Viola is lucky that she has orders to fill in today’s economy. But she is concerned about her business cash flow. She needs to understand her own small business financing options so she can continue to grow. Her long-time commercial bank, which provided a $1.5 million line of credit over the years, is about to drop her. Her CPA recommended she use factoring; her current banker suggested a non-bank line of credit. Which one is best for her? Or should she grab whatever is available just to keep the business going?
When it comes to capital financing options, even savvy entrepreneurs seem to harbor misconceptions. For an overview of each option, as well as the cost (expected rate of return) associated with each option, read on. But you should always consult with your team of advisors and conduct a cost analysis to help you make the right decision.
Private capital markets represent businesses with less than $500 million in revenue. The capital or financing resources are very different than those for publicly traded companies. In general, there are six broad categories of capital available for the private capital markets: bank lending, equipment leasing, asset-based lending, factoring, mezzanine and private equity.
The choice you make depends on several factors: why you need the capital, what you are using it for, how much you are willing to pay for the cost of the capital, how much control you want to have in your business, the financial institution’s requirements and whether you personally are guaranteeing the capital.
Let’s agree on some terminology to help understand each category. Let’s assume that Brittney, your daughter, just graduated from a top Ivy League school and got a job in White Plains, N.Y., which is close to Manhattan but requires her to do some driving. She needs a car, but living expenses are so high she doesn’t have the ready cash. She comes to you for advice. She did her research and found that the car she wants is about $20,000, including taxes, registration, etc. The lender, the company that will lend her the money, requires 10 percent down, or $2,000. She does not have the money and hopes she can borrow from you, at which point you become the investor.
Lenders always want their money back (the amount they lend) plus predetermined interest on an annual basis. The lenders must use the underlying asset–in this case the car–as collateral to lend. So the lender will lend $18,000 to her, and the lender’s name will be on the car title. Brittney will pay the money, with principal and interest, back on a monthly basis for 36 months. If she fails to pay, the lender will repossess the car. You, the investor, on the other hand, don’t need the car as collateral, but you want to take 10 percent ownership (or equity position) of the car. But you’re not looking for a return of the amount you lend. You’re looking for net profit distribution annually from the car plus potential appreciation (or growth) of the car.
Obviously, there is no net profit from a car, but most businesses do have a net profit. The lender always takes a collateral position of assets of your business. The investor takes some form of ownership (or equity) of the business. The cost to Brittney is the interest plus all necessary legal paperwork to record the transactions and all hidden fees associated with this loan. The lender is in business to make a profit; therefore, it expects to get something back that we’ll call the expected rate of return. Hence, we will use cost and expected rate of return interchangeably here.
Six Small Business Financing Options
1. Bank lending is either government-related or commercial bank lending. Government-related loans are SBA 504 loans, 7(a) loans, micro-loans or loans through the recent 2009 Recovery Act. The most popular lenders are commercial banks’ credit lines. The borrower pays interest only on the amount actually borrowed. Many business owners use a personal line of credit from their primary residence when they can’t get a credit line for business. In some cases, business owners personally guarantee these loans to their business from their bank. Sometimes the bank may take other cash accounts or an insurance policy as collateral as one type of personal guarantee. The expected rate of return ranges from 5.3 percent to 13.3 percent, assuming a 7 percent prime rate.
2. Equipment leasing includes bank leasing, captive leasing, specialty leasing or venture leasing. You’re using your underlying equipment or asset as collateral to the bank in exchange for a term loan. Things to watch out for here are equipment or assets that depreciate faster than their fair market value. For example, a construction company’s brand new loader may cost $30,000. Two years into the term loan, the fair market value might be only $12,000. Even if you don’t want the equipment, you’ll still owe the bank roughly $18,000 plus interest. Analysis of rent vs. lease should be considered, especially if the equipment or asset might be idled and not produce income for your business. The expected rate of return ranges from 8 percent to 16.5 percent, assuming a 7 percent prime rate.
3. Asset-based lending is using your accounts receivable, inventory, and machinery and equipment as collateral in exchange for the lending institution providing a 50 percent to 80 percent advancement on these. For example, your current average accounts receivable is $1 million. The lender can lend you $500,000 in advance before you actually receive the money from your customers. It sounds and looks like a line of credit.
Commercial and community banks typically do asset-based lending, but some non-banks do it as well. Non-banks don’t follow strict banking regulations, so they are much more flexible on their loans. Most non-banks are private equity groups that specialize in specific industries, such as medical practice or small businesses with less than $20 million revenue. They will take control over collateralized assets, such as accounts receivable. They set up a locked box to receive payments directly from your customers, calculate the outstanding balance and charge fees on a daily basis. Often there is an upfront fee for an audit of the books. The expected rate of return ranges from 8.9 percent to 16.3 percent, assuming a 7 percent prime rate. It also depends on which tier or amount you need.
4. Factoring is a process of selling your accounts receivable at a discount. This turns your accounts receivable into cash. This is not a loan. Depending on the amount of your accounts receivable, the expected rate of return ranges from 34 percent to 50 percent, assuming a 7 percent prime rate. Only use this when you can’t get less expensive financing.
5. Mezzanine. In general, there are two types of mezzanine: debt mezzanine capital and equity mezzanine capital. This type of loan is a much higher risk. This type of loan (or investor) generally gets paid after bond in a liquidation event. The reason you use the DMC is for continuing growth, along with some type of management buyout and later-stage company expansion. EMC is used for an ambitious plan to grow the business. It’s often used pre-IPO or to acquire another small- or high-growth company. Most of the mezzanines (investors) are used to take the company to the next level or in transition to sell to third parties. The expected rate of return ranges from 22.4 percent to 29.2 percent, assuming a 7 percent prime rate.
6. Private Equity. This is investors taking the equity position of a private company; the private-equity group will become your business partner. This mostly likely is in the later stage of a company’s life cycle. Most private equity groups tend to take minority control. They can also use recapitalization or a direct buyout. Recapitalization is like selling your company twice. Let’s say you sell 50 percent ownership to a private-equity group. Then the private-equity group sells to a third party at a much higher price. You benefit from the growth of the company the second time. The expected rate of return is about 40 percent, assuming a 7 percent prime rate.
As your business grows, you will need capital financing. You need to do the analysis carefully. At the end of the day, you either have a lender or a boss (investor). Both are after your business performance because they are in business for profit, too. The right team of advisors can lead you through this process. But as an entrepreneur, you also need to make sure of your risk and return on that investment. You should not assume any risk unless you’ll get something back. You need to cash in at some point, such as triple your company’s current benchmark value. Do you have a clear road map that can help you get there? If not, plan carefully and early before jumping into any relationship with a lender or an investor.