Published March 03, 2011
After years of tight credit, funding is beginning to trickle back into small business.
Unfortunately, that trickle won’t necessarily reach everyone. If you’ve had past credit issues, for instance, conventional funding may be almost impossible to obtain. Or you could be an entrepreneur with an idea that banks won't touch with a 10-foot credit line.
The good news is that investment firms, websites and other resources offer a variety of alternative funding sources. Here are three that may be new to you.
With royalty lending, financing is granted in return for future revenue. Rather than a fixed payment plan, loan repayment is based on company performance. That, says Heather Onstott of LaunchCapital, a Cambridge, Massachusetts, debt and equity financing firm, makes royalty lending ideal for seasonal companies and others with unpredictable revenue streams.
Another plus is the absence of equity share or other stakes in the company. "This allows the entrepreneur to keep 100 percent of his or her company," says Onstott.
On the downside, royalty lending is pure debt. That can prove to be a long-term drag on cash flow. And since the loan is tied to company performance, success may be your own worst enemy, as payback can prove exceedingly expensive if a company flourishes.
"Although the repayment is typically capped, the effective rate can exceed 30 percent over time," says Onstott. "Mitigate this by ensuring that the business you fund has a greater potential return to you than what you pay your investor."
As the name implies, crowdfunding is a funding option designed to link small businesses and entrepreneurs with pools of prospective investors. Accessible through a number of websites, crowdfunding allows entrepreneurs to present their businesses or ideas to community members who are looking to provide financial backing but typically aren’t professional investors.
Crowdfunding is similar to peer-to-peer funding in that lenders and borrowers come together through nontraditional venues. But while peer-to-peer lenders participate for a return on their money, crowdfunding lenders are often repaid with goods or services. That can make it ideal for business owners who are looking for an inexpensive funding source.
The major caveat: It may be cheap, but don't expect crowdfunding to be a cash cow.
"This funding model is best for smaller capital needs, such as $25,000 or less, so it's not a good model for raising more substantial sums," says Sally Outlaw of peerbackers.com, a crowdfunding website. "And to be successful, they really have to shake that money tree and get out there and stay in front of their social circle."
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If you've got a healthy investment portfolio but your small business or idea scares off conventional funders, stock loans may be an option worth considering — although there are some risks that warrant attention.
In a nutshell, a stock loan is based on the quality of stocks, Treasuries and other kinds of investments in a businessperson's personal portfolio. For instance, an investor may lend up to 85 percent of the value of a high-quality portfolio — that means stocks or other investments that are relatively stable in price, but also liquid (attracting a lot of buying and selling activity).
One of the biggest pluses of stock loans is that they're relatively easy to obtain. Since the quality of the portfolio determines eligibility, there are no credit checks necessary, no requirement of cash flow or profitability, and no submission of financial statements.
"The business can be in terrible condition but if the stocks are good quality, the loan will be approved," says Stu Lustman, managing director of Southern Lending Solutions in Atlanta. "Funding is quick — usually within three weeks — interest rates are low, and payments are interest only."
Although stock funding seems similar to borrowing on margin, one difference crops up if the portfolio suffers a significant price drop. With margin loans, the investor has to make up the difference. But with stock loans, a business owner has the option of simply giving up the stock and not paying back the loan at all.
"If a client walks away from the loan, they understand they sacrifice the collateral — and that's it," says John Dumonceaux, president of Custom Commercial Finance in Bartlesville, Oklahoma. "There isn't even a negative effect on a person’s credit score."
While simply giving up stock may or may not be a downside, one decided drawback to stock loans is that possession of the stock is transferred to the lender's custodial bank during the loan period. In effect, you lose control of the stock. Additionally, transferring the stock may carry tax ramifications.
Alternative funding sources may prove a lifesaver for small businesses in need, but don't be a kid in a candy store. Make certain that the expense of the funding is more than offset by your eventual return. "As with any funding, it pays to do your homework — read carefully what you are getting and at what cost, and ensure that your project returns exceed the cost of your funding," says Onstott.
Jeff Wuorio is a veteran freelance writer and author based in southern Maine. He writes about small-business management, marketing and technology issues.