When Eric Estoos decided it was time to move his cloud computing company out of his basement in 2010, he needed financing but wasn’t willing to relinquish any ownership or give away equity.
“I was able to establish a lot of momentum on my own, but I was getting to the point that 95% of my time was running the day-to-day operations and I couldn’t focus on sales,” he said.
Estoos didn’t want a traditional bank loan or to approach venture capitalists, so he started looking at alternative financing.
“I started knocking on doors at angel investors, I was looking for different options to procure some capital, but I didn’t want to give up half my equity to an angel investor. I was really just trying to beat the bushes in terms of what is out there,” Estoos said.
While flipping through a business magazine, he came across revenue-based financing company Lighter Capital in Seattle and was intrigued.
“Their payback horizon was 24-36 months, they weren’t looking to make their money back next month,” he said. “They were willing to commit and focused on what I was doing long term.”
Instead of a fixed-interest payment every month – which is required from traditional bank loans -- revenue-based funding (RBF) sets a fixed percentage, usually around 3-5%, of revenue as a fee paid to the lender until the loan is repaid.
The practice isn’t new and was traditionally used in the pharmaceutical and entertainment industries. But since the 2008 financial collapse that froze credit markets that have yet to fully thaw, more start ups and small businesses are looking for alternative funding methods.
Most RBF loans are between $50,000 to $250,000, and according to BJ Lackland, CEO of Lighter Capital, most of his clients have their money with a week after filling out an application.
“They now have debt outstanding that they need to pay back and until it’s paid back, a percentage of their revenue is going to go like a royalty stream to us. Effectively, we are the investor in the company,” Lackland said. “Instead of taking equity as a bank would, or take a personal guarantee, we are taking a percentage of revenue for a period of time until they pay us back.”
Estoos received $100,000 initially in revenue-based funding from Lighter Capital and reports his sales are up 260% since the first loan. “We’ve been able to double staff, we’ve moved into a 3,000-square foot office, we are now truly a functioning company. I’ve gone from chief doer to managing departments. We’ve been able to develop a customer management system to manage our growth…we are now able to position ourselves to take that next leg up.”
But not all businesses sell a product that creates a steady revenue stream they can tap for loans. Take Towan Isom, CEO of Isom Global Strategies, a Washington, D.C.-based marketing and management firm that specializes in corporate conference and event planning. She works on a contractual basis and most of her work is with the federal government (her largest client is FEMA) but she also works with Nike (NYSE:NKE) and ITT Defense.
Her contract pool saw much growth last year, good news for her business, but tough on cash flow since payment tends to come after the work is complete.
“[Conferences] are large output of cash initially. When dealing with hotels, you have to put out literally $50,000 to book a block,” Isom said.
To meet her working capital needs, Isom turned to factoring, which involves a third-party buying a company’s invoices – for a fee -- and providing a cash advance based on the unpaid bills. Factoring companies tend to advance about 70-90% of an accounts receivable. Once a deal is struck, companies can have their money within a couple days.
“Right now factoring is a big part of the trying to pull the economy back together, we are fulfilling a need that allows companies to access working capital, where they have been stuck in certain situations without any access to capital,” said Gary Honig, president of factoring company Creative Capital Associates (which funded Isom’s business).
He explained that his company’s fees are based on customer’s credit and volume of invoicing.
“If you are funding $1 million a month, you are going to get one type of fee. If you [fund] $10,000 a month, you are going to get another type of fee,” Honig said. “The more volume, the lower the fee.”
Just like revenue-based funding, factoring is a more expensive way to secure a loan.
“For us, factoring is factoring is a better way to get the cash quicker and respond faster to help your clients, the perspective for us is to be able to respond faster to our client needs and for us, that 1-2% fee that we pay is worth it, “ he said. ”It also comes down to how well you negotiate.”
Second-tier financing options are more expensive than traditional loans and experts warn small business owners research a company and compare lending terms before signing a deal.
“Always look at the most low cost way,” said Bill Dunkelberg, chief economist for the NFIB. “Take into account your time, interest rates and fees. You are going to find the best credit plans and loans will be in the banks, then credit unions. Pledging revenues and all other kinds of things are going to be more expensive, so you must prepare for that.”
Before working with a lender, Charles Green, advisor to the financial service industry, recommends business owners analyze their books and know their sales numbers.
“Many of them don’t know their real gross margin, how much money are they really making on every sale,” Green said. “If you are making a 40% profit and paying out 36% option to finance, you are never going to get ahead and make solid money.”
According to Isom, her company has been growing 10% annually the last two years, and she plans to hold steady when she hits 250 employees. While she doesn’t plan to use factoring long term, for right now, it gives her a piece of mind that she has enough money in the bank.
“Once we get to the point where our books … where we are looking at a profit of 10% and we have a certain amount of money in the bank where we feel comfortable , for us right now that is a million dollars, then we will phase off the factoring.”
A strategy applauded even by those doing the factoring.
“Factoring should be seen as a bridge, a tool to get to institutional financing, and we are more than happy to have a client of ours graduate a get a bank loan, that is really the idea,” said Honig.