an agreement through the use of a simple promissory note.

Angels

Angels represent an informal market of individual investors and business persons/entrepreneurs who may or may not frequent the small business investment area. Access can be through any business contact, but is usually the result of professional sourcing through a financing consultant, attorney, accountant, and/or other type of business adviser. A solid business plan with professional support is usually required to achieve an investor comfort zone which also usually includes due diligence review. Risk evaluation and pricing are usually the major issue, as opposed to ownership sharing. The Hampton Roads Private Investor Network provides some confidential access to private investors for small businesses in the Hampton Roads region.

Seed – Seed money is used in the beginning planning stage of a small business.

  • Stage 1 – usually refers to the stage after the product has proven viable
  • Stage 2 – A follow on funding round based upon sales progress
  • Stage 3 – later stages to fund growth

Bridge – any short term financing to provide interim funds between funding cycles or until the next imminent event

Private Equity Placements

This form of financing is subject to several regulatory and legal requirements. Accordingly, direct support and continuing assistance from a professional team of financial, legal, and accounting advisors is required to assemble the necessary written materials and establish a successful financial marketing plan. A complete business plan is necessary and due diligence should be expected. Ownership sharing and valuation can be significant issues.

Strategic Partners

This evolving area of equity financing in its most basic form, represents some other business enterprise(s), related or unrelated to your venture investing to achieve some advantage, economic or non-economic, by providing goods, services, support, and/or attractive credit arrangements to you in return for goods, services, and/or a potential equity position. For example, a major product or material supplier may grant very favorable payment terms to allow extended time for receivables recovery and improving and/or stabilizing cash flow in return for exclusive dealing, the prospect of larger orders by tracking a firm’s success, handsome interest charges, and/or even potential equity involvement.

This type of financing is extremely effective and, due to its focus, quite efficient. It can occur in a wide variety of forms and can even involve direct competitors in teaming arrangements. Sourcing is usually with professional financial and business advisors requiring a good professional support team, and solid business planning.

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