Alternative financing versus venture capital: what is the best option to boost working capital?

There are several potential financing options available for cash-strapped businesses that need a healthy dose of working capital. A bank loan or line of credit is often the first option homeowners think of, and for businesses that qualify, this may be the best option.

In today’s uncertain business, economic and regulatory environment, qualifying for a bank loan can be difficult, especially for businesses just starting out and those that have experienced some type of financial hardship. Sometimes business owners who don’t qualify for a bank loan decide that seeking venture capital or bringing in equity investors are other viable options.

But are they really? While bringing venture capital and so-called “angel” investors into your business has some potential benefits, there are also drawbacks. Unfortunately, owners sometimes don’t think about these drawbacks until the ink has dried on a contract with a venture capitalist or angel investor, and it’s too late to back out of the deal.

Different types of financing

One problem with bringing in equity investors to help provide a working capital boost is that working capital and equity are really two different types of financing.

Working capital, or money used to pay for business expenses incurred during the time period until cash from sales (or accounts receivable) is collected, is short-term in nature, so it must be financed through a short-term financing tool. However, equity capital must generally be used to finance rapid growth, business expansion, acquisitions, or the purchase of long-term assets, which are defined as assets that are paid off over more than a 12-month business cycle.

But the biggest drawback of bringing equity investors into your business is a potential loss of control. When you sell equity (or shares) in your business to venture capitalists or angels, you’re giving up a percentage of ownership of your business, and you may do so at an inopportune time. With this dilution of ownership more often than not comes a loss of control over some or all of the larger business decisions that need to be made.

Owners are sometimes tempted to sell shares because there is little (if any) out-of-pocket expense. Unlike debt financing, you generally pay no interest with equity financing. The equity investor obtains the return on him through the ownership interest acquired in his business. But the long-term “cost” of selling stock is always much higher than the short-term cost of debt, both in terms of real cash cost and soft costs like losing control and management of your business and the potential future. value of the shares of ownership that are sold.

Alternative financing solutions

But what if your business needs working capital and you don’t qualify for a bank loan or line of credit? Alternative financing solutions are often suitable for injecting working capital into companies in this situation. Three of the most common types of alternative financing used by these types of companies are:

1. Full factoring service – Businesses sell outstanding accounts receivable on an ongoing basis to a merchant finance (or factoring) company at a discount. The factoring company then manages the account receivable until it is paid. Factoring is a well-established and accepted method of temporary alternative financing that is particularly suitable for fast-growing businesses and those with concentrations of customers.

2. Financing of Accounts Receivable (A/R) – Accounts receivable financing is an ideal solution for businesses that are not yet bankable but have a stable financial condition and a more diverse customer base. Here, the company provides details on all accounts receivable and pledges those assets as collateral. The proceeds from those accounts receivable are sent to a safe deposit box while the finance company calculates a loan basis to determine how much the company can borrow. When the borrower needs money, they make an advance request and the finance company advances the money using a percentage of the accounts receivable.

3. Asset Based Loans (ABL) – This is a line of credit secured by all of a business’s assets, which can include accounts receivable, equipment, and inventory. Unlike factoring, the business continues to manage and collect its own accounts receivable and submits collateral reports on an ongoing basis to the finance company, which will periodically review and audit the reports.

In addition to providing working capital and allowing owners to maintain control of the business, alternative financing can also provide other benefits:

• It’s easy to determine the exact cost of financing and get a raise.
• Professional collateral management may be included depending on the type of facility and lender.
• Real-time online interactive reports are often available.
• It can provide the company with access to more capital.
• It is flexible: financing comes and goes according to the needs of the company.

It is important to note that there are some circumstances in which equity capital is a viable and attractive financing solution. This is especially true in cases of business expansion and acquisitions and new product launches: these are capital needs that are generally not well suited to debt financing. However, equity capital is often not the right financing solution to solve a working capital problem or help close a cash flow gap.

a precious commodity

Remember that business wealth is a precious asset that should only be considered in the right circumstances and at the right time. When seeking equity financing, this should ideally be done at a time when the business has good growth prospects and a significant cash need for this growth. Ideally, majority ownership (and therefore absolute control) should remain in the hands of the founders of the company.

Alternative financing solutions, such as factoring, A/R and ABL financing, can provide the working capital that drives many cash-strapped businesses that don’t qualify for the need for bank financing, without diluting ownership and possibly relinquishing control of the company at an inopportune time for the owner. As long as these businesses become bankable later on, it’s often an easy transition to a traditional bank line of credit. Your banker can refer you to a commercial finance company that can offer you the right type of alternative financing solution for your particular situation.

taking the time to understand everybody the different financing options available for your business, and the pros and cons of each, is the best way to ensure you choose the best option for your business. Using alternative financing can help your business grow without diluting your ownership. After all, it’s your business, shouldn’t you keep as much of it as possible?