The use of financing is vital as it allows companies to leverage the time value of money (TVM) to put future expected cash flow to use to ensure the business has adequate operating funds. Nearly 1 in 5 small companies in the U.S. fail within the first year. 38% of the failed businesses point to the inability to raise new capital and running out of cash as the central issue. Securing financing for your company is of paramount importance for the sustainability and resilience of a business.
To solve the problem of securing funding, some SME business owners bootstrap with seed money from their savings or donations from family and friends. But most businesses lack the backing of private funding and require a more mainstream financing solution.
Typically, SMEs depend on external sources of financing to support their businesses. The two main categories of external financing are debt financing and equity financing – but one other option is growing in popularity. Invoice factoring is considered a type of asset-based financing. It is not a loan – it is the liquidation of an asset that does not adversely affect the business’s financial structure.
Each financing type has advantages and disadvantages that must be considered when selecting a funding solution for your business. Learn how to choose the right financing for your business to get funds when needed.
Know your business financing options
When SME owners consider business financing, they often think that the traditional forms of debt and equity are their best options. This may be true for some companies, but not for all. Every business has different strengths, hindrances, and objectives that affect its financing needs. When selecting a financing option, it is best to consider all forms before choosing the best solution for your business.
Let’s begin with a definition of each financing option:
Debt financing is when you borrow money from a bank or lender to finance your business and agree to repay it with interest at a future date – usually on a regular schedule.
Equity financing is when you sell partial business ownership to raise capital. Proceeds are typically generated through the sale of shares to an individual or group of investors or via an initial public offering (IPO).
Invoice factoring is the selling of invoice receivables in exchange for immediate payment. This alternative financing option is unique in that it does not incur debt or dilute ownership in your business.
What to consider when choosing the right business financing?
Each option helps you raise money for capital to pay bills, stock up on inventory, purchase equipment or real estate, and hire additional employees. But how do you choose the right business financing?
Here are some of the key factors to consider when deciding between financing options:
- Financing need/urgency: How fast do you need cash? Debt financing generally offers a quicker way to get funds compared to equity. Often, equity financing is a lengthy process, depending on the viability of your business plan and the receptiveness of investors. Invoice factoring provides the fastest speed of funding with approvals processed and first funding starting in days, not weeks or months.
- Need for control: If you want to maintain independent control over your business management, debt financing or invoice factoring are the better options. Because equity financing involves selling a portion or a stake in your business, your ownership is diluted, and management control is shared.
- Risk tolerance: Debt and equity financing involve risk but of different kinds. Debt financing requires regular payments to a creditor. Failure to make payments may lead to the loss of collateral assets or being declared bankrupt. Equity financing reduces your ownership stake in the business. The more equity you sell to one or more investors, the more you risk losing control of the company. Invoice factoring provides the least risk as each invoice financed becomes the collateral security for advanced funds. If an invoice remains unpaid after 90 days, the business risks having to buy back the invoice.
- Qualification for funding: With debt financing, lenders will look at your credit history and ability to repay the loan to determine the funding you can access. Most SMEs cannot qualify for conventional bank financing because the credit requirements are too high. Equity financing depends on your ability to prove the business’s viability, scalability, and sustainability. A strong business plan, high valuations, and significant growth potential are needed to attract investors. Invoice factoring provides the most manageable qualification requirements. If your business has creditworthy customers, qualification for invoice factoring is simple and quick, even for start-ups.
- Repayment: How would you rather pay for financing? With debt financing, you’ll agree with the creditor to pay back the principal and interest regularly. Regular loan payments will place an additional burden on future cash flow. Equity financing carries no repayment obligation, but you provide earnings to shareholders for their ownership stake in the business. Invoice factoring fees are a small percentage of the invoice value deducted from the amount of money advanced, plus minor transactional fees billed separately.
When to use debt, equity, or invoice factoring
Each financing option has unique benefits and drawbacks, which should be considered when deciding between them. The option you choose will depend on your business goals, the need for control, and risk tolerance.
Here’s a breakdown of when each financing option is right for your business.
When is debt financing right for your business?
Debt financing has many advantages. For instance, you still maintain complete control over your business, you can forecast expenses, and the interest you pay is tax deductible.
However, if the economy experiences a meltdown, or your company hits hard times or doesn’t grow as you expected, the debt could dampen the business’s growth.
