David Vs Goliath: How Alternative Financing Can Help Meet Cash Flow Challenges
During my dozen-plus years in the alternative financing industry, I have seen what I call the “David vs. Goliath” scenario play out so many times that I can usually spot it within the first few minutes of talking to a small business owner about his cash flow challenges. Here’s a common example of how it usually looks:
A small tool manufacturer has hit the mother lode, landing a large contract to supply a big box hardware chain with hammers, wrenches and other assorted tools. The owner’s (let’s call him David) excitement is muted, however, when he realizes that the price of doing business with a Goliath like this is accepting the large customer’s extended payment terms, which in this case are net-60 days from receipt of the tool manufacturer’s invoice.
Cash is king in today’s business and economic environment, and large corporations are sitting on piles of it. Unfortunately, this is forcing many of their small vendors to scramble to finance lengthening internal cash flow cycles.
And it’s not just small manufacturers who are fighting these Goliath-sized battles, either. I recently talked to the owner of a small technology firm whose largest customer (representing 70 percent of his sales volume) is now stretching out payments well beyond the normal net-30 days, which is putting a severe strain on his cash flow. In fact, two tech bellweathers, Cisco and Dell Computer, recently announced that they are extending their vendor payment terms to as long as four months.
This David vs. Goliath scenario illustrates the risk-reward calculation small business owners often must make when they have the opportunity to do business with a large customer. The boost in sales, of course, is great, but they have to be able to survive the cash flow lag created by the extended payment terms.
If they can’t finance the lag from internally generated working capital, then they’ll need some kind of outside cash infusion. With many banks still operating under the tighter credit procedures that they’ve implemented in the wake of the financial crisis, more and more small businesses are turning to alternative financing options.
Two of these options that have become increasingly popular among small businesses are factoring and accounts receivable (AR) financing. These are both considered “alternative” financing tools because they fall outside the realm of traditional bank financing vehicles like term loans and lines of credit.
Factoring is the sale of a vendor’s receivables to a commercial finance company (or “factor”) at a discount. For example, suppose a vendor has just sent a $5,000 invoice to a large customer that pays in 45-60 days. Instead of waiting to get paid, the vendor could sell the invoice to a factor and receive 80 percent (or $4,000) the next business day. The balance, less the factoring fee (typically between 2-5%), is paid to the vendor when the factor collects the invoice.
The vendor typically decides which invoices to sell to the factor, which assumes management of the receivable until it is collected. This includes performing credit checks on the vendor’s client(s), analyzing credit reports, mailing invoices and documenting payments.
Exponential Business Growth
Accounts receivable financing is a little different. Here, vendors can borrow up to a certain percentage (80 percent) of the value of their qualified receivables (this is known as the borrowing base) on a revolving basis, similar to a bank revolving line of credit. Unlike a bank credit line, which is usually secured by hard assets like plant, equipment and real estate, the AR line is secured by the receivables themselves.
The beauty of an AR line of credit is that as sales grow, so does the potential borrowing base and the vendor’s access to capital, thus enabling exponential business growth. Every time a sale is made, more money can potentially be advanced to the business, and interest is charged only on the amount advanced.
It’s important to keep in mind that factoring and AR financing are usually not considered to be permanent sources of financing. Rather, they are designed to help companies weather temporary periods of financial instability or rapid growth that make them unattractive risk candidates for most banks. After 12-18 months, these businesses may become bankable again and resume lending relationships with traditional banks.