Today’s market for small business credit is highly diversified. It’s worthwhile for business owners to increase their understanding of the types of debt financing that are best suited to short-term and long-term business funding needs.
Here are a few popular choices:
Asset-Based Loans (“ABLs”)
Most small business bank loans are secured by some type of asset. For seed-stage and early-stage businesses, primary “loan coverage” is likely to be in the form of a personal guarantee from the company’s founders or a pledge of specific assets such as personal investment accounts or certificates of deposit.
As a business progresses, bank loans are secured more by the company’s assets than the founder’s assets. Company assets can include equipment, raw materials, finished goods or the value payments due from customers, called “accounts receivable.”
Asset-based loans and lines of credit are offered by national and local banks as well as independent finance companies. The amount of funds that are advanced under ABLs is dependent on an agreed percentage of the value of the secured assets – typically 70% to 80% of eligible accounts receivable and 50% of finished inventory. Notice the phrase “eligible receivables.” Asset-based lenders rarely lend against accounts receivables from customers that don’t pay invoices in less than 90 days. Sales to individuals or small companies may not be considered as “eligible” for loan advances.
Interest rates vary according to the size of the loan line and financial position of the borrower. Sometimes banks tack on additional “audit” or due diligence fees that increase the overall costs of borrowing through an ABL. Larger banks tend to ask for personal guarantees of company founders, and require companies to transfer all other banking relationships over to the bank.
Factoring is a close cousin to asset-based finance in terms of providing extra working capital to companies in exchange for a secured interest in a company’s accounts receivable.
Unlike traditional accounts receivable financing which lends against the value of eligible accounts receivable, factors usually purchase eligible receivables directly from the business owner. Customer payments are then forwarded directly to the factor, not the business or “seller” of the receivable assets. Factors make a profit on the transaction through fees and purchasing the accounts receivable at a discount to its face value.
Historically, factoring has been a popular form of working capital finance for the garment industry. Today, factoring can be a cost-effective form of finance for service businesses that sell their services to large, credit-worthy customers on a frequent basis. Factoring is also a go-to type of funding for companies as they emerge from Chapter 11 bankruptcy filings.
Visit Ask on Purpose to learn the differences between non-recourse factoring and recourse factoring
Credit cards are an efficient and popular source of fast cash to process travel expenses, make one-time purchases or pay for ongoing services from online or offline vendors.
The dangers of taking on too much credit card debt are well known. If the business can’t pay off the monthly bill in full, then growing interest costs reduce the amount of cash the business has to invest in growth.
Like personal credit cards, all small business credit cards are guaranteed by the individual who signs the credit card application, which is usually the business owner. However, unlike personal credit cards, business credit card issuers can impose retroactive rate increases “any time and for any reason.” Issuers can also hit business owners with late fees associated with weekend payments or due dates that fall in the middle of the day. Furthermore, business credit cards are not obligated to apply payments to outstanding balances at the highest interest rates. The annual fees and interest rates for business credit cards tend to be higher than for personal credit cards.
One advantage of professional credit cards over personal credit cards is the potential to establish credit in the company’s name with Dun and Bradstreet or “D & B.” If this is the primary purpose for taking on the added financial risks of a business credit card, make sure your business credit card issuer reports activity to D&B. Professional business credit cards may send credit payment information to the different business credit reporting agencies or not at all.
Micro-loans, also known as micro-finance and micro-credit, are a relatively new type of loan product in the United States. The reason why this form of credit is called a “micro-loan” is its small size. First loans may be as little as $500, which may be a perfect credit vehicle for entrepreneurs who want to buy computers, culinary equipment, film production gear or other types of equipment. With consistent loan repayment and business advancement, borrowers may be able to qualify for additional loans up to $35,000. The average first micro-loan advance is approximately $2,000.
A distinguishing feature of micro-loan providers is their willingness to lend to first-time business owners who may not have good credit. Further, in some cities, interest rates can be less than small business credit cards, even to entrepreneurs with a low personal credit score.
In addition to granting loans, most micro-lending organizations offer low-cost or free business training courses for prospective or active borrowers. Some larger organizations provide skilled coaches and mentors with expertise in accounting, marketing, product development and sales.
Not all micro-lenders provide loans in the same way. Some organizations provide loans directly to individual borrowers while others follow the “peer lending” model, in which a group of small business borrowers are jointly responsible for all loans to group members.
Micro-lenders are not providers of emergency funding, bill payment or debt repayment financing. Their purpose is to help start and advance business ownership in America in communities that are eager for new job creation. See the Funding Directory for micro-lenders in your state.