That said, debt financing is suitable if:
- You’re comfortable with the risk: With debt financing, you risk losing collateral assets if you fail to repay the loan per the agreement’s terms. Debt financing is a good option if you are comfortable meeting regular payments on time and in full.
- You can qualify for the loan or credit: Lenders want assurance that your business has a good credit history and strong future cash flows to service the debt load.
- You understand the restrictions imposed by debts: Financial debt covenants are conditions included in a loan agreement, typically put in place to protect the lender. Covenants set limits on the borrower’s financial activities and require the borrower to maintain specific financial ratios or performance levels. Understanding these conditions is critical before signing a loan agreement.
- You want to retain control of your business: Lenders are more interested in managing their portfolios than running your business. They may have specific controls over your finances, but the company’s management structure is unchanged.
The following are examples of different debt financing options to consider:
- Term loans
- Business credit lines
- Asset-based lending
- Business credit cards
When is equity financing right for your business?
Equity financing offers a low-risk funding option without the burden of debt in exchange for a stake in your company.
You also access talented investors with expertise and experience in your industry. So, you get both funding and the investor connections you need to grow the business.
Consider equity financing if:
- You want to avoid debt: Debt financing is a liability to your business as you’ll need to pay back the loan with interest, but equity financing has no repayment obligations.
- Your business can’t qualify for a loan: Start-ups, small businesses that are yet to be profitable, and companies with insufficient credit can’t qualify for debt financing. But if the business offers strong growth potential, investors may be happy to buy in for an equity share.
- You can benefit from industry expertise: Equity investors often have experience and significant connections in the industries they buy into. Their involvement with your organization can provide valuable knowledge and guidance to help facilitate growth.
- You don’t mind ceding some control of your business: The price for equity financing is future dividend payouts and a change in ownership. Loss of independent control of your company must be considered.
The following are examples of different equity financing sources to consider:
- Venture capital/private equity
- Angel investors
- Family and friends
When is invoice factoring right for your business?
With this financing option, you sell your accounts receivable invoices to a factoring company at a discount in exchange for immediate cash. The factoring company advances you money for each invoice financed, then coordinates with your customers to collect payment.
This type of financing is suitable for businesses that issue invoices regularly and have an extended billing cycle.
Consider invoice financing if you want:
- Fast funding
- Reliable cash flow
- Easy account management
- Full transparency and control of your funds
- Flexible credit limits that keep pace with your company’s growth
The factoring company works directly with your customers to collect invoice payments. A professional accounts receivable team trained to be courteous and respectful typically shortens days sales outstanding while maintaining healthy customer relations. However, there’s no guarantee that the factoring company will collect all invoices successfully. Invoices that remain unpaid after the recourse period (usually 90 days) must be repurchased from the factoring company.
The main benefits of invoice factoring include the following:
- Access to immediate working capital
- Improved cash flow to grow your business
- Easy qualification – approval is based on the credit strength of your customers
- Minimal asset risk – each invoice becomes its own collateral asset
In today’s lending environment, SMEs are limited to the financing options they have. Traditional banks have restricted credit to small businesses in favor of lending to corporate clients with less risk and more profits to be made. Equity financing depends on investors having confidence in your business model to generate future growth from which they can benefit. Because of this, companies with diminishing profit levels in a low-growth economy are having difficulty getting investors to buy-in.
Invoice factoring offers a third type of business financing without the drawbacks of debt or having to dilute ownership. It is ideal for companies needing to improve cash flow but lack hard assets for collateral or have insufficient credit history.
Business resilience and growth can be challenging, especially during an economic slowdown, but both are essential to the long-term sustainability of the business. Business financing is essential to support operations and fuel growth. The appropriate choice for business financing will depend on various factors, such as the business’s financial situation, the level of risk involved, and the financing terms.
It’s important to carefully consider the costs and terms of each financing option before making the right decision for your business.
eCapital is an innovative alternative lender with the flexibility to manage complex financial challenges and the resources to fund double-digit million-dollar facilities. Since 2006, eCapital has been a trusted financial partner for thousands of small to mid-size companies in all stages of development. Our customer base continues to grow as our reputation for dedicated service and forward-thinking solutions to even the most complex situations endure. Strong client relationships anchored in mutual trust are essential to our business model.
For more information about how invoice factoring supports businesses through all stages of development, visit eCapital.com