Small businesses often fail to grow for lack of funds to cover short term working capital needs, not because business is bad! The biggest challenge faced by most small businesses is how to fund the growth that makes owning your own business a worthwhile endeavor. Once a business is up and running, cash flow issues, funding growth, dealing with the natural ebb and flow of the sales cycle, become the daily issues that can potentially undermine the financial future of the business. Traditionally, start-ups use a small business loan, as seed capital, which remains an ideal, low risk approach. Private investment is another common, but more costly, route for small business to take in business capital. Regardless of the merits to either source of funds, when does it make sense for small business to use alternative sources of funding, like Invoice Factoring?
There are many reasons why traditional bank financing may not be a good option for you. The loan application process can be long and cumbersome. The delay from the time of submission of the application to loan disbursement can be substantial as well, putting extra constraints on your ability to timely pay your operating costs. In some cases, you may not be creditworthy, or you may have used up your available credit limit, or you may have too much trade and other debt built up in your business.
In the case of private investment, capital cash injection is given in exchange for equity in the business. This type of investment can take various forms, but it will ultimately end in diminished equity in the company that you worked so hard to build. While more often used by large corporations, the costs associated with private investment are more seriously felt by small businesses, especially in situations where there is only one or very few owners involved. Private investment usually demands ownership rights which dilutes the value of ownership shares and usually creates a situation where the private investor has a preferred status relative to the original owner and priority in terms of getting repaid. Additionally, it usually results in a lack of control over the decision making processes relative to the demands of the investor and the capital invested. These hidden costs need serious consideration.
So, how do you finance an unexpected opportunity to double your sales? Given any opportunity to meaningfully increase your sales, how do you manage, especially when you know that your customers will expect customary payment terms? Making application for a new or expanded bank line of credit can result in long and protracted negotiations. If the banker decides your desire or ambition to grow is too aggressive or financially risky, then where do you turn? If you have no or limited availability to draw on a traditional line of credit, then you will most likely miss the opportunity to increase your sales. The time it would take to acquire capital from a private investor is certain to be even more protracted and costly. Well, this is a good example of when you should consider an alternative funding source like “Factoring”. Factoring is the financing industry term used to describe the sale of accounts receivable (open invoices) at a discount from their face value. It may not sound common, but over $1 trillion in sales is factored worldwide annually. In the United States, there are many independent finance companies that offer Factoring. Some banks even have Factoring divisions. In modern times, Factoring has become a champion of small business and an ideal alternative to a bank loan or private investor funds.
Factoring involves the sale of accounts receivable at a discount. Essentially, you sell your receivables (open invoices that are due to you from your customers) to a “Factor”, who discounts the value of them and pays you in advance of actually collecting payment on the receivables. The discount taken by the Factor generally ranges from 1%-3% for invoices collected in the normal course of business. Essentially, the Factor is providing you with funds, not on the basis of your creditworthiness, but on that that of your customers. So, even though your borrowing profile may not be ideal for a bank lender, as long as your customers are creditworthy, you can leverage that to establish a factoring line and obtain funds from a Factor.
For example, you may be a start-up, hotshot delivery service, but your customer could be Baker Hughes who may take 40 plus days to pay your invoices! You may not be a good prospect for a bank loan, but you may be an ideal prospect for factoring! AND, here’s the wonder of factoring, you do not take on the burden of bank debt, nor do you dilute your equity. Yes, you incur an expense in the form of a discount fee, but the expense does not come out of your pocket upfront and should be viewed as a cost of doing business. The simple truth is that factoring allows you to fulfill your main goal of getting financing in a timely manner and enables you to take advantage of a growth opportunity that you otherwise would lose. The same line of reasoning works for generating cash to support your ongoing business operations. Like most businesses, the majority of your cash is tied up in receivables (open invoices). Regardless of whether your need for funds is for payroll or inventory or other critical operating cost, factoring is an ideal way to get funds to cover it.
Establishing a factoring relationship with a Factor should be relatively simple. Remember, the Factor is mainly concerned about the credit worthiness of your customer accounts. So, in comparison to the underwriting process that a commercial bank is obligated to undertake when considering a loan, relatively little or no emphasis is placed by a Factor on approving you for a factoring line. Generally, you are required to authorize the Factor to take a priority security interest in your receivables. In considering factoring, if you have inadvertently pledged your receivables to a bank in connection with a loan for inventory or equipment, then all that would be required would be that the bank release its security interest in the receivables.
I think what you will find most surprising is that factoring is highly endorsed by financial professionals, including banks. Business clients have many needs, and good advice, be it from lawyers, accountants or bankers, should be enlightening. The disclaimer offered by most is that Factoring is more costly than traditional bank financing. This is true due to the effort expended by the Factor to ensure the receivables are collectable. Although, factoring may be more expensive, it is generally considered a short-term (6 months to 2 years) funding solution for small businesses. Factoring essentially enables a business to grow and buy time until it qualifies for traditional bank financing. Traditional bank financing and private investment are the irreplaceable cornerstones of corporate finance. The challenge is getting to the point where you can truly benefit from their value. Regardless of business size, from small to large, factoring should be considered as an alternative to private investor funds and traditional bank financing.
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