Here are a few of the types of loans you might consider when thinking about debt financing.
The First Step: Bank or SBA Loans
Within the senior debt class, there are different types of debt with different levels of relative seniority. Nearly all organizations will make use of a line of credit provided by a bank or a financial institution; this is usually secured by current assets or inventory and is typically the first to be repaid.
Business lines of credit give you access to a specific amount of money and only require repayments and incur interest if you use the money. These lines of credit are often revolving, which means you don’t have to reapply once you’ve paid the balance down.
Bank term loans, which provide a lump sum of money which you pay back over a certain period of time, are a great form of debt to consider as they’re relatively cheap and low risk. However, bank loans can be hard for businesses to secure. In order to qualify for a bank loan, business owners need strong personal and business credit, a large asset base, a detailed business plan, and solid industry experience. Small local or regional banks are more likely to be flexible in structuring a loan that works for your business.
If your business doesn’t qualify for a traditional bank loan, the Small Business Administration (SBA), a government entity, may be able to help you bridge the gap. According to MultiFunding's Ami Kassar, the SBA “partially guarantees traditional bank loans (between 50-85% of the loan amount) to lower lender risk and reduce interest rates on loans up to $5 million in value.”
Don’t expect the process to be seamless. Kassar says that “the SBA has a reputation of being laboriously measured and overly bureaucratic” and that “for business owners seeking quick capital, the turn-around times and legwork for an SBA loan are often prohibitive, even if the money is available at a lower rate and with more attractive terms than its competitors.” But he adds that with the right guidance, the process can run smoothly.
TYPES OF SBA LOANS:
- 7(a) loans are the most common type of business loan guaranteed by the
SBA covering a broad range of collateral and business types.
- CDC/504 covers real estate and equipment loans.
- SBA Express: The SBA can expedite the borrowing process for a higher premium on smaller loan amounts (under $350,000).
- CAPLines: SBA’s CAPLines program helps small businesses borrow for short- term and cyclical working capital needs.
- International Trade Loans: The International Trade Loan offers loans up to $5 million
Drawbacks to SBA loans include the complicated, bureaucratic process and the need to research lenders — “remember, the SBA itself doesn’t make loans (it only insures them),” notes Kassar. The SBA also requires owners with more than a 20 percent stake to personally guarantee the loan.
Regardless of how much cash your company is carrying, as a CEO, you should consider acquisitions an option when looking to accelerate growth and expansion. Payment plans, LBOs, and the SBA are all financing options with flexibility that demand little-to-no cash commitment on your part and grant you access to a
wider variety of potential targets. While each carries its own risks, those pale in comparison to the future rewards that the right acquisition can bring your business.
Putting Up Collateral: Asset-Based Loans
Asset-based loans are, as their names suggest, loans provided by banks against the value of a company’s assets. Relevant assets include: accounts receivables, inventory, and even fixed items like equipment and physical buildings. Typically, banks will be willing to lend 50-70% of the value of the agreed-upon assets.
FINANCING RISKIER PROJECTS
Since banks providing asset-based loans have collateral to call in the event that the loan is not repaid, they may be willing to offer this type of financing for riskier projects. For instance, if your company is looking to start a new line of business, you may be able to borrow against the assets of your existing line to finance the development of your new line.
Also, assuming your company is in good financial health and that you have a steady stream of receivables, asset-based loans can also be among the easier types of debt to secure. As with any attempt to secure financing, it is important to be able to show the long-term viability
Naturally, to pursue asset-based funding, a company needs to have strong assets against which to borrow. As a result, SaaS and other web-based companies are typically not ideal candidates for asset-based loans.
Companies considering the possibility of borrowing against their receivables must also consider the strength of those receivables. Receivables with uncertainty of being repaid are unlikely to be accepted by banks as collateral in a loan agreement, and it is possible that a bank will want to audit the firm on the paying end of an A/R to evaluate its likelihood of repayment. Thus, it is helpful to have long-standing
customers or large firms as clients if you are seeking to use receivables as collateral. If your primary customers are small companies or your client relationships are not long- standing, you may need to borrow against other assets or pursue other types of debt.
Any time an asset is being held as collateral, there is risk that the asset could be lost, especially in cases where asset-based loans are being used to finance new ventures. While banks may be willing to finance riskier lines of business with asset-based loans, it is important that you be confident in your ability to repay the loan without surrendering an asset.
In the event that you choose your receivables as the asset to back your loan, it is very possible that the bank providing the loan to you will instruct your debtors to pay them directly. While this situation obviously streamlines your loan repayment process, it also takes a chunk of cashflow out of your hands, which can be an uncomfortable feeling. The potential loss of receivables is one factor to consider when deciding whether or not to take asset-based financing.
