Cash-strapped companies that require a steady supply of working capital have many financing options. Owners often think of a bank loan or line credit first. However, for qualified businesses, this might be the best option.
It can be challenging to qualify for a bank loan in today’s uncertain economic, regulatory, and business environment. This is especially true for new businesses and people who have been through financial difficulties. Owners of businesses that aren’t eligible for bank loans may decide to seek venture capital or bring on equity investors.
Are they really worth it? There are many potential benefits to having venture capitalists and “angel” investors in your business. However, there are also drawbacks. Owners sometimes forget about these drawbacks after the contract has been signed with an angel investor or venture capitalist. It’s too late to cancel the deal.
The problem with equity investors being brought in to provide working capital boosts is that equity and working capital are two different types.
Working capital is money used to pay business expenses during the time lag before cash from sales (or accounts payable) is collected. It is therefore short-term and should be financed using a short-term financing instrument. However, equity should be used to finance rapid growth and business expansion. It also can be used for the acquisition of long-term assets. Assets that are repaid over a 12-month period are called long-term assets.
The biggest problem with bringing in equity investors to your business is the possibility of losing control. Venture capitalists and angels may sell shares or equity in their business. This means that you could lose control of your business. This dilution in ownership often leads to a loss or control over the most crucial business decisions.
Owners may be enticed by the prospect of little or no out-of pocket expense to sell their equity. Equity financing is not like debt financing. You don’t pay interest. Equity investors get their return through the ownership stake they gain in your company. The long-term “cost” of selling equity is much greater than that of borrowing. This includes both the actual cash cost and soft costs such as the loss of control over your company and future potential value of ownership shares sold.
Alternative Financing Solutions
What if you are unable to qualify for a loan from a bank or a line of credit and your business requires working capital? In this case, alternative financing options are often the best option to inject working capital into businesses. These three types of alternative financing are the most popular.
1. Full-Service Factoring: Businesses can sell their outstanding receivables on an ongoing basis to a factoring company (or commercial finance) at a discounted price. The receivable is then managed by the factoring company until it is paid. Factoring is an accepted and well-respected method of temporary alternative financing that is particularly well-suited to companies with high customer concentrations and rapidly growing businesses.
2. Accounts Receivable Financing (A/R Financing) – A/R financing can be a great solution for companies that have stable financial conditions and a diverse customer base, but aren’t yet bankable. The business will provide details about all receivables and pledge those assets as collateral. The company receives the proceeds from these receivables in a lockbox. Meanwhile, the finance company calculates the borrowing base to determine how much the company can borrow. The borrower makes an advance request when it needs money. The finance company advances money by using a portion of the accounts receivable.
3. Asset-Based Lending (ABL), – This credit facility is secured by all assets of the company, including A/R, equipment, and inventory. The business, unlike factoring, continues to collect and manage its receivables. It submits collateral reports to the finance company on an ongoing basis. They will then review the reports and audit them periodically.