11 Jul Early Stage: Step 12 – Alternative forms of business finance
Editor’s note: This is the 12th in a series of articles on developing start-up companies in the technology or biotechnology sectors.
Madison, Wis. – In Step 11, we discussed other forms of finance beyond equity financing, namely debt financing. This discussion focused on traditional money borrowing to purchase business assets. The lender takes a direct security interest in the asset and the business agrees to pay it off over time via a note.
There are other forms of debt. The most commonly used is straight leasing. A true lease is a transaction in which at the end of the lease term, the lessee (the business owner) must pay the fair market value of the leased asset to acquire the asset.
If the purchase price at the end of the lease term is low, then it is more likely a financing transaction and is considered debt.
If it is a true lease, then the business should analyze the cost of that lease and decide what to do at the end of the lease term. Does the business wish to acquire the property or does it wish to acquire other property to replace it? For example, many companies have true leases for computers, copiers, and other such equipment. Every three years or so, they return the leased equipment and replace it with updated versions. The business essentially has a constant monthly expense for the leased assets.
On a shorter lease?
Another lease type is a financing lease. In this type of lease, the business borrows the money through the lease. This borrowing should be compared to other debt borrowing costs the business incurs. The business should compare interest rates and other terms to make sure the lease is a fair price. I advise consulting your lawyer or CPA to make sure that you are comfortable with the lease terms.
This transaction is documented with a formal lease agreement. In addition, since this is really a debt substitute, the lessor/lender will probably file a financing statement and security agreement as discussed in Step 11. At the end of the lease’s term, then the lessee will own the asset if it pays the nominal buy-out price.
Another financing form you may see is a sale\leaseback. In a sale\leaseback, the business seeks to maximize the value of the assets on its balance sheet, such as real estate or other valuable property. The business usually has substantial equity in these assets or owns it free and clear without any debt. The business “sells” this asset (typically real estate) to a third party who would in turn lease it back to the company. A leaseback can be a true lease or one of the financing transactions as discussed above. Large retail public companies such as Walgreens routinely use this technique essentially to use fixed assets, usually real estate, as a source of working capital.
The receivables factor
Finally, another option for financing is factoring (selling) receivables. In a company that has large accounts receivable, it may be normal to sell those receivables to a third party for instant cash. The third party buys these receivables either with or without recourse. If they are purchased with recourse, the third party that purchases the receivables can transfer them back to the seller if they are unable to collect the agreed upon amount on them (usually a percentage of the original value). Recourse factoring provides more cash to the seller than sale without recourse.
When the receivables are sold without recourse, the business owner sells the receivables and the buyer must collect them or lose the uncollectible receivables. These transactions are often used for companies with large receivables that also might be desperate for cash because these transactions are usually quite costly to the business owner.
The next version of Early Stage will focus on leasing real estate.
Previous Early-Stage articles by Joe Boucher
• Joe Boucher: Early Stage: Step 11 – Other forms of finance
• Joe Boucher: Early Stage 10: The nuances of federal laws
• Joe Boucher: Early Stage, Step 9: Raising capital in the securities landscape
• Early Stage, Step 8: Misclassifying workers brings risk
• Joe Boucher and Bonnie Wendorff: Early Stage 7, Part I: Just what is an employee?
• Joe Boucher: Early Stage: Step 6 – Taxes, taxes, taxes!
• Joe Boucher: Early Stage: Step 5 – Forming the entity
• Joe Boucher: Early Stage, Step 4: Cautionary trademark tales
• Joe Boucher: Early Stage, Step 3: Naming the entity
• Joe Boucher: Early Stage Step 2: Choosing a domain name
• Joe Boucher: Starting a tech business? Step 1 is minding the intellectual property
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