Options for Funding Growth with External Working Capital
In my recent blog, Understanding and Managing Working Capital for Growth, I discussed ways to increase internal working capital through effective management of your inventory, accounts receivable, and accounts payable. Good management strategies in these areas can contribute to business growth that is typically slower, “organic” growth.
To expand your business at a faster rate, you will undoubtedly need access to external working capital. For example, term loans or leasing are an option for the purchase of long-term fixed assets while refinancing may be consideration for existing fixed assets such as equipment – expenses for which you should not use internal working capital.
Generated through equity or debt, external working capital comes at a cost to the company in the form of interest or loss of a percentage of ownership. I have received numerous questions about this topic lately, so I will share some options for generating external working capital, and how they differ.
- Selling stock to the public is not a viable option for most small businesses since it requires a substantial cash outlay up front to create an IPO (Initial Public Offering).
- Venture Capital involves selling part of your business to outsiders. Typically seeking a high return and focused on profitability, these buyers’ objectives may conflict with your own goals for your business.
- Preferred Stock sales generate external working capital through a combination of equity and debit. Returns are guaranteed to buyers, but no voting rights accompany the stock. Check with your tax professional for more information about using this option – certain entities (e.g., Sub-S) can have only one class of stock.
- Personal funds can be injected into the company by a business owner who is able to do so.
Debt – Long-term
- Term Loans, typically financed for 5 to 10 years, are collateralized with fixed assets of the company. These loans can be suitable for businesses that require a substantial investment in equipment and machinery. Loan payments are paid out of future profits derived from the fixed assets.
- Equipment Leasing is another form of long-term financing. The business effectively rents, rather than purchases, the fixed assets.
- The U.S. Small Business Administration (SBA) offers six types of loans. Banks may be more open to making these loans since the SBA guarantees a portion of the repayment.
Debt – Short-Term
- Trade Credit involves negotiating favorable extended payment terms with vendors and suppliers.
- Accounts Receivable Financing provides a loan that is secured by A/R. The lender makes advances against A/R and collects payments directly from customers.
- Accounts Receivable Factoring means that A/R is sold to a third party who collects payments directly from customers. This option typically requires a long-term contract with the factoring company and a high volume of A/R.
- Inventory Financing allows the lender to make advances against the value of inventory including raw, work-in-process, and finished goods. This is not a good option for new businesses.
- Line of Credit is also known as a demand loan. Funds are borrowed and repaid during the loan period, providing flexibility for seasonality and normal peaks and valleys of cash flow.
As you can see, there are diverse financing options through which external working capital can be generated for your business. The key is to clearly identify which loan or use of equity fits your business and plans for its growth. To be approved for any type of financing, the business must be able to provide accurate financial records, past and present. And with few exceptions, the owner will be required to provide a personal guarantee for loans. A note related to our times…. Some lenders are inquiring into how COVID has or may affect a company as part of their process for consideration of funding.
For help in determining which of these options may be your best solution for generating external working capital, feel free to contact me for a complimentary consultation.