When institutional investors aren’t interested, where can small or medium-sized businesses turn for capital to fuel growth? You’ve likely heard of convertible debt, merchant credit advances, and crowdfunding, but are any of those the best option for your company? Here’s a primer on the capital structure and what types of financing make sense at differing stages of corporate development.
When deciding which alternative funding option is the best for your SME, it is important to first understand what alternative financing is. Alternative financing is a means of obtaining capital outside of the traditional banking systems which you are probably familiar with. For example, this includes sources such as online loan marketplaces, crowdfunding platforms, third-party payment providers, and cryptocurrencies to name a few. These sources tend to be more flexible than banks, which are notoriously strict with their qualifications for traditional loan sources. Alternatives allow businesses with poor credit or certain challenges access to capital in situations where they may not be able to access capital otherwise. Below, we have broken down various alternative funding sources and some important details to understand about each:
- SBA Loan: SBA loans are loans that are backed by the government which are intended to assist small businesses in finding the funding they need. In particular, the SBA assists small businesses that are disadvantaged and might not be able to get help otherwise. A business can expect amounts from $50,000 all the way up to $5,000,000. Terms also cover a broad range, typically from 10-25 years to maturity. One downside to SBA loans is they’re famous for being slow and paperwork intensive. Interest rates here tend to be favorable, starting around 8%.
- Line of Credit: In many situations, a line of credit (“LOC”) can offer a business a source of working capital to fulfill orders and other financial requirements of a business. These facilities are designed similar to credit cards in that a financing source will generally give you a sum of money which you can draw on as needed, only charging interest on those funds which are utilized. These types of facilities can also act as a financial safety net for a business, providing funds to draw on when the business is in a cash crunch for things such as payroll, order fulfillment, etc. Depending on the use of proceeds, amount of the line which is utilized, and the state of the borrower, these can range anywhere from 5%-20% annually.
- Factoring: Factoring is a type of financing that is intended to free up the cash tied up in outstanding invoices. Generally, how these facilities work is: The invoice factoring company, will purchase your unpaid invoices and front you typically 85-95% the value of the income to be realized in the future from the payment of that invoice by your customer. The factoring company then collects payment directly from your customer and sends you the remaining amount of the invoice, minus the factoring fee (generally 1%-5%). Your factoring fee is determined, in part, by how long it takes your customer to pay and therefore how long the factoring company must wait to be paid back.
- Convertible Debt: A convertible debt small business financing structure is a mix of debt and equity financing. The money raised is considered a loan, but at some future date the loan can convert to equity if the lenders choose so. Generally, you will negotiate an interest rate which is associated with the loan. Additionally, the details regarding how the lender can convert the debt facility into equity is negotiated at the time of the loan as well. Generally, the conversion features an agreement to give the lender a discount or warrant on an upcoming round of equity funding. These will generally carry interest rates in the 8%-12% range and a 20% or more conversion discount.
- Merchant Cash Advance: Technically, a merchant cash advance (“MCA”) is not a loan, it is an advance on your future earnings. While they are similar to short-term loans, they generally have a lower standard for approval, have a factor-type fee structure, and are one of the most expensive financing options available. They generally carry no set maturity date; these companies will instead collect out the money until they are paid in full with a return. Rates here generally start around 18% and can go significantly higher than that.
- Crowdfunding: As implied by the name, crowdfunding is a capital raising mechanism where a company will utilize a group of people (the “crowd”) to raise capital. There are three main types of crowdfunding:
- Equity: Company sells an equity stake to raise funds
- Debt: Company borrows money from a crowd of investors
- Reward: Company raises money and provides a reward to those who commit capital
Investors can pledge money at any point during your campaign, as long as it’s within the timeframe you set from the start. Once you’ve hit the target and the campaign closes, your crowdfunding website will take a cut from the total amount raised. The harsh reality of crowdfunding is that you’ve set very public expectations and failing to meet them or missing promised timescales will frustrate people, turn them off to the product, and put you in the firing line for bad publicity. Because of this, it is very important to have a comprehensive plan before rolling out a crowdfunding campaign. Costs associated with such a campaign will depend on the structure and the current state of the business at the time of launch.
While lenders use a variety of tools to determine your qualifications for a loan, none of these metrics are representative of your credit worthiness or strength of your character. So as you begin the process, it’s important to remember that you will likely face rejection when going through this process, especially if you are not educated on the different sources. Furthermore, majority of all small business financing requests are rejected.
That said, it is always helpful to consult with an expert, such as TAP, when determining what the best financing options are for your business. Not only can TAP assist you in navigating the complex landscape of small business financing but TAP also provides direct capital solutions to our clients through TAP Capital & TAP IDEA. If you would like to hear more about how TAP can assist you and your business, please reach out to us here.