How to Find Alternatives to Bank Financing
Fashion accessory manufacturer had a bank line of credit for most of the 35 years the company has been in business. Then the credit crisis erupted in 2008 and the company's bank, under financial pressures, reined in the New York City firm's revolving credit line.
'The banks have gone from reckless to reclusive,' says Norman Abramson, COO of Worldwide Dreams, which has 100 employees and manufactures handbags, belts, and scarves.
Since Worldwide Dreams is a distributor to a variety of department stores, including Nordstrom's and Wal-Mart, among others, the company was able to find alternative financing with a factor. The company secured a $9.5 million credit line from Capital Business Credit, a commercial finance company headquartered in New York that specializes in supply chain financing. Factors can range from banks, such as Wells Fargo, to independent lenders. They provide interim financing to small and midsize businesses by agreeing to purchase the business' outstanding receivable at a discount.
'We were prepared to lend more against the assets than their prior lender was prepared to do,' says Andrew Tananbaum, CEO and founder of Capital Business Credit. 'We were prepared to help the company with the type of line of credit that can support the business' growth.'
Factoring is one of a number of alternative sources of financing for small and midsize businesses when a bank pulls their credit line or says no to a traditional business loan. During the recent credit crisis, when bank loans dried up for many small companies, untraditional types of lending, like factoring, equipment sale lease-backs and cash advances on credit card sales, saw a boom in business.
The following sections will detail some of the most popular types of alternative funding sources, how they work, and the pros and cons.
Alternative Financing: Factoring
Factoring is a financial transaction that gives a business quick access to cash to help fund growth or overcome cash flow woes. This global industry doles out an estimated $2 trillion per year, with $150 billion of that in the U.S., according to Factors Chain International, a global network of 267 independent factoring companies.
The way it works is that a business sells its accounts receivables to the factor at a discount, giving the business immediate access to capital instead of waiting the 30 or 60 days for a customer to pay. There are several differences between factoring and traditional bank loans. With factoring, the financier is looking at the value of the firm's receivables, not necessarily the company's credit history or risk. A factor purchases the firm's invoices, pays the firm upfront and collects on those invoices from the customer -- unlike a bank loan that has to be repaid in regular installments. 'Bank lending is much more cash-flow and balance-sheet lending and factoring is more collateralized lending,' Tananbaum says. 'We are lending against collateral – your receivables – and while a bank may take assets as collateral they are really looking at historic cash flows and your ability to repay the loan.'
Pros: Factors assume the credit risk if a customer defaults, and they'll provide other services including collections and accounts receivable bookkeeping.
Cons: The factor charges commissions and interest for its bundle of services. The fees can vary from less than 1 percent to a few percentage points -- and interest at the prime rate to several points over prime on the balance of receivables you sell, making it steeper than most bank loans.
Alternative Financing: Equipment Sale-Leaseback
For a business that owns expensive equipment or machinery outright, one option is to find a lender who will buy the equipment for a lump sum and then lease it back to the business, in what's called a sale-leaseback. In general, businesses should lease things that depreciate in value and buy things that appreciate in value, says Steve Lankler, vice president of marketing for Direct Capital, a finance company headquartered in Portsmouth, N.H. 'You are going to be able to immediately get cash for the value of the asset you own, which may be critical to your business,' Lankler says. 'You keep the equipment, you can write-off 100 percent of the monthly payments in most cases, and you can use the cash any way you wish.'
Pros: The business still retains use of the equipment but also gets an infusion of funds.
Cons: You now no longer own that asset and you have to pay off the cost of the equipment, plus interest.
Alternative Financing: Merchant Cash Advance
A growing number of capital providers are willing to give businesses a lump sum upfront in exchange for a share of a merchant's future credit card sales. If your business accepts credit cards, this may be an option to consider if your personal credit isn't the best and your business needs cash quickly, Lankler says. The way it works is that lenders review your average monthly credit card receivables and, based on those receivables, provide you a short-term loan. Every time a credit card transaction occurs, a portion of the sale is used to pay back your loan. Establish a consistent pattern or history, and it's easier to renew these loans, Lankler says.
Pros: Unlike traditional loan, there are no due dates and no fixed payments to meet.
Cons: While there's no traditional interest rate, the provider takes a cut of up to 17 percent of your credit card receivables.
Alternative Financing: Purchase Order Financing
This type of financing is for businesses that are in danger of not being able to promptly fulfill a customer's purchase order, thereby risking the sale. A financing agent will advance money or issue a letter of credit against a signed purchase order for finished goods or value-added products to help fund manufacturing and fulfillment of the order. This is helpful for importers/exporters, for example, who must pay for their supplies immediately when placing orders for raw materials, but whose customers may take 60 days or more to pay. Once the goods are shipped to the customer and invoiced, the transaction is closed out.
Pros: Financing is dependent on the customer's credit and the non-cancelable nature of its purchase orders, not the business' credit.
Cons: Purchase order finance providers take effectively a portion of the gross margin of the purchase order.
Alternative Financing: Microloans
Microloans – as the name suggests -- tend to be rather small in amount, but they can go up to the $100,000 to 150,000 range. The Association of Enterprise Opportunity, the industry's trade group, says members help 300,000 businesses each year and have lent more than $2 billion in the U.S. over the past 10 years.
Pros: Microloans are awarded to businesses with lower credit scores than banks require and they don't require as much documentation.
Cons: Interest rates are higher than bank loans, ranging between 12 and 18 percent depending on the borrower's credit and other factors.
Alternative Financing: Auctioning Receivables
Another option is auctioning off your receivables to investors over a network like The Receivables Exchange (TRE), a capital marketplace launched in 2008 that now has more than 65 buyers and 1,000 sellers. For sellers, TRE offers quick access to working capital in a process they control – they can set the price at which they will sell their receivables and can offer an eBay-like 'buy it now' option. For buyers, they typically purchase receivables at less than face value and make a quick profit when those invoices are paid.
Pros: The auction setting can generate higher bids for receivables than traditional factoring because the process is competitive.
Cons: Traditional factors will also offer such services as bookkeeping and collections, but those are not options when you auction receivables on an exchange.
For now, Worldwide Dreams is happy to be working with a factor. 'The business climate is still less than wonderful, but we're doing fairly well,' Abramson says. 'I don't have to worry every night whether the bank is going to get cold feet and yank our line of credit. With a factor, you have the hard assets pledged to the factor and that takes a lot of the uncertainty out of the relationship. Banks tend to want to lend you money when you don't need it.'
Factors Chain International A global network of more than 250 leading factoring companies in 66 countries that seeks to facilitate trade through factoring and other financial services.
Commercial Finance Association Industry association for more than 300 asset-based financial service firms in North America.
North American Merchant Advance Association Not-for-profit trade association representing organizations in the U.S. and Canada that provide working capital advance products based on credit, debit or other card and electronic payment-related revenue streams to small and mid-sized businesses.