By: Aparna Iyer
The Need for Commercial Financing
The Economic Perspective:
Financing a business is very different from obtaining a loan for personal reasons. From the economic perspective the expenses that have to be borne by a business can be broadly classified into the following categories: Fixed Costs and Variable Costs. Fixed costs remain the same regardless of the level of production. In other words, whether or not a business is in operation, the amount of fixed costs will remain the same. Expenditure on machinery and equipment is an example of a fixed cost. Variable costs, on the other hand, change depending on the level of production. Variable costs are directly related to the level of production. The cost of raw materials is an example of variable cost. Hence, from the point of view of an economist: Total Cost = Total Fixed Cost + Total Variable Cost
The Accounting Perspective:
From the perspective of accounting, costs can be classified as implicit or explicit. Explicit costs are expenses which can be accounted for in monetary terms. Both, rent and wages paid, are explicit costs. On the other hand, a businessman who does not pay his wife for assisting him in day-to-day workings of a business, is said to incur implicit costs. Hence, for the purpose of accounting, total cost can be defined as: Total Cost = Explicit Cost + Implicit Cost
The above discussion clearly illustrates the importance of commercial financing.
Commercial Financing for Business
Commercial financing is needed, not only during the start up phase, but also during the development, operating and growth phase. Let us take a look at the financing required during these two phases.
Pioneer Phase or Start Up Phase
Seed capital is usually provided by friends and family members of an entrepreneur. This funding is necessary for activities like market research in order to test the feasibility of the business venture. The amount of seed capital is usually small.
A business can also be funded during the start up phase by angel investors. Angel investors are affluent people who finance a business for reasons best known to them. In other words return on investment or ROI may not be the sole criteria for funding. Angel investors may not demand participation rights in the business and they generally provide finances on a small scale.
Venture capital is provided by institutional investors like banks, hedge funds and pension funds, who believe that the enterprise is capable of generating long term profits. Venture capitalists usually come into the picture after the business has established a few basic operations. Since venture capitalists invest other people’s money, they are very particular about the return on investment (ROI). Moreover, they demand participation rights in the form of preferred stock, and they may also be a part of the Board of Directors.
Development, Operating and Growth Phase
Commercial Construction and Real Estate Financing:
Banks, credit unions and other lending institutions provide commercial construction loans. US Small Business Administration loans (SBA loans) are also available for small entrepreneurial ventures. Depending on the needs of the business, an entrepreneur can avail of acquisition and development loans, bridge loans, mini-perm loans, take-out loans, joint venture loans and loans for purchasing real estate . These loans supplement loans provided by venture capitalists and angel investors.
Asset Sale Leaseback:
Asset sale leaseback is common in case of real estate. In this case the entrepreneur sells an asset only to rent it back from the buyer. The main reason for asset sale leaseback is to remove the asset from the balance sheet of a company while retaining its use. Asset sale leaseback is undertaken for accounting and tax purposes.
Generally buying equipment does not pose a problem even if the business does not have adequate finance. This is because the equipment functions as collateral against which a business borrows money for purchasing the same. However, start ups prefer leasing equipment. The business is required to make monthly payments towards the rent of leased equipment. At the end of the leasing period start ups have the choice of either buying the equipment or continue leasing it.
Many times a business uses invoice factoring in order to convert its accounts receivables to cash so that it can meet its expenses in case it encounters delay in receiving payments from the customer for services rendered. In case of invoice factoring, the business sells its invoice to a third party and receives up to 80% of the value of the invoice. Once the customer pays for the services rendered, the business obtains the remaining value of the invoice less the amount of fee charged by the third party.
Lines of Credit:
Lines of Credit are usually obtained by the business to meet its working capital requirements and avoid cash flow problems. A line of credit, unlike a loan, is not a lump sum amount on which the borrower is expected to pay interest. Using a line of credit is similar to using a credit card. Depending on the needs of the borrower, the amount of money required can be withdrawn from the sanctioned loan, and interest is paid only on the amount used/withdrawn and not on the amount sanctioned.
These are some ways of financing a commercial business. In addition to these popular ways of financing, entrepreneurs can obtain a number of other short term and long term loans. They can also make use of credit card advances in case of good credit history. Financing is a prerequisite for the establishment and the successful operation of any business. Regardless of whether the business is in the pioneer, growth, or mature phase, the importance of commercial financing never diminishes although the amount of finance required may vary.