The Basics of Alternative and Nonbank Financing

The good news is that despite the dismal credit environment, there are many nonbank financing options available to companies that need a cash infusion, whether to beef up working capital or help facilitate growth.

The bad news is that business owners often shy away from nonbank financing because they don’t understand it. Most automatically rely on their banker for financial information, and many bankers (not surprisingly) have only limited experience with options beyond those offered by the bank.

To help ease the fear that entrepreneurs often have of alternative financing, here’s a primer on the most common types of nonbank financing.

• Full-service factoring: If a business has financial challenges, full-service factoring could be a solution. Factoring means a business enters into an agreement to sell its outstanding receivables on an ongoing basis to a commercial finance company (also referred to as a factoring company) at a discount -- typically between 2 percent and 4 percent. Then the factoring company manages the receivables until they’re paid. If they’re not paid, that’s the factor’s problem. This can be a useful source of cash when a traditional line of credit is simply not available.
• Spot factoring: Here, a business can sell just one of its invoices to a factoring company, without any long-running commitment to minimum volumes or terms. It sounds like a good solution, but it should be used sparingly. Spot factoring is typically more expensive than full-service factoring -- the discount is usually in the 5 percent to 8 percent range -- and often involves extensive controls. In most cases it does not solve the underlying problem: lack of working capital.
• Accounts receivable financing: A/R financing is a good solution for companies that are not yet bankable but do have good financial statements and need more money than a traditional lender will provide. The business must submit all of its invoices to the A/R finance company and pay a collateral management fee of 1 percent to 2 percent to have them professionally managed. A borrowing base is calculated daily and, when funds are requested, an interest rate of prime plus 1 to 5 points is applied. If and when the company becomes bankable, this arrangement is fairly easy to transition to a traditional bank line of credit.
• Asset-based lending: This is a facility secured by all the assets of a company, including accounts receivable, equipment, real estate, and inventory. It’s one alternative for companies with the right mix of assets and a need for at least $1 million. The business continues to manage and collect its own receivables but submits an aging report each month to the ABL company, which reviews and periodically audits the reports. Fees and interest make this product more expensive than traditional bank financing, but in many cases it provides access to more capital. In the right situation, this can be a very fair trade-off.
• Purchase order financing: This is ideal for a business that has purchase orders but lacks the supplier credit it needs to fill them. The business must be able to demonstrate a history of completing orders and the account debtor placing the order must be financially strong. In most cases, a PO finance company requires the involvement of a factor or asset-based lender in the transaction. PO financing is a high-risk kind of financing, so the costs are usually very high and the due diligence required is quite intense.

The message I am trying to convey is simply that “financially challenged” business owners should not be afraid to consider alternative or nonbank financing options. It’s a fairly simple matter to learn what they are, how much they cost, and how they work. Alternative financing is a much better option than facing the challenges of growth or turnaround alone. It is a known fact that the vast majority of business failures are due to a lack of working capital, but it doesn’t have to be that way.

With a more complete understanding of these different types of nonbank financing, you’ll be in a better position to decide if they might be the answer to your financing challenges.

Tom Klausen is senior vice president of First Vancouver Finance, which has offices in Vancouver and Toronto. FVF provides creative financing solutions to small and mid-size businesses across Canada.