A drop in the value of the asset used to collateralize your loan can also cause the bank to recall part, if not all, of your borrowed amount. This can throw the operations of any business into turmoil. As a result, as mentioned before, it is important to collateralize asset-based loans with stable, predictable assets.
For the right companies, asset-based financing can be an extremely effective
means by which to take on debt. It can be easy to acquire and simple to maintain.
It is important, however, that the assets underlying the loan are strong and stable. Uncertainty with underlying assets can cause banks to recall loan amounts or possess assets, scenarios that can do more to harm a business than the original loan did to help.
A type of asset-based lending, invoice factoring helps provide businesses with a continuous flow of operating capital. Business owners might use this capital to pay creditors or taxes, meet payroll, or alleviate financial stresses associated with growth.
Invoice factoring entails selling your company's invoices to a lender. On the day the invoice is due, the factor pays the company some percentage of the invoice. Later, when the factor collects the invoice, it pays the company back the remaining balance, minus a fee. In essence, invoice factoring enables an organization's accounts receivable to serve as working capital for the business.
Factoring doesn’t mean necessarily mean your business is struggling. Business owners may use factoring to increase working capital and facilitate growth. Factoring provides an alternative to a traditional bank loan, especially for businesses who can't currently qualify for a bank loan. Factors can provide a reliable, and fast, source of financing for these
Between Debt and Equity: Mezzanine Financing
In the architecture world, a mezzanine is described as an intermediate floor of a lesser width that’s positioned between two main floors, while theater buffs know the mezzanine is the lowest balcony or forward part of a balcony. A mezzanine seat often is considered second rate — although some mezzanine views actually offer the most-coveted sightlines.
In the financing world, so-called mezzanine debt also often has a so-so reputation — a reputation that isn’t necessarily deserved. In fact, it’s been used successfully for years.
“Mezzanine debt gets its name because it blurs the lines between what constitutes debt and equity,” the Motley Fool writes.
For our purposes, mezzanine debt is cash flow that sits in the second lien position behind asset-based lenders; in return for their risk, lenders often incorporate an equity kicker such as stock warrants or bonus payments tied to company valuation. Typical loan lengths are three to five years
Mezzanine debt can be put to good use, especially for companies that have a strong cash flow to support the debt. It’s not generally tied to secured assets, but is lent based on a company’s repayment ability — also known as free cash flow. And mezzanine debt allows a business to obtain financing without having to issue equity and dilute ownership. That increases leverage.
Corporate expansion projects, acquisitions, leveraged buy-outs (LBO), management buy-outs and recapitalizations may all be financed by mezzanine debt. It’s often used for smaller LBOs that otherwise don’t have access to the junk bond market.
One catch, however, is that pricing can be across the board. Given its subordinate position, interest rates are going to be relatively high to start, so be sure to shop around for the best deal. But why would borrowers want to pay those higher rates, which might be 20 percent or more? For one thing, smaller companies often have limited options.
And remember that the IRS considers the interest on debt a tax-deductible expense, which bring the effective interest rate way down.
Mezzanine lenders may also include features that can make payments more management. PIK toggles — where interest is added to the loan balance — are one example. Thus, if a borrower can’t make a normally scheduled payment, the interest (or at least part of it) can be deferred.
Firms that are growing quickly won’t need a mezzanine loan for too long. That’s because as the company grows, its value increases as well. At that point, you could be able to refinance all debt into a single senior loan at much more palatable terms.
So, who exactly invests in mezzanine debt?
Large institutional investors such as commercial banks, insurance companies, private equity firms and mezzanine funds are common investors.
Mezzanine debt can fill the space between a senior bank loan and available equity to fund the cost of a transaction. It is commonly used for acquisition financing and ownership restructuring (such as in a leveraged buyout), although it can also be applied to growth opportunities or to finance dividend payments for company shareholders. Deciding when to use mezzanine debt can be tricky as there is no standard transaction where it is deemed appropriate. However, for a business that needs to grow above and beyond what other forms of financing can support and is confident in its ability to generate returns beyond the higher cost of this form of capital, the answer may be yes.
No Collateral Needed: Unsecured Business Loans
Unsecured business loans provide companies with financing without the need to provide working capital to businesses who don’t qualify for traditional bank financing. They can also be used in conjunction with bank financing as subordinated debt.
Though costs can be higher than other alternatives, these loans can come in handy to fix a cash flow crunch or any other immediate need. (Though these loans are commonly referred to an unsecured loans, they do typically require a UCC, or Uniform Commercial Code, filing, which indicates lenders have a secured party interest in your business, albeit on a subordinated or junior basis). Merchant cash advances are when you sell a portion of your future sales in exchange for immediate cash. Lending companies in the space also offer true business loans with daily or weekly payments. Both types can be funded within 24- 48 hours, but loans are preferable since they are fully tax deductible.