Beyond the Bank Loan

Beyond the Bank Loan

Funding your small business? Bank loans are good, but consider these options.

Given how frequently we are contacted to write business plans and develop business strategy, it’s amazing how often a small business owner wants the business plan solely so their business can get a loan.  And as much as loans are a great way to finance your business, there are two problems with this approach:
First, the reason for developing a business plan shouldn’t be merely to qualify for a loan. Banks and guarantors want you to have a business plan to demonstrate that you are thinking strategically and can map out a successful future for your business, not to create an artificial hurdle to obtaining a loan (more on this in a future article). Second, there are many other ways to finance a business beyond a simple long term bank loan, and though only a few are appropriate options in any given situation, all should be considered by small business owners and budding entrepreneurs before they put in the effort to seek a bank loan.
  1. Long term bank loans. Let’s start with the most-considered option, long term loans. Frequently granted by banks, loans give money to borrowers in exchange for a promise to return the money to the lender, with interest. There are many different flavors of bank loans, but the two most common are secured and unsecured loans. With a secured loan, the you as the borrower not only promise to return the money with interest, you also reinforce that promise by pledging something valuable you own that the lender may take away from you if you do not pay.  Something valuable might include a car, a home, a prized family heirloom, or even a work of art.  Because you have pledged that valuable asset as collateral, secured loans typically have much lower interest rates than unsecured loans.
    As the name implies, unsecured loans are not backed by a valuable asset in the same way that a secured loan is. Because there is no asset behind it, banks rely more upon other factors before giving you a loan – your prior borrowing history, your payment history, your income, and other factors that make up your credit score.  They also charge higher interest rates on unsecured loans because of the increased risk. Whether you are considering secured or unsecured loans, remember that banks are generally very cautious and conservative.  It takes an awful lot of good loans at 7 or 8% interest rate to make up for one bad loan where they lose 100% of the amount loaned, so they’re unlikely to loan your business money unless your business has a proven track record of success and strong credit history to back it up.  Similarly, organizations like the US Small Business Administration, which backs many small business loans, are unlikely to guarantee a loan to a risky the borrower.
  2. Bank lines of credit.  Though loans tend to be long term, banks also provide short term loans called lines of credit. With a line of credit, the bank offers to loan you a maximum amount of money for short term use that you can spend only when you need it, much like making a charge on a credit card. There is an expectation that a line of credit will be paid off relatively quickly, so lines of credit tend to have higher interest rates than long term loans to recoup the transaction costs. Lines of credit also have the added risk that banks may suddenly decide to reduce in your line of credit when you most need them, making them somewhat less valuable than a long term loan.
  3. Borrow against receivables (A/R factoring). When a business has sold products or services but has not yet collected money for them, those fund are called receivables or Accounts Receivable (A/R).  In some cases, it can take a while before an invoice is paid by the purchaser for a variety of reasons — contract stipulations and purchaser’s power among them. In order to access this money more quickly, a business can borrow against those receivables.  In exchange for early payment by a third-party lender, the business allows the lender to collect the invoice directly and collects a fee of between 1 and 5% of the total invoice.If your a services business and your only asset are your account receivable, A/R factoring can be a good way to accelerate payment. However, your clients may misinterpret this to mean that you are struggling financially, so consider how they will react and be sure to give them a heads-up before you pursue this option.
  4. Credit cards.  When the loan you need is small enough, it may simply be best to obtain one or more credit cards for your business.  As long as your credit rating is decent, credit cards are relatively easy to obtain, offer low introductory rates and frequently allow you to obtain cash for any purpose via cash advances. Unfortunately, they also are short term and unsecured, so they have higher interest rates than other types of loans. This typically makes them a much riskier way to finance your business, so use them carefully and sparingly.
  5. Peer-to-peer lending.  Like bank loans or bank lines of credit, peer-to-peer loans give money to your business in exchange for a promise to repay the lender, with interest over a period of months or years.  Unlike bank loans, however, you are borrowing money from another person or business that has additional money on hand, and you are using an online platform to introduce you to people or businesses interested in making the loan. Lending Club (www.lendingclub.com) and Prosper (www.prosper.com) are two prominent examples of peer-to-peer lending platforms for commercial loans, but Grameen bank makes very small micro-loans to individuals in developing countries.  It’s important to note that the peer-to-peer lending platform takes a percentage of the loan amount – typically 1 to 3% – as a fee for introducing you to the lender. Despite this, peer-to-peer lenders are not necessarily looking for the same low-risk borrower that a bank seeks, so this may increase the chances of you obtaining a loan for your business. For more information, see Lending Club’s site for a description of how peer-to-peer lending works (https://www.lendingclub.com/public/how-peer-lending-works.action).
  6. Crowd-funding.  Similar to peer-to-peer lending, crowd-funding obtains funding for your business from one or more peers and is facilitated by an online platform.  Unlike peer-to-peer lending, the people who give money to you via crowd-funding are typically not looking to loan you money. Instead, they want something else – an early version of your product or equity ownership of part of your business.  Like peer-to-peer lending, online platforms like Fundable (www.fundable.com) or Kickstarter (www.kickstarter.com) take a percentage of the funds generated as a fee. They also aggregate contributions from many small contributors until you reach your funding goal.Crowd-funding is not without its downsides, however.  It may take a while for you to draw enough interest to fund your business. Or, though your idea may be quite profitable, it may not be “sexy” in the eyes of the investing public, so it may be ignored.  Also, raising a significant amount via crowd-funding frequently means giving up ownership of some of your business, which now makes you accountable to other individuals. Every time you make a significant business decision, you’ll now have other people weighing in and looking over your shoulder.Nevertheless, if you are considering selling part of your business already and you have a trendy product or service, crowd-funding could well be a good option.
