Sources of Financing
Business capital comes in many forms. In fact, businesses use a variety of financial resources to grow, acquire assets and expand product and service offerings. Which source of capital is best for your business? It depends on how much capital you need, how you plan to use it, how long you need it, and what interest rate you're willing to pay.
Here's a look at the most popular types of business financing to consider.
Loans include term loans, credit lines, and credit cards. A business can also obtain financing from suppliers or vendors. For example, when a raw materials supplier allows 30 days for payment (net 30), the industry standard, you actually receive a loan for goods or services rendered for a month.
- Term loans deliver capital now. Your company repays the loan in pre-arranged monthly installments over a defined period of time. The advantage to term loans is that you can repay the loan ahead of schedule. The downside? The lender usually charges fixed interest on the amount borrowed - interest you continue to pay even after the loan has been paid down considerably.
On the other hand, term loans usually come with lower interest rates because they're collateralized, i.e., the business backs the loan with assets such as real estate or accounts receivable, limiting the lender's risk.
- A line of credit is a flexible business borrowing option because your business borrows only when necessary up to a pre-determined limit.
The advantage of a credit line is simple. Your business only borrows the capital it needs when it needs it, avoiding unnecessary interest charges on unnecessary funds. Lines of credit are especially useful when your company pays for items over time. For example, you only pay progress payments as you expand your new facility or hire new staff. A line of credit can be easier to manage than a term loan because you only pay interest on what you borrow.
- Credit cards used by a business, are similar to personal credit cards. They're a great way to make purchases of business-related items. They also simplify bookkeeping at tax time and, in some cases, the interest on credit card balances is a legitimate business deduction, though not always. Discuss tax implications with the company accountant.
Business credit cards also enable you to take quick cash advances. However, because credit card cash advances are not backed by collateral, the interest rates are usually higher - much higher - than a line of credit or term loan backed by business assets.
Government-Backed Grants and Loans
The federal government, and many state, regional, and municipal governments, maintain economic development agencies that offer direct grants and other types of financial assistance to encourage entrepreneurs to start or expand small businesses.
- State and Local Economic Development Loans and Grants are offered to train employees, develop new products (especially eco-friendly products), expand markets, improve facilities, and for general business development that broadens the community's tax base.
These economic development grants and loans are low-interest and offer flexible terms because they help communities create jobs and keep down the tax burden on home owners, making them a popular choice for businesses, economic development agencies, and tax payers, who benefit with lower property tax bills each year.
Contact your municipality or the local Chamber of Commerce (CoC) for access to business capital at low interest rates. These development loans help your business and your community — a win-win arrangement.
- Small Business Administration (SBA) loans are guaranteed by, or financed by, the Small Business Administration — a federal government agency. Typically, SBA loans offer favorable, flexible terms and attractive interest rates because the SBA assumes a portion of the lender's risk.
Private Investors (aka, angels) are private investors. Family members, for example, often invest in the businesses of relatives. Angels typically invest for non-monetary reasons. They want to help their friends or family so terms are usually more beneficial to the business, not the angel-lender.
At the other end of the lending spectrum, angel investors are wealthy individuals or private companies that seek high returns on their investments. Most small business owners turn to friends and family first, but don't overlook local, professional investors to provide funds at favorable terms in return for a business ownership stake.
These professional lenders are often the best source for short-term financing, though you can expect to pay higher interest rates because the angel assumes fiscal risk in making the loan — all part of the risk versus reward equation that professional angels look at very closely.
Venture Capitalists (VC) are typically companies that pool investor capital to invest in start-ups and growing companies. In return, they usually expect an ownership position in the business for the term of the loan, with a buy-out clause once the loan obligation has been met by your company.
Ownership usually takes the form of stock shares, or an equity position, in case the company is unable to meet the repayment terms outlined in the loan agreement.
Venture capitalists sometimes expect some control over company management to ensure the business moves forward. This control may involve a new company officer, a new business partner, or a member of the company's board of directors designated to oversee business activity and protect the VC's investment in your company's future.
Asset-Based Financing and Factoring
Seasonal businesses often run lean at certain times of the year and fat at other times. These businesses include agri-businesses, retail outlets, clothing manufacturers, and other companies that keep a close eye on the calendar.
For seasonal businesses, there are several financing options to help get through the slow times.
Asset-based financing is a form of borrowing where assets are used as collateral in order to qualify for a loan. Say your business owns equipment. You use that equipment as collateral for a loan to finance the purchase of inventory, supplies, and meet other business needs. Inventory can also be used as collateral to obtain financing when capital is needed to purchase additional inventory.
Factoring occurs when a lender pays your business the money your customers owe you — the amount of your accounts receivable — in exchange for a percentage of these funds. In effect, your accounts receivable serves as collateral for the loan.
Commercial Real Estate Loans
Commercial real estate loans are used to purchase, construct, or refinance commercial, industrial, or investment properties. Terms are usually stringent and interest rates are higher than, for example, the rates you'd pay for a second mortgage on your home.
The typical commercial realty loan amount is approximately 75% of the property's appraised value, and interest rates are typically higher — sometimes quite a bit higher — because the lender is assuming the risk of losing some or the entire loan amount.
To determine the right source of financing for your company, weigh your company's ability to qualify for credit, your business goals, and your short- and long-term credit and cash needs. Then choose the type of financing that delivers the lowest interest rates and the most flexible payment terms to suit your needs.
As a savvy borrower, you've got options. Choosing the right option requires some research and, perhaps, some consultation. A good source for impartial information is the commercial loan officer at your local bank.