Exploring Alternative Sources of Financing (article)

March 2009

Exploring Alternative Sources of Financing

If traditional credit sources are not an option, businesses seeking capital might consider some less conventional financing methods

With commercial bank loans in short supply, it’s a rare credit-reliant U.S. business that hasn’t directly felt the tremors from the national credit crunch. In the event your bank isn’t responding to your needs for operating capital or funds for expansion, acquisition or capital purchases, the following discussion of alternative sources of financing may help you bridge the economic downturn.
Be aware that there are unscrupulous sources for some of these alternatives. As always, you are encouraged to perform due diligence on your potential source, since they will surely do the same with respect to you.

Venture Capital. Typically, venture capital firms are interested in investing in businesses that have significant growth potential. “Significant growth” means generating very large returns on investment, usually greater than 50% annually or three to five times their investment in five to seven years. An entrepreneur is more likely to receive a serious hearing from a venture capitalist if the venture firm learns of the business through referral by bankers, brokers, attorneys, accountants or investors. Venture capitalists will expect a strong marketing plan, and they will also closely examine the qualifications of the management team.

Many public companies have either a venture fund or business development group, or both, for strategic alliances and acquisitions. Generally, the venture arm of a public company will invest only “behind” a venture capitalist, leaving the due diligence and active management to the venture capital investor.

For more on the plusses and minuses of attracting venture capital, see Lynn Westergard’s article, “Venture Capitalists: An Alternative to Lenders?”

Angels. Angels use their own money to invest in small companies. They provide funding and a varying range and depth of value-added assistance to the entrepreneur. Many of the new breed of angel investors have organized into formal and informal groups, many of which have staff to screen and evaluate business plans submitted by entrepreneurs seeking funding. The best way to contact these financing sources is through local chambers of commerce, economic development authorities, business incubators and local universities.

Microlenders. Microloans are small loans, typically in the range of $5,000 to $25,000, made to businesses that can’t get financing elsewhere. Microlenders often focus on a particular interest, such as making small loans to female or minority entrepreneurs. Some are not-for-profits, relying on donations from charitable organizations and individuals to provide business loans and training to entrepreneurs.

Microloans generally carry higher interest rates than bank loans but often are subsidized by federal, state and local grants. In many cases the microlender must also provide training or education to its entrepreneurial borrowers.

Peer-to-Peer Networks. In borrowing via a peer-to-peer lending network (e.g., Prosper, Lending Club and Zopa), borrowers list the amount they need, details about their business and why they need the loan. Individual lenders then decide whether to offer them funding. In many cases, these lenders are fellow entrepreneurs looking to make a nice return while assisting other business owners. Thanks to the credit crunch, peer-to-peer loans to businesses are on the rise. As an alternative financing option, these loans offer many benefits, including fast delivery and competitive rates.

Commercial Finance Companies. Commercial finance companies make both personal and business loans at interest rates several points above that which banks charge. Like banks, commercial finance companies focus on your ability to repay the loan; however, they are more willing than banks to rely on the quality of your collateral rather than your track record or profit projections. Loans typically are for one year, at interest rates ranging from 18% to 36%.

Joint Ventures, Mergers and Acquisitions. Joint ventures and other forms of business combinations have become increasingly popular in recent years, and virtually any company can benefit from having a strong corporate partner. These agreements must be carefully structured to avoid inadvertently relinquishing major rights, such as royalties or marketing, or overall control of the business itself. Expectations for both sides should be carefully documented.

Credit Unions. A growing number of business owners are turning to credit unions and private lenders who rely less on credit scores and more on a borrower’s business model or track record.

Seeing a new opportunity for revenue growth, credit unions have made a big push into the small business market, with business lending estimated to have grown by more than 18% since 2006. Credit unions typically grant smaller loans than banks — the average size of a business loan in 2007 was less than $190,000 — but, since they are non-profits that are more community-oriented, credit unions can base lending decisions on more subjective criteria than those used by big banks.

Factoring Accounts Receivable. An effective way to grow a business with limited working capital is by utilizing a factoring company to discount your accounts receivable. In fact, with good supplier credit and a professional factoring company, you may need a lot less capital than you think. The factoring company can also provide you with credit management expertise.

The concept is similar to a retailer that accepts a credit card: You receive the money right away, while the factoring company waits for payment. By having the immediate use of your money, you can begin to concentrate on making the next sale.

Factoring is more expensive (typically 3% to 5% of your invoice) than most other forms of finance; therefore, it is important to find ways to build it into your pricing and/or earn it back from suppliers. There are also savings realized by not having to perform necessary credit functions yourself. If you can use the factoring monies to add new business, then the costs of factoring may be justifiable.

Supplier Financing. If suppliers or other vendors comprise the bulk of your payables, supplier financing may be an option for accessing liquid working capital. Traditionally, supplier financing involves stretching out payables from “due on receipt” or “net 30” days to 60 to 90 days or longer. Supplier financing is most feasible when the supplier is relatively large and has good credit, and the best time to have this discussion is in advance of the purchase. Do not depend too much on trade credit from one supplier, though; if repayment problems arise, you may find your major source for supplies cut off when you need it most.