  7. Private placement.  Though many individuals are not aware of this, nearly all states in the USA permit you to sell portions of your business via private placement memos. Private placement is similar to a large business selling shares on a stock exchange, but private placement has specific limits that are typically based on the number of individuals who can own shares, on the amount that can be raised and on the way in which you approach prospective buyers.  It’s called private because you can’t simply post your opportunity online and allow anyone to buy in.  In Maryland, you can learn more about private placements by contacting the Attorney General’s office at http://www.marylandattorneygeneral.gov/ and asking about a “Limited Offering of Securities”. For other states, I suggest visiting the state’s website and searching for “securities” or “private placement”.
  8. Angels & venture capital (VC’s).  Believe it or not, there are both individuals and businesses seeking out opportunities to invest in other businesses in exchange for equity.  Made famous by the TV show “The Shark Tank”, angel investors are individuals who are looking for promising businesses to invest as little as $100,000 and as much as $5 million, while venture capital firms are more interested in providing between $5 million and $100 million.  Before pursuing this path, it’s important to consider how likely your chances of success will be. Both angels and VC’s are not only looking for a solid business, they are also looking for a business with something extremely unique and valuable — a new formula, a patented process, a protected market or other intellectual property. If you can’t offer those, no matter how well your business is doing, they aren’t likely to consider you.Most efforts to attract venture capital, in particular are long shots for most businesses. Depending upon how early they are investing in your business, VC’s want returns on investment in the 25 to 1 range or higher in a time horizon at or less than five years. That’s a lot of appreciation, really fast.  You also have a very active partner in your business in your VC — one who may force you out if you don’t grow the business quickly enough.Before you consider Venture Capital too seriously, I encourage you to read about the good and the bad of Venture Capital at Entrepreneur magazine (https://www.entrepreneur.com/article/248377), (https://www.entrepreneur.com/article/247161) and (https://www.entrepreneur.com/article/230526)
  9. The three F’s.  Though angels are hard to find, there are other people who are more accessible who may have the money you need to grow your business. Known as the three F’s — friends, family and fools — these are the people in your immediate network who might consider giving you money.  While there is some risk that you will damage your personal relationships by borrowing from these individuals, they are also the most likely to believe in you and to help you financially.  When approaching the three F’s, we typically advise you to:  (1) Be professional; present the same factual information you would present to other investors — how much you need, what you will do with the money, how much money you will make with the money, and how they will be repaid (loan with interest, equity, etc.). (2) Assess how much can this person afford to give without putting themselves (or loved ones) in financial jeopardy. Then, don’t ask for more than that amount, even if it may mean you have to approach multiple friends or family members. (3) Be honest. It’s okay to be optimistic, but don’t lie about the business opportunity or embellish about your likelihood of success in a way that will jeopardize your long term relationship with this individual.  (4) Make a written agreement. Whether it’s a loan or equity, make a written agreement with the other party and stick to it.  This will not only demonstrate your intent to honor the agreement, it will also make it easier to raise money in the future and to avoid misunderstandings.
  10. Sell something you own.  A friend of mine in the pizza business likes to post a picture of a 1971 Camaro Z28 once owned by John Schnatter, the founder of Papa John’s Pizza, to remind us that Schnatter gave up his favorite set of wheels to get funding to start the business.  Like him, most of us have something we own that can raise a decent chunk of capital if we’re willing to part with it — a coin collection, a prized baseball card set, a musical instrument or an antique.  While it may be hard to let go of these, it may also be the best way to provide the funding your business needs.  And, if it’s matched by funding from others, it may go quite a bit further than you expect.
  11. Your 401K.  Depending upon how much you or your spouse have saved for retirement, it may be possible for you to borrow against your 401K to provide funding for your business.  This can be relatively easy to do because you control and have ready access to the funding. However, it is not without risks. You must pay back the loan just like any other. And, if you or your spouse leave the job where you contributed to the 401K, you may have to pay back the entire loan immediately, or face tax penalties.  Despite this, if you or a spouse have a healthy 401K and you feel confident you can pay back the loan, this can be a decent option.
  12. Seller-financing. Usually, when you want to borrow money, it’s because you want to buy something. Often, that something is big – like a truck, or a piece of machinery, or a block of software licenses.  If this is the case, don’t be afraid to ask the seller to loan you the money to buy the big-ticket item — particularly if this is your only remaining option.  Many sellers will be willing to make the deal; others, will make the loan short term, until you show you can make the payments and find a lender.
  13. A second job.  It’s hard to imagine working a second job when you’re throwing all of your effort into your small business. But, sometimes its the best way to raise money short term until your business earns enough to pay for what it needs.  If you have no credit history because you’re young, it also may be the only way to make the money you need.  So, you might find it embarrassing, at first, to be seen at that second job by someone who knows you from your budding business, it can also be a way to gain their respect because of your dedication.  If all other avenues have failed and you truly believe in your business, consider it.
Though you have probably dismissed some of these options immediately, perhaps I’ve introduced one or two new options you haven’t considered, opening the door to some new alternatives to financing your business.  And, while seeking a bank loan may still be your first choice, perhaps the options presented here will serve as a backup plan in the unfortunate event that your bank says “no”.  After all, every entrepreneur, from Walt Disney to Steve Jobs, has heard “no” more than a few times, only to find another way to achieve success.

Donald Patti is a Principal Consultant with Cedar Point Consulting, a business coaching and consulting firm based in the Washington, DC area, where he assists organizations in growing their businesses and improving organizational performance. Cedar Point Consulting can be found at http://www.cedarpointconsulting.com.

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