Business Planning and Types of Financing

Customer Financing for Small Business

In certain industries, it is customary and acceptable to obtain financing from customers or clients in the form of a down payment. This gives the business the money needed to buy materials and pay employees during production and reduces the exposure of non-payment after delivery. This type of financing is most common in industries where production takes many months or where the product is specially created for the customer and would be difficult to sell to another party, such as artwork, signs, special orders and construction.

Receivable Financing for Small Business

In return for a business pledging its receivables, lenders are normally willing to lend up to 80 percent of the value of the receivables. The customers are usually notified that their accounts have been used as collateral, but they pay the company directly, not the financing institution. When the receivable is collected, the business pays the lender, thereby reducing both the loan balance and the borrowing base until additional sales are used to recalculate a new borrowing base. The interest rates are usually high and often there are additional service fees charged by the lender.

Factoring

Factoring is an alternative form of receivable financing, and typically more costly. With factoring, the business essentially sells its receivables to a factor for a certain percentage of the value of the receivables. The extra cost arises because the factor assumes the credit risk of the borrower’s customers and administers collection of the receivables. In a sale, the business’ customer pays the factor, who pays the business, less the interest rate and fees. A typical factoring company charges about six percentage points above the prime interest rate, compared to a typical bank loan of three percent over prime.

Leasing

Leasing is a fast-growing method of financing the acquisition of capital equipment. Under a lease agreement, a business can acquire immediate use o f capital equipment without the expense of buying it. Although leasing can be more expensive than buying equipment outright – especially with the loss of tax benefits from capital depreciation – it enables small businesses to avoid tying up large amounts of capital, an important benefit for small businesses that can more profitably use their limited capital in other areas. Leasing is also an attractive option with technology that is advancing rapidly, such as computers. A cancelable lease passes the risk to the leaser.