Pinnacle Business Solutions
Financial Review Issue #43
Dear Paul,

What is the Best Type of Financing for Your Business?
Overview  

Finding the right financing for your business can be a challenging task.  However, if you understand a few of the basics when it comes to your financing options, you can reduce the amount of time it takes to find that financial partner and increase your chances of getting the right financing for your business. 

Just like any industry there are many different financial resources, each with a different area of focus or specialty.  The financial resource that is right for you depends on several factors:  the industry your business is in, the stage of your business, the amount of financing you need, the amount of time you need the financing, the amount of control in your business you are willing to give up, your business and personal qualifications, and how much you are willing to pay for the funds. 

In financing, the risk reward trade-off holds true, the greater the risk the financial resource is taking, the greater the return they are expecting to receive from their investment.  Understanding where your company and your financial resource are on the financing spectrum will help you determine if there is a good match between debtor and creditor.

Rate of Return

  

Debt vs. Equity

One of the first questions you need to ask yourself when determining your capital requirements, are you willing to give up some ownership or control of your company?  If you are, than you may be a candidate for equity financing, if you are not, then you are more likely a candidate for debt financing. In general, with debt financing, there is a clearly defined:  loan amount, interest rate and term, and you are required to make periodic fixed principle and interest payments over the term of the loan whether your company is profitable or not.  However, the financing resource does not have ownership of your company or the ability to directly control the direction of the company.  In general, with equity financing, there are no fixed periodic principle and interest payments, and there are no fixed terms as to when the investment needs to be paid back.  However, in return for their investment, you give the investor, an ownership stake in the company, a share of the company profits, and the ability to control the overall direction of the company.  

Debt Financing

There are many types of debt financing including: loans, lines of credit, factoring, and purchase order financing

Loans - are typically used for financing the purchase of fixed assets such as buildings and equipment.  They are generally provided by banks and finance companies, have a fixed term 3+ years, a fixed annual interest rate, and a fixed monthly principle and interest payment.  They are typically secured by the fixed asset being purchased.   Loans are typically made for 50% - 80% of the value of the fixed asset being purchased.  In general, this type of debt financing is usually provided to companies that are breakeven or profitable and have been in business for 3+ years.  Interest rates currently range from approximately 7% to 12% per year.

 

Lines of Credit - are typically used for financing working capital needs and are used on as needed basis.  They are expected to revolve on a regular basis, that is, you borrow money one month then pay it back with interest the next.  They are generally provided by banks and finance companies and have:  an upper limit of dollars that can be used at one time, a fixed term of 1 year, a variable annual interest rate, and a variable monthly payment depending on the amount of funds being used.  They are typically secured by such things as accounts receivable and inventory.   In general, this type of debt financing is usually provided to companies that are breakeven or profitable and have been in business for 3+ years.  Interest rates currently range from approximately 7% to 12% per year.

 

Factoring - also used for financing working capital needs, is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party (called a factor or finance company) at a discount in exchange for immediate money with which to finance continued business. Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables (essentially a financial asset), not the firm's credit worthiness. Secondly, factoring is not a loan, it is the purchase of a financial asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three.  Factors usually factor a limited number of invoices, for a limited time (30-60 days), and charge a fixed interest rate which ranges from 1%- 3% per 30 days and is collateralized by the accounts receivable.  Invoices may be factored with or without recourse.  In general, this type of debt financing can be provided to new and established businesses.

Purchase Order Financing - also used for financing working capital needs, is a financial transaction whereby a business which has orders for its product, can get a loan from a financing company to purchase the materials and labor needed to produce the product which is needed to fulfill those orders. Purchase order financing is usually provided by finance companies.  It has a limited term (30 -90 days), has a fixed interest rate which usually ranges from 1%-3% per 30 days and is collateralized by the materials.  In general, this type of debt financing can be provided to new and established businesses.

Equity Financing

There are many types of equity financing including public stock and private stock   

Public Stock - companies that issue public stock have the ability to raise largeBuilding amounts of capital from a variety of investors all over the world.  There stock is usually traded on a regular basis on public stock exchanges such as the New York Stock Exchange ("N YSE") or the "National Association of Securities Dealers Automated Quotations ("NASDAQ").  They are regulated by the Securities and Exchange Commission ("SEC").  A publicly held company is required by the SEC to publicly disclose its financial performance in detail on a quarterly basis. As with equity financing, their investors, own a portion of the company, share in the company profits and can have control over the company direction by utilizing their voting rights.

Private Stock - companies that issue private stock have the ability to raise capital from a limited number of accredited investors in the world. There stock is not traded on a regular basis on the public exchanges.  However, they are regulated by the Securities and Exchange Commission.  Unlike a publically held company, a privately held company does not have to disclose its financial performance to the public.  As with equity financing, their investors, own a portion of the company, share in the company profits and can have control over the company direction by utilizing their voting rights.

Angel Investment - a private equity investment which is generally raised from a small group of accredited investors (high net worth individuals).  This group of investors varies dramatically, but could be professionals, business owners or business executives.  They could invest on their own or through angel investment groups.  These investors usually invest in early stage companies that have the ability to grow rapidly. They usually invest between $25K and $1M and actively participate in management.  In general, these investors concentrate their investments in industries they are familiar with.  They may have previously worked in the industry, invested in the industry or owned businesses in the industry.    In general, these investors prefer to exit their investment in approximately 5 years.  

Venture Capital Investment - a private equity investment which is generally raised from institutional investment groups.  These investment groups vary in size from $50M to $5B.  These investors usually invest in technology companies that have some initial sales and have the ability to grow rapidly. They usually invest between $1M and $50M and can actively participate in management.  In general, these institutional investors concentrate their investments in certain industries they believe have the greatest potential for growth.  These investors prefer to exit their investment in approximately 7 years.  

Financial Partner Research

 

People shaking handsBefore you begin contacting prospective financing sources, it is a good idea to do your research.  Understand what industries your prospective financing resource has invested in, what type of financial products they have to offer, what size investments they generally make, what their investment risk profile looks like, and what other services they can offer such as management support and business development support.  Much of this information can be obtained through referrals from your CPA, attorney or bank, by researching financial resource websites, by contracting your industry association and by interviewing your prospective financial resource. 

 

Finance Package

 

Before you contact your prospective financing resource, you will also want to prepare your financing package, which usually includes: historical business tax returns, historical personal tax returns, historical business financial statements, interim business financial statements, aged accounts receivable and accounts payable reports, a personal financial statement, a business financial forecast, articles of incorporation, a use of funds statement and a business overview/plan.  You only get one chance to make that good first impression on your financial resource, so take the time to do it right!  Ensure you have a complete and accurate finance package that really presents your business in the best possible light.  If you have never prepared a finance package before, get help from an expert!  A good CFO or CPA firm can help you through the process.

 

Closing

 

Finding the right financing for your business can be a challenging task.  However, if you understand the type of financing you need, how to locate that financial resource, and what information they will need from you, you can reduce the amount of time it takes to find that financial partner and increase your chances of getting the right financing for your business.  A great financial partner can really have a positive impact on your bottom line!

 

Sincerely,
 

Paul J. Beckert MBA, CPA
President,
Pinnacle Business Solutions
Quick Links
 

Key Points of Interest 

  

Angels invest between $25K and $1M in early stage companies that have the ability to grow rapidly.

 

Factoring and purchase order financing can be provided to new and established

businesses..  

 

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