Accessing capital
Capital options for your business.
All entrepreneurs are eventually faced with a big decision on how to finance their business growth. One may have launched a business with money saved up over time, or borrowed from friends and family, but for most of us (unless you are among the lucky few that runs a unicorn business that takes off without earthly capital needs), a strategic look at financing becomes as important as defining how you sell to or service your customers.
One fact is clear: Capital is the fuel that businesses run on and having the right structure for your unique situation is paramount to success. Below, I review basic options for financing your business starting with short-term, or near-cash options such as credit cards and ending with ownership investment options including Angel Investment. Every business is unique and requires a separate review of the balance sheet to successfully implement a capital strategy; but at a high level, near-cash financing is best used to finance operations, inventory and other non-fixed assets, while long-term financing is best used for fixed assets like equipment and real estate. If your balance sheet is high on current assets like inventory, but reliant too much on cash-flow or mortgage debt, you lack the flexibility to react to a changing market. If your business has a high equipment or fixed asset base financed by suppliers and credit cards, you are bound to run out of operating cash. The right mix of debt in sync with your business’ asset needs is critical.
“Equity comes in many forms, from sweat-equity provided in exchange for a party’s services, to common voting shares in exchange for cash”
Shorter-term Financing (Near-Cash)
We start our review by looking at short-term financing options which are near cash in their liquidity. The upside of near cash is that it is relatively liquid and can be deployed in your business quickly and at great ease.
Credit Cards
Although it’s a risky approach, there are many examples of successful businesses being started on credit card debt. With the right card you can earn cash back rewards which immediately reduce your costs and almost all credit cards will provide you with the benefit of reducing your immediate cash outlay and stretching payments anywhere from 14-30 days. If you are in a business that can quickly turn inventory or services into cash by having customers who pay quickly, this is an appealing approach.
Crowdfunding
Another near cash example which also provides liquidity is using customer’s money to fund your operations. Pre-payments from customers in the form of crowdfunding has become an incredibly popular form of capital raising in the last decade as multiple Internet based intermediaries have made the process seamless. In this approach the entrepreneur pre-sells their products or services in exchange for cash from customers as a pre-payment. The business is then able to acquire products, equipment or other operational necessities to fulfill their promised to customers.
Suppliers
When dealing with physical inventory, it is often the case that a business can use its suppliers as a source of funding. This is accomplished easily by setting up a supplier account with say, 60-day payment terms. If the business can sell the inventory and require payment from their customer in under 60 days, they have a positive cash balance during the interim period between customer payment and when the supplier payment is due. Take a business that buys inventory on 60 days terms from a supplier and can sell to a customer immediately without having to store the product in inventory. If the customer pays within 30 days, the business is left with free cash for 30 days in its operations to fund other activities. In this example, none of the owner’s cash was tied up in inventory to conduct the transaction and both supplier and customer are happy. Win-Win-Win.
Receivables Factoring
To speed up receivables turnover or offset collections risk, some businesses will choose to use factoring. Essentially, factoring is when a company (the seller) sells their interest in an amount due from a customer (the receivable) to a third party (the factor) for a discounted rate. In exchange for selling the receivable, the factor gives cash to the seller immediately and takes ownership of the receivable, often along with the collection risks. This form of financing provides a shorter window of collections for the seller and may partially insulate against risk of collection in the short-term. It is not without its downside however, since the business must ensure to charge enough up front so the loss in discount is affordable.
Line of Credit
Once a business is established or has securable assets such as accounts receivable or inventory, another popular method of business financing is to use a line of credit. In this type of product, a lender takes security over a company’s selected assets in exchange for advancing funds through an overdraft-like facility. This method is usually cheaper than paying interest rates to a credit card company, but it comes with restrictions on how much a bank will provide and, in most cases, increased financial reporting and scrutiny from the provider. This type of financing usually comes along with restrictive covenants put on the lender to maintain a certain ratio of debt to income or other measures of leverage.
Longer-term Financing
As a business builds its fixed assets, the demand for long term cash becomes apparent since an organization can starve of cash without the proper capital structure balance.
Cash-flow Loans & Mortgages
Cash flow loans are a popular choice for more established businesses and generally provided by a lender in exchange for security over selected assets. The major difference between a line of credit and a cash flow loan is that the loan will amortize over a select number of periods (either months or years) and eventually be paid back in full by the company. This is a good method for financing equipment or other fixed assets when the business would like predictable cash flows and interest costs. Many lenders today will even provide a revolving loan which acts like a cash flow loan that the business can repeatedly draw upon up to a maximum limit as new equipment or other assets are required. Like a line of credit, this type of capital usually comes with restrictive covenants put on the borrower.
Like a cash flow loan, a mortgage is an amortizing bank facility that is secured primarily by real estate. Because of real estate’s less risky valuation and history of steadily appreciating in value, mortgages are generally a cheaper form of funds due to the inherently lower valuation risk of the secured assets.
