At very minimum, 30% of Americans have poor credit. If you are sitting in between two people, look to your left, and then a look to your right. Odds are, one of you has a poor credit report following you around or no credit at all!
Even worse, according to a recent report from the Corporation for Enterprise Development, it is possible that Americans have even worse credit than previously believed. Per their latest report on citizens being excluded from the financial mainstream, 56% of consumers have subprime credit scores. More troubling, many Americans have no idea why their credit scores are so low, or how poor credit can impact their daily life. The numbers looked grim in a recent LA Times piece:
- One-quarter of Americans—23%, more specifically—did not know that their ability to rent an apartment hinged at least marginally on their credit report.
- 45% did not realize poor credit scores can cause them to pay more for car insurance.
- Half—49%–of Americans did not know that a bad credit rating can limit their mobile phone service options.
- Over half did not understand that bad credit scores can even raise the amounts they pay on utility deposits.
The startup world is certainly not immune from this information gap. Entrepreneurs can bring incredible vision, planning, and strategy to the table, but a few missed bills three years beforehand or issues paying down a car note can spell trouble for their ability to finance their operations. You shouldn’t feel shame if you find yourself in this situation; when Sir Richard Branson started up a little store called Virgin Records a few decades ago, he drew on personal savings and bootstrapped with friends and relatives to pay those early bills. He certainly couldn’t draw on excellent credit to finance his vision traditionally as he had no credit history to speak of at the time.What is an owner of a burgeoning business to do when faced with these obstacles to traditional bank financing? Several strategies, such as accounts receivable factoring, PO Funding, SBA loans, SBA microloans, bootstrapping, and business grants offer small business owners an ability to fund critical business needs, such as equipment, more people, and inventory.
Accounts Receivable Factoring
Financing using your accounts receivable is an easy to understand the process. This method converts 30-90 day old accounts receivable into cash now. Besides the immediate liquidity, AR credit protection and collection services are outsourced saving an entrepreneur both time and money.
While accounts receivable factoring terms will differ from different factoring companies, they typically involve a factoring company paying between 80-90% of face value of accounts receivable to the company. After your company’s customer pays the factoring company’s lockbox, you will receive the reserved amount of 10-20% minus the factoring fees.
If you are considering utilizing accounts receivable factoring to finance your operations, keep in mind that several variables will impact the percentage of the receivable you will be paid upfront. These variables include:
- The age of the receivable—newer receivables tend to be more valuable.
- The size of the company charged with the receivable—larger, more established companies tends to be considered a more valuable receivable account than smaller, less established companies.
- Dilution History-what percentage of your invoices do not get paid.
Broadly speaking, the higher the likelihood of repayment, the more valuable the receivable will be to factoring firms.
Non-Recourse versus Recourse Accounts Receivable Factoring
A component of receivables factoring that is crucial to understand is non-recourse vs recourse. There is a great deal of information on the Internet about recourse vs non-recourse factoring. Much of it is wrong. When choosing a Factoring Company it is best that you understand what you are being offered.
Recourse Factoring: This means that if the invoice is not paid by your client by a certain date, the Factoring Company can charge that invoice back to you or you can replace that invoice with another good invoice. In some ways, this is similar to a line of credit from a bank with a borrowing base as one of the loan requirements. If an invoice becomes unpaid for example, longer than 90 days a bank won’t let you borrow against it or a factor will ask you to replace either the advanced funds or give them another good unfunded invoice.
Non-Recourse Factoring: The Factoring Company gives you a credit guarantee that they are responsible for the collection of your invoices. It might be all your invoices or just those from certain clients. Typically this guarantee is in case your client files for bankruptcy. This is a critical point to understand that it is not a guarantee that you are protected for good or services that your client disputes for not meeting specifications. You are also not protected if your clients pay slower than normal. However, this “insurance policy” against bankruptcy is critical for your survival. Linen’s n Thing’s, Circuit City, FAO Schwartz, Adelphia, Delta Airlines- all examples of companies that filed bankruptcy that were once thriving companies.
Purchase Order Financing
Purchase order financing is a funding option for businesses that need cash to fill single or multiple customer orders. In many businesses, cash flow problems exist. There will be times where there is simply not enough money available to cover the costs of doing business. As a result, there may be an order from a client that isn’t able to be fulfilled due to a lack of cash. A company may not be able to afford the supplies necessary to meet the client’s particular needs. Having to turn the order down would obviously mean a loss of revenue and perhaps even a tarnished reputation.
If word gets around that a company is turning away business because they can’t afford to complete jobs, customer trust is diminished. Groups that considered giving that company their business will likely think twice. Therefore, to avoid such scenarios, it is imperative that businesses find the money that they need. For some companies, purchase order financing is a great way to go.
Purchase order financing involves one company paying the supplier of another company, for goods that have been ordered to fulfill a job for a customer. This is an advance and may not be for the entire amount of the supplies, but it will cover a large portion of it. In some cases, companies can qualify for 100% financing. The purchase order finance company will then collect the invoice from the end customer. The purchase order finance company makes their money by charging the company in need of funds various fees. These fees are taken out of the collected invoice. The remaining amount is returned to the company.
A second option is for the purchase order financing company to open up a line of credit with the supplier. The line of credit will be opened in their name and backed by them. This allows businesses with poor credit or few assets to get the supplies that they need.
Purchase order financing can be quite advantageous. It is pretty easy to qualify for and much easier than bank financing. Also, it does not require a company to have stellar credit. What is important is the creditworthiness of the client who has created the purchase order. If this person has a strong credit history, then purchase order financing is pretty easy. Many companies will require that the client be a commercial one or a government agency. There might also be other requirements. For example, the company may need to be profitable or earn so much in sales each month. The requirements will likely differ based on the financier.
