In the last article in our series on how to fund a business we, talked about how to raise money for a new business. In today’s article we are going to continue our business financing discussion, with a look at working capital and how to raise money for an existing business.
Raising Working Capital For A Small Business
Most small business owners think of working capital as the money they have in their bank account. However, if you’re asked about working capital by a banker or investor, the technical answer is current assets (which includes cash, accounts receivable, and inventory) minus current liabilities (which includes debts and expenses due to be paid in the next 12 months). For the purposes of this article, we are sticking with the common sense definition of money in your bank account.
There are several reasons why a healthy, profitable business may need more working capital:
Many businesses from income tax preparers to gift stores have a particular season in which they make a disproportional amount of their income. During the off-season, they may operate at a loss and deplete their working capital. These companies may need to find temporary sources of more working capital.
You may have demand for your product and services that you are unable to meet. To meet the demand, you might have to stock-up on inventory or hire more employees. Unfortunately, this requires spending money in advance of benefiting from the additional revenue. The money needed to cover these expenses may surpass a firm’s available resources, creating a need for more working capital.
Sources Of Working Capital For Small Businesses
The good news is that there are many places where one can get additional working capital in the scenarios just mentioned. Some providers of working capital can put cash in your hand within a few days. Additionally, many of these providers don’t even require that the owner of the business provide a personal guarantee (agree to pay the loan from their pocket if the company cannot). On the downside, these sources tend to be very, very expensive with an effective interest rate of 30 to 70%.
Below, I highlight different sources of working capital. (Hat tip to Ian Mount and his NY Times article “When Banks Don’t Lend, There Are Alternatives, Though Often Expensive”.)
Merchant Cash Advances
If you have lots of credit card receipts, you can borrow against future revenue from those credit card receipts using a form of financing called merchant cash advances. Merchant cash advance specialists like AdvanceMe will give you a lump sum payment.
When you borrow money, you agree to pay back a fixed sum. The amount will vary based on your circumstances, as well as the company loaning the money. As an example, for a $40,000 advance, the borrower / merchant might be required to pay $52,000.
Merchant Cash Advances vs. Bank Loans
Unlike a bank loan, with a merchant cash advance there is no fixed monthly payment. Rather, a set percentage of your company’s credit card receipts will go to paying back the loan every month, until the agreed amount is paid.
The more reputable merchant cash advance companies will not allow the percentage of revenues they take for the loan repayment, to exceed 9% of a business’ average monthly revenue (including credit cards and cash).
While the repayment process could take 3 months or 12 months, generally speaking merchant cash advances are designed to be paid off in full in 6 to 9 months. In the example just provided, if the loan was paid back in 6 months, the effective interest rate would be 60%!!!
Benefits Of Merchant Cash Advances
- You can get a merchant cash advance even if you have a poor credit history.
- You don’t have put up personal assets, like your house or car, to collateralize it.
- You can get funds in a few days to a week.
- You can usually borrow between $5,000 and $100,000 per retail store, depending on revenues.
- If the business does poorly, your required payments go down.
Cons Of Merchant Cash Advances
The effective interest rate is typically between 60 and 100%. As a result of the high cost of the loans, many like John Tozzi from businessweek have compared merchant cash advances to usury.
New Cheaper Alternatives To Merchant Cash Advances
There is a new breed of company that is providing short-term funding to small businesses. Two leading companies in this category are Kabbage and On Deck Capital. Kabbage specializes in providing cash advances against online sales to online sellers on sites like eBay, Amazon and Etsy. On Deck Capital provides loans of $5,000 to $250,000 to small businesses of all types.
Similarities with Traditional Merchant Cash Advance Companies
- They provide short-term financing. The amount owed is paid off over time; there is no lump sum to be paid at the end.
- They look closely at a firm’s revenues and cash flow to determine how much can be borrowed.
However, there are also very significant differences:
- Payments are fixed and do not vary with revenue.
- The average interest rate is much lower, in the 20 to 30% range. That’s around half the amount charged by traditional merchant cash advance companies.
On Deck Capital and Kabbage are much better alternatives to traditional merchant cash advances. However, I suspect that it may be harder to get approved for financing by these companies, or that they may only be willing to loan smaller amounts than what’s available via a traditional merchant cash advance companies.
Factoring: The Primary Source of Working Capital for B2B Companies.
If you’re business is a business to business (B2B) business, factoring is the traditional source of working capital. With factoring, you are either selling your invoices, or getting a cash advance against your invoices.
For example, lets say you’re a small manufacturer of clothing and get an order from a large department store. The department store will not pay you until 30 days after you receive the clothing, however, producing the goods requires upfront expenses. In this case, you might want to factor your invoice.
The Three Types of Factoring
Invoice Factoring – You receive a large lump sum payment in exchange for the invoices, generally around 70 -75% of the invoices’ value. The factoring company is responsible for collections. After collections are completed, you receive the remainder of the money minus any uncollectable payments and the fees for factoring.
Non-Recourse Factoring – You receive a large lump sum payment in exchange for invoices, which is higher than you would receive for normal invoice factoring. However, there are no further payments even if all invoices are collected in full.
Confidential Factoring – Normally, collections of the invoices are conducted using the factor’s name. In confidential factoring, collections are done in your company’s name.
Factoring companies are generally interested in relatively sizable invoices. The smallest minimum that I have seen advertised is for $10,000 but, a more realistic number would be $50,000 to $100,000 in invoices.
Figuring out the cost of invoice factoring can be tricky, There generally is a fee for providing the service (which can run anywhere from 0.5 to 3% of the value of the lump-sum being provided) and an “interest” payment based on how long collections take. For a smaller company, factoring can cost 3-5% for essentially a 30 to 60 day loan. On an annualized basis, this would equate to an interest rate from 18% to 70%.
A good resource to learn more about factoring is the CIT Factoring University.
That’s our article for today. If you have any questions or comments please leave them in the comments section below. Also be sure to read the next article in this series, where we discuss bank loans.
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