Five Questions Every Owner Should Ask When Obtaining Working Capital for their Small Business
As a first time borrower evaluating options for non-bank capital, navigating the alternative financing market can be confusing and, in many cases, downright frustrating. There are so many different products – small business loans, cash advances, equipment leases, invoice factoring, to name a few – how do you know what is right for your business? There are also many different types of companies – lenders, brokers, and marketplaces – how do you decide which type of firm will help you access the right product for your business? Then you get to the financing providers. There are hundreds, if not thousands, of alternative lenders and cash advance companies. How do you know which company to choose?
Most importantly, how do you know you are working with a financing provider that is looking out for your best interests and won’t induce you into a high cost debt cycle your business may never be able to escape?
The Coalition for Responsible Business Finance (CRBF) wants to help.
To help you navigate this process, we’ve laid out the five key questions you should ask. In the alternative finance market, there are many responsible funding companies that will offer the right product for your business; however, there are some companies that offer products filled with hidden costs that can send your business into a cycle of high cost debt your business may never be able to escape.
Finding the right provider is 99% of the battle in alternative finance; to help you find the right funder, we’ve laid out five questions you should ask prospective financing provider. And remember, the first option isn’t always the best option, so if you asked these questions and don’t feel like you’ve received suitable answers, look elsewhere.
#1 – Who are you working with?
Are you a direct lender or a broker? This is always the first question you should ask. An honest, knowledgeable broker can help you find the right alternative capital solution for your business. Alternatively, a bad broker can be disastrous. Unfortunately, some brokers will look to place you with the product that generates the most commission for them, not the best product for your business. If the company states they are a direct lender or direct funder, ensure their company name is on the contract if you pursue a loan, advance, or factoring solution; if it’s not, ask why and if the answer isn’t sufficient, move on. One final recommendation: check TrustPilot or other customer review sites to read about the experiences of previous customers with the potential financing provider.
If you decide to work with a broker, ensure that broker has your best interests in mind. Ask them to present you with several alternatives, not just short term capital solutions such as cash advances. Most importantly, ask the broker how much they are being paid in commission to arrange the capital and how that commission is incorporated into the transaction.
#2 – What is the total cost for the additional capital?
With so many different types of products in the market – short term loans, medium term loans, SBA loans, cash advances, invoice factoring, equipment leasing, to name a few – comparing cost can be difficult as not all offers are presented with a uniform cost metric. While Annual Percentage Rate (“APR”) is the most widely known cost metric, it isn’t universally relevant across all products, especially products that aren’t “credit”. However, the best actors in the space, such as the companies in the CRBF, recognize the need for uniformity and are pushing towards a universal mechanism that allows small businesses to fully understand the cost of different types of products.
When you are working with a specific financing provider, ensure you know the total cost of the loan, including any upfront fees (origination fees, broker fees, or other) as well as any prepayment penalties or prepayment discounts before you sign any paperwork. If you are searching for a small business loan and would like to evaluate the deal across a few metrics such as total payback and APR, ask the lender to provide them to you. If they won’t provide this to you, you should probably contact another lender.
When shopping for the best deal, use web-based calculators to compare products. Nav has agood website that has a number of product-specific calculators and may be accessed by clicking here.
#3 - What happens if I default?
This is a scenario every business owner doesn’t want to consider, but it’s imperative to understand what happens in the event you experience hiccups in your business and miss a few payments, or in the worst case scenario, your business fails. Many financing providers will require a personal guarantee, and you need to read that language carefully (even better, have a lawyer look at it) to make sure you know what happens if you are unable to pay the financing back.
An important distinction between a business loan and cash advance is in the personal guarantee. For business loans, the personal guarantee typically will hold you liable for all monies owed regardless of the success of your business. However, for cash advances, the personal guarantee is only a guarantee of performance; that means if you abide by your contract and your business fails, the cash advance company cannot legally collect on the outstanding balance.
Finally, understand what liens, if any, are placed on your business and how these liens could restrict your business going forward. Once you pay back your financing, be sure to ask you provider to release the lien on your business.
#4 - What happens if I need more capital?
This is a critical question to ask, especially if you are accessing short term financing. Responsible borrowers typically won’t borrow more money than they need, which leads us to the following question: what happens if you need more money?
You may think you can just go back to your original funder and request more capital, but many short term funders won’t allow you to access more money unless you are 50% or more paid down on the original financing. And once you do qualify for additional capital, what happens to your outstanding balance? In today’s financing environment, most providers require small businesses to pay their current balance in full before the funder will provide the small business with additional capital …and will use the money from the next advance or loan to pay off the outstanding balance. Be careful of what is called, “Double Dipping.” Here is what the term means:
Assume a $100,000 loan at a 1.20 “cents on the dollar” cost or factor rate, making the initial balance $120,000. When the contract is paid down to $50,000 the customer refinances their balance with a new $100,000 contract at 20% interest fee, which is the same as their first contract. The customer may believe their cost of funds is 20%.
If the new contract proceeds, in part, will pay off the existing balance of $50,000, the customer will receive $50,000 in new funds not at 20% as the contract implies, but at 40%, as their balance increases from $50,000 to $120,000 ($70,000) for $50,000 in new funding.
“Double Dipping” causes the business to pay twice for the same money. Clearly disclosing the true costs and mechanics of these kinds of transactions can prevent small business owners from being misled or confused about the actual cost of the financing. The combination of excessively high contractual payments which trigger repeat funding to cover cash flow, and aggressive sales tactics which attempt to compel customers to repeatedly renew/refinance for additional capital makes “douple dipping” a real problem. That is why we advise small business ownersto directly ask their funding provider if they “Double Dip” at the time of renewal. If you do not get a direct answer to the question, our advice is to choose a different provider.
#5 – Can I pay off my balance early?
There are two distinct terms to understand here: “no prepayment penalties” and “early repayment discounts”. They may sound the same, but the meaning is very different. If a loan or advance has “no prepayment penalty”, that means you can pay off the remainder of financing contract at any point without any additional fees outside of contractual amount owed; but that does not necessarily mean you can pay off your contract by just repaying the remaining principal. In the short term financing market, this distinction is critical. Most providers use “fixed cost” contracts which, instead of accruing interest on a daily, weekly, or monthly basis, state the amount owed regardless of when the contract is paid in full. In these cases, you need to ask your potential funding provider if there is any early repayment discount or early repayment benefit. An early repayment discount allows you to repay a “fixed cost” contract early and the lender or cash advance provider will waive a certain amount of unpaid interest or fees.
All members of the CRBF are committed to providing small businesses with additional capital in a responsible way and the coalition wants to assist responsible small business borrowers by providing information (like these questions to ask) that help borrowers make responsible decisions.