How to Choose the Right Source of Capital for Your Growing Business
Every entrepreneur will face a point in building her business where she will think about taking out a loan or some other type of credit.
Start-ups often rely on personal savings or personal borrowing from friends and relatives to get off the ground. After you’ve burned through that seed money, the next step often involves a commercial loan of some sort.
Louis Greenblatt, President of Evergreen Working Capital of Baton Rouge, La., says it’s important to think not just about how much money you need, but where it will come from. He has more than three decades of experience in commercial finance, including 12 years as a banker and more than 20 years running factoring companies, which provide clients with upfront cash so they don’t have to wait to collect on their invoices.
Start-Ups: Look to the Angels
The first thing people growing a business need to understand is that banks aren’t usually the best option for young companies in need of capital, Greenblatt says. And banks are reluctant to provide commercial loans without a proven track record of revenues and profits.
“People think banks are there to lend money to all businesses, but their mission is to make safe loans. That’s their model, they must have a high degree of confidence they’re going to get it back,” Greenblatt says.
If you’re at the startup or growing stage and want to get a bank loan, you’ll almost certainly be required to put up personal assets as collateral. That obviously holds all types of risks, since the fate of the business is now tied to things like the home your family lives in or your retirement assets.
A better option might be private equity, from angel investors. These are successful entrepreneurs or wealthy individuals looking to help the next generation — and the chance to strike gold with the hot new thing. Be forewarned, Greenblatt says: They’ll want a piece of equity in return for the investment. You may not want to give up a slice of the pie, but it’s better than taking out high-cost loans while profitability remains on the horizon. “The biggest mistake companies make is borrowing money to fund losses,” Greenblatt says. “If you have to burn money while ramping up operations, it’s better to burn equity.”
Get a Line – or a Loan
Once you have a demonstrable flow of revenue, the company can look to get a line of credit for short term needs or a long term loan for buying equipment or property. These can be good for building that track record with the bank.
For lines of credit, banks like to see a growing business get in and out of them in a year or less. Once you’ve demonstrated responsibility with that first line of credit, you can think about a larger line or another type of loan. If you’re only paying the interest and can’t occasionally make a sizeable reduction on the principal balance, the experience won’t gain you any favor with the bank, Greenblatt says.
Term loans have a time frame for repayment which is usually tied to the life of the asset being financed, such as a 3- to 5-year payback for equipment or a vehicle, or 10 to 20 years for a piece of real estate. Again, banks will still want to see your demonstrated cash flow to support the repayment terms of the loan before they’ll give it to you. They want enough cushion between how much money the business is generating and the debt service required.
Traditional commercial loans are reserved for financially sound companies with a track record of profitability, Greenblatt says. Expect to jump through some hoops and have your financial records thoroughly examined. These are best for viable, expanding businesses looking to take the next step.
Avoid “Hot Money”
Greenblatt also advises growing companies to avoid MCA lenders, a relatively new type of credit also known as merchant cash advance lenders. They promise a quick infusion of capital without a lot of hassles. (“Get a small business loan in 7 minutes.”)
Greenblatt says they come with extremely high costs and repayment schedules which are so aggressive, the businesses may not have time to benefit from the cash infusion. These loans typically require daily or weekly payment drafts to your company’s bank account to fully repay the loan in six to 12 months, and you better have the funds in your account to cover the withdrawal.
“They’re wreaking havoc in companies when cash flow doesn’t support the quick payback,” Greenblatt says. “The product often doesn’t match the needs of the company, and those types of lenders seem not to care.”
The secret is to seek the type of loan that meets the needs of the stage your business is in right now, and where it wants to go.