Unlike bank financing lenders, purchase order financing hinges mostly on the financial strength and creditworthiness of the company who has placed an order with a particular business, and not on the business itself. This makes it a viable option for new businesses and those with average credit.
Small Business Administration (SBA) Loans
The Small Business Administration (SBA) was founded in 1953 by Dwight Eisenhower, but its roots go back to the Reconstruction Finance Corporation (RFC) of the Herbert Hoover administration. The SBA was originally conceived to “counsel, aid, protect and assist, insofar as possible, the interests of small business concerns.” As such, the SBA offers guarantees to certain small businesses to help finance investments and operations.
The SBA 7(a) Loan Program is the most popular guarantee program utilized by small businesses and startups alike. The program was specifically designed to aid small businesses that lack access to more traditional methods of financing, and therefore is often an ideal choice for proprietors with low credit scores.
According to the SBA 7(a) Loan Program regulations, you are eligible for financing consideration if you can demonstrate a need for funds, a sound business plan, an operation for profit, reasonable equity to invest, and meet the SBA size standards for your specific industry.
If approved, you can receive up to $5 million in loans to fund various startup costs. Most firms utilize this to finance equipment purchases, but these funds can also be used to purchase new land, repair existing capital or equipment, purchase or expand an existing business, or refinance existing debt.
While the Small Business Administration doesn’t lend out funds directly from the agency, they offer a guarantee to banks to help induce lending to small businesses. Furthermore, there are additional specialized programs within the structure to target firms that are:
- Focused on exporting
- Located in underserved communities
- Employ members of the military community
- Looking to meet short-term or cyclical liquidity needs
Microfinancing was practiced by several small parties dating back to the 18th century; Jonathan Swift utilized the concept to create the Irish Loan Funds in the 18th century, Lysander Spooner obsessed over the concept in the 19th century as a tool to spur entrepreneurship and alleviate regional poverty, and Friedrich Wilhelm Raiffeisen applied it to a cooperative of banks centered on financing farming in rural Germany.
By all accounts, the first fully commercialized version of the practice came about in Bangladesh in the 1980s. Muhammad Yunus founded Grameen Bank on the foundation of using his own capital to dole out very small investments to poor entrepreneurs at low-interest rates. As Yunus’s efforts and ideas began to spread, microfinancing reached Latin America and additional areas of the developing world rapidly. It’s now a full-blown industry, and Yunus was awarded the Nobel Peace Prize in 2006 for his role in alleviating poverty and introducing sound entrepreneurial practices to the working poor.
By 2009, the microfinancing industry had reached a new peak of $38 billion globally. Though growth has decelerated to an extent, the industry still expects annual growth hovering between 10-15%–a fairly robust growth rate for a moderately mature industry.
On its face, the practice makes a considerable amount of sense. Plenty of entrepreneurs lacks both the access to traditional financing mechanisms as well as a community of middle-class benefactors who can provide angel investments of varying amounts. As such, microloans can be used to fund early investments in entrepreneurship from traditionally underserved and disadvantaged communities. To that end, firms like BancoSol, WWB, and Pro Mujer target microloans to female-owned businesses. Lest the lack of credit history fools you, these microloans tend to be good business in addition to good ethics—they boast a repayment rate of 95-98%.
Bootstrapping and Grants
Finally, never forget to pursue all that delicious low hanging fruit. As any entry-level business school course will teach you, bootstrap, bootstrap, and then bootstrap some more. By working up a small but significant pool of personal savings, intensely focusing on controlling costs, and leveraging early revenue returns, entrepreneurs can finance early-stage operations without having to resort to venture capital or traditional bank financing. While difficult, this approach allows entrepreneurs to retain utmost control of their operation in the formative early stages, thus allowing for the execution of the specific entrepreneurial vision. Forbes recently ran down the 8 most important benefits of bootstrapping, which include:
- Creative freedom
- Improved products
- Matching risk to reward
- Smarter decision-making
Grants can also serve as the other side of the low hanging fruit coin. Many entrepreneurs forget to look into the public (or, at times, private) grant side of financing their operation, but the world of business grants can offer excellent financing terms—particularly if the small business is operated by women. There are certainly tradeoffs; many government grants can’t be used to cover startup costs or daily expenses. But if your small business is run by women and focused on specific purposes that need financing, don’t forget to check out potential grants. A comprehensive list to start from includes:
- InnovateHER Challenge
- Small Business Innovation Research and Small Business Technology Transfer programs
- Women’s Business Centers
- Economic Development Agencies
- Small Business Development Centers
- Amber Grant
- Eileen Fisher Women-Owned Business Grant
- FedEx Small Business Grant
- Mission Main Street Grants
Parting Thoughts on Bad Credit and Business Loans
Americans fall into the trap of bad credit on a daily basis, and entrepreneurs are affected by this. Whereas bad credit for consumers can impact their ability to finance potentially optional personal consumption, low credit scores for entrepreneurs can create significant liquidity crunches and threaten ongoing operations. If you find yourself in this scenario, don’t panic.
There are a significant amount of options for you to consider depending on your needs. Small Business Administration loans, accounts receivable factoring, microfinancing, bootstrapping, and grants all represent potential avenues to meet your financing needs and alleviate any looming liquidity crisis. These options represent costs, benefits, and tradeoffs, however, so make sure to do your homework on each one and choose the best strategic fit for your small business needs.