Understanding Lending Sources For Start-up Businesses

If you were to start your own business, how would you go about securing working capital? How would you ensure that you not only had the money to get your venture off the ground, but that you also had the capital you needed to survive your first few years of operation?

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Granted, these aren't easy questions to answer. However, answering them is critical to making sure your new company is a success.

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Entrepreneurs and new businesses wrestle with these aforementioned questions on a daily basis. Finding the answers involves taking the time to investigate all the financing options at your disposal. Ultimately, there are several credit sources that can help you remove financing as a going concern.

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New business owners as well as existing businesses are always looking for lending sources that are capable of working with them long-term, ones willing to keep them financed through the good times and the bad. However, it's not just about having seed financing to get the business going. It's ultimately about having enough capital to finance your company for years to come. However, finding these willing lending partners is no easy task.

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Understanding Creditors and Financing Sources

Some creditors eliminate high-risk industries altogether. These creditors won't advance capital no matter how strong the company's financials are or how strong their credit rating is. For these creditors, the risks in the industry are too much to overcome. Even the best performing enterprises in a high-risk market have a hard time securing capital.

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In other instances, a creditor will advance capital under a number of stringent conditions. They may place greater emphasis on certain assets and or asset classes. Other creditors will only provide short-term capital advances. Yet, in other instances, a creditor will only advance capital if they are able to own a portion of the enterprise. In the end, securing financing is a constant concern. To help you in your pursuit, we'll compare bank financing, venture capital financing and asset-based financing.

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Bank Financing

Banks base their decisions to lend capital based on a number of different conditions. For established enterprises, the decision to advance or increase a company's credit line comes down to assessing a number of performance-based variables. First, the bank will need to review the company's financials. This involves assessing the company's balance sheet, its profit and loss statement, and its cash flow statement. Second, the bank will also need to see a consistent record of performance over a given period of time. This involves reviewing the company's sales, gross profit and net profit over a three to five year period. Third, banks tend to advance capital when a company falls under an acceptable debt-to-equity ratio. In this case, no bank will advance funds if the debt owed by the company isn't sustainable and can't be repaid.

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Unfortunately, entrepreneurs and new businesses don't have the luxury of history or performance on their side. They can't use their financials or refer to a strong debt-to-equity ratio. Instead, they must focus on other avenues.

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It's critical that entrepreneurs separate their own personal finances from their company's finances. This involves having a solid business plan with a cohesive marketing strategy. This is needed in order to show the bank that you are more than capable of repaying the loan or advance you receive. Ultimately, it's about defining the banks return on investment. The main question you must answer is the following: Why should the bank advance you credit and how will you repay that capital advance?

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Venture Capital Financing

A venture capitalist isn't merely interested in extending credit. Their expectations are much higher. In fact, it's common for them to expect a 25 to 35 percent return on investment. However, there is an important distinction to be made between an everyday venture capitalist and an angel investor.

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The venture capitalist is more concerned with a solid return. An angel investor wants a solid return and a stake in the enterprise. In essence, the angel investor is looking for a personal opportunity with the company. Their goals are to be more than just a source of credit. Ultimately, they want to bring their experience to the table.

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Ideally, an angel investor will have some relevant industry or market experience that can help the new business venture. However, that immediately implies that they'll need to own a portion of the business. This is not always easy to grant for new business ventures and entrepreneurs. Ultimately, there is a trade-off that must be understood when pursuing an angel investor. So how does a venture capitalist or angel investor decide to advance capital?

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Venture capitalists and angel investors aren't merely concerned with a company's finances. In fact, in a number of cases, they are more than willing to invest in enterprises that are less than creditworthy. These investors are more focused on the company's potential. They review the company's value proposition, its product or service's potential for success, the strength of the company's market position, its marketing strategy and plan, and finally, the company's overall potential for growth.

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Banks based their decision to advance capital on the strength of a business's tangible assets and or the strength of the new venture's overall business and marketing plan. Venture capitalists base their decisions to lend on a venture's potential for success. However, it's entirely different when it comes to asset-based financing. Instead of reviewing tangible assets and financials, an asset-based lender focuses on other asset classes, ones that are more easily converted to cash.

Asset-Based Financing

There are essentially three main financing vehicles with respect to asset-based financing. These include receivables factoring, purchase order financing and inventory financing. Each solution is based on assigning a predetermined value to these aforementioned assets. The company can then use these assets in order to set up a renewable credit line. So what can you expect from each option?

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Accounts Receivable Assets: Accounts Receivables Financing involves a third party financing company called a factoring company that advances working capital based on the value of a company's receivables. This instant infusion of cash allows companies to avoid the constant hassles that accompany extended receivable collection times. The sale of the receivable means the financing company takes over on receivables collection. Once the customer pays their bills, the factoring firm reimburses the company the difference from the original capital advance and the final collected amount.

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Purchase Order Financing

Instead of using receivables as a financing vehicle, a company can opt to use its customer purchase orders and contracts as collateral against a capital advance. The purchase order financing company will pay the company's vendors directly, thereby allowing the company to finance its current and future sales, in addition to its operations. Purchase Order Financing must have a factoring relationship before applying for po finance. Keep in mind that a purchase order from a client is not considered an asset but it is an ingredient of the receivable assets and predicts the future cash flow of the company. The risk the lenders have on this type of financing is if the order gets canceled do to events that cannot be controlled.

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Inventory Financing

Inventory financing allows entrepreneurs and new business owners to use their inventory of finished goods as collateral against a capital advance. The inventory is often discounted and the new business venture must maintain a certain sales volume in order to remain within the terms of the agreement. However, it is an excellent credit source for enterprises that have a solid product offering, but few financing alternatives.

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All of these aforementioned lending sources have pros and cons. Deciding upon a credit source comes down to understanding your situation and the assets in your company's possession. Start by choosing the option most applicable to your situation. Next, work your approach around the strength of your proposal. In the end, providing a focused proposal will ensure that you get the financing your enterprise requires.