Growing companies usually require more working capital during their periods of rapid growth. In past insights we have calculated the amount of additional capital needed for a business as it grows, and the additional capital required is often surprisingly large. In this insight, we need to speak of the sources of working capital and the implications to the future financial health of the choices made when selecting one financial resource.
Venture or angel-financed companies with plenty of working capital sometimes are immune to this need for some time into their growth, but at some point it will become clear that the cheapest form of finance is not equity in a growing enterprise. If the equity value of a company is growing at the same rate as the company, say 40% per year, 
almost any form of debt financing may be preferable as a way of preventing further dilution from issuing additional equity.
The problem is that few small, growing companies seem to be attractive to most banks for traditional unsecured or asset-backed loans. The exception is for those venture-backed companies with a significant cash balance remaining in the bank, which ironically make the most attractive customers for banks to offer loans. The banks want to maintain their venture relationships and of course, want to use the existing company cash in their bank as collateral for – you guessed it – their loans to the company. The term of art is “compensating balances,” and certainly using existing cash to leverage new loans makes the company more liquid, but at a price, as the compensating balances cannot be touched and are essentially frozen for the duration of the bank loan.
[Email readers, continue here…] There are asset-based lenders of every size willing to take more risk and finance the growth of young companies without requiring compensating balances. Using the company’s receivables and inventories as collateral, such lenders often also ask for a uniform commercial code (UCC) filing, perfecting their first interest in all of the remaining assets of the company – including intellectual property, the latter often being by far the most valuable asset the company has to protect.
Loan covenants are always required that clearly state how much net equity, the minimum current ratio, and other minimum financial requirements must be maintained to be compliant, and state the penalties for non-compliance – which are always severe, often threatening to call or cancel the loan in its entirety.
One of the important items in a calculation of amounts available to be borrowed is the amount of qualifying collateral, defined usually as the amount of net accounts receivable less than 60 days old, after deducting government billing – and all receivables from companies with some balances over 60 days. To this net number, the lender will then apply a percentage, from 50% to 80% as the amount available for borrowing under the agreement.
It is important to calculate the true cost of such money. It is typical to charge an interest rate that is higher than a normal bank loan for asset-based loans. Also tacked on is a “float period,” typically two to five days, amounting to additional interest as if the money paid back is still outstanding for that time as compensation for the time to clear checks paid into the lender either by your customers directly (lock box method) or by you. A five day float increases the actual interest rate by up to an additional 2% over the stated rate. Then there is the loan audit fee, often more than $4,000 a year, to pay for the lender’s auditor to make sure the collateral and company are compliant with the covenants of the loan. Lenders sometime add a charge for loan oversight, called a consulting fee, and very often make warrants (a promise to later sell the lender stock at a fixed price) a part of the deal. When calculating the true cost of a working capital loan, after adding all of these elements and estimating the value of the warrants in dilution to the shareholders, you may be shocked at the number when expressed as an annual percentage rate.
And yet, such a loan does rise and fall with need. And it is often cheaper than the cost in dilution of issuing additional stock to obtain working capital. These decisions require knowledge by management, help from accountants and or attorneys, and an understanding at the start of such a relationship that borrowing from asset-based lenders is like entering a marriage where the other partner has all the power to ensure success in the event that anything goes wrong with the original plans.
Very good info Dave. This is extremely helpful and useful. Well done!
Les Spielman
Thanks for illuminating exactly how complex start-up financing really is. I have used my savings along with current revenues to finance my company. I’ve also deferred (perhaps to eternity) any salary for me and my partner/wife for the last eight years.
The most important thing to understand is that when you really must have money is when it’s hardest to get. Conversely, when you don’t have to have money is when it’s easiest to get.
For this simple reason, you have to get out your crystal ball and polish it up well. When you’re feeling good about your cash flow and balance sheet is exactly the time to consider financing. Will additional money beyond your revenues be useful or even necessary in the near future — six to twelve months, the time required to obtain the financing?
Can you find other means to finance your business? If you ask your suppliers for a longer payment period, that’s financing. Asking your customers for quicker payment is also a form of financing. Deferring your salary is financing. So is raiding your retirement accounts.
Going to a bank or venture capitalist should be your last resort. Angels are the second-to-the-last resort unless you can find one who really gets your vision and is willing to become involved in helping you far beyond money — in other words, becoming a partner in your venture. Not many do, but finding one is like finding gold.
My business was growing at 50% a year until the recession finally found its way into my industry. Suddenly, we had lots of red ink. I had enough personal reserves to loan the money to my company, lots of money from my perspective. Now, we’re growing again and expect 100% or better growth for the next several years. My loan is safe.
Had I obtained financing or investment during that 50% period, I may have had help with the bad period or may have had to give up control of my company or even had to sell it outright. With an outrageous profit margin, once we cover our fixed expenses, we may be able to self-finance from our growth until we seek to break out of our market niche and realize fully the potential of our patented technology. Hyper-growth almost always requires some sort of financing.
Great article. I would like to add… I would suggest staying away from scenarios where you have to pay a finders fee. You will be approached, and/or meet people who claim to have relationships that can open doors and close deals. They may be able to open doors, but its only the lender who can close that deal to their own underwriting guidelines.
We had a situation at a past company using a person who wanted a finders fee. They introduced us to a great bank, and although the APR was high, it was cheaper than other forms of financing. Problem is, once we factored in the finders fee and the adjusted APR simply did not make sense. We would have to have waited a year to honor a non-circumvent to work with that lender.
Great info and comments! Insightful and timely.
Thanks Dave- an important topic.
A comment: in your discussion of receivables-based lending you said “after government billing is deducted”. You are right, in my (somewhat dated) experience lenders were not willing to finance government receivables. After much search I found that Silicon Valley Bank would do it and on reasonable terms and it was a real life-saver for my company.
BTW, there were also outfits that would do factoring (i.e. outright buying receivables) or inventory financing but I found that their terms were unaffordable.