Part Four. The Debt Investment Instruments.
Small businesses are often in need of quick capital that can’t be accessed through traditional sources like bank loans or credit cards. The financial crisis of 2008 left hundreds of thousands of small businesses with restrained demand for working capital to grow their businesses.
Banks severely restricted access to capital, disproportionately affecting small and medium size businesses: annual loan originations to businesses with $1 million or less in revenue fell dramatically between 2007 and 2013. Only 2.4 million traditional loans were originated to businesses with $1 million or less in revenue in 2013, down 54% from 2007. This created an opportunity for new players.
When it comes to funding, there are two dominant options: equity and debt. Similar to equity approach, debt investment carries some degree of risk but represents a loan, typically with an interest payment. Debt provides many instruments to fund a business:
Consumer Loans - firms giving an opportunity to invest in the loans they grant. The leading firm in this category is Lending Club, with an online platform enabling investment in their debt - over $13 billion loans issued. The amount you can borrow usually depends on your credit report, credit score and income. Loan-based financing also has legal restrictions based on the state legislation.
Micro Loans - small loans that can start as low as $100 to small business owners or entrepreneurs typically in developing countries. Leading company in this space is Kiva with over $800 million in loans. These are small amounts of money - Kiva U.S. loans can only be as large as $10,000.
Factoring means buying the resold debt - a factor may pay the seller 60% to 80% of the amount owed and then try to collect the entire amount receivable from the debtor. This is investing in debt that's owed to the secondary creditor. This type of financing basically requires you to sell your accounts receivables at a discount, which means that this option is not for every business.
Business Credit Line - enables you to borrow up to $100,000 and pay interest only on the money borrowed. You can draw and repay funds as you wish, as long as you don’t exceed your credit limit. A line of credit is a good option to finance recurring inventory purchases or short-term expenses but the APR could range from 14% to 108%.
Another approach that is gaining popularity and interest is revenue-sharing or royalty-based financing which is a hybrid small business loan that combines attributes from venture-capital funding and bank loans. Royalties are a unique form of investment: instead of owning a share of the company's stock that fluctuates daily, investors are entitled to a monthly/quarterly/annual payment that is based on the company's revenue. In other words, investors lend money for a guaranteed percentage of revenue for whatever the business is selling. This debt repayment structure has a time limit or a return cap - once reached, the debt is repaid.
This type of financing might be the answer for entrepreneurs in need of capital to grow because of these unique characteristics:
- It’s a loan, but different from the one you would get from a bank;
- Revenue sharing is a structure that fits in nicely with existing or future bank loans, or VC and Angel funding;
- Unlike traditional capital, this funding is not dilutive (no equity involved);
- There are no fixed payments, no set time period for repayment and no collateral to secure.
- Lenders assess the business’s finances and projected business growth to determine the eligibility and loan amount.
Revenue sharing is a great way to fund a business, especially if entrepreneurs are ‘allergic’ or hesitant about sharing or selling ownership of their company. There is no need to agree on a valuation of the business, there’s no personal liability, and there are no worries during a down month of sales because payments are tied to a percentage of revenue not an interest rate.
Part Five would be about Crowdfunding.
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