It is likely that at some stage in the life of your business, you have found yourself in need of short-term capital. Perhaps you were developing or launching a new product or service, or had to staff up for a large contract, or your customers were slow in paying. All of these can put pressure on your cash flow and capital requirements and typically, at this stage, companies turn to conventional lenders – like banks.
However, this doesn’t work for every business. Some firms may not want to add additional debt to their balance sheets, or they may need short-term funding to cover current account spending that is unsuited to conventional bank loans. And, of course, it’s possible the bank may refuse the application. This is where a CEO may turn to a factoring company and invoice factoring.
Invoice factoring is a financing solution that enables companies to stabilize cash flow by unlocking the cash sitting in unpaid receivables. Invoices are treated as collateral, with the firm in need of capital selling an invoice to a factoring company. The factoring company then collects payment on the invoice and pays the issuing company between 70-90% of the value of the invoice.
Why factoring companies may not be your best option
I’ve long had issues with factoring companies and the use of this practice as a method for raising or dealing with short-term capital requirements and cash flow problems.
First, the amount deducted by the factoring company is, in my view, typically too high. You’re effectively eroding your margin and your profit. The cost is far higher than any conventional debt instrument.
The second issue is that, typically, having sold your accounts receivable to the factoring company, it is they who approach your customer for payment. The obvious problem is that this telegraphs to your client that you are experiencing cash flow problems. It looks bad, and it can potentially cause problems later on, allowing uncertainty and doubt to enter into the minds of your clients as to your stability as a future supplier. For example, if you were a time-critical parts supplier, you could be inadvertently poisoning the well.
For these reasons and more, I do not recommend this as a solution for any of the businesses I advise.
A short-term fix to a long-term problem
But what if you’ve been denied capital from a conventional lender? This may speak to deeper issues facing your business that you will need to address whether you’re raising capital, considering an M&A transaction or seeking to sell your business. For example, inconsistent earnings may be a symptom of failures in the sales or business development processes.
Failure to secure capital by conventional means may also be a sign that there are problems with your financial management systems, inadequate fiscal discipline or an inability to manage operations to budget. Or, as the owner, you just may be pulling too much money out of your business.
The best sources of capital come from within
But how else can you raise capital? One of my many business dictums is that the best sources of capital are from within; meaning, with some in-depth analyses, businesses can often find the capital they need from internal savings without the need for external sources.
A solid plan for the execution of cost-cutting measures can reduce your need for short-term capital, improve cash-flow and provide resources for investment. This isn’t about hacking at the drivers of growth in your business, like your marketing budget or sales team. But, one exercise we undertake for clients is cost rationalization, for which a starting point is your Transaction Service Agreements –the services your business is buying from third-party providers; for example, telecom services. We negotiate with your providers for a better deal, in some cases, saving them hundreds of thousands to millions of dollars annually. You’d be surprised how many businesses never look at these areas for cost reductions.
In one business, as part of the assessment, we devised a plan to immediately eliminate all unnecessary expenditures and worked with senior management to implement controls that would require a higher level authority to authorize future expenditures. We also implemented a detailed daily cash reporting and forecasting model, as well as a 12-month financial forecast. Ultimately, not only did we address the rationalization of certain costs, but we revised and enhanced the revenue model, eventually making the company cash flow positive.
Find the right lender and develop a relationship
Sometimes, you can have a well-run business and still be unable to raise capital from a conventional lender. This can be due to the failure to develop an in-depth relationship with a lender, or the inability to find a lender that properly understands your business. This last point is crucial.
There are multiple sources of capital — commercial lenders, banks, private equity firms, etc.- all of whom have different levels of knowledge about industries and market segments. Lenders also have differing investment profiles of what or who they’re willing to invest in, as well as different lending profiles. Matching a company’s needs with the right source of capital is part of the art and science of business. For example, local banks in Washington D.C. really understand the government contractor business model.
Knowing your company’s financial strengths and weaknesses, understanding the preferences and proclivities of the lending industry, and avoiding factoring companies are vital to raising capital wisely and successfully.
Tom Springer is a founding partner in Springer Lawson & Associates, a consultancy of former C-level executives who help mid-market companies maximize enterprise value in advance of, during, and following major business transactions or disruptions.