How nontraditional debt can help provide financing for start-ups

Sarah Schmidt, senior vice president, Capital Finance Division, Bridge Bank

Sarah Schmidt, senior vice president, Capital Finance Division, Bridge Bank

Start-up companies in need of financing may not want to dilute ownership by bringing on additional investors. Fortunately, there are nontraditional financing products that can meet the need for capital.

“Revenue-producing start-up companies have options other than equity and one is going down the nontraditional debt financing route,” says Sarah Schmidt, senior vice president in the Capital Finance Division at Bridge Bank.

Smart Business spoke to Schmidt about nontraditional financing methods and how they work.

What nontraditional financing sources are available?

The two primary nontraditional financing sources are purchase order (PO) facilities and accounts receivable (AR) facilities. What makes those facilities attractive is that unlike a traditional bank line that requires low leverage, profitability and positive net worth, you can secure a PO facility or AR facility that is not governed by restrictive covenants. Instead, they focus on the value of the purchase orders and receivables. Leveraging your balance sheet by utilizing a PO or AR financing facility gives you the opportunity to limit your equity needs and, in turn, limit your ownership dilution.

Nontraditional financing facilities are more expensive than a traditional bank line but can provide significant value to owners of a company when they are able to preserve ownership and maintain a flexible access to working capital.

How do these facilities work?

With a PO facility, once a company receives a purchase order from a customer, it sends it to the bank and the bank advances a certain percentage against the purchase order. Once the purchase order coverts to a receivable, the bank advances against the receivable at a higher advance rate, repays the PO advance and provides additional working capital to the company.

Invoice by invoice financing traditionally involved the sale of the receivable at a discount, called factoring, but many banks and financial institutions instead lend against specific receivables while maintaining a secured-first priority position in the asset or pool of assets. This arrangement mirrors the structure of a more traditional bank line of credit, but manages the repayment risk by increasing the collateral monitoring and controls.

The mechanics of the facility are quite basic: When a company issues an invoice to its customer for the delivery of goods or completion of services, etc., and it has an invoice financing facility, the invoice, along with the backup information evidencing fulfillment, is sent to the bank. The advance is processed after completing the necessary due diligence on the invoice and customer. The bank is less concerned with financial covenant compliance in this scenario and is, instead, focusing on the strength of the company’s collateral.

Are these nontraditional financing methods particularly geared toward start-ups?

Most start-ups can’t qualify for traditional financing because of a lack of historic profitability, high leverage, an unproven business model and/or limited repayment sources — cash flows, outside assets of guarantors, etc. Since many entrepreneurs invest their nest egg into their companies, their personal guarantees don’t typically evidence significant outside net worth.

Depending on how much equity they’ve raised compared with cumulative net income (losses), they may report a negative net worth, which limits their ability to meet minimum leverage requirements. Companies with zero to $20 million in revenue often have trouble meeting financial covenant requirements for traditional bank financing. Their only other options might be really expensive mezzanine or venture debt, which they may not be able to secure, or selling equity in the company by bringing on new investors.

While strategic investors can help to take your company to the next level through key relationships, industry experience and general business acumen, nontraditional financing can be a great option to leverage a growing balance sheet and limit ongoing equity dilution.

Sarah Schmidt is senior vice president, Capital Finance Division, at Bridge Bank. Reach her at (415) 508-2501 or [email protected]

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