Typically entrepreneurs (and their investors) view capital sources in two camps: equity-based and debt-based. Many entrepreneurs barely have their business idea on paper before they explore giving away equity in exchange for capital (think Shark Tank) or take on debt before they’ve established revenue.
Special thanks to Lara Hodgson and John Hayes of NOW Corp who are investing in ways to help small businesses free up their existing capital. While having an impassioned conversation with Hodgson about the opportunities that exist by using ‘revenue’ as a source of capital, she shared an analysis with me outlining capital source types. She suggests that there are in fact 4 sources of capital: equity, debt, grants and sales/revenue.
Equity as a source of Capital
There are 3 types of equity for funding operations: Public Equity, External Private Equity and Internal Equity. Public equity or securities include IPOs and crowdfunding efforts. The stakes are high, the reporting and regulatory requirements are higher. External private equity is capital raised from angels, VCs and institutional private equity. These forms of capital ideally come with business advisory support because the cost of this capital is high and the investment in keeping these investors informed or integrated is time intensive. Internal equity is owner’s equity or retained earnings that sometimes ends up attached to debt instruments in the form of guarantees. Equity is a high cost, high risk and high maintenance form of raising capital and it is not for the novice.
Debt as a source of Capital
Some entrepreneurs who aren’t prepared to venture into equity capital—and frankly may not need to if the funding sought is under $200,000—seem happy to take on debt as a necessary element of growth. Debt includes commercial and industrial loans/leasing, real estate and unsecured debt. There isn’t room here to go into every form of debt, but you probably read most in the business press about Commercial & Industrial Lending. C&I lending is any loan to a business not secured with real estate. Few of us have commercial real estate sitting around to use as collateral and so we assume debt with other asset-based lending (ABL). While we may find lenders that offer unsecured loans, typically we secure our debts with receivables or inventory. These capital sources include leases (where the equipment is the collateral), factoring (where loans are secured by the receivables themselves), receivables discounting (also called ‘recourse factoring’ where the small business still maintains the liability for non-payment) or a Merchant Cash Advance.
I previously viewed factoring and merchant cash advances as safe, ready cash until Hodgson pointed out an interesting flaw in the model that can negatively impact an entrepreneur’s ability to grow with this form of financing. As business owners we regard our receivables as assets of the business, but in factoring and merchant cash advances, those transactions are classed as liabilities. This means that while you may get your hands on that cash quickly, your balance sheet isn’t really pretty because you’ve just taken your receivables asset and booked it as debt. You’re not showing any balance sheet progress. While you may have cash for operations, your financial position looks no better and you likely won’t qualify to assume other loans or debt. This is a critical distinction to Hodgson. Having the cash you need for today’s operations doesn’t help you secure the financing you need for tomorrow’s operations. I don’t know any entrepreneur in business to run a revenue flat operation…they want to grow. It takes capital to grow and so a funding solution that only enables you to acquire the capital you need to stay where you are today is not a growth solution.
Grants as a source of Capital
Most people think of non-profits when they think of grants, but the truth is there are grants available in sectors that are critical to our economy or national interests. Think of the growth in the healthcare sector as regulations have taken hold and innovation is being incentivized. There is a wealth of information on Federal grants available to small businesses on the Small Business Administration (SBA) website. In my own state of Georgia, we have several high-growth workforce development initiatives that are accompanied by grant opportunities. I recommend doing some research on your state or industry’s mission-critical economic drivers and see if you may be missing out on potential grants.
Revenue as a source of Capital
Finally, there is the category of cash equivalents or near-cash equivalents. Cash equivalents include accepting checks or electronic funds transfers. Near-cash equivalents include merchant services such as accepting business credit cards for payment. A new category of near-cash equivalent (or revenue accelerators, as NOW Corp refers to its NOWaccount) is a payment service that in practice works similar to factoring but is not booked as debt. This is where Hodgson gets really fired up because a payment service that gives you near immediate access to your cash from receivables, without being booked as debt, leaves the business cash healthy and balance sheet healthy. You have the cash to operate today while being eligible to use other forms of debt for growth.
Have your broadly considered your capital options?
The next time you look at your cash balance and capital needs, don’t oversimplify your options. You don’t need to give 35% of your business to Mark Cuban (although I’m sure he’d love to have a piece of your ‘New Age Lemonade Stand.’) You also don’t need to hold off on starting your business until you can secure an SBA loan. Start today generating revenue, turning it into cash and using your own capital—and the creativity that got you into business for yourself—to grow the next great American business. How great would it be to be able to say, ‘I built this business, I kept my equity and I keep growing my own capital pool’? Pretty great, I’d say.
