Summary: Finding the right source of financing for a startup is one of the most challenging tasks for founders. Guided by what they see in the popular media, founders often think that the best way to finance a company is with venture financing, angel financing, or a business loan. This is not the case.
Few startups are funded with venture financing, loans, or similar options. Most entrepreneurs use their savings to finance their companies.
This article covers a realistic way to finance your startup’s organic growth. It can be an effective way to finance your small company without giving up equity. We cover the following:
- The reality of small business financing
- Do you sell on net-30 terms?
- Finance your startup with factoring
- Advantages and limitations
- Simple qualification and fast deployment
- Strategy
1. The reality of small business financing
Getting any type of financing for a new business is very difficult. The popular media is full of stories about entrepreneurs who used venture funding and became billionaires. This group represents a very small minority of startups. Most startups fail to get any funding at all.
There are two general ways to fund a startup. The first option is to sell equity to investors. This approach gives money to the company and transfers some equity/ownership to the investors. You don’t have to pay the investors back, but the investors are now company owners – just like you.
The second option is to use debt and get a loan. Loans don’t give an ownership interest to the lender. However, you need to pay the loan back according to the contract. Missed payments could put you in default and allow the lender to foreclose your business (and personal) assets.
a) The reality: low chance of success
Venture capitalists (VC) and angel investors often spread their investments among several startups that meet one important characteristic. The startup must have the potential to generate a substantial exit for the investor. An exit is when the investor sells their stake, ideally generating a high return.
VC investors understand that most of their investments will fail or generate small exits. However, a few may generate substantial returns that provide an opportunity for a large exit. Unless your company has the potential to generate outsized returns – and most don’t – you won’t be able to get VC funding.
Getting a loan is equally hard. Banks lend only to companies and people with enough collateral to repay the loan. If your company or its owners don’t have collateral, banks won’t lend you money. Even if your potential for growth appears amazing.
For this reason, most entrepreneurs and founders bootstrap their startups. The entrepreneur often pays for expenses out of their savings and grows their businesses organically. However, there are some tools that can help you finance your company’s organic growth.
2. Do you offer net-30 terms?
Startups focusing on business and government clients often have to offer net-30 terms. These terms allow clients to pay their invoices in 30 to 60 days. In our experience, most founders overlook the effects of offering terms on their cash flow. These effects can be substantial.
Offering terms decreases your available cash until the invoices are paid. You could experience cash flow problems if you don’t have an adequate cash reserve. Furthermore, these problems could worsen if your company is growing quickly. This is one reason why some successful startups get into trouble.
You can improve your cash flow by offering select clients a discount for early payment. This strategy can work well if your problems are small. However, it may not be sufficient if you are growing quickly or have moderate cash flow problems.
3. Finance your startup with invoice factoring
Startups can bridge the cash flow gap created by offering terms using invoice factoring. Factoring behaves much like a line of credit secured by your accounts receivable. Your company gets an advance, which varies between 80% and 90% of the invoice’s face value. The remaining 10% to 20% acts as a reserve that is returned, net of fees, once the invoice is paid.
The main difference between factoring and other solutions is that most factoring lines are not structured as loans. Instead, they are structured as the finance company’s purchase of your accounts receivable.
This difference is important because it affects how the transaction is underwritten. Factoring companies finance invoices payable by end customers with good business credit. Additionally, the invoice cannot be subject to encumbrances.
To learn more, read “How Does Invoice Factoring Work?”
4. Advantages and limitations
Factoring lines have several advantages over other solutions. However, they also have some limitations you must consider before using this type of financing.
a) Advantages
The main advantage of factoring is that it can improve your cash flow quickly. This solution was created to help companies with cash flow problems due to slow-paying accounts receivable. Additionally, the line has other important advantages:
- Available to startups/new companies
- Line grows with your sales
- Allows you to offer terms to clients
- Simple qualification criteria
- Can be deployed quickly
b) Limitations
The following are the main limitations of factoring lines:
- Helps only if problems are due to slow-paying invoices
- Comparatively expensive
- Requires high profit margins (> 20%)
5. Simple qualification requirements and fast deployment
Most factoring lines have simple qualification requirements. The requirements vary by factoring company but generally include:
- Have quality invoices
- Your invoices can’t be encumbered by liens
- There is no immediate risk of bankruptcy
Factoring lines can usually be deployed quickly, in 5 to 10 business days. The factoring company can often complete its part of the due diligence quickly, provided it gets all required documents in a timely manner.
6. Funding strategy
Using financing reduces your profit margins and should be used carefully. Consider using financing only while building a cash reserve that allows you to operate independently. This strategy requires financial discipline and planning.
You can use financing when the company is growing quickly and exceeds your cash reserves. However, you must ensure that your company can absorb the cost of financing and still generate attractive profit margins.
Need factoring to finance your startup?
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