Financial Capital: 5 Broad Financing Options for Middle Market Firms
While a middle market company has many critical relationships, such as those with customers, suppliers, and employees, its relationship with its financial capital providers may be the most important of all.
Credit can be the lifeblood of expanding businesses, allowing for investment in new projects, the purchase of needed equipment, and more. Since the credit crunch beginning in 2007-08, banks have increasingly tightened their commercial lending standards and credit has become more difficult to obtain and more expensive, with higher interest rates and more demand for collateral. According to a National Center for the Middle Market survey, "54 percent of middle market companies said one of their key challenges was gaining access to financing."
Alternative financing, in combination with bank financing or through combining different sources of nonbank financing, may be your best bet in getting your growth projects and equipment purchases off the ground. In fact, the same NCMM survey said that over one-third of middle market companies use nonbank sources of financial capital for their business.
Here are five alternative financing sources that you should consider.
- Factoring. Factoring is a traditional form of nonbank finance used by retail companies, among others. You simply transfer your accounts receivable to a third party, also known as a factor, in exchange for cash. Of course, the factor won't give you back 100 percent of the value of your accounts receivable but will discount the value, perhaps to 80 percent of face value, depending on the agreement and the payment history of your customers. About 20 percent is kept in reserve, depending upon the final payment from customers. Obviously, factoring provides cash flow to your middle market company, but there are also risks, as with any relationship. When you select a factor, due diligence is important, as is scrutinizing all agreements for risk.
- Peer-to-peer lending. Peer-to-peer lending is growing, especially online. It may include friends or strangers interested in your business. More likely, it's an online source of crowdfunding from websites such as prosper.com, peer-lend.com, or kickstarter.com. Go to one of these sites, post the project or purchase that you're seeking funding for, and then visitors to the site can offer you financing on various terms. Of course, there may be limits on the size of the funding request or the type of project that the crowd seeks to fund. You'll need to research these issues carefully beforehand, but crowdfunding is a trend that isn't going away.
- Asset-backed financing. These are loans or instruments (such as convertible debt instruments) that are backed by your assets, which may also give the lender the right to convert the debt into equity under certain conditions. One of the benefits of asset-backed financing is that the lender has more security and less risk, which may enable them to provide financing under conditions that are more advantageous to you. The drawback is the potential loss of equity in the future; the relationship could potentially turn into an unwanted, creeping partnership. There are other kinds of asset-based financing that uses your equipment as collateral. The NCMM survey summarizes the potential benefits and risks: "Asset-based financing can be cost-effective because the loans are secured by specific assets; but [if you] miss some payments, equipment that is critical to the operations of your company may be repossessed."
- Finance companies and insurance companies. These are, according to the NCMM survey, "the most important sources of nonbank financing, whether measured by total sums provided or by frequency of use." Some insurance companies have direct lending programs that aren't so different from commercial banks' programs. Finance companies have a wide array of types and methods, sometimes specializing in equipment purchases or other transactions. Research these options carefully.
- Hedge funds, venture capital funds, and private equity funds. These are becoming increasingly important sources of credit for middle market firms. You will have more flexibility in defining the relationship than with bank lenders, but you'll also need to pitch the value of the project/purchase that you require funding for and have a more free-flowing negotiation of funding terms. The good news is that the access to funds may be quick and the credit availability large. But again, you need to take care of messy relationship issues and equity-sharing arrangements that may arise during the negotiation and the life of the loan. While these three sources of capital may be more comfortable funding a higher-risk project, they may also expect more return on investment.
Boston-based Chuck Leddy is an NCMM contributor and a freelance reporter who contributes regularly to The Boston Globe and Harvard Gazette. He also trains Fortune 500 executives in business-communication skills as an instructor for EF Education. Circle him on Google+.