Financing Your Business
From the moment of inspiration, the most
common question a business owner will have is, “How am I going to pay for that!?”
Great ideas and great businesses are launched every day, it is the cornerstone
of the American Dream and essential
to the US economy. Over 80% of people in the US are employed by small
businesses. However, financing your business is often one of the most difficult
things a business owner will have to deal with.
Let’s take a moment then to look at what debt
is, the types of debt, and how debt is used in the life of a business.
Most commonly known as money owned by one party due to another, debt.
Debt is a topic that makes many business owners cringe. Most business owners don’t want to think about it, talk about it or deal with it. Being a Debtor can often have a negative connotation and most people are psychologically debt adverse, who wants to owe anybody anything. The word itself frightens most. It can allude to a lack of cash flow, inability of funding stability and even have dire consequences for an individual or business, basically it boils down to a fear of loss.
However there is another side to debt which is not apparent on its surface. Debt allows for a business to grow and to produce a return on investment for the business owner. Debt is indeed a major player driving the world economy. I want to discuss why debt should not be as feared as it is and its benefits for businesses. So we’ll start by looking at the two major categories of business debt.
Working Capital vs. Capital Budgeting
It is important to break down the type of debt the business is considering as well. The two main functional areas are Working Capital and Capital Budgeting.
Working Capital typically refers to the capital required to handle the business obligations on a short-term basis. These needs include inventory, payroll, and monthly recurring bills. Typically these needs are financed by cash on hand. However, there are a number of short term working capital financing options that include Lines of Credit, Loans, and Receivable Factoring:
- Lines of Credit (LOC)- Typically a bank issued product, the LOC is a facility where the business can borrow money on a floating basis and interest is charged on the outstanding balance. LOCs are typically unsecured and are offered to businesses that are established and are considered a low credit risk.
- Working Capital Loans – These loans are typically funded to the business owner in a matter of days where capital is needed urgently. The terms of repayment is typically under one year and often involve a daily or weekly repayment until the loan is repaid.
- Receivable Factoring – Factoring involves the lender paying a certain percentage of the businesses outstanding accounts receivable. Typically the lender will pay 90% of the issued invoice (subject to review of the businesses customers) and once the invoice is paid the business will receive an additional % based upon the factoring company’s fees.
Capital Budgeting, as discussed in previous articles, involves the analysis and planning for the financing of longer term assets. Typically, the capital budgeting process will assess the cost of the asset, the life of the asset, and the return that asset will produce for the business. Then the business must decide how to fund that asset. The two methods of funding are either Debt or Equity.
Equity financing is usually done by using existing cash that the business has on its balance sheet. Additionally, the business may issue and sell some of its ownership (via stock, membership units, or a percentage) in return for cash. In either form of exchange of the businesses cash for the asset, the overall return on Equity (ROE) should be taken into consideration. A very simplistic analysis of ROE, Net Income divided by Total Equity, should provide the business owner with a percentage that can then be compared to the cost of debt.
Debt financing involves the business borrowing from an outside source and may involve multiple sources of debt alternatives. The most common are Term Loans, Equipment Financing Agreements, and Equipment Leases.
- Term Loan – A typical bank loan with a stated term of repayment and typically a fixed rate over that term. In many cases these term loans may include the backing of the Small Business Administration (SBA), whereby the Government guarantees a portion of loan for a fee typically charged to the borrower. Term loans will typically involve a blanket lien on all of the businesses assets in addition to the personal guarantee of the owner(s).
- Equipment Financing Agreements – Also know as and EFA, this type of agreements is typically tied to a specific asset or piece of equipment. A traditional EFA will have a fixed term, usually expressed in months, that is loosely tied to the life of the asset. Typically and EFA will transfer ownership of the asset at the time of inception and the business is debtor to the lender.
- Equipment Leases – Equipment Leases are contracts for the rental of equipment whereby the business owner (Lessee) has possession and use of the equipment and pays the lender (Lessor) a payment for use of the asset. In most cases there is an agreed upon option for the Lessee to purchase the asset at the end of the Lease term.
Debt as a Strategic Resource
Believe it or not, debt can be used as a strategic resource to expand operations and increase revenue! Try to think about debt in a different light, perhaps as an employee. An employee is a paid asset whom you trade your cash for their time, this time produces work which translates into revenue. Debt works the same way, only your investment is not into a person but rather capital to help drive your business.
Shifting gears, so whether a business uses a debt vehicle such as a loan or equipment lease as means to finance a piece of equipment, the business is actually paying a fee for the use of that equipment. That fee is what you pay in order to produce the revenue associated with it. And assuming you are a profitable small business and you pocket more than the fee (or monthly payment) for the equipment – you’ll be making a profit! Overall this type of transaction allows you to increase your revenue, serve your customers and preserve your cash.
Debt that Hurts, and Debt that Helps
Yes debt impacts how your business borrows in the future, however in a good way.
At ILS many of our business customers voice a concern over their personal credit and how it is going to affect their ability to get financing for their newer or start up business. (Many lenders and banks classify a start-up as a business with less than two years in operation).
From a credit perspective it is helpful to think of a start-up as a new born infant in the world of commerce. At inception, the business has no credit history, good or bad. In nearly half of our client relationships, ILS is the first Lender to the business. Individuals whom “look best on paper” are those that can show experience paying their debt obligations – and hopefully on time. Credit history of up to five years may be reviewed and generally five open trade lines are favorable – as it shows the individual is active in paying their debt obligations.
So if a business is just starting out the most important indicator of how the debt will be repaid is personal credit of the owner(s). In most cases, the business will pay its obligations much like personal credit of the businesses owner(s). This is not the only assessment of risk, other factors include industry, asset being financed, reserves, and even geographic location.
Side Note: There is a very important distinction between revolving debt and installment debt. Revolving debt being – everyday credit card charges. Installment debt being – monthly payments with interest and principal; like mortgages and car loans. Installment debt is tied to a piece of collateral which is real tangible personal property. And so those types of debts are not considered the same way as revolving debt is.
As a lender we run into a lot of credit card debt. It is no secret that the average US adult has racked up $16,000 in debt, but this is still not a deal breaker when needing more financing. Best case scenario is an individual having the ability to borrow on a revolving line but has not maxed out the credit limit – which would not allow the ability to borrow more.
So it is just the right combination of debt. And remember a mix of credit history is key.
Debt and Future Ability to Borrow
Jumping to stage two, as the business matures the business itself, builds its’ own credit file. A lender, such as ILS will report to a national credit reporting agency for business debt (loan, lease etc.).
The start-up company then starts building its’ own credit file, also referred to as history. Its’ ability to borrow by itself in the future will be greatly enhanced. In addition to that – creditors can look at the company as a standalone entity, and how it pays its obligations. On the personal side, even though the owner may have to personally guarantee the debt early on, that debt is not reported to the national credit report as revolving or installment debt. It is not reported at all to the personal credit report, as long as the debt is handled in accordance with the terms of the loan, lease or EFA (Equipment Finance Agreement) – many terms are used interchangeably.
So in recap, debt’s lifecycle begins with a heavy lean on the individual’s credit and as the business grows and matures the early debt allows for subsequent borrowing to become easier and more cost effective.
*In this article Debt is referencing to various types of business loans, working capital, leasing and financing.
ILS – Innovative Lease Services is a commercial lender and provider of custom Leases, Loans and Financing Programs. Visit www.ilslease.com or call 800-438-1470 for more information.
Article by Angela Faringhy, Innovative Lease Services.