By Lori Karpman President & CEO Lori Karpman & Associates Ltd
The term ‘small business’ generally refers to businesses generating under $3 million in annual sales, which is not so small to most people. Traditionally start ups avail themselves of the Canadian Small Business Loan Program offered by all chartered banks whereby the borrower is only required to personally guarantee up to a maximum of 25% of the amount borrowed, and can receive up to $350,000 if they qualify. The SBL is meant to finance hard costs like equipment, furnishings and leasehold improvements but does not cover working capital or any intangibles like goodwill or entry fees (for example the Initial Franchise Fee on a franchise purchase). The SBL still remains the lowest risk and most favored choice for seed capital.
Once the business is up and running, business owners become concerned about cash flow and funding of future growth. Customarily the financing options used are traditional bank debt financing (with 100% guarantee), or additional private investment via loan or equity. Each of these options achieves the goal of providing funding but at what cost? Bank financing burdens the business further with debt for repayment of capital and interest. If the goal is to fund growth, taking on additional debt certainly takes a chunk out of the disposable funds available to finance that growth and affects the financial position of the company for years to come. A private investment or loan whereby the injection of capital is given in return for an equity interest in the business or a loan at a higher rate of interest than the bank, results in a dilution of the existing shareholders equity. Depending on the amount of the investment there may be a loss of control over the decision making process as well. For these reasons, private financing is widely considered the most expensive form of financing there is.
What if your company is not creditworthy, has used up its available credit limit, is in violation of debt/equity ratios on current loans or cannot find a private investor?
The solution for many companies with accounts receivable is called “factoring” and it’s a boon to small business. Factoring is not new and has been used as far back as the Roman Empire, but has grown significantly in the past few years. Over $1 trillion in sales is factored worldwide annually and many US banks have factoring divisions. Canadian banks have stayed away from this financial market and have no plans to enter it. Factoring involves the sale of the totality, or a portion of, your accounts receivable to a ‘factor’ that purchases them at a discounted rate. The discount rate is based on several factors including the industry’s payment history and the creditworthiness of the account. Up to 70% of the discounted value is usually paid within 24 hours once the account is open, which takes about 2 weeks. The remaining 30% less the discount fees is paid when the factor collects on the account. For example, Company A receives a large purchase order for a major new account but does not have the funds to buy the raw materials to produce the order. It does however have a receivable from Wal-Mart for $100,000. By factoring the company receives an immediate influx of $70,000 cash to purchase the raw materials and gets to take advantage of a lucrative business opportunity that otherwise would not have been possible. As a result, companies that factor see their businesses double, triple (or more!) within 2-5 years. The secret to this method of financing is that the factor is not concerned with the creditworthiness of the company (vendor of the receivable) but rather of the account to be collected, in this case, Wal-Mart. Businesses leverage the creditworthiness of their customers to raise funds needed for operations or expansion. With factoring companies avoid the extra financial burden of bank debt and have not diluted their equity or control. The discount rate (which is not interest but a discount fee) is treated as an expense to the company. Furthermore, as the factor takes over collections entirely, many companies can reduce their overhead expenses and eliminate an accounting position. Most significantly, factoring allows companies to receive financing in a timely manner and opens up a pool of opportunities that would otherwise have evaded it. As it provides a steady cash flow, it is ideal for seasonal businesses and overall is a much simpler process than bank financing. In the event that bank financing is already in place, banks will willingly cede their priority on accounts receivable.
Factoring is highly endorsed by financial professionals, including banks and frankly, it makes a lot of sense that they would. Banks favor factoring because it provides necessary capital to its existing clients to keep them financially afloat when the bank cannot help. Fact is, small and medium businesses often fail because of short term cash flow problems, not because the business is not viable. Traditional bank financing and private investment can never be replaced; they are the cornerstones of corporate finance but as a result of factoring, small businesses are becoming big businesses at a faster pace than ever!
Lori Karpman is the President and CEO of Lori Karpman & Associates Ltd, a full service consulting and law firm. Please visit www.lorikarpman.com for more information.