Before putting the “for sale” sign out for your business consider first your objectives and know what other funding options are available. If your objective is obtain funding to finance an expansion or investment in new equipment a sale of equity in your business is not the best option. More traditional or alternative financing is a better option in such cases, as you do not lose ownership.
Before applying for funding or any form of financing consider the steps needed to prepare your business for a sale as most of those will be needed to quality for financing as well
Bank or credit institution
A loan is money you lend from a financial institution, such as a bank. The loan needs to be repaid in installments in a fixed time period and includes interest. In order to qualify for a loan you need to safeguard repayment and the bank could request additional securities such as a pledge on assets as collateral. A mortgage loan is the most common example of this, where the underlying asset (often a house) acts as collateral.
No equity is transferred to obtain a loan and you keep full ownership of your business. However, loans can be made conditional to fulfillment of certain covenants. A loan covenant is a condition in a loan arrangement that requires the borrower to fulfill certain conditions or which restricts the borrower from taking certain actions. Violation of a covenant may result in penalties or the bank being able to recall the loan immediately. In exceptional cases the bank can even obtain ownership of the shares in your business. Loan covenants often include financial metrics to which the business must comply, such as debt / EBITDA ratio, debt / equity ratio, interest coverage ratio (operating profit / interest expenses). Actions a company cannot take under loan covenants are obtain more debt, engage in M&A activities, sell key assets or pay-out dividends above a certain threshold. To measure compliance with the covenants the bank will request periodic financials reports of your business (e.g., balance sheet and income statement, including calculation of covenant ratios per quarter). Covenants can be waived, either temporarily or permanently, at the discretion of the lender.
A line of credit is a relatively smaller amount which can be requested at your home bank. With a line of credit you can have a negative balance in your bank account (up to a maximum credit line amount). The requirements are less than those for a term loan and you have the flexibility whether or not to use the funds. The downside is that the interest percentage is relatively high. A line of credit should only be used to bridge a financing need in a very short time period (e.g., several days).
Next to traditional bank financing, due to the introduction of crowdfunding and crowdlending, more hybrid forms of financing can be seen. For example, online application for relatively small credit lines
Crowdfunding is a form of alternative financing where relatively small funds are raised by a large group of people through an internet platform. Several types of crowdfunding exist, with the most popular ones being reward-based crowdfunding, equity crowdfunding and debt-based crowdfunding (also known as peer to peer lending or crowdlending).
- Reward-based crowdfunding: businesses pre-sell their products, ideas or services in exchange for an early release of such products or services. No debt is provided nor is any equity transferred. An example of reward-based crowdfunding is Kickstarter. The amounts are relatively small and are focused on development of new products or ideas.
- Equity crowdfunding: businesses offer a portion of their equity (or shares) in their business in exchange for funds. Especially popular for start-ups which are not yet generating revenues or profits. Due to the lack of this, they are unable to obtain traditional financing through a bank. Investors hope to invest in a business that will eventually succeed and even turn out to be an “unicorn”, matching Microsoft, Google or Facebook. Downsides for entrepreneurs are the need to have a formal legal entity, increased scrutiny and more stakeholder involvement. An example of equity crowdfunding is AngelList. The amounts are larger, more documentation and qualification is required, both for investors as well as businesses.
- Debt-based crowdfunding: businesses apply for a loan, which is funded through a crowdlending internet platform. The borrower needs to apply online and based on the assessment of the platform the interest rate and credit risk is determined. Investors can fund a portion of the loan and in return receive interest. The platform receives a percentage of the loan as a service fee. The amounts are larger, but the requirements and commitments for businesses are less significant than equity crowdfunding.
As a result of the low (or even negative!) interest rates in many parts of the world and extremely volatile stock exchanges, crowdfunding and crowdlending are increasing significantly in popularity
Rather than purchasing your equipment you can choose to lease it. A lease is a financial arrangement you have with a credit institution (i.e., the lease company or lessor). You as a lessee has to pay the lessor for the use of a specific asset, such as a building, machine or vehicle. The lessor holds the legal ownership of the asset until end of the lease arrangement and you as the lessee have the operational ownership.
Capital lease or financial lease
In a capital lease or financial lease you will use a credit institution to buy the asset you selected. You engage in a financial lease arrangement with the credit institution in which you can use the asset in return for monthly payments. Depending on the contractual arrangement, at the end of the lease term you have either the option to acquire the asset or the requirement.
The difference between operational lease and financial lease is important from an accounting perspective. For a financial lease, you recognize both the asset and the liability on your balance sheet. The payments of monthly installments decrease the liability. In the case of operational lease you do not recognize the asset and the liability on your balance sheet. The monthly installments are recognized as expenses in your income statement.
Whether or not an arrangement classifies as operational or financial depends on the accounting principles in your country. When the lease term is relatively short and the asset has a significant value at the end of the arrangement it is more likely to be operational lease. When the lease term is close to the useful life of the asset and you as a lessee have a requirement to purchase the asset at the end of the arrangement it is more likely to be classified as financial lease.
The classification of lease arrangements directly impacts the valuation of your business: in case of a financial lease your business has a higher net debt, with operational lease your business has a lower EBITDA as result of the deducting of the lease expenses
A sale-and-leaseback transaction is a financial transaction in which you sell an asset your business owns to a credit institution. Consequently, you lease the asset back for the long-term. In other words, you engage in a financial lease arrangement. This is often done for buildings or other tangible fixed assets your business owns.
The objective and advantage of this type of arrangement is to obtain cash which was otherwise “trapped” in your fixed assets. Especially, when you need cash to finance an expansion, finance your working capital or need to repay debt this is a good option.
Factoring is a form of financing where you sell your trade receivables to a third party (often a bank or other credit institution). For this sale you will directly receive the money of the receivable (after a discount) and the third party will continue to collect the receivable from your customer using the normal collection term you agreed with that customer.
Depending on the type of transfer you can still have a collection risk. If the sale is “without recourse”, the purchaser of the receivable (i.e., the credit institution) holds the collection risk and if the debtor does not pay the invoice the credit institution loses his money. If the factoring is “with recourse”, the purchaser of the receivable can collect any unpaid invoices from you.
The objective of factoring is to directly obtain cash from a sale. This is useful when you are facing short-term cash needs. For receivable factoring to work you need to have corporate customers (i.e., business customers). The costs or discount you need to provide will depend on the payment history of your customers and their credit rating.
Reverse factoring or supplier factoring
In reverse factoring or supplier factoring you offer a factoring solution to your suppliers. You transfer your trade payable to a credit institution. The credit institution engages with your suppliers on the payment of these invoice amounts. The suppliers can choose when they want their invoices to be paid by the credit institution; the earlier the payment, the more discount they need to provide.
The advantages of this arrangement are that you as transferer can pay your supplier invoices over a longer period of time (likely +100 days versus standard 15 – 30 days). The advantage for the supplier is that he has control over when he wants to collect the money and can manage his cashflow better. This type of arrangement is most seen with large corporates who hold significant bargaining power over their suppliers (as the suppliers have little say in the arrangement).
Factoring or leasing needs to be performed by traditional financial institutions, whereas crowdfunding and lending can be performed by online platforms
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