by Tom Klausen
Contrary to what most small business owners think, financing a business is not rocket science. In fact, there are only three main ways to do it: via debt, equity or what I call “do it yourself” financing.
Each method comes with benefits and drawbacks you should be aware of. At various stages in your business’s life cycle, one or more of these methods may be appropriate. Therefore, a thorough understanding of each method is important if you think you may ever need to secure financing for your business.
Debt and Equity: Pros and Cons
Debt and equity are what most people think of when you ask them about business financing. Traditional debt financing is usually provided by banks, which loan money that must be repaid with interest within a certain time frame. These loans usually must be secured by collateral in case they cannot be repaid.
The cost of debt is relatively low, especially in today’s low-interest-rate environment. However, business loans have become harder to come by in the current tight credit environment.
Equity financing is provided by investors who receive shares of ownership in the company, rather than interest, in exchange for their money. These are typically venture capitalists, private equity firms and “angel” investors. While equity financing does not have to be repaid like a bank loan does, the cost in the long run can be much higher than debt.This is because each share of ownership you divest to an investor is an ownership share out of your pocket that has an unknown future value. For example, think of what a 10 percent ownership stake in Microsoft would be worth today if Bill Gates had sold this to an equity investor early on. Equity investors often place terms and conditions on financing that can handcuff owners, and they expect a very high rate of return on the companies they invest in.
My favorite kind of financing is the do-it-yourself, or DIY, variety. And one of the best ways to DIY is by using a financing technique called factoring. With factoring services, companies sell their outstanding receivables to a commercial finance company (sometimes referred to as a “factor”) at a discount. There are two key benefits of factoring:
Drastically improved cash flow Instead of waiting to receive payment, the business gets most of the accounts receivable when the invoice is generated. This reduction in the receivables lag can mean the difference between success and failure for companies operating on long cash flow cycles.
No more credit analysis, risk or collections The finance company performs credit checks on customers and analyzes credit reports to uncover bad risks and set appropriate credit limits essentially becoming the business’s full-time credit manager. It also performs all the services of a full-fledged accounts receivable (A/R) department, including folding, stuffing, mailing and documenting invoices and payments in a ledgering system.Factoring is not as well-known as debt and equity, but it’s often more effective as a business financing tool. One reason many owners don’t consider factoring first is because it takes some time and effort to make factoring work. Most people today are looking for instant answers and immediate results, but quick fixes are not always available or advisable.
Making It Work
For factoring to work, the business must accomplish one very important thing: deliver a quality product or service to a creditworthy customer. Of course, this is something the business was created to do in the first place, but it serves as a built-in incentive so the business owner does not forget what he or she should be doing anyway.
Once the customer is satisfied, the business will be paid immediately by the factor it doesn’t have to wait 30, 60 or 90 days or longer to receive payment. The business can then promptly pay its suppliers and reinvest the profits back into the company. It can use these profits to pay any past-due items, obtain discounts from suppliers or increase sales. These benefits will usually more than offset the fees paid to the factor.
By factoring, a business can grow its sales, build strong supplier relationships and strengthen its financial statements. And by relying on the factor’s A/R management services, the business owner can focus on growing sales and increasing profitability. All of this can occur without increasing debt or diluting equity.The average business factors for about 18 months, which is the time it usually takes to achieve growth objectives, pay off past-due amounts and strengthen the balance sheet. Then the business will likely be in a better position to search for debt and equity opportunities if it still needs to.
Tom Klausen is the Senior Vice President of First Vancouver Finance (FVF), which has offices in Vancouver, BC and Toronto, ON. FVF provides creative financing solutions to small and medium-sized businesses across Canada. Tom has worked in the alternative lending industry for more than 25 years and consults with businesses struggling to obtain traditional financing. You can reach him at TKlausen@FVF.ca or visit http://www.FVF.ca.