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What to Know About Starting a Small Business – Part Two

February 1, 2018

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Financing Options and Challenges

Welcome back to part two of our three-part blog series on starting a small business. In this post we will discuss financing options for small businesses, as well as the related challenges for those that are in the market for small business lending options.

In part one of this series, we discussed eight considerations for starting and developing a small business. Two of the key points we raised were the importance of a strong business plan and the development of a cash-flow projection.

A major reason many start-up companies fail is because the business tends to be undercapitalized. In layman’s terms, this means the business is struggling to manage cash flow and has insufficient funding to support its ongoing operations. In our last blog, we stressed that “cash is king” for good reason. When starting a new venture, many small business owners will face a period of needing additional capital, either short or longer-term, to support operations and ensure the survival of the business. A recent Statistics Canada study showed that 51% of Canadian businesses requested external financing in 2014. We suspect the percentage would be significantly higher for new or early-stage companies.

With these facts in mind, you might be asking yourself how a small business owner can finance his or her business? In the past, many small businesses would likely seek “traditional” financing from the big Canadian banks (Big Banks). However, in recent times, the Big Banks have begun moving away from small business lending, which has opened the door for a variety of alternative lending sources and options. Below we will discuss a few potential lending sources for small business owners. Remember, we are not talking about large public companies who have a multitude of blue-chip assets to put up as loan collateral.

1. Government loans

The Canadian Government has a Canada Small Business Financing Program (CSBFP) that offers loans of up to $1 million for qualifying businesses. In order to qualify for a loan under the CSBFP, a company must be a start-up or existing business with gross revenues of $10 million or less. The loan must be used to finance the cost of the purchase of land or buildings for commercial businesses, the purchase of new or used equipment or the purchase of leasehold improvements. The clear downside to the CSBFP is that it is intended to stimulate spending of a “capital” nature; business owners who require working capital or inventory financing will not qualify under the program.

2. Traditional commercial lending products

Big Banks are often a logical first choice for small business owners, as these institutions all advertise some form of small business lending program. However, as noted above, with small operations that either have little or no credit history and few assets to offer as security, it is not uncommon for a small business owner to be turned away by these types of institutions. There are also mid-tier products available, such as Business Development Bank’s small business lending or Vancity’s micro loan program. Mid-tier institutions like these tend to have less-stringent lending requirements and may take a more entrepreneurial approach to small business lending.

3. High interest alternative lending products

Due to the conservative nature of the Big Banks, businesses will often have to consider alternative lenders. Alternative lenders are less risk-adverse, however, this comes at a cost; higher interest rates and fees will price in the higher risk tolerance. As the lending landscape changes and online products become more and more prevalent, there seems to be no shortage of alternative lenders available. Generally, these lenders may have a term loan product in the $50,000 to $100,000 (maximum) range, with varying interest rates depending on the loan term. Alternative lender’s loans tend to be shorter-term in nature (i.e. 1-3 years). The longer the loan term, the more the borrower can expect to pay in interest and we suspect that a borrower may pay interest of 20% or more over the life of the loan. Another form of alternative lending is a product that sees a borrower repay the lender from daily debt and credit card sales (sometimes referred to as a merchant loan). Again, this type of loan may be significantly easier (and quicker) to receive than a bank loan. That being said, the borrower needs to ensure that they understand the future cash flow impact of having sales automatically reduced by the lender through taking a percentage of sales each day. This type of loan will also have a high effective interest rate.

4.Use of personal assets/covenant

If a small business owner has insufficient business assets to obtain a bank loan, but holds personal assets, they may choose to sell assets to generate cash for the business venture, borrow funds against those assets and place the cash into the business and/or use the personal assets as collateral to obtain a business loan. A good example of this would be a Vancouver homeowner, who in the current real estate market, may have extra home equity that they want to use for their business. However, it’s important to remember that even if the business is a corporation (i.e. a separate legal entity), any personal assets pledged to the bank can be realized if the loan goes into default. In other words, the concept of a “corporate veil” is not relevant in this scenario. At Smythe Insolvency, we have seen many examples where the business owner gives a lender a mortgage on his or her personal home and the loan subsequently goes into default. Do not assume the bank won’t foreclose/realize on your personal assets to recover funds!

5. Other sources: friends/family, crowdfunding, new partners, Groupon, etc.

It is not uncommon for a new business to obtain seed capital from the owner’s parents, other family or close friends. Sometimes an owner may choose to bring in a new partner (and his or her accompanying new investments) to help finance the business. A more recent financing option is the use of Groupon i.e., selling coupons for future goods/services at discounted prices to accelerate cash collections. Another option is the use of crowdfunding. This income source sees a business raise small amounts of money from a large number of people, most often using the Internet. There are three primary types of crowdfunding, including donation-based, rewards-based and equity-based. As with the other financing options discussed above, rewards-based and equity-based crowdfunding come with an associated future cost. Future costs aside, this relatively new form of fund raising has been proven to be effective for many start-ups.

As a convenient segue into the final instalment of our three-part small business series, we would be remiss to not mention another method of financing a business which usually arises, not out of choice or intention, but out of necessity. Sometimes during a cash flow crunch, a business may finance its operations by not remitting GST or employee source deductions to the Canada Revenue Agency in a timely fashion. In other words, the cash is available but instead of being properly remitted to the government, the business uses it to pay other operating expenses. Often, business owners will do this expecting and fully intending, to be able to pay off the tax arrears “next month.” Unfortunately, in many cases, the problem perpetuates itself and the tax arrears turn into a debt that is very dangerous and unmanageable.

On that note, stay tuned for the final article in this series where we explore financial warning signs and options for troubled businesses!

If you are thinking about starting your own small business, or if you are looking for financial solutions or counselling for a current small business, contact one of our experienced Licensed Insolvency Trustees today.

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