Small Business Financing

26. June 2009 by admin.

Financing a Small Business (Part 1)           

            Whenever I receive a call from a prospect looking for financing (aka “money”), I have one goal – to assist that prospect in solving his problem, whether it means using IFG’s financing product or another form of financing.  How do I determine what is the best method of financing?  Easy, I listen to the story.

            There are all types of financing sources out there.  Some are well known (bank loans, venture capital, etc.), while others are less familiar (PO financing, factoring, cause based microlenders, etc.).  The truth is, when I’m listening to a business owner discuss why financing is needed and what the business situation is, it becomes quite obvious that if there is a solution (sometimes there isn’t), what that solution should be.

Reasons Businesses Need Money

            Many financial professionals like to pretend that finance is a complex subject.  It is not.  Before we talk about the pros and cons of the financing types, let’s discuss the reasons businesses need money in the first place.

            When a company is started, money is needed to pay for a few basic necessities, such as telephones, computers, business entity formation and business cards.  Additionally, some staff may be needed to answer phones or sell the product or service.  This is generally referred to as “startup capital.” 

Once a company is up and running, let’s assume they are actually able to sell their product or service.  If they are a manufacturer, they will need to purchase raw materials and labor.  Then they will deliver the goods to their customers.  The money needed between the time of production and the time they collect from their client is termed “working capital.”  Working capital is needed not just in manufacturing, but in service businesses as well, as a company typically pays their employees for the work they perform well before they receive any cash from their customers. 

Finally, companies that need to purchase real estate or machinery are said to be making “capital purchases,” and thus need “capital financing.”

Three Ways To Finance A Business

            Now that we have identified the different needs for financing, let’s begin our discussion on the financing types.  There are basically three ways a business can be financed (for the sake of this discussion, I will exclude grants and gifts):  loans, equity or assets. 

Loans

            By definition, a loan is the act of giving money, property or other material goods to another party in exchange for future repayment of the principal amount along with interest or other finance charges.¹  Loans can be provided by family, friends, banks or other non-bank lending institutions.  Loans typically come in two forms.  A line of credit is a flexible loan that allows the borrower to access funds up to a certain lending limit as they are needed.  A term loan is when money is lent to a client in a lump sum.  The client then makes periodic payments throughout the life of the loan.  These payments can be for interest only or for both interest and principal.

            Loans are an excellent and inexpensive source of funds, and are usually a company’s first choice when money is needed – and why not?  If a company can borrow money at a low cost and not give away any ownership of the business, it seems like a good situation, and I couldn’t agree more.  In fact, one of my first questions when discussing financing with a business owner is, “Have you talked to your bank?” 

So what are the downsides to borrowing money to fund business growth?  First, getting a loan is not always easy.  The lender wants to be sure they are going to be paid back, so they will investigate credit scores and business history.  There may be some industries that a lender refuses to lend to.  Also, in some situations (not all) the process can be time consuming.  Third, the lender may provide funding that is not as sufficient for a growing company.  The company may have to reapply if the company is growing and is in need of more funds.  If the lender takes assets as collateral in this situation, it may severely limit the financing options available to a company in the future.  Finally and maybe most important, the bank expects to be paid back on a set schedule, usually monthly.  If a company is seasonal or has a bad month, the bank still expects its money.

So when is borrowing money the right decision for a company?  This may sound overly simplistic, but when a business knows with a lot of confidence what its cash flow situation will be, and thus can make scheduled payments, then borrowing makes sense.  Also, when a business is looking to purchase assets such as real estate, borrowing is the best solution.  Finally, assuming you borrow from a person or institution that can grow with you as your business grows, then you should use loans to finance a business.

Posted in Uncategorized | Print | No Comments »