Properly financing your new, small business

When I graduated with my MBA in Finance I went to work with Silicon Valley Bank. Silicon Valley Bank (SVB) is a commercial bank much like Bank of America or Chase but SVB focuses on a niche market in the commercial lending world.

SVB would essentially follow venture capitalist or other private equity firms/individuals in financing new, growing businesses. When these private equity companies funded these businesses, they would own part of the equity of the company. Should the company take-off, this outside ownership could essentially be quite expensive to the company's founders and other stakeholders - image giving up 50% or more of your firm to early stage financiers. Given its expensiveness, all equity that was infused into the company was earmarked for future growth and development. It was not nor should not ever be used to purchase items for the daily operations of the company (items other than business development) - items like equipment, machinery, tools or even business office equipment like computers, servers, printers, desks, copy machines, etc., not to mention other everyday necessities like rent, utilities, insurance, payroll, supplies, etc, etc, etc.

This was one of the major reasons that we at SVB followed these private equity players into these companies. We would lend these new ventures the capital needed to fund other business requirements - requirements that should not be funded via that very expensive private equity. Our benefits included: Term loans who principal balances decreased with payment over time, low interest rates as our facilities were secured by business assets and a hands off approach (unlike VC or other private equity players who take board seats).

In today's market, this same philosophy can be followed - even for companies that don't receive private equity funding.

Most new entrepreneurs, when thinking about or seeking funding for their business, tend to focus on obtaining one, single, all inclusive loan to cover all of its needs. Now, that would be OK provided that the business only had one, single need. But, most businesses do not - especially start-up, small businesses. Most new companies need everything from working capital for marketing, development, payroll and growth to inventory or equipment - either basic office equipment like computers and copy machines to equipment for operations like machinery, tools, transportation/shipping, etc.

If your small business needs working capital, it will, for the most part, attempt to seek an unsecured loan given that the new business has yet to collect business assets that can be used as collateral. What this means to a lender is more risk. More risk means higher costs to the business in obtaining that loan. Unsecured lending rates could be as high as 22% annually and include fees of up to 5% - not to mention huge oversight and reporting requirement from the lender - all of which add unnecessary expense to the company. However, should the business be able to secure part or all of the loan with some form of collateral (called a secured loan) - interest rates would drop by more than half, fees would be reduced to nearly nothing and most reporting requirement would disappear.

Thus, it does not make much sense to obtain an unsecured loan to purchase hard assets like equipment or other needed durable goods as you would surely be overpaying for those assets.

Let's look at an example:

Your business needs $100,000 in funding - 50% for working capital and 50% for equipment and machinery.

You go down to your bank and ask for an unsecured $100,000 SBA loan and get approved at 18% interest (variable - but we will assume that it does not change for the life of this loan) for 6 years to include a 1.5% bank fee and a 3% SBA fees. You hold this note for the entire 6 years and pay the balance to zero - subtracting out the original balance - your cost of obtaining and servicing that loan is:

Fees:

   1.5%      $1,500
   3.0%      $3,000

Interest: 18%    $64,216 - provided that the rate does not change.

Total cost of loan: $68,716

This scenario does not take into account the reporting requirements and their expense that your business would have had realized over the life of this loan - requirements that could easily include another 5% to 10% in overall loan costs.

Now, let's say that you broke down these funding requirements based on need. Therefore, you only need $50,000 in working capital and $50,000 in an equipment loan - let's look at these costs.

Trying to keep this comparison as close as possible - let's assume that you still pursue a SBA loan for the $50,000 in working capital - however, keep in mind that at a lesser amount being requested - there are other means of obtaining the $50,000 - other than a SBA guaranteed loan - i.e. your bank may do it themselves without the SBA guarantee or there are many non-bank lenders that would easily provide this amount of funding - by cutting out the SBA - you reduce your overall expenses via less fees and reporting requirement expenses.

Since this loan is for a lesser amount, the risk to the bank and SBA are reduced - thus your interest rate is set at 13% for the 6 years with all fees remaining the same.

For the equipment - you find a non-bank equipment lender that loves to work with start ups and approves funding for the $50,000. Since this loan is secured by the equipment, you are only charged an interest rate of 9% for the 6 years (life of the equipment). Additionally, this lender only charges a 1% fee and does not have any reporting requirements.

Under this scenario, your total cost of these loans would be:

Working Capital Loan:

Fees:

   1.5%      $   750
   3.0%      $1,500

Interest: 13%    $22,267

Equipment Loan:

Fees:

   1.5%      $   500

Interest: 18%    $14,892

Total cost of loans: $39,909

A total and complete savings for your business - money that can be plowed back into the company for growth and development or taken out for the owners benefits - of a whopping $28,807 or 42% over the all inclusive, single loan.

The goal in any business financing endeavor is to ensure that you are getting the best deal for you and your business. Saving nearly $29,000 in interest and fees by merely seeking loans based on need or attempting to secure those loans with business assets is great business financial management.

There are many non-bank equipment lenders that deal only in equipment loans and love to work with start-up companies or small businesses. They have great programs that offer better rates and terms. Your bank is not your only method of financing your new, growing business. It really does pay to shop around!

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