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Financing Sources for Small Businesses
The increase in banking regulations as a result of the recent crisis, as well as the continued acquisition of small and community banks by larger banks have significantly changed the lending environment particularly for small businesses.
Access to the appropriate financing is an on-going challenge for small businesses. Traditional bank financing is the most desirable. Based on relationships with loan officers, this type provides the lowest cost of financing.
The U.S. Small Business Administration provides financing to small businesses in the form of SBA loans of different types. The 7(a) loan is a general small business loan. 504 loans are for real estate and equipment. There is also a micro loan program which provides small, short-term loans to small businesses. If these more traditional types of financing are not obtainable there are a variety of alternative forms of financing for small business. These alternative types of financing carry higher interest rates and costs. Some are extremely expensive.
Alternative Types of Financing:
- Non-Bank Lenders - For businesses that do not meet the credit standards of a traditional bank, a non-bank lender could be an option. Non-bank lenders issue loans and lines of credit typically backed by Accounts Receivable and Inventory. The interest rates are usually in the 8% to 12% range. This could provide a business with the opportunity to improve their debt service and leverage to possibly qualify for lending from a traditional bank over time.
- Accounts Receivable Factoring –The factoring company takes ownership of a company’s accounts receivable by paying cash immediately, generally between 80% and 95%, for their customer invoices. When the customer pays the factoring company, the factoring company will remit the remainder less their fee for the arrangement. The cost of this arrangement depends on many variables. Many accounts receivable factors now have an online presence. Interested companies can apply for factoring agreements by submitting an online application with very quick approval.
- Short Term Loans– Recently a number of non-bank finance companies have entered the market offering loans to small businesses that do not meet the credit standards of banks. These companies are not subject to banking regulations. The loans are generally under $100,000 and have a term less than 9 months. The loan decision is made quickly, mostly approved. These loans have high interest rates. The payments for these loans are deducted directly from the borrower’s bank account. Recently these funding companies have been very aggressive and actually call business owners and ask how much money they need. Business owners should proceed with caution.
- Advance on Credit Card Sales - Similar to the short term loans, certain companies that provide merchant services for credit card processing are now able to provide funds as an advance against future credit card sales. Once the advance amount and maximum payback period are determined, the payments are deducted daily based on the predetermined percentage of credit card sales. The effective interest rate of these loans and credit card advances can range from two to four percent per month.
- Purchase Order Financing – This funding arrangement could be applicable to companies that sell goods to credit worthy customers or governments, and receive order volumes larger than their financial capacity. In this case the funder pays the company’s supplier and carries the obligation until goods are shipped. Upon invoicing the customer for the goods, the purchase order financer generally will want to close out the arrangement. This will likely mean that the company will need to utilize accounts receivable factoring to obtain the funds necessary to pay the purchase order financer. When both purchase order financing and accounts receivable factoring are utilized the financing costs are significantly high, but are less than the cost of bringing in an equity partner. So why would a company do this? It allows a company to grow much faster and fulfill orders much larger than it could without the financing.