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3 Commonly Misunderstood Forms of Business Financing

By Bill Elliott, Ryan Black, and Jorge Varela

Business financing options seem endless and, let’s face it, sometimes are confusing. Each type affects your company’s cash flow, taxes, operations, and overall competitiveness very differently. Small and emerging businesses need to choose very wisely as the right type of capital is essential to growth.

Of course, the old adage holds true: your customers provide the best type of capital. However, pre-revenue startup businesses and many high-growth companies don’t have past profits, or profits aren’t substantial enough to fuel growth, so they often need external financing.

We speak with business executives every day, and understand the hype and confusion surrounding business financing. In this overview, we outline three commonly misunderstood financing options for small businesses, their benefits, and why you’d use them.

Venture Capital & Angel Investors

We’ve all heard about tech startups raising millions of dollars and achieving sky-high valuations with each successive round of capital. Despite the media coverage, fewer than 1% of all businesses Lady leading a meeting raise capital this way. While many entrepreneurs chase VC funding, a more important question is whether VC funding is right for the business:

Ideal Businesses

Hyper-growth companies (usually technology) with little or no collateral, unpredictable cash flow, and large capital needs. The business executives should strategize a large exit (sale, IPO, etc.), generally within seven years.

Key Benefits

The right VC or angel investors have beneficial industry connections, provide management expertise, and lend credibility to fledgling companies. Unlike debt financing, which businesses repay with interest, VC and angel investments provide equity financing, which doesn’t affect day-to-day cash flow.

Important Considerations

Aside from the difficulty of obtaining VC funding, entrepreneurs should be ready for:

  • Handing over equity – It’s no longer just your company, so you share any upside with investors. Subsequent rounds of capital dilute your ownership even further.
  • Handing over control – VCs appoint seats to your company’s board of directors. Even if they are not on the board, many investors want to be actively involved and expect to help navigate the company. If enough investors lose faith in your leadership, they can fire you from your own company.
  • Pressure to Grow — Investors expect massive returns on their investment within a few years. As your company grows, maintaining this pace becomes increasingly challenging. With every capital round, investors expect the value of their equity stake to grow.
  • Devoting time – Raising equity financing can consume all the time and effort of at least one person in your team, often the CEO. Furthermore, once you have raised capital, you need to raise subsequent rounds at least until you are cash flow positive. Make sure your executive team is equipped for this.

Accounts Receivable Financing

Accounts Receivable Financing, also known as Business people discussing graphs Accounts Receivable Factoring, is one of the least understood and under-utilized financing options. With an agreement, you sell your products and services to customers and then bill them. Then an accounts receivable financing company pays you cash quickly for those customer invoices, which helps you pay bills, make payroll, buy more supplies, or reinvest in your business. The company collects payment from your customers, keeping you looking forward, focused on running your business.

Unlike with loans, your company’s credit history is less important than the credit-worthiness of your customers, so accounts receivable financing can be a good option for businesses that sell to well-established, stable businesses that have long payment terms.

Ideal Businesses

Consider receivable financing if your business sells to well-established, credit-worthy clients, but needs faster cash flow, such as if you’re:

  • selling to governments & Fortune 500 companies
  • running a healthy, high-growth business reinvesting quickly
  • lacking an extensive credit history
  • looking for ways to improve cash flow

Key Benefits

  • Outsource collections — Receivable financing removes your worry and hassle of collecting payment from large, bureaucratic, and slow customers, frees up your staff, and increases efficiency.
  • Flex credit — Companies with little credit history or even a checkered credit history can still qualify.
  • Turn invoices quickly — Your business can get cash from receivable financing in as little as 24 hours, depending on circumstances.
  • Build credit — A positive accounts receivable financing relationship can open your options when your financing partner is part of a larger financial institution, such as First Business Bank*, which also offers Asset-based Lending.

Important Considerations

  • Take a long view — Seek a long-term receivable financing partner to get the best rates and service as opposed to “one-off” deals.
  • Consider reputation – Accounts receivable financing companies do not all follow the same standards. A partner like First Business Growth Funding, which is backed by a reputable financial institution, is required to follow federal regulations and honor transparency.
  • Read before signing — Understand all the details of your receivable financing agreement fully before signing it.
  • Stay organized — An accounts receivable financing agreement doesn’t mean you wash your hands of customers. You still need to secure basic documentation from them, such as purchase orders and signed statements of work.
  • Leverage experts — Use your financing partner to your advantage; they can help you avoid customers that are not credit-worthy and alert you to red flags that can make or break your business.

SBA Loans

The Small Business Administration (SBA) is a U.S. government agency that supports entrepreneurs and small businesses. One of their most popular and important financing tools is the 7(a) loanprogram. Business owners work with banks to secure SBA loans — the SBA typically guarantees a large part (75%) of the loan. This guarantee helps lenders offer loans to businesses that otherwise may not fit into the bank’s lending policy guidelines for reasons like collateral shortfall, limited business credit history, or longer amortization requirements.

Ideal Businesses

Businesses with healthy, predictable cash flow and a proven management team are good candidates for an SBA loan, even if they have limited collateral assets. Furthermore, SBA loans can be used for a variety of general business purposes, such as:

  • Establishing a new businessBuilding construction
  • Acquiring an existing business
  • Long-term working capital for operational expenses, accounts payable, or even purchasing inventory
  • Short-term capital needs for seasonal financing, construction financing, and exporting
  • Purchasing equipment, machinery, furniture, supplies, and real estate
  • Refinancing existing business debt. The maximum loan amount is $5 million, and the borrower must qualify as a ‘small business’ per the SBA’s guidelines. Because the emphasis is on cash flow, lenders like to see a two-year history of financial statements, but projections can be used for startup loans.

Key Benefits

  • Loan can have a collateral shortfall
  • SBA loans have flexible equity requirements. Conventional loans, in contrast, may require 20% down.
  • Longer loan amortization (sometimes as long as 25 years for real estate) with no balloon payments
  • As with any loan, you don’t give up ownership in your business
  • As with most business loans, you may expense loan interest, reducing your potential tax liability. Remember to check with your accountant for specifics about your own tax situation.

Important Considerations

  • Owners must be actively involved in running the business
  • For real estate deals, business must occupy 51%+ of square footage
  • May require personal guarantee and personal real estate assets
  • As with any loan, you must make regular loan payments and adhere to the stipulations in the loan covenant
  • Not all SBA lenders are equal – pick an SBA-designated Preferred Lending Partner who is an expert in the SBA’s policies and can help you navigate through the process, so you can get the most favorable loan for your business

You owe it to yourself and your business to understand the benefits and implications of various sources of financing. The right financing vehicle can be a catalyst to launch your company’s growth, just as the wrong one can hold you back. To determine the best financing options for your business, you should clearly understand your business model, strategy, and stage of development, but also your business goals and desired trajectory for the next five to seven years. You should also seek out reputable partners who can provide you with a wide range of options, resources, and objective advice to help you get the most favorable terms for your business.

*Member FDIC, Equal Housing Lender

 

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