Debt Financing
There are various types of debt financing and different kinds of lenders:
Asset-based lenders
Some sources lend money to businesses based on such assets as receivables, inventory, equipment or real estate – all forms of collateral. If you’re an established business with a proven history and solid customer base, a bank can be a good source of inexpensive financing (prime +1 or 2 points). And if your relationship’s good, your business is healthy and your assets have enough value, it may not require personal guarantees or additional collateral.
UPSIDE
- Market-based interest rates.
- No equity relinquished.
- Business assets are collateral.
DOWNSIDE
- This may require personal guarantees, and if there’s a downturn in business, it could have big, bad economic consequences for you personally.
Cash flow lenders
Some cash sources specialize in lending against the current and projected cash flow of the business. Many companies don’t have hard assets like inventory, heavy equipment or real estate, but may have an excellent history of profitability and positive cash flow. Having a long-standing relationship with the bank, building trust and confidence as it sees you grow, and periodically sitting with the bankers when you don’t need financing, can be among the best ways to win this kind of inexpensive financing. Generally, personal guarantees and other collateral are required for small- and medium-sized, closely held businesses.
UPSIDE
- Market-based interest rates.
- No equity relinquished.
- Business operating history and projections are collateral.
DOWNSIDE
- May require personal guarantees, and if there’s a downturn in the business, it could have terrible economic consequences for you personally.
Factoring receivables (for growth companies) and purchase orders (for newer businesses)
Some lenders specialize in credit risk financing (they’ll review your customers’ credit quality) and loan money against your receivables for less than their face value (12 to 30 percent depending on credit quality). They then assume the risk of collecting your receivables.
Similarly, and more useful to newer businesses, these same lenders assess your customers’ credit quality and related purchase orders and, if credible, advance funds against the POs at less than face value. Like a factored receivable, when your customers pay for your goods or services, the lender gets the difference between the discount and the actual face value of the transactions.
These approaches should be used only fallbacks or stop-gaps, not routinely, unless you can pass on some or all of the financing costs to your customers -- not likely.
UPSIDE
- Immediate cash flow from your sales activities.
DOWNSIDE
- Sizable discount from the face value of your receivables -- a material cut in your selling margins and profits.
Mezzanine debt
This plays second fiddle to other types of bank debt, usually at a higher interest rate because there’s more risk in being a lower priority than other obligations. This debt almost always includes a “kicker” on the end of the loan, a piece of equity that increases the overall take for the lender. Mezzanine debt is often used to finance acquisitions and buyouts.
UPSIDE
- The debt comes second to existing loans.
- It’s a great source of capital for specific transactions, like acquisitions and divestitures.
- It’s more expensive than traditional bank debt, but generally less costly than equity.
DOWNSIDE
- If the business underperforms or there’s an economic downturn, this debt can actually be more expensive than the equity value when things were good.
- Cash-flow needs can cut into earnings if the acquisition or other reason for the loan doesn’t pan out as expected.