Financing your small business can be a complicated endeavor. The number of options can be intimidating. Big banks, community banks, private capital, non-bank lenders, factoring companies, fintech companies, or private capital sources are just a few. Exploring the options can be very time consuming and can possibly lead to little success. I think most business owners would rather spend time improving their operations, selling more, and focusing on the day-to-day requirements of the company. However, how you finance your company today can ultimately be a long-term critical decision.
There are many different types of businesses and stages of growth. Financing sources can differ widely depending on these factors. I sometimes use a medical analogy when talking about financing a business: “Sometimes your needs can be met by the general practitioner, but sometimes you may need to go to a specialist.”
In this analysis, I will only include B2B businesses, which is defined as a business that sells their product or service to other businesses and not directly to consumers.
Early or Start-up Stage
These businesses typically need some level of seed capital or angel capital. Think of the television show Shark Tank. Many of these companies may have a great idea, industry experience, demand for their product or service, and a targeted potential customer base. Usually these businesses either have owner-invested capital, friends and family money, or are seeking additional capital to build their business platform so they can deliver on customer orders, acquire materials, and pay employees and vendors.
Another financing option is to factor invoices, which can be a great financing vehicle since these businesses have lower unpredictable revenue and little in hard assets for banks to have an interest. Many early- stage businesses cannot afford to wait 45-60 days to get paid on their invoices. Through factoring, businesses get access to cash by providing invoices to the factoring company and receiving 80-90 percent of the value of the invoice. Once the invoice is paid by the customer, the remaining amount is given back to the business (invoice payment less the original advance and fees). Factoring is very common for early-stage entrepreneurs that need more cash than what they had originally invested in the business.
As revenue grows, new sources of funding are available. As sales increase, so do accounts receivable and inventory. Assets financed at this stage can also include equipment. Many businesses are still building revenue, perhaps very quickly. Sales and profits may be somewhat unpredictable, but improving in a positive direction although the balance sheet may still lack significant equity. Consequently, banks may still want to sit on the sidelines until revenue, profitability, and business net worth are more predictable and substantial. Since accounts receivable, inventory, and equipment are usually increasing, a business will start to experience cash pressure, or running out of cash. If a business is not properly financed, then cash starts to disappear and the business starts to run into problems – unable to pay employees, vendors, rent, etc. on time. Once these problems appear, employees may leave, vendors may stop supplying, and customers may stop ordering since there is no longer a product or service that the company can supply as needed. This environment is perfect for factoring and asset-based line of credit facilities. Both financing vehicles provide much needed cash to the business from the values of the accounts receivable, inventory, and equipment. As a company grows and reaches mid-stage, asset-based lines of credit become more accessible due to the company’s need for cash from the assets.
After successive years of improving revenue, earnings, and growing retained earnings, a business becomes more predictable and stable. If earnings have continued to be put back into the business, its balance sheet will be stronger and its borrowing relative to its net worth becomes lower (debt to worth). Less reliance on borrowing cash against assets is required, so less borrowing is required relative to what the business is worth. At this point, more traditional sources of capital open up, like bank and SBA financing. A key question for a business at this stage revolves around the long-term outlook of the company – is there potential high growth in the future? If so, more cash will be required to support the business and an asset-based line of credit may be more appropriate for the business so it can achieve its sales targets and still have enough cash to support its day-to-day working capital needs.
Regardless of the phase of a business, it is paramount for owners to identify cash requirements for the business now and its anticipated needs in the future. It pays to research different sources and find the financing source that is best suited for their specific needs.
Where does your business fit in the financial spectrum? Think asset-based lending is right for your company?
Jeff Wright has been with the Hitachi team since 2006 and contributes more than 30 years of experience in the banking and commercial finance industry. He is currently responsible for business development in the Midwest region, and works with businesses and their trusted advisor network to provide factoring and asset-based lending services.
Contact Jeff at (248) 259-3749 or firstname.lastname@example.org.