Financing: How to Do It Yourself
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”
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
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:
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:
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
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.
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