Bonds
Corporate bonds are more likely to be found in a public market, but smaller private placements are possible. A bond is a cash loan secured by selected assets of a company with interest payments on a periodic basis, typically referred to as a coupon (from the literal coupons historically provided in public markets and used to claim interest). Bonds have a maturity date in which the principal payment becomes due and the financial instrument is cancelled. As mentioned, this is not a popular option in smaller private markets, but worth mentioning for their simplicity and potential application in some scenarios.
Leasing
Leasing is another option available to businesses who wish to finance equipment or other fixed assets but who do not want to own the underlying asset. With leasing, one party (lessee) typically signs an agreement to use an asset for a predefined period (often its useful life) in exchange for the financing company (lessor) receiving lease payments. In this case the asset’s ownership does not transfer to the user (lessee), but rather ownership stays with the financing party (lessor). When the lease term ends, the asset remains the property of the original owner and the lessee ceases to make payments. This form of financing can be incredibly useful when using depreciable assets such as equipment when the business wishes to replace the asset often, or when requiring a piece of real estate without the ability or desire to own the asset. In many cases, a lease will include provisions for the lessor to charge other ancillary costs such as maintenance or utilities.
Asset-Based Lending
Gaining in popularity recently is the financial practice of Asset-Based Lending or ABL. The concept of ABL is that, unlike cash-flow loans, an asset is leveraged directly for its liquidation value and traditional cash-flow ratios take a back seat. Similar to a line of credit facility, ABL assigns a loan-to-value ratio based on the underlying asset class, but unlike a traditional credit facility, ABL is typically more aggressive (read higher leveraged) in its lending ratio. Also like a line of credit, ABL facilities generally do not amortize over a certain period with fixed payment schedules, but instead perpetually provide a high leverage rate of borrowing against assets (including inventory, receivables, equipment and other fixed assets in some scenarios). ABL is best used by borrowers with solid asset values rather than those involving work in process or highly perishable goods due to the ability of a lender to be assured of the asset’s value and therefore provide a high leverage ratio.
Equity and Equity-Like
After considering debt options, a very appealing option for providing your business with the right capital is to bring in equity. Equity (and equity-like) options come in the form of cash most often, but also generally is accompanied by market expertise or operational advice from the providing party.
“A business requires fuel to run properly, and the capital structure of the business sets up an organization for either success or failure”
Sub-debt or Mezzanine Financing
Before bringing on additional equity partners in a share offering, many entrepreneurs will opt for hybrid debt-equity capital commonly referred to as sub-debt (named for its position on the collectability hierarchy after debt but before equity) or mezzanine financing (named for its level between debt and equity). Sub-debt is often met with skepticism from borrowers due to its high cost, but when one wants to maintain more control (not to mention watering down the distribution of profits), it can be a viable option. As mentioned, sub-debt is often only collectable in the event of company distress after the senior secured creditors have been satisfied, therefore it commands a higher interest rate. In some cases, sub-debt may take a royalty in the form of a percentage of sales, profit or other measure as a portion of their higher return for the greater risk. Like almost all debt, sub-debt can come in the form of an amortizing loan with regular payments or as a lump-sum payment at some point in the future. Either way, sub-debt is a step of debt along the corporate finance spectrum before one lands in the equity category.
Common or Preferred Equity
Equity comes in many forms, from sweat equity provided in exchange for a party’s services, to common voting shares in exchange for cash. Either way, equity is often (but not always) a participant in the business decision making process (voting board members in for example) and a participant in the share of profits when distributed to owners through dividends. When shares are non-voting, they are referred to as preferred shares, which come with the added benefit of being paid out in priority before common shares in the event of a liquidation. Common shares rank last in priority of being paid but come with the extra benefit (or burden to some) of having a say in how the business is run (through voting) and sharing in the profits.
Like many of the other debt categories, equity can come from any number of sources including staff, family, friends, suppliers, customers or a public market. A specific type of equity investor that focuses on early stage, high growth companies is an Angel Investor who usually takes a common equity position in exchange for providing seed or growth capital along with strategic advice to the business. Angel Investors will usually want to hold an investment for a short period of time such as five to seven years and have a planned exit within this time period. Business failure rates run high in early stage companies so Angel’s will typically demand high rates of return for their cash and expertise.
Summary
As illustrated above, a business faces many decisions in its journey to grow and acquire capital through the process. Like any complicated structure, a business requires fuel to run properly, and the capital structure of the business sets up an organization for either success or failure.
Key Takeaways
Capital is the fuel that business run on and having the right structure for your unique situation is paramount
Near-cash financing is best used to finance inventory and other non-fixed assets, while long-term financing is best used for fixed assets like equipment and real estate
Having the asset-side and liability-side of your balance sheet out of sync can create long-term cash problems for any business
Capital structure ranges from near-cash financing like credit cards and lines of credit to long-term financing such as cash-flow loans and mortgages
Sub-debt provides a hybrid capital option between traditional debt and equity that can provide great value in the right situation
Growing your business demands the right capital structure with a mix appropriate for the business and can setup an organization for success or failure