Alternative Financing Vs. Venture Capital: Which Option Is Best for Boosting Working Capital?
Several potential financing options are available to cash-strapped businesses that need a healthy dose of working capital. A bank loan or line of credit is often the first option owners think of – and for companies 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 start-ups and those that have experienced financial difficulty. Sometimes, business owners who don’t qualify for a bank loan decide that seeking venture capital or bringing on equity investors are other viable options.
But are they? While there are some potential benefits to bringing venture capital and so-called “angel” investors into your business, 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 two different types of financing.
Working capital – the money used to pay business expenses incurred during the time lag until cash from sales (or accounts receivable) is collected – is short-term, so it should be financed via a short-term financing tool. Equity, however, should generally be used to finance rapid growth, business expansion, acquisitions, or the purchase of long-term assets, defined as assets repaid over more than one 12-month business cycle.
But the biggest drawback to 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 are giving up a percentage of ownership in your business, and you may be doing so at an inopportune time. With this dilution of ownership most often comes a loss of control over some or all of the most important business decisions that must be made.
Sometimes, owners are enticed to sell equity because there is little (if any) out-of-pocket expense. Unlike debt financing, you don’t usually pay interest with equity financing. The equity investor gains its return via the ownership stake acquired in your business. But the long-term “cost” of selling equity is always much higher than the short-term cost of debt, in terms of both actual cash cost and soft costs like the loss of control and stewardship of your company and the potential future value of the ownership shares 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 appropriate for injecting operating capital into businesses. Three of the most common types of alternative financing used by such companies are:
1. Full-Service Factoring – Businesses sell outstanding accounts receivable on an ongoing basis to a commercial finance (or factoring) company at a discount. The factoring company then manages the receivable until it is paid. Factoring is a well-established and accepted method of temporary alternative finance that is especially well-suited for rapidly growing companies and those with customer concentrations.
2. Accounts Receivable (A/R) Financing – A/R financing is an ideal solution for companies that are not yet bankable but have a stable financial condition and a more diverse customer base. The business details all accounts receivable and pledges those assets as collateral. The proceeds of those receivables are sent to a lockbox while the finance company calculates a borrowing base to determine the amount the company can borrow. When the borrower needs money, it makes an advance request, and the finance company advances money using a percentage of the accounts receivable.
3. Asset-Based Lending (ABL) – This credit facility is secured by all of a company’s assets, including A/R, equipment, and inventory. Unlike factoring, the business continues to manage and collect its receivables and submits collateral reports on an ongoing basis to the finance company, which will review and periodically audit the accounts.
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