What To Look For In A Financing Product - Part 2

  • By John Scharbach
  • Published 3/8/2016

If you’re convinced that part of being a savvy business owner is responsibly using the financing tools at your disposal, then you need to know your options. There’s no such thing as a one-size-fits-all financing product. Every business owner should understand the best use for each.

There are six basic financing options:

  • Equity
  • Line of credit
  • Credit card
  • Factoring
  • Merchant cash advance
  • Term loan

Equity

A lot of business owners think of equity as free money. This is wrong. There’s nothing free about it. Yes, you don’t have to make debt payments, but you have the permanent high interest rate of equity. If you have a choice between debt finance and equity finance, you should probably choose debt. Equity is just too expensive.

Cost aside, equity also brings another problem: business partners who typically want a say in how you run their business. Business partners actually end up being a significant driver of dissolution or destroyed friendships. It’s not the money that’s the problem so much as the day-to-day struggle for control over the vision.

So, as a general rule, we do not believe raising equity is the best way to fund a business. It is simply too expensive and too complicated (to say nothing of the legal and compliance issues). If debt is not an option, you’re better off bootstrapping.

The biggest exception to this general rule is when future revenues would not support the amount of debt required to meet the need.

This is most commonly the case with startups (not to be confused with pre-revenue or early-stage businesses). Startups, by definition, have no reasonable expectation of future revenue, and even if they did, they have no idea when that revenue will appear. Therefore, they have no business fooling with debt.

If you do decide to pursue the equity route, try to ask for it at the right time. You want to bargain from a position of strength: strong revenues, viable business model, plenty of cash on hand, etc. You’ll get a higher valuation, which means more money for less equity.

Best use: Equity is best used for businesses whose cash needs far exceed their anticipated revenues, most typically startups.

Line of Credit

A line of credit is like a credit card on steroids. You get a max limit (usually somewhere south of $100k) and you can draw down and pay back. Interest rates are good for well-qualified borrowers and tolerable for less-qualified borrowers. Plus you only pay for what you use, which is great economics.

In light of that, here’s the honest truth from a lender that does not offer a line of credit: every business should have a line of credit. It is the cheapest cash cushion available.

But three words of caution:

First, do not put your house up as collateral on a line of credit. That is a fantastic way to lose your house.

Second, a line of credit is a short-term financing option, not a long-term financing option. Don’t misuse it. We’ve met a lot of business owners who tie up their line of credit with long-term projects. This just ties up the line of credit and they end up paying unnecessarily high interest rates.

Third, a line of credit is not the same as cash in the bank. During the last recession, too many business owners discovered that lines of credit are not guaranteed. The terms can change or they can be cancelled. The lender can even go out of business.

Best use: A line of credit is best used to smooth out cash flows in the short term.

Credit Card

A business credit card is exactly what it sounds like.

It’s a lot like a line of credit with one major difference: you can typically only use it at a point-of-sale. That means you can’t use your business credit card for payroll or similar expenses. As a result, it is limited as a cash-flow management tool. Plus rates tend to be sky high.

Best use: It’s nice to have one, but you shouldn’t rely on it for anything besides convenience.


Factoring

Factoring is basically just an advance on your accounts receivable. The structure varies between factoring companies, but the idea is the same: you trade your future income on accounts receivable in exchange for present income. And the factoring company takes a fee.

This structure means that factoring tends to be credit agnostic—you don’t need an awesome credit score to get a factoring deal.

On the flip side, you actually have to have accounts receivable to give as collateral. So you still need to find the money to fill a purchase order before you can generate the invoice and factor against that invoice.

In terms of rates, the APR usually starts in the 20s or 30s (2 to 3% a month plus fees) for the strongest borrowers, and go up from there. These rates aren’t great, but they aren’t unreasonable. Factoring makes sense if you have a truly short-term need (specifically, less than 60 days).

But the problem we’ve observed with factoring is that it usually ends up being used as a revolving line of credit, inflating the terms from reasonable to problematic. Too many businesses get caught in that “factoring trap” and could make better use of longer-term loans to fund a true growth strategy rather than a temporary bridge between the cost-of-goods-sold on an order and the reimbursement on larger purchase orders.

Best use: Factoring is a solid short-term bridge, often as a last resort. But it’s not a substitute for proper financing. If you’re factoring deal after deal, it’s time to get a proper term loan.


Merchant Cash Advance

Technically, a merchant cash advance is a sale of future income or credit card receivables in exchange for present money, usually at a substantial discount. (Think of it as factoring for people without invoices.) But oftentimes it’s just a high-interest loan.

The value proposition on MCAs is speed. They can move money quickly, often because they don’t bother to take the time to understand the business. But that comes with a trade-off. If they don’t understand your business, they are not pricing it correctly. “Easy money is a synonym for hard money.” The easier it is to get it, the higher the rate is going to be.

A note of caution: Our experience is that MCAs are the #1 reason otherwise solid businesses fail. They run into unexpected cash-flow issues, they need money fast, they get an unaffordable MCA, it eats up their cash flows, they have to take a second MCA, and the death spiral begins. That’s why we like to say, “If you’re not planning for cash-flow problems, you’re planning for an MCA.”

Plan ahead.

Best (only?) use: You needed money yesterday to meet a super-urgent super-important need (making payroll, replacing key equipment) and every day of delay is money out of your pocket.

Term Loans

Term loans are basically just a slug of cash, which is what makes them the most flexible financing option. You can use cash for anything, which is part of why “cash is king.”

We believe that every profitable business should have a substantial cash reserve. If they don’t have that reserve, they should “rent” it in the form of a term loan. Yes, you’ll have to make interest payments, but those payments are best thought of as rent or insurance premiums. But there’s no better way to manage unexpected expenses than cash in the bank.

Beyond that, term loans are also good for financing long-term needs (e.g., build-outs, equipment purchases) and large expenses (e.g., large inventory purchases).

Best use: Financing specific projects and needs and flexible cash-flow management tool.

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