By Ed Castano of BlueVine Capital Inc.
One of the greatest challenges of running a small business is securing financing. In the first few years of operation, without steady profitability and a track record, it can be difficult or impossible for a new business to secure a traditional loan or line of credit from one of the big banks. In fact, close to 80 percent of small business loans are rejected every year.
One positive outcome from the Great Recession and resulting credit crunch was the emergence of alternative fundraising paths and solutions for entrepreneurs. Today, there are many new players when it comes to financing. However, these new options complicate the decision for small business owners: What options are available, and which financing path is best for me?
The answer boils down to one factor: cost versus effort. With any form of financing, there will be a tradeoff in the effort required to secure funding and the repayment cost. For instance, a bank loan requires a tedious application but yields a low cost, while options at the other end of the spectrum are faster and easier to apply for but can come at a higher cost.
Knowing which financing path is best for you requires careful consideration of the tradeoff between cost and effort – as a business owner, should you be focusing on completing loan applications or on running your business? So let’s examine five alternative fundraising options, listed in increasing order of cost.
Available for established companies with strong credit
This is your plain vanilla or four-door sedan of commercial loans. These types of loans are repaid in payments over a set period of time, usually between one and 10 years. Term loans are often used to raise capital to purchase equipment or fixed assets necessary for ongoing operations.
While often associated with banks, term loans are increasingly available through non-bank entities like Funding Circle and Lending Club. However, even term loans from these alternative financiers still require a significant amount of effort for approval, including a vetting process that examines your financials, tax returns, capital needs, collateral, business plan and credit capacity.
Pursuing this financing option makes the most sense for established small businesses that have excellent credit, strong cash flow and don’t have urgent cash flow needs.
Best for B2B companies for working capital purposes
For some businesses, waiting for invoices to be paid can stifle growth. For these businesses, invoice factoring (also known as “invoice financing” or “accounts receivable financing”) presents an elegant solution: a business can sell invoices to a third-party company in exchange for immediate cash, foregoing the 30/60/90-day waiting period for customer payment. Under this model, the invoice factoring service advances 80 to 90 percent of the invoice upfront, and the remainder (minus fees) after your customer makes their payment.
This option falls in the middle of both cost/effort spectrum for small businesses. Young or rapidly-growing B2B businesses that are looking for a fast solution to cash flow issues should consider pursuing this financing option.
Recently, online factoring companies have emerged that marry the benefits of factoring with the ease and convenience of online solutions that small businesses have come to expect.
Lines of Credit
Best for SMBs that need easy access to cash on an as-needed basis
Similar to a personal credit card, business lines of credit allow you to obtain funds when you need them, without having to reapply each time you want additional funding. You have access to a certain amount of financing (your credit limit) and can withdraw any amount you need, at any time, for any business reason, up to your credit line.
This financing option is ideal for companies with fluctuating working capital who want full flexibility. Compared to merchant cash advances, lines of credit are relatively affordable as a quick funding source. However, the credit score requirements and cost are usually higher than invoice factoring.
Cash Flow Loans
Best for B2B companies that don’t qualify for a line of credit or factoring
Whereas invoices financing gives you an advance on money already owed to you, cash flow loans are extended based on expected business. Cash flow financing companies will examine a combination of information about your business, from historical cash flow to seller history to reviews, to determine how much money to lend businesses.
This financing option is ideal for merchants who pay upfront for inventory costs or for businesses lacking assets to act as collateral. This option could be used for rare major purchases but only if strong margins support the high fees.
Merchant Cash Advances (MCA)
Suitable for companies that accept credit cards and don’t qualify for other alternative financing solutions
At the far end of low-effort, high-cost options are MCAs, one of the quickest financing options available for small businesses. Instead of putting up collateral, small businesses pay back the advances by giving up a percentage of daily credit card sales until the amount borrowed (plus fees) has been fully repaid.
This option is well suited for companies like restaurants that have strong daily credit card transactions. This daily revenue stream allows for quick approvals. The downside to this ease in applying and speed of approval is that MCAs generally carry the highest rates of any of these funding options, some as high as 200 percent APR.
Now that you know your options, which choice makes the most sense for your business? Your optimal financing path depends on the state and needs of your business. If you need money fast, avoid effort-intensive options like bank loans. If your low margins mean you must watch rates closely and you have time to spare, traditional options may be a better fit for your needs. If flexibility is key, find a line of credit. Remember, access to working capital is a strategic advantage that not only helps you run your day-to-day operations, but also lets you invest in your business to take it to the next level.
Ed Castano is VP of Marketing at BlueVine Capital Inc, where he is tasked with accelerating the company’s growth. Prior to joining BlueVine, Ed was a Senior Product Manager at Intuit—maker of QuickBooks, TurboTax and Mint.com. Ed began his career as an Associate Consultant at Bain & Company, where he advised Fortune 100 clients on growth strategy. As a former small business owner himself, Ed understands the unique challenges faced by small businesses and is eager to arm them with the knowledge they need to thrive.
The views, opinions and positions expressed within this guest post are those of the authors alone and do not represent those of CBS Small Business Pulse or the CBS Corporation. The accuracy, completeness and validity of any statements made within this article are verified solely by the authors.