Finding sources of working capital to expand a small business is an ongoing challenge for every entrepreneur these days, but especially for those in retail. Start-ups in the design and technology sectors can often find venture capitalists to provide long term loans, or even use crowdfunding sites like Kickstarter to find cash.
But for retail businesses it usually comes down to more traditional means of raising capital such as angel investors, business loans and merchant capital advances. So what are the pros and cons of these different sources of working capital?
Angel investors are people – often family and friends – who provide initial working capital in return for shares in the business or some sort of agreed payback at a later date.
A business loan can usually only be secured after the business has been in operation for a while and can demonstrate sufficient profitability to show that it can afford to make the principal and interest payments on the loan.
A merchant cash advance is a different type of small business loan that certain types of finance companies offer to retail businesses who make a large proportion of their sales through credit or debit cards.
The Pros and Cons
Find Cash from Angel Investors
Most small businesses have to start with help of angel investors unless the business owner has enough cash to launch the business without outside help. Sometimes angel investors can be an ongoing source of working capital and provide cash not only to cover the start-up expenses, but future expansion as well.
But most times, angel investors want their payback within six months or a year, so the small business owner has to look for other sources of capital to expand.
Bank loans are the cheapest, but usually banks require some collateral as security for the loan, and many small business owners either don’t have property that they can mortgage, or don’t like to take the risk of losing their home in the event that the business fails.
Various finance companies can provide business loans without providing collateral, but these unsecured loans are usually at much higher interest rates, and can involve long application processes.
Merchant Cash Advance
A merchant cash advance is another type of unsecured loan that is essentially an advance on future sales, and is repaid by the finance company taking a small percentage of credit and debit card sales. This is done automatically through the point-of-sale terminals that the retailer uses for credit and debit card sales.
Merchant cash advances incur interest rates that are higher than bank loans, but this is offset by the much quicker application process and thus higher turnover of the working capital.
Usually merchant cash advances can be approved in 2-3 days provided the business owner can provide at least six months of verified sales records.
They also have the advantage over bank loans and traditional business loans from other finance companies of being variable, rather than being tied to a fixed repayment schedule. This means that if sales are slow, the repayments are less. But if sales are high, the repayments are higher too, so the loan gets paid off more quickly.
The disadvantages of merchant capital advances are the higher interest rates – which means they are best suited to high turnover businesses – and the fact that businesses need to have had 6-12 months trading with credit and debit card sales exceeding $10,000 a month.
So until a business reaches that level of sales, it has to rely on other investors and unsecured fixed term loans from finance companies, which don’t have the flexibility of the variable merchant cash advance repayments.
Find Cash for Future expansion
As the business expands, opportunities to secure further working capital will expand too, because the longer the track record of the business, the easier it is to find cash from new investors or obtain business loans.
Often businesses start out relying on angel investors, and then use finance companies to provide merchant cash advances to build the business, and after that rely on cheaper business loans from commercial banks to expand.
Throughout this cycle it is important to have a business plan, incorporating cash flow forecasts that are updated regularly, as this is something that every person or institution providing finance will need as part of their review or application processes.
Some banks and finance companies offer free advisory services too. So if the business owner is not an accountant or finance specialist, then these advisory services should be taken advantage of.
The companies offering these free advisory services do so because it’s in their interest to establish a close working relationship with their clients and help guide them in managing their finances, and thus help to ensure that their loans will be repaid.