The Cost of Business Financing

There is a tremendous amount of talk surrounding government bailouts and stimulus funding from TARP money for banks and financial institutions to specific stimulus grants for industries likes the Recreational Vehicle Manufacturers and Clean Tech.

This noise is very confusing to many current or potential business owners. Many feel that if these groups or industries can get free money or low cost funds then why not them. Thus, they begin looking for financing options that appear to have similar features like those of the bailouts or the stimulus provisions. I guess it never hurts to look.

There is an old saying, if it sounds too good to be true, it probably is. Nothing in this world is free - especially when it comes to business. In fact, businesses usually pay more than consuming individuals for the same products or services. Just look at the Airline Industry. Fly during the week and your price is higher as most of the passages are business travelers. Fly over the weekend (which most business travelers will not do) and the price drops.

Just keep two topics in mind when seeking to finance your business: 1) 99.9% of all businesses in this country will never receive any type of bailout or free money and this usually means that your business is included in the 99.9%. And 2) everything costs something - especially when financing your business.

There is a cost to all financing - no matter what type or what you get told by the sales person and those costs come in many forms and usually in combination. For example:

Traditional business loans usually require some type of fee at origination or funding, then include the interest charges (all costs to your business). Further, many traditional business loans come with indirect costs like continued reporting to the lender (takes time and money to report) as well as limitations on the use of funds or even the use of business assets (while these are meant to protect the lender - think covenants, restrictions and blanket liens - they also can restrict the business in being flexible when new opportunities arise); again costing the business future profits.

Private equity - venture capital or angel capital is costly in the fact that the business owner 1) has to give up a portion of the company (sometimes a very large portion) - meaning that future growth and profits now belong to someone else and 2) lose control of the direction of the business. Instead of growing your company strategically for long-term benefit and profits, most investors want the biggest pop in the shortest term and will seek to change a company's philosophy to ensure this happens even at the expense of sound long-term financial policy - then they get out - many times leaving the company reeling.

Asset based lending. While many of these programs have benefits in the form of only encumbering a single or set of assets like accounts receivables or credit card receipts and many times provide funding to businesses that have been turned down for other financing options, these types of funding programs do come with high costs (mostly related to the fact that the business cannot get financing elsewhere).

These types of loans or advances can be confusing as their costs are not laid out like traditional loans in the form of a variable or fixed interest rate. Most of these programs call their costs fees and make them very hard to compare to traditional loan products.

Take for example accounts receivable factoring. A Factor might quote a rate of 4% for 30 days. But, what does this mean? Is this an annual rate of 48% (4% times 12 months) or something entirely different? Most factoring fees are set based on a per diem (daily) rate or per 30 day rate. Daily rates or monthly rate can be very confusing to borrowers who are only familiar with Annual Percentage Rates (APR).

The bottom line here is simple. All financing costs something and it is really up to the business owners to understand those costs and be able to relate them to each other when comparing options. But, it does not end there. Any time that a business is seeking financing it first has to understand what the benefits are that it hopes to achieve.

It can be OK to pay high fees and interest for business capital when the opportunity being pursed far out weighs those costs. Example, your business has an opportunity to purchase a new machine for $100,000 that will increase your business two fold. Your business currently makes approximately $4,000 a month in profit and this machine will increase that to $8,000 per month for the life of the machine (let's say five years). Your business has been turned down by its bank and other financial institutions simply because they are not lending to small businesses.

Your only other option is a non-bank equipment lender who charges the following: A variable rate (prime plus some factor) that relates to approximately 18% in the current market, an up front fee of say 2% of the loan amount or $2,000 and monthly reporting and valuation of your company and the asset that relates to about $200 per month.

Under this scenario, if your business chooses to take this loan - after five years, it would have paid back the original $100,000 plus an additional $66,000 ($52K in interest, the up front fee and the monthly maintenance and reporting costs) - relating to a total cost of 66% of the original loan amount. While this is extremely high - is it worth the risk?

If your business can increase its profit by $4,000 per month for 5 years (the life of the machine) it stands to earn some $240,000 during that period. Subtract out the costs of $166,000) and the business is left with a present value of $74,000 - $74,000 over 5 years that the business would not have had if it did not take the loan. Negating the time value of money, this business could see its interest rate increase up to over 38% before this opportunity costs more than it brings in.

The questions that remains are can the business actually double its profits each month, will the prime rate increase dramatically in the next 60 months - both items outside the control of the lender - and does the business owner have other opportunities that can make even more money for the same costs (if so, then those other opportunities should be taken first).

While financing a business can be extremely confusing and costly, if the outcome is profitable (brings in more than it costs) then the financing because secondary in nature to the overall benefit (which differentiates itself from consumer financing). The bottom line is not to get stuck by only one factor of the deal (the financing) but to put on a financial hat and look at all aspects - the benefits as well as the costs.

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