Stretching out payables is not the only form of supplier financing. If you have been a very good customer, the supplier may even be willing to provide you with a short- or medium-term loan secured by the inventory or equipment the supplier provides you.

You may also ask a key supplier to provide you with a longer-term loan to finance the purchase of another business or its assets or to give you working capital or expansion capital. To secure longer terms, expect to make that supplier the sole or majority supplier of that product for a designated period of time – at least for the term of the loan. A bonus to consider: If the loan is secured by the supplier’s products, the supplier is likely to value your inventory higher than a bank would.

Renting and Leasing vs. Buying. Reducing expenses is another way of raising capital because it frees up funds. One way to reduce cash outflow is to lease assets rather than buy them. Renting or leasing can free up equity capital for investment in other areas of greater return, can free up borrowing power (improving cash leverage) for more critical borrowing, requires no down payment, fixes the rate for a set term, allows you to deduct the full expense from your taxable income, and still allows you the flexibility to exercise purchase options at a later date at a predetermined price.

Leasehold Improvements. When you are negotiating a lease for commercial space, the cost and payment of tenant improvements is a major issue. The landlord or property manager will often agree to provide a portion or all of your leasehold improvements against a longer term lease. A three- to five-year lease gives you a reasonable negotiating position for including leasehold improvements in the deal and paying for these through your rent over the course of the lease. This may represent tens of thousands of dollars in start-up expenditure, and off-laying that can significantly reduce the start-up cash and equity required. In addition, it can make a balance sheet appear healthier when its ratios are examined. In this instance, it would be prudent to hire an attorney with experience in commercial leasing and landlord-tenant matters.

Advance Payment from Customers. You might consider negotiating a full or partial advance payment from customers to help finance the preparation costs related to taking on their business. In some project-oriented industries, it is customary to receive stepped (partial) payments payable at defined stages of project progress, prior to the completion of the project.

Equity Financing. Besides financing debt with a lender, you may be able to obtain financing for your business by sharing its ownership with others. Through equity financing, additional individuals or firms provide capital for the business but may or may not take part in its operations.

If your business is incorporated, it may be able to obtain equity financing through the issuance of a number of instruments, such as common stock, preferred stock, convertible debentures and debt with warrants. Keep in mind that corporations are more highly regulated than other forms of business organization. It can also be very expensive to raise funds through common stock offerings.
Debt Instruments. If the business opportunity you are pursuing is the purchase or expansion of an existing business, you may want to consider various debt instruments. Advantages include retaining equity, fixed interest payments and flexible payment/payback terms. As noted above, convertible debt (quasi-equity) is useful for companies that have a high degree of risk but do not want to immediately give up a large portion of equity and/or voting rights. The conversion feature of convertible debt is attractive to investors or banks that typically make loans but require equity for their added risk.

Small Business Administration. The Small Business Administration is an independent federal government agency that assists small businesses. The SBA provides loan guarantees and, if funds are available, makes a very limited number of direct loans. To receive any financial assistance from SBA, a business must be unable to secure reasonable financing from other sources and must fit the SBA’s generalized criteria defining a “small” business. A loan proposal for the SBA is generally more complex and requires more documentation than one for banks; however, for loans less than $150,000, the SBA can process loan guarantee requests relatively quickly.

Certified Development Companies. The SBA’s Certified Development Company/504 loan program provides growing businesses with long-term, fixed-rate financing for major fixed assets, such as land and buildings. Typically, a 504 project includes a loan secured with a senior lien from a private sector lender covering up to 50% of the project cost, a loan secured with a junior lien from the CDC (backed by a 100% SBA-guaranteed debenture) covering up to 40% of the cost, and a contribution of at least 10% equity from the small business being helped.

Grants. There are two broad classifications of federal government grants for businesses: a general purpose or operating support grant, which is used to pay general operating expenses, and a project development or project support grant. In some situations, charitable foundations can be a source of grant income as well. Common project grants for businesses include planning grants, start-up (or “seed money”) grants, specialized research, and facilities and equipment grants.

Grant proceeds can be non-taxable and are typically interest-free. In some cases, grantee businesses are not required to submit to a credit check, post security deposits, pledge collateral or enlist co-signers. If you are a taxpayer and a U.S. citizen, you can apply for government grants even if you are bankrupt or have a negative credit history. (Visit www.unclesamsmoney.com.) Charitable grant terms are unique to the sponsoring organization and may not be available except for certain endeavors. Charitable organization research can be performed at www.guidestar.org.

Conclusion

As you looked through this article, some of the financing options may have looked appealing, while others ranged from non-applicable to repugnant. As to the latter, bear in mind that most of these alternatives are short-term solutions. The day is coming when credit will loosen, banks will revert to more reasonable lending practices, and relative normalcy will reign.

In the meantime, we would be happy to explore with you the financing alternatives that make the most sense for your company and industry and that are a good fit for your personal business practices and standards.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.