At some point in the course of a small business’ life, it is virtually assured that the company will need financing to best grow and carry out its operations. Almost all businesses in the U.S. today rely on some form of financing. And in contrast to personal finance, where interest payments and loans are almost always no better than a necessary evil, income-producing businesses can make the use of credit facilities a very strong business move and, in some cases, even better than using cash. For these reasons, it is important for small business owners to understand the many different forms of credit and other means of financing available to them.
Small business is still in the financial big leagues
Many small business owners are relatively unsophisticated when it comes to big-league finance. Start talking about warrants, mezzanine tranches and convertible options and you’re likely to see the average mom-and-pop business owner’s eyes glaze over. But while small business finance isn’t rocket science, it is important to understand the many different options that exist for financing. When used with skill, small business finance can provide many creative options for nudging fledgling operation out of the nest and towards the sky.
Bank loans and lines of credit aren’t the only options
For small businesses that need relatively large amounts of capital, that have proven revenue models, are operating in established industries and have ownership that is personally financially responsible, going with traditional bank financing or other forms of traditional business lending will likely prove to be the best option. All things being equal, traditional lending offers far higher limits, lower fees, lower interest and better terms than other forms of small business financing. But traditional lending does come with some risks and costs. For instance, small business loans are often partially secured by the owner’s personal assets. For million-dollar business loans, this can mean that a potential future default may carry the risk of the business owner losing their home.
Additionally, there are an increasing number of small businesses that simply don’t conform to the typical standards that traditional lenders impose. In these cases, even for companies that have the potential to make a killing, the businesses may find it virtually impossible to secure a traditional bank loan or a small business line of credit. For these companies, alternative financing may be the more attractive — indeed, the only — option.
Small business credit cards
Small business credit cards are very similar in function and requirements to personal credit cards. The only difference is that they often come with far higher credit limits. This form of financing can be appropriate for small business owners who need capital but not too much. Approval for small business credit cards can often be instant. And the credit limits for small business cards is typically in the $10,000 to $25,000 to start. Another benefit is that credit cards are almost always unsecured, meaning that no collateral has to be risked. This is one of the only forms of true unsecured business credit, a consideration that makes it very attractive for businesses that don’t mind the low limits.
However, the downside is that these cards can come with hefty fees and, if the balance is not meticulously paid in full and on time every month, credit cards can quickly become one of the most expensive form of financing around. Another issue is that many businesses simply need far more capital than is usually possible to obtain through a credit card. And in most cases, someone with the credit score needed to get approved for a $25,000 small business credit card will usually have what it takes to get approved for a small business line of credit that can easily be 40 times that amount.
Invoice and other asset-based finance
Many small businesses have valuable assets. This can be real estate, capital equipment or accounts payable. Financing that uses the latter for of asset backing is known as invoice finance or factoring. For companies that don’t have sufficient credit or perceived revenue stability to secure more traditional financing, invoice and other asset-backed financing can be a great way to generate a lot of cash on short order.
Invoice financing can be thought of as a kind of title loans for businesses. They can be fast, with approval coming in as little as a day. Businesses can also be approved for amounts that rival small business lines of credit. The downside is that the fees can be very high and the invoice finance company literally owns part of the business’ future cashflows. This can have an adverse effect on the business’ customers in some cases, as invoice finance companies may take over the collections process themselves.
Mezzanine finance and angel investors
For companies that have unproven business models that would simply be deemed to risky for traditional lenders and that need large infusions of capital, mezzanine finance and angel investors can be a means of generating the needed capital.
Mezzanine finance is typically used to refer to a combination of loan and equity finance where the lenders get some form of equity stake in the company. Angel investors are a kind of mezzanine financiers, usually taking on the financing of some of the riskiest startup ventures, which typically have a very high probability of failure.
The upside of mezzanine finance, in all its forms, is that it can provide critical money to businesses that may otherwise have no way of proceeding. The downside is that this form of financing often results in severe dilution of the owner’s equity when the companies do take off. In the case of angel investors, because every successful company may be financing 20 or 30 failures, these investors often look for returns in the 3,000 to 4,000 percent range. This means owners and founders often get the extremely short end of the stick in these deals.
What’s best for your company
While traditional bank financing is often best for those firms that can get it, the alternative forms of financing provide a nice backup and plenty of food for thought when considering what type of small business financing to pursue.