Business owners have the option of leasing certain assets rather than buying them outright. The other advantage of leasing is to extend the payments for use of an asset, which is often equipment or software.
There are two primary types of leases: operating leases and capital leases.
An operating lease allows businesses to use an asset over a specific period of time. The asset value does not appear of the business’ balance sheet because the business does not own the asset. At the end of the lease term, the equipment returns to the lessor. The monthly lease cost is expensed like any other company expense on the business’ income statement. This type of lease is well-suited to business owners who want to avoid owning assets that might become obsolete quickly or may not be needed by a business over a long period of time.
A capital lease transfers ownership of an asset to the business as the end of the lease term. In general, a capital lease is a form of longer-term financing usually extending more than five years. The business is generally responsible for maintenance, insurance and other expenses related to the asset. On the business’ financial statements, the related asset and payment liability are recorded on the business’ balance sheet. Further the business may claim depreciation and deduct interest expense on the asset.
The fine print of leasing agreements will usually include some type of personal guarantee by the business owner; however, the extent of the guarantee may be negotiable.
Leasing is a competitive industry. Many equipment suppliers have relationships with a specific leasing company and receive a referral fee from introducing a new customer to the leasing company.
Revenue-based loans or “RBLs” are a relatively new kind of loan that is well-suited to growing companies that don’t have other types of tangible assets (accounts receivable, inventory or equipment) to lend against.
Typically, companies receive an advance of approximately 10% to 30% of its prior year revenues. Lenders are paid back each month based on the company’s current monthly revenue results. Companies with fast revenue growth will repay the RBL faster than slower revenue growth companies.
Certain types of Internet businesses and companies that receive predictable monthly royalties from licensing deals are good candidates for RBLs. However, RBL lenders rarely work with companies with gross profit margins that are less than 40% to 50%, which is a high bar for non-technology companies to achieve.
The cost of an RBL is not usually quoted in interest rate terms so it is important for business owners to work the numbers to understand the cost of the lending relationship.
Many revenue-based lenders may ask for some sort of “equity kicker” in your business in the form of a warrant or some other option that allows the lender to buy shares of the company’s common stock.
Purchase order financing
Purchase order financing, sometimes called “structured finance” or “supply chain finance” is a form of credit provided mostly to manufacturers and product distributors to finance the cycle of purchasing supplies, producing goods and completing sales to end customers.
This type of funding can cover one or several verified purchase orders from government buyers or large companies with superior credit. It is especially helpful to companies that need to finance seasonal business that has little chance of purchase order cancellation or return of goods.
Purchase order financing can be structured in different ways but usually involves the flow of capital to pre-pay a supplier that is required to complete a purchase order from a large end buyer. The purchase order finance company charges service fees that are collected at the time of invoice payment directly from the end customer. The remaining amount is returned to the business owner.
Commercial Letter of Credit
A Letter of Credit or “LC” is an important component of facilitating import and export transactions whereby a financial institution will contractually guarantee the payment for good or services to a supplier through another corresponding or “confirming” financial institution. Letters of Credit also protect the purchaser of goods by not releasing payment until the financial institution receives confirmation of the shipment of goods.
Letters of Credit involve precision. A financial institution’s obligation to pay is not based on the quality of good produced as part of a purchase agreement but by the specific terms and conditions of the LC. Fees associated with LCs are based on the type and credit risk associated with the specific LC and credit worthiness of the buyer.
A commercial mortgage is a form of long-term financing that helps business owners finance the purchase of office buildings, warehouses, retail shopping centers and other properties that generate revenues for the owners. Commercial mortgages can also be used to refinance or renovate an existing property.
Borrowers pay fees and monthly interest on a fixed rate or variable rate. Credit availability is based on the property’s income stream paid by tenants or property value. Similar to residential mortgage markets, lenders have reduced the amount of financing available against a property’s value since the recession.
Many of the types of loans listed here are offered by banks that participate in the Small Business Administration (“SBA”) member loan program. In general, if a small business owner defaults on a short-term or long-term loan that is part of the SBA loan program, then the lender can turn to the federal government for some payment relief.
The pricing and application fees associated with SBA-backed loans may be higher or lower than loans offered by independent financial services companies and community savings and loan institutions, so comparison credit shopping is recommended to business owners. However, SBA-backed loans can offer business owners longer payment terms than traditional bank loans.
The SBA offers special programs to support international trade; women, minority and veteran-owned businesses; and disaster recovery loans.
See the Start on Purpose Funding Directory for a list of SBA member lenders in your state.