Having a small business with bad credit and unable to find working capital, cash flow needs can be the biggest nightmare for any small business owners. Factoring companies understand the pain of not having good credit when business is struggling for cash flow and working capital.
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 weak 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 this 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 indeed not immune to 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 bring on excellent credit to finance his vision traditionally as he had no credit history to speak of at the time.
What is the 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 easy to understand the process. This method converts 30-90 day old accounts receivable into cash now. Besides the immediate liquidity, A/R 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 get the payment upfront. These variables include:
- The age of the receivable—newer receivables tends 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 receive payment.
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 is when your client does not yet receive the payment of the invoice on a specific date, the Factoring Company can charge that invoice back to you. However, you can have the option to replace that invoice with another good invoice. In some ways, recourse factoring 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.
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 specific 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 also do not have protection if your clients pay slower than usual. 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 companies, cash flow problems exist. There will be times where there is 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 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 will diminish. Groups that considered giving that company their business will likely think twice. Therefore, to avoid such scenarios, it is imperative that companies 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 its 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 more comfortable 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 companies and those with average credit.
Small Business Administration (SBA) Loans
The Small Business Administration (SBA) was founded in 1953 by Dwight Eisenhower. However, its roots go back to the Reconstruction Finance Corporation (RFC) of the Herbert Hoover administration. The SBA was initially 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 — therefore making this 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
Several small parties dating back to the 18th century has been practicing microfinancing. 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. Friedrich Wilhelm Raiffeisen also 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 capital to dole out minimal 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. Yunus was able to receive the Nobel Peace Prize in 2006. Such an award is 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 is hovering between 10-15%–a relatively 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, you can use microloans 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. Additionally, entrepreneurs can finance early-stage operations without having to resort to venture capital or traditional bank financing. While challenging, this approach allows entrepreneurs to retain the complete control of their process in the early formative stages. Thus, it allows for the execution of the specific entrepreneurial vision. Forbes recently ran down the eight most essential 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 indeed tradeoffs; many government grants can’t be for covering startup costs or daily expenses. But if your small business is run by women and gives focus 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 daily, and this affects entrepreneurs. Whereas lousy 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. Aside from that, this will help alleviate any looming liquidity crisis. These options represent costs, benefits, and tradeoffs. However, ensure to do your homework on each one and choose the best strategic fit for your small business needs.