Borrowing Money? Investor funding? How much will it cost to fund your company’s growth?
The Cost of Financing
Your company is growing. You are doing what it takes to fund the growth, but are you considering the cost of financing? Are you holding large balances on your credit cards rather than seeking a bank line of credit? Are you looking for an investor without having considered an SBA loan?
The type of financing you choose should be both cost-beneficial and fit within your overall strategy. In this article, we’ll review the cost of some of the common financing options for growing companies. The goal is to help you make a better decision about how you finance your company. This may also encourage you to review the costs of your current financing and make sure it’s the least expensive option for your needs.
The Costs of Some Common Financing Options
Bootstrapping
For many companies, their very early-stage financing is bootstrapping, or funding that is not from institutional or professional investors. Entrepreneurs are resourceful in financing the start-up of their business and bootstrapping reflects the various avenues they take including loans from family and friends, negotiating cash-friendly terms on customer and vendor contracts, use of personal credit cards, and savings, etc.
Bootstrapping costs
It may seem prudent to try and manage growth without additional outside financing. There are costs to this approach, some of them not so obvious, including:
Limited Growth - A profitable business model often hides the importance of cash in meeting targets. Assuming your business model projects growth, add a cash flow calculation to it and you might see that limited financing means limited growth. When you run out of cash to fund working capital or buy inventory, you have hit the ceiling on how much you can grow without additional capital.
Bootstrapping Interest and Fees - Supplementing your cash flows with credit cards or other bootstrapping options can be very costly; about 18% or higher is the typical cost. Keeping ahead of these payments gets increasingly difficult as you grow, as does the monthly balance. Often this results in ‘cost creep’ where what once seemed a reasonable source of funds becomes an expensive cash flow trap.
Time, Effort, Lost Sleep - Possibly the most common and most costly aspect of bootstrapping is the strain it puts on cash flow management. Owner’s time and attention redirects from focusing on the core business issues to thinking about cash. Being a skilled cash juggler may feel entrepreneurial, but as it takes more of your attention you will realize it’s not where your time is best spent. It’s hard to quantify the ‘cost’ of losing sales because you are too busy managing cash, but this is a cost you need to consider.
Enterprise Value At Time of Exit - Thinking about your business with the exit in mind is critical to maximizing the value you will get out of your business. Doing this takes planning and forethought but the payoff is tremendous. Having weak, or poorly planned financing hurts the value of your business when you try to sell it or seek investment. Buyers look for predictability, sustainability, and transferability. To understand how financing impacts this, put yourself in the shoes of a potential buyer. If a business you were considering buying showed you a strategic plan, and how the financing structure fit into that plan, wouldn’t you pay more for that business? You are losing future value by having financing that is not a part of your overall strategy.
Outgrowing Bootstrapping
As your company grows, it will likely run up against the limitations of bootstrapping. You may experience cash getting increasingly tight as revenues grow. Buying new equipment or hiring personnel needed to support your growth may become more difficult to pay for. Anticipating the need for additional financing and knowing what is best for your goals will put you in a better position to negotiate favorable financing terms.
Debt or Outside Investment (Equity)
The graph below shows the approximate range of expected annual rates of return for some common sources of funding. This represents the approximate return an investor or lender expects for this type of financing but it’s also a good indication of your cost.
Expected Annual Rate of Return for some common financing options. The investor or lender’s expected return varies depending on factors such as company size, collateral, company and industry risk profile.
Debt
Debt financing options include credit cards, factoring, receivables or inventory financing, equipment leases, lines of credit, SBA loans, bank, and private term loans. This list is not all-inclusive. It is a sample of the more common debt options.
Debt requires that you pay back the principal amount of the loan plus interest or fees. The typical borrowing costs, interest, and or charges, by type, are discussed in the sections that follow.
SBA Loans
Loans backed by the Small Business Administration are one of the lowest cost options available to fund startup costs, buying a business, working capital, inventory, equipment, land, real estate, and building purchases.
Loan Rate APR (Annual Percentage Rate)
The current annual loan rates, or interest, are approximately the following:
SBA 7(a) Loan Rates: 6% to 8%
SBA CDC/504 Loan Rates: 3.63% to 6.112%
SBA Microloan Rates: 6.5% to 13%
Guaranty Fee
Guaranty fees are annual fees on the portion of the loan that is guaranteed by the SBA. Typical fees are 0% to 3.5%.
Packaging Fee
Some lenders may charge approximately a ‘packaging fee’ of $2K to $4K, for preparing the loan.
Origination Fee
The cost charged by the lender to originate the loan is typically between 0.5% and 3.5% of the loan amount.
Other Fees:
A lender may charge other fees, including application fees, credit check fees, appraisal fees, packaging fees, and closing fees. Also, you may incur the costs to compile the information for the loan application and period reporting.
Personal Guarantee
Personal guarantees from anyone who owns more than 20% of your business are a common requirement of SBA loans. Though technically not a cost, having this personal guarantee may increase your costs of personal or other business loans.
Bank Loan or Line of Credit
Term loans, construction loans and other bank loans not backed by the SBA are another option.
APR
Currently, the APR for some conventional bank loans of this type are:
Traditional bank loan 4.2%–8%
Construction loan 5.5%–6.5%
Bridge loan 9%–13%
Term loan 4% to 13%
Factoring
Factoring is the sale of your accounts receivable at a discount. It is a credit service designed to convert assets into cash, but it is not a loan. It is different from a loan in that it is the sale of an asset for cash.
To you, it may feel like a loan, but its unique nature includes unique costs that you need to understand to assess the total cost you will incur. Costs of factoring include the discount fee, the reserve or holdback, clearance days, audit fees, and filing fees.
Discount Fees
The discount fee typically consists of a commission charged as a percent of the receivables factored and an interest rate for the cash advance. Commissions range from 1 to 10% and interest averages from prime (approximately 3.25%) to prime + 5% (approximately, 8.25%).
Reserve or Holdback
The reserve or holdback is the invoice amount minus the advance, plus the fee that the factor holds until the factor rebates the client. This holdback is meant to protect the factor from bad debt. Reserves can be 5% to 50%, depending on the history of your collections.
Clearance Days
Clearance days are the number of days that it takes to apply the funds received by the factor to your account. Clearance days have a significant cost impact as fees continue to accrue during this period.
Audit Fees
Factors may require an annual audit of your receivables. The cost of these audits can range from $1,000 to $5,000 per year.
Invoice Fees
Factors may charge a fee for each invoice submitted.
Filing Fees
Factors may pass along state filing charges incurred for perfecting their security interest in your receivables.
Factoring costs are often listed as ‘per 30 days,’ but annualizing these costs will help compare them to other options. Annualized costs for factoring range from approximately 15% to 65% of the balance factored.
Equipment Leasing
Equipment leasing is borrowing equipment from a company that owns the equipment. The cost of an equipment lease consists of finance charges, maintenance of the equipment, service fees, and the cost to purchase the equipment at the end of the lease if you choose to do so.
Finance Charge
The finance charge may be stated as a lease factor. The lease factor is the fraction of the payment that pays for the equipment each month. For example, a 36-month lease with a lease factor of .045 means the lessee will pay 4.5% of the equipment cost per month or 162% (4.5% X 36 months). 100% of this is the total equipment cost, and 62% is the lease finance charge. 62% over three years is an APR of approximately 20.6%. The typical range of equipment lease finance charges is 7% to 16%.
Maintenance costs are the cost associated with keeping up the equipment. Service fees are any additional fees to service the lease.
The net cost of equipment leasing is typically between 7% and 22%.
Private Equity, Venture Capital and Angel Investors
Determining the cost of equity investment is not easy because the cost to you depends on uncertain future events. For example, if you give me $1,000 for 10% of my company, my cost is dependent on how valuable my company is when I sell it and have to share 10% of the proceeds with you.
You can begin to understand the cost of this type of investment by understanding an investor’s expected rate of return.
Investor Required Rates of Return
The required rate of return is the total return that the investor expects to receive from his or her investment in your company. Pepperdine’s Private Capital Report shows the following required rates of return for Private Equity, Venture Capital, and Angel Investors:
Private Equity 37% for companies with $1M EBITDA and 25% for companies with $10M EBITDA
Venture Capital 33% for seed, startup and early stage companies and 28.8% for later stage companies
Angel Investors 33% for seed, startup, and early stage companies and 18% for later stage companies
These are the median required rates of return and are a good benchmark to help you compare the cost of this type of financing to others. Keep in mind that each investment decision is unique, and the required rate of return depends on a variety of considerations, including the level of risk associated with your company.
Other Costs and Benefits
Further complicating an understanding of the cost of this type of financing is the various forms it can take and the terms of the agreement.
For example, investors may take a convertible promissory note with deferred interest. The note may be convertible into options that are exercisable at various stages of the company’s growth. Interest may be deferred for the first year or two. Or they may take a convertible preferred stock position. They likely want a seat on the board and have additional reporting requirements and hire consultants to help on key projects. They may require the company to pay legal and other costs of the deal. They may compel the company to hire in order to meet benchmarks.
These costs may be somewhat offset by the benefit that many investors bring to the company. Including advice, oversight, encouraging best practices, strategic vision, a professional network, and other positive intangibles that they bring to the table.
How do you calculate the net cost of all of this? You could develop a forecast and model the terms of a specific investment and estimate the cost, but knowing the actual cost will likely not be possible without the benefit of hindsight. At a minimum, you should understand that the cost of taking on this type of investment needs to be considered carefully.
Summary
How you finance your company should be a part of your larger strategic plan and should not be based solely on costs. Nevertheless, understanding the costs of financing will help you make a better decision about which option fits best with your plan.
To talk further about how financing fits in your company’s strategic plan, use this link to contact Highpoint CFO.
Sources and Further Reading:
Understanding the SBA 7(a) Loan Fees: Both for Borrowers and Lenders
What are the Current SBA Rates
Using the SBA 7(a) Loan for Small Business Expenses
Do SBA Loans Require a Personal Guarantee?
What are the Current SBA Rates?
Average Small Business Loan Interest Rates in 2020: Comparing Top Lenders
