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Alternative Financing Vs. Venture Capital: Which Option Is Best for Boosting Working Capital?
There are many possible financing options available to cash-strapped businesses that need a healthy dose of working capital. A bank loan or line of credit is often the first option owners think of—and for qualified businesses, it can be the best option.
In today’s uncertain business, financial and regulatory environment, qualifying for a bank loan can be difficult – especially for start-up companies and those who have experienced any type of financial hardship. Sometimes, business owners who don’t qualify for bank loans decide that seeking venture capital or bringing in equity investors are other viable options.
But are they really? While there are some potential advantages to bringing venture capital and so-called “angel” investors into your business, there are also disadvantages. Unfortunately, owners sometimes don’t think about these drawbacks until the ink is dry on a deal with a venture capitalist or angel investor—and it’s too late to back out of the deal.
Different types of financing
One problem with bringing in equity investors to provide working capital growth is that working capital and equity are actually two different types of financing.
Working capital—or money used to pay business expenses that are delayed until cash from sales (or accounts receivable) is collected—is short-term in nature, so it must be financed through short-term financing instruments. However, equity must generally be used to finance rapid growth, business expansion, acquisitions or the purchase of long-term assets, defined as assets that are paid off over more than one 12-month business cycle.
But the biggest drawback to bringing equity investors into your business is the potential loss of control. When you sell equity (or shares) of your business to venture capitalists or angels, you are giving up a percentage of ownership in your business, and you may be doing so at an inopportune time. With this loss of ownership often comes the loss of control over some or all of the most important business decisions that must be made.
Sometimes, owners are tempted to sell equity by the fact that there is little (if any) out-of-pocket expense. Unlike debt financing, you usually don’t pay interest with equity financing. An equity investor receives their return through the ownership stake they receive in your business. But the long-term “cost” of selling equity is always much higher than the short-term cost of debt, both in terms of real cash costs and soft costs like control and stewardship of your company and potential future losses. Value of ownership shares sold.
Alternative financing solutions
But what if your business needs working capital and you don’t qualify for a bank loan or line of credit? Alternative financing solutions are often suitable for injecting working capital into businesses in this situation. The three most common types of alternative financing used by such businesses are:
1. Full-Service Factoring – Businesses sell accounts receivable on an ongoing basis to a commercial finance (or factoring) company at a discount. A factoring company manages receivables until they are paid. Factoring is a well-established and accepted method of temporary alternative finance that is particularly well-suited for fast-growing companies and those with customer concentration.
2. Accounts Receivable (A/R) Financing – A/R financing is an ideal solution for companies that are not yet bankable but have a stable financial position and a more diverse customer base. Here, the business provides details on all accounts receivable and pledges those assets as collateral. The proceeds of those receivables are sent to the lockbox while the finance company calculates the borrowing base to determine the amount the company can borrow. When a borrower needs money, it requests an advance and the finance company advances the money using a percentage of accounts receivable.
3. Asset Based Loan (ABL) – This is a credit facility secured by all of the company’s assets, which may include A/R, equipment and inventory. Unlike factoring, the business continues to manage and collect its own receivables and submit collateral reports on an ongoing basis to the finance company, which will review and periodically audit the reports.
In addition to providing working capital and enabling owners to retain control of the business, alternative financing can provide other benefits:
- It is easy to determine the exact cost of financing and get the increase.
- Professional collateral management may be included depending on the type of facility and the lender.
- Real-time, online interactive reporting is often available.
- This can give the business access to additional capital.
- It is flexible – financing ebbs and flows with the business’ needs.
It is important to note that there are certain situations in which equity is a viable and attractive financing solution. This is especially true in the case of business expansions and acquisitions and new product launches – these are capital requirements that are generally not amenable to debt financing. However, equity is generally not a suitable financing solution to solve working capital problems or to help plug cash flow gaps.
A precious commodity
Remember that business equity is a valuable asset that should be considered only in the right circumstances and at the right time. When equity financing is sought, ideally it should be done at a time when the company has good growth potential and significant cash requirements for this growth. Ideally, majority ownership (and thus, full control) should remain with the company founder(s).
Alternative financing solutions such as factoring, A/R financing and ABL can boost working capital that many businesses do not qualify for in need of bank financing – without diluting ownership and possibly relinquishing control of the business to the owner at an inopportune time. If and when these companies later become bankable, it is often an easy transition to a traditional bank line of credit. Your banker may be able to refer you to a commercial finance company that can offer the right type of alternative financing solution for your particular situation.
It takes time to understand all The different financing options available for your business, and the pros and cons of each, is the best way for you to choose the best option for your business. Using alternative financing can help your company grow without diluting your ownership. After all, it’s your business – shouldn’t you keep it as much as